Financial Health of Forex Brokers

I received a follow-up email from the DCIO or the Division of Clearing and Intermediary Oversight, a legal arm of the Commodity Futures Trading Commission.  My questions were:

1. How can the data (FCM merchant report) best be interpretated to conclude the financial health of a broker?
2. What would be grounds for a broker having to halt operations based on the data from this report?

Their response, which was from the Special Counsel was long but the information indispensable.  Click [Read More] to read their entire response.

The 2 important points I got from the response were:

1. The FCM report that shows a firms net adjusted income is not totally indicative of financial health mainly because, in her words,  "a firm's transactions and positions (proprietary or customer), exposed to market events can impact capital levels quickly."  This is very similar to our (we traders) capital levels in a high risk market such as foreign exchange.  Market events can impact our balance quickly. 
2. Similar to the Refco situation, in her words, "should an FCM with liabilities to customers for off-exchange retail foreign currency have to halt its operations due to a loss of capital, those customers may be left in the position of unsecured creditors of the entity with respect to trying to collect anything from the FCM." 

The scary thing is that even though Forex retail firms keep customer funds separate from operating funds, your funds are subject to seizure from creditors first, which I'm sure Refco customer are well aware.  This needs to change and additional regulation should be adopted to counter this.  

First, regarding financial health, the CFTC's minimum net capital rule, Regulation 1.17 that you were sent a link to, provides that CFTC registered futures commission merchants  ("FCMs") operate with required minimum net capital.  The minimum required is generally based on a percentage of the margin required for exchange-traded futures transactions held through the FCM.  However, this regulation does not apply a minimum capital threshold applicable to the volume of anentity's off-exchange retail forex transactions other than absolute minimum dollar level of capital of $250,000.

The National Futures Association has however, enhanced its capital requirements for its members that offer retail forex or that operate unregistered affiliates that offer retail forex based on their affiliation with the registered member, and the link provided by Ms Diaz to NFA's website has that information.

Capital requirements are not a substitute for financial health.  A firm's transactions and positions (proprietary or customer), exposed to market events can impact capital levels quickly.  To determine the financial health of a broker, one would want to not only rely on the reported or required adjusted net capital, but also conduct appropriate due diligence, such as investigating the firm's risk management practices and controls in place to provide for the protection of its own assets and its customer assets.

As far as grounds for having to halt operations, for futures commission merchants registered with the CFTC, should the firm's net capital decline below the capital requirement, the CFTC has the ability to cause the firm to cease operations and transfer all customer exchange-traded futures positions to a firm with adequate capital under Regulation 1.17.

However, transferring off-exchange retail forex transactions may be more difficult, as such transactions are governed by their contractual terms and any forex firm offering these transactions may be the only counterparty with whom they can be offset or closed out by such terms. For positions of this type, which may be neither fungible nortransferable, the credit risk of the dealer/counterparty should be a major concern to a customer.  Should an FCM with liabilities to customers for off-exchange retail foreign currency have to halt its operations due to a loss of capital, those customers may be left in the position of unsecured creditors of the entity with respect to trying to collect anything from the FCM.

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