The Federal Reserve Board ("FRB") has adopted Regulation NN covering retail foreign exchange transactions ("retail forex transactions") of banks.1 Regulation NN implements section 742(c)(2) of the Dodd-Frank Act, which amends the Commodity Exchange Act ("CEA") to provide that a regulated U.S. financial institution may not enter into, or offer to enter into, certain types of foreign exchange transactions with a retail customer except in compliance with a rule or regulation of a federal regulatory agency allowing the transaction. In general, a retail forex transaction is an agreement, contract, or transaction in foreign currency that is a contract of sale of a commodity for future delivery (or an option on such a contract) or an option (other than an option executed or traded on a national securities exchange.2 The FRB rule applies to state member banks, uninsured state branches and agencies of foreign banks, Edge and agreement corporations, and bank and thrift holding companies ("banks").3 As discussed below, a bank currently engaged in retail forex transactions must give notice to the FRB by June 12 in order to continue in that business and otherwise adopt measures to address the obligations imposed by Regulation NN. As discussed below, a bank currently engaged in retail forex transactions must give notice to the FRB by June 12 in order to continue in that business and otherwise adopt measures to address the obligations imposed by Regulation NN.
I. Scope of Retail Forex Transactions
A "retail forex transaction" generally includes the following transactions in foreign currency between a bank and a person that is not an eligible contract participant4:
- A future or option on such a future;
- Options not traded on a registered national securities exchange; and
- Certain leveraged or margined transactions.
This definition has several important features. First, certain transactions in foreign currency are not "retail forex transactions," and therefore are not subject to the prohibition in section 742(c)(2) of the Dodd-Frank Act. For example, a "spot" forex transaction in which one currency is bought for another and the two currencies are exchanged within two days is not a "future" and would not meet the definition of a "retail forex transaction," because actual delivery occurs as soon as practicable. Similarly, a "retail forex transaction" does not include a forward contract with a commercial entity that creates an enforceable obligation to make or take delivery, provided the commercial counterparty has the ability to make delivery and accept delivery in connection with its line of business. In addition, "retail forex transaction" does not include an "identified banking product" or a part of an "identified banking product."5
In addition, the definition of "retail forex transaction" covers rolling spot forex transactions offered or entered into on a leveraged or margin basis (so-called Zelener contracts6), including transactions traded on the Internet, through a mobile telephone, or on an electronic platform. A rolling spot forex transaction normally requires delivery of currency within two days, like spot transactions. However, in practice, these contracts are indefinitely renewed every other day and no currency is actually delivered until one party affirmatively closes out the position. Although some courts have held them to be spot contracts in form, the FRB determined that the contracts are economically more like futures than spot contracts, including transactions traded on the Internet, through a mobile telephone, or on an electronic platform. A rolling spot forex transaction normally requires delivery of currency within two days, like spot transactions. However, in practice, these contracts are indefinitely renewed every other day and no currency is actually delivered until one party affirmatively closes out the position. Although some courts have held them to be spot contracts in form, the FRB determined that the contracts are economically more like futures than spot contracts.
II. Notice Required to Engage in Retail Forex Transactions
A banking institution is required to notify the FRB prior to engaging in a retail forex business. A bank engaged in retail forex transactions as of the effective date of Regulation NN, May 13, 2013, who promptly notifies the FRB will have six months, or a longer period provided by the FRB, to bring its operations into conformance with the rule. A bank that notifies the FRB by June 12, 2013, subject to an extension by the FRB, and submits the information requested by the FRB thereafter will be deemed to be validly operating its retail forex business.
III. Contents of Notice to FRB
A bank that seeks to commence or continue involvement in retail forex transactions must send a notice to the FRB that includes (i) information on customer due diligence (including credit evaluations, customer appropriateness, and "know your customer" documentation); (ii) new product approvals; (iii) haircuts for noncash margin; and (iv) conflicts of interest. In addition, the bank must certify that it has adequate written policies, procedures, and risk measurement and management systems and controls to engage in a retail forex business in a safe and sound manner and in compliance with the requirements of Regulation NN. Once a bank has sent its notice, the FRB will have 60 days to seek additional information or object to the notification in writing, or the notification will be deemed effective. If the FRB asks for additional information, the notice will become effective 60 days after all the information requested is received by the FRB, unless the FRB objects in writing.
IV. Other Obligations under Regulation NN
Regulation NN imposes a full array of obligations to ensure customer protection and that a bank conducts retail forex transactions in a safe and sound manner. In addition to the material requirements summarized below, a bank is required to provide customers with transaction confirmations and monthly statements, obtain specific authorization to trade from a customer, and to establish and enforce internal rules, procedures, and controls to prevent deceptive or unfair practices, such as front-running.
Capital Requirements. A bank that offers or enters into retail forex transactions must be "well capitalized" as defined in FRB Regulations H, Y, and LL or the bank must obtain an exemption from the FRB. An uninsured state-licensed U.S. branch or agency of a foreign bank must apply the capital rules as provided under section 225.2(r)(3) of Regulation Y.7 An Edge corporation or agreement corporation must comply with the capital adequacy guidelines that apply to an Edge corporation engaged in banking under section 211.12(c)(2) of Regulation K. In addition, a bank must continue to hold capital against retail forex transactions as provided in the existing capital regulations. An Edge corporation or agreement corporation must comply with the capital adequacy guidelines that apply to an Edge corporation engaged in banking under section 211.12(c)(2) of Regulation K. In addition, a bank must continue to hold capital against retail forex transactions as provided in the existing capital regulations.
Margin. Regulation NN requires a bank that engages in retail forex transactions, in advance of any such transaction, to collect from the retail forex customer margin equal to at least two percent of the notional value of the retail forex transaction if the transaction is in a major currency pair, and at least five percent of the notional value of the retail forex transaction otherwise. A "major currency pair" is a currency pair with two major currencies. The major currencies specified in the regulation are the U.S. Dollar ("USD"), Canadian Dollar ("CAD"), Euro ("EUR"), United Kingdom Pound ("GBP"), Japanese Yen ("JPY"), Swiss franc ("CHF"), New Zealand Dollar ("NZD"), Australian Dollar ("AUD"), Swedish Kronor ("SEK"), Danish Kroner ("DKK"), and Norwegian Krone ("NOK"), as well as any other currency as determined by the FRB.
Prohibited Transactions. A bank and its related persons may not engage in fraudulent conduct in connection with retail forex transactions. In order to address potential conflicts of interest, a bank is prohibited from acting as counterparty to a retail forex transaction if the bank or its affiliate exercises discretion over the customer's retail forex account.
Disclosures. Regulation NN also requires a bank to provide retail forex customers with a risk disclosure statement tailored to address certain unique characteristics of retail forex in banking institutions. The prescribed risk disclosure statement in Regulation NN describes the risks associated with retail forex transactions. The disclosure statement makes clear that a bank that wishes to use the right of set-off to collect margin for or cover losses arising out of retail forex transactions must include this right in the risk disclosure statement and obtain separate written acknowledgement. A bank must also disclose to retail customers the percentage of retail forex accounts that earned a profit, and the percentage of such accounts that experienced a loss, during each of the most recent four calendar quarters.
Recordkeeping. A bank is required to maintain
retail forex account records, financial ledgers, transactions
records, daily records, order tickets, and records showing
allocations and noncash margin, as well as records relating to
possible violations of law. Regulation NN also prescribes document
maintenance standards, including the manner and length of
maintenance. Finally, a bank is required to record and maintain
transaction records and make them available to customers.
Footnotes
1 78 Federal Register 21,023 (Apr. 9, 2013), to be codified at 12 C.F.R. Part 240.
2 See section 2(c)(2)(B)(i)(I) of the CEA. 7 U.S.C. § 2(c)(2)(B)(i)(I).
3 The Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Commodities Futures Trading Commission have adopted similar regulations applicable to banking organizations and financial institutions subject to their jurisdictions.
4 See 7 U.S.C. §1a(18). The definition of "eligible contract participant" generally requires a corporation, partnership, organization, trust, or other proprietorship, organization, trust, or other entity to have total assets exceeding $10 million and an individual to have more than $10 million in assets invested on a discretionary basis.
5 See section 401(b) of the Legal Certainty for Bank Products Act of 2000. 7 U.S.C. §27(b).
6 CFTC v. Zelener, 373 F. 3rd 861 (7th Cir.2004). In Zelener, the retail forex dealer retained the right, at the date of delivery of the currency to deliver the currency, roll the transaction over, or offset all or a portion of the transaction with another open position held by the customer.
7 Regulation Y provides that for purposes of determining "well capitalized status," a foreign banking organization whose home country supervisor has adopted capital standards consistent in all respects with the Capital Accord of the Basle Committee on Banking Supervision ("Basle Accord") may calculate its capital ratios under the home country standard; and (B) a foreign banking organization whose home country supervisor has not adopted capital standards consistent in all respects with the Basle Accord shall obtain a determination from the Board that its capital is equivalent to the capital that would be required of a U.S. banking organization.
Regulation NN implements section 742(c)(2) of the Dodd-Frank Act, which amends the Commodity Exchange Act ("CEA") to provide that a regulated U.S. financial institution may not enter into, or offer to enter into, certain types of foreign exchange transactions with a retail customer except in compliance with a rule or regulation of a federal regulatory agency allowing the transaction. In general, a retail forex transaction is an agreement, contract, or transaction in foreign currency that is a contract of sale of a commodity for future delivery (or an option on such a contract) or an option (other than an option executed or traded on a national securities exchange. The FRB rule applies to state member banks, uninsured state branches and agencies of foreign banks, Edge and agreement corporations, and bank and thrift holding companies ("banks"). As discussed below, a bank currently engaged in retail forex transactions must give notice to the FRB by June 12 in order to continue in that business and otherwise adopt measures to address the obligations imposed by Regulation NN.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
