Overview of Forex Regulation at the State Level
Why is my state regulating over-the-counter Spot Forex?
Although it is commonly believed that the CFTC has exclusive jurisdiction over all commodity transactions, many states have chosen to step in and regulate in areas that the CFTC does not. One of these areas is off-exchange, or over-the-counter, foreign exchange trading.
The Commodity Exchange Act (“CEA”), passed by congress in 1936, is the basis of most commodity law in the U.S. With the recent amendments made by the Commodity Futures Modernization Act of 2000, the CEA provides the framework within which commodity traders and commodity account managers operate.
The CEA gives exclusive jurisdiction to the CFTC to regulate all commodity future and commodity option contracts traded on regulated exchanges. However, the CEA does not grant any jurisdiction to the CFTC in matters of foreign currency traded in the spot or forward markets. So that means that forex traders don’t have to register with anyone, right? Wrong.
The Arizona Court of Appeals decided in a 2003 decision, Eastern Vanguard Forex v. Arizona Corporation Commission, that the carve out in the CEA did not preempt states from regulating over-the-counter spot forex. Instead, the court came to the opposite conclusion, stating that the CEA specifically reserved the area for the states to legislate.
This interpretation may come as a surprise to many forex traders, but arguing preemption is an uphill battle. The states are often very reluctant to give up authority to the federal government, especially when it comes to their ability to protect citizens from investment fraud. The resulting regulatory landscape is intensely complicated and may require a spot forex trader or the manager of a forex fund to register with each state in which they have clients.
Colorado, for example, has a lengthy commodity code that grants regulators broad authority to oversee commodity transactions. The Colorado Commodity Code defines foreign currency as a commodity and requires forex managers to register with the CFTC as a futures commission merchant (FCM). This, of course, is a hefty mandate. Registration as an FCM is extremely burdensome and requires, among other things, $500,000 in net capital which must be evidenced by audited financial statements.
While it may be possible to obtain relief from state registration requirements through a written interpretive or exemptive opinion from the state securities division, obtaining relief is never guaranteed. Even a well crafted argument based on sound legal principles may sit on the desk of an administrator for 6 months to a year before a response is issued. If you can get it, though, no-action relief is a good outcome, and as long as you conduct your business in accordance with the description in your letter, you will not be subject to enforcement action.
Operating out of compliance is risky. Some states are becoming quite aggressive in pursuing unregistered forex traders and managers. Pennsylvania has recently been pursuing forex account managers who utilize a Percentage Allocation Management Module (PAMM), a technology from FXCM that allows forex account managers to execute trades for multiple, separate accounts, saving the time and cost of executing trades manually and individually. The accounts are not pooled, per se, but Pennsylvania has taken the position that forex accounts managed through a PAMM platform are securities, and would thus require state registration.
This position is extreme and threatens registration for all omnibus account managers, but fighting the issue in court is probably not worth it for most small managers. Also, a victory in one state does not mean that any other state is going to decide the issue the same way. The headache of multiple lawsuits in multiple states could disrupt a business for several years.
Off-exchange forex is one of the only areas left where the states are able to exert influence over the operation of national and global markets. There are state enforcement agencies all over the country looking to make their presence felt and justify their own existence. The only thing forex manager and traders can do, faced with this type of regulatory nightmare, is get informed on the issues. This can be a daunting task with so little information available.
What is certain is that when you are starting a new forex operation or are looking at your current business, consider carefully whether you should register and how you might operate so as to fit within an exemption. The consequences to your business of operating without conducting an examination of the applicable rules can be serious. If you don’t know whether the states in which you do business are regulating forex managers, then your best bet is to consult with a licensed attorney that specializes in these complex issues.
Much is yet to be determined regarding the future of state influence in the booming forex industry, and although it is likely that harmonization will occur eventually, legislative changes can be agonizingly slow. Truly, many top security and commodity regulators believe that the only way to fully protect investors and the market at large is for state and federal regulators to work together. As of today, due to the law’s intricacy and disparity, it seems that forex managers have been cast into operational doubt, with few places to turn for good information or genuine help.
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