When people think of the domestic forex market in the United States, the regulator that comes to mind as the one that polices brokers, while educating and protecting retail forex traders, is the Commodity Futures Trading Commission (CFTC). There is, however, a thriving futures market in the U.S., and many of the derivatives that are traded there are currency related. In this special arena, the National Futures Association (NFA) provides the regulatory oversight, and it is sometimes referred to as a “cousin” of the CFTC.

According to the NFA’s official website, it is “the self-regulatory organization for the U.S. derivatives industry, including on-exchange traded futures, retail off-exchange foreign currency (forex) and OTC derivatives (swaps). The NFA has developed and enforced rules, provided programs, and offered services that safeguard market integrity, protect investors, and help our Members meet their regulatory responsibilities and has done so for more than 30 years.”

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    It goes on further to add that the “NFA is a non-profit, independent regulatory organization. We do not operate any markets. We are not a trade association. We operate at no cost to the taxpayer. We are financed exclusively from membership dues and from assessment fees.” In other words, it is not a government regulator, but it has the right of enforcement over its members, thereby requiring them to abide by certain professional standards and codes-of-conduct. Violations could result in penalties or expulsion, followed by the loss of an operating license.

    The Congress created the CFTC in 1974, and the same legislation authorized the formation of a membership group to self-regulate the futures industry. The NFA was formed in 1982. The new Dodd-Frank legislation in 2010 expanded the role of the CFTC to also regulate swap dealers, who the CFTC now requires to register and become members of the NFA. The NFA’s headquarters are in Chicago, and they have an additional office near Wall Street in New York City.

    How does the NFA fight fraud and abuse?

    The NFA demands the “highest levels of integrity of all market participants and intermediaries.” Preventing fraud and abuse is one way to instill investor confidence, and the NFA achieves this objective in the following way:

    • Rigorous registration screening:  For anyone wishing to register with the CFTC or become a member of the NFA, the NFA performs stringent professional fitness and background checks for all firms and their individual employees, including FBI fingerprint examinations and reviews. Individual registrants are also required to pass comprehensive proficiency exams;
    • Comprehensive compliance rules: In this arena, the NFA code-of-conduct requirements apply to “sales practices, recordkeeping, reporting, risk disclosure, discretionary trading, disclosure of fees and minimum capital requirements.” There are also teams that perform regular onsite examinations to ensure compliance, and, as an added bonus for client peace of mind, the firm performs daily electronic confirmations to ensure that customer funds are held in segregated accounts at banks and other depositories;
    • Strong enforcement authority: What happens when a member is found to be in violation of the rules? There are various disciplinary actions the NFA employs, including “expulsion, suspension for a fixed period, prohibition from future association with any NFA Member, censure, reprimand and a fine of up to $250,000 per violation.”
    • Trade practice and market surveillance: As a sideline, the NFA also provides regulatory oversight of “electronic trading platforms to ensure the fair treatment of customers and to maintain orderly markets.”

     

    Why is regulation of a derivatives exchange important for a trader?

    Financial derivatives are complex. Dealing in them can involve many intermediaries and counterparties, each of which must be operating on a secure and sound basis for the exchange to function properly and to instill the level of investor confidence necessary for smooth operations. The futures industry is not small by any means, either. The NFA has scope over approximately 3,900 firms and 54,000 associates, and, if one in the group falters, it can ripple through the entire network. Capital adequacy is key to the well functioning of the system, as a whole.

    The automated surveillance of segregated customer accounts is actually a relatively new feature installed after two major defalcations occurred over the past two years. MF Global collapsed in October of 2009, causing customer losses in excess of $1.6 billion. In August of 2010, it was discovered that the CEO of Peregrine Financial Group had been fabricating banking reports to mislead regulators as to the safety of customer funds. A $200 million loss was recorded in that case.

    Major frauds are almost always the exception, rather than the rule, but prevention comes from strict compliance oversight activities and programs. It is also important that a strong regulatory spirit be maintained in the banking arena, as well, since most all funds flow through these intermediaries at some point in the capital flow process. (For more information, click here to read more on “Why is regulatory oversight so important?”)

    Concluding Remarks

    Regulatory bodies perform an important role in our financial markets to prevent fraud and abuse, establish high professional standards for all involved, educate investors as to the risks at hand, and to ensure that all capital flows proceed in an uninterrupted fashion from start to finish for each transaction. Insuring integrity in the system breeds investor confidence, the necessary ingredient for all financial markets, if they are to operate smoothly and efficiently.

    The National Futures Association is but one of many groups that perform this vital role in the U.S. financial marketplace. As for the forex industry, they work hand-in-glove with the CFTC to protect traders from unscrupulous brokers and fund managers, while maintaining high standards of integrity and ethical codes-of-conduct for all involved. Your regulator is your friend, just as much as the trend that you are constantly seeking in the volatile foreign exchange market.

    Read more about the CFTC here.


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