Regulatory Impact on Forex Trading in Canada

Without a national securities regulator , the regulation of the non-interbank foreign exchange (forex) market and dealers in Canada have long been a patchwork of rules, regulations and policies from a handful of provincial securities commissions. However, recent regulatory developments have significant implications for Canadian and non-Canadian providers of online retail forex trading, particularly those now doing business in any Canadian jurisdiction on an unregistered basis.

In 2009, the Canadian Securities Administrators (CSA) introduced harmonized registration requirements for financial industry participants across all CSA jurisdictions. Separately, securities regulators in Quebec and Ontario addressed the registration requirements of dealers and advisors trading in Contracts for Difference (CFDs) and forex contracts.

On February 1^st the Derivatives Act (QDA) came into force in Quebec. Under the Act, a broad definition of "derivative" captures online forex trading as trading in over-the-counter (OTC) derivatives, which requires dealers trading such products with Quebec clients to seek registration, or the appropriate exemption. Trading activities of commercial hedgers who qualify under the "accredited counterparty" definition are "carved out" from the provisions of the QDA.

Under National Instrument 31-103 (NI 31-103) that took effect on September 28th, firms and individuals who deal in securities, provide investment advice or manage investment funds face a streamlined process for dealer and adviser registration in multiple jurisdictions. NI 31-103 also prohibits registrants from providing margin unless they are members of the Investment Industry regulatory Organization of Canada (IIROC).

On October 27th the Ontario Securities Commission (OSC) issued Staff Notice 91-702 and concluded that offerings of CFDs, forex contracts and other similar products in Ontario constitute "securities" for the purposes of Ontario securities law. Unless an exemption is granted, these products are subject to securities law and other regulatory requirements, including registration and prospectus requirements. For all intents and purposes, Ontario has joined British Columbia in regulating forex trading as securities trading.¹

Pursuant to these regulatory developments, only registered investment dealers who are IIROC members are permitted to trade forex on margin with retail or accredited investors. In Quebec, Ontario and B.C., there are additional qualifying requirements, and requirements related to prospectus and reporting issuer status, among others. Regulators are prepared to exempt these requirements under certain conditions, including IIROC membership, compliance with the terms of registration, provision of a risk disclosure document, etc.

In the 3 largest provinces, securities regulators have now published formal positions that trading forex contracts with investors on margin is a registrable activity.

British Columbia

The B.C. Securities Commission (BCSC) considers forex contracts to be “securities” because they have the inherent characteristics of instruments intended to be regulated under the Act. In the 1990s, the BCSC considered three cases involving forex contracts. In all three cases, BCSC regarded the forex contracts as “instruments for speculating on currency contracts”, that they were investment contracts and thus, subject to the registration requirements of the B.C. Securities Act.

According to the BCSC, a foreign exchange contract or "forex" contract is a security that is a forward contract involving a leveraged agreement between two or more parties to exchange different currencies at a future time or times.

Although a forex contract is based on the spot rate, it is neither a spot contract in the traditional sense because it has no 2-day settlement, nor is it a forward contract because it has no forward maturity date. There is also no mechanism or obligation for delivery.

In BCP 31-601 Registration Requirements, the BCSC asks forex dealers in B.C. to register as exchange contract dealers. However, since publishing the policy, the regulator has gained a greater understanding of forex dealers' business and the risks related to trading forex on margin. Consequently BCP31-601 has been amended in January 2008 and a forex dealer is required to register as an investment dealer with the Investment Dealers Association (IDA). However, exemptions are available.

Blanket Order 91-501 exempts dealers from registration and prospectus requirements when trading “OTC derivatives” with “Qualified Parties”. "OTC derivative" is defined to encompass forward contracts, commodity contracts, contracts for differences, options on those contracts, and any other type of contract, option or instrument commonly considered to be an OTC derivative.

Blanket Order 91-502 exempts short term foreign exchange transactions from the definition of a futures contract or a security under the B.C. Securities Act, where the terms of the transactions require settlement not later than three business days after the entering into the transactions. Blanket Order 91-502 exempts the traditional spot FX transaction with 2-day settlement, but not leveraged online forex.²

Blanket Order 91-503 exempts contracts providing for physical delivery of commodities from the definition of a futures contract or a security under the B.C. Securities Act, where the contracts contain an obligation to make or take future physical delivery of a commodity, and do not allow for cash settlement in place of physical delivery.

Quebec

Following the passage of the Derivatives Act (QDA) by the National Assembly in June 2008, the Autorite des marches financiers (AMF) published the Derivatives Regulation and Policy Statements that came into force on February 1^st 2009.

A “derivative” is defined in the QDA as: "an option, a swap, a futures contract or any other contract or instrument whose market price, value, or delivery or payment obligations are derived from, referenced to or based on an underlying interest, or any other contract or instrument designated by regulation or considered equivalent to a derivative on the basis of criteria determined by regulation.”

An “over-the-counter” derivative is a derivative other than a standardized or exchange-traded derivative. Trading forex contracts with Quebec clients is regulated as over-the-counter currency derivatives.

A qualifying requirement in section 82 of the QDA is set out for the creation and marketing of over-the-counter currency derivatives offered to Quebec clients.

The AMF provides dealers with an exemption from this qualifying requirement if certain conditions are met. The dealer must, among other things:

register with the AMF and be an IIROC member;
have sufficient resources to carry out its activities and to comply with regulation;
provide the registration information of its officers or directors to the AMF;
provide a website detailing information about the derivative, its characteristics, its risks, its trading method, its margin requirements and the costs of trading;
offer the OTC currency derivatives on an electronic platform as principal;
follow KYC rules, identify and evaluate the client’s level of knowledge, experience and risk tolerance in respect of the derivative;
provide the client with a risk information document.

The QDA provides a “carve out” for trades carried out on behalf of "accredited counterparties" who are exempted. A hedger is listed under the "accredited counterparty" definition - similar to the "Qualified Party" exemption in BC 91-501.

The hedger definition³ describes the activities carried out by parties exposed to currency risk and who enter into OTC derivative transactions to mitigate that risk.

The AMF has the authority to determine if a person not listed in the definition of an "accredited counterparty" should be included (see subsection 13 which states "a person specified by regulation or designated by the Authority as an accredited counterparty under section 87").

Ontario

Pre OSC 91-702

Until the publication of OSC 91-702, the provincial regulator has not formally taken the view that spot forex contracts are securities under the definition of "security" for the purposes of Ontario securities law. However, the decision of the Supreme Court of Canada in Pacific Coast Coin Exchange v. Ontario (Securities Commission) [1978] 2 S.C.R. 112, and the various judicial and administrative decisions issued subsequent to that case have left little doubt that the OSC considers trading forex contracts with investors on margin to be a registrable activity in Ontario.

In the absence of a formal position on registration requirements for dealers who offer trading in forex contracts to Ontario investors, the online retail forex market in Ontario has remained wide open to offshore, unregistered dealers, until now.

Post OSC 91-702

OSC 91-702 is published with the intent to provide interim guidance until:

1. there is a harmonized CSA approach to the regulation of OTC derivatives, and/or

2. the introduction of new or revised derivatives legislation in Ontario.

It is interesting to note that OSC 91-702 references the Quebec Derivatives Act and not the B.C. legislation although the BCSC has been regulating forex dealers since the 1990s.

OSC 91-702 concludes that forex contracts, and more broadly, CFDs in general, when offered to investors in Ontario, engage the purposes of the Ontario Securities Act and therefore constitute “investment contracts” and “securities” for the purposes of Ontario securities law. In the view of OSC staff, the offering of forex contracts also involves a trade and a distribution of a security, and they are also “derivatives” for the purposes of Ontario securities law.

Under OSC 91-702, dealers in forex contracts who trade with Ontario clients must be registered as IIROC regulated investment dealers, who must comply with registration, prospectus, proficiency, capital adequacy, and minimum margin requirements.

Investors may also have civil remedies against forex dealers who fail to comply with securities law, including a right of rescission for a forex transaction and/or damages for losses, on the grounds that such transactions were conducted in breach of securities law.

IIROC regulated investment dealers can apply for a prospectus exemption to trade forex contracts with Ontario clients.

A prospectus exemption is granted based on the applicant’s IIROC membership, providing a risk disclosure document to clients and financial disclosure about the CFD counterparty if it is not the registrant, etc.

National Instrument 31-103

On September 28th 2009 the Canadian Securities Administrators adopted NI 31-103 Registration Requirements and Exemptions, Companion Policy 31-103CP Registration Requirements and Exemptions, related documents, and consequential amendments to national and multilateral instruments.

The twin purpose of the CSA registration reform project is the creation of a flexible and efficient national registration regime for registrants and investor protection. The Instrument and related amendments harmonize, streamline and modernize registration requirements across Canada for firms and individuals who sell securities (and exchange contracts in some jurisdictions), offer investment advice or manage investment funds.

Why should members of the forex industry care about NI 31-103?

NI 31-103 does not address the issue of registration requirement for forex dealers. However, there is a restriction and an exemption that together provide the unmistakable conclusion that forex dealers who are not IIROC members will no longer be permitted to trade with Canadian clients. Why?

1. Forex is, by its nature, traded on margin or leverage provided by the dealer.

2. 13.12 Restriction on lending to clients

A registrant must not lend money, extend credit or provide margin to a client.

3. 9.3 Exemptions from certain requirements for SRO members

(1) An investment dealer that is a member of IIROC is exempt from the following requirements to the extent the provisions apply to the activities of an investment dealer:

(k) section 13.12 [restriction on lending to clients];

What are the practical implications?

The jurisdictions of B.C., Ontario and Quebec have established that trading forex contracts on margin with investors is a registrable activity under relevant legislation, regardless of whether such contracts are traded with retail or accredited investors, and that the appropriate category of registration for forex dealers is the “investment dealer” category, which requires IIROC membership. While other jurisdictions have yet to adopt formal rules and policies, it is conceivable that similar positions will be taken with respect to registration and other requirements for forex dealers in the rest of Canada.

Targeting the offering of CFDs, forex contracts and other similar OTC derivatives to retail investors in Ontario, the intent behind OSC 91-702 is to regulate products that allow an investor to obtain economic exposure without acquiring ownership of the reference asset. Where OSC 91-702 intersects with NI 31-103 is the “investor protection” concern posed by OTC derivatives being traded on margin, among other things, and the CSA’s view that only registrants who are IIROC members should be permitted to offer margin to clients.

Although legislation in B.C. and Quebec capture most, if not all, manners of forex transactions, some types of transactions are exempted by the BCSC while the AMF offers a “carve-out” for hedgers in particular. However, it is unclear whether commercial hedging in the foreign exchange market constitutes a “registrable” activity within the scope of Ontario securities law, especially where currencies are physically exchanged and delivered, and also where margin may be involved. We are awaiting clarification from the OSC.

IIROC Minimum Margin Requirements

IIROC members are required to margin the unhedged foreign exchange positions of clients according to IIROC Regulation 100.2 (d)(iv). In reference to Dealer Member Rule 100.2(d)(v)(B) and (C), there is in place a monitoring mechanism whereby the volatility of all foreign currencies in Groups 1, 2 and 3 are monitored by IIROC on a daily basis.

Where IIROC minimum margin rates are held uniform across the membership to foster fair competition, they are high compared to the industry benchmark of 1% charged by forex dealers from most foreign jurisdictions. The global and open-bordered nature of the online forex market makes it difficult for securities commissions to impose meaningful sanctions on unregistered dealers. Without effective enforcement, many Canadian investors continue to be attracted to the offshore environment, especially lightly regulated jurisdictions in Belize, Cyprus, Anguilla, etc.

Regulators frequently mention “investor protection” as a primary objective that drives regulatory policy initiatives. IIROC members who are forex dealers also agree that this is a priority concern because clients who trade with unregistered dealers that are not subject to the rigorous standards of Canadian regulation may be at risk, and any potential fraud and failure of insolvent dealers tarnishes the entire industry. Where some IIROC members and IIROC may differ is the approach to achieving this goal.

Dealer members have discussed margin rates and methodology with IIROC on numerous occasions. It has been pointed out that: the industry benchmark of between 1% to 2% margin for major currency pairs correspond to the implied volatility of the underlying currencies; IIROC margins are also high compared to the CME; the margin methodology is flawed where individual margins of the component currencies in non-USD and non-CAD cross pairs are aggregated; the benefits of real-time risk management and auto-liquidation of positions that mitigate debit balance risk for the investor and market risk for the dealer are overlooked.

While margin rates should properly reflect the risks of the financial instruments being traded, they could also be an effective tool in leveling the playing field between unregistered dealers and IIROC members. Regulators could impose registration requirements on the dealers who sell to the residents in their jurisdiction, but traders will inevitably gravitate to the jurisdiction with the most competitive terms and conditions in a global trading environment. Where enforcement within the membership of an SRO can uphold rules and protect investors, it may be a tall order to expect securities commissions to crack down on every single offshore dealer who trades with Canadian clients without registration or exemption.

IIROC could bring more Canadian investors under its regulatory umbrella and fulfill its mandate of investor protection. If IIROC minimum margin requirements become more competitive, the playing field would be substantially leveled between unregistered offshore dealers and IIROC members because more Canadian investors would voluntarily keep their accounts with domestic dealers. With the benefit of CIPF protection, most Canadian investors would prefer to trade in a well regulated environment even at a slight margin disadvantage, and this would ultimately better safeguard the interests of more investors, rather than having to rely on regulatory sanctions to identify, pursue and enforce against those unregistered dealers into giving up their Canadian clients.

Simply stated, offering a carrot to the investor can do much more for investor protection than threatening the unregistered dealer with a stick.

Between IIROC and the various securities commissions, does the mandate of investor protection only cover those investors who trade with a registered dealer? Do regulators have a further responsibility to use administrative tools to encourage investors to remain inside the Canadian regulatory framework?

There is no indication that IIROC may find the above argument persuasive. In fact, OSC 91-702 has stated that “IIROC staff are currently reviewing the margin rates it has prescribed for certain over-the-counter derivative products, including CFDs and spot forex contracts, and may propose rules prescribing higher minimum margin rates for such products in the future.”

Against the backdrop of the recent financial crisis where excessive leverage has been blamed as a catalyst for the meltdown, and Canadian regulation of financial markets being held up as a model of excellence, it is unlikely that regulators would agree to higher leverage for investors to speculate in the forex market, when in fact the emerging trend is towards more regulatory oversight and tighter controls over leverage.

Only a few national regulators outside North America currently cap forex leverage offered by dealers to retail clients. For example, the Securities and Futures Commission (SFC) in Hong Kong imposes a strict 5%/3%/1% regime on initial / maintenance / liquidation requirements. The Monetary Authority of Singapore (MAS) limits leverage to 50:1.

We note that the NFA has just eliminated an exemption for FDMs to offer margin rates lower than prescribed. After November 30th 2009 all FDMs have to collect the full 1%/4% for major/exotic currency positions. The Financial Services Agency (FSA) in Japan has also announced plans to phase in higher margin requirements: dealers will be required to collect a minimum 2% by August 2010 and 4% by August 2011.

Changes to Registration Requirements

Only IIROC regulated investment dealers can trade OTC forex contracts with Canadians.

In the provinces of B.C., Ontario and Quebec, dealers must comply with additional prospectus and qualifying requirements respectively, unless an exemption is granted.

For salespeople at registered dealer firms, IIROC has stated that futures proficiency is required to trade forex contracts. In Ontario and BC, additional proficiencies may apply.

Only registered portfolio managers can advise clients and manage forex accounts on a discretionary basis.

A fund that trades forex contracts will likely require registration as an Investment Fund Manager. If the fund distributes its units to the public it would also require dealer registration.

Commercial FX firms that offer only hedging services to corporate clients and money transfer services to retail clients currently comply with FINTRAC regulation but are not registered with the applicable securities commission or regulated by IIROC. It remains to be seen whether any changes are pending in response to the recent regulatory developments.

CFTC/NFA Regulation - Update

For registered dealers in Canada who have found themselves competing in the online retail FX market with Forex Dealer Members (FDMs) regulated by the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA), it is important to have a basic understanding of the regulatory environment in which they operate.

The CFTC Reauthorization Act of 2008 has clarified the CFTC’s authority over forex transactions with retail customers. The CFTC delegates regulatory responsibilities to the NFA who provides oversight for every firm and individual trading futures and forex with the public. According to the NFA, forex is defined as: “leveraged off-exchange or OTC foreign currency futures and options and any other agreement, contract, or transaction in foreign currency where one party is a customer. A customer is any party to a forex trade who is not an eligible contract participant (similar to accredited investor in Canada).”

The NFA definition of forex has the same catch-all quality similar to the QDA’s definition of OTC derivatives. However, the clear segregation of regulatory functions between SEC/FINRA and CFTC/NFA has put the U.S. far ahead of Canada in the uniform regulation of forex market and dealers. NFA Bylaw 1507(b) specifically excludes “securities” from the forex definition “if the transaction is not a futures or options contract.” Traditional spot FX transactions requiring two-day settlement for the physical exchange of deliverable currencies are also not regulated by the NFA as forex.

The CFTC/NFA regulates counterparties to OTC forex trades with retail customers. Futures Commission Merchants (FCMs) who earn more than 35% of their revenues from forex are regulated by the NFA as FDMs.

SEC/FINRA regulated broker-dealers can also offer leveraged forex trading to customers. However, FINRA has recently submitted a rule change proposal to the SEC requesting that broker-dealers limit the leverage offered to customers in forex transactions to no higher than 1.5:1. Clearly, U.S. regulators want to confine the oversight of forex trading to the CFTC/NFA.

Recent Developments

Minimum capital requirements for FDMs have increased from $250K to $20 million.
Market making FDMs to maintain additional capital equal to 5% of customer liabilities when they exceed $10 million.
Exemption from collecting the full customer security deposit for dealers maintaining > 150% of regulatory capital is eliminated as of November 30th 2009. FDMs are now required to charge customers the full 1%/4% margin deposit for major/exotic currencies.
Hedging has been disallowed in the same customer account.
Positions have to be closed based on FIFO.
New proposals from CFTC in January 2010 include limiting leverage in forex transactions to 10:1.

Footnotes

¹ In the view of OSC staff, CFDs are also “derivatives” for the purposes of Ontario securities law.

² Please see 91-502 CP published on December 4th 2009 to clarify when a forex contract is a security http://www.bcsc.bc.ca/policy.aspx?id=9354&cat=9%20-%20Derivatives.

³ Derivatives Act, section 3, subsection 12.