Category: Financial Regulation

Offshore Retail Forex Trading Accounts For Americans Are Being Forced Back To The U.S.

September 23, 2010 | By: Robert A. Green, CPA


Offshore Forex Trading Is Heading Back To U.S. Shores

New CFTC retail forex rules are going into effect exactly as we thought they would. Although we’re still waiting for more formal guidance from the CFTC and NFA, they both have improved their Web site sections on the subject. 

Foreign accounts transferred back to the U.S.
Most U.S.-based retail forex brokers (not banks) are registering with the NFA as RFEDs. If they don’t register their foreign affiliates as RFEDs too, they’re automatically transferring all U.S. resident retail forex trading accounts back to their U.S. RFED firms, by the CFTC’s Oct. 18 deadline. The trader has no choice in the matter.

Remember, the new retail forex rules do not apply to “eligible contract participants,” which are large non-retail accounts defined in prior blogs and in the rules. We’re noticing that more and more offshore brokers who first thumbed their noses at the new rules are falling into line and respecting the rules. 

Foreign commercial banks unaffiliated with any U.S.-based FCM or RFED may have a 360-day extension from registering as a U.S. financial institution. We heard they may have 360 days from the date Dodd Frank Fin Reg was enacted (July 21). We have not confirmed this yet, though. 

Dummy offshore corporations: Not a good idea
Even if you hear from some that the CFTC may focus its enforcement efforts against foreign unregistered intermediaries rather than on individual traders, it’s important to understand the CFTC considers evasion a “prohibited transaction.” Forming a dummy offshore corporation to open a retail off-exchange forex trading account with an unregistered offshore bank or broker is considered evasion, according to the CFTC. Attorneys, CPAs and financial advisors who suggest using dummy corporations to evade these CFTC rules may face challenges by their professional license boards and bars on infractions to their ethical codes of conduct. 

If you are foolish enough to use a dummy offshore corporation in this regard, you still need to disclose your American ownership of the corporation to your foreign broker, who may deny the account treating it as an American-owned account. If you don’t make that “know the client” disclosure, the broker may have grounds to take action against you. 

RFED U.S.-based forex accounts lack protection
Commercial banks like Citi FX Pro offer FDIC insurance protection and segregation protection in bankruptcy. Securities brokers offer SIPIC protection. Futures brokers don’t have any quasi-governmental insurance protection, but at least they have a “segregation” of assets regime in a bankruptcy filing, which is a lesser form of protection. 

The problem for RFED forex brokers in the U.S. is they don’t have a quasi-governmental insurance program and they can’t even offer futures segregation protection in a bankruptcy filing either. For this reason, some U.S. forex brokers previously suggested that their clients use their affiliates offshore. We heard that the UK offered some money protection on forex brokerage accounts. 

In a bankruptcy filing in the U.S. (think Refco), segregated futures accounts have seniority over other creditors and equity holders, so futures account holders get paid first. The problem for forex accounts with RFEDs is that futures segregation regimes aren’t respected on forex accounts in bankruptcy filings because the rules refer to futures traded on exchanges and forex is traded off exchange. This is an oversight from Congress. This is not the case for commercial banks; only brokers. 

A CFTC official told me he feels forex is still safer under their new rules with registration of RFEDs, minimum capital requirements, better disclosure and lower leverage. There may be some money protection issues in the UK, but working with an unregistered broker or bank and using unlimited leverage might make it more unsafe overall. Traders may have trouble and higher costs seeking remedies in foreign jurisdictions too. If a retail trader enters a prohibited transaction working with an unregistered RFED offshore, he may not have rights to use U.S. courts either. Some forex brokers in the UK and other jurisdictions may register with the NFA as RFEDs and then continue to offer money protection in the UK, although they will still need to adhere to the new CFTC rules on leverage and more.

Bottom line
If you trade retail forex off exchange, make sure your broker or bank is duly registered in the appropriate manner with the CFTC, as either an RFED with the NFA or a commercial bank (U.S. or foreign) with U.S. bank regulators. Both RFEDs and commercial banks may offer leverage up to 50:1 on the major currencies. Only the commercial bank may offer protection on your money. Skip the idea of setting up a dummy offshore corporation to work with a non-registered foreign broker or bank. 

Can American Off-exchange Retail Forex Traders Evade Strict New CFTC Rules By Trading On Offshore Platforms?

September 1, 2010 | By: Robert A. Green, CPA


Questions Linger Regarding New Forex Rules

Congress and regulators have thrown the forex trading industry a huge curve ball and we are all scurrying to get answers to important questions.

Many questions remain regarding trading offshore to evade leverage and other constraints posed by the new CFTC rules. Today we try to answer a few more questions along these lines. The answers are still unclear, and we await new NFA guidance, which was promised to one forex dealer executive. A forex dealer executive told me the NFA may actually be waiting on the CFTC regarding the overseas issue, and he expects it will take more than a few days. The overseas firestorm is probably underway. 

According to one leading forex broker executive, the CFTC author of these new retail forex trading rules said the Dodd-Frank (DF) change classifying financial institutions (FI) as “U.S. only” (see CFTC Q&A “who can offer..” section) won’t be made for 360 days from DF enactment (7/21/10). This gives EU banks offering forex trading to U.S. customers time to register in the U.S. But I think FI refers to banks and not CFTC-registered FCMs, which probably include the FDMs (forex-dealer merchants, the prior designation) too. The DF list has FI, SEC-registered and CFTC-registered companies, plus insurance companies and more. FI and FCM seem to be different categories.

So if this forex broker says its U.S. retail forex traders using offshore platforms from its affiliates have more time to close accounts, that may not be true in my view. If the foreign account is deemed a foreign affiliate of an existing CFTC-registered FDM, then using the 360-day extension seems inappropriate to me for financial institutions. If it’s a foreign institution such as an EU bank with no U.S. CFTC-registered FCM or FDM registrations, then maybe it’s okay to use the 360-day extension. 

Hopefully the NFA and/or CFTC will clarify this important issue soon. There are plenty of people asking these important questions, as thousands of Americans have offshore retail forex trading accounts.

It makes sense to me that DF gives 360 days to foreign institutions to form U.S. affiliates if desired. To spring a prohibition on foreign financial institutions offering forex trading to U.S. customers as of Oct. 18, 2010 (the effective date of the new CFTC rules) would be extremely undiplomatic on a global country-by-country dealing basis. There may be lawsuits and diplomatic requests made and this takes plenty of time to deal with properly.

This type of financial transaction/trading protectionism is rearing its ugly head on several international stages already. The U.S. is upset about EU rules and proposed rules requiring U.S.-based investment advisers to register in the EU for a required “passport” to raise money from EU investors. This is a huge problem for the U.S.-based investment-management industry. EU banks are upset about new U.S. “FATCA” tax rules requiring EU banks to report to the IRS U.S. customers in their ranks. FATCA ties in with this FI U.S.-only forex trading rule too, as it can help enforce it. 

According to the forex dealer executive I spoke with, the NFA plans to issue a notice to members perhaps today or in a few days to clarify DF and the new CFTC retail forex trading rules, mostly for implementation issues. This expected notice may not speak to the foreign trading issues, although hopefully it will. 

One big implementation issue is how currently CFTC-registered FDMs (under CRA) go about converting their registrations to the new DF-category of RFED. Will this be automatic? How can FDMs make many changes in their registration by Oct. 18, the implementation date for the new CFTC rules? 

This executive said many U.S. forex dealers currently use offshore platforms and affiliates for segregation of funds in the UK for asset protection purposes. He said if a person files for bankruptcy in the U.S., their UK forex trading account capital and rights are protected from U.S. bankruptcy courts. Leverage is unlimited in the UK, but usually 100:1. U.S. customers avoid the NFA’s controversial hedging rule when trading in the UK. He said capital isn’t a big issue because many U.S. forex dealers can absorb more U.S. customers to repatriate from the UK and other international affiliates. I presume leading forex dealers can move UK capital back to U.S. too as needed. This executive says non-residents (international business) may want to stay in the UK since the U.S. leverage is lowered to 50:1. He said U.S. platforms can handle things. The biggest concern is upsetting some U.S. clients who already set up foreign-based accounts and now may have to redo all the paper work back into the U.S. 

U.S. FDMs in the forex dealer coalition are fine on these new rules per this executive. Most are already registered as FDMs and compliant with the NFA, and 50:1 leverage is reasonable in their view. They expect the RFED change to be fairly easy to accomplish. 

I see a big problem for foreign forex dealers operating from tax havens. Most don’t have U.S. operations or branches and they won’t want to register in the U.S. Registration for foreign companies probably requires a U.S. operation, subsidiary or branch office designation. Branch office taxes can lead to trouble on Section 482 transfer pricing tax issues (where the profits are booked). If the IRS finds trouble with tax haven cheating, it can pounce on these institutions. Therefore, I presume many tax-haven forex dealers may lose forex trading business to CFTC-registered RFEDs who will be happy to win back this business. 

Forex IB (Introducing Broker) CFTC-registration changes are important too. The final rules are better than expected from the proposed rules. With final rules, a forex IB can simply register with the NFA on its own in the same manner as futures IBs do now. They don’t need that troublesome (proposed rule) guarantee from an FDM, although they have that choice too. Few FDMs want to take that kind of risk or tie up their capital by guaranteeing a forex IB.

There are many characters in the forex industry that inappropriately blur the lines between education, investment advice, money management and other related services. Many of these forex players may be drawn into registration in some capacity with the NFA and CFTC, perhaps as an IB, and many will want to avoid that registration for many different reasons. Some may have trouble passing NFA back ground checks. Others don’t want the NFA oversight over their perhaps fraudulent or inappropriate business models. Many don’t want to be burdened with other rules like disclosure and reporting. Many will surely have trouble with the conflicts of interest rules too.

The attorney and author of this article said to me via email: I spoke with an attorney at the CFTC Monday who is dealing with these rules. His interpretation was that because of the change to the CEA by Dodd-Frank from “financial institution” to “U.S. financial institution”, overseas forex intermediaries that are not registered as FCMs or RFEDs will not be able to serve as counterparty to U.S.-based retail investors with respect to OTC forex transactions. This would apply to futures and options and futures “look alike” contracts. I say that the enforcement issues are unresolved in our article both because of the practical realities involved in enforcing this rule and because this was just an opinion of one regulator, not of the Agency.

Excellent comment on our FaceBook page:
Robert: I spoke with both the NFA and the CFTC by phone. The most knowledgeable was a guy in the compliance dept at the CFTC. He says the rules apply to any brokerage, foreign or domestic, that wants to do business with U.S. traders. So, while the regulations are not aimed at traders themselves, they are indeed aimed at any/all brokers that do business with U.S. traders. In other words, if we have accounts at FXCM UK or Dukascopy (Switzerland) or anywhere else in the world, the CFTC will force those brokers to change our leverage to 50:1. The only good news I heard was the definition of what the “major currencies” are. Apparently the NFA has a list of what it considers the major currencies. This is in the Financial Regulations section of the NFA manual. Fortunately this includes (in addition to USD) the EUR, GBP, JPY, CHF, CAD, AUD, NZD and even the Norwegian, Swedish and Danish currencies. In other words, any currency that retail traders are likely to trade will be at 50:1 not 20:1. I can live with that. I’m not happy about the excessive intrusion of our government into our business, but I can live with this.

New CFTC Forex Trading Rules Call For 50:1 Leverage

August 31, 2010 | By: Robert A. Green, CPA


New CFTC Forex Trading Rules Call For 50:1 Leverage

The CFTC has published its highly anticipated final rules for trading off-exchange retail forex. As discussed on prior blogs, the recently enacted Dodd-Frank Fin Reg bill forced the hand of the CFTC to act by Oct. 19 because it would otherwise bar non-eligible contract participants from off-exchange retail forex trading. The CFTC acted in the nick of time because these new rules are effective on Oct. 18, 2010 — one day before the Dodd-Frank deadline. 

Some of the changes are crystal clear — like new 50:1 leverage limits on major forex currencies — but the equally important rule about allowing or barring offshore trading is not yet clear per documents published to date. One off-exchange retail forex broker concluded Tuesday that offshore trading won’t be allowed after the effective date, implying that offshore forex brokers will have to register with the CFTC as well and will be subject to these same new rules. 

The CFTC’s new leverage rule calling for a minimum 2 percent deposit on trading major forex currencies off exchange (50:1 leverage) seems on par with what commercial banks like Citi FX Pro offer their retail forex trading customers now. 

It’s a wise move by the CFTC to reduce leverage by two times — 100:1 to 50:1 under the new rules — rather than going way over board with its original proposal of 10:1 leverage. Unlike most off-exchange retail forex dealers in the U.S., Citi FX is not regulated by the CFTC; it is subject to bank regulation. 

It’s important to note the CFTC grants the NFA powers to set leverage rules higher than these new minimum percentages. 

Thankfully, the CFTC responded to the pleas from the off-exchange retail forex trading industry saying the CFTC’s proposed 10:1 leverage rule would put the industry at a huge competitive disadvantage to on-exchange currency futures trading (30:1), commercial bank forex trading (50:1) and offshore off-exchange retail forex trading (200:1). The new deposit rule for non-major currencies is 5 percent (20:1).

Regulators and Congress are often sensitive to chasing business (and fraud) abroad with new rules as well as taking business away from small businesses and handing it over to big banks. The CFTC also wants the U.S. to remain competitive for foreign traders, as foreign traders can continue to trade offshore without concern about registration in the U.S. 

It seems these new rules will put a stop to Americans trading retail forex offshore to evade CFTC rules. That trend picked up the pace in recent years and it may need to be reversed quickly. But we aren’t completely certain of this yet. We will study the new rules and see if offshore trading remains feasible for Americans under extraterritorial provisions of the Dodd-Frank Fin Reg bill. (We discussed how offshore trading might be a problem for American’s using offshore forex platforms on our recent blog and podcast.) 

We base our initial thoughts on the first documents released by the CFTC (links below). In the CFTC’s Q&A document, see the “Who can offer off-exchange forex transactions to retail customers” section. It states that Dodd-Frank Fin Reg changed the definition of allowable financial institutions to “only U.S. financial institutions.” The next section, “What is the scope of the CFTC’s jurisdiction,” implies that unless the entity is regulated by the SEC or bank regulators – again for U.S.-only financial institutions – the default catchall regulator is the CFTC. It makes sense that the CFTC would act in this manner, but again, we aren’t certain of these rules yet. Nothing in these CFTC documents specifically exempts offshore forex platforms or brokers from these new rules, either. Stay tuned for further observations.

For more information: 

CFTC releases final rules regarding retail forex transactions: Click here. 

Final rule regarding retail foreign exchange transactions (summary): Click here.

Federal Register: Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries:Click here.

Questions and answers regarding final retail foreign exchange rule: Click here.

CFTC unveils retail currency-trading rules: Click here.

U.S. Forex Traders May Not Be Able To Skirt Rules By Moving Accounts Offshore

August 10, 2010 | By: Robert A. Green, CPA


Long Arm Of Congress Leans On Forex Traders

The Dodd-Frank Fin Reg bill may extend the CFTC’s rules for retail forex trading to foreign trading platforms that are also marketed to Americans. This might mean U.S. resident traders won’t be able to evade CFTC rules for the proposed 10:1 leverage and the recent LIFO trading NFA rule change by using a foreign trading platform. Some foreign forex trading platforms offer 200:1 leverage and spread betting (no requirement for LIFO accounting).

The CFTC hasn’t finalized its January 2010 proposed rule changes for “Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries”, including a proposed reduction of leverage from 100:1 to 10:1.

A tax and regulatory attorney colleague replied to my questions on these issues: “Our Congress takes a very broad reach of the extraterritorial reach of our securities and commodities regulatory laws. Solicitation of customers who are U.S. persons — even though the solicitation is made outside the U.S. by a non-U.S. person — is covered. That is why, for example, foreign futures exchanges that want to offer their products to U.S. customers must obtain a 30.10 order from the CFTC qualifying them to solicit U.S. customers. As a practical matter, of course, enforcing that extraterritorial jurisdiction can be difficult (is the U.S. going to invade the Cayman Islands?)”

If 10:1 retail forex trading leverage is enacted by the CFTC/NFA, can U.S.-based retail spot forex brokers easily move their U.S. trading customers to their UK affiliates? It seems like the U.S. broker would be switching them to a foreign affiliate to evade U.S. regulations, and based on my colleague’s statement, I think it could be a problem.

U.S. forex traders may be left with two unfortunate choices. Trade on CFTC-sanctioned foreign OTC platforms respecting CFTC rules on LIFO and perhaps 10:1 leverage or take their chances in offshore tax havens (reportable on tax returns). Why go to foreign platforms if the rules are the same and perhaps invite more IRS questions? Why go to offshore havens if it’s potentially illegal and a tax problem – with the IRS scrutinizing offshore accounts?

Tax-haven platforms may never get CFTC sanction, so will they be illegal under Dodd-Frank, or, will it be a viable way to navigate around the U.S. forex trading leverage constraints?

Many comments published on the CFTC site say it’s a bad idea to chase U.S. forex trading business to tax and regulatory havens where there’s much more fraud. The way Congress wrote Dodd-Frank, it seems like it’s either going to be sanctioned by U.S. regulators or prohibited entirely. Can a U.S. person report forex transactions on their tax return from counterparties that are not sanctioned?

My colleague said Dodd-Frank Section 929Y has one reference to “extraterritorial” (which means ”foreign”) saying the SEC has jurisdiction to regulate extraterritorial swap contracts. We think this same extraterritorial concept may apply to retail forex trading too. The CFTC regulates retail forex, whereas the SEC has authority over swaps. The Dodd-Frank bill couldn’t possibly mention every point, leaving much to interpretation by regulators. We think the CFTC may interpret the legislative text to mean the CFTC has extraterritorial control over retail forex too. It would be too simple for Americans to avoid the new rules with foreign brokers otherwise. If the CFTC has extraterritorial powers on retail forex, then foreign-based brokers will probably not do business with non-eligible contract participants. Good size hedge funds and proprietary trading firms may be qualified participants. Foreign banks and brokers with U.S. affiliates will fear the U.S. regulators attacking their U.S. operations. 

Might there be an opening for retail forex trading to move into prop trading firms — with traders joining these firms as partners — inside and outside the U.S.? By combining trading capital with other traders, a group of individuals may achieve eligible contract participant status. There are regulatory problems with prop trading firms too, as covered on this blog. 

We’re working on these very important issues for U.S. forex traders. We hope to have more information on our conference call Thursday at 4:15pm ET. We discussed it on last week’s podcast too.

Excerpts from the Dodd-Frank bill:

PROHIBITION-‘(I) IN GENERAL- Except as provided in subclause (II), a person described in subparagraph (B)(i)(II) for which there is a Federal regulatory agency shall not offer to, or enter into with, a person that is not an eligible contract participant, any agreement, contract, or transaction in foreign currency described in subparagraph (B)(i)(I) except pursuant to a rule or regulation of a Federal regulatory agency allowing the agreement, contract, or transaction under such terms and conditions as the Federal regulatory agency shall prescribe.

(a) In General- The Securities and Exchange Commission of the United States shall solicit public comment and thereafter conduct a study to determine the extent to which private rights of action under the antifraud provisions of the Securities and Exchange Act of 1934 (15 U.S.C. 78u-4) should be extended to cover-

(1) conduct within the United States that constitutes a significant step in the furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors;

(2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.

(b) Contents- The study shall consider and analyze, among other things–

(1) the scope of such a private right of action, including whether it should extend to all private actors or whether it should be more limited to extend just to institutional investors or otherwise;

(2) what implications such a private right of action would have on international comity;

(3) the economic costs and benefits of extending a private right of action for transnational securities frauds; and

(4) whether a narrower extraterritorial standard should be adopted.

(c) Report- A report of the study shall be submitted and recommendations made to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House not later than 18 months after the date of enactment of this Act.

Swaps Tax Treatment Confusion Cleared Up With Fin Reg

July 22, 2010 | By: Robert A. Green, CPA


The “Restoring American Financial Stability Act of 2010” — also known as “Fin Reg” — signed into law on July 21 moves many derivative contractors from the private marketplace to clearing on futures exchanges. In Section 1601 of the bill, Congress makes it crystal clear this movement isn’t like trading and it doesn’t afford these derivatives contracts the regulated futures contract tax treatment in Section 1256.

Swap contracts – a form of credit insurance – were at the center of the credit crisis. AIG wrote far too many of these swap contracts (pocketing the premium) and lacked sufficient capital to cover its eventual credit losses at the height of the financial panic. Regulators lacked transparency since swaps were private derivatives contracts. 

Fin Reg addresses these problems by moving many derivative swap contracts into clearing on futures exchanges to provide market-based transparency of pricing and terms and normal exchanged-based margin and leverage rules. However, in moving to futures exchanges, Congress did not want to reward swap contracts with the lower 60/40 treatment in Section 1256. 

The new law amends Section 1256 to broaden the list of contracts that are barred from the definition. Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. Under pre-Act law, the term Section 1256 contract doesn’t include securities futures contracts or options on such a contract unless the contract or option is a dealer securities futures contract. 

Law change
For tax years beginning after July 21, 2010 all of the following also are excepted from the definition of a Section 1256 contract: any interest-rate swap, currency swap, basis swap, interest-rate cap, interest-rate floor, commodity swap, equity swap, equity-index swap, credit default swap, or similar agreement. (Code Sec. 1256(b), as amended by Act Sec. 1601. You can find Section 1601 – Title XVI – Section 1256 Contracts on the last pages of the bill.) 

The Conference Report says the change addresses the recharacterization of income as a result of increased exchange trading of derivatives contracts by clarifying that Code Sec. 1256 doesn’t apply to certain derivatives contracts transacted on exchanges. 

Leading tax attorney for investment-management businesses Roger Lorence emailed me, stating that “Swaps were not 60/40 under prior law. The new law clarifies that their status is not 60/40. Leading experts have expressed their views that there was confusion in the marketplace about the treatment of swaps cleared by clearing arms of exchanges, although the swap contracts themselves were not traded on a qualified board or exchange (traded on a QBE is a requirement for 60/40 treatment). There is a difference between clearing and trading — trading means a designated contract market for that contract has been approved by the CFTC and swaps are not eligible for designation as a contract market (there can’t be trading in a swap). No contract that legitimately is 60/40 now loses 60/40 under this bill. The amendment is designed to foreclose aggressive taxpayers from taking the position that swaps are 60/40.”

Thanks Roger, this clarifies my question about traders gaining a new opportunity to trade these derivatives contracts – they don’t get this opportunity. They can gain from the transparency on the exchange clearing. 

FINRA’s Notice To Prop Traders

June 22, 2010 | By: Robert A. Green, CPA

Are FINRA, the SEC and others about to pounce on day prop trading firms? 

In April, FINRA’s released its Regulatory Notice 10-18, which includes guidance on master and sub-account arrangements. This document has prompted much debate since its release. 

Over the past decade, regulators prodded the prop-trading industry to move away from engaging prop traders as independent contractors. Instead, prop traders were asked to join the firms as LLC members.

A person trading a firm’s capital should either be an employee (as in Wall Street banks and brokerage houses) or an owner of the firm. Regulators tried to clean up the low-hanging fruit, preferring licensed brokers to join prop trading firms organized as broker dealers. Many are “non-customer” broker dealers meaning they don’t any business with retail customer accounts. Customers can have up to 4:1 margin as pattern day traders per Reg T margin rules. Prop traders are only limited within the firm, so many can have 10:1 or greater leverage, making prop trading quite attractive.

One major bone of contention is the issue of deposits. Employee prop traders rarely pay deposits on Wall Street, and only pay them occasionally in prop trading firms. Independent contractor and LLC member prop traders usually are requested to pay deposits. The deposit size has a direct (although somewhat hidden) connection to how much leverage they are afforded by the firm and how much their share of trading profits will be (60 to 100 percent depending on deposit size).

In prop trading firms, these deposits are rarely treated as LLC member capital contributions, and they’re connected to a sub-account’s trading performance and used to cover sub-account trading losses. When traders leave a firm, most agreements demand they pay back losses in excess of their deposit accounts.

Another concern is the issue of “special allocations” of sub-account trading profits. Special allocations seem to push the envelope of what the IRS allows in partnership returns. The Wall Street employee prop trader may have a sub-account to trade and track performance, and then receive a bonus based on performance — perhaps 50 percent compensation (the Wall Street model), whereas many prop traders automatically receive 99 or 100 percent of the trading profits. We understand FINRA may regard the latter payouts as indicative of a beneficial owner — perhaps a disguised customer account. Some firms may need to change to 80/20 splits to keep muster.

While some prop trading firms offer the employee-model option with 60/40 or 50/50 payouts, some still rely on the LLC or contractor model, paying out more than 80 percent. Firms seem to make money on services, or rebates. In my opinion, rebates are a form of collecting commissions, and if this is the case, the broker should be registered as a commission broker dealer.

The IRS allows special allocations in partnership returns, which an LLC files. Special allocations stand up to IRS scrutiny if they follow the money. It’s odd to me that prop traders who are Class C or D members, yet don’t share in firm-wide profits and losses and even their own losses, can still receive 99 or 100 percent of their LLC class profits on their own sub-trading account. Traders eat what they kill.

The FINRA notice seems bent on identifying “beneficial owners” hidden in prop trading firm master and sub-account relationships. Beneficial owner is a legal term where specific property rights (“use and title”) in equity belong to a person even though legal title of the property belongs to another person. This often relates where the legal title owner has implied trustee duties to the beneficial owner.

Over this past decade on this story, many have used the term “disguised customer accounts.” Are FINRA and the SEC looking to force retail traders back into a customer account peg instead of a prop trading firm peg? If so, those traders would be forced back into regular retail compliance including 4:1 pattern day trader rules and more.

The FINRA notice list asks clearing firms to spot these red flags and then take action. Many clearing firms may not be able to see these red flags, because prop trading firms structure things in a somewhat deceptive manner. For example, if a prop trading firm has a large brokerage account and many domestic and foreign traders, those details (including trader names) may be hidden from the clearing broker. Sub-accounts may be labeled with non-identifying (by legal name) information like just account numbers.

Here, I’ve included the the FINRA Notice 10-18 list in bold, and my comments thereafter. The notice states a firm will be on inquiry notice if:

1. Sub-accounts are separately documented and/or receive separate reports from the firm.Firms document exact sub-account activity in reports often given to each prop trader.

2. Firm addresses the sub-accounts separately in terms of transaction, tax or other reporting.Firms summarize these reports into year-end tax reporting, including either 1099-Misc, Schedule K-1 or W-2.

3. Services provided to the sub-accounts engender separate surveillance and supervision risk management. Firms often oversee each trader and compare their risk, gains and losses to deposit amounts, offset losses against deposits, and request deposit replenishment. This isn’t always seen by clearing firms.

4. Firm has financial arrangements or transactions with the sub-accounts, or separate account terms, that reasonably raise questions about beneficial owners. Traders receiving 99 or 100 percent payouts on trading gains seem like beneficial owners. If the firm was truly an owner too, wouldn’t it receive a bigger share of the trading gains? Arrangements vary by sub-account and trader.

5. Sub-accounts incur charges for commissions, clearance and similar expenses. Yes. Firms charge traders for various services including education, tools, desk charges, commissions (in some cases), rebates and other services.

6. Firm has evidence of financial transactions or transfers of assets or cash balances that would reasonably evidence separate beneficial-ownership of the sub-accounts. In my view, that refers to traders making deposits, although they are rarely credited to sub-accounts. Most firms are somewhat cute about keeping the deposits off to the side and not transferring them into the sub-accounts.

7. The firm is aware of or has access to a master account or like agreement that evidences that the sub-accounts have different beneficial owners. The firm’s LLC agreement, listing Class C and D prop traders is this type of document, in my view.

8. The firm has evidence that a party maintaining a master/sub account arrangement has interposed sub-accounts that have or are intended to have the effect of hiding the beneficial-ownership interest. If the sub-accounts have account numbers without names of the traders, that could be deemed a form of hiding, I presume.

9. The number of sub-accounts maintained is so numerous as to reasonably raise questions about beneficial ownership. Many prop trading firms have numerous sub-accounts, so this is a concern too.

10. Items 3, 4, 5, 6, 8 and 9 would not apply in the case of a registered IBD or a bona fide IA arrangement described in the Notice. In my opinion, a prop trading firm organized as a non-customer broker dealer (BD) can’t claim it’s an IBD per this notice, as IBDs have customer accounts. FINRA is telling clearing firms they can rely on the customer IB to have handled compliance on its customers. Even if the broker dealer is registered as a customer BD, the prop traders in question aren’t treated by those firms as customers, so I don’t believe the firms can avail themselves of these exceptions in connection with application of this FINRA regulatory notice. I believe these prop trading firms can’t claim IA status either, as the traders are active and not passive investors, and the firms generally aren’t registered investment advisors.

FINRA is asking clearing firms for help here and they may not see these red flags. Although, if they have huge accounts with these firms, compliance forces them to understand their client and know what’s happening behind the scenes. To claim ignorance is probably not acceptable either.

If FINRA and/or the SEC examines these prop trading firms, they can easily see these red-flag items. What action will they take from there? Can prop trading firms restructure their business models to share more with their traders, so the traders aren’t deemed beneficial owners? Will that please the regulators? Does FINRA equate beneficial owners with “should be” customer accounts? It will be interesting to see how the IRS will react, too. 

Prop trading firms in the grips of the regulators may consult their lawyers for protection. They may disclose their pertinent information and not tell traders everything they should learn on their own. Attorneys representing prop trading firms are expected to handle their clients’ needs by law and not necessarily serve the public’s interest. It’s always a good idea to consult your own attorney, and not necessarily the attorney representing your prop trading firm.

We help many prop traders on their tax planning and preparation and consult with them on big picture items too. In the past, many traders decided to continue prop trading because the leverage and access was attractive and they took payouts to retain as little money as possible at risk in the firms. Keep your eyes and ears open on this story.