Reduced Financial Freedom? What Dodd Frank Could Mean to You

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 |  Includes: GLD, SLV, UDN, UUP
by: James Bibbings

If you’re like many of us, you may be wondering when people are going to stop uttering the phrase “In this economy, … .” Since the world’s financial system took a turn for the worst in 2007, this saying has been used time and time again by countless people. In fact, it is the underlying sentiment that contributed to U.S. regulators drafting the Dodd Frank Wall Street Reform Act of 2010 (“Dodd Frank” or “Act”). Dodd Frank, for those of you who don’t know, is a massive financial legislation intended to prevent a future financial Armageddon. In drafting the Act, a great deal of time was spent paving the way for the eventual regulation of over-the-counter (“OTC”) financial derivatives; a purportedly large contributor to the world’s near financial collapse. In this regard, the intent of the U.S. Congress was undoubtedly to reign in what it saw to be reckless leverage within the financial system. However, in trying to capture all OTC derivatives under the new regulations, two products, unrelated to the failure of the economy, were also included: (1) Retail OTC Forex and (2) Retail OTC Precious Metals.

As of July 15, 2011, Dodd Frank will be implemented with respect to retail OTC precious metals contracts, thereby affecting both brokers and traders of this contract type. Dodd-Frank has already become effective with respect to retail OTC forex, except for certain delayed provisions regarding broker-dealers. As a result, the requirements of Dodd-Frank should not be a surprise to the forex industry, as preparations for these changes have largely been completed. The Commodity Futures Trading Commission (“CFTC”), and the self regulatory organization National Futures Association (“NFA”), took the lead on this issue and published guidance for forex firms many months ago. Forex traders and brokers within the U.S. should therefore see little difference in their respective trading experiences beginning on July 15th. On the other hand, foreign brokers not registered in the U.S. will now be forced to terminate any and all relationships they may have with U.S. persons. This has already begun to happen in many instances – in some cases forcing U.S. customers to exit trades at times they may not otherwise have chosen. Likewise, traders working with brokers and clearing firms in jurisdictions outside the U.S., and who are not registered, may see substantial changes in their trading arrangements and in many cases a total cessation of their trading activity.

As of July 15, 2011, Dodd Frank will effectively ban the trading of most retail OTC contracts for gold, silver, and all other metals. In particular, Section 742(a) of Dodd Frank prohibits any person [which includes companies] from entering into, or offering to enter into, a transaction in any commodity with a person that is not an eligible contract participant or an eligible commercial entity, on a leveraged or margined basis. The intent of this provision was to expand the narrow so called “Zelener fix” in the Farm Bill enacted by Congress during 2008. [Previously the Farm Bill enabled the CFTC to pursue anti-fraud actions involving rolling spot transactions and/or other leveraged forex transactions without the need to prove that they are futures contracts.] The expansion of authority given by Dodd-Frank to the CFTC now allows them to regulate virtually all retail cash commodity market products that involve leverage or margin – in other words OTC precious metals.

The prohibition in Section 742(a) does not apply, however, to metals transactions that result in actual, physical delivery of the metal traded within 28 days, or if such a transaction creates an enforceable obligation to deliver the metals product between a seller and a buyer that have the ability to deliver, and accept delivery of, respectively, the commodity in connection with their lines of business. This may be problematic for many brokers and traders, since in most spot metals trading virtually all contracts fail to satisfy these requirements. As a result, although courts have yet to interpret Section 742(a), this Section is likely to have a significantly restrictive impact on the OTC cash precious metals industry. This in turn may affect forex traders and brokers working with dealers that offer precious metal-currency pair trading within their trading platforms. Those who offer such transactions or intend to be a counterparty to OTC metals transactions should seek professional help to discuss possible operational and regulatory contingency plans. Retail traders also should be aware of this provision, as they too will be ineligible to enter into such contracts.

As noted above, implementation of these new provisions on July 15, 2011 will likely have a mixed impact on the financial industry. Changes to the OTC forex market in the U.S. should be somewhat muted since most firms have been preparing for this day and thus are already registered with the CFTC or have made other business plans. Unfortunately, for many OTC precious metals brokers and traders, July 15th will mark the end of an era. For those of you in these categories, it could be said that some of your financial freedoms have been taken away. Few – if any – would argue that OTC metals trading contributed to the global financial collapse. It is unfortunate that activity which was not attributed to the events which produced Dodd-Frank is nevertheless being prohibited. As a small consolation to those of you affected, the next time someone says “In this economy,” you can stop them and offer back: “Trust me, I know.”

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.