Security Futures Products
Trading and Execution Issues
A Presentation by Regina Thoele
Associate Director of Compliance
National Futures Association
Today, I am going to cover the section of our Compliance Rule 2-30(j) that deals
with suitability. Then I will discuss our Fair Commission Rule, Best Execution
issues and conclude with a discussion of Margins.
Suitability of Recommendations
As you know, the area that I have been covering thus far today deals with NFA’s
Compliance Rule 2-30. As NFA Members, you all know that this is considered
our “Know Your Customer” rule. NFA Members have never dealt with a
“Suitability” rule. However, if you plan to offer security futures products to your
customer, you will need to deal with the issue of suitability.
First of all—under Rule 2-30(j)(3)—A Member shall not recommend a
transaction/strategy to a non-institutional customer without making a
reasonable effort to obtain current information regarding the customer’s financial
status and investment objectives. Note that this only applies to
recommendations made by the Member and this does not apply to
discretionary accounts.
Basically you have an ongoing suitability requirement and, from what you are
aware of (i.e, they have lost $50,000 trading with you), you may need to ask if the
information is still current
For purposes of this rule an institutional customer is defined as:
(i) a bank, savings and loan association, insurance company,
registered investment company, a registered CPO, or a pool
operated by a registered CTA;
(ii) an investment adviser registered with the SEC or with a state
securities commission or a registered CTA;
(iii) an investment company exempt from registration, a CPO
exempt from registration, a pool operated by an exempt CPO, an
investment adviser exempt from both federal and state registration,
or a CTA exempt from registration;
(iv) a registered B/D or FCM; or
(v) any other entity (whether a natural person, corporation,
partnership, trust, or otherwise) with total assets of at least $50
million.
You should note we have included in our rules references to CPOs and CTAs.
Rule 2-30(j)(4) says that a Member shall not make a recommendation without
reasonable grounds for believing it is suitable for a customer based on the
customer’s current investment objectives, financial situation and needs,
and any other information known by the Member.
Rule 2-30(j)(5) says that a Member shall not make a recommendation unless he
has a reasonable basis for believing the customer has knowledge and
experience to be capable of evaluating the risks of the transaction and is
able to financial able to bear the risks.
Let me summarize our new section (j) of Rule 2-30:
of account –procedurally what you need to do and what you need
to have documented
(j)(1)---opening
(j)(2)---verify information by sending to customer if you didn’t receive it in writing
to begin with
(j)(3)---can’t recommend unless reasonable efforts to obtain current financial
information on customer financial status and investment objectives
(j)(4)---don’t recommend transaction unless reasonable grounds for believing
transaction suitable based on customer’s objectives and financial situation
(j)(5)--- don’t recommend transaction unless reasonable grounds for believing
customer capable of evaluating risks and financially able to bear risk
Fair Commissions -- NFA Compliance Rule 2-37(g)
The SEC required NFA to adopt a fair commission rule comparable to NASD
Rule 2440. Most Members will not be required to make any changes to their
commission practices for Rule 2-37(g) with regards to security futures. This rule
is almost identical to the provisions of NASD Rule 2440 that relate to agency
transactions. The rule states that Members shall not charge customers more than
a fair commission which takes into consideration the following:

The expense of executing the order;


The value of any service the Member may give based on its experience in
and knowledge of the security futures; and
The market in that product (i.e., what’s the going rate).
Additionally, Members that deal with institutional-based customers can continue
to negotiate commissions based on volume.
The Interpretive Notice is consistent with NFA’s traditional approach, which
requires full disclosure of fees and commissions. See NFA Interpretive Notice on
Interpretation of NFA Compliance Rule 2-4: Guidelines for Disclosure by FCMs
and IBs of Costs Associated with Futures Transactions.
Best Execution
The SEC required NFA to adopt a Best Execution rule comparable to NASD Rule
2320. A copy of NFA’s proposed Interpretive Notice is included in this section of
the web site.
The SEC believes that best execution is a common law requirement even though
there is no fungibility or national market system. Therefore, NFA has drafted an
Interpretive Notice which addresses Best Execution as an Interpretation of NFA
Compliance Rule 2-4 -- Just and Equitable Principles of Trade. The Notice sets
forth the Member’s best execution obligation yet provides the Member with
flexibility in meeting this obligation. The Notice also reminds Members of their
obligations to put their customer’s interest before their own when soliciting and
executing futures transactions.
In those cases where security futures are listed on more than one market and are
not materially different, the Member has an obligation to use reasonable
diligence to ascertain where a customer’s security futures order will receive the
most favorable execution available.
Let me emphasize that Best Execution does not apply to the Member when a
customer instructs the Member to direct an order to a particular market. In other
words, you can encourage the customer to tell you which exchange that want
you to execute the trade on.
What the Member needs to know to comply with their Best Execution obligation:
1.
A Member should consider the relevant facts and circumstances in
determining which market to route an order. Some of these factors
include:


the character of the market including, but not limited
to, price, volatility, liquidity, depth, speed of execution
and pressure on available communications;
The size and type of transaction; and

The location and accessibility to the customer’s
intermediary of primary markets and quotation
sources.
Members and Associates must also consider differences in the fees and
costs (to the customer) associated with executing the transaction in each
market.
Other issues to be aware of:
1.
A Member shall not channel an order through a third party unless
the Member can show that by doing so it obtained the most
favorable execution available for the customer unless:

specifically instructed by a customer or customer’s designee;
or

necessary to obtain the execution of an order
A Member firm that has not fulfilled its best execution obligation will also be
deemed to have violated NFA Compliance Rule 2-4.
NFA recognizes that speed of execution is extremely important in the futures
markets, and checking multiple markets each time an order is received may
actually disadvantage customers by delaying execution of their orders.
Therefore, NFA does not expect Members and Associates to evaluate execution
quality on an order-by-order basis.
Members and Associates should, however, consider the above factors when
establishing their order-routing practices and must perform a regular and rigorous
review of those practices to ensure that order flow is directed to markets
providing the most advantageous terms for execution of customer orders. (For
example, a Member must consider how technology changes impact their order
routing practices.)
Best Execution Summary
Best execution is not simply a matter of the best price. Obviously, price is
important and the most important, but Best Execution is not simply a matter of
best price. All of the factors discussed above are important in determining
whether a customer order received the most favorable terms available under the
circumstances.
NFA will provide further guidance if necessary as the markets for security futures
products evolve.
Margins
As of today the final rules in this area have not been issued. However, it is
anticipated that the margin requirement for both initial and maintenance will be
20% of the current market value of such position.
The “current market value” will mean the daily settlement of such security future
as shown by any regularly published reporting or quotation service
Obviously a firm can decide to set margin requirements at a higher level.
At this stage it appears that the most likely solution is that an FCM notice
registered B/D customer will follow the existing rules for margining. A stand-alone
rule will mostly likely be issued for margin purposes
A fully registered B/D FCM will probably follow the account depending on
whether it is a securities or futures.
However for both, the collection, collateral, etc., will follow the rules associated
with the type of account (securities or futures).