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e8-21865

  • FR Doc E8-21865[Federal Register: September 18, 2008 (Volume 73, Number 182)]

    [Proposed Rules]

    [Page 54097-54106]

    From the Federal Register Online via GPO Access [wais.access.gpo.gov]

    [DOCID:fr18se08-25]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Parts 1 and 38

    Execution of Transactions: Regulation 1.38 and Guidance on Core

    Principle 9

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Proposed rules.

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    SUMMARY: The Commodity Futures Trading Commission (``Commission'' or

    ``CFTC'') is re-proposing a number of amendments to its rules, guidance

    and acceptable practices, initially proposed on July 1, 2004,\1\

    concerning trading off the centralized market, including the addition

    of guidance on contract market block trading rules and exchanges of

    futures for commodities or derivatives positions. The Commission is re-

    proposing these amendments and requesting comment as part of its

    continuing efforts to update its regulations in light of the Commodity

    Futures Modernization Act of 2000 (``CFMA'').

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    \1\ 69 FR 39880.

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    DATES: Comments must be received by November 17, 2008.

    ADDRESSES: Comments should be sent to the Commodity Futures Trading

    Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington,

    DC 20581, attention: Office of the Secretariat. Comments may be sent by

    facsimile transmission to 202-418-5521 or, by e-mail to

    secretary@cftc.gov. Reference should be made to ``Proposed Rules for

    Trading Off the Centralized Market.'' Comments may also be submitted by

    connecting to the Federal eRulemaking Portal at http://

    www.regulations.gov and following comment submission instructions.

    FOR FURTHER INFORMATION CONTACT: Gabrielle A. Sudik, Special Counsel,

    Division of Market Oversight; Telephone 202-418-5171; e-mail

    gsudik@cftc.gov; Commodity Futures Trading Commission, Three Lafayette

    Center, 1155 21st Street, NW., Washington, DC 20581.

    SUPPLEMENTARY INFORMATION:

    I. Background

    Commission Regulation 1.38 (17 CFR 1.38) sets forth a requirement

    that all purchases and sales of a commodity for future delivery or a

    commodity option on or subject to the rules of a designated contract

    market (``DCM'') should be executed by open and competitive methods.

    This ``open and competitive'' requirement is modified by a proviso that

    allows transactions to be executed in a ``non-competitive'' manner if

    the transaction is in compliance with DCM rules specifically providing

    for the non-competitive execution of such transactions, and such rules

    have been submitted to, and approved by, the Commission.

    The Commodity Futures Modernization Act of 2000 (``CFMA''),\2\

    which was enacted after Regulation 1.38 was promulgated,\3\

    significantly changed the Federal regulation of commodity futures and

    option markets by replacing ``one-size-fits-all'' regulation with

    broad, flexible core principles.\4\ At the same time, the CFMA modified

    section 3 of the Commodity Exchange Act (``Act'') (7 U.S.C. 1 et seq.),

    making a finding that transactions subject to the Act provide ``a means

    for managing and assuming price risks, discovering prices, or

    disseminating pricing information through trading in liquid, fair and

    financially secure trading facilities,'' and providing that the purpose

    of the Act is now, among other things, ``to deter and prevent price

    manipulation or any other disruptions to market integrity; to ensure

    the financial integrity of all transactions subject to this Act and the

    avoidance of systemic risk; to protect all market participants from

    fraudulent or other abusive sales practices and misuses of customer

    assets. * * * '' \5\ The CFMA also expanded the types of transactions

    that could lawfully be executed off the centralized market.

    Specifically, the CFMA permits DCMs to establish trading rules that:

    (1) Authorize the exchange of futures for swaps; or (2) allow a futures

    commission merchant, acting as principal or agent, to enter into or

    confirm the execution of a contract for the purchase or sale of a

    commodity for future delivery if the contract is reported, recorded, or

    cleared in accordance with the rules of a contract market or

    derivatives clearing organization.\6\ At the same time, exchanges must

    balance such rules with Core Principle 9 (7 U.S.C. 5(d)(9)) (Execution

    of transactions), which states ``The board of trade shall provide a

    competitive, open, and efficient market and mechanism for executing

    transactions.''

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    \2\ Public Law 106-554, 114 Stat. 2763 (2000). Under the CFMA,

    such DCM rules may be effected by the certification procedures set

    forth in section 5c(c) of the Commodity Exchange Act and 40.6 of the

    Commission's regulations.

    \3\ Regulation 1.38 was originally adopted in 1953 by the

    Commodity Exchange Authority, the predecessor of the Commission. See

    18 FR 176 (Jan. 19, 1953). For subsequent amendments, see 31 FR 5054

    (Mar. 29, 1966), 41 FR 3191 (Jan. 21, 1976, eff. Feb. 20, 1976), and

    46 FR 54500 (Nov. 3, 1981, eff. Dec. 3, 1981).

    \4\ The CFMA was intended, in part, ``to promote innovation for

    futures and derivatives.'' Sec. 2 of the CFMA. It was also intended

    ``to reduce systemic risk,'' and ``to transform the role of the

    [Commission] to oversight of the futures markets.'' Id.

    \5\ 7 U.S.C. Sec. 5 (2000).

    \6\ See Section 7(b)(3) of the Act.

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    In 2001, the Commission promulgated regulations implementing

    provisions of the CFMA that established procedures relating to trading

    facilities, interpreted certain of the CFMA's provisions, and provided

    guidance on compliance with various of its requirements.\7\ Later, in

    2002, the Commission promulgated amendments to those regulations in

    response to issues that had arisen in administering the rules, noting

    that the Commission would consider ``additional amendments to the rules

    implementing the CFMA based upon further administrative experience.''

    \8\ Consistent with that rationale, the Commission now proposes to

    amend Commission Regulation 1.38 and Commission guidance and acceptable

    practices concerning Core Principle 9 as it relates to Commission

    Regulation 1.38 to include changes that the Commission has developed

    based upon its experience administering those provisions.

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    \7\ See 66 FR 14262 (Mar. 9, 2001) and 66 FR 42256 (Aug. 10,

    2001).

    \8\ See 67 FR 20702 (Apr. 26, 2002) and 67 FR 62873 (Oct. 9,

    2002).

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    [[Page 54098]]

    II. Discussion of the Proposed Rule Amendments, Guidance and Acceptable

    Practices

    A. The Commission's July 1, 2004 Notice of Proposed Rulemaking

    On July 1, 2004, the Commission published proposed amendments to

    Regulation 1.38 and Commission guidance concerning Core Principle 9,

    found in Appendix B to Part 38 of the Commission's Regulations (17 CFR

    Part 38) (the ``July 1, 2004 NPRM'').\9\ The Commission proposed to

    update the language of Regulation 1.38 to more accurately identify the

    types of transactions that may lawfully be executed off a contract

    market's centralized market and to simplify the language of the

    Regulation. The Commission also wished to provide more detail regarding

    acceptable practices for how contract markets can satisfy the

    requirements of Core Principle 9, particularly on four general topics:

    Electronic trading systems, general provisions for transactions off the

    centralized market, block transactions, and the exchange of futures for

    a commodity or a derivatives position.

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    \9\ 69 FR 39880 (July 1, 2004).

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    The Commission received seven comment letters in response to the

    July 1, 2004 NPRM: From the Chicago Mercantile Exchange (``CME''), the

    Futures Industry Association (``FIA''), the Chicago Board of Trade

    (``CBOT''), the U.S. Futures Exchange (``USFE'') (two letters), the DRW

    Trading Group (``DRW''), and Man Financial. The comments addressed

    eight general areas of concern: The proposed amendments to Regulation

    1.38, the Commission's proposed guidance for compliance with Core

    Principle 9 in general, block trading in general, the minimum size of

    block transactions, block trade prices, the time within which parties

    must report block trades to the exchange, block trades between

    affiliated parties, and the exchange of futures for a commodity or a

    derivatives position. Some comments offered specific recommendations

    regarding the proposed amendments, while other comments were of a more

    general nature.

    Between the publication of the July 1, 2004 NPRM and this current

    proposal, the Commission has continued to gain experience in

    administering Regulation 1.38 and Core Principle 9. Staff has also

    learned more about the common practices involved in transactions done

    off of the centralized market from the comment letters received, from

    informal interviews with various entities in the futures industry, from

    DCM rule submissions, and from informal studies of trading data related

    to off-centralized-market transactions. In light of this, as well as

    the length of time that has passed since the July 1, 2004 NPRM, the

    Commission has determined to re-propose amendments to Regulation 1.38

    and the guidance to Core Principle 9. Commenters are invited to submit

    feedback on all areas of this proposal, including those areas already

    addressed in earlier comment letters.

    B. Core Principle 9 Guidance and Acceptable Practices

    This proposal contains regulations, guidance and acceptable

    practices. Commission regulations, such as Regulation 1.38, are

    requirements that all contract markets must follow. Such regulations go

    beyond mere illustrations of how a contract market may comply with a

    section of the Act; they are requirements that stand alone and that the

    Commission believes are necessary in order to comply with the Act. In

    issuing guidance, the Commission strives to offer advice about how

    contract markets can ensure compliance with sections of the Act. The

    Commission recognizes that in certain areas there is more than one

    possible approach that would allow a contract market to comply with a

    related Section of the Act. For example, as will be discussed below,

    there can be more than one way to determine an appropriate minimum size

    for block trades. The Commission offers guidance on such subjects in an

    effort to inform the exchanges of what it believes are some reasonable

    approaches to take when tackling such issues and concerns to be

    addressed in complying with Core Principles. The acceptable practices

    provide examples of how exchanges may satisfy particular requirements

    of the Core Principles; they do not establish mandatory means of

    compliance.\10\ Acceptable practices are more specific than guidance.

    An exchange rule modeled after an acceptable practice will be presumed

    to comply with the related Core Principle, since the Commission has

    already found such practice complies with that Core Principle. The

    Commission wishes to emphasize that acceptable practices are intended

    to assist DCMs by establishing non-exclusive safe harbors.\11\ The

    introduction to Appendix B to Part 38 makes it clear that the

    acceptable practices in Appendix B are not the sole means of achieving

    compliance with the Act:

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    \10\ See Section 5c(a) of the Act 7 U.S.C. 7a-2(a).

    \11\ The Commission notes that safe harbor treatment applies

    only to compliance with the specific aspect of the Core Principle in

    question. In this regard, an exchange rule that meets a safe harbor

    will not necessarily protect the exchange or market participants

    from charges of violations of other sections of the Act or other

    aspects of the Core Principle.

    Acceptable practices meeting the requirements of the core

    principles are set forth in paragraph (b) following each core

    principle. Boards of trade that follow the specific practices

    outlined under paragraph (b) for any core principle in this appendix

    will meet the applicable core principle. Paragraph (b) is for

    illustrative purposes only, and does not state the exclusive means

    for satisfying a core principle.\12\

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    \12\ See also A New Regulatory Framework for Trading Facilities,

    Intermediaries and Clearing Organizations Proposed Rules, 66 FR

    14262, 14263 (March 9, 2001).

    The Commission also notes that it drafted the acceptable practices

    based on its experience in reviewing exchange rules and in considering

    related matters currently facing the Commission. The acceptable

    practices provided in the proposal are, in large measure, modeled on

    exchange rules that have previously been found to satisfy the

    requirements of Core Principle 9. The Commission does not mean to imply

    that it will find other rules unacceptable. Indeed, some of the

    acceptable practices explicitly note that a DCM could adopt rules that

    differ from the acceptable practice, although any such deviation would

    still require the DCM and parties to trades to comply with Core

    Principle 9, as required by section 5(d)(1) of the Act.

    The Commission believes that its proposed issuance of guidance and

    acceptable practices will generally ease the burden on exchanges in

    complying with Core Principle 9. Without the adoption of these

    amendments, DCMs are without any meaningful guidance as to whether

    their requirements for trading off the centralized market comply with

    Core Principle 9. These amendments provide certainty for those rules

    that fall under an acceptable practice, while the burden for those that

    fall outside of the acceptable practices is no greater than before. The

    Commission believes that it would not be appropriate to lessen the

    specificity of the acceptable practices because doing so would render

    the guidance meaningless.

    C. General Changes to the Re-Proposed Amendments

    The amendments proposed in this rulemaking are in large measure

    substantively similar to what was proposed in the July 1, 2004 NPRM.

    This proposal, like its predecessor, strives to update the language of

    Regulation 1.38 to more accurately

    [[Page 54099]]

    identify the types of transactions that may lawfully be executed off of

    a contract market's centralized market and to simplify the language of

    the Regulation. The proposed language also updates Regulation 1.38 to

    make it clear that DCMs may self-certify (not just seek approval for)

    rules or rule amendments related to transactions off the centralized

    marketplace. This proposed amendment is consistent with section 5c(c)

    of the Act, which allows for the certification of any DCM rule or rule

    amendment.

    In addition, Regulation 1.38 requires, subject to certain

    exceptions, that all purchases and sales of a commodity for future

    delivery or a commodity option on or subject to the rules of a DCM

    should be executed by open and competitive methods. The implicit

    assumption in Regulation 1.38 is that trading should take place on the

    centralized market unless there is a compelling reason to allow certain

    transactions to take place off the centralized market. Similarly,

    exchange rules and policies that allow such transactions should ensure

    that the impact on the centralized market is kept to a minimum. For

    example, certain types of off-centralized market transactions, such as

    block trades and exchanges of futures for related positions, can create

    new positions or reduce prior positions. If these transactions become

    the exclusive or predominant method of establishing or offsetting

    positions in a particular market, it might jeopardize the centralized

    market's role in price discovery and would not comply with Core

    Principle 9, which provides that trading be competitive, open and

    efficient.\13\ Other types of off-centralized market transactions are

    bookkeeping in nature, such as transfer trades or office trades, which

    move existing positions between accounts. These transactions do not

    affect the price discovery mechanism of the centralized market because

    they do not establish or offset positions.

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    \13\ See also, section 3(a) of the Act, which finds that

    transactions subject to the Act provide ``a means for managing and

    assuming price risks, discovering prices, or disseminating pricing

    information through trading in liquid, fair and financially secure

    trading facilities.'' Using the example above, markets on which

    transactions are exclusively or predominantly carried out by blocks

    are not liquid markets. Furthermore, it has been questioned whether

    markets are fair if they do not offer viable centralized trading.

    This also calls into question such a market's compliance with

    designation criterion 3, 7 U.S.C. 7(b)(3), which requires the

    exchange to establish and enforce trading rules to ensure fair and

    equitable trading through the facilities of the contract market.

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    This proposed rulemaking also addresses the same four general

    topics under Core Principle 9 that were addressed in the July 1, 2004

    NPRM: Electronic trading systems, general provisions for transactions

    off the centralized market, block transactions, and the exchange of

    futures for a commodity or a derivatives position.

    The majority of changes made since the July 1, 2004 NPRM strive to

    do one of two things. First, the Commission has attempted to clarify

    any language that was ambiguous, particularly in response to questions

    raised in the comment letters. Second, the proposed acceptable

    practices under Core Principle 9 have been redrafted to more closely

    resemble the language of the acceptable practices for the other Core

    Principles. The Commission believes that in addition to harmonizing the

    language of the acceptable practices, these changes make the language

    of the acceptable practices easier to read.

    The Commission has made more significant changes to the proposed

    amendments in three areas, based on the comment letters received, as

    well as the Commission's own experience in administering Regulation

    1.38 and Core Principle 9. These three areas, discussed in more detail

    below, concern the appropriate minimum size of block trades; when block

    trades may be permitted between affiliated parties; and exchanges of

    futures for a commodity or derivatives position, including the

    permissibility of transitory exchanges of futures for a commodity or

    derivatives position (``transitory EFPs'').

    D. The Minimum Size of Block Trades

    In the July 1, 2004 NPRM the Commission proposed that an acceptable

    minimum size for block trades would be at a level larger than 90% of

    the transactions in a relevant market (``90% threshold'') or, for new

    contracts with no relevant market, 100 contracts. CME, CBOT, DRW, FIA

    and USFE all offered comments regarding those proposed acceptable

    practices. CME and CBOT disagreed with the Commission's proposed

    minimum sizes of the 90% threshold and 100 contracts: CME thought the

    numbers were arbitrary, unresponsive to market needs and inconsistent

    with the Commission's oversight role. Similarly, CBOT believed there

    may be instances where 90% or 100 contracts could be too high or not

    high enough. CBOT suggested that an acceptable minimum block trade size

    be at the point where the block would move the market or where the

    customer would not be able to obtain a fair price or fill the order on

    the centralized market.

    DRW suggested that the Commission clarify its intent that the

    minimum block trade size should be derived from the size of trades in

    the entire relevant market, which should include the central market,

    related derivatives markets and the cash market. DRW also suggested

    that using the 90% threshold would result in artificially low minimums

    because many transactions in the central market are often broken down

    into smaller trades at the same price. DRW suggested tying the minimum

    block trade size to the size of orders instead of trades or by

    developing a risk-based system that would consider both outright and

    spread transactions.

    USFE seemed to imply that the 90% threshold should be lower for

    options than for futures. USFE noted that options transactions,

    particularly combination trades, are more complex than futures trades

    and require more human intervention than other trades. The options

    market is therefore more conducive to trading off the centralized

    market. While USFE did not suggest a different minimum threshold for

    options, it indicated that more off-centralized-market trading of

    options was necessary until technology could accommodate complex

    options positions on the electronic trading screen.

    In response to these comments, as well as the Commission's own

    increased knowledge about block trades, the Commission is changing the

    proposed guidance and acceptable practices on this topic. In this

    regard, the Commission's guidance for determining appropriate minimum

    sizes relies on the purpose for allowing block trades. Block trades are

    allowed to be transacted off the centralized market for two reasons.

    First, prices attendant to the execution of large transactions on the

    centralized market may diverge from prevailing market prices that

    reflect supply and demand of the commodity. This is because the

    centralized market may not provide sufficient liquidity to execute

    large transactions without a significant risk premium, so that the

    prices of such trades tend to reflect, to a significant degree, the

    cost of executing the trade. Accordingly, reporting these prices as

    conventional market trades would be misleading to the public. Second,

    block trading facilitates hedging by providing a means for commercial

    firms to transact large orders without the need for significant price

    concessions and resulting price uncertainty for parties to the

    transaction that would occur if transacted on the centralized market.

    Using these reasons as guidance, block trades should be limited to

    large orders, where ``large'' is the number at which there is a

    reasonable expectation that

    [[Page 54100]]

    the order could not be filled in its entirety at a single price, but

    would need to be broken up and executed at different prices if

    transacted in the centralized marketplace. As such, the proposed

    guidance notes that minimum block trade sizes should be larger than the

    size at which a single buy or sell order is customarily able to be

    filled in its entirety at a single price (though not necessarily with a

    single counterparty) in that contract's centralized market, and

    exchanges should determine a fixed minimum number of contracts needed

    to meet this threshold.

    The Commission now believes that its previous means of determining

    an appropriate minimum size--the 90% threshold--may not be appropriate

    for all markets because this figure does not necessarily correspond

    with the size of the order that would move the market price. Because

    the determination of what constitutes a large trade will vary between

    DCMs, contracts and even over time, the acceptable practices will not

    set forth an explicit threshold, but will instead leave it to the DCMs

    to determine appropriate minimum sizes, based on the above purpose.\14\

    This new approach should also address DRW's concern that using trade

    size alone to determine a threshold might result in lower-than-

    appropriate minimum sizes, because breaking an order into several small

    trades ideally should not affect the overall volume or liquidity of the

    centralized market. Similarly, the presence of many small trades

    submitted by multiple traders will also not artificially lower the

    appropriate minimum block trade size. The Commission also understands

    that, as exchange volume migrates from floor trading to electronic

    trading, the average size of transactions tends to decrease, resulting

    in artificially low 90% thresholds and minimum block trade sizes that

    are too low given the criteria discussed above.

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    \14\ In this regard, the guidance could result in different DCMs

    arriving at different minimum size requirements for the same or

    similar futures contracts, if the liquidity and volume on each DCM

    is different.

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    One method by which DCMs could determine what number of contracts

    is an appropriate minimum size would be to assess the market liquidity

    (the number of contracts the centralized market is able to absorb at

    the best execution price) and market depth (which measures the

    potential price slippage if a large order were to be executed in the

    centralized market). For example, a DCM could examine a contract's

    market liquidity over time and determine that a certain size order in

    that contract could rarely, if ever, be filled in its entirety at the

    best price, and set a minimum block trade size based on this data. Such

    calculations should be re-examined periodically, as volume, liquidity

    and market depth change over time to ensure that a contract's minimum

    block trade size remains appropriate. Such an analysis would most

    easily be done for an electronically-traded contract, since trade data

    about the contract is easy to gather and analyze.

    Calculating a minimum size based on market liquidity and depth is

    not the only possible way to determine what size order should be

    considered ``large.'' DCMs could employ other methods to reasonably

    determine what size order would move the price in the centralized

    market. For instance, along with a review of trade sizes and/or order

    sizes, DCMs could interview experienced floor brokers and floor traders

    to determine what size order is generally too large to fill at a single

    price. This method might be most appropriate for open-outcry markets

    because DCMs will not have the same type of trade data generated by

    electronic trading platforms, and will not as easily be able to

    determine, based on electronic data, what size order is ``large.''

    For new contracts that have no trading history, a DCM should strive

    to set its initial minimum block trade size based on what the DCM

    reasonably believes will be a ``large'' order (i.e., the order size

    that would likely move the market price). So, for example, the DCM

    might base its initial minimum block trade size on sources of data

    other than transaction data in that particular contract such as

    transaction patterns in related futures or cash markets, the DCM's

    experience regarding other newly-launched contracts, and/or a survey of

    potential market users to determine how many contracts might be

    executed in a typical transaction. Where a DCM is unable to determine

    an appropriate minimum size (due, for instance, to the lack of data in

    other markets or other methods for estimating an appropriate minimum

    size), the Commission believes it would be an acceptable practice for a

    DCM to set the minimum block trade size at 100 contracts. In the past,

    the Commission has considered 100 contracts to be a reasonable figure

    to use as the minimum size until enough market data exist to allow that

    figure to be adjusted, if need be. Once there is adequate trade data to

    re-evaluate the minimum size, the DCM should ensure that it be adjusted

    to a level where a trade would move the centralized market, if traded

    there.

    In this regard, the Commission proposes as an acceptable practice

    that DCMs review the minimum size thresholds for block trades no less

    frequently than on a quarterly basis to ensure that the minimum sizes

    remain appropriate for each contract. As noted in the proposed

    guidance, such review should take into account the sizes of trades in

    the centralized market and the market's volume and liquidity. This

    review and any necessary adjustments should be made to both new and

    existing contracts. In addition, quarterly reviews of minimum block

    trade sizes should take into account whether the minimum sizes ensure

    that block trades remain the exception, rather than the rule. As noted

    above, transactions off the centralized market should remain an

    exception as the expectation is that most trading will occur on the

    centralized market. Exchanges that established their minimum sizes for

    block trades long ago may find they need to adjust their minimum sizes

    as a result of changes in volume, liquidity, or the typical sizes of

    transactions in the respective market.

    Finally, the Commission notes that DCMs are free to require a

    minimum size that is larger than what the guidance suggests a ``large''

    trade would be. They are not obligated to set the minimum size at the

    smallest acceptable minimum size.

    E. Block Trades Between Affiliated Parties

    Based on comment letters and the Commission's growing experience

    with implementing Core Principle 9, the Commission has determined to

    revise Regulation 1.38 and the related acceptable practices regarding

    block trades between affiliated parties. An affiliated party is a party

    that directly or indirectly through one or more persons, controls, is

    controlled by, or is under common control with another party. These

    proposed changes differ from the July 1, 2004 NPRM's treatment of block

    trades between affiliated parties.

    Block trades between affiliated parties may be permitted by DCMs,

    so long as appropriate safeguards are in place to guard against the

    heightened possibility that transactions between two closely related

    parties are more susceptible to abuse, such as setting unreasonable

    prices, artificially boosting volume, money passing, or wash trading.

    It is not always clear that two related parties are motivated solely by

    their own separable best interests, since they often both report to or

    are accountable to a single person or entity, and as such they may be

    encouraged by those in control of both sides of the transaction to

    engage in trading strategies that benefit from abusive trading

    practices. It is for this reason that the Commission believes it

    [[Page 54101]]

    is appropriate that DCMs that allow block trades between affiliates

    also include additional safeguards to guard against the heightened

    possibility of abuse, and that DCMs must have rules to ensure that

    these safeguards are satisfied.

    The Commission proposes to amend Regulation 1.38 by requiring that

    when block trades take place between affiliated parties: (i) The block

    trade price must be based on a competitive market price, either by

    falling within the contemporaneous bid/ask spread on the centralized

    market or calculated based on a contemporaneous market price in a

    related cash market; (ii) each party must have a separate and

    independent legal bona fide business purpose for engaging in the

    trades; and (iii) each party's decision to enter into the block trade

    must be made by a separate and independent decision-maker. Under the

    acceptable practices for Core Principle 9, a DCM could permit block

    trades between affiliated parties that meet these requirements and are

    otherwise appropriate parties to engage in block trading.\15\

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    \15\ Similarly, the proposed acceptable practices regarding the

    prices of block trades also include reference to Regulation 1.38 as

    it relates to block trades between affiliated parties.

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    The Commission believes these proposed requirements for block

    trades between affiliated parties strike an appropriate balance between

    making clear that such trades are allowable and ensuring that each

    party is acting independently when it agrees to enter into such a

    transaction. The requirement that affiliated parties who engage in a

    block trade meet objective criteria regarding that block trade will

    help guard against the possibility that such closely related parties

    might collude in some type of abuse.

    F. Exchange of Futures for a Commodity or for a Derivatives Position

    In the July 1, 2004 NPRM, the Commission proposed to include

    acceptable practices regarding the exchange of futures for a commodity

    or derivatives position (often referred to as an exchange-for-physical

    or EFP, although it also includes, but is not limited to, similar

    transactions such as exchanges-for-swaps or exchanges-for-risk).

    Specifically, the Commission proposed a definition of what constituted

    a bona fide EFP in the Core Principle 9 acceptable practices. The

    Commission received comments from FIA, CBOT and CME regarding these

    acceptable practices. Among other things, the commenters requested the

    Commission clarify that trades commonly known as ``transitory EFPs''

    are still permitted and that third parties may effect the cash portion

    of an EFP transaction.

    In response to these comments and other concerns that have arisen

    since the July 1, 2004 NPRM, the Commission is proposing to make two

    substantive amendments to its acceptable practices regarding exchanges

    of futures for a commodity or derivatives position. First, the

    Commission is proposing to expand the acceptable practices regarding

    EFPs' bona fides, pricing, reporting, and DCMs' publication of EFP

    transactions. Second, the Commission is proposing to make clear that

    transitory EFPs are permissible when each part of the transaction--the

    EFP itself and the related cash transaction--is a stand-alone, bona

    fide transaction.

    The Commission is proposing to offer general acceptable practices

    for exchange of futures for a commodity or derivatives position,

    including a definition of what constitutes a bona fide EFP, the pricing

    of the legs, the reporting of the transaction to the exchange, and the

    exchange's obligation, consistent with Regulation 16.01, to publicize

    daily the total quantity of exchanges of futures for a commodity or

    derivatives position. In response to the comment letters, the

    Commission is proposing to clarify in the text of the acceptable

    practices that a DCM may permit a third party to facilitate the

    transfer of the cash leg of an EFP, so long as the commodity or

    derivatives position is passed through to the party receiving the

    futures position. These provisions are meant to be consistent with

    previous publications by the Commission, including the 1987 EFP Report

    prepared by the Commission's then Division of Trading and Markets and

    the 1998 EFP Concept Release.\16\

    ---------------------------------------------------------------------------

    \16\ DIVISION OF TRADING AND MARKETS, REPORT ON EXCHANGES OF

    FUTURES FOR PHYSICALS (1987) (the 1987 EFP Report); 63 FR 3708 (Jan.

    26, 1998) (the 1998 EFP Concept Release).

    ---------------------------------------------------------------------------

    The essential elements of bona fide EFPs have been provided in the

    guidance to Core Principle 9 below. The proposed elements are found in

    current contract market ``exchange of futures'' rules and are based on

    the essential elements for bona fide EFPs detailed in the 1987 EFP

    Report.\17\ The elements include separate but integrally related

    transactions, an actual transfer of ownership of the commodity or

    derivatives position, and both legs transacted between the same two

    parties. The Commission notes that the determination whether an actual

    transfer of ownership has occurred will depend upon the facts and

    circumstances of each transaction. In each instance where an exchange

    of futures for a commodity or for a derivatives position is linked to

    another offsetting transaction, the particular facts and circumstances

    may warrant a determination that there was not an actual ownership

    transfer of each leg of the commodity or derivatives position.

    ---------------------------------------------------------------------------

    \17\ See generally, the 1987 EFP Report. See also, CBOT Rules

    331.08; CFE Rule 414; CME Rule 538; KCBT Rules 1128.00, 1128.02,

    1129.00, and 1129.02; MGE Rule 719; NYBOT Rules 4.12 and 4.13; NYMEX

    Rules 6.21, 6.21A and 6.21E; and OCX Rule 416.

    ---------------------------------------------------------------------------

    Further, the Commission is proposing that the acceptable practices

    relating to the bona fides of an EFP should apply to transitory EFPs as

    well. A transitory EFP involves both an EFP and an offsetting cash

    commodity transfer. For example, party A purchases the cash commodity

    from party B and then engages in an EFP whereby A sells the cash

    commodity back to B and receives a long futures position. As a result

    of these two transactions, the parties acquire futures positions but

    end up with the same cash market positions they had before the

    transaction.

    To be a legitimate transitory EFP, the cash transaction must be

    bona fide and the EFP itself must be bona fide. As with an EFP, a

    primary indicator of a bona fide cash transaction is the actual

    transfer of ownership of the cash commodity or position. In this

    regard, the cash leg of the transaction must be able to stand on its

    own as a commercially appropriate transaction, and may not be

    intrinsically linked to the EFP transaction. A cash commodity transfer

    that cannot stand on its own may indicate that there was no actual

    economic risk in the cash leg of the related EFP and may raise concerns

    about whether the EFP involved an ``exchange'' of futures contracts for

    cash commodity as required by Section 4c(a) of the Act. There must be

    no obligation on either party that the cash transaction will require

    the execution of a related EFP, or vice versa.

    G. Other Proposed Acceptable Practices

    The rest of the proposed acceptable practices are for the most part

    similar to what was proposed in the July 1, 2004 NPRM. As with the

    acceptable practices discussed more fully above, the Commission

    considered the comment letters when re-drafting these acceptable

    practices, and strove to clarify any ambiguities and make them easier

    to read. And, as in the July 1, 2004 NPRM, the Commission notes that

    these proposed acceptable practices are based in large measure on

    existing DCM rules.

    [[Page 54102]]

    1. Block Trade Prices

    In the July 1, 2004 NPRM, the Commission proposed acceptable

    practices regarding the prices of block trades. The most basic element

    of this acceptable practice is that prices be ``fair and reasonable.''

    In its comment letter, CBOT noted an inconsistency between the text of

    the July 1, 2004 NPRM proposed guidance and the preamble and also

    questioned whether ``circumstances'' of the party or market could or

    should be relevant in determining whether a block trade price is fair

    and reasonable. In this proposal, the Commission intends to eliminate

    the ambiguity and to make clear its belief that a DCM could permit

    ``circumstances'' to be a factor in determining whether a block trade

    price was fair and reasonable. Such an approach could include, for

    example, the participants' legitimate trading objectives or the

    condition of the market. The Commission does not believe that

    permitting such flexibility will harm the centralized market because,

    regardless of how a block trade price is determined, it must still be

    fair and reasonable. The ability to price the trade away from the

    centralized market is not a carte blanche to set unfair or unreasonable

    prices.

    2. Block Trade Reporting Times

    In the July 1, 2004 NPRM, the Commission proposed in its acceptable

    practices that block trades should be reported to the contract market

    within a reasonable period of time. In response, DRW made two

    suggestions: First, that reasonable reporting times for block trades

    should be as close to immediately after the completion of the trade as

    possible, with a maximum of no more than 5 minutes; and second, that

    parties to a block trade should not be allowed to trade in the

    centralized market until information about the block trade has been

    made public.

    The Commission will re-propose that block trades should be reported

    to the contract market within a reasonable period of time. The

    Commission declines to establish a specific length of time in order to

    allow exchanges to determine what an appropriate length of time should

    be on a contract-by-contract basis. But the Commission notes that most

    current DCM rules require reporting of block trades within 5

    minutes.\18\ A small number of DCM rules allow as many as 15 minutes,

    but the Commission understands these are limited to contracts that have

    very high block trade minimum size thresholds or where the contracts

    are typically traded as part of large and complex spreads, requiring

    more time to double check details and convey the information to the

    exchange.\19\ When determining length of time for parties to report

    block trades, DCMs should consider the importance of providing

    information about block trades to the market as well as the potential

    for abuses, such as front running, and whether longer reporting periods

    may heighten the potential for abuse. Additionally, staff has

    previously noted that allowing a few minutes' delay between the time a

    block trade is executed and reported will allow the market price to

    continue to respond to prevailing supply and demand factors, and not be

    unduly influenced by the block itself. In other words, a reporting

    delay will help the centralized market avoid the momentary price and

    volume distortion that would occur if large trades were made on the

    centralized market in the first place. In regards to whether parties to

    a block trade may trade in the centralized market before the block

    trade information is published, the Commission believes that the

    reporting window offers parties to the block trade an opportunity to

    hedge or offset the trade, which in turn supplies information to the

    centralized market. As such, the Commission believes that compliance

    with the Core Principles does not require that DCMs restrict the

    ability of parties to a block trade from making transactions on the

    central marketplace before the block trade is reported. DCMs, however,

    are permitted to forbid such trading.

    ---------------------------------------------------------------------------

    \18\ See, e.g., CBOT Rule 331.05(d); CME Rule 526(F); NYMEX Rule

    6.21C.

    \19\ See, e.g., CME Rule 526(F).

    ---------------------------------------------------------------------------

    3. Publication of Transaction Details

    The Commission is re-proposing that DCMs would publicize details

    about transactions off the centralized market immediately upon the

    receipt of the transaction report. The Commission wishes to clarify

    that it does not intend to impose new publication requirements on DCMs

    in regards to trades made off the centralized market beyond what is

    required by the Commission's regulations. So, for example, DCMs would

    need to publish the total number of exchanges of futures for a

    commodity or for a derivatives position, as required by Commission

    Regulation 16.01. But there would be no similar requirement to publish

    office trades or transfer trades.

    Similarly, the proposed guidance also identifies publication of

    block trade details by DCMs immediately upon receipt of block trade

    reports as an acceptable practice.\20\ The proposed acceptable

    practices also would require the DCM to identify block trades on its

    trade register.

    ---------------------------------------------------------------------------

    \20\ This also is an element of compliance with Designation

    Criterion 3 (Fair and Equitable Trading) and Core Principle 8 (Daily

    Publication of Trading Information).

    ---------------------------------------------------------------------------

    4. Recordkeeping

    Current Commission Regulation 1.38(b) provides that every person

    handling, executing, clearing, or carrying trades, transactions or

    positions that are not competitively executed, must identify and mark

    by appropriate symbol or designation all such transactions or contracts

    and all associated orders, records, and memoranda. In addition to

    updating the language of Regulation 1.38(b), the proposed amendments

    add this requirement to the guidance under Core Principle 9, in order

    to provide consolidated guidance regarding recordkeeping practices

    pertaining to transactions off the centralized market.

    Similarly, acceptable block trade rules would require parties to,

    and members facilitating, a block trade to keep appropriate records.

    Appropriate block trade records would comply with the requirements of

    Core Principle 10 and Core Principle 17. Records kept in accordance

    with the requirements of Statement No. 133 (``Accounting for Derivative

    Instruments and Hedging Activities''), issued by the Financial

    Accounting Standards Board (``FASB''), would be satisfactory.\21\

    Acceptable block trade rules would require that block orders be

    recorded by the member and time-stamped with both the time the order

    was received by the member and the time the order was executed. When

    requested by the exchange, the Commission or the Department of Justice,

    parties to, and members facilitating, a block trade shall provide

    records to document that the block trade is executed in accordance with

    contract market rules.

    ---------------------------------------------------------------------------

    \21\ FASB Statement No. 133 provides guidance on the use of

    accounting for corporate hedge activity involving derivative

    transactions. The statement includes guidance on documenting the

    hedging relationship.

    ---------------------------------------------------------------------------

    5. Testing of Automated Trading Systems

    The guidance for Core Principle 9 also addresses the testing and

    review of automated trading systems. Currently, the guidance states

    that acceptable testing of automated systems should be ``objective,''

    and calls for the provision of ``objective'' test results to the

    Commission. The proposed guidance would also call for the provision to

    the

    [[Page 54103]]

    Commission of test results of any ``non-objective'' testing carried out

    by or for a DCM (such as informal in-house reviews) regarding the

    system functioning capacity or security of any automated trading

    systems. Although the results of ``non-objective'' testing would be of

    more limited use, the Commission believes that test results of any

    ``non-objective'' testing carried out by or for the DCM should also be

    provided to the Commission.

    6. Parties to a Block Trade

    The Commission is proposing that block trade parties are required

    to be eligible contract participants (``ECPs'') as that term is defined

    in Section 1a(12) of the Act, although commodity trading advisors

    (``CTAs'') and investment advisors having over $25 million in assets

    under management, including foreign persons performing equivalent

    roles, are allowed to carry out block trades for non-ECP customers.

    A majority of exchanges that permit block trading prohibit persons

    from effecting block trades on behalf of customers unless the person

    receives a customer's explicit instruction or prior consent to do

    so.\22\ The proposed rulemaking incorporates this prohibition as an

    acceptable practice.

    ---------------------------------------------------------------------------

    \22\ See CME Rule 526(C), CFE Rule 415(a)(i), CBOT Rule

    331.05(a), NYBOT Rule 4.31(a)(ii)(A), OCX Rule 417(a)(i), and USFE

    Rule 415(c).

    ---------------------------------------------------------------------------

    III. Request for Comment

    The Commission requests comment on all aspects of this proposal.

    IV. Related Matters

    A. Regulatory Flexibility Act

    The Regulatory Flexibility Act \23\ requires federal agencies, in

    proposing rules, to consider the impact of those rules on small

    businesses. The rule amendments proposed herein will affect DCMs, FCMs,

    CTAs and large traders. The Commission has previously established

    certain definitions of ``small entities'' to be used by the Commission

    in evaluating the impact of its rules on small entities in accordance

    with the RFA.\24\ The Commission has previously determined that

    DCMs,\25\ registered FCMs,\26\ and large traders \27\ are not small

    entities for purposes of the RFA. With respect to CTAs, the Commission

    has determined to evaluate within the context of a particular rule

    proposal whether CTAs would be considered ``small entities'' for

    purposes of the Regulatory Flexibility Act and, if so, to analyze the

    economic impact on the affected entities of any such rule at that

    time.\28\ The Commission believes that the instant proposed rules will

    not place any new burdens on entities that would be affected hereunder,

    and the Commission does not expect the proposed amendments in most

    cases to cause persons to change their current methods of doing

    business. This is because requirements under this proposal, if adopted,

    would be similar to most existing DCM requirements.

    ---------------------------------------------------------------------------

    \23\ 5 U.S.C. 601 et seq.

    \24\ 47 FR 18618-21 (Apr. 30, 1982).

    \25\ Id. at 18618-19.

    \26\ Id. at 18619-20.

    \27\ Id. at 18620.

    \28\ Id. at 18620.

    ---------------------------------------------------------------------------

    Accordingly, the Commission does not expect the rules, as proposed

    herein, to have a significant economic impact on a substantial number

    of small entities. Therefore, the Chairman, on behalf of the

    Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the

    proposed amendments will not have a significant economic impact on a

    substantial number of small entities. The Commission invites the public

    to comment on this finding and on its proposed determination that the

    entities covered by these rules would not be small entities for

    purposes of the Regulatory Flexibility Act.

    B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 imposes certain requirements on

    federal agencies (including the Commission) in connection with their

    conducting or sponsoring any collection of information as defined by

    the PRA. The proposed rule amendments do not require a new collection

    of information on the part of any entities subject to these rules.

    Accordingly, for purposes of the Paperwork Reduction Act of 1995, the

    Commission certifies that these rule amendments do not impose any new

    reporting or recordkeeping requirements.

    C. Cost-Benefit Analysis

    Section 15 of the Act, as amended by section 119 of the CFMA,

    requires the Commission to consider the costs and benefits of its

    action before issuing a new regulation. The Commission understands

    that, by its terms, Section 15 does not require the Commission to

    quantify the costs and benefits of a new regulation or to determine

    whether the benefits of the proposed regulation outweigh its costs. Nor

    does it require that each proposed regulation be analyzed in isolation

    when that regulation is a component of a larger package of regulations

    or of rule revisions. Rather, Section 15 simply requires the Commission

    to ``consider the costs and benefits'' of its action.

    Section 15(a) further specifies that costs and benefits shall be

    evaluated in light of five broad areas of market and public concern:

    Protection of market participants and the public; efficiency,

    competitiveness, and financial integrity of futures markets; price

    discovery; sound risk management practices; and other public interest

    considerations. Accordingly, the Commission could, in its discretion,

    give greater weight to any one of the five enumerated areas of concern

    and could, in its discretion, determine that, notwithstanding its

    costs, a particular regulation was necessary or appropriate to protect

    the public interest, to effectuate any of the provisions, or to

    accomplish any of the purposes of the Act.

    The proposed amendments constitute a package of amendments to

    Regulation 1.38 and to guidance that the Commission originally

    promulgated to implement the CFMA. The amendments are proposed in light

    of past experience with the implementation of the CFMA and are intended

    to facilitate increased flexibility and consistency. Some sections of

    the proposed amendments merely clarify or make explicit past Commission

    decisions concerning transactions off the centralized market.

    As most provisions incorporate DCM rules previously approved by the

    Commission or submitted to the Commission under its self-certification

    procedures, the proposed amendments would not, in most cases, impose

    new costs on DCMs or market participants. The great majority of current

    DCM rules already meet the acceptable practices proposed. Furthermore,

    these amendments incorporate standards that the Commission has

    previously determined protect market participants and the public, the

    financial integrity or price discovery function of the markets, and

    sound risk management practices. Moreover, the additional clarification

    of acceptable practices provides a benefit to markets and market

    participants. In addition, the amendments are expected to benefit

    efficiency and competition by providing more detailed guidance as to

    acceptable means of meeting the applicable designation criteria and

    core principles, thus allowing a greater degree of legal certainty to

    the markets and market participants.

    After considering the five factors enumerated in the Act, the

    Commission has determined to propose the rules and rule amendments set

    forth below. The Commission invites public comment on its application

    of the cost-benefit provision. Commenters also are invited to submit

    any data that they may have quantifying the costs and benefits of the

    [[Page 54104]]

    proposed rules with their comment letters.

    List of Subjects

    17 CFR Part 1

    Block transactions, Commodity futures, Contract markets,

    Transactions off the centralized market, Reporting and recordkeeping

    requirements.

    17 CFR Part 38

    Block transactions, Commodity futures, Contract markets,

    Transactions off the centralized market, Reporting and recordkeeping

    requirements.

    In consideration of the foregoing, the Commission hereby proposes

    to amend Chapter I of Title 17 of the Code of Federal Regulations as

    follows:

    PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    1. The authority citation for part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h,

    6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a,

    13a-1, 16, 16a, 19, 21, 24, and 24, as amended by the Commodity

    Futures Modernization Act of 2000, Appendix E of Pub L. 106-554, 114

    Stat. 2763 (2000).

    2. Section 1.38 is revised to read as follows:

    Sec. 1.38 Execution of transactions.

    (a) Transactions on the centralized market. All purchases and sales

    of any commodity for future delivery, and of any commodity option, on

    or subject to the rules of a designated contract market, shall be

    executed openly and competitively by open outcry, or posting of bids

    and offers, or by other equally open and competitive methods, in a

    place or through an electronic system provided by the contract market,

    during the hours prescribed by the contract market for trading in such

    commodity or commodity option.

    (b) Transactions off the centralized market; requirements.

    (1) Notwithstanding paragraph (a) of this section, transactions may

    be executed off the centralized market, including by transfer trades,

    office trades, block trades, inter-exchange spread transactions, or

    trades involving the exchange of futures for commodities or for

    derivatives positions, if transacted in accordance with written rules

    of a contract market that provide for execution away from the

    centralized market and that have been certified to or approved by the

    Commission. Every person handling, executing, clearing, or carrying the

    trades, transactions or positions described in this paragraph shall

    comply with the rules of the appropriate contract market and

    derivatives clearing organization, including to identify and mark by

    appropriate symbol or designation all such transactions or contracts

    and all orders, records, and memoranda pertaining thereto.

    (2) Block trades between affiliated parties; requirements. An

    affiliated party is a party that directly or indirectly through one or

    more persons, controls, is controlled by, or is under common control

    with another party. In addition to the other requirements of this

    section, block trades between affiliated parties are permitted only in

    accordance with written rules of a contract market that provide that:

    (i) The block trade price must be based on a competitive market

    price, either by falling within the contemporaneous bid/ask spread on

    the centralized market or calculated based on a contemporaneous market

    price in a related cash market,

    (ii) Each party must have a separate and independent legal bona

    fide business purpose for engaging in the trades, and

    (iii) Each party's decision to enter into the block trade must be

    made by a separate and independent decision-maker.

    PART 38--DESIGNATED CONTRACT MARKETS

    3. The authority citation for part 38 is revised to read as

    follows:

    Authority: 7 U.S.C. 2, 5, 6, 6c, 7 and 12a, as amended by the

    Commodity Futures Modernization Act of 2000, Appendix E of Pub. L.

    106-554, 114 Stat. 2763 (2000).

    4. Appendix B to Part 38 is revised to read as follows:

    Appendix B to Part 38--Guidance on, and Acceptable Practices in,

    Compliance With Core Principles

    Core Principle 9 of section 5(d) of the Act: EXECUTION OF

    TRANSACTIONS--The board of trade shall provide a competitive, open,

    and efficient market and mechanism for executing transactions.

    (a) Guidance.

    (1) Transactions on the centralized market.

    (i) Purchases and sales of any commodity for future delivery,

    and of any commodity option, on or subject to the rules of a

    contract market shall be executed openly and competitively by open

    outcry, by posting of bids and offers, or by other equally open and

    competitive methods, in a place or through an electronic system

    provided by the contract market, during the hours prescribed by the

    contract market for trading in such commodity or commodity option.

    (ii) A competitive and open market's mechanism for executing

    transactions includes a contract market's methodology for entering

    orders and executing transactions.

    (iii) Appropriate objective testing and review of a contract

    market's automated systems should occur initially and periodically

    to ensure proper system functioning, adequate capacity and security.

    A designated contract market's analysis of its automated system

    shall address compliance with appropriate principles for the

    oversight of automated systems, ensuring proper system

    functionality, adequate capacity and security.

    (2) Transactions off the centralized market.

    (i) In order to facilitate the execution of transactions,

    transactions may be executed off the centralized market, including

    by transfer trades, office trades, block trades, inter-exchange

    spread transactions, or trades involving the exchange of futures for

    a commodity or for a derivatives position, if transacted in

    accordance with written rules of a contract market that specifically

    provide for execution of such transactions away from the centralized

    market and that have been certified to or approved by the

    Commission.

    (ii) Every person handling, executing, clearing, or carrying

    trades off the centralized market shall comply with the rules of the

    applicable designated contract market and derivatives clearing

    organization, including to identify and mark by appropriate symbol

    or designation all such transactions or contracts and all orders,

    records, and memoranda pertaining thereto.

    (iii) A designated contract market that determines to allow

    trades off the centralized market shall ensure that such trading

    does not operate in a manner that compromises the integrity of price

    discovery on the centralized market or facilitate illegal or non-

    bona fide transactions.

    (3) Block trades-minimum size.

    (i) When determining the number of contracts that constitutes

    the appropriate minimum size for block trades, a contract market

    should ensure that block trades are limited to large transactions

    and that the minimum size is appropriate for that specific contract,

    by applying the principles set forth in this section. For any

    contract that has been trading for one calendar quarter or longer,

    the acceptable minimum block trade size should be a number larger

    than the size at which a single buy or sell order is customarily

    able to be filled in its entirety at a single price in that

    contract's centralized market. Factors to consider in determining

    what constitutes a large transaction could include an analysis of

    the market's volume, liquidity and depth; a review of typical trade

    sizes and/or order sizes; and input from floor brokers, floor

    traders and/or market users. For any contract that has been listed

    for trading for less than one calendar quarter, an acceptable

    minimum block trade size in such contract should be the size of

    trade the exchange reasonably anticipates will not be able to be

    filled in its entirety at a single price in that contract's

    centralized market. An appropriate minimum size could be estimated

    based on centralized market data in a related futures contract, the

    same contract traded on another exchange, or trading activity in the

    underlying cash market. The exchange could also consider the

    anticipated volume,

    [[Page 54105]]

    liquidity and depth of the contract; input from potential market

    users; or consider that exchange's experience with offering similar

    new contracts. The minimum size thresholds for block trades should

    be reviewed periodically to ensure that the minimum size remains

    appropriate for each contract. Such review should take into account

    the sizes of trades in the centralized market and the market's

    volume and liquidity.

    (b) Acceptable practices.

    (1) General matters relating to trade execution facilities.

    (i) General provisions. [Reserved]

    (ii) Electronic trading systems.

    (A) The guidelines issued by the International Organization of

    Securities Commissions (IOSCO) in 1990 (which have been referred to

    as the ``Principles for Screen-Based Trading Systems''), and adopted

    by the Commission on November 21, 1990 (55 FR 48670), as

    supplemented in October 2000, are appropriate guidelines for a

    designated contract market to apply to electronic trading systems.

    (B) Any objective testing and review of the system should be

    performed by a qualified independent professional. A professional

    that is a certified member of the Information Systems Audit and

    Control Association experienced in the industry is an example of an

    acceptable party to carry out testing and review of an electronic

    trading system.

    (C) Information gathered by analysis, oversight, or any program

    of testing and review of any automated systems regarding system

    functioning, capacity and security must be made available to the

    Commission upon request.

    (iii) Pit trading. [Reserved]

    (2) Transactions off the centralized market.

    (i) General provisions.

    (A) Allowable trades. Acceptable transactions off the

    centralized market include: transfer trades, office trades, block

    trades, inter-exchange spread transactions or trades involving the

    exchange of futures for commodities or for derivatives positions, if

    transacted in accordance with written rules of a contract market

    that specifically provide for execution away from the centralized

    market and that have been certified to or approved by the

    Commission.

    (B) Reporting. Transactions executed off the centralized market

    should be reported to the contract market within a reasonable period

    of time.

    (C) Publication. The contract market should publicize details

    about block trade transactions immediately upon the receipt of the

    transaction report and publicize daily the total quantity of the

    exchange of futures for commodities or for derivatives positions and

    the total quantity of the block trades that are included in the

    total volume of trading, as required by Sec. 16.01 of this chapter.

    (D) Recordkeeping. Parties to, and members facilitating,

    transactions off the centralized market should keep appropriate

    records. Appropriate recordkeeping for transactions off the

    centralized market would comply with Core Principle 10 and Core

    Principle 17.

    (E) Identification of trades. Section 1.38(b) of this chapter

    establishes the requirements regarding the identification of trades

    off the centralized market. It requires contract market rules to

    require every person handling, executing, clearing, or carrying

    trades, transactions or positions that are executed off the

    centralized market, including transfer trades, office trades, block

    trades or trades involving the exchange of futures for a commodity

    or for a derivatives position, to identify and mark by appropriate

    symbol or designation all such transactions or contracts and all

    orders, records, and memoranda pertaining thereto.

    (F) Identification in the trade register. The contract market

    should identify transactions executed off the centralized market in

    its trade register, using separate indicators for each such type of

    transaction.

    (ii) Block trades.

    (A) Acceptable minimum block trade size.

    (a) New contracts or contracts that have been listed for trading

    for less than one calendar quarter. If an exchange has no reasonable

    basis upon which to estimate an initial minimum size, a minimum

    block trade size of 100 contracts would be appropriate.

    (b) Periodic review. The minimum size thresholds for block

    trades should be reviewed no less frequently than on a quarterly

    basis to ensure that the minimum size remains appropriate for each

    contract.

    (B) Appropriate parties.

    (a) Acceptable block trade parties should be limited to eligible

    contract participants. However, contract market rules could also

    allow a commodity trading advisor registered pursuant to Section 4m

    of the Act, or a principal thereof, including any investment advisor

    who satisfies the criteria of Sec. 4.7(a)(2)(v) of this chapter, or

    a foreign person performing a similar role or function and subject

    as such to foreign regulation, to transact block trades for

    customers who are not eligible contract participants, if such

    commodity trading advisor, investment advisor or foreign person has

    more than $25,000,000 in total assets under management.

    (b) Affiliated parties. An affiliated party is a party that

    directly or indirectly through one or more persons, controls, is

    controlled by, or is under common control with another party.

    Section 1.38(b) of this chapter establishes the requirements

    regarding block trades between affiliated parties. Contract market

    rules could permit block trades between affiliated parties that meet

    the requirements of Regulation 1.38 and are otherwise appropriate

    parties.

    (C) Aggregation of orders. The aggregation of orders for

    different accounts in order to satisfy the minimum size requirement

    should be prohibited except in appropriate circumstances.

    Aggregation would be acceptable if done by a commodity trading

    advisor registered pursuant to Section 4m of the Act, or a principal

    thereof, including any investment advisor who satisfies the criteria

    of Sec. 4.7(a)(2)(v) of this chapter, or a foreign person

    performing a similar role or function and subject as such to foreign

    regulation, if such commodity trading advisor, investment advisor or

    foreign person has more than $25,000,000 in total assets under

    management.

    (D) Acting for a customer. A person should transact a block

    trade on behalf of a customer only when the person has received an

    instruction or prior consent to do so from the customer.

    (E) Recordkeeping. Parties to, and members facilitating, a block

    trade should keep appropriate records. Appropriate block trade

    records would comply with Core Principle 10 and Core Principle 17.

    Records kept in accordance with the requirements of FASB Statement

    No. 133 (``Accounting for Derivative Instruments and Hedging

    Activities'') would be acceptable records. Block trade orders must

    be recorded by the member and time-stamped with both the time the

    order was received and the time the order was reported, and must

    indicate when block trades are between affiliated parties. When

    requested by the exchange, the Commission or the Department of

    Justice, parties to, and members facilitating, a block trade shall

    provide records to document that the block trade is executed in

    conformance with contract market rules.

    (F) Reporting. Block trades should be reported to the contract

    market within a reasonable period of time.

    (G) Publication. The contract market should publicize details

    about the block trade immediately upon the receipt of the

    transaction report and publicize daily the total quantity of the

    block trades that are included in the total volume of trading, as

    required by Sec. 16.01 of this chapter.

    (H) Identification in the trade register. The contract market

    should identify block trades as such on its trade register, and

    should identify when block trades are between affiliated parties.

    (I) Pricing. (a) Block trades between non-affiliated parties

    should be at a price that is fair and reasonable. Consideration of

    whether a block trade price is fair and reasonable could take into

    account the size of the block plus the price and size of other

    trades in any relevant markets at the applicable time, or the

    circumstances of the market or the parties to the block trade.

    Relevant markets could include the contract market itself, the

    underlying cash markets and/or other related futures or options

    markets. If a contract market rule requiring a fair and reasonable

    price includes the circumstances of the parties or of the market, a

    block trade participant could execute a block transaction at a price

    that was away from the market provided that the participant retains

    documentation to demonstrate that the price was indeed fair and

    reasonable under the participant's or market's particular

    circumstances.

    (b) Block trades between affiliated parties are subject to the

    pricing requirements of Sec. 1.38(b) of this chapter.

    (iii) Exchange of futures for commodities or for derivatives

    positions.

    (A) Bona fide exchange of futures for commodities or for

    derivatives positions. The exchange of futures for commodities or

    for derivatives positions would include separate but integrally

    related transactions involving the same or a related commodity, with

    price correlation and quantitative equivalence of the futures and

    cash legs. An exchange of futures for commodities or for derivatives

    positions would be between a buyer of futures who is the seller of

    the corresponding commodity or derivatives position and a

    [[Page 54106]]

    seller of futures who is the buyer of the corresponding commodity or

    derivatives position. A third party could be permitted to facilitate

    the purchase and sale of the commodity or derivatives position as

    long as the commodity or derivatives position is passed through to

    the party that receives the futures position. The transaction would

    have to result in an actual transfer of ownership of the commodity

    or derivatives position. It also would have to be between parties

    with different beneficial owners or under separate control, who had

    possession, right of possession, or right to future possession of

    the commodity or derivatives position prior to the trade, the

    ability to perform the transaction, and resulting in a transfer of

    title.

    (B) Pricing. The price differential between the futures leg and

    the commodities leg or derivatives position should reflect

    commercial realities, and at least one leg of the transaction should

    be priced at the prevailing market price.

    (C) Transitory exchange of futures for commodities or for

    derivatives positions. Parties to an exchange of futures for

    commodities or for derivatives positions could be permitted to

    engage in a separate but related cash transaction that offsets the

    cash leg of the exchange of futures for commodities or for

    derivatives positions. The related cash transaction would have to

    result in an actual transfer of ownership of the commodity or

    derivatives position and demonstrate other indicia of being a bona

    fide transaction as described in paragraph (a). The cash transaction

    must be able to stand on its own as a commercially appropriate

    transaction, with no obligation on either party that the cash

    transaction be dependent upon the execution of the related exchange

    of futures for commodities or for derivatives positions, or vice

    versa.

    (D) Reporting. Exchanges of futures for commodities or for

    derivatives positions should be reported to the contract market

    within a reasonable period of time.

    (E) Publication. The contract market would publicize daily the

    total quantity of exchanges of futures for commodities or for

    derivatives positions that are included in the total volume of

    trading, as required by Sec. 16.01 of this chapter.

    (iv) Office trades. [Reserved]

    (v) Transfer trades. [Reserved]

    Issued in Washington, DC on September 12, 2008 by the

    Commission.

    David Stawick,

    Secretary of the Commission.

    [FR Doc. E8-21865 Filed 9-17-08; 8:45 am]

    BILLING CODE 6351-01-P

    Last Updated: September 18, 2008



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