Joseph B. Dial, Chairman
Nancy Danielson, National Farmers Union
Jim Sanford, National Cotton Council of America
Glenn Moeller, National Corn Growers Association
Robert White, National Grange
Paul Hitch, National Cattlemen's Association
Robert Bold, National Association of Wheat Growers
Scott Hackett, Millers' National Federation
Trenna Grabowski, American Agri-Women
Neal Gillen, American Cotton Shippers Association
Mark Scanlan, Independent Bankers Association of America
Richard Ellinghuysen, National Farmers Organization
Kate Coler, American Bankers Association
Steve Patton, National Council of Farmer Cooperatives
Bill Dodds, National Grain and Feed Association
Jim Lindau, National Grain Trade Council
Gary Hellerich, American Soybean Association
Ken Ackerman, USDA-Risk Management Agency
Steve Oman, American Farm Bureau Federation
Dave Lyons, North American Export Grain Assn.
Todd Vanhoose, Farm Credit Council
Gary Madson, National Pork Producers Council
Dan Shaw, National Grain Sorgum Producers

C O N T E N T S

PAGE

Welcoming Remarks

Commissioner Joseph B. Dial
Chairman, Agricultural Advisory Committee

The CFTC "White Paper" on the Prohibition of Agricultural Trade Options
Paul Architzel, Chief Counsel
Greg Kuserk, Industry Economist
Division of Economic Analysis

"A Day at the Commission"
Examples of Issues CFTC Deals with Day-to-Day
Susan Bovee, Associate Director, Division of Enforcement
Steve Braverman, Associate Director Rule Enforcement, Division of Trading and Markets
David Fickert, Industry Economist, Division of Economic Analysis

CFTC's "Fast Track" Contract and Rule Approval Process
Paul Architzel
David Van Wagner, Special Counsel, Contract Markets Section, Division of Trading and Markets

Approval Process to Establish New Futures Exchange
Alan Seifert, Deputy Director, Contract Markets Section, Division of Trading and Markets
Fred Linse, Chief, Agricultural Commodities Unit, Division of Economic Analysis

Report on USDA's Risk Management Education Program - Summit on September
14, 1997 in St. Louis, Missouri
Ken Ackerman, Administrator, Risk Management Agency, U.S. Department of Agriculture

Presentation by National Cotton Council of America on their Risk Management Education Program
Kevin Brinkley, Economist, National Cotton Council of America

The CFTC-Agricultural Advisory Committee Website - http://www.cftc.gov/cftc/cftccommittees.htm

Comments on the Proposed Legislation to Amend the Commodity Exchange Act
Randy Green, Staff Director, U.S. Senate Committee on Agriculture, Nutrition and Forestry
Stacy Carey, Staff Director, U.S. House of Representatives Committee on Agriculture, Subcommittee on Risk Management and Specialty Crops

Status of New Delivery Points for CBT Grain Contracts including the Wheat Contract
Dr. Craig Pirrong, Washington University at St. Louis, CBOT Grain Delivery Task Force 188

- - -

P R O C E E D I N G S

CHAIRMAN DIAL: If everyone would come in and take their seats, we would like to get started. We have a very, very full agenda with lots of interesting topics, and we want everyone to have an opportunity to express themselves and talk about these subjects to the fullest extent possible. Our Chairperson, Brooksley Born, is speaking to the National Grain Trade Council today in Arizona. She asked me to bid you welcome on her behalf and express to you her regrets that she wasn't able to be here herself in order to do that, and to also tell you what a valuable role the Agricultural Advisory Committee plays in CFTC's deliberations and considerations.

We have one of our Commissioners with us at the present time. I'd like to recognize Commissioner John Tull. John, would you stand up so folks could see you? Thank you, sir. John, of course, has a distinguished career that he put on hold to serve as a CFTC Commissioner, a distinguished career in agriculture, and has received quite a number of awards and has been recognized by several industries, as a matter of fact, for his yeoman service in agriculture.

I want to recognize and to thank my staff. This type of meeting takes a considerable amount of time and effort and coordination, and obviously we couldn't do it without them. Kimberly Harter, who most of you have occasion to visit with from time to time, is my Administrative Assistant. She is the one that puts all of this together and makes the trains run on time and sees that all of the equipment and everything is set up. John Foltz is my Special Assistant. Don Heitman is my Legal Counsel. If it wasn't for Don, I guess I'd stay in hot water all the time instead of just part of the time.

Let's begin now by quickly going around the table, and the members that are seated here at the table, if you would identify yourself and the organization that you're with, and if this is your first meeting, well, tell us that so we will know, so the folks in the audience will know, those of you who are serving your organization at this first meeting for you. So Steve, we'll start with you.

MR. OMAN: Steve Oman representing American Farm Bureau.

CHAIRMAN DIAL: Be sure and turn on your mikes and pull them as close to you as you can.

MR. OMAN: Steve Oman representing the American Farm Bureau.

MR. ACKERMAN: I am Ken Ackerman, the Administrator of the Risk Management Agency at USDA.

MR. HELLERICH: I'm Gary Hellerich, representing the American Soybean Association.

MR. LINDAU: I'm Jim Lindau sitting in for Bob Peterson for the National Grain Trade Council. Normally I'm with Minneapolis Grain Exchange.

MR. DODDS: Bill Dodds, representing the National Grain and Feed, and Kendall Keith, president of the National Grain and Feed, is with us today.

MR. PATTON: I'm Steve Patton representing National Council of Farmer Cooperatives.

MS. COLER: I'm Kate Coler with the American Bankers Association, and this is my first meeting.

MR. ELLINGHUYSEN: I am Richard Ellinghuysen representing National Farmers Organization.

MR. SCANLAN: I'm Mark Scanlan with the Independent Bankers Association.

MR. SHAW: I'm Dan Shaw with the National Grain Sorghum Producers sitting in for Bill Kubecka, who is from Texas and about two months late planning and decided he better stay down there and finish planning his crop.

MR. SANFORD: I'm Jim Sanford, representing the National Cotton Council.

MR. MOELLER: I'm Glenn Moeller. I represent the National Corn Growers Association, and this is my first meeting.

MR. WHITE: I'm Robert White, and I represent the National Grange.

MR. HITCH: I'm Paul Hitch. I'm chairman of the Live Cattle Marketing Committee of National Cattlemen's Beef Association, and I represent them.

MR. BOLD: I'm Robert Bold, representing National Association of Wheat Growers.

MR. HACKETT: I'm Scott Hackett representing Millers' National Federation.

MS. GRABOWSKI: I'm Trenna Grabowski, representing American Agri-Women and our national president, Jane Pettibone, is here today.

CHAIRMAN DIAL: Delighted to have you.

MR. GILLEN: I'm Neal Gillen. I'm Executive Vice President of the American Cotton Shippers Association.

CHAIRMAN DIAL: Before we get down to business, I think it's appropriate for me to advise you that this past month, the Commission and the staff of CFTC lost a valuable staff member and a good friend when Blake Imel suffered an apparent heart attack while hiking in one of his favorite parks.

Blake held a Bachelor's Degree in Agricultural Economics from Purdue University and a doctorate in agricultural economics from the University of Wisconsin. He worked for USDA's Economic Research Service and the commission's predecessor agency, USDA's Commodity Exchange Authority, before joining the CFTC in 1974.

Over his 22 years of outstanding service with the Commission, Blake's institutional memory, experience and expertise were invaluable to all who served with him and to the futures industry we regulate. Blake lost his parents as a teenager and went to live with his Uncle Ralph and Aunt Phyllis on their farm near Frankfurt, Indiana. As Deputy and for the past two years Acting Director of the Division of Economic Analysis, Blake was an integral part of the Commission's major policy decisions concerning the futures industry and agriculture.

He never failed to reflect on how those decisions would affect Uncle Ralph. To Blake, Uncle Ralph was symbolic of this country's farmers, and Blake understood and sincerely cared about all of them. As long as there is a CFTC, Blake Imel's legacy of concern for American agriculture will endure. I would ask if you would join me in a moment of silence in the memory of and respect of our friend Blake Imel.

[Moment of silence observed.]

CHAIRMAN DIAL: Thank you very much. The first item on your agenda is the CFTC White Paper on the Prohibition of Agricultural Trade Options. In a moment, Paul Architzel, the Chief Counsel, and Greg Kuserk, Industry Economist, for the Division of Economic Analysis will make the presentation on that paper.

But before they do that, I would like to make one brief comment. One of the most outstanding and successful players in professional hockey was asked once by a reporter why he was so much better than those that he played with. And Wayne Gretzky replied, well, it's very simple. Most of these guys skate to where the puck is. I skate to where the puck is going to be. The CFTC White Paper on the Prohibition of Agricultural Trade Options is the commission's recognition that risk management in American agriculture is going to be at a different place and fill a different role in the future than the needs that it faces today.

And for that reason, we are submitting this white paper for public consideration, and at the appropriate time for comment in order that the Commission can make a prudent and judicious decision about what action it should take on the prohibition of agricultural trade options. The white paper is now up on the Internet as we speak. You can find it at CFTC's Website under "What's New". It also will be on the Agricultural Advisory Committee's Website and the Division of Economic Analysis' Website. So Kimberly, what's our Web address? It should be on that paper that you've got right there in front of you, that one.

MS. HARTER: www.CFTC.gov/ag.

CHAIRMAN DIAL: Okay. CFTC.gov/ag for the ag committee. Okay. I'll turn it over to Paul Architzel and Greg Kuserk for their presentation on the CFTC White Paper, staff white paper, on Ag Trade Options.

MR. ARCHITZEL: Commissioner Dial, members of the committee, it's a pleasure to be here today to brief you on the Division of Economic Analysis’ study entitled, "Policy Alternatives Relating to Agricultural Trade Options and other Agricultural Risk Shifting Contracts," also referred to as the staff white paper.

With me today, also from the Division of Economic Analysis, is Greg Kuserk, a senior research economist and co-author of the study. The commission has considered the issue of whether to remove the prohibition on the offer and sale of trade options on the enumerated commodities several times. It has been the subject of several meetings of the Commission's Agricultural Advisory Committee over the years and was one of the first items of business of the first Agricultural Advisory Committee under the chairmanship of Commissioner Kalo Hineman.

In fact, consideration of this issue was one of the impetuses behind formation of a permanent agricultural advisory committee. Trade options are off-exchange options offered for business-related purposes to a producer, processor, merchant or commercial user of the commodity which is the subject of the option. Currently, Commodity Futures Trading Commission Rule 32.2 prohibits the offer or sale of off-exchange options on those agricultural commodities which are enumerated in the Commodity Exchange Act.

These include, among others, wheat, cotton, rice, corn, oats, soybeans and livestock. Although prohibited for the above commodities, trade options are permitted to be offered and sold for all other commodities. There have been suggestions to the commission that the existing prohibition on the offer or sale of such off-exchange trade options on the enumerated agriculture commodities should be ended. Others support the continuation of the existing prohibition, however.

On December 19, 1995, the commission hosted a public roundtable to discuss this issue once again and to provide a forum for members of the public to provide their views. 17 members of the public participated representing a broad cross section of agricultural interests as well as academia and the futures industry. In addition, written comments were accepted and incorporated into the record. Some still expressed reservations over the wisdom of lifting the prohibition.

In general, however, based upon a perception that those engaged in agriculture today have a greater need for risk shifting instruments, roundtable participants expressed varying levels of support for relaxing the prohibition. The Commission directed the staff to study the issue and to report on its findings. I now would like to highlight for you the division's analysis and discuss briefly the division's recommendations to the Commission.

Before that, I just would like to reiterate one more time that the views and recommendations discussed today are those of the Division of Economic Analysis. They do not necessarily reflect the views of any commissioner or the commission itself at this time. In our analysis, we provided a thorough description of ag trade options including the regulatory history of it, their economic purpose, and the differences between on-exchange and off-exchange instruments, particularly the differences between forwards and futures.

Picking up at that point, we then specifically discussed the benefits and the potential risks of agricultural trade options, and that's where I'd like to start today in highlighting our analysis. With regard to the benefits of trade options, the first benefit certainly is that there is a potential variety of sources for the vending of these option instruments. Notably, at the first handler level, elevators and other first handlers of the commodity may offer these instruments if permitted.

A variety of agricultural interests have said that producers tend to trust first handlers with whom they deal in the cash market and would prefer to be able to access risk shifting instruments through the people with whom they have a business relationship in the cash market.

Secondly, trade options may be able to permit a greater precision of hedging in that they may be customized by size, location, commodity grade or other specifications. The final potential benefit is there may be some flexibility in financing offered at the first handler level to producers. This may be that the premium for the option, the actual cost of it, may not be collected until the producer brings the crop in, in which case the premium may be paid for as an adjustment to basis on the crop as opposed to having to pay for the premium up front. There are other kinds of financing flexibilities that may be offered as well.

We then went on to discuss the risks of trade options. First of all, we analyzed the potential risk of increased fraud caused by the decentralized nature of vending off-exchange instruments, in general, and trade options in this case, in particular. In the past, going back to the '70s when the commission was first formed, the commission noted that there was a widespread problem with fraud in off-exchange instruments generally, and we certainly have to be cognizant of that history.

Secondly, because of the decentralized nature of the vending of the instruments, there would be no centralized market to provide self-regulatory oversight of the vending of the instruments For an agency of our size, or any agency, that represents a problem of resources as far as being able to surveil and oversee the offering of those kinds of instruments when it's in decentralized type environment.

The lack of standardization may also lead to increased fraud. Generally, for exchange traded instruments which are standardized, people have the ability to understand them, to learn how they operate. In the case of non-standardized instruments, where each instrument may vary, there's an increased risk that people may not understand how that particular instrument works or may interact with their business.

And that is associated with the problem of the learning curve. In this case, options have not been offered off-exchange for the greater part of 50 years or more. No one has experience at this point with those kinds of instruments, and it can be expected that there will be a steep learning curve until people become acquainted with them, how to use them and how they interact with their business.

Other risks associated with trade options may include some of the following: credit risks. Credit risks may come into play because of the asymmetric credit relationship between the grantor of an option and the purchaser. One side of an option pays the premium up front typically. The other side needs to perform on it. And that leads to particular types of problems with regard to credit risk between the two.

Operational risk is also something that needs to be focused upon. There are concerns about internal controls at the first handler level in particular. During the commission's Roundtable on Agricultural Trade Options, several people indicated that the elevators that they had been involved with did not have good internal controls and didn't have the capability of assessing how these kinds of instruments would interact with their own balance sheet or with those of the customers. That's an important concern that needs to be addressed in focusing on these issues.

We've noted in the past that many of the problems we've had in or related to commodity trading or futures trading may have related to lack of good internal controls. That remains a concern. Also systemic risk is a concern, but not in the typical way we may think of it with regard to financial instruments. In this case, I think the systemic risk is characteristic of rural economies where there may only be one elevator in a town or in a region. If that elevator gets into trouble because of this instrument or some other type of trading behavior, the effects of a failure by one elevator may spread throughout the town or the regional economy. It's different from the systemic risk that we think about in terms of financial instruments with a bank going down and whether or not that will affect other banks and other people in the financial sector. Here it may be localized to a particular town or region. Nevertheless, it's something that needs to be considered and addressed.

We next discussed some of the restrictions or regulatory approaches that can address some of the potential risks that we outlined. And in this discussion, we are simply highlighting those kinds of restrictions which would be possible to address, some of the risks that we identified. First of all, there would be possible restrictions on the nature of the parties. Two kinds of restrictions are size limitations on the parties themselves or a minimum size on the size of the transactions. One of the limitations of this type of restriction is that it may restrict the benefit of having trade options to those who might most find them useful, and that is certainly something that the commission needs to consider.

Also, as far as vendors of the instruments, we could have a registration requirement either under current commission registration categories or a new category for registration. We could have simply notification to the commission that an entity is offering to vend these instruments or we could have a line of business requirement. Currently for non-agricultural commodities, the requirement is that the person being offered the option is a commercial, which means that you could have non-commercials offering the options. Another approach to consider in this aspect of agricultural trade options is requiring that both parties be commercials. I think typically that's going to follow the way we envision that initially these would be offered and would also prevent or guard against the kind of fly-by-night operations starting up where someone isn't a commercial already.

Finally, we could have an education requirement for either the vendor, the buyer or both counter parties. It's unusual to have that kind of requirement directly on users of an instrument. However, it has been done before in connection with the pilot option program that was done under the Department of Agriculture. There was an education requirement for people participating in that program. The study goes on to highlight some of the benefits of having that kind of program and some of the costs involved including the potential that such an education requirement could be used as a lure to people to attend what might be marketing seminars rather than actual educational type of seminars.

We also could place restrictions on the instruments or their use, and these restrictions could follow either being conditions of lifting the prohibition or they could be given in the form of guidance. The trade option rule itself is not completely open-ended. There are requirements in it, one of which I mentioned earlier, which is that the instrument be vended to a commercial. The second one is that the instrument, that the option, be solely for purposes related to the option buyer's business as such.

The commission really hasn't had an opportunity to discuss that requirement in much detail. This may be an appropriate time for the commission to look at that requirement, which is an existing one in the trade option rule, and how that would apply specifically in the case of agricultural trade options. Some of the issues may be, and as we discuss in the study, whether the instrument is being used to manage risk, and how that ties into the requirement that the instrument be related to the business as such. And we looked at factors such as size of the instrument compared to the underlying cash position, timing of expiration of the cash position, and other factors like that.

We also looked at the issue of option writing to generate income and how that related to this requirement. Some of the practices include writing covered calls, and that is something that the commission would need to consider if it determined that it was going to lift the prohibition, is how that practice relates to the conditions for lifting the prohibition?

Also, we looked at regulation of marketing, disclosure requirements and account information requirements. We've heard that in relation to hedge-to-arrive contracts, which I talked about in this committee last year, one of the complaints we heard was that people didn't know where they were at particular times, and that relates to getting timely information about accounts.

Other possible limitations we looked at were required cover of market risk and how the trade options would be covered, and also, as I discussed earlier, internal controls. We also looked at a number of related issues which don't concern ag trade options directly. However, they related generally to this area, and we thought it was appropriate that the commission or the division address all the issues that are currently outstanding.

The first one relates to forward contracts having option like features, and this goes back to the 1985 interpretation which is the last time or the most authoritative statement that there is regarding what's a forward contract. That interpretation was done through example, giving three examples, two of which were forward contracts, one of which was a trade option. We've heard from various people that because of changes in the cash market, it would be helpful to have additional examples laid out or additional guidance separating forward contracts from other types of instruments, and certainly in one of our recommendations we agree that that should be considered and looked at again to provide more guidance.

Secondly, we looked at the issue of the swaps definition and how that related to the prohibition on ag trade options. There has been some amount of ambiguity or confusion on the part of some people on whether or not swaps instruments are affected by the prohibition on agricultural trade options.

And finally, we looked at the issue of comparability of treatment for exchange traded markets. Again, during the roundtable, this issue was brought out that if the commission were to determine to lift the prohibition on ag trade options, what effect, what implications does that have for exchange-traded instruments?

I'd like to just summarize what our recommendations were to the commission. Again, these are the division's recommendations. The commission will have to consider whether or not they agree and want to act on them or not. The first one, the first three actually go together. Unfortunately, they are in chronological or logical sequence, not necessarily the most important one first. The first one is to deny a petition for rulemaking which is currently pending. The reason we need to do that and recommend that the commission does that is in order to then proceed on to the next two, and we recommend that the commission consider lifting the trade option prohibition subject to appropriate conditions, and to accomplish that, that the commission publish in the Federal Register an Advanced Notice of Proposed Rulemaking. That Advance Notice of Proposed Rulemaking would rely upon the division's study for its analysis, and would ask questions of the public: number one, is this a good idea to lift the prohibition; and, two, if it is, what kinds of conditions or regulatory requirements are appropriate to doing that?

The next recommendation is that the commission confirm the prohibition on agricultural trade options does not apply to the scope of the swaps exemption and that has to do with the commission's granting of hedging exemptions to certain types of companies.

And the last recommendation, as I mentioned earlier, is that the commission as resources permit, update and reissue the 1985 OGC interpretation, and that would be done through a variety of mechanisms. I'd be happy to answer any questions.

MR. GILLEN: Paul, did you consider a minimum capital requirement such as what you have with dealer options?

MR. ARCHITZEL: That goes to the issue of what kind of cover would be appropriate, and there is any number of ways of addressing that. During the roundtable, the exchanges indicated that they believed it was appropriate to have a one-for-one cover requirement, that if you issue a trade option you lay that risk off on a one-to-one basis on the exchange.

Another way of dealing with that problem would be to have some kind of capital requirements, and I think there are a variety of mechanisms. One of the things we'll be seeking public comment on is what's the best way of dealing with that issue, but certainly that is an issue that needs to be addressed.

CHAIRMAN DIAL: Please identify yourself.

MR. LINDAU: I'm Jim Lindau from the National Grain Trade Council. Where is the demand for ag trade options coming from? As you read the list of contracts that are currently covered by them, I think you did not mention soybeans, cotton. Is there a great deal of activity in those areas? I'm curious to know who really is looking for this?

MR. ARCHITZEL: I think we've heard from a variety of agricultural groups that do have interest in having this kind of instrument available. I'm not sure that it breaks down by specific commodity. Certainly, we've heard from many interests who are affected by the FAIR Act that because the FAIR Act will leave them feeling the need to hedge and manage their risks better, their market risks, and in that type of environment they may be able to use these to their benefit.

MR. LINDAU: Is there any evidence that there's great activity in those commodities where ag options are not denied? Soybeans, for example?

MR. ARCHITZEL: Soybeans is one of the enumerated commodities. An example of a non-enumerated commodity might be cocoa or dairy products, that type of thing. And I would say, no, there is not evidence of a great amount of activity that we're aware of. On the other hand, these changes in the cash market and in government support programs are sort of getting underway now so that what went on in the past may not be indicative of future needs.

MR. DODDS: Jim, I would just say in general the grain producer wants them. He'll use them much like he uses cash grain contracts. He would rather sell a cash grain contract to a local dealer than hedge his grain in Chicago.

CHAIRMAN DIAL: Any other questions? Identify yourself, please.

MR. ACKERMAN: I'm Ken Ackerman with USDA. In describing some of the regulatory restrictions that you say potentially could be put in place, I take it you're not proposing any of those potentials, but those are ones you're asking for comment on--

MR. ARCHITZEL: Right. At this time, we're just identifying potential approaches.

MR. ACKERMAN: Some of those sound like they would be creating something of a regulatory network over the elevators in terms of registration or reporting or tracking of types of transactions or controlling types of transactions. Are there precedents for that kind of regulation in other areas?

MR. ARCHITZEL: Well, I think there are a number of ways of approaching even the type of regulatory requirements we've outlined. For example, if they're self-effectuating conditions of the exemption, there wouldn't necessarily be tracking and reporting to the commission. It might only be that an elevator would have to satisfy the requirements in order to be a vendor of these type of instruments. For example, if there were an internal controls requirement, it may only be that the elevator have review by a CPA that certifies it has internal controls, and then it will be qualified to do the business. So it doesn't necessarily follow that it's creating an entirely new level of oversight.

Nevertheless, the commission certainly could determine that safety, prudence and caution suggested that more oversight would be a good thing, and I think that depends in part on the kinds of comments we get from the public.

CHAIRMAN DIAL: Other questions?

MR. GILLEN: What is your time frame on your notice of proposed regulation?

MR. ARCHITZEL: Somebody always asks that. This is a priority for the division and I believe for the commission to get this in the Federal Register. Because we've done the study, most of the analysis is already done, so I expect that the Advance Notice of Proposed Rulemaking will appear in the Federal Register in a short time period. And after that, I suppose it depends upon the nature of the comments we receive how quickly the process moves forward.

MR. GILLEN: Neal Gillen again. Are you going to give it a 60 or 90 day comment period?

MR. ARCHITZEL: I think that's up to the commission and that hasn't been determined yet. Do you have a view of that?

MR. GILLEN: A minimum of 60, I'd say.

MR. ARCHITZEL: Generally I find that when we try and move things faster, we get requests for an extension of time, but that's certainly up to the commission to determine.

CHAIRMAN DIAL: Okay. We have time for one last question. Okay. Thank you very much, Paul and Greg. You both have performed yeoman service in writing and making available this white paper. As I said in my remarks to introduce Paul and Greg and the presentation on their white paper, the commission will look forward to receiving your comments and your observations and your opinions.

We'll move now to the next item on the agenda. As the commissioners and the chairperson are out and about visiting with those who are part of the industry that we regulate and our counterparts in other government agencies and in the private sector in general, perhaps the most commonly asked question of us is, well, what's going on over at CFTC?

So we have an opportunity to speak to that, but I thought that it was appropriate that you all at least hear a snapshot, if you will, presentation about the people who carry out the daily work of the commission, who make it possible for the commissioners to comment on what's going on over at CFTC to do so. And these folks are obviously the staff, and I entitled this topic on the agenda as "A Day at the Commission." It obviously is not going to be all encompassing because the commission has so much to say grace over that none of you have the time to stay here long enough to hear what a day at the commission really consists of, but once again I have asked representatives from the Division of Enforcement, the Division of Trading and Markets, and the Division of Economic Analysis to briefly give you an idea of just some of the things that they do that make up a day at the commission, which is the work of the commission that's manifested in everything that comes out of the commission and becomes apparent in the activities of the industry that we regulate and has an impact on American agriculture.

So, first, I'm going to call on Susan Bovee, who is the associate director of the Division of the Enforcement for her presentation.

MS. BOVEE: Thank you, Commissioner Dial. I'm pleased to be here today with such an illustrious group of representatives of the agricultural industry. I don't know if anyone knew this when they asked me to speak, but my mother is a Nebraska farmer, and I'm very deeply imbedded in the entire agricultural economy of this country so I'm delighted to see so many of you here.

As Commissioner Dial said, I'm an associate director of the Enforcement Division, and that job involves heading up a team of 12 attorneys and investigators, and I'm one of four associate directors in this division. So we have approximately 55 people being led by this group of associate directors and under the jurisdiction of my superiors, a deputy and a director of this division.

And our purpose and job is to investigate and to litigate violations of our Commodity Exchange Act and the regulations under it. The Division of Enforcement gets it leads for what to investigate from a number of sources. Sometimes we read about things in the paper just as you do and get curious about them. Sometimes we receive information from one of the other divisions of this agency. Often we get calls, either from people we know or from persons who wish to remain anonymous in the public, to tell us that they think something strange is going on in this particular pit of an exchange or at this brokerage firm, and no matter where the input comes from we set about to look into those matters.

In order to make the best use of our resources, we don't just dive headlong into everything full tilt. We have a procedure in which we start into an investigation for about 20 hours and take kind of a hard, close and fast look at what we're doing to see if there is any merit in going on, if it makes sense, if it's cost effective. If it seems to be, if there is not just a whiff but a distinct odor, then we'll open an investigation and move forward in a somewhat more formal fashion.

Those investigations can either be those in which we use subpoena power, which require the approval of the commissioners themselves before we can do so, or it can be informal, in which case we don't have the ability to command people to give us documents or to come and testify, but we do have the ability to make phone calls, do research, look at documents that we have or that we can request. Either way, we proceed down the investigational road until we finally come to some understanding of what's been happening and whether or not that actually amounts to a violation of our act or regulations.

We investigate a number of different kinds of people, and by people I mean both individuals and organizations. The first bunch of them could be loosely categorized as persons who are registered with us under our act. Those are people who conduct a business that requires them to be registered. They advise commodity futures trading, they run commodity pools, they are commodities brokerage firms, they trade in the pits as floor brokers or floor traders. And so we have the ability just by looking at the registrants under our statute to get quite a wide view of the commodity futures industry. But that isn't where our ability stops. We in addition have the ability to look beyond our own registrants to those who are not registered but perhaps should be in the first instance, and even if they need not be are either conducting or facilitating some kind of violation under our act or regulations.

It's one of the ways that our commission differs from the exchanges. Exchanges generally when they set about to investigate a problem are limited to interviewing and reviewing their own membership and their membership files. They don't operate with subpoena authority and they're not able to go outside the four corners of their exchange to find out what's going on. We are able to do that and have often found, as a matter of fact, that we are able to join forces with an exchange when there is certain conduct in which both exchange members and persons off an exchange are involved because that way the people on the spot at the exchange are able to tell us a lot about what's going on. We are able then to share with them information about what we learn off exchange. So we've had some fruitful joint efforts in that area.

Beyond that, though, we have the ability to go into whole areas that exchanges really neither touch nor see. There is an enormous amount of off-exchange fraud in this country. Some of it is small potatoes possibly from your perspective. It's, you know, a handful of people who invest a handful of dollars and maybe all together it amounts to $50,000 among ten people. But these are often schemes in which people have invested their meager savings, and this is the sort of thing which although it doesn't seem to make a difference to the gross national product makes a great deal of difference to people in a small community that have been affected by a fraudulent scam run by somebody who is not registered with us.

We are entitled under our statute to investigate those matters and have had many great successes in pursuing those people, in getting funds back for those who have been wronged, and to get injunctive relief which prohibits them from ever engaging in this conduct again at the peril of being held in contempt of court if they do.

So this is the kind of conduct that doesn't even come to the attention of an exchange for the most part because by the time the transaction reaches them, the exchange would have no reason to believe it's not legitimate. The fraud occurs further upstream between an unregistered person and the customers with whom he's dealing. So I think that's a way that our division adds particular value to the system of self-regulation that exchanges engage in.

Now, we also undertake to look at various kinds of specific conduct in particular commodities, and here is where we play no favorites. We look at fraud issues across the board whether it's in agricultural commodities or otherwise, and there are many kinds of ways in which these things come up. I thought I would give you just a couple of examples of things we have done in the agricultural area fairly recently, which shows really the breadth of how we try to address the marketplace and to ensure its safety for all participants.

In one action last year, the Division of Enforcement brought a complaint against an employee of a large cattle operation who was the lead trader who was hedging the cattle operations functions and who was deceiving his employer by sharing the information about his cattle operation trades with his brother who ran a brokerage firm. His brother was registered with us, and it was only through a painstaking backtracking of telephone records, which we were able to subpoena as well as the testimony of certain persons who are out of exchange jurisdiction that enabled us to put together a paper trail that was incontrovertible. It showed absolutely that before every large position was put on by this cattle operation through the man that we sued, his brother placed trades through his own brokerage firms.

This kind of fraud is known as trading ahead, and it is illegal and it tends to undercut the safety of the marketplace and to make prices infirm and untrustworthy. It is the very heart of our surveillance job and our oversight and our investigatory purpose to root out that kind of thing and to prosecute it to its fullest. We brought charges against these brothers and achieved, I think, a very handsome settlement. And I think even more importantly than the effect on the particular defendants, we were able, I think, to send a strong message to the marketplace that these activities are watched. They are watched not only by the Division of Enforcement but by the other fine divisions of this agency whose job it is to monitor a lot of these activities.

And you can't just assume that because you're one fellow who's nowhere near Washington that your conduct won't be scrutinized, and so I think that's one way in which we help protect the agricultural marketplace. Another recent example that I'll just give a very broad-brushed description of is an instance in which we have overseen trading in a particular agricultural pit and determined by taking a close look to make some recommendations to our commission along with the Division of Trading and Markets about the way the exchange handled these particular matters. The exchange had taken disciplinary actions, had imposed some sanctions, and after reviewing what the exchange did, the Division of Trading and Markets and the Division of Enforcement together agreed that these sanctions and this action seemed less than perfect.

This matter is currently before the commissioners and with both Commissioners Dial and Tull here today, I don't want to say more about the balance of the issues here. But because this was an agricultural pit and the matters involved trading conduct in that pit and the reliability of the pricing of the commodity in that pit, we thought this was a matter of the first importance. I see Commissioner Holum back there. I'm sorry. You came in while I was speaking. This is a matter of great importance, I think, to the integrity of the agricultural marketplace, and I assume that in the fullness of time, some of what I'm talking about will become less mysterious as the matter moves through the commission.

These are just a couple of ways in which we address agricultural matters almost everyday. Obviously we're active in other commodities as well, but I think the dedication of the many attorneys in this division, and I don't mean to forget to mention that we have three other branch offices in which both attorneys and investigators also play a large role in this division in New York, Chicago and Los Angeles. I think all told with all of those offices plus our headquarters office, we are able to add considerable value to marketplace protections and to a certain amount of sense of safety and settleness that all of you can feel so that when you market or grow or sell commodities that you understand that the pricing of those commodities is reliable and will remain reliable because people are working to make sure that it will. I'm happy to answer any questions if you have any. I know I've taken up more than my time here.

CHAIRMAN DIAL: Any questions? Jim?

MR. LINDAU: One quick one. What's the average duration of an investigation of say one large enough to involve an exchange from beginning to filing a report?

MS. BOVEE: Gee, I didn't come with that statistic in my pocket.

MR. LINDAU: It doesn't have to be perfect.

MS. BOVEE: I would think especially as we deal with larger and larger entities or institutions the matters tend to slow down, often because the matters before us are very important or are matters of first impressions. So I would think above a year, possibly less than two years, is probably the likely trajectory of those kinds of matters. For somewhat smaller matters involving more garden variety types of fraud or misconduct, things can move quite quickly. We have been able to bring a case, investigate and bring a case in as little as 17 days. And in that matter achieved a preliminary injunction after 17 days against the conduct of a fellow that stole--I don't know--about $3 million from a group of persons who thought they were investing in a commodity pool and who apparently were not.

So we can move quite quickly when we have to. Obviously, the facts of these kinds of things differ enormously. Where there are large matters at stake, we try to deliberate and we try to be careful. The idea is not to rush to judgment or to stampede anybody in any particular direction. So I think as the stakes go up, the pace slows down.

CHAIRMAN DIAL: Any other questions? Thank you very much, Susan.

MS. BOVEE: Thank you.

CHAIRMAN DIAL: Appreciate it. As Steve Braverman, the Associate Director for the Rule Enforcement, Division of Trading and Markets, moves to the podium, let me recognize Commissioner Barbara Holum who came in. Barbara, thank you very much for being with us this afternoon. Steve.

MR. BRAVERMAN: Thank you, Commissioner. Well, first, let me say that it's a real pleasure to be here talking to this group about some of the day-to-day operations that go on at the CFTC. What I'm going to talk about today I think is something that you all will be interested in, especially those here that are users of the markets, and that is the very critical and fundamental statutory and regulatory obligation that the commission has, and that is to ensure that exchange surveillance programs are operating effectively and that the commission itself has a program for overseeing those self-regulatory programs.

As Commissioner Dial said, I'm an associate director in the Rule Enforcement Unit of the Division of Trading and Markets. We have approximately eight attorneys in Washington and 20 or so investigators out in our regional offices who carry out the function of oversight of exchange trading practices and exchange compliance programs. First, let me just give you a brief background on the regulatory framework within which the exchanges have to operate with regards to enforcing their rules.

First, exchanges, of course, are self-regulatory organizations. They have to implement procedures to enforce standards that are set out by the Commodity Exchange Act and the commission's regulations. Some of these standards include trading standards for floor brokers. These standards, which have been in effect for, oh, I think since 1974 or '5, the inception of the commission, prohibit floor brokers from such dual trading abuses as trading ahead of customer orders, trading against customer orders, disclosing customer orders to other members on the floor, any types of prearranged trading or accommodation trading, any kinds of wash trading or money passes in the pit.

These are some of the trading standards that are set out. There are also standards for recordkeeping requirements. These recordkeeping requirements were enhanced in May of 1990 after the CFTC/FBI sting. We at that time required additional recordkeeping to include collection of trading cards 15 minutes after each half hour bracket so that the trading cards will be taken out of the executing broker's hand in a much more expeditious fashion than it was before. We required the floor brokers to record all their trades in non-erasable ink, and there were other recordkeeping requirements that also served to deter traders from any potential trading abuses.

Thirdly, we have standards which say that the exchanges have to diversify their governance, board governance, disciplinary committee governance. We increased the representation of public directors on exchange boards of governance. And those are some of the examples of some of the standards that the exchanges have to follow. Exchanges have compliance systems and programs to enforce rules against members. These include programs to effectively monitor various sub-programs that they have in effect, and one of them would be market surveillance. They must have an effective program for enforcing their market surveillance function, market surveillance being knowing who the traders are in a particular market, knowing what the fundamental issues are reflective of supply and demand, open interest, basis relationships, inter-market spread relationships and so on.

The second part of the program must address trade practice abuses. They must have a program to identify potential trade practice abuses such as the ones I listed before. They have to have the capacity to thoroughly investigate those potential violations and if they find a reasonable basis to believe that any of their trading rules were indeed violated, they would, of course, have to have an effective disciplinary program to deter, hopefully deter other brokers from committing the same types of violations.

We look at all of these programs from an oversight perspective including an exchange's audit trail program, which is their program for quite simply reconstructing trading. Audit trails have, of course, been a very popular subject lately, and we look at each exchange's audit trail system and how accurate that system is and how effective that system is in identifying who executed what order, for who, at what time, and what commodity in order to be able to reconstruct trading and prove violations.

Our program for overseeing these different sub-programs at the exchanges consists of an integrated program of floor surveillance, computerized surveillance, and record surveillance, to conduct direct oversight of exchange trading activity on a daily basis. And what I mean by that is that each day commission staff are reviewing all trades that take place on all the exchanges using our computerized surveillance system in an attempt to identify for further investigation possible violative trading activity.

We also conduct what we refer to as rule enforcement reviews. These are audits, if you will, of each exchange periodically in which we review an entire exchange's compliance program or at times we will focus our attention on a particular issue at each of the exchanges and examine that issue at all of the exchanges which we call a horizontal rule enforcement review.

For instance, we have gone into each of the exchanges over the past couple of years and issued reports on their ability to enforce their rules concerning insertions and deletions from time and sales records. We have gone in and looked at each exchange's program for enforcing their rules for handling out-trades and errors that occurred during the day. These reports, the horizontal reports, we try to apply a best practice approach to our recommendations. We look at each exchange's program and select what we think is the best practice approach and make appropriate recommendations.

The cornerstone, I suppose, of our oversight surveillance program is our own computerized surveillance system. We refer to this as the Exchange Database System, or EDS. We receive computer tapes every month from each exchange of all the trading activity and we load those tapes on our mainframe computers in Chicago, and our investigators in the region are then able to download that information on their personal computers at their desk and manipulate that information in order to satisfy their needs.

For example, trading ahead of a customer order, we will sort the trading activity. We'll sort the trading activity by contract usually, select a period of time, and tell the computer to isolate for us any traders who received a better price for their own account within a minute of executing a customer account order that they had in their hand. And the parameters can be flexible. We say within a minute. We follow up on those exceptions and we investigate those.

Another example would be looking for patterns of noncompetitive trading and accommodation trading. We can isolate, for instance, any particular trader or traders who trade opposite each other on what seems to be a consistent basis. We can manipulate that data to point out any patterns between two traders in the same market who seem to be trading preferentially with each other which might be an indication of a noncompetitive trade or a prearranged trade if they're not going to the pit.

The system has been very successful and has resulted in many referrals to our Division of Enforcement and to the relevant exchange where the activity has taken place, and we are always continuing to update the technology on that system. EDS, I'll also mention, is used and has been used to reconstruct trading during major market events such as the March '96 wheat expiration, the July '89 soybean situation, the '87 stock market crash. We turn to the EDS system to help us reconstruct markets during those significant market events where it's so critical to get an accurate reconstruction and to determine whether or not there were any violative activity taking place during that time period. So that's been a very, very useful tool for the commission staff.

The other facet of our oversight that I mentioned before would be the Rule Enforcement Review Program. This program is actually mandated by Congress in the 1992 Futures Trading Practices Act. We are now statutorily obligated to review each exchange's compliance systems once every two years as practicable. The rule enforcement reviews are reports to the commission which evaluate an exchange's entire program or one facet of their program, and these reports serve as sort of a report card to each exchange as to how they are performing from a compliance perspective, and each one is read by other exchanges so that the effect is across all exchanges.

When we do a rule enforcement review, typically, it's very in depth. We will go out to the exchange and spend four or five days out there. We'll look at investigation files and disciplinary files. We'll look at their computerized surveillance systems which all the exchanges at this point in time use. We look at their recordkeeping reviews which can lead to substantive investigations, and we conduct our own independent tests of an exchange's one minute trade timing system for the accuracy of that system, and we also conduct our own independent tests of exchange trading documents, trading cards and order tickets, to make sure that members are in compliance with those rules.

Over the history of the rule enforcement reviews, we've made many recommendations for enhancements. The exchanges for the most part have embraced those recommendations and have implemented those recommendations. Some of the more significant results from rule enforcement reviews, in my view, have been the improved automated surveillance systems that are now used at all the exchanges. Of course, the larger ones have more sophisticated systems because they can afford them. But even the smaller ones who used to thumb through tons of paper to look for trading violations have automated their systems also as a result of recommendations made by commission staff. Increased levels of sanctions is another positive result from rule enforcement reviews.

Increased scrutiny of time and sales records to make sure that they're accurate, to make sure that if a broker wants to insert a trade or delete a trade, that that trade, in fact, took place, and we made a recommendation, in fact, in the horizontal review of that subject that all inserts and deletions have to be approved by at least two members of a pit committee or a floor committee, whereas before it was much less scrutinized and we think that that's a real positive step.

We've also made general improvements to audit trails and recordkeeping generally and at some exchanges we recommended eliminating cross trades where a broker crosses a customer's trade directly against his own account, which was a controversial matter several years ago. We've gotten some exchanges to do that, to prohibit that.

And just finishing up, I guess rule enforcement reviews assure the quality of exchange enforcement programs and they also educate exchanges as to the regulatory standards for meeting their self-regulatory obligations. And I just got the word that my time is up so I will ask for any questions?

CHAIRMAN DIAL: Bill.

MR. DODDS: Steve, from your perspective, what's the frequency of a broker problem? I mean is it once a month or ten a year or--

MR. BRAVERMAN: Well, from time to time we will get customer complaints directly here at the commission, which are typically complaining about a bad fill or complaining about an inaccuracy in the time of sales, insertions and deletions that don't make sense. Most of them are bad fills and the allegation is that the broker traded ahead of the customer's order and pocketed his fill. The frequency of those? They're not very frequent. The exchanges, on the other hand, also receive customer complaints. And our experience is that they're not that frequent at the exchanges either. The larger exchanges in Chicago, of course, get more complaints than others because of their activity level. But for the most part, actual customer complaints are down.

CHAIRMAN DIAL: Steve.

MR. PATTON: Steve, early in your remarks, you mentioned standards of board governance. I was wondering if you could expand that for me so I could understand that a little better?

MR. BRAVERMAN: The Futures Trading Practices Act of 1992, I believe, required exchange governing boards to be more diverse in their membership, and as part of that, boards now have more public director representation and diversity across floor membership so that there is equality among representation of the FCM community, the floor broker community, and the local community. So it's a much more balanced yet diverse governing situation.

CHAIRMAN DIAL: One last question.

MS. DANIELSON: Steve, on the number of complaints, you said it was down. Would it be one a month or I mean just any kind of range on that?

MR. BRAVERMAN: Well, I don't have any numbers precisely. But, you know, I think I would attribute it to the activity in the stock market, if I may. The levels of trading in some futures markets has flattened out and there is less volatility, and when there is less volatility, then there's less reason for customers to complain about bad fills, which is typically what they complain about. And I think that's an offshoot of a lot of money going into the stock market, not that there's not a lot of equity in the commodity markets, but when you get a market like the Eurodollars, which has been fairly flat of late, at least until interest rates were raised last month, you're taking the volatility out of the market, and you're going to have less customer complaints.

MS. DANIELSON: I'm just trying to get an idea on volume because you read about cases every once in awhile, but I don't know if those are really the exceptions?

MR. BRAVERMAN: I really couldn't give you a number. I mean from my experience, in a typical year a large exchange could get a couple of dozen given no anomalous market events, and a smaller exchange could get half of that or less.

MS. DANIELSON: Thank you.

CHAIRMAN DIAL: Okay. Steve, thank you very much--

MR. BRAVERMAN: Thank you.

CHAIRMAN DIAL: --for that excellent presentation. We'll move now to a presentation by David Fickert, who is the Industry Economist, Division of Economic Analysis, and David has flown over from our Chicago office to make this presentation on EA, as we call it, surveillance activities.

MR. FICKERT: Thank you, Commissioner Dial. The Division of Economic Analysis consists of Market Analysis Division, Research Division, and Market Surveillance Division. I'm from the Market Surveillance Division. Market surveillance has regional offices in Chicago, as Commissioner Dial mentioned where I'm from, New York, Kansas City, and our headquarters staff here in Washington.

Today I'd like to give you an overview of some of the day-to-day tasks and some of the issues that are relevant for Market Surveillance. Market Surveillance's primary mission is to detect and prevent futures market disturbances and to help ensure futures contracts trade and liquidate in orderly manner. As the title would indicate, Economic Analysis is there to look at the economics of the marketplace and the participants in that market. To do this, we collect two primary types of data.

We collect public data, which is obviously available to anyone. That data would include market news, reports, supply and demand numbers, cash prices, and all the data that's associated with futures trading: prices, volume, open interest, deliveries and all that goes along with that. The CFTC Market Surveillance staff also collects confidential data. This data would include exchange clearing member positions, individual large trader positions. Within large trader positions, that would include the actual futures position, background data on the trader, their location, what businesses they're involved in, and in some cases for hedgers we also collect cash position data.

This would be--and the confidential data--in addition, these two, the clearing member data and the large trader data, are collected on a daily basis. That's the clearing member and large trader data are collected daily from the FCM community.

Additionally, Market Surveillance collects private data as needed for different market events. Individuals are contacted and we will collect data including intentions to deliver or intentions for their trading position, cash position data, purchases, sales commitments, and other data to get some understanding of what's happening economically in the market with regard to the expiring futures contracts, all futures contracts, but specifically the expiring futures contracts.

Additionally, we're in constant contact with exchange staff and our counterparts in market surveillance at the exchanges to gather additional information. I've brought some examples that we can take a look at of some of the day-to-day things that we're doing in Market Surveillance. I'd like to use March corn expiration for our examples. Some of this data has been changed obviously for confidentiality reasons, but a lot of it, public information, we're using the actual data here.

This chart represents open interest. It's comparison of what we like to look at, some of the factors we like to look at, to judge what is going on in the marketplace. Just to give you quickly the general structure of this chart, this line represents the 1997 data, this line is '96, and then the previous years, the high-low range for that data, and what we're doing is counting down days till expiration.

1997 in this case you can see the open interest was above previous years, and we do this across all expirations taking a look at to see what kind of a decline, what kind of liquidation we get in the open interest, one of the measures to see how the market is performing. In this case, as I mentioned, 1997 is above 1996 and above what we've seen in the past years' ranges, possibly something that we would want to take a closer look at and determine why do we have this situation.

More public data that we're looking at: corn basis comparison. This happens to be for the second week of March. We compare at multiple locations, the delivery points: Chicago, Toledo, St. Louis, also basis values for Ohio Train, Evansville, Decatur, Illinois and other points, to take a look at what cash prices are with relationship to the current futures situation. In this case, again we're looking at the March expiration here--it happens to be basis for May though--to get some understanding where we are currently across multiple locations, the star representing '97, where we've been in the past, and where those locations, the values of those locations relative to one another.

All of the factors that we look at, both the public and private data, we're trying to piece together what's going on in the market. This is a representation of the March-May spread. In this instance, 1997 was an inverted market. Also, 1996 was an inverted market, but normally we're looking at a market that is in a carry. So this is another factor that we would put in, try to piece together a puzzle to determine what's going on from some of the public data that we have available.

And this is the last piece of public data that we have, I'm sorry, today. It's corn stocks in deliverable Board of Trade warehouses. 1997 is right down here. Obviously, as you can see, just by looking at the graph, 1997 falling so far outside of the previous year and of past years, another factor that you put in including in what you're doing and trying to evaluate the overall market situation and where from an economic point of view there might be concerns. This is the total deliverable supply that's available to be delivered quickly on a contract and this case on the March contract. Supplies could move into deliverable positions, but this is what we're facing at the time. And so when we're looking at what is going to happen as the market expires, we have to take into account the potential deliverable supply.

The other source of information we have is confidential data. The primary source of confidential data we have is our large trader reporting data. This chart represents reporting traders on one single day and their make-up in the marketplace alongside. Significant portion is made up by merchandisers, processors, floor merchandisers, floor traders and brokers, non-reportable positions--people who are below the CFTC reporting level, who we have no information on--the long side positions. Equally we have the short side positions. In this particular case, on the short side we had much greater number of non-reportable traders so less information, but again we still had merchandisers, processors, some of the other people who make up the positions in the market.

We know their positions because they're reporting every single day their position to the CFTC if they're over the reporting level. We have background data on them so we can determine who they are and put them into a particular class as we analyze the market.

The surveillance data is summarized for the commission senior staff and for the commissioners in surveillance briefings on Friday using a surveillance report. This is a more detailed data on the large trader data. We have the largest clearing positions broken down by what they have in their own accounts and what they have in customer accounts. The largest long positions, the largest short positions, ranked by size, and a little bit of the permanent records or what would be public data, exchange type data. We'll review this information looking at how large someone's position is. If ABC Grain has a position--this is in million bushels, by the way--for corn, 23 million bushels, their percent of the open interest is 32 percent of the open interest. As we will look at concentration and market participants and try to gather more information on those people, find out what their intentions are, find out why they're holding this position, what their hedge is against, with again the idea of trying to understand what's happening in the market to try to make sure we have a good idea of what's going on if things seem out of the ordinary. If we've heard a complaint, if it just seems to be an abnormal situation, we will take a look and try to contact these traders, usually via phone call, and find out what their perspective is on their market.

Steve Braverman mentioned the surveillance system. He was talking about the Exchange Database System which is a system that monitors what's happening in the trading pit and who's trading with who. We monitor position data and who owns the position. It's a little bit different than the type of data that they're looking at in the Trading and Markets Division. We have the ownership of the position. They also can look at that data, but we're looking specifically at who owns the position and what the relevance is to the economic part of the market as opposed to possibly more the mechanical part of the market of actually the trading.

The CFTC tries not to become a factor, but if we see concentrations that are very large or we have concerns because some of the fundamental factors seem to be outside their normal ranges or at an unusual level, the CFTC may have to become a factor. We normally start with phone calls, contacting traders, asking them what they intend to do. Potentially we could send warning letters after a verbal warning. Finally, after a formal warning, the commission potentially could have an emergency action, but obviously that's no one's intention.

Additionally, as I mentioned, we're in constant contact with the exchanges. The exchange has their own procedures. They have their business conduct committee, which reviews positions, finds out what traders are doing in the market, and if they feel they need, they will take steps to encourage participants to liquidate or roll positions or whatever the case may be to liquidate in an orderly manner.

Market surveillance goal is not to become a factor in the market but to continuously collect the information on the market and its participants so if need be the commission has what it needs if they need to become involved in a market expiration. Take any questions.

CHAIRMAN DIAL: Any questions?

MR. HELLERICH: Yes, Gary Hellerich from ASA. These investigations and so forth, you discover things that are not in order or out or order and so forth, you turn that over then to Division of Enforcement then to continue on with that or how is that process handled?

MR. FICKERT: Potentially something could be turned over to the Division of Enforcement. Our primary goal is to work before the contract ever gets to expiration, to be involved if need be before the contract expires to try to make sure it expires in an orderly fashion. If something were to be a major event and warrant a situation, then Enforcement would become involved in it. Steve Braverman or I'm sorry--they alluded to the March '96 wheat. That was something that eventually became an enforcement issue. But our goal is to make sure we're constantly on top of what's happening in the marketplace, contacting traders, contacting exchange, monitoring positions every single day to see what's happening in the market, and if need be encouraging people to act in an orderly fashion as the contracts expire.

MR. HELLERICH: Okay. Then what you're telling me then in that March expiring May contract in wheat there, you were on top of that then as far as it came toward expiration time?

MR. FICKERT: We have been following the March wheat contract right up to expiration, yes.

MR. HELLERICH: Okay. There is a lot of concerns about that out in the country, you know. Hey, why wasn't somebody watching this thing? Why did it get way out of hand? And so it's helpful to be able to come back and say, well, these things were being monitored and so forth.

MR. FICKERT: It was being monitored. Without specifically commenting obviously on any of it, it was being followed by the Market Surveillance staff, both at the Board of Trade and at the CFTC.

CHAIRMAN DIAL: Any other questions? Okay. Well, thank you very much, David. We'll move now to a presentation on CFTC's Fast Track Contract and Rule Approval Process, and I'll ask Paul Architzel to return to the podium and present Division of Economic Analysis part on the Fast Track Contract and Rule Approval Process.

MR. ARCHITZEL: David was just talking about contract expiration and our concern about price manipulation and orderly trading. One of our primary jobs here is to oversee the futures markets to minimize their susceptibility to such price manipulations or distortions. We think that one of the best ways of doing that is good contract design. If a contract is well designed, generally it becomes harder to manipulate the contract.

Following from that, we also think that preapproval of contracts is important, the reason being that after a contract starts to trade, it becomes more difficult to change its terms and conditions since they're listed so far out. Any time we would like to see a change made, it may not take effect for a year or more, so that in essence we're stuck living with having to do close surveillance of that contract while it trades out and new terms come in. So we think it's very important to look at contracts before they start to trade.

On the other hand, we also know that the ability to innovate and introduce new contracts is really important to the exchanges and their ability to compete. And we're pretty sensitive to that. Over the years, we've made great efforts to try and cut our review time of new contracts, preapproval time, while they're being reviewed, and we've been very successful with that. This chart shows the period from 1983 to the present, and it shows that our average review time has gone from over a year to down to about 90 days for the average contract.

Last year we approved about 90 contracts futures and options, which gives you an idea of the volume we're looking at in our designation process. In addition to new contracts, we're also looking at amendments to terms and conditions of existing contracts, and these are also important to look at because they may affect commercials in the market, they may affect the pricing on the contract, or they may affect delivery points, for example, which has a direct bearing on commercial interests using the contract.

Now, what we've done and to be even more responsive to the exchanges in this process, is to promulgate new fast track rules, and what these rules do is cut our review time even further, and this summarizes where our time periods currently are. We either will review new rules in ten days if they're very routine and fall into certain categories or 45 days if they're not routine-type contract terms.

With regard to new contracts, certain types of new contracts like cash settled contracts not on agricultural commodities can be reviewed in ten days. All other contracts will be reviewed in 45 days. Those are all contracts which are physically delivered as well as cash settled agricultural contracts. Now under this fast track review, if it's a 45 day period, we have an opportunity for public comment, which we think is very important. We may have contacted some of your members or you for trade interviews or we may have a public comment period in the Federal Register in which you will have an opportunity to write in views on your contract. We think it's important to be able to find out from the trade, from commercials, and out in the trade what their views of certain proposals by the exchanges are in order to review them better.

The other part of the fast track procedures are that these time periods give us an opportunity to work with the exchange toward fixing a contract that has a problem that may be fixed and getting it approved and trading. So we're trying to provide an efficient system where we're not wasting our time writing a lot of letters or doing a lot of paperwork or legal requirements or procedures to get the contracts out of here and trading, and we think that certainly our procedures do that.

The goal of our fast track rules are to compress the time for commission review of new contracts and amendments to contract terms and conditions, to provide certainty to the exchanges when our review will be finished so that they can go ahead and plan on their marketing and launching their new contracts. However, one of our goals is also to preserve the preapproval review that I spoke about, to ensure that the contract design is built into the contracts from the beginning, and also to steer clear of inefficient and costly corrections that would have to occur later if we didn't have the preapproval process.

We also built into this system a little bit of flexibility which we think is important based on our experience over the years. We have a 30 day period that we can extend, the basic ten or 45 day periods, and that would be for complex or novel contracts or specific rule proposals. Some contracts are more complex than others. The first time you may have a cash-settled contract, for example, it takes longer to review it. There are more people who have interests that need to be spoken to, and there may be more legal issues that need to be resolved. There is some flexibility that's required, and we've built in a certain amount of that flexibility into the system.

Finally, our other goal was to maintain an opportunity for public comment either through the Federal Register at a comment period or through conducting trade interviews on our own. We think that that's an important aspect of our current procedures that needs to be maintained.

One of the ways we've gone about cutting our time periods is to provide for more electronic use and processing. This overhead transparency is the page from our Website. It can be accessed through "What's Pending" and under this, the first page are all fast track contracts and also rule proposals will go up later. We're currently in the process of getting this set up. By using this, anyone of you will be able to access our Website, see what's pending. You will be able to access directly the terms and conditions of the proposed contract and then using a return signal from the program, you will be able to send in your comments directly to us by return e-mail.

In this way, we'll be able to compress the time we take for public comment periods, give you all an opportunity to comment and make it easier for us to process the paperwork part of it, which leaves us more time to do our analysis. So that our pre-trading analysis of contracts will continue at about the same depth and intensity, and yet we can make the whole process run a lot faster by providing for an electronic handling of this.

We have asked the exchanges to provide their submissions electronically, and the first, this page is up and running now on our Internet and Website, and we are making use of it. So far we haven't gotten any comments in on it yet, but we've only gotten one or two contracts in at this point using the fast track procedures. Are there any questions I can answer?

MR. ACKERMAN: Paul, what is the general volume of new contract proposals that you're receiving these days?

MR. ARCHITZEL: Well, we did 90 last year. For this year, the calendar year, we're up to 41. So I would say that the exchanges continue to develop new contracts at a fairly rapid pace, and we are keeping pace with them now despite the fact that we have fewer staff than we did ten years ago. We certainly have greater expertise and more efficient systems to deal with that load.

CHAIRMAN DIAL: How many comment letters have come in on the proposal for changing the delivery terms to the CBT corn and beans?

MR. ARCHITZEL: At this point, we have about 370 in house and it looks like the flow is still coming in. None of those have come in electronically. They're all on paper, which is an amazing burden considering we need four or five copies in our division alone for people to look at. So the time spent in xeroxing that number of comments is quite a burden. Hopefully, this new system will ease that, and we'll be able to process things quicker.

CHAIRMAN DIAL: Any other questions? Okay. We'll move on then. Thank you very much, Paul. We'll move on to a presentation by David Van Wagner, Special Counsel, Contract Markets Section, Division of Trading and Markets, who is going to talk about fast track and the rule approval process.

MR. VAN WAGNER: Good afternoon. In addition to the fast track review procedures for rules that relate to contract terms and conditions, as mentioned by Mr. Architzel, the commission recently adopted a similar rulemaking to streamline the process for the review of exchange rules that do not relate to contract terms and conditions. This body of rules covers a wide variety of subject matters ranging from straightforward rules such as exchange administrative matters and exchange membership requirements to more sophisticated rules such as automated trading systems, margining systems and market maker procedures.

The types of rules covered by these provision's also demand a wide variety of regulatory responses from the commission. Some require commission approval under a section of the act or the commission's regulations. Some require approval because the submitting exchange requested that treatment, and some may be put into place without approval but upon the prior review of the commission. The commission deals with a large volume of these non-term and condition rule proposals. We handle about 300 of these submissions per year, and each submission might actually contain a number of rules within it. This average of about 300 submissions a year has continued for the past three fiscal years.

Under the new fast track rule review procedures, all non-term and condition rule changes are either deemed approved or permitted to go into effect without approval ten days after they're received by the commission unless the commission finds that the submission either raises novel or complex issues or is of major economic significance. In these circumstances, the commission will retain proposal for additional review of either 45 days or 75 days in those instances where it decides to publish the submission for comment in the Federal Register.

At the end of this extended 45 or 75 day review period, the commission again will either deem the proposal approved or allow it to go into effect without approval unless, of course, we initiate disapproval proceedings for the submission. Prior to the adoption of these fast track rule review procedures, there were two review tracks for non-term and condition rule changes. Rule changes which didn't require approval were disposed of within ten days of receipt. Those that did demand approval were disposed of within 180 days.

So these new fast track procedures will have little if any effect on those rules which do not require approval, but it will significantly reduce the amount of time that we will have to look at those which do require approval, cutting it down from 180 days to as little as ten and at most 75 days. The commission's new fast track procedures should help the exchanges to implement their rule changes in a prompt and timely manner and it's also responsive to the exchanges' needs to act in a fast moving competitive environment.

The fast track procedures, however, retain the requirement that all rules be subject to prior review. With prior review, the commission is able to assess the impact of these rule changes on persons who might not have been involved in exchange's formulation of the rules such as non-member market participants and the general public. In addition, prior review ensures that the commission is able to solicit either informally or formally the views of market users, other regulators and other interested parties with respect to a rule proposal. These parties often provide us with insights and help as to the possible impact of rule proposals. I'd be happy to answer any questions you might have about this.

MR. LINDAU: Did you say how many of these requests you receive in a year?

MR. VAN WAGNER: Well, right now we probably average about 300 rules submissions. They might contain a variety of rules within them, but 300 of these non-term and condition rule submissions.

MR. LINDAU: And of that number, how many are rejected?

MR. VAN WAGNER: Most of them are not. Well, actually very few are actually disapproved. There are a handful which, upon the urging of staff, the exchanges might withdraw. There is a significant number of them which are modified after interaction with Commission staff here. It's definitely an iterative process between us and the exchanges when they come in with things.

MR. GILLEN: I'd like to ask you about one of the contract rule change proposals in your handful. That is a rule change that was proposed by the New York Cotton Exchange, I believe, in 1993 or 1994 to render ineligible from the certified stocks cotton that was pledged to the CCC loan as collateral. The commission placed a tremendous burden on the exchange. It submitted a list of vague questions for the exchange to answer to which they did, and somehow this proposal is still pending. I don't think it's on any type of track. It's been derailed, and I just wonder how the commission staff or the commission can place itself in a position to be determining what an economic purpose is?

MR. VAN WAGNER: I have to admit I'm not particularly familiar with that submission. Sometimes the give and take can be laborious, but--

CHAIRMAN DIAL: Fred Linse with the Division of Economic Analysis.

MR. LINSE: Mr. Gillen, as you may recall, that particular proposal was submitted for commission approval, I believe, on two occasions. The division after reviewing the proposal, which included contacting people in the industry and reviewing public comments submitted in response to the Commission’s Federal Register notice on the proposal (many of which were of negative nature), we determined there was serious policy questions about the potential impact of this proposal on the deliverable supply of the commodity available for delivery on the futures contract. Accordingly we remitted the proposal to the exchange for further justification.

The current status of the proposal is that it is back with the exchange. The exchange may respond to the Commission’s request for further justification if they so choose.

MR. GILLEN: Am I to interpret your answer to say that the commission is predisposed to disapprove the rule change?

MR. LINSE: We haven't made any determination to disapprove the proposal, but we did feel there appeared to be serious policy concerns. We are still expecting the exchange to provide more justification for the proposal that would alleviate these concerns, if the exchange decideds to resubmit the proposal.

MR. GILLEN: I'll just finish and raise a question. Are these policy concerns or political concerns?

MR. LINSE: No, these are policy concerns.

CHAIRMAN DIAL: Any other questions?

MR. VAN WAGNER: Thanks very much.

CHAIRMAN DIAL: Thank you very much, David. We'll move now to the final item on the agenda before we take our break, which is the Approval Process to Establish a New Futures Exchange. Alan Seifert, the Deputy Director of the Contract Markets Section, Division of Trading and Markets, will make a presentation for T&M, and then Fred Linse will return to finish with the presentation, the part by Economic Analysis.

MR. SEIFERT: Good afternoon. We will now move on from specific rules and designations to, as Commissioner Dial indicated, a discussion of the designation process for an entirely new exchange. The self-regulatory core of a new exchange is found in its proposed rules. Those rules have various different characters. One category of rules is dictated by the various standards that you've heard various speakers talk about that are found throughout the Commodity Exchange Act and the commission's regulations. And those standards run the gamut from governance, financial minimum standards, disciplinary program standards and so on.

The second category of rules, which Fred Linse will talk about, are those rules which address terms and conditions of contracts that are to be traded on the exchange themselves. The third category of rules are those rules which while not required to be put in place by any specific provision of the act or the commission's regulations are rules which are not inconsistent with those provisions and the exchange elects to put into place subject to commission review.

In addition to reviewing all of those rules, which in the instance of a new exchange amount to a substantial number, the commission staff will also look at the other aspects of the self-regulatory program of the exchange. Those aspects include the human resources that will be directed toward the various functions that have to be performed by a self-regulatory organization, the significant operational programs that have to be in place. These are most notably, provision for the clearing and matching of trades on schedules and with collection of funds that meet the appropriate regulatory standards, and, of course, as has been mentioned here before, the programs that the exchange will have in place to assure that there is compliance with its rules including effective surveillance programs to address the different areas that have been discussed heretofore.

Once an exchange has all these rules in place, they've been reviewed by the commission, the commission has either approved them or allowed them to go into effect, then the exchange has a legal obligation to enforce those rules, and then we move on past the actual designation process. Insofar as an exchange intends to provide for trading through an electronic means, then part of the commission's assessment of the proposed exchange's readiness to become an exchange is to determine whether the electronic means selected by the exchange will be adequate for them to serve their intended purposes.

The commission in 1990 adopted a set of international standards that were sponsored by an organization some of you may know whose acronym is IOSCO. Those standards are the guiding light for the commission's technical staff in looking at electronic trading systems. There are ten standards. I'll just mention a few. They go most notably to issues such as access to the system. A big concern is the extent to which someone might gain unauthorized access, the extent to which people at a computer might be able to enter trades when they were not the authorized party to do so.

What we identify as the “algorithm” is of fundamental importance the system. It is basically the provisions that determine who gets matched against whom under what terms in the actual operation of the market. Obviously, the fairness that that algorithm provides for or fails to provide for is fundamental to the existence of that prospective exchange.

That's an overview of the exchange designation process. I'm now going to address a specific proposed exchange that's before the commission. There has been some press on this so I'm sure that some of you have heard about this exchange. It's dubbed Futurecom. It is intended to be the first futures exchange that will operate via the Internet. Initially it's to provide for cash settled live cattle futures and option contracts. Members will be provided access through a password and user ID to what have been identified as secure Futurecom servers that will be provided by Futurecom. Orders will be entered on standard electronic data entry forms. Matching will take place anonymously in accordance with very simple price time priority algorithm provisions.

Users will be able to receive real time quotes and account information throughout the operation of the trading day. Trading hours are proposed to be 8 a.m. to noon Central Standard Time. This proposed exchange is one that raises some novel and complex issues. It is the first of potentially a large number of Internet exchanges. If the commentary of some of the people in the industry is to be taken seriously, there are a number of other entities and individuals waiting in the wings to pursue this type of exchange operation. So since it is the first time that the commission is looking at this, since the Internet is to some extent a moving target, this will be something that will be scrutinized carefully by the commission staff and the commission.

The initial submission came in in January of this year. There was a Federal Register release requesting comment that was published the last day of January. Process-wise, we are in the early stages of consideration of this exchange. The exchange just this week sent in a substantially revised rule book that is something that we will be looking at in the immediate future. We have begun, in consultation with the computer staff at the CFTC, our technical review of the exchange systems that will be employed in the operation of Futurecom.

At this point, the commission staff have open questions regarding how this exchange will operate. We don't have necessarily all the information that we will need to have in order to evaluate this exchange, but the process is underway. After we review the most recent submission, then at an appropriate time, we will make more information available to the public. Clearly there already have been and will be significant additions to what is before the commission in the record of Futurecom that will need to be made available to interested parties, and we will do so.

In sum and finally, the issues that we probably will be spending most of our time on in dealing with Futurecom will address the clearing mechanism and procedures, the compliance and surveillance programs of the exchange, and more generally just getting enough information that assures us as to the ability of the exchange to fulfil its self-regulatory duties. As I have mentioned, we'll be looking at access and security issues related to the fact that the way that people will be gaining access to this market will be through the Internet. Those are my remarks. I'd be glad to answer any questions.

MR. HITCH: Paul Hitch. Is there a two-step process or is it all tied up in one? And the question is you have an exchange, you have a contract; is the approval process considering both the establishment of the exchange and the approval of the contract or is that--I mean I can consider if there are two, you could get an exchange approved and a contract denied, and you've got an exchange with nothing to trade on it.

MR. SEIFERT: Well, that wouldn't really be a very successful venture, and therefore the answer is that, yes, the commission staff's review of both goes forward simultaneously. Fred Linse, who will be before you in a moment, will talk about his simultaneous review of the contract. So, yes, we review the entire package at the same time.

MR. ACKERMAN: Alan, there have been other computerized trading systems before. Could you talk a little bit about what makes doing it on the Internet different? Is it simply a matter of security or are there other factors?

MR. SEIFERT: Well, I as you know am a lawyer, and so I'm not necessarily going to identify every technical issue, but there certainly is the fundamental difference that people are not going to be using telephones or other, heretofore conventional means of communication. They're going to be communicating through getting on-line through some Internet vendor. There will be issues of getting through and of looking at the adequacy of encryption. There will be various issues that go to the operation of the Internet generally, but then there are also related technical issues regarding the hardware that will be selected by Futurecom that we will be looking at very carefully because there are all kinds of issues about vulnerability and so forth whenever you have hardware. That aspect is more common to previous electronic trading systems.

MR. ACKERMAN: Do I understand you right that someone could have access, say, by getting on the Internet through America On Line or a system like that? And at that point, ther

About the CFTC

Additional Information

Commodity Futures Trading Commission Agricultural Advisory Committee

23rd Meeting

Wednesday, May 14, 1997 1:00 p.m.

Commodity Futures Trading Commission
Agricultural Advisory Committee

Wednesday, May 14, 1997
1:00 p.m.