CFTC Annual Report 1997

Division of Trading and Markets

The Commission's Division of Trading and Markets (T&M) oversees the compliance activities of the futures industry's self-regulatory organizations (SROs), which include the U.S. commodity exchanges and the National Futures Association (NFA). T&M develops, implements, interprets and oversees enforcement of regulations which protect customer funds, prevent trading and sales practice abuses, and assure the financial integrity of firms holding customer funds.

Review and Approval of Exchange Rules

The staff of T&M promotes and enhances self regulation by reviewing proposed exchange rules for consistency with the Commodity Exchange Act (CEA) and Commission Regulations. During FY 1997, T&M reviewed, and the Commission approved, 233 new rules or rule amendments submitted by exchanges. T&M also reviewed and permitted 365 exchange rules to become effective. Significant exchange rules approved by the Commission or permitted to go into effect by T&M in FY 1997 include the following:

Rule Enforcement Oversight and Trade Practice Surveillance

The CEA requires each exchange, through a program of continuing rule enforcement, to ensure that its members adhere to exchange rules. Before T&M recommends approval of an application to trade a futures or option contract, it considers whether the exchange maintains an adequate rule enforcement program. T&M periodically reviews each exchange's rule enforcement program and conducts follow-up reviews if it finds a need for improvement in an exchange's programs. When appropriate, the reviews include recommendations for improvements and schedules for implementing those recommendations. In addition, T&M reviews particular practices or program areas across exchanges in ''horizontal'' reviews which facilitate the adoption by exchanges of ''best practices.'' During FY 1997, T&M completed the following reviews.

Audit Trail and Dual Trading. T&M staff followed-up on SRO compliance with audit trail and dual trading requirements. The CEA requires each exchange to have trade monitoring systems that enable effective detection, deterrence, and prosecution of trading abuses. The staff tested and evaluated exchange audit trail systems and other trade monitoring system components. Based on this work, the Commission granted three exchanges (CSCE, Comex, and NYCE) unconditional exemptions from the statutory dual trading prohibition. The Commission will consider the exemption petitions of two other exchanges (CME and CBOT) early in FY 1998.

Horizontal Broker Association Review. T&M assessed the adequacy of exchange rules designed to prevent trading violations attributable to members of broker associations. T&M reviewed exchange programs for enforcing broker association rules. In particular, T&M reviewed programs for monitoring the trading activity of broker association members at the five largest exchanges. T&M evaluated each exchange's procedures for the registration of, and collection of data on, broker associations and their members. T&M found the exchanges' programs consistent with the Commission's regulations for the registration of broker associations. T&M also found that each exchange employs its surveillance systems to varying degrees to monitor broker association trading activity. The report includes several recommendations to improve the exchanges' programs for the registration, collection of data, and oversight of broker associations and their members.

CBOT March Wheat. T&M reviewed the adequacy of disciplinary actions taken by CBOT with respect to the expiration of the March 1996 wheat futures contract. T&M made recommendations to the Commission for modification of those sanctions and of CBOT rules relating to settlement prices for post-close trading sessions. T&M also filed a brief with the Commission in the disciplinary action.

Chicago Board of Trade. T&M reviewed CBOT's market surveillance, trade practice surveillance, and disciplinary programs and the order ticket and trading card components of its audit trail system. T&M found adequate surveillance and disciplinary programs and found general compliance of CBOT members with the audit trail requirements for the preparation of order tickets and trading cards. The Division recommended that CBOT take steps to improve the timeliness of both its market surveillance and trade practice investigations and to improve compliance with Commission requirements concerning trading card collection.

New York Futures Exchange. T&M found generally adequate audit trail, trade practice surveillance, and disciplinary programs at NYFE. The Division recommended that NYFE implement procedures to hasten the completion of all order ticket reviews. In addition, T&M recommended that NYFE take disciplinary action against members that have unusually low compliance with recordkeeping requirements, regardless of NYFE's practice of warning first time offenders.

New York Cotton Exchange -- T&M issued a report on NYCE's financial and sales practice program and concluded that NYCE's program generally meets the Commission's regulatory requirements. The report recommended that NYCE: (1) broaden the criteria in its written program for monitoring high risk firms to provide for heightened surveillance in certain circumstances; (2) amend its written program to include notification to the Commission if a firm fails to maintain current books and records; (3) revise pay/collect reports to state separately options premium data and futures data; and (4) revise financial report analysis forms to include the date on which the review of each financial report was started.

Exchange Clearing Organizations (BOTCC and CME Clearing House) -- T&M's reviews of BOTCC and CME Clearing House cover their compliance with the Commission's segregation and related recordkeeping rules. T&M found both clearing organizations in compliance with all applicable Commission segregation-related requirements. In addition to routine segregation matters, the Division also reviewed new program developments at both clearing organizations, including common settlement and banking arrangements. Also, with respect to BOTCC, the review included ''sub-custodial'' bank account arrangements for the safekeeping of securities and the LIFFE/Link.

Oversight of the National Futures Association (NFA)

The Commission promotes self regulation through delegation of authority to the NFA and oversight of NFA activities. The staff coordinates regulatory efforts with the NFA. For example, the T&M staff participates in and chairs the Registration Working Group, which brings together the NFA and Commission staff members to discuss registration issues of mutual concern.

The staff periodically evaluates how the NFA and CFTC can best use their resources to oversee the industry. During FY 1997, the T&M staff prepared and the Commission issued an Order delegating to the NFA several functions related to activities under Part 30 of the Commission's rules concerning foreign futures and options. In addition, the Commission issued an Order, developed by T&M, authorizing the NFA to take adverse registration action involving floor brokers, floor traders or applicants for registration in either category. The staff also determined that certain functions, including review of disclosure documents, could be delegated to the NFA. The Division drafted a Notice and Order delegating these functions. Staff will work with the NFA in the next fiscal year to ensure the successful transfer of these functions.

Pursuant to a Commission order effective July 3, 1997, the NFA will no longer forward statutory disqualification matters to the Commission for review. Under authority delegated by the Commission, the NFA processes applications and conducts background checks for applicants in all registration categories. The NFA may take adverse action against applicants and registrants. However, with respect to the floor broker and floor trader registration categories, the NFA, prior to the Commission's order, forwarded to the Commission for review any case where there is a potential statutory disqualification for which the NFA did not propose to deny or revoke registration. During FY 1997, T&M reviewed the files of 57 floor broker or floor trader applicants or registrants forwarded by the NFA. In addition, during FY 1997, T&M processed approximately 1,300 requests for withdrawal from registration.

The staff reviews and recommends approval of NFA oversight activities. During FY 1997, T&M recommended, and the Commission approved, several National Futures Association (NFA) initiatives and programs which enhance customer information and protection, including:

To ensure effective oversight by the NFA, T&M periodically undertakes reviews of the NFA's activities. During FY 1997, the staff conducted a review and advised the NFA of inaccuracies of data in its MRRS (Membership, Registration, Receivables System) due to firms' failure timely to report their AP terminations and required ethics training. The NFA corrected the problems by improving enforcement of ethics training and by requiring registrants timely to report previously terminated APs. T&M also reviewed the NFA's compliance program covering members who are registered as CPOs and CTAs. T&M found that the NFA's compliance program generally meets the Commission's regulatory requirements. The Division made recommendations in the following areas: (1) enhancement of the audit priority system for improved selection of members to be audited; (2) expansion of the NFA's promotional material review program; (3) modification of the FACTS system with respect to reporting funds under management; (4) establishment of procedures to identify members requesting withdrawal of their NFA membership prior to audit; (5) development of criteria to assist in implementing the NFA's amendment to Compliance Rule 2-29 with respect to hypothetical performance; (6) amendment of the self-examination checklist to improve monitoring of members' internal control procedures; (7) updating the checklist for desk review of disclosure documents; (8) follow up concerning filing of annual reports required for Rule 4.7 and offshore pools; and (9) measures to address failures to respond to annual questionnaires. In addition, T&M reviewed the NFA's registration program to assess actions taken in response to recommendations for action in prior year's reviews.

Oversight of Financial Practices

The Commission conducts direct audits of clearing organizations and firms handling customer money to ensure compliance with capitalization and segregation rules. In FY 1997, Division of Trading and Markets' activities to ensure sound financial practices by clearing organizations and firms holding customer funds included:

Rulemakings and Guidance

The Commission develops regulations to ensure sound financial practices of clearing organizations and firms and to promote and enhance self-regulation by the industry. The agency also facilitates the continued development of an effective, flexible regulatory environment, responsive to evolving market conditions, by providing exemptive, interpretive or other relief, as appropriate. This guidance fosters the development of innovative transactions, trading systems and similar arrangements.

SRO Rules and Guidance

During FY 1997, T&M undertook a number of initiatives to increase the efficacy of SRO programs and Commission oversight of self-regulatory organization (SRO) programs. Staff recommended and the Commission adopted the following final rules, advisories, or interpretations.

Expedited Review of Contract Market Proposals -- These rules shorten the Commission's timeframe for reviewing complex contract market rules and streamline the rule review process. Under the new rules, the Commission deems approved or permitted to be put into effect all proposed rule changes that do not affect the terms or conditions of a futures contract. The exchange may implement such rule change ten days after Commission receipt, unless the Commission elects to review the proposal further for either a 45- or 75-day period.

Potential Conflicts of Interest by Exchange Governing Board Members -- These rules require SROs to adopt rules prohibiting governing board, disciplinary committee, and oversight panel members from deliberating and voting on any matter in which the member has a personal or business relationship with the named party in interest or in which the member has a substantial financial interest in the outcome.

Guidance Concerning Automated Systems -- The Automated Systems Advisory explains that each contract market and clearing organization must use due diligence to ensure that its automated systems function in a way which reduces risks from system failure and assures equitable access to the markets. SROs must also conduct oversight and risk analysis addressing the areas specified by the International Organization of Securities Commissions in its Principles for the Oversight of Screen-Based Trading Systems.

Guidance on Commission Rules Preventing Fabrication or Destruction of Trading Records -- These final rules concern preparation, submission, and correction of trading cards. The rules, which are applicable to all trading records, require that the correction of errors on trading records not render illegible the original information. The rules also require that a ply of any trading card that is rewritten in order to correct errors be submitted in accordance with contract market rules for the regular collection of trading cards.

Guidance to Facilitate Use of Markets by Managed Funds Advisors -- This interpretation makes the account identification requirement applicable to bunched orders. The Commission simultaneously issued an order approving an NFA interpretive notice concerning the placement, execution, and allocation of bunched orders by CTAs and FCMs. The NFA notice generally provides that bunched orders may be placed so long as the appropriate account identifier information and the allocation responsibilities of all participants are provided before or with placement of the order.

Guidance on Financial Matters -- During FY 1997, T&M staff provided the following guidance on financial regulatory matters:

CPO and CTA Rules and Guidance

The T&M staff develops and interprets Commission regulations relating to registration, disclosure, managed funds, segregation of funds, ethics training, and other requirements applicable to commodity professionals and commodity pools. The staff responds to requests for exemptions and other relief from regulations and prepares advisories and guidelines on the application of Commission regulations. The staff also develops regulatory approaches to off-exchange derivative instruments, prepares Congressional testimony, and drafts reports and proposed legislation. Staff comment on regulations and interpretations prepared by other divisions and offices. During FY 1997, activities included the following:

Electronic Media -- T&M staff drafted the following documents which were adopted by the Commission:

Streamlining -- Assisted the Commission in exploring areas where regulatory burdens may be reduced, such as proposing rule amendments that would streamline the Commission's existing rules governing risk disclosure statements required to be furnished by FCMs and IBs to customers prior to opening commodity interest accounts. These proposed rule amendments would eliminate the requirement to provide risk disclosure statements to customers with high levels of financial resources.

Civil Monetary Penalties. -- Drafted a new Rule 143.8 to adjust for inflation the maximum civil monetary penalties that may be assessed under the CEA, which was adopted by the Commission on October 21, 1996. This action was taken to comply with the Debt Collection Improvement Act of 1996. The T&M staff has responsibility for the agency's debt collection program. During FY 1997, the staff collected approximately $1,652,000.

Financial Oversight Coordination -- Maintained strong working relationships with other financial oversight organizations and groups, such as the President's Working Group on Financial Markets. In response to a Congressional inquiry, staff assisted in preparing a report concerning recent actions by federal agencies to reduce risks in financial markets.

Banking Issues -- Prepared a draft of a comment letter from the Commission to the Board of Governors of the Federal Reserve System conveying the Commission's support for proposed amendments to Regulation Y designed to remove restrictions on subsidiaries of bank holding companies operating as FCMs and CTAs and to defer to certain Commission requirements relating to such subsidiaries.

Uniform Commercial Code -- Drafted a comment letter from the Commission to the National Conference of Commissioners on Uniform State Laws concerning a proposed amendment to draft Article 2B of the Uniform Commercial Code.

Responses to Public Inquiries -- In FY 1997, T&M staff prepared over 300 responses to requests for exemption, no-action positions and interpretations relating to registration, disclosure and other regulatory requirements.

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