The Commission's Division of Trading and Markets (T&M or Division) develops, implements, and interprets regulations promulgated under the Commodity Exchange Act (CEA), which protect customers, prevent trading and sales practice abuses, and assure the financial integrity of the futures markets and firms holding customer funds. In addition, T&M oversees the compliance activities of the futures industry self-regulatory organizations (SROs), which include the U.S. commodity exchanges, their clearinghouses, and the National Futures Association (NFA). The Division also conducts trade practice surveillance, performs financial and sales practice compliance audits of registrants, reviews exchange and futures association rule amendments and submissions, and oversees the registration of industry professionals.
Concept Releases, Rulemakings, and Guidance
The Commission has been engaged in a comprehensive regulatory reform effort designed to update, modernize, and streamline its regulations. This reform effort includes concept releases, rulemakings, and guidance to develop an effective, flexible regulatory environment that responds to evolving market conditions.
During FY 1998, the Division proposed, and the Commission issued, several concept releases to gather information and solicit public views about important policy questions. After evaluating the responses to the concept releases, the Commission will determine whether it is appropriate to begin a formal rulemaking process on the topics raised in each release. The Commission issued the following concept releases to gather public comments on significant issues:
· Over-the-Counter Derivatives - Public comment was sought on whether the Commission's current regulatory structure applicable to over-the-counter derivatives should be modified. In particular, the release requested comments on whether the Commission's current regulatory provisions exempting certain types of over-the-counter derivatives from some provisions of the CEA were adequate in light of the explosive growth in the over-the-counter derivatives market.
· Placement of Foreign Board of Trade Computer Terminals in the U.S. - The concept release sought public comment regarding the proper standards to be applied in considering applications from foreign boards of trade desiring to place terminals in the United States, such as whether a foreign board of trade should be exempted from the requirement for designation as a U.S. contract market and, if so, what requirements and conditions should be imposed.
· Noncompetitive Transactions Executed on or Subject to the Rules of an Exchange - A concept release on the regulation of noncompetitive transactions executed on or subject to the rules of a contract market raised questions about the oversight of transactions involving (1) the exchange of futures contracts for cash commodities; (2) other noncompetitive transactions, such as the exchange of futures contracts for swap agreements and block trades; and (3) the use of execution facilities for noncompetitive transactions.
· Maintenance of Customer Funds Overseas or in Foreign Currencies - T&M staff recommended and the Commission published a concept release concerning possible revisions to the Division's Interpretation No. 12, relating to maintenance of customer funds and the location of depositories. The release sought public comment on how to address the risks associated with holding segregated customer funds offshore or in foreign currencies, including U.S. bankruptcy treatment of these funds.
· Performance Data and Disclosure for Commodity Trading Advisors and Commodity Pools - T&M staff recommended and the Commission published a concept release concerning commodity trading advisor (CTA) and commodity pool rate-of-return and disclosure issues. The release sought public comment on improving risk profile data for both CTA programs and commodity pools, providing a theoretically sound basis of computation and presentation for rate of return and related risk profile data, providing CTA client account information to futures commission merchants (FCMs) for risk management purposes, and improving the presentation of historical performance and risk profile data.
During FY 1998, T&M recommended and the Commission published several rule proposals and final rules. These rulemakings covered a wide range of topics, from SRO regulation to financial reporting requirements, including the following:
· Allocation of Bunched Orders - The Commission approved a final rule amendment to Regulation 1.35(a-1) permitting certain bunched customer orders to be placed on U.S. futures exchanges without individual customer account identifiers either at the time of order placement or report of execution. Bunched orders may be placed by registered CTAs,investment advisers, and other regulated account managers (subject to certain conditions) on behalf of customers who have been identified as sophisticated "eligible participants" in Part 36 of the Commission's regulations. The rule requires these orders to be allocated to customer accounts no later than the end of the day the order is executed.
· Expanded Use of Micrographic and Electronic Storage Media - This release requested public comment on proposed amendments to Regulation 1.31 which would allow registrants to use micrographic and electronic storage media in lieu of paper for recordkeeping in many circumstances. The amendments are designed to maximize the cost reduction and timesaving of electronic storage while retaining safeguards to ensure reliability in the recordkeeping process.
· Futures-Style Margining of Commodity Options - The Commission repealed Regulation 33.4(a)(2), thereby permitting the futures-style margining of commodity options. This action does not impose an obligation on exchanges to adopt futures-style margining, but rather permits each market to determine whether to implement that approach.
· Standards Regarding Potential Conflicts of Interest at SROs - Regulation 1.69, reproposed by the Commission during FY 1998, would establish enhanced standards regarding potential conflicts of interest at SROs. This regulation would require SROs to adopt rules prohibiting members of their governing boards, disciplinary committees, and oversight panels from deliberating and voting on matters in which they have either a relationship to a named party or a financial interest in the outcome of the proceeding.
· Change in Trading Hours - Amendments to Regulation 1.41(k), which were adopted by the Commission during FY 1998, allow a contract market that has previously received Commission approval for trading between 6:00 p.m. and 7:00 a.m. in at least one of its designated contracts to change its trading hours. Such a change will be deemed approved by the Commission one business day after receipt of written notice of the change.
· Exemptive, No-Action and Interpretative Letters - The Commission published a proposed rule to provide guidance to the industry and to the public regarding procedures to request exemptive, no-action and interpretative letters from Commission staff. The proposed rule would create a level playing field for regulated entities and members of the public who seek such letters and would enable the Commission staff to respond quickly to incoming requests.
Financial Reporting and Disclosure
· Electronic Reporting - T&M staff recommended and the Commission approved a rule amendment permitting the use of a personal identification number in lieu of a manual signature to attest to the completeness and veracity of a report. To save development costs and to make electronic filing systems compatible with and transparent to the filing firms, the Commission adapted for its own use the filing software that was co-developed by the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBT). Through September 30, 1998, the Commission received 821 financial reports electronically from 87 FCMs who are members of CME and CBT. T&M staff also began working with the National Futures Association which is developing a system to permit electronic filing of its members' financial reports.
· Elimination of the "Short Option Value Charge"- The Commission eliminated the "short option value charge" that the Commission had required FCMs to take when computing their net capital. Previously, in calculating its adjusted net capital, an FCM was required to deduct a capital charge, based upon four percent of the market value of commodity options sold by option customers on or subject to the rules of a contract market or a foreign board of trade. The Commission rescinded this charge because it found that the charge was not closely correlated to the actual risk of the customer's short option positions and because there are other protections in place to address this risk.
· Notification of Undersegregration of Customer Funds or Undercapitalization - Final rule amendments to Regulation 1.12 require FCMs to notify the Commission immediately when they "know or should know" that they are not in compliance with the requirements for segregation of customer funds or for capital. These amendments shorten the time from when an FCM learns of undersegregation or under-capitalization problems and the FCM is required to report to the Commission.
· Elimination of Risk Disclosure and Bankruptcy Disclosure Statements - The Commission eliminated the requirement that FCMs and introducing brokers (IBs) provide certain categories of financially sophisticated customers with risk disclosure and bankruptcy disclosure statements and obtain from these customers written acknowledgements of receipt of the risk disclosure statement before opening a commodity futures or option account on their behalf.
Exemptive Relief and Guidance
In FY 1998, T&M staff responded to a high volume of requests for guidance concerning the applicability of regulations to specific transactions, products, persons and market circumstances. Division staff issued over 230 responses to written requests from members of the public and the regulated industry to provide guidance concerning compliance. These responses consisted of exemptive letters, no-action positions and interpretative guidance.
Review and Approval of Exchange Rules
The Division promotes and enhances self-regulation by reviewing proposed exchange rules and amendments for consistency with the CEA and Commission regulations. In many cases, these rule submissions present complex new trading procedures, market structures, and financial arrangements which raise novel issues. In some cases, the submissions also require Commission rule amendments or interpretations to facilitate implementation of the SRO rule changes. During FY 1998, the Division reviewed, and the Commission approved, 212 new exchange rules or rule amendments. The Division also reviewed and permitted 479 exchange rules to go into effect without prior Commission approval. Significant exchange rules approved by the Commission or permitted to go into effect by the Division in FY 1998 include the following:
· Cantor Financial Futures Exchange - The Commission approved designation of the Cantor Financial Futures Exchange (CFFE), a computer-based exchange, as a new contract market for futures contracts on U.S. Treasury one-, five-, and ten-year notes and thirty-year bonds. CFFE was formed pursuant to an agreement between the New York Cotton Exchange (NYCE) and Cantor Fitzgerald, LP, an inter-dealer broker in the U.S. Treasury securities market. CFFE contracts are traded over the same trading system that CFFE uses to trade government securities and are cleared by the Commodity Clearing Corporation. NYCE provides all regulatory functions.
· NYMEX Specialist Market Maker Program - The Commission approved a New York Mercantile Exchange (NYMEX) proposal establishing a Specialist Market Maker (SMM) Program. The Program is intended to enhance liquidity in new or low-volume futures contracts. The SMM will be a NYMEX member or member firm appointed by NYMEX to act as a market maker in a designated contract market. The SMM will be required to maintain a continuous physical presence on the floor of the exchange throughout the regular trading session, manage a limit order book, and provide a two-sided market in the relevant contracts. The SMM will receive certain exchange funding and will be entitled to trading priorities.
· NYCE and CSCE Merger - The Commission approved rules submitted by NYCE and the Coffee, Sugar and Cocoa Exchange (CSCE) that facilitated a merger of the two exchanges. Initially, the exchanges will merge staff but will continue as separate legal entities under the control of a common holding company, the Board of Trade of the City of New York (NYBT). The two will later merge into NYBT, with NYBT being the surviving legal entity. At that time, former NYCE and CSCE full members will have joint trading rights in all NYCE and CSCE futures and option contracts.
· "Project A" Side-by-Side Trading - The Division allowed into effect without prior Commission approval a CBT rule proposing side-by-side electronic and open outcry trading of certain financial contracts during regular trading hours. Project A, CBT's electronic trading system, was used previously only for overnight trading of high-volume contracts. The Division determined that CBT adequately demonstrated Project A's ability to handle reasonably anticipated daytime trading volume for high-volume contracts.
· Globex2 Electronic Trading System - The Division allowed into effect without prior Commission approval amendments proposed by the CME implementing a new operation system for its Globex electronic trading system, referred to as Globex2. The new system provides various improved features, including the capacity to process various types of orders including market orders, stop limit orders, market-if-touched orders, and one-cancels-other orders.
· NYCE and Citrus Associates Merger - The Division allowed into effect without prior Commission approval a proposed merger of the Citrus Associates of NYCE (Citrus) and NYCE. Prior to the merger, NYCE and Citrus were separate affiliated legal entities.
· CME Trader's Instant Treasury Access Network - The Division allowed into effect without prior Commission approval CME's proposed Trader's Instant Treasury Access Network (TITAN). TITAN offers members the ability to trade cash U.S. Treasury instruments and to arrange financing for cash Treasuries via inter-dealer broker terminals placed in the Eurodollar quadrant of CME's trading floor.
· BOTCC and CCOS Account Cross-Margining - The Division reviewed and the Commission approved cross-margining of certain non-proprietary accounts carried by clearing members of the Board of Trade Clearing Corporation (BOTCC) and its subsidiary, the Clearing Corporation for Options and Securities (CCOS), on behalf of participating market professionals. CCOS will provide clearance and settlement services for certain cash government securities transactions executed through the Chicago Board Brokerage, Inc., a subsidiary of CBT.
· CME Pit Space Dispute Resolution Guidelines - The Division allowed into effect without prior Commission approval proposed CME guidelines for the resolution of pit space disputes on the trading floor. The Division's "1997 Broker Association Rule Enforcement Review" recommended that the exchanges establish procedures addressing the allocation of pit space. CME responded with a proposal setting forth detailed procedures to be followed and factors to be considered in resolving pit space disputes. The proposal makes clear that pit space is not the property of any member and therefore cannot be sold.
· Review of Exchange Emergency Actions
New York Mercantile Exchange - The Division reviewed an emergency action taken by NYMEX and prepared a report to Congress as required by law. The emergency action, taken during extreme movement in both the electricity futures and cash markets, temporarily expanded price fluctuation limits to allow trading in the second month of the Cinergy and Entergy Electricity futures contracts. The Division report concluded that it was appropriate for NYMEX to permit temporary rules to remain in effect for the duration of the emergency.
New York Cotton Exchange - The Division reviewed an emergency action taken by NYCE and prepared the required report to Congress. The emergency action, taken in response to foreign exchange and capital control actions of the government of Malaysia and the Malaysian central bank, suspended trading of all contract months in Malaysian ringgit futures after the September 1998 contract and allowed trading in the September 1998 contract for liquidation purposes only. The Division concluded that it was appropriate for NYCE to permit the temporary rules to remain in effect for the duration of the emergency.
The Commission conducts a financial oversight and audit program that buttresses periodic audit, daily financial surveillance, and other self-policing programs administered by the exchanges and NFA. The effort includes oversight of financial compliance programs of SROs and direct quality control audits to assess the efficiency of their programs. The oversight and audit of SRO programs are necessary to ensure that SRO member firms are properly capitalized and that customer funds are held in segregation by appropriate custodians and are protected from misappropriation. This oversight also involves conducting audits of clearing organizations and firms holding customer funds and reviewing reports filed by registrants and SROs.
In late FY 1998, the Division increased its oversight and audit of FCMs and CPOs in response to the economic turbulence created by the near-collapse of a major hedge fund. T&M issued "special calls" for information and sent auditors to review the books and records of firms that were experiencing financial difficulties. In addition, the Division conducted its routine activities, including:
· Auditing and examining 51 FCMs, CPOs, CTAs, and other registrants to test industry self-regulatory programs and to address special issues, including review of compliance in support of the investigations and proceedings of the Division of Enforcement.
· Reviewing 4,121 financial reports filed by registrants in FY 1998.
· Processing 158 risk assessment filings.
· Issuing 275 warning and non-compliance letters based upon audits and review of financial reports.
· Investigating 185 special required notices that report such events as reductions of capital of registered firms.
As part of its Year 2000 efforts, the Division issued two Year 2000 advisories which list the minimum elements of a Year 2000 plan, including update and testing of systems and contin-gency planning in the event of malfunction. The advisories also articulate reporting and disclosure requirements regarding the Year 2000 programs of Commission registrants and require that audits of Commission registrants include a Year 2000 readiness inquiry. In this connection, the Division worked with the American Institute of Certified Public Accountants to develop a set of agreed-upon procedures for use by outside auditors of Commission registrants.
SRO Rule Enforcement Oversight
The CEA requires each exchange, through a program of continuing rule enforcement, to ensure that its members adhere to exchange rules. The Division oversees, reviews and reports to the Commission on the self-regulatory compliance programs of the exchanges. When appropriate, the reviews include recommendations for improvements and schedules for implementing those recommendations. During FY 1998, in connection with reviews of trade practice, market surveillance, audit and financial surveillance, and related SRO compliance programs, staff conducted reviews of the rule enforcement programs of the following exchanges:
· New York Cotton Exchange - The Division completed a review of the trade practice surveillance and disciplinary programs at NYCE. It found that NYCE's trade practice and disciplinary programs are generally adequate, but recommended that NYCE increase the size of its compliance staff, identify possible recordkeeping violations during the course of conducting investigations, and consider any profit made by a member from his or her violative conduct in determining the appropriate sanction. A separate review of NYCE's market surveillance program was completed earlier in the fiscal year. The Division concluded that, since the prior review, NYCE had made improvements to its large trader reporting system and speculative position limit enforcement program. However, the Division suggested further improvements.
· Commodity Exchange, Inc. (COMEX) - The Division completed a review of the market surveillance program at the COMEX division of NYMEX. The review concluded that COMEX's market surveillance is adequate, but made three recommendations for improvement: (1) COMEX should convene its Control Committee more frequently during potentially problematic contract expirations; (2) COMEX's investigations of possible price manipulation should encompass a sufficient scope of market activity; and (3) COMEX's exchange of futures for physicals inquiries needs improvement.
· Kansas City Board of Trade - The Division completed a review of the market surveillance, trade practice surveillance, and disciplinary programs at the KCBT. It found that KCBT generally maintains adequate compliance programs and made two recommendations for improvement: (1) KCBT should ensure that all investigation reports contain a clear articulation of the rationale for closing investigations; and (2) KCBT should impose monetary and/or other sanctions on members who repeatedly violate the same or similar Exchange rules.
· New York Mercantile Exchange and Chicago Mercantile Exchange - The Division conducted full scope reviews of the audit, financial and sales practice compliance programs of NYMEX and CME. The Division found that both exchanges' programs were well designed, their staff generally execute their reviews thoroughly, and their programs comply with applicable regulatory requirements. T&M made no major recommendations for enhancements to the programs.
· Audit Trail and Dual Trading - The Division continued its review of SRO compliance with audit trail and dual trading requirements. Based on this work, the Commission granted an unconditional exemption from the statutory dual trading prohibition to CME for its S&P 500 futures contract market. It also issued proposed orders that would grant conditional exemptions to CME for seven affected contract markets and to CBT for 13 affected contract markets. An audit trail accuracy test was conducted at NYMEX as part of a review of its petition for a dual trading exemption. NYMEX was subsequently given an opportunity to supplement its petition prior to Commission consideration.
Oversight of the National Futures Association (NFA)
The Commission promotes self-regulation through delegation of authority to the NFA and oversight of NFA activities. In addition, T&M coordinates regulatory efforts with NFA. For example, T&M staff participate in and chair the Registration Working Group, which brings together the NFA and Commission staff members to discuss registration issues of mutual concern. During FY 1998, the Registration Working Group reviewed the integrity of the registration database, the standardization and monitoring of conditions applied to persons with past disciplinary histories, the screening and tracking of rogue brokers, and the improvement and refinement of the fitness review process.
T&M staff periodically evaluate how the NFA and CFTC can best use their resources to oversee the industry. The Division also reviews all proposed NFA rules and rule amendments. The following highlights work accomplished with regard to NFA during FY 1998:
· The Commission issued an Order, developed by T&M, authorizing the NFA to perform certain functions regarding CPOs and CTAs, including the function of reviewing CPO and CTA disclosure documents. In addition, the Commission authorized NFA to process the following: (1) notices of eligibility for exclusion of certain otherwise regulated persons from the definition of CPO; (2) notices of claim for exemption from certain Part 4 requirements with respect to commodity pools and CTAs whose participants or clients are qualified eligible participants or qualified eligible clients; (3) claims of exemption from certain Part 4 requirements for CPOs with respect to pools that principally trade securities; (4) statements of exemption from registration as a CPO; (5) notices of exemption from registration as a CTA for certain persons registered asinvestment advisers; and (6) notices of claim for exemption from provisions of Part 4 for certain registered CPOs operating offshore pools.
· The Division allowed into effect without Commission approval NFA's proposed amendments permitting it to grant registration to agricultural trade option merchants (a new category of registrants) and their associated persons.
· The Division reviewed and the Commission approved a revision to NFA's procedures for the handling of settlement offers in disciplinary matters. The revision was prompted by circumstances in an NFA disciplinary case involving a respondent who attempted to withdraw a settlement offer that had been tendered to NFA.
· The Commission authorized NFA to approve applications for floor broker or floor trader registration and to maintain the registration of any floor broker or floor trader who may be subject to statutory disqualification from registration without forwarding such cases to the Commission for review.
· The Division conducted a rule enforcement review of NFA's audit, financial, and sales practice compliance program. T&M found that the program was well designed and complied with applicable regulatory requirements. The Division made no major recommendations for enhancements to the program.
Cooperative Efforts with Other Regulators and Industry Participants
· Year 2000 Compliance - The Commission participates in various working groups regarding Year 2000 issues, including the President's Council on Year 2000 Conversion. The Commission also has been actively working with the Futures Industry Association in connection with its execution of an industry-wide Year 2000 testing program. In addition to issuing Year 2000 advisories which list the minimum elements of an adequate Year 2000 plan, the Division has been reviewing the programs of each SRO to bring its systems into compliance and to address the readiness of its members. Finally, the Commission has made its own mission critical systems compliant and will ensure that all of its systems are compliant in FY 1999.
· Financial Oversight Coordination - T&M staff maintained strong working relationships with other financial oversight organizations and groups such as the President's Working Group on Financial Markets. In response to actions by other financial oversight organ-izations, staff worked on issues concerning risk assessment, capital requirements, internal controls, disclosure, accounting, market practices relating to trading in derivative instruments, bankruptcy law revisions, and contingency planning for market emergencies.
· Financial Products Advisory Committee - The Financial Products Advisory Committee was formed to provide a forum for the discussion of regulatory initiatives, including regulatory reform issues and methods for addressing new regulatory challenges. T&M staff participated in various meetings to address issues such as futures-style margining of options, bunched order allocation, notional funds, non-competitive transactions, foreign terminals in the U.S., and Year 2000 issues.
· Civil Monetary Penalty (CMP) Collection Program - T&M, in cooperation with the Division of Enforcement, operates a CMP collection program to reinforce Commission sanctions by assuring vigorous pursuit of penalties assessed. During FY 1998, the Commission collected approximately $125,804,000 in penalties.