The Year in Review
Reauthorization and Regulatory Reform
FY 2000 witnessed a series of events that resulted in substantial revisions to the Commodity Exchange Act (CEA) and the transformation of the Commission from a front-line regulator to an oversight agency. The process began with legislative recommendations to Congress in November 2000 from the President's Working Group on Financial Markets (PWG), based on a study requested by the Chairmen of the Senate and House Agriculture Committees. The PWG urged Congress to exclude from the CEA transactions in financial instruments conducted over-the-counter or electronically by financial institutions and other persons with demonstrated economic capacity. The PWG stated that statutory exclusions, together with other recommendations contained in its report, were needed to enhance legal certainty for over-the-counter (OTC) markets, to promote innovation, and to reduce systemic risk.
The PWG acknowledged that exchange-traded futures markets could face a competitive disadvantage unless they were afforded regulatory relief. The PWG accordingly asked Congress to grant the CFTC explicit authority to provide appropriate relief consistent with the CFTC's determination of the public interest. The Chairmen of the House and Senate Agriculture Committees responded 21 days after receiving the PWG's recommendations with a request to the Commission to exercise its exemptive authority to fashion immediate relief for U.S. futures markets. Congress itself proceeded to consider legislation to reauthorize the CFTC, drawing significant guidance from the PWG's recommendations.
In response to Congress' request, Chairman Rainer formed a staff task force to create a new regulatory framework that would meet the Commission's public policy goals in a manner responsive to changing conditions in U.S. futures markets. To assist in this effort, the Commission held two public roundtables and one Agriculture Advisory Committee meeting in December 1999. To assure that the task force considered an array of perspectives, the staff met frequently with participants in the derivatives markets, who represented a range of industry views. The task force proposed a framework establishing three kinds of trading facilities, subject to differing levels of Commission oversight. The task force also considered less sweeping regulatory relief for market intermediaries. A report outlining the new framework was submitted to Congress in February 2000. Its ideas provided further guidance to Congress as it proceeded with reauthorization legislation.
Meanwhile, the Commission staff began drafting rules to implement the framework. Proposed rules were published for comment in June 2000. In addition to trading facilities, the comprehensive rules package addressed clearing, intermediaries and OTC transactions.
In response to another request from Congress, staff from the Commission and the Securities and Exchange Commission began meeting to determine whether the trading of single-stock futures should be permitted, and if so, under what conditions. The agencies reached an agreement in September 2000 and submitted it to Congress. The agreement provided for joint jurisdiction over single-stock futures and narrow-based stock index futures. Broad-based index futures remained under the CFTC's exclusive jurisdiction. The agreement also provided objective standards for determining whether a particular group of securities constitutes a narrow-based stock index.
Legislative and regulatory activity continued on parallel tracks through the remainder of the year. In November 2000, the Commission adopted final rules for comprehensive regulatory reform. This action was superseded the following month, when Congress passed and President Clinton signed the Commodity Futures Modernization Act of 2000 (CFMA). The CFMA repealed the ban on single-stock futures and implemented a joint regulatory framework for the new product; enacted the principal provisions of the Commission's new regulatory framework; brought legal certainty to trading in OTC financial markets; clarified the CFTC's jurisdiction over certain aspects of the retail market in foreign exchange trading; and gave the CFTC authority to regulate clearing organizations. The CFMA also reauthorized the Commission for five years.
Fraudulent Internet Solicitations
On May 1, 2000, the Commission announced the initial results of a coordinated enforcement initiative with the Federal Trade Commission (FTC) and SEC aimed at cleaning up Internet websites. The Commission targeted sites that fraudulently promote commodity trading systems and advisory services to the general public. As part of the initiative, the Commission filed and simultaneously settled 10 administrative enforcement actions. In a second Internet sweep on September 6, 2000, the Commission filed four additional administrative actions, and also filed a civil injunctive action in a fifth case. On the same date that the first coordinated actions were filed, the Commission issued a Consumer Advisory warning the public about websites selling commodity trading systems that guarantee high profits with minimal risk. The Advisory warns consumers that commodity futures and options are typically high risk endeavors, that no computer trading system can guarantee profits, and that the hypothetical results used by many trading system promoters to advertise their systems can be unreliable. This Consumer Advisory is available on the Commission’s website along with other Advisories concerning possible fraudulent activity in the commodity futures and option industry.
During the week of February 28, 2000, the Commission participated with law enforcement and consumer protection agencies from 27 countries in an interagency Internet Surf. The Commission alone examined approximately 300 Internet websites and identified dozens for follow-up review. On March 28, 2000, the Commission participated in an Internet Surf Day organized by the International Organization of Securities Commissions (IOSCO) that included the participation of 21 regulators in 18 countries. The sites identified for follow-up review by the Commission and the National Futures Association (NFA) involve commodity futures and options in a variety of ways, such as: 1) computerized trading systems promising highly successful buy and sell signals; 2) trade recommendations based on seasonal trends in the prices of commodities like heating oil and gasoline; and 3) purported profit opportunities on commodities such as foreign currencies (or forex), precious metals, and stock indices.
Internet Surveillance Training
On June 15 and 16, 2000, the Commission and the SEC jointly hosted a second Internet Surveillance Training Program for relevant enforcement staff from members of IOSCO’s Working Party on Enforcement and Exchange of Information (WP4). The program was held at the Commission’s Washington, DC, headquarters. This training program brought together experts from regulators with Internet enforcement programs to provide instruction on areas such as the use of search engines for detecting securities offenses, Internet resources that identify authors of anonymous newsgroup postings and e-mail messages, and methods of preserving and authenticating electronic evidence. There was also a panel discussion on the organization of Internet surveillance and Internet enforcement programs. The Commission reached out to foreign as well as domestic authorities, such as the Federal Bureau of Investigation (FBI), to share knowledge and experiences at the training program. The program was attended by 22 participants from 19 different jurisdictions.
Fraud in Connection with Illegal Commodity Contracts
During FY 2000, the Commission’s Enforcement program actively sought to protect the public from wrongdoers who fraudulently solicit customers for what are purported to be financed speculative purchases of precious metals and other commodities but which are in fact illegal futures or option contracts. The Commission brought two civil injunctive actions charging defendants with this type of misconduct during FY 2000. The Commission also issued a Consumer Advisory warning the public of companies that purportedly sell investments in precious metals and other commodities based on sales pitches fraudulently claiming that customers can make a lot of money, with little risk, by purchasing metals through a financing agreement. The Consumer Advisory is available on the Commission’s website.
Fraudulent Trade Allocation
In November 1999, the Commission filed a five-count civil injunctive action against IB Capital Insight Brokerage, Inc. (Capital Insight) and its president, owner, and associated person (AP), S. Jay Goldinger. The complaint alleged that Goldinger and Capital Insight violated the anti-fraud, registration, and recordkeeping provisions of the Act and Commission regulations in connection with a fraudulent trade allocation scheme. Specifically, the complaint alleged that Goldinger and Capital Insight engaged in a mix-and-match trade allocation scheme, while trading for customers in Treasury bond futures contracts and options on these contracts at the Chicago Board of Trade (CBOT). The complaint alleged that Goldinger and Capital Insight purposefully failed to provide account numbers until after they knew the prices at which the trades had been confirmed in order to allocate profits and losses among their customers. The complaint further alleged that Goldinger and Capital Insight also misrepresented trading risks to customers and sent false trading statements to their customers in order to conceal their fraudulent trading scheme. Finally, the complaint alleged that Capital Insight failed to register as a commodity trading advisor (CTA) and failed to prepare written records, including account identification of customer orders, immediately on receipt of such orders. The court entered a consent order of permanent injunction on November 12, 1999 in which Goldinger and Capital Insight, without admitting or denying the allegations of the complaint, were permanently enjoined from further violations as charged and were ordered to pay $6 million in disgorgement. CFTC v. Goldinger, No. 99-11543 WMB (C.D.Cal. filed Nov. 9, 1999).
In a series of subsequent administrative orders, the Commission accepted offers of settlement from Constantine Mitsopoulos, an FB at Refco Inc., and three phone clerks who worked for him (Margaret Dull, Richard Marisie, and Lisa Budicak), finding that they facilitated Goldinger’s trade allocation fraud by not obtaining account identification information at the time they received orders from Capital Insights and by changing the account identification on trades already assigned to a customer account. See In re Mitsopoulos, et al., CFTC Docket No. 99-17 (CFTC enter April 10, Aug. 31, and Sept. 26, 2000).
Unlawful Commission Kickbacks
In February 2000, the Commission issued an order simultaneously instituting administrative proceedings and accepting an offer of settlement from Sogemin Metals, Inc. (SMI), a registered IB, based on an unlawful and undisclosed commission arrangement involving SMI’s brokering of futures and option transactions in metals for two Chilean clients, Corporacion Nacional del Cobre de Chile (Codelco), the world’s largest producer of copper, and Empressa Nacional de Mineria (Enami), another large producer. These transactions were executed by Sogemin Metals Limited (SML), SMI’s parent company. The order found that SMI failed to disclose to Codelco and Enami that SML paid return commissions to a Cayman Islands company controlled by SML’s Chilean agent, whose principals included individuals with close family connections to the head futures traders at Codelco and Enami. The order further found that this illegal scheme also involved kickbacks from these commissions to certain SMI senior employees and to the head futures traders at Codelco and Enami without the knowledge of the management of those companies. Without admitting or denying the Commission’s findings, SMI consented to the entry of an order that directed SMI to: 1) cease and desist from further violations as charged; 2) pay a $500,000 civil monetary penalty; and 3) comply with a series of undertakings to, among other things, adopt a strict monitoring procedure for commission rebates, revise SMI’s internal procedures manual, and create an SMI compliance manual. In re Sogemin Metals, Inc., CFTC Docket No. 00-4 (CFTC filed Feb. 7, 2000).
In FY 2000, the Commission approved 29 new futures and option contracts. Of the 29 contracts approved, two were approved under 10-day fast-track provisions and 13 were approved under 45-day fast-track provisions. In addition, exchanges filed 23 new contracts for listing under the Commission’s certification procedures, which permit exchanges to certify their own contracts and list them prior to receiving Commission approval. Several of the approved contracts represent innovative approaches designed to meet specialized hedging needs of producers and firms. For example, the Commission approved futures and option contracts based on US agency notes and barge freight rates. Also, the Commission reviewed futures and option contracts based on wood products produced in several regions in the US, as well as various livestock contracts and a regional electricity contract.
International Regulatory Cooperation
On May 17, 2000, the Commission and the United Kingdom (UK) Financial Services Authority (FSA) entered into the Arrangement on Warehouse Information (Arrangement) enhancing the existing US/UK Memorandum of Understanding on Mutual Assistance and the Exchange of Information (dated September 25, 1991). The new arrangement is intended to facilitate exchanges of information between the Commission and the FSA for surveillance and enforcement purposes regarding deliverable commodities that are traded in both jurisdictions.
The Commission also continued to participate in the International Organization of Securities Commissions (IOSCO). In particular, actions involving responding to events in the financial markets related to the activities of hedge funds and other highly leveraged institutions (HLIs) continued to dominate a significant part of Commission activities in IOSCO during FY 2000. The Commission actively participated in the IOSCO task force on implementing the IOSCO report, Objectives and Principles of Securities Regulation. The objectives and principles were adopted as a statement of international “best practices.” In addition, the Commission contributed to IOSCO’s activities to address challenges posed by the Year 2000 problem, including the development of a draft statement on Year 2000 testing and contingency planning. The Commission worked with IOSCO to examine the status of regulating electronic markets and the need for revisions to IOSCO’s 1990 statement of regulatory principles and provided an updated analysis and commentary in its 1999 Survey of the Regulation of Over-the-Counter Derivatives Transactions, which examined the regulatory regimes in 16 jurisdictions across Europe, Asia, and North and South America.
The Commission adopted Rule 30.12 permitting certain foreign firms, acting in the capacity of FCMs and IBs, to accept and execute foreign futures and option orders directly from certain sophisticated US customers without having to register with the Commission. Commission staff developed a revised interpretation of the foreign futures or foreign options secured amount requirement set forth in Rule 30.7, clarifying that the requirement for FCMs to obtain an acknowledgement from a depository, with respect to the treatment of foreign futures and option customer funds, applies only to the treatment of funds by the initial depository. No-action letters were issued to the International Petroleum Exchange of London Limited (IPE) in November 1999 and to the Singapore Exchange Ltd., formerly known as Singapore International Monetary Exchange (SIMEX), in December 1999. A supplemental no-action letter was also issued to the London International Futures Exchange (LIFFE) in December 1999. In June 2000, a no-action letter was issued to the Hong Kong Futures Exchange (HKFE). The Commission also issued a Statement of Policy in June 2000 indicating that foreign exchanges that had already received no-action relief could trade additional contracts upon notice to the Commission, obviating the need for subsequent no-action letters.
During FY 2000, the Commission made significant progress in reducing the pending no-action requests for futures contracts on foreign stock indices traded on foreign exchanges. These requests involve complex regulatory issues and close coordination with the SEC. The reduction of pending requests was greatly facilitated after a meeting between Commission and SEC officials held on February 22, 2000. At that meeting, the SEC agreed to streamline its review process and reached a consensus with the Commission on several regulatory issues. As a result, the Commission has issued no-action relief for 15 foreign exchange-traded stock index futures contracts listed on six different exchanges during FY 2000, more than during any prior fiscal year. The previous high was six contracts during FY 1994. Also as a result of the February meeting, the Commission and the SEC agreed that letters would be issued deeming requests withdrawn that did not meet Commission criteria or that were stale. The Commission issued seven such letters during FY 2000.
Electronic Trading Developments
The Commission is faced with an increasing number of important issues concerning the impact of technological changes on methods of transacting business on futures exchanges and a proliferation of designation applications for new electronic futures exchanges. During FY 2000, the Commission designated the Merchants’ Exchange of St. Louis, L.L.C. (MESL) as a contract market for the automated trading of deliverable Illinois Waterway and St. Louis Harbor barge freight futures contracts. The Commission also designated, by orders dated March 13, 2000, FutureCom, Ltd. (FutureCom), a Texas limited partnership owned by the Texas Beef Group, as a new contract market for the automated Internet-based trading of cash-settled live cattle futures and option contracts. FutureCom is unique in that it is the first Internet-based futures exchange and every member is its own clearing member.
On August 22, 2000, staff notified the CBOT that it could make effective immediately, without Commission approval, CBOT’s new rules for “e-cbot,” a new trading platform using technology adapted from the electronic trading system employed by Eurex Deutschland. E-cbot replaced the CBOT’s existing electronic trading system, Project A, as part of a strategic alliance between CBOT, Eurex, and other affiliates. Staff also allowed into effect a rule proposal from the Chicago Mercantile Exchange (CME) permitting link arrangements with various foreign exchanges (in addition to Marché ā Terme International de France (MATIF), with which CME already had such an arrangement). Under the new rules, members of CME and a linked foreign exchange will be able to trade not just cross-exchange contracts listed on Globex, but all products accessible on either exchange’s automated trading system.
On May 1, 2000, staff notified the New York Mercantile Exchange (NYMEX) that its proposed linkage with Singapore Exchange Derivatives Trading Limited (SGX-DT) for the purpose of trading on NYMEX ACCESS, its automated electronic trading system, was approved and could be made effective immediately. ACCESS terminals are now located in England and are linked with SGX-DT, Sydney Futures Exchange (SFE), and Hong Kong Futures Exchange. Staff also issued a no-action letter permitting the operation and use of an automated system for buying and selling electricity for delivery in the future, without the system operator obtaining contract market designation pursuant to Section 5 of the Commodity Exchange Act. The system enables commercial entities that meet specified eligibility requirements to buy and sell electricity for on-peak hours in one-month blocks, up to 12 months in advance of delivery.
CME and NYMEX Demutualization
The Commission approved a CME proposal to convert the exchange from an Illinois not-for-profit membership organization to a Delaware for-profit stock corporation and a corresponding order transferring all of CME’s current contract market designations to the new entity, the Chicago Mercantile Exchange, Inc. Although there are other for-profit futures exchanges, CME’s proposal was the first demutualization plan of an existing exchange approved by the Commission. In preparing its recommendation, staff analyzed the potential impact of the plan on the ability of the new for-profit exchange to perform its self-regulatory responsibilities effectively, as well as the plan’s impact on other current CME activities. The Commission’s action was based on certain specified conditions relating to the self-regulatory functions of the exchange.
The Commission also approved a NYMEX proposal to convert the exchange from a New York not-for-profit membership organization into a Delaware membership company that is a subsidiary of a Delaware for-profit stock corporation, NYMEX Holdings, Inc., and the issuance of an order transferring all of NYMEX’s current contract market designations to the new entity. NYMEX’s proposal was approved subject to conditions similar to those imposed with respect to CME.
Streamlining of Reviews of Exchange Rule Changes
The Commission reviewed its approval requirements for submissions of proposed rule changes by exchanges. In June 1999, the Commission proposed amendments to Rule 1.41 to increase the number of exchange rule changes that can become effective immediately and those that may go into effect within three days or 10 days of submission to the Commission. The proposed procedures also will permit exchanges to reduce significantly the number of filings of rule changes they are required to make to the Commission. In a Federal Register release published on November 26, 1999 (64 FR 66428), the Commission sought comment on a proposal to revise its procedures for the review of contract market rules and rule amendments.
Under the proposed revision of Regulation 1.41, a rule (except for terms and conditions of contracts on commodities enumerated under Section 1(a)(3) of the Act) could be placed into effect on the business day after the Commission had received a submission for the rule. There would be no delay in the implementation of the rule to allow for prior Commission review. The submission for the rule would have to include: 1) the text of the rule or amendment, with redline, as applicable; 2) a brief explanation of the rule; 3) a description of any substantive opposition; and 4) a “certification” that the rule is not inconsistent with the Act or with Commission regulations. To ensure that a board of trade seeking initial designation as a contract market would continue to undergo detailed analysis, the process could be used only by a contract market with at least one non-dormant contract.
During FY 2000, the Commission adopted amendments to Rule 4.7 to add several categories of persons to the definitions of “qualified eligible participant” (QEP). Under Rule 4.7, commodity pool operators (CPOs) who solicit only QEPs and commodity trading advisors who advise only QEPs may claim exemption from certain otherwise applicable disclosure, reporting, and recordkeeping requirements. In addition, the Commission adopted amendments to Rule 4.5 to add plans defined as “church plans” under the Employee Retirement Income Security Act of 1974 to the types of employee benefit plans that are not construed to be commodity pools (and whose operators are not required to register as CPOs).
During FY 2000, the Commission adopted an amendment to Rule 1.17 that deletes the existing restriction on the withdrawal of equity capital from an FCM or IB based on a percentage of the amount of funds an FCM is required to segregate. This rule was adopted in light of other early warning capital standards and the degree of surveillance performed by self-regulatory organizations (SROs). The Commission also adopted amendments to ease the regulatory burden imposed on SROs, FCMs, and IBs by allowing SROs to rely on a securities designated examining authority’s approval of any proposed subordination agreement, proposed prepayment of a subordinated loan, or reduction in such a loan.
Oversight in the New Regulatory Environment
The Commission’s oversight role will depend to an even greater extent than before on review of: 1) SRO adherence to the core principles governing their compliance with the Act and Commission regulations; and 2) unusual market events that can reveal systemic problems and risks. One such review during FY 2000 concerned trading in Commodity Exchange, Inc. (COMEX) gold options on September 28, 1999. On that date, the gold options market was severely strained by an extraordinary spike in volume, volatility, and price, accompanied by a more than 12-fold increase over the normal number of trades processed. This resulted in significant problems in the execution, clearing, and settlement of customer orders. Staff reviewed these events in detail to determine whether orders were received, executed, and cleared in accordance with exchange trading rules, whether systemic problems were revealed, and what corrective steps should be taken to ameliorate the impact of such market conditions should they recur. The report recommended, among other things, that COMEX adopt or upgrade various computer technologies for processing and recording gold option trades; hold special sessions to resolve trade processing problems in such situations; and develop a mechanism to determine the extent and location of improperly cleared trades in high volume situations.
Year 2000 Preparedness
Building on extensive involvement in Year 2000 preparation at both the domestic and international levels, staff designed and executed a comprehensive plan for monitoring and addressing Year 2000 developments during the millennium transition. In part as a result of Commission efforts, the United States futures industry did not experience any material Year 2000 problems. Within the Commission, the Commission’s information technology staff prepared for the Year 2000 rollover. As a result of good project management and risk assessment, the Commission’s transition to 2000 was uneventful.
Information Technology Assessment
During FY 1999, the Commission contracted with Electronic Data Systems for an independent assessment of the Commission’s information technology program. The assessment was conducted between January and June 2000, with a report issued in July 2000. The report included a number of specific recommendations including: 1) structural changes to the Office of Information Resources Management (OIRM) organization; 2) establishment of a new information technology strategic planning body with enhanced senior management involvement; 3) a staff increase from 35 to 58 FTEs; 4) implementation of skill requirements for staff based upon the Chief Information Officer’s (CIO) Council Core Competencies framework; 5) infrastructure changes including an enhanced information security program; and 6) reengineering of the change management process.
The Commission initiated a number of these changes with existing resources. The OIRM organization has been modified to support the required changes and the Commission established an Executive Management Council to develop integrated Commission-wide strategies for the effective use of financial, human, information technology and physical resources to support the mandates of the Commission. Other changes are predicated on a substantial increase in information technology resources. Some of this increase can be found within existing Commission resources. The Commission intends to reallocate for information technology six existing positions. These positions will be filled during FY 2001. Beyond this, the Commission will seek additional resources if necessary to implement the critical recommendations of the IT assessment. The Commission will seek authority for 10 additional positions in FY 2002 for a total of 51 full-time equivalents (FTEs). After FY 2002, the Commission will seek authority to bring the staff of OIRM to 58 FTEs. With full staffing, the Commission will be positioned to complete the implementation of the recommended changes to its IT program.