[Federal Register: November 15, 2004 (Volume 69, Number 219)]
[Notices]
[Page 65584-65591]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr15no04-64]
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COMMODITY FUTURES TRADING COMMISSION
In the Matter of the Intercontinental Exchange, Inc. Petition for
Expansion of the Definition of an Eligible Commercial Entity Under
Section 1a(11)(C) of the Commodity Exchange Act
AGENCY: Commodity Futures Trading Commission.
ACTION: Order.
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SUMMARY: In response to a petition from the Intercontinental Exchange,
Inc. (``Intercontinental''), the Commodity Futures Trading Commission
(``Commission'' or ``CFTC''), pursuant to section 1a(11)(C) of the
Commodity Exchange Act (``Act''), is issuing an order that deems,
subject to certain conditions, brokers and traders associated with the
International Petroleum Exchange (``IPE''), a recognized investment
exchange (``RIE'') located in the United Kingdom (``U.K.''), who are
either authorized by the Financial Services Authority (``FSA'') or
registered with the IPE,\1\ when acting in a proprietary trading
capacity, to be an ``eligible commercial entity'' as defined in section
1a(11) of the Act.\2\ Accordingly, subject to certain conditions as set
forth in the Commission's order, IPE members authorized as commodity
brokers by FSA or registered as local traders with IPE, when acting for
their own accounts, are permitted to enter into transactions in exempt
commodities on exempt commercial markets pursuant to section 2(h)(3) of
the Act. In order to participate, the FSA-authorized broker or IPE-
registered trader must either be an eligible contract participant, as
that term is defined in section 1a(12) of the Act, or have its trades
on the exempt commercial market guaranteed by a clearing member that is
both a member of an FSA-recognized derivatives clearing organization
and is an eligible contract participant.
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\1\ Registration with IPE is not registration with FSA or any
other government entity. Criteria and procedures for obtaining
membership or trading privileges on IPE are discussed below.
\2\ The Commission previously determined to expand ECE
eligibility to include, subject to certain conditions, Commission-
registered floor brokers and floor traders. See 68 FR 2319 (January
16, 2003). That action applied to Commission-registered floor
brokers and floor traders conducting business on electronic or open
outcry markets. Similarly, this action applies to IPE brokers and
local traders conducting business on IPE in either electronic or
open outcry trading environments. As used in this Federal Register
notice and in the prior Federal Register notice, the term
proprietary trading means trading for one's own account.
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EFFECTIVE DATE: This order is effective November 15, 2004.
FOR FURTHER INFORMATION CONTACT: Clarence Sanders, Special Counsel,
Division of Market Oversight, Commodity Futures Trading Commission,
Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
Telephone: (202) 418-5068. Electronic mail: [email protected].
SUPPLEMENTARY INFORMATION:
I. Statutory Background
The Commodity Futures Modernization Act of 2000 (``CFMA''), Public
Law No. 106-554, was signed into law on December 21, 2000. Under
amendments implemented by the CFMA, section 2(h)(3) of the Act
authorizes trading in an ``exempt commodity'' \3\ on an exempt
commercial market (``ECM'') meeting the requirements of section 2(h)
(3)-(5). Under those provisions, transactions between an eligible
commercial entity (``ECE'') in an exempt commodity on an ECM are exempt
from all but certain limited requirements of the Act.\4\
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\3\ Section 1a(14) of the Act defines the term ``exempt
commodity'' to mean a commodity that is not an excluded commodity or
an agricultural commodity. Section 1a(13) defines the term
``excluded commodity'' to mean, among other things, an interest
rate, exchange rate, currency, credit risk or measure, debt
instrument, measure of inflation, or other macroeconomic index or
measure. Although the term ``agricultural commodity'' is not defined
in the Act, section 1a(4) enumerates a non-exclusive list of several
agricultural-based commodities and products. The broadest type of
commodities that fall into the exempt category are energy and metals
products.
\4\ Under section 2(h)(3), ECMs are markets that meet the
requirements of section 2(h)(3)-(5) by notifying the Commission of
their intention to operate a trading facility in reliance on the
exemption and by limiting themselves to transactions: (1) In exempt
commodities, (2) entered into on a principal-to-principal basis by
ECEs, and (3) executed or traded on an electronic trading facility.
An ECM is not a registered entity, but is required to notify the
Commission of its intention to operate an electronic trading
facility in reliance on the exemption set forth in section 2(h)(3).
The notification of operation as an ECM must include several
certifications and, pursuant to Commission regulation 36.3(c)(3), a
representation that it will require each participant to comply with
all applicable law and that it has a reasonable basis for believing
that authorized participants are ECEs. Section 2(h)(4) reserves,
with respect to transactions eligible for the 2(h)(3) exemption,
certain provisions of the Act, including certain anti-fraud and
anti-manipulation provisions.
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Section 1a(11) of the Act lists those eligible contract
participants (``ECP'') \5\
[[Page 65585]]
that are qualified to be ECEs.\6\ As defined under section 1a(11),
floor brokers and floor traders, even if determined to fall within the
definition of an ECP, do not, as a category, fall within the statutory
definition of an ECE. Thus, commodity brokers and traders, whether
conducting business in either electronic or open outcry trading
environments, are prohibited from entering into transactions on ECMs.
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\5\ Section 1a(12) lists those entities and individuals included
within the ECP category. Included generally as ECPs are financial
institutions; insurance companies; and investment companies subject
to regulation; commodity pools and employee benefit plans subject to
regulation and asset requirements; other entities subject to asset
requirements or whose obligations are guaranteed by an ECP that
meets a net worth requirement; governmental entities; brokers,
dealers, and futures commission merchants (``FCM'') subject to
regulation and organized as other than natural persons or
proprietorships; brokers, dealers, and FCMs subject to regulation
and organized as natural persons or proprietorships subject to total
asset requirements or whose obligations are guaranteed by an ECP
that meets a net worth requirement; floor brokers or floor traders
subject to regulation in connection with transactions that take
place on or through the facilities of a registered entity or an
exempt board of trade; individuals subject to total asset
requirements; an investment adviser or commodity trading adviser
acting as an investment manager or fiduciary for another ECP, and
any other person that the Commission deems eligible in light of the
financial or other qualifications of the person.
\6\ Section 1a(11) defines the term ECE by listing those
entities and individuals considered to be ECEs. Generally, an ECE is
an ECP that (1) in connection with its business, demonstrates the
ability to make or take delivery of the underlying commodity; incurs
risk, in addition to price risk related to the commodity; or is a
dealer that regularly provides risk management or hedging services
to, or engages in market-making activities with, the foregoing
entities with respect to the commodity or derivatives transactions
in the commodity; or (2) is other than a natural person or
government entity and regularly enters into transactions with
respect to the commodity, subject to certain qualification or total
asset requirements; or (3) such other persons as the Commission
shall determine appropriate.
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Section 1a(11)(C) of the Act, however, vests the Commission with
discretion to expand the list of entities qualifying as an ECE.
Specifically, under that provision, the definition of an ECE shall
include ``such other persons as the Commission shall determine
appropriate and shall designate by rule, regulation, or order.''
Therefore, a Commission-determination recognizing that IPE brokers and
traders, either authorized by FSA or registered with IPE, are
considered to be ECEs would permit these entities to enter into exempt
commodity transactions on ECMs pursuant to section 2(h)(3) of the Act.
II. The Petition
A. Scope of Request
By letter dated February 9, 2004, Intercontinental requested that
the Commission issue an order pursuant to section 1a(11) of the Act
that would expand the ECE category to include certain IPE brokers and
local traders, who are either authorized by FSA or registered with IPE,
thus permitting them to trade on ECMs.\7\ Intercontinental operates a
commodities trading platform for energy and metals (the
``Intercontinental electronic platform'') and is itself an ECM.
Intercontinental also owns IPE, a U.K. futures exchange that trades
energy futures products. The Intercontinental electronic platform is
used by IPE for its electronic trading system. Intercontinental stated
that including IPE brokers and local traders as ECEs would be
consistent with the CFMA and would recognize their value as both
liquidity providers and market makers.
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\7\ Intercontinental submitted its notice of operation as an ECM
to the Commission on December 27, 2001. Intercontinental is one of
11 ECMs that have submitted notices to the Commission to date.
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As more fully described below, Intercontinental's request applies
to certain IPE brokers and local traders conducting business on IPE in
either electronic or open outcry trading environments.\8\ Specifically,
Intercontinental proposed that eligible IPE brokers must be located in
the U.K., be authorized and regulated by the FSA, and be a member of
the IPE. For IPE local traders, Intercontinental proposed that eligible
local traders be located in the U.K., be outside the scope of the
Financial Services and Markets Act of 2000 (``FSMA''), and be a member
of, or registered to, the IPE. Additionally, for both brokers and local
traders, Intercontinental proposed that they have, as a part of their
business activities, the business of acting as a broker or local trader
but need not have any connection or experience in the underlying
physical commodity. Finally, Intercontinental proposed that an eligible
IPE broker or local trader must be an ECP or, if not an ECP, then the
IPE broker or local trader must have its trades on the ECM guaranteed
by an entity that is both an ECP and a clearing member of a U.K.
recognized clearing organization.
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\8\ The two classes denominated as brokers or local traders
encompass four separate types of holders of trading privileges on
IPE. Within the broker class there are Floor Members and General
Participants. Floor Members hold privileges to trade on the IPE
floor, whereas General Participants may trade only through the IPE
electronic trading system. After establishment by IPE of the General
Participant class, Floor Members were eligible to be grandfathered
as General Participants. Also new Floor Members can elect to qualify
as General Participants. The class denominated as local traders by
IPE can similarly be broken down into two separate trader types.
These are called Local Members and Individual Participants. Local
Members may trade on the IPE floor, but Individual Participants may
trade solely through the IPE electronic trading system. During July
2003 IPE introduced a new ``electronic'' membership structure. FSA
recognizes all four classes as ``members,'' irrespective of whether
the individual class is vested with equity or voting rights. See FSA
Handbook Glossary at M8, 01/10/04, which defines a member as ``a
person who is entitled, under an arrangement or agreement between
him and that body, to use that body's facilities.''
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In its petition, Intercontinental noted that the Commission has
previously expanded the eligibility criteria for ECE status to include
Commission-registered floor brokers and floor traders when acting in a
proprietary trading capacity. In this respect, Intercontinental
commented that the relief it seeks for IPE brokers and local traders is
an appropriate extension of the Commission's previous expansion of the
ECE definition. Moreover, Intercontinental contends that the IPE
brokers and local traders, much as the CFTC registered floor brokers
and floor traders qualifying under the Commission's prior action, are
commodity professionals supervised by a central regulator, the FSA, or
the IPE. Intercontinental also notes that the IPE brokers and local
traders regularly trade on the IPE as part of their business and would
utilize ECMs in connection with their trading activities.
Intercontinental also observes that the Commission's prior action
effectively acknowledges that floor brokers and floor traders are
sophisticated market participants who are subject to a comprehensive
regulatory scheme, such as that provided under FSA and IPE regulations.
Intercontinental concludes that IPE brokers and local traders satisfy
similar criteria, including that of having their trades guaranteed by
the arrangements put in place by an RIE, and should therefore be
eligible for the same type of relief.\9\
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\9\ FSA recognition requirements place obligations on an RIE to
put in place satisfactory arrangements for securing clearing and
settlement services, which generally will be carried out by a
Recognized Clearing House.
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B. IPE Brokers
The petition requests that the ECE definition be expanded to
include IPE brokers that are located in the UK when acting in a
proprietary capacity. The IPE brokers include IPE Floor Members and IPE
General Participants. IPE Floor Members may trade in either the open
outcry or electronic markets; General Participants are restricted to
the electronic market only.
As the petition describes, IPE brokers are firms authorized to
transact business on behalf of customers or for the firm's proprietary
account.\10\ When acting on behalf of customers, the firm's business
activities fall within the scope of the FSMA. Thus, a firm conducting
such
[[Page 65586]]
activities in the UK is subject to regulation by the FSA. Among other
qualifying criteria, such firms must obtain FSA authorization prior to
engaging in the commodity brokerage business.\11\
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\10\ Although IPE brokers have FSA authorization to conduct
transactions on behalf of customers, any relief granted in response
to the Intercontinental petition would be solely for their
proprietary trading activities.
\11\ Under the U.K. regulatory regime, FSA also is responsible
for approving persons who perform certain ``controlled functions''
for an authorized person. The FSA has specified 27 separate
controlled functions, which fall into two main groups. The first of
these two groups is the ``significant influence functions'' group,
which includes activities carried out by persons in positions having
a significant influence over conduct of the firm, such as governing
functions (a Board Director or Chief Executive) or required
functions (Compliance Officer or Money-Laundering Reporting
Officer). The other group is the ``customer functions'' group, which
includes persons performing advisory functions or customer trading
and investment management functions.
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As there are two separate trading venues at IPE, conduct of
business by IPE brokers may take two different forms. Each IPE floor-
based broker (i.e., Floor Members) is represented on the trading floor
by one or more individual traders.\12\
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\12\ In order to qualify for membership as a Floor member on
IPE, an applicant also must meet a schedule of IPE eligibility
requirements. Under this schedule, an applicant must (1) be a firm
or company, (2) meet IPE requirements on record-keeping, training
and fitness of staff and directors, and implement internal
procedures to ensure compliance with regulations, (3) meet minimum
IPE-established net worth requirements, (4) maintain a properly
established office in an IPE-approved location for the conduct of
business, (5) have a continuing interest in trading and maintain
trading staff on the IPE floor, (6) be a clearing member of
LCH.Clearnet or be a party to a clearing agreement with another firm
that is a member of LCH.Clearnet, and (7) hold at least one seat on
IPE, where the applicant wishes to self-execute transactions on the
IPE floor.
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General Participants are IPE brokers authorized to conduct business
solely on the electronic trading platform. IPE-established eligibility
requirements for this class of membership differ from those applicable
to floor members. However, both classes of IPE brokers are authorized
by FSA and therefore under FSA oversight. When operating on the IPE
electronic trading platform, representatives of IPE General
Participants are registered with the IPE as a Responsible Individual
(``RI'') or, alternatively, are registered with the FSA as an Approved
Person linked to a particular General Participant.\13\
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\13\ Under the applicable schedule of requirements, the
applicant must (1) demonstrate fitness to be a member, (2)
demonstrate sufficiency of controls and procedures to ensure that
employees, agents, and representatives are fit and proper, suitably
qualified and experienced, adequately trained, and properly
supervised, (3) maintain a properly established office in an IPE-
approved location for the conduct of business, (4) meet minimum IPE-
established financial standing requirements, (5) be a party to an
IPE-prescribed Platform User Agreement, (6) maintain access to the
Trading Server via a front end application meeting IPE criteria, (7)
be a clearing member of LCH.Clearnet or be a party to a clearing
agreement with another firm that is a member of LCH.Clearnet, (8)
hold all necessary licenses, authorizations, and consents or
qualifies for an exclusion permitting the conduct of business on the
Platform in accordance with applicable law and regulation, and (9)
identify the location of all RIs, along with related details and
information on order routing, upon request from IPE.
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C. IPE Local Traders
The petition also requests that the ECE definition be expanded to
include IPE local traders located in the UK. Under IPE rules, local
traders are authorized to trade for their own account but are
prohibited from engaging in customer brokerage. As noted above, IPE
local traders as a class are composed of two separate types of holders
of trading privileges. These are Local Members and Individual
Participants.\14\ Qualifying criteria for these two trader classes
differ in some respects. Local Members hold privileges to trade on the
IPE floor.\15\ Individual Participants are authorized to trade solely
on the electronic trading platform.\16\
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\14\ A third local trader class, Trade Participant membership,
also exists but relief is not being sought for this class. Trade
Participants are companies limited to trading for their own account.
\15\ To qualify as an IPE Local Member an applicant must (1)
demonstrate fitness as a member and an intention to comply with IPE
regulations, (2) register with IPE and successfully pass the
Registered Floor Trader examination, (3) demonstrate that the
applicant will become a party to a clearing agreement with a
clearing member of LCH.Clearnet, (4) demonstrate that the applicant
is entitled, upon admission to membership, to acquire or lease a
minimum of one seat on IPE, (5) demonstrate that the applicant is
either a sole trader or a company where 90 percent of issued share
capital is owned by the sole trader or 90 percent of voting rights
of a non-share capital company is held by the sole trader, and (6)
provide any other information or documents requested by IPE.
\16\ To demonstrate eligibility an applicant as an Individual
Participant must (1) demonstrate fitness as a member and an
intention to comply with IPE regulations, (2) register with IPE as
an RI and successfully pass the Registered Trader examination, (3)
be a party to an IPE-prescribed Platform User Agreement, (4)
maintain access to the Trading Server via a front end application
meeting IPE criteria, (5) demonstrate that the applicant will become
a party to a clearing agreement with a clearing member of
LCH.Clearnet, and (6) demonstrate substantial experience trading on
a UK futures exchanges, or otherwise meet the Intermediate Customer
Standards found in FSA Conduct of Business Rule 4.1.9R.
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Notably, both Local Members and Individual Participants are outside
the scope of the FSMA and therefore need not be authorized by the FSA--
either when trading on IPE on behalf of their own account or on behalf
of other IPE members.\17\ However, both Local Members and Individual
Participants must be members of, or registered with, the IPE, and must
meet independent qualifying criteria established by IPE under an FSA-
recognized regime.\18\ The IPE actively monitors Local Member and
Individual Participant trading activity, and has authority to impose
sanctions for improper trading conduct.\19\
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\17\ IPE Local Members and Individual Participants were
determined to be outside the scope of FSMA by Order 2001. Local
Members and Individual Participants may be individuals or
corporations, although in the case of a corporation, 90 percent of
the share capital or voting rights must be held by a single member.
\18\ FSA confirms that IPE regulations appear to meet the
requirements in the FSA sourcebook on Recognized Investment
Exchanges and Recognized Clearing Houses.
\19\ All IPE members and holders of trading privileges must
execute an IPE-prescribed agreement consenting to be bound by IPE
rules. See IPE Rule B.1.4.
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D. Qualifying Experience for Individual Participants
IPE affirms that it will determine whether an applicant has
substantial qualifying experience by applying the standards set out
under the definition of an Intermediate Customer contained in FSA
regulations. In particular, IPE represents that the standards defining
an expert private client as an Intermediate Customer found in Rule
4.1.9R of the FSA Conduct of Business (``COB'') sourcebook will be
applied as the primary guide in determining the adequacy of an
applicant's experience for this purpose.
COB Rule 4.1.9R imposes a two-tiered regulatory structure on
financial services firms servicing accounts of expert private clients.
This structure is divided between (1) procedural steps in establishing
a client relationship with an expert private client and (2) objective
steps in determining the adequacy of the expert private client's
trading and business experience. More specifically, under FSA
regulations, a financial intermediary is required to classify a client
in one of three classifications: these are private (``retail'')
customer, intermediate customer, or market counterparty.\20\ Provisions
under COB Rule 4.1.9R, permit a financial services firm to classify a
client who would otherwise be a private, or retail, customer as an
Intermediate Customer only upon a determination that the client is an
``expert'' private client.
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\20\ See COB Rule 4.1.4, FSA Handbook, Release 034, September
2004.
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COB 4.1.9R requires a firm to assess the adequacy of a client's
experience and knowledge as an expert private client.\21\ In this
respect, COB Rule
[[Page 65587]]
4.1.9R requires that a firm inquire about the client's knowledge,
understanding, and awareness of risks in the applicable investments and
markets. The rule also requires a firm to consider the length of time
the client has been active in the applicable markets, the frequency of
dealings, and the extent to which the client has relied on advice.
Finally, the rule instructs a firm to inquire about or consider the
size and nature of any transactions undertaken for the client, and the
client's financial standing, including where appropriate an assessment
of the client's net worth and portfolio holdings.
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\21\ Under the first tier, which concerns the establishment of a
client relationship, COB Rule 4.1.9R requires that a firm take
reasonable care to determine that the client has sufficient
experience and understanding, disclose in writing the regulatory
protections waived by such classification, provide the client
sufficient time to consider the determination, and obtain the
client's written consent or otherwise demonstrate that informed
consent has been given by the client.
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Essentially, IPE has determined to adopt the COB Rule 4.1.9R
standards as qualifying criteria for applicants as IPE Individual
Participants. Thus, these standards, otherwise imposed upon financial
services firms regulated by FSA, will also be part of IPE procedures
and serve as a screening device for determining the sufficiency of an
applicant's experience and knowledge for admission on the IPE as an
Individual Participant. In this respect, IPE confirms that its
application of the criteria found in Rule 4.1.9R, to assess experience
and knowledge of Individual Participant applicants, will be part of an
independent determination made by IPE management. Moreover, IPE
represents that any prior status an applicant may have attained as a
customer of a financial services firm would not be determinative of
eligibility, but that IPE would undertake an independent assessment of
the applicant's experience and knowledge under the standards of COB
Rule 4.1.9R.
E. Comments
The Intercontinental petition was published in the Federal Register
for a 15-day public comment period on March 22, 2004.\22\ In addition,
the Federal Register release includes a series of questions posed by
the Commission regarding the petition. Those questions focus on whether
the petition should be granted; what conditions if any should apply;
whether any grant of the petition should be specifically tailored to
the Intercontinental ECM or be more broadly applied to other ECMs as
well; whether relief should extend to IPE traders with rights to trade
only on the IPE electronic platform, or to IPE locals not registered
with the FSA and, if so, what standards should apply to evaluate the
qualifications of such persons.
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\22\ 69 FR 13286 (March 22, 2004).
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In total, the Commission received three comment letters responding
to the Federal Register notice, two of which were submitted by the New
York Mercantile Exchange (``NYMEX'') in letters dated April 7, and May
27, 2004. The other comment was submitted by Intercontinental in a
letter dated April 28, 2004. The Intercontinental comment letter
primarily responded to issues critically raised in the NYMEX letter of
April 7, 2004.
1. NYMEX Comment Letters
The NYMEX comment letters include a generalized critical assessment
of the petition. In so doing, the letters characterize the relief being
sought as ``broad and unrestricted,'' and argue against the grant of
the petition. In arriving at this conclusion, NYMEX emphasizes several
different aspects of the IPE institutional and regulatory environment.
In particular, NYMEX sets out its view of the regulatory landscape
governing ECMs as one in which statutory exemption is conditioned on
the commercial nature of the market. Following this line of reasoning,
NYMEX asserts that the IPE electronic traders are best characterized as
representing a retail rather than a commercial interest and, on that
basis, concludes they should be denied eligibility to obtain trading
privileges on ECMs.
In amplifying its objection to a grant of access for IPE electronic
traders, NYMEX asserts that granting the petition for IPE electronic
traders would open ECM access to a ``potentially large group of
unschooled and unsophisticated electronic traders who are not required
to be registered here or in the U.K.'' NYMEX further concludes that
granting such regulatory relief could impose risks to the integrity of
trading on an ECM. Thus, NYMEX concludes that a grant of relief sought
by Intercontinental would be contrary to statutory intent and the
public interest.
Along a similar line of reasoning, NYMEX questions whether the IPE
local traders (both Local Members and Individual Participants) could
meet commercial standards justifying access to an ECM. NYYMEX supports
this conclusion by arguing that the lack of FSA registration for IPE
local traders, combined with a lack of express qualifying and trading
participation requirements, raises a question as to whether such
traders could serve as effective ``liquidity providers'' on an ECM.
NYMEX also questions whether the petition is imbued with a full
understanding of the meaning of ``trading for one's own account''
within the context of obtaining trading access to an ECM.
The NYMEX comments also respond to the Commission's inquiry whether
any regulatory response to the petition should be tailored specifically
to permit IPE members to trade solely on Intercontinental or should be
more broadly designed to permit IPE members to trade on other ECMs as
well. Although more generally opposing the grant of the petition,
NYMEX, in response to this question, comments that it is unable to
identify any factual circumstances that would be unique to
Intercontinental's ECM. On this basis, NYMEX concludes there is no need
to tailor any hypothetical relief to the specific factual circumstances
of the Intercontinental ECM and, in this respect, questions the wisdom
of ``creating private definitions for public statutory categories.'' In
summary, although NYMEX argues against granting the petition, NYMEX
suggests that in any grant of relief the Commission ``may wish to
consider allowing such IPE members to trade on other ECMs.''
2. Intercontinental Letter
As noted, Intercontinental submitted a comment letter dated April
28, 2004. That letter generally responds to the issues raised in the
NYMEX letter of April 7, 2004. At the outset, Intercontinental notes
that the IPE, as an RIE regulated by FSA, is subject to a panoply of
FSA requirements, which, according to Intercontinental, are designed to
protect the functioning of the market and the interests of users.\23\
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\23\ Recognized Investment Exchanges and Recognized Clearing
Houses, FSA Handbook, Release 033, July 2004. More specifically,
Intercontinental represents that Part 2.7 of the RIE Sourcebook
imposes obligations requiring an RIE to restrict membership to
applicants (1) over whom it can with reasonable certainty enforce
its rules contractually, (2) who have sufficient technical
competence to use its facilities, (3) who it is appropriate to admit
to membership having regard to the size and sophistication of users
of its facilities and the nature of the business effected by means
of or cleared through its facilities, and (4) if appropriate who
have adequate financial resources in relation to their exposure to
the UK recognized body or its central counterparty. See also FSA
Handbook Glossary at M8, 01/10/04, which defines a member as ``a
person who is entitled, under an arrangement or agreement between
him and that body, to use that body's facilities.'' Thus, all
holders of IPE trading privileges are deemed ``members,'' and are
regulated as such under FSA regulations, irrespective of whether
individuals within a particular class of traders hold any equity or
voting rights in IPE.
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Intercontinental also comments that these FSA requirements on
member access to an RIE should also be read in conjunction with the
rules and requirements independently applied by
[[Page 65588]]
IPE.\24\ As a supplement to these rules and requirements,
Intercontinental comments that IPE also applies a membership due
diligence screening process in which the IPE inquiry seeks information
on an applicant's personal history including, but not limited to, the
applicant's experience and knowledge of derivatives trading, whether an
individual applicant has been registered by another regulatory body,
has ever been disciplined by another regulatory body, or been
insolvent. Additionally, Intercontinental comments that, as part of the
due diligence screening, IPE conducts an identification inquiry under
anti-money laundering standards and reviews or confirms all information
obtained with appropriate agencies.
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\24\ These are the same rules and requirements outlined above in
Section II.
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With respect to IPE contracts traded on the electric platform,
Intercontinental comments that IPE makes available two different
training programs for new members before they can access the system. As
a consequence of these requirements, Intercontinental maintains that
the characterization by NYMEX that IPE electronic traders are
``unschooled and unsophisticated,'' or of a retail nature, is not
accurate. On this basis, Intercontinental concludes that the IPE
members should be viewed as eligible to access the over-the-counter
contracts traded on Intercontinental's ECM.
Intercontinental's comment letter also notes that it is not seeking
relief solely for its own ECM, but rather does not oppose broad ECM
access for the IPE membership. Intercontinental also acknowledges that
relief is being sought solely for ``principal-to-principal'' trading.
While not responding to any aspect of NYMEX's comment letter,
Intercontinental did add several clarifications with respect to its
relief request. For instance, Intercontinental remarks that its systems
are adequate to enforce the requirement that IPE members eligible for
relief must be located in the U.K., as it inquires into a participant's
physical location by collecting information on a participant's
principal business address. Intercontinental also comments that it
conducts an anti-money laundering inquiry for privately-owned companies
in which the participant must present the company's registered address,
as well as collecting the address and telephone number for each user as
part of its process for new market users.
III. Discussion
Under the CEA, ECMs are commercial markets executing principal-to-
principal transactions. In view of the unregulated nature of these
markets, Congress intended that access should be confined to
professional traders--either ECEs as defined in section 1a(11) or other
traders that have an interest in the underlying commodity as part of
their business operations, perform a market-making role, or otherwise
provide a similar trading function that improves market liquidity.
As noted above the Commission has previously acted to expand the
ECE definition to include floor brokers and floor traders registered
with the Commission and acting in a proprietary capacity, since these
persons operate as knowledgeable, experienced professional traders who
historically have provided a trading function that improves market
liquidity.\25\ The Commission stated in the Federal Register notice
accompanying that action that in order to qualify as an ECE under the
Order, the ``CFTC-registered floor broker or floor trader must be a
member of a DCM or otherwise have trading privileges on a DCM * * *
[and act] as a floor broker or floor trader, either on a DCM's open
outcry market or [perform] an equivalent function on the DCM's
electronic market.'' In the Federal Register notice, the Commission
also acknowledged, as professional traders providing market-making type
activities, that the floor broker or floor trader ``need not have any
connection to or experience in the underlying physical commodity.''
Finally, the Commission stated that the ``floor broker or floor trader
must either be an ECP or have its trades on the ECM guaranteed by a
clearing member that is both a member of a CFTC-registered derivatives
clearing organization and an ECP.''
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\25\ 68 FR 2319 (January 16, 2003). The Commission also
incorporated floor brokers and floor traders in the definition of an
ECE as it relates to trading on a Derivatives Transaction Execution
Facility. See Commission Regulation 37.1(b), and the discussion
thereunder at 66 FR 42256.
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Underlying the Commission's prior action was the notion that
registration was a proxy for the aforementioned knowledge, experience,
and professionalism, and for the provision of a market-making or
similar trading function that improves market liquidity.
As outlined above in Section II.A, Intercontinental maintains that
its petition seeks relief of a similar nature, and further represents
that granting its request would constitute an appropriate extension of
the Commission's prior action. Although NYMEX supported the
Commission's prior action, NYMEX now opposes the Intercontinental
petition for IPE traders. In contrast to Intercontinental's
declaration, the comment letters submitted by NYMEX argue that the
Intercontinental petition fails to satisfy standards established under
the Commission's prior action to include CFTC-registered floor brokers
and floor traders in the definition of an ECE.
The Commission believes that granting relief for IPE brokers would
comply with the Commission's prior action to expand the ECE category to
include CFTC-registered floor brokers and floor traders. IPE brokers,
by virtue of having received FSA authorization as a prerequisite to
engaging in the conduct of commodity brokerage on IPE, conform to that
part of the standards enunciated in the Commission's prior action. The
Commission also has entered into an information-sharing arrangement
with the FSA.
With respect to IPE floor and electronic local traders, NYMEX
correctly concludes that these traders are neither authorized nor
approved by FSA, the U.K. regulator with jurisdiction over commodity
futures exchanges and other instrumentalities operating in the U.K.
financial services industry. Nonetheless, the Commission believes that
it is appropriate to include these traders under the ECE category
since, as identified above, IPE floor and electronic local traders do
have to meet a schedule of criteria in order to establish eligibility
as an IPE Local Member or Individual Participant. In order to
demonstrate fitness, both IPE Local Members and Individual Participants
must, among other things, successfully pass the Registered Trader
examination that is administered by IPE.\26\
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\26\ See IPE Rule G.10(c). The Registered Floor Trader exam
tests knowledge of trading behavior and of the rules and regulations
of IPE.
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As either an applicant or an IPE-approved trader, Local Members and
Individual Participants must meet a schedule of fees that is
essentially the same for both classes of membership. Each applicant is
required to pay an application fee of 500 pounds. If accepted to
membership, each applicant would then be required to pay an annual
subscription fee of 350 pounds per seat or membership. Additionally,
each applicant would be subject to an annual minimum activity charge of
1000 pounds, if the applicant failed to trade at least 4000 lots per
year.
Other applicable criteria differ for each of these two trader
classes, most
[[Page 65589]]
notably with respect to evidencing an adequate level of experience and
knowledge. Local Members are required to either purchase or lease a
seat on IPE and to serve both a trainee and probationary period. While
in trainee status, an applicant may only enter a trading pit as an
observer.\27\ In order to achieve probationary status, an applicant
must pass the Registered Trader exam. During the probationary period,
an applicant may execute transactions on the exchange, but only under
the supervision of another IPE member.\28\
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\27\ See IPE Rule 1.3.2.
\28\ See IPE Rule 1.6.7(f).
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After completion of the probationary period, the applicant's
performance is subjected to peer review by other IPE members and the
IPE Trading Committee.\29\ Final acceptance or denial of membership is
conditioned on confirmation of the IPE Trading Committee. Thus, the
trainee and probationary periods required of Local Members appear to
serve as a training period or apprenticeship preparatory to a new
member receiving full floor trading privileges.
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\29\ Under IPE Rule 1.6.7, the probationary period runs for a
period of 90 days unless terminated earlier at the discretion of the
IPE Trading Committee.
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For Individual Participants, who only have trading privileges for
the IPE electronic system, IPE has implemented other requirements that
differ from those applicable to Local Members. Under IPE requirements,
as in the case of Local Members, Individual Participants must also show
fitness to be a member. However, as outlined above in Section II.C, in
addition to successfully passing the Registered Trader Exam, applicants
for Individual Participant membership must demonstrate substantial
experience trading on a U.K. futures exchange, or otherwise satisfy the
standards defining an Intermediate Customer under FSA Conduct of
Business Rule 4.1.9R.
According to Intercontinental, electronic trader eligibility is
limited to existing IPE-registered traders, to traders at other U.K.
exchanges, to other individuals with substantial trading experience on
U.K. futures exchanges, or to traders who have successfully passed the
Registered Trader exam. Thus, according to Intercontinental, FSA-
developed standards under COB Rule 4.1.9R, which define an intermediate
customer, are used by IPE as a screening device to differentiate
professional from retail experience among applicants.
As the above suggests, criteria set out under COB Rule 4.1.9R are
intended for use in determining whether a client would have experience
meeting or qualifying at the intermediate customer level. Thus COB Rule
4.1.9R instructs that, in determining a client's experience and
knowledge, a firm should inquire about:
1. The client's knowledge, understanding, and awareness of risks in
the applicable investments and markets,
2. The length of time the client has been active in these markets,
the frequency of dealings, and the extent to which client relied on
advice,
3. The size and nature of the transactions undertaken for the
client, and
4. The client's financial standing, which may include an assessment
of net worth and portfolio.
As a practice that is functionally parallel to that required of
financial firms under COB Rule 4.1.9R, Intercontinental has represented
that IPE will confine eligibility for admission as an electronic trader
to applicants with:
1. Sufficient knowledge and understanding of market and risks,
2. Who were active on such markets for a reasonable length of time,
3. Who have traded in appropriate size and quantity, and
4. Who have appropriate financial standing.
In this respect, IPE confirms that it will apply the criteria found
in Rule 4.1.9R applicable to assessing experience and knowledge of an
expert private customer as part of an independent determination made by
IPE management. Moreover, IPE represents that the prior status an
applicant may have attained as a customer of a financial services firm
would not be determinative of eligibility, but that IPE would undertake
an independent assessment of the applicant's experience and knowledge
under the standards of COB Rule 4.1.9R.\30\
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\30\ IPE is posting the Individual Participant application form
on its Web site. The application form includes an eligibility
requirement in reference to the Intermediate Customer standards
under FSA COB 4.1.9R. There are no specific FSA regulations
governing an RIE's record-keeping obligations regarding membership
applications or documents relating thereto. However, IPE maintains
that Money Laundering Regulations 1993 require IPE retention of new
client records, including IPE members, for a five-year period
following the termination of the business relationship. In the case
of an IPE member or holder of trading privileges, the five-year
period would run from the date of rejection or resignation from
membership.
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As a general matter, IPE also maintains that as an RIE it is
organized as a wholesale market and is not open to retail membership.
In this regard, IPE points out that FSA rules and standards found in
the Recognized Investment Exchange and Clearing House sourcebook
(``REC'') impose requirements on types of applicants eligible for
membership. Among other things, REC Rule 2.7.3 states that FSA may
conduct assessments of whether access to a UK recognized body's
facilities is based on criteria designed to protect the orderly
functioning of the market and the interests of investors. Further, Rule
2.7.3 states that FSA, in conducting any such assessments, may
consider: (a) Whether the RIE limits access as a member to persons over
whom it can with reasonable certainty enforce its rules, (b) who have
sufficient technical competence to use the market's facilities, (c)
whom it is appropriate to admit to membership having regard for the
size and sophistication of users of its facilities and the nature of
business thereon, and (d) where appropriate, the adequacy of financial
resources in relation to a member's exposure to the UK recognized body
or central counterparty.\31\
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\31\ Administratively, REC Rule 2.7.3 also seeks to ensure that
an RIE's membership criteria are objective in their scope and are
applied in an objective, non-discriminatory manner. Specifically,
for access to electronic markets, REC Rule 2.7.4 provides that the
FSA may review an RIE's rules and practices concerning procedures,
controls, and security for inputting instructions into the system;
the facilities provided and restrictions imposed on clients
inputting instructions into the system; practices used to detect,
identify, and prevent instructions to the system that breach any
relevant restrictions; the quality and completeness of the audit
trail; and procedures governing the determination to suspend system
trading or member access.
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As noted, IPE local traders need not be authorized or approved by
FSA as a pre-condition in obtaining trading privileges on IPE. The U.K.
approach therefore differs somewhat from that applied under U.S.
regulation, where Commission requirements mandate registration with a
government body for both floor brokers and floor traders. However, even
though qualifying determinations for local traders are reserved to IPE,
those procedures are subject to FSA supervision. Thus, notwithstanding
the formalistic differences in the treatment of local traders in the
U.S. and U.K. regulatory systems, the Commission believes that the U.K.
regulatory structure facilitates and enforces a level of regulation for
the IPE local traders that meets applicable standards of
professionalism established under the Commission's prior action
expanding the ECE category to include
[[Page 65590]]
CFTC-registered floor brokers and floor traders.\32\
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\32\ The Commission has found the U.K. regulatory program
generally comparable to the U.S. framework pursuant to a grant of
relief under CFTC regulation 30.10. The review for this
determination focused generally upon firms acting in the capacity of
futures commission merchants for U.S. customers trading on U.K.
exchanges, rather than on proprietary trading by brokers and
traders. See 68 FR 58583 (October 10, 2003).
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IV. Conclusion
After consideration of the Intercontinental petition, and the
additional material submitted by Intercontinental to accompany the
petition, and the comment letters submitted in response to the Federal
Register notice, the Commission has determined, consistent with the
Intercontinental petition, that it is appropriate to issue an order,
pursuant to Section 1a(11)(c) of the Act, that includes certain IPE
floor and electronic brokers and traders, subject to certain
conditions, within the definition of an ECE for eligibility to trade on
an ECM.\33\ As in the prior action to expand the ECE definition to
include CFTC-registered floor brokers and floor traders, either in open
outcry or electronic markets, the Commission believes that expanding
the definition to include IPE floor and electronic brokers and traders
is consistent with the purposes of the CFMA.\34\ Moreover, and again as
in the prior action, the Commission believes that inclusion of IPE
floor and electronic brokers and traders in the definition of an ECE
could potentially increase competition and efficiency, and reduce
liquidity risk, on ECMs.
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\33\ As noted, Intercontinental seeks to include in the
definition of an ECE four separate types of holders of trading
privileges on IPE: the broker class is composed of Floor Members and
General Participants and the local trader class is composed of Local
Members and Individual Participants.
\34\ The Commission's prior action to include CFTC-registered
floor brokers and floor traders in the ECE definition specifically
acknowledged that the prior action would reach a ``floor broker or
floor trader, either on a DCM's open outcry market or [when]
performing an equivalent function on the DCM's electronic market.''
See 68 FR 2323 (January 16, 2003).
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As noted above, underlying the Commission's prior action was the
notion that registration serves as a proxy for the aforementioned
knowledge, experience and professionalism, and for the provision of a
market-making or similar trading function that improves market
liquidity. Commission action taken here makes a similar finding for IPE
floor and electronic brokers and traders with respect to their
knowledge, experience and professionalism, and their ability to provide
market-making or similar trading functions that improve market
liquidity.
The Commission also notes that IPE registration of electronic local
traders is based on eligibility pursuant to the Intermediate Customer
standards under FSA COB 4.1.9R. The Commission considers the inclusion
of this process in IPE registration as a reasonable proxy for an
electronic local trader's knowledge, experience, professionalism, and
ability to provide a market-making or similar trading function that
improves market liquidity. Moreover, the Commission believes that the
IPE has the experience and ability to apply the standards in an
efficient and prudent manner. The Commission points out that these
determinations are based on materials provided by, and/or
representations made by, IPE and FSA and, as such, are particular to
IPE. If another market or governmental regulator petitioned the
Commission for a similar expansion of the ECE definition, an analogous
showing to the Commission would be necessary.
The Commission also notes that it has previously expanded the ECE
definition for purposes of trading on a DTEF.\35\ That action
incorporated within the ECE definition registered floor brokers and
floor traders, whose trading obligations are guaranteed by a registered
FCM, when trading for their own accounts on a DTEF.
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\35\ Commission regulation 37.1(b).
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In order to qualify as an ECE under the Commission's order, an IPE
floor or electronic broker or trader must be a member of IPE or
otherwise have trading privileges on IPE and be located in the U.K.
Pursuant to those requirements, the qualifying IPE floor or electronic
broker or trader also must be authorized by FSA or registered with IPE.
The IPE floor or electronic broker or trader must have as a part of its
business the business of acting as a commodity broker or local trader,
either on IPE's open outcry or electronic market, but need not have any
connection to or experience in the underlying physical commodity. The
Commission believes that the trading expertise of IPE floor or
electronic brokers or traders would be applicable to trading in any
commodity product traded on an ECM. Among other things, the ability of
an IPE floor or electronic broker or trader to interpret market
momentum, and facilitate the adjustment of market prices to new
information, is more a function of trading expertise than of experience
in the underlying physical commodity.
A qualifying IPE floor or electronic broker or trader must be
either an ECP or have its trades on the ECM guaranteed by a clearing
member that is both a member of an FSA-recognized derivatives clearing
organization and an ECP. The Commission believes that requiring either
the IPE floor or electronic broker or trader, or the guarantor thereof,
to be an ECP provides sufficient financial backing for the IPE floor or
electronic broker or trader and mitigates any credit and collection
risk that might otherwise arise. The Commission notes that the
guarantor of an IPE floor or electronic broker or trader would be
placing its own money at risk, and expects that such guarantor would
carefully consider the risk involved in the provision of the guarantee
for that particular broker or trader.
V. Cost Benefit Analysis
Section 15 of the Act, as amended by section 119 of the CFMA,
requires the Commission to consider the costs and benefits of its
action before issuing a new order under the Act. By its terms, section
15 does not require the Commission to quantify the costs and benefits
of its action or to determine whether the benefits of the action
outweigh the costs. Rather, section 15 simply requires the Commission
to ``consider the costs and benefits'' of its order.
Section 15(a) further specifies that the costs and benefits of the
proposed order shall be evaluated in light of five broad areas of
market and public concern: (1) Protection of market participants and
the public; (2) efficiency competitiveness and financial integrity of
futures markets; (3) price discovery; (4) sound risk management
practices; and (5) other public interest considerations. The Commission
may, in its discretion, give greater weight to any one of the five
enumerated areas of concern and may, in its discretion, determine that,
notwithstanding its costs, a particular order is necessary or
appropriate to protect the public interest or to effectuate any of the
provisions or to accomplish any of the purposes of the Act.
The subject order is intended to reduce regulatory barriers to
permit certain IPE floor or electronic brokers or traders, when acting
in a proprietary capacity, to enter into transactions in exempt
commodities on ECMs pursuant to section 2(h)(3) of the Act if such
entities are either ECPs or have obtained a financial guarantee for
such transactions from a clearing member that is both a member of a
FSA-registered derivatives clearing organization and an ECP. The
Commission has considered the costs and benefits of the order in light
of the
[[Page 65591]]
specific provisions of section 15(a) of the Act.
A. Protection of Market Participants and the Public
The order would deem certain professional IPE floor or electronic
brokers or traders meeting the required conditions who are ECPs, or who
have guarantees from clearing members that are members of FSA-
registered derivatives clearing organizations and are ECPs, to be ECEs
under section 1a(11)(c) and thus permit them to enter into proprietary
transactions in exempt commodities on ECMs. Under the Act, ECEs are
sophisticated investors who have the financial wherewithal or trading
expertise to participate in these markets. Accordingly, there should be
no effect on the Commission's ability to protect market participants
and the public.
B. Efficiency and Competition
The order is expected to benefit efficiency and competition by,
among other things, providing essential trading expertise to the market
that enhances price discovery through both the speed and efficiency of
market adjustment to new fundamentals and by generally increasing the
pool of potential counterparties for participants trading on exempt
commercial markets.
C. Financial Integrity of Futures Markets and Price Discovery
The order should have no effect, from the standpoint of imposing
costs or creating benefits, on the financial integrity of the futures
and options markets. The order should enhance the price discovery
function of such markets.
D. Sound Risk Management Practices
The order should have no effect, from the standpoint of imposing
costs, on the risk management practices of the futures and options
industry. Where an individual or entity is qualified as an ECP, the
individual or entity has been deemed under the Act to be sufficiently
responsible to execute trades in certain excluded or exempt commodity
transactions, and no further mitigation of credit risk is necessary.
Moreover, where an individual or entity does not qualify as an ECP, the
order requires that a clearing member of an FSA-recognized derivatives
clearing organization that is itself an ECP guarantee the trades in
order to mitigate the credit and collection risk.
E. Other Public Interest Considerations
The order is consistent with one of the purposes of the Act as
articulated in section 3 in that it would promote responsible
innovation and fair competition among boards of trade, other markets,
and market participants.
VI. Order
Upon due consideration, and pursuant to its authority under section
1a(11)(C) of the Act, the Commission hereby determines that certain
professional International Petroleum Exchange (``IPE'') floor or
electronic brokers or local traders, who are authorized by the
Financial Services Authority (``FSA'') or registered with the IPE, when
acting in a proprietary capacity, are appropriate persons as defined in
section 1a(11)(C) and, thus, are deemed to be eligible commercial
entities and may enter into contracts, agreements or transactions in an
exempt commodity on an exempt commercial market under the following
conditions:
1. The contracts, agreements, or transactions must be executed on
an exempt commercial market that meets the requirements of section
2(h)(3)-(5) of the Act.
2. The IPE floor or electronic broker, denominated as either a
Floor Member or General Participant pursuant to IPE membership rules,
must be a member of IPE or otherwise have trading privileges on IPE, be
located in the U.K., and be subject to the rules of IPE.
3. The IPE local trader, denominated as a Local Member or
Individual Participant pursuant to IPE membership rules, must be a
member of IPE or otherwise have trading privileges on IPE, be located
in the U.K., and be subject to the rules of IPE.
4. The IPE Floor Member or General Participant must be authorized
and regulated by the FSA.
5. The IPE Local Member or Individual Participant must be
registered with the IPE.
6. The IPE Floor Member, General Participant, Local Member, or
Individual Participant must have as a part of its business the business
of acting as a professional commodity broker or trader on either the
IPE open outcry or electronic markets.
7. The IPE Individual Participant must meet and satisfy the current
qualifying standards of an Intermediate Customer pursuant to FSA
Conduct of Business (``COB'') Rule 4.1.9R. IPE must notify the
Commission of any changes to the standards included in FSA COB Rule
4.1.9R.
8. The IPE Floor Member, General Participant, Local Member, or
Individual Participant must be either an eligible contract participant,
as that term is defined in section 1a(12) of the Act, or have its
trades on the exempt commercial market guaranteed by a clearing member
that is a member of an FSA-recognized derivatives clearing organization
and is an eligible contract participant.
Issued by the Commission this 8th day of November, 2004, in
Washington, DC.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 04-25282 Filed 11-12-04; 8:45 am]
BILLING CODE 6351-01-P