TO: The Commission
FROM: Division of Trading and Markets
RE: Many of the Specific Issues Raised in the Joint Petition for Exemption
Submitted by the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange Pursuant to Section 4(c) of the Commodity Exchange Act Can Be Currently Addressed Without Any Exemptive Relief under Section 4(c)
DATE: August 4, 1999
By letter dated June 25, 1999, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange (collectively referred to as the "Exchanges") submitted a joint petition to the Commission, pursuant to Section 4(c) of the Commodity Exchange Act ("Act"), requesting an exemption from certain statutory and regulatory requirements for all boards of trade that have been designated by the Commission as contract markets.
The Division of Trading and Markets ("Division") believes that many of the specific issues raised in the Exchanges' petition can be addressed through the existing regulatory regime without any need for exemptive relief under Section 4(c) of the Act. In order to illustrate this point, the Division has compiled below a list of specific actions which the Commission has taken in many of the areas in which the Exchanges seek relief.
II. Many of the Specific Issues Raised in the Exchanges' Joint Petition for ExemptionCan Be Currently Addressed Without Section 4(c) Relief
The Exchanges' petition cites eight particular statutory and regulatory requirements that they believe must be addressed to create regulatory parity with foreign exchanges. Most prominently, the Exchanges are seeking an exemption for all boards of trade already designated as contract markets by the Commission from the contract market designation requirements for new contract submissions, set forth in Sections 5 and 6 of the Act, and the contract market rule review and approval process, set forth in Section 5a(a)(12) of the Act. The Commission, however, has already addressed the Exchanges' stated need to list contracts in a prompt and expeditious manner by issuing its recent proposed rule authorizing the trading of certain new contracts prior to Commission approval.1 Aside from the contract approval issue, the Division believes that as many as six of the remaining seven areas of requested relief can be currently addressed through the existing regulatory regime.
A. Payment for Order Flow and Liquidity Programs
According to the Exchanges' petition, U.S. contract markets may disadvantaged by the ability of foreign exchanges to pay for order flow and/or provide inducements for market makers or customers to trade their products.2 If U.S. contract markets are precluded from responding to such programs for regulatory reasons, the Exchanges state that the concentration of liquidity in certain contracts may move to the foreign exchanges where it cannot be easily recaptured.
The Act, however, does not generally prohibit U.S. contract markets from making payments for order flow. Indeed, the Commission has already approved or allowed into effect numerous proposals establishing incentive programs at various contract markets, including the Coffee, Sugar & Cocoa Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange.3 These programs, which historically have been used to encourage market participation in specified new or low volume contracts, often provide market makers or other trading entities with monetary compensation either as a flat "retainer" whereby the market maker is paid a fee for its presence in the trading pit, as a discount on trading volume that meets or exceeds certain specified thresholds, or as a payment per transaction. Other programs provide market makers and, in certain cases, their customers with trading priorities that they would not otherwise obtain under traditional open and competitive execution procedures.
B. Guaranteed Pricing or Execution Quantity
According to the Exchanges' petition, in contrast to foreign exchanges, U.S. contract markets are unable to adopt certain trading methodologies that provide guaranteed price and/or execution quantity. The Exchanges state that their customer business will be unfairly diverted to those foreign exchanges that permit such practices.
However, the Commission has taken an active role in encouraging contract markets to develop alternative execution procedures for their markets. In a recent Commission Advisory on Alternative Execution, or Block Trading, Procedures for the Futures Industry,4 the Commission announced its intention to consider contract market proposals to adopt alternative execution, or block trading, procedures for large size or other types of orders on a case-by-case basis under a flexible approach to the requirements of the Act and the Commission's regulations. The Commission recognized that such procedures could utilize any combination of competitive and noncompetitive trading practices.5 Under this approach, each contract market will retain the discretion to permit alternative execution procedures and will be able to develop procedures that reflect the particular characteristics and needs of its individual markets and market participants. Commission staff expects to receive such a proposal from a contract market in the immediate future.
In addition, the Commission has already approved or allowed into effect numerous contract market proposals which provide for the noncompetitive execution of orders or which implement guaranteed price or quantity execution procedures.6 As a most recent example, on January 7, 1999, the Commission approved New York Mercantile Exchange Rule 6.21A which authorizes the noncompetitive exchange of futures contracts for qualifying swap agreements ("EFS transactions") pursuant to the terms and conditions of a three-year pilot program.7
C. Price Reporting
In their petition, the Exchanges state that many significant market participants would rather withhold relevant information about their transactions, including price and/or quantity, until they have been able to act in another market or execute additional transactions. The Exchanges state that, although the Act does not require real time price reporting, the Commission has precluded U.S. contract markets from delaying price reports to accommodate certain market participants. The Exchanges are concerned that if competing foreign exchanges decide to delay the reporting of certain types of transactions, such as block trades, to the general marketplace, these exchanges will unfairly capture market share from U.S. contract markets.
The Division believes that price reporting generally is integral to the price discovery process and to the assurance of open and competitive futures markets. However, in the very areas that serve as the basis for the petition, the Act authorizes and the Commission has permitted significant exceptions to the general policy of having immediate dissemination of transaction information for certain noncompetitive transactions. For example, subject to contract market rules, exchanges of futures contracts for physicals ("EFPs") may be negotiated and arranged outside of the trading hours of the relevant contract market and then reported to such contract market by the next business day. Although EFP volume is published by the relevant contract market, EFP price information (for the futures or the physical legs) is generally not released to futures market participants or the general public. Similarly, pricing information regarding EFS transactions at the New York Mercantile Exchange also would not be released. Moreover, in the block trading area, to which the Exchanges particularly refer in their petition, as noted above the Commission recently issued an Advisory on Alternative Execution, or Block Trading, Procedures for the Futures Industry. Through this Advisory, the Commission indicated its willingness to consider contract market proposals adopting alternative execution procedures for large size or other types of orders. Such procedures could include the delayed reporting of certain transaction information.
D. Account Identifiers
According to the Exchanges' petition, neither the Act nor the Commission's regulations specifically require account identification information to be entered into a trading terminal prior to the execution of a customer order. However, the Exchanges state that the Commission has imposed such a requirement as a condition of approval for the electronic trading systems operated by U.S. contract markets. The Exchanges state that U.S. contract markets are unfairly burdened by the Commission's account identification requirement and that they will lose market share to the competing foreign exchanges that are not subject to such a requirement.
The Division believes that account identifiers are critical to the contract markets' audit trail requirements and help to prevent the improper allocation of trades among accounts and other fraudulent trading abuses. Despite the importance of account identification, the Commission has implemented significant yet appropriate exemptions to this requirement. For example, in May of 1997, the Commission approved a National Futures Association interpretive notice, which established standards and procedures for allocating bunched orders pursuant to a predetermined allocation scheme.8 Under the notice, a futures commission merchant ("FCM") may omit including account numbers on order tickets provided that the FCM has a pre-determined allocation scheme. In August of 1998, the Commission amended Regulation 1.35(a-1) to allow bunched orders for certain eligible customers to be placed on a contract market without specific customer account identification, either at the time of order placement or at the time of execution.9 Under the amendment, bunched orders placed by eligible account managers on behalf of eligible customer accounts can be allocated at the end of the day on which the orders are executed.
Finally, experts have advised that recent technical advances have eliminated the need to enter full account numbers into electronic trading terminals, and that selection defaults and short codes can instead be used.
E. System Performance, Capacity and Security
According to the Exchanges' petition, the Commission has precluded U.S. contract markets from launching new products on their electronic trading systems pending the Commission's review and approval of system performance, capacity, and security tests. The Exchanges state that their foreign competitors will not be subject to the same review and approval process.
The Commission's review of newly created electronic trading systems has been and continues to be based on the principles developed by the international regulatory community - specifically the International Organization of Securities Commissions ("IOSCO"). Moreover, in connection with Commission staff's review of no-action requests from foreign exchanges to place their trading terminals in the U.S., the recognition and acceptance of the IOSCO principles by foreign jurisdictions is one of the important, necessary conditions for the grant of such relief. Thus, domestic and foreign exchanges are subject to similar requirements in this regard.
1 See 64 FR 40528 (July 27, 1999) (notice of proposed rulemaking). Comments on the proposed rulemaking must be received by the Commission on or before August 26, 1999.
It should be noted that under existing procedures for the review and approval of new contracts, U.S. contract markets' initial launch date for such contracts is often well after designation and many contracts are not listed for trading until months or even years later. In this regard, of the 201 new contracts that were approved by the Commission during the period 1996 through 1998, about one-fourth (46) have not yet been listed for trading. For the other 155 contracts, the average period of time between designation and listing was approximately three months (87 days). Only 29 contracts were listed for trading within ten days after Commission approval. These facts, combined with the Commission's proposed rule providing for the immediate listing of certain new contracts prior to Commission approval, should ensure a procedure that preserves the benefit of the approval process while allowing for exchanges to meet any competitive threat.
2 In their petition, the Exchanges list "payments for order flow" and "inducements to make markets or trade" as two separate areas of requested relief. For purposes of this Memorandum, the Division has combined these two areas together into a single discussion.
3 See, e.g., Coffee Sugar & Cocoa Exchange Registered Market Maker Program (approved by the Commission on April 30, 1991); Chicago Board of Trade Modified Market Maker Program for the Wilshire Small Cap Index Futures Contract (allowed into effect without prior Commission approval on June 18, 1993); Chicago Mercantile Exchange Principal Market Maker Program (approved by the Commission on April 20, 1995); New York Mercantile Exchange Specialist Market Maker Program (approved by the Commission on July 8, 1998).
4 See 64 FR 31195 (June 10, 1999); 64 FR 34851 (June 29, 1999) (corrections).
5 As noted in the Advisory, the Commission uses the term "noncompetitive transactions" to refer to those transactions that are negotiated and executed by counterparties other than through open outcry or other competitive means, but in accordance with the written rules of contract market that have been submitted to and approved by the Commission.
6 See e.g., Chicago Mercantile Exchange Rule 549 ("Large Order Execution") (approved by the Commission on September 27, 1991); Chicago Mercantile Exchange Rule 554 ("Large Lot Trading of Currency and Currency Cross-Rate Futures Contracts") (approved by the Commission on March 18, 1993); New York Cotton Exchange FINEX Division Rule 1.10-B ("Block Order Execution") (approved by the Division pursuant to delegated authority on June 11, 1993); New York Futures Exchange Rule 312 ("Block Order Execution") (approved by the Division pursuant to delegated authority on March 31, 1994); Chicago Mercantile Exchange Rule 521 ("All or None Transactions") (approved by the Division pursuant to delegated authority on May 2, 1996).
7 See Commission Press Release No. 4228-99 (January 11, 1999).
8 See 62 FR 25470 (May 9, 1997) (approved National Futures Association Interpretive Notice to Compliance Rule 2-10 relating to the Allocation of Block Orders for Multiple Accounts).
9 See 63 FR 45699 (August 27, 1998).