The Commission performs a thorough review of the registration applications of all entities seeking to be registered as DCMs and DCOs. Multi-disciplinary review teams of attorneys, industry economists, trade practice analysts and risk analysts are needed to ensure that the Commission undertakes a thorough analysis of such applications to ensure compliance with the applicable statutory core principles and Commission regulations. Site visits may be required to validate needed technical and self-regulatory capabilities.
Implementation of Dodd-Frank regulations will begin in FY 2012 with a surge of new registration activity in all market segments. This activity will include an increase in the number of entities, as well as an expansion of the scope of registration requirements as a result of amendments to and the addition of new core principles. To facilitate the orderly transition to a regulated marketplace, the Commission will undertake a phased approach to implementation for SEFs. This phased approach includes temporary registrations, which grant "grandfather" relief for those entities that currently provide a marketplace for the listing and trading of swaps. Under the proposed rule, upon the request of an applicant, the Commission may grant temporary relief for qualifying entities that, due to their operations, will be required to register as a SEF in order to continue operating as of the effective date of the regulations. It will enable a qualifying entity to operate without full registration on a short-term basis during the pendency of the application review process on the condition that it otherwise operate in compliance with requirements under the Dodd-Frank Act. Many applicants will be able to continue operations under temporary registration, while the Commission performs the due diligence necessary for full registration. Likewise, the Commission intends to undertake a phased approach to implementation for swap data repositories, by allowing provisional registrations. There is currently no provision for comparable, phased implementation for DCMs, designated clearing houses, or other entities.
The Commission anticipates that it will receive a surge in applications of SEFs for registration beginning in the second half of FY 2012 through the beginning of FY 2013, as rules are finalized. The Commission intends to re-prioritize staff to meet this one-time expected surge.
The Commission's Strategic Plan emphasizes the importance of working closely with the NFA to ensure that intermediaries meet high qualification and fitness standards through the registration process. In addition, the Commission thoroughly reviews the registration processes and conducts direct examinations of swap dealers and major swap participants to identify deficiencies and confirm that they are corrected in a timely manner.
The Commission has obligations to review new product filings and amendments to rules relating to products by registered entities, as well as issuing no-action letters related to product issues. The current scope of work includes reviewing new futures and option contract filings, reviewing contract rule submissions, participating in reviews of applications for designation as contract markets, and developing new rules and policies to accommodate innovations in the industry. Currently, the Commission conducts due diligence reviews of new contract filings to ensure that the contracts are not readily susceptible to manipulation or price distortion, and that the contracts are subject to appropriate position limits or position accountability. The Commission also analyzes amendments to contract terms and conditions to ensure that the amendments do not render the amended contracts readily susceptible to manipulation and do not otherwise affect the value of existing positions. In order to prioritize work with product reviews and rulemakings, the Commission has begun to implement a procedure that assigns greater review priority to contracts that have achieved certain thresholds of trading volume and open interest.
Regulation of the swaps marketplace will drive the need to review a large number of new products introduced by DCMs and SEFs to verify that the contracts are not readily susceptible to manipulation and are subject to appropriate position limits or position accountability. In addition, the Commission will have several product-review responsibilities. The Commission will need to evaluate transaction and pricing data collected by swap data repositories to determine appropriate block trade threshold levels that registered SEFs, DCMs, and market participants may use to delay public reporting of swap transaction and pricing data. In addition the Commission may need to evaluate market data and characteristics to determine whether a swap contract that is listed on a DCM or SEF has been "made available to trade" and, accordingly, is subject to the trade execution mandate of the Dodd-Frank Act. In this regard, the Commission expects that SEFs and DCMs will actively seek such determinations for swaps that are subject to the mandatory clearing requirement. Moreover, the Commission expects to evaluate event contracts under a special review process to determine if they involve prohibited activities and other DCM contracts to determine whether a sufficient proportion of trades occur on the centralized marketplace in compliance with the Core Principle 9 requirement that the price discovery process of listed contracts be protected. The Commission has established a new objective and performance measure in its Strategic Plan to ensure that reviews of swaps submitted to the Commission are completed within statutory and regulatory deadlines.
A primary mission of the CFTC is to foster the fair, open and efficient functioning of the commodity derivatives markets. Critical to fulfilling this statutory mandate is the protection of market users and the public from undue burdens that may result from excessive speculation. Large concentrated positions in the physical commodity markets can potentially facilitate price distortions given that the capacity of any market to absorb the establishment and liquidation of large positions in an orderly manner is related to the size of such positions relative to the market and the market’s structure. Concentration of large positions in one or a few traders’ accounts can also create the unwarranted appearance of appreciable liquidity and market depth which, in fact, may not exist. Trading under such conditions can result in sudden changes to commodity prices that might otherwise not have occurred if traders’ positions were more evenly distributed among market participants. Position limits address these risks by ensuring the participation of a minimum number of traders that are independent of each other and have different trading objectives and strategies. Consistent with the Strategic Plan, the Commission anticipates performing risk analysis and stress-testing on large trader and clearing member positions, a total of approximately 600,000 positions in FY 2013, to ascertain those with significant risk and confirm that such risks are being appropriately managed.
The Commission currently sets and enforces position limits with respect to certain agricultural products. In addition, the Commission authorizes DCMs to set position limits and accountability rules to protect against manipulation and congestion and price distortions. The proliferation of economically-equivalent instruments trading in multiple trading venues, however, warrants extension of the Commission-set position limits beyond agricultural products to metals and energy commodities. The Commission anticipates that this market trend will continue as, consistent with the regulatory structure established by the Dodd-Frank Act, economically-equivalent derivatives based on exempt and agricultural commodities are executed pursuant to the rules of multiple DCMs, SEFs, and other Commission registrants. Under these circumstances, uniform position limits should be established across such venues to prevent regulatory arbitrage and ensure a level playing field for all trading venues. Because it has the authority to gather data and impose regulations across trading venues, the Commission is uniquely situated to establish uniform position limits and related requirements for all economically-equivalent derivatives.
A block trade is a large transaction that is negotiated off a trading floor or facility and then executed on an exchange’s trading facility, as permitted under exchange rules. The size of the transaction is presumed to be of a sufficient size that its execution on the centralized market could not be filled at a single price and would move the market. The trade would then be transacted off the centralized market, with the details of the trade reported to the exchange as soon as practicable. The exchange then reports the trade to the market, with an appropriate time delay. The Dodd-Frank Act expands the Commission’s authority to swaps, requiring that appropriate block sizes be established.
The Commission will be required to review, evaluate, and make a determination on the eligibility of a swap to be cleared, as well as the eligibility or continuing qualification of the DCO to clear such a swap. All DCOs that clear swaps must submit the contracts to the Commission, who must then make a decision as to whether the swaps are subject to mandatory clearing. The CFTC has 90 days after the submission, including a 30-day comment period, to make such determinations. There currently is no requirement for the CFTC to make similar determinations in the futures market. Though estimates of the total number of contracts that will be submitted for clearing, and how they will be handled with the Commission (e.g., the Commission may be able to group many by class) are highly uncertain, one data point is that the largest swaps clearinghouse currently clears nearly one million unique contracts. Furthermore, according to data from the Bank for International Settlements, the total notional amount of over-the-counter derivatives outstanding as of the end of December 2010 is $415 trillion for interest rates; $29 trillion for credit default swaps and $2 trillion for commodities. It is safe to assume there will be more DCOs clearing more products and that the risk profile of these cleared products will be more complex than the historically regulated futures and options.
The Commission routinely reviews new rules and rule changes adopted by registered entities to assure they meet the statutory core principles of the CEA and the regulations of the Commission. The CEA and Commission regulations establish procedures for certification and/or approval of new contracts, new rules and rule amendments submitted by existing registered entities— DCMs and DCOs — as well as new registered entities — SEFs and swap data repositories. Under the enhanced certification review procedures, staff must determine whether rules subject to the 10-day review timeline present novel or complex issues, are certified with inadequate explanation, or are potentially inconsistent with the CEA or Commission regulations, requiring a stay of the certification to conduct a more in-depth 90-day review.
In addition, the Commission must undertake a review of all current regulated entities to ensure they meet the new and amended core principles, and Commission regulations implementing such core principles, set forth in the Dodd-Frank Act. The Commission’s Strategic Plan includes specific performance measures that address the review of entity rules.
Market oversight and surveillance are highly dependent on the ability to acquire large volumes of data and the development of sophisticated analytics to identify trends and/or outlying events that warrant further investigation. To the extent possible, the CFTC is seeking to leverage applications and analysis across the organization through the use of XML-based industry standardized data sets. It is anticipated that through the collection of standardized data sets, the Commission will have the unique and essential ability to aggregate data received by all market participants, allowing a more encompassing view of futures, options and swaps transactions. This aggregated data will allow the Commission to conduct market-level surveillance and perform financial risk analyses of market participants. This capability is particularly important with the expansion of the Commission’s mandate in the disaggregated swaps markets, as market participants may have swaps data residing in multiple swap data repositories, multiple DCMs, and multiple SEFs. The Commission’s ability to view aggregated data across this industry landscape is essential. Investment in information technology (IT) is mandatory for this aggregation and also supports all facets of Commission market, financial, and risk surveillance programs. Furthermore, to address this need the Commission established a Strategic Plan objective to ensure that information technology systems support the Commission’s existing and expanded responsibilities to ensure financially sound markets, mitigate systemic risk, and monitor intermediaries.
The Commission monitors trading and the positions of market participants on an on-going basis. Commission staff screen for potential market manipulations and disruptive trading practices, as well as trade practice violations. Staff also monitors changing market conditions and developments, such as shifting patterns of commercial or speculative trading or the introduction of new trading activities, to assess possible market impacts on internal review techniques and/or evaluate the impact such changes may have on exchange trading rules and contracts.
Market and trade practice surveillance technology receives and processes seven to eight million transaction records multiple times a day for multiple scenarios, taking less than 15 minutes per scenario. Where previously eight hours were needed to review approximately 1,000 transactions manually, Commission staff is now alerted to questionable activity in the millions of daily transaction records and thousands of daily position records so that they may analyze market activity and systematically identify market manipulations and suspicious market activity. Automated surveillance tools allow staff to identify market participants that have concentrated market power and arms the CFTC with the knowledge and analytic capabilities necessary to take appropriate market surveillance actions. Futures and options end-of-day position data for large traders are collected from reporting firms and open interest, volume, price, and clearing member data is collected from exchanges. Exchanges electronically transmit to the CFTC the daily positions of each clearing member. Clearing members, futures commission merchants and foreign brokers (that is, the reporting firms) electronically file daily reports consisting of the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations. This data is used to monitor futures and options trading in order to detect any market anomalies that may occur and to identify situations that could pose a threat of manipulation so that appropriate preventive actions can be initiated. Automated alerts and profiles enable staff to conduct surveillance in the rapidly expanding area of electronic trading, both intra and inter-exchange and across side-by-side platforms. The details of each individual trade are collected from exchanges overnight and loaded and processed for reporting, analysis, and profiling, providing staff with greater efficiency and flexibility by performing sophisticated pattern recognition and data mining and helping detect novel and complex abusive practices. Alerts of potential trade practice violations are generated for review by market compliance and surveillance staff. In FY 2012, CFTC will begin receiving large trader commodity swaps position data that will be integrated with futures and options data to enhance market surveillance.
Beginning in FY 2012, the Commission anticipates enhancing its automated surveillance tools to: 1) include participant profiling (to determine trading/activities out of the norm), 2) include new alert models and additional analytic reports based on new data types not currently received at the Commission (e.g., order data), 3) build upon the existing list of automated alerts to refine existing alerts and create new ones, and 4) incorporate ownership and control records data. In FY 2013, CFTC anticipates receiving ownership and control records in order to associate end-of-day position data with the intra-day trade data, building an integrated view of this data that allows the market surveillance staff to better oversee the markets. This functionality will culminate in the detection of intra-day position limit violations.
Staff conducts risk and financial surveillance of DCOs, clearing futures commission merchants, and other market participants such as swap dealers, major swap participants, and large traders that may pose a risk to the clearing process.
Financial and risk surveillance technology allows staff to identify large traders whose positions may pose financial risk to the industry or a clearing firm, analyze an owner's holdings and project the effect of market moves on these holdings, perform "what if" stress testing and risk scenarios to determine the effect of market movement on margin, and evaluate overall portfolio risk under different market conditions. Financial and risk surveillance technology also allows staff to monitor futures commission merchants by storing and analyzing monthly financial statements and annual reports provided to the Commission to report net capital positions and other financial information. The Commission’s current financial and risk surveillance technology has been primarily applied to futures and options on futures products. Following the collection of position data on cleared swaps and over-the-counter products, which began in a limited capacity for existing DCOs in FY 2011 and will continue expanding through FY 2013, the Commission will update existing and introduce new financial and risk surveillance technology to expand data intake, surveillance, analysis, and reporting. This effort will begin in FY 2012 and continue into FY 2013, focusing on the different requirements for each asset class (e.g., interest rate swaps and credit default swaps).
CFTC also maintains a business analytics platform that provides staff with a powerful set of tools for performing data analysis. The platform allows staff analyzing industry data to keep pace with the continuing growth in industry data volume and complexity. The Commission will improve its ability to conduct economic analysis by providing additional data partitioning, parallel processing, high-performance indexing, and query optimization. These improvements will allow staff to more quickly gather subsets of enterprise data for analysis, optimize the analytics performance, and reduce extraction, transformation and loading times for very large order message volumes, market reconstructions and simulation, complex swap valuation, and high frequency and algorithmic datasets. In FY 2012 and FY 2013 the Commission anticipates deploying hardware and software tools to increase the loading and analysis of high volume datasets, and facilitating the sharing and reuse of independently-developed analytic routines and problem-specific datasets.
The implementation of automated surveillance systems is designed to improve the efficiency and effectives of the Commission’s surveillance programs across four dimensions: first, staff will have more time for analyzing pre-screened data, and allow them to focus on the participants, issues and trends that have the biggest market impact. Second, it will expand the breadth of surveillance by using computer algorithms to routinely scan data for potential trade violations or market conditions that may have previously been overlooked. Third, documented staff analyses can be used as an additional source of information to identify trends or patterns of concern; and fourth, potential violations will be recorded, tracked and referred to other divisions (e.g., enforcement) to ensure appropriate follow-up. The Commission anticipates building upon the automated surveillance capability, started in its trade practice compliance area and expanded into the large trader reporting area, to also cover financial and risk surveillance functions.
Examinations are formal, structured assessments of a regulated entities’ operations or oversight programs to assess on-going compliance with statutory and regulatory mandates. Regular examinations are the most effective method of ensuring that the entities’ are complying with the core principles established in the CEA:
Examinations are performed by multi-disciplinary teams of individuals, attorneys, industry economists, trade practice analysts, risk analysts and accountants depending on the scope. As described in Goal Two of the Strategic Plan, it is the Commission’s goal to move to annual reviews of significant entities, to ensure the effectiveness of Commission regulations.
The Commission protects market participants and other members of the public from fraud, manipulation and other abusive practices in the commodities, futures and swaps markets. Its cases range from quick strike actions against Ponzi enterprises that victimize investors across the country, to sophisticated manipulative and disruptive trading schemes in markets the Commission regulates including oil, gas, precious metals and agricultural goods. The importance of the Commission's enforcement responsibilities are specifically addressed in Strategic Plan Goal Three, which emphasizes cooperative enforcement to increase the Commission's effectiveness in identifying and deterring illegal conduct.
The Commission has the authority to: 1) shut down fraudulent operations and immediately preserve customer assets through asset freeze and receivership orders, 2) terminate manipulative and disruptive schemes, 3) ban defendants from trading and being registered in its markets, and 4) seek restitution, disgorgement and monetary penalties up to the greater of three times the amount of a defendant's gain or a fixed statutory amount. From FY 2002 to date, orders for more than $3 billion in civil monetary penalties, restitution and disgorgement have been imposed in Commission cases.
For example, in FY 2011, the Court ordered an interim distribution of nearly $800 million to Ponzi victims, equivalent to more than 60 percent of the victims' losses in that case. In another case, the Commission charged a group of defendants with manipulating the price of crude oil, and alleged they made in excess of $50 million in ill-gotten gains (that case is pending in Federal court in New York).
Since FY 2009, the Commission has received more than 2,500 leads from multiple sources concerning potential wrongdoing. Most of these leads were from members of the public and other miscellaneous sources. While all leads merit careful attention, most leads do not ultimately result in an enforcement action for a number of reasons including limitations on CFTC jurisdiction. Experience proves that leads generated internally at the CFTC, or from others in law enforcement or self-regulatory organizations, are much more likely to lead to a CFTC enforcement action.
As the outreach and education activities, funded through the Customer Protection Fund in FY 2012, reach a wide audience, it is likely that the number of leads will increase and strain the Commission's ability to triage and investigate them efficiently.
During the past two fiscal years, the Commission has opened more than 800 investigations including a record number of new investigations in FY 2011. The scope and level of effort associated with investigations varies widely. Manipulation investigations are generally far more time consuming than fraud and other types of investigations. For example, based on a review of length of time spent on investigations for approximately 150 enforcement actions filed by the Division of Enforcement, the average length of time spent on investigations resulting in charges filed involving fraud and trade practice have been less than one year, investigations leading to charges for supervision have been open for slightly more than one year, while investigations leading to charges of manipulation have taken more than two years to complete.
Enforcement of the Dodd-Frank Act and regulations promulgated thereunder will increase the Commission's enforcement burdens for a number of reasons. For example, the Dodd-Frank Act extends the Commission's anti-fraud jurisdiction to the swaps markets, and clarifies its jurisdiction with respect to certain retail off-exchange transactions, including transactions in precious metals. This expansion is expected to translate into more investigations, and more enforcement actions. Indeed, in just the first wave of DFA enforcement, concerning registration violations, the Commission filed 23 actions in FY 2011.
As a result of the Dodd-Frank Act, there will be new types and an increase in the number of CFTC registrants including exchanges, SEFs, swap data repositories, clearing organizations, intermediaries and dealers that require the Commission to issue concomitant regulations. The Commission's enforcement workload will include investigations concerning any violations by these new registrants of these new rules.
In addition, the Dodd-Frank Act established anti-manipulation authority over swaps and new broader anti-manipulation authority in the futures markets. While preventing manipulation is critical to the Commission's mission to help protect taxpayers and the markets, as noted above manipulation investigations and litigations are quite time consuming. The Dodd-Frank Act also includes a prohibition on disruptive trading. The Commission anticipates that disruptive trading investigations and litigation will be time intensive, particularly when high-frequency and algorithmic trading is involved, due to an inherent complexity comparable to that of market-wide manipulation investigations.
The Commission will continue to aggressively pursue domestic and international cooperative enforcement efforts. The Commission routinely works with domestic and international financial regulatory and criminal counterparts on multi-jurisdictional and multi-national investigations. There has been a significant increase in both the number of outgoing and incoming international requests each year since FY 2008. This change is directly related to the increase in enforcement cases in general, but is likely to be accelerated given the global nature of the swaps marketplace.
The new CFTC oversight of the swaps market, new anti-manipulation and other authorities, incentives for whistleblowers, and the increasing effectiveness of market surveillance, financial and risk surveillance, and business analytics technology will require expanding the capacity and increasing the capability of legal support technology that is provided through the Commission's case management system (eLaw). eLaw provides a variety of critical automated litigation support services to Commission staff in connection with their investigative and litigation matters. These services include technology designed to assist with the overall management of documents and data that may be relevant to a matter, case or request. The eLaw Electronic Data and Discovery Group processes data either received or to be produced by the Commission for further review by staff. The Litigation Support Group helps staff search and review potentially relevant documents using a suite of applications. The Computer Forensics Group employs specialized tools and techniques to properly identify, preserve, recover and analyze digital evidence.
The Commission increasingly relies upon digital evidence to establish and prosecute violations of the CEA. This evidence may include, for example, website content, audio tapes of trader calls with customers, customer account statements, bank records, and/or a computer hard drive or corporate server. The body of active enforcement digital evidence has grown from less than one terabyte or approximately 200 million pages in 2006 to over 15 terabytes today, the equivalent of 3 billion pages, and is expected to continue to increase. With eLaw technology support, staff is able to review significantly larger amounts of evidentiary material in a fraction of the time it would take to conduct a manual review. For example, with automated tools staff can search for certain keywords in the more than 500,000 documents in a typical price investigation in less than 30 seconds rather than taking 50,000 hours to conduct the same search manually. Staff can search the more than 250,000 audio files in a large price investigation in less than 30 seconds rather than taking 20,000 hours to review the evidence manually. The eLaw PreDiscovery tool rapidly ingests digital evidence and loads it into Commission databases, providing the evidence to Enforcement staff in one to two days rather than the several days it would normally take to outsource such processing.
In addition to supporting enforcement, eLaw supports: 1) legal activities throughout the Commission, which are also expanding with increased CFTC authorities, 2) the increased scope of the market, and 3) increased Commission legal activity in support of Dodd-Frank implementation. eLaw supports the Commission's defensive litigation, internal investigations, and the processing of privacy and Freedom of Information Action (FOIA) requests, all of which involve the management of large volumes of information. eLaw Forensics supports the preservation of electronically stored information that is subject to a "litigation hold" or other preservation obligations.