The Division of Trading and Markets (“Division”) has completed a rule enforcement review of the self-regulatory programs of the Chicago Mercantile Exchange (“CME” or “Exchange”).1 The purpose of this review was to evaluate the Exchange’s market surveillance, trade practice surveillance and disciplinary programs for compliance with Sections 5a(a)(8) and 5a(b) of the Commodity Exchange Act (“Act”) and Commission Regulation 1.51. The Division also reviewed certain aspects of the Exchange’s audit trail system for compliance with Commission Regulation 1.35. The review covers the target period of August 1, 1997 to July 31, 1998.
The Division’s previous rule enforcement review of the Exchange’s compliance program was presented to the Commission on April 4, 1995 (“1995 Review”).2 In the 1995 Review, the Division found that the Exchange had adequate trade practice surveillance and disciplinary programs, and made recommendations to enhance the Exchange’s investigation and disciplinary logs. With regard to the Exchange's audit trail program, the Division recommended that the Exchange: (1) employ a more rigorous enforcement program for noncompliance with spread reporting requirements; (2) take steps to improve members’ compliance with the trading card collection requirements of Commission Regulation 1.35(j), and the timing requirements for trades executed for other members present on the floor; (3) establish audit trail review procedures to examine a meaningful number of order tickets and trading cards for each member during back office audits; and (4) initiate a summary disciplinary action procedure designed to encourage compliance with trading document recordkeeping requirements by imposing increasingly higher fines or, in the alternative, apply its bracketing accuracy disciplinary regime, which involved two preliminary warning letters followed by referral to a disciplinary committee, to other Regulation 1.35 recordkeeping violations.
During an on-site visit to the Exchange, Division staff interviewed several Exchange officials, including the Senior Vice President of Market Regulation and several of his managers. Division staff also reviewed Exchange documents that included, among others, the following:
§ Computer reports and other documentation used routinely in the conduct of market surveillance and trade practice surveillance programs;
· Market surveillance and compliance manuals and guidelines;
· Selected trade practice investigation and market surveillance investigation files, and all disciplinary action files for cases closed during the target period;
· Trade practice investigation, market surveillance, and disciplinary action logs;
· Minutes of the disciplinary committee meetings held during the target period; and
· Back office audits that include trading card and order ticket reviews.
The Division provided the Exchange with the opportunity to review and comment on a draft of this report on September 2, 1999. On September 9 and 13, 1999, Division staff conducted exit conferences with CME trade practice surveillance and market surveillance staff, respectively, to discuss the report’s findings and recommendations.
III. CURRENT FINDINGS AND RECOMMENDATIONS
A. Market Surveillance
· The CME generally has an adequate market surveillance program. The Exchange heightens surveillance with respect to the spot and next deferred contract month as these contracts approach expiration. This surveillance begins just prior to first notice day in agricultural markets and a month before the spot month in financial markets.
· Staff closely monitors cash and futures prices, spread and basis relationships, size and ownership of deliverable supply, size of large trader positions relative to the total open interest and deliverable supply, and the positions of other large traders and clearing members. Contract expiration files generally do not contain sufficient documentation of surveillance activities performed prior to last trading day.
· The Exchange’s Large Trader Reporting System produces on-line and hard-copy reports that are used by staff to monitor large positions and enforce speculative position limit rules. The Division found one potential speculative limit violation that was not identified by the Exchange for seven days.
· Market surveillance staff does not document contacts with major market participants conducted before or during the expiration month to keep abreast of cash market developments and trading strategies and intentions.
· Most market surveillance reviews were completed expeditiously. However, several position accountability reviews should have been completed in a more timely fashion. In addition, staff should contact account holders directly, where practicable, when seeking timely information concerning the nature of positions that have exceeded position accountability levels.
· The Exchange’s Market Surveillance Guidelines do not contain current procedural information with respect to EFP and position accountability enforcement.
· The Exchange should implement the following enhancements: (1) document interviews with major market participants, including information concerning trading strategies and intentions; (2) contact account holders directly, where practicable, when making position accountability inquiries and obtain and document all necessary information; and (3) augment Expiration Summary Files with documentation of expiring month surveillance activities that take place prior to the last trading day.
· The Exchange should take steps to improve the timeliness of position accountability reviews, and include procedures for monitoring EFPs and position accountability thresholds in its Market Surveillance Guidelines.
B. Audit Trail Components: Order Tickets and Trading Cards
· The Exchange maintains an adequate program for conducting back office audits to review clearing firms’ and members’ compliance with order ticket and trading card recordkeeping requirements. In response to a recommendation in the 1995 Review, the Exchange has significantly increased the number of trading documents it reviews during back office audits.
· The Exchange has expanded its automated CTR enforcement program to track certain errors in trade time and sequencing data and to provide feedback to members and clearing firms through reports that reflect daily and month-to-date performance.
· Exchange members have a high level of compliance with respect to order ticket account identification and timestamping requirements. The Division also found that members generally demonstrated a high level of compliance with several trading card recordkeeping requirements. However, member compliance fell below an acceptable level for several important recordkeeping standards addressed below in the Division’s recommendations.
· Neither the Exchange’s practice of issuing deficiency letters nor its CTR enforcement program results in the imposition of a summary fine for trading document recordkeeping violations at any stage of the process.
· The Exchange should augment its deficiency letter process and CTR enforcement program by implementing a summary fining schedule, or otherwise modify its programs appropriately, to increase member compliance with trading card recordkeeping requirements.
· The Exchange should take appropriate action to ensure that trading cards reflect the trade date, clearing firm, and underlying commodity, and are timely collected and timestamped.
· The Exchange maintains an adequate trade practice surveillance program through the use of automated computer surveillance, visual floor surveillance, and video camera surveillance. The CME is the sole domestic futures exchange to integrate video surveillance into its trade monitoring system. The CME is also the only domestic futures exchange to voluntarily restrict dual trading in certain contracts.
· During the target period, a large number of trade practice investigations were generated as a result of routine surveillance activities, and several investigations of serious trade practice violations resulted in the imposition of significant penalties.
· Investigations were thorough, well analyzed and generally completed in a timely manner. However, investigation files were not maintained in accordance with Exchange procedures. In this regard, only one of the investigation files examined by the Division included a “record of action” sheet documenting telephone conversations and other investigation-related actions. Further, the files reviewed by the Division did not include a memorandum itemizing investigation interview tapes, which are stored separately from investigation files.
· Three investigations were closed with no action or a warning letter, but recommended continued monitoring of the members involved. The Division was unable to find evidence that the Exchange continued to monitor the members’ trading activity.
· In accordance with CME file maintenance procedures, the Exchange should ensure that investigators complete record of action sheets, when required, for each investigation or maintain an investigation progress log indicating all significant actions, and the dates of such actions, taken in developing an investigation. In addition, investigators should prepare a memorandum itemizing the interview tapes associated with a particular investigation prior to their storage in a separate area.
· The Exchange should document follow-up monitoring activities of members when such monitoring is recommended in a closeout memorandum.
D. Disciplinary Program
· The Exchange maintains an effective disciplinary program. Disciplinary matters are promptly referred to a disciplinary committee, disciplinary proceedings are completed in a timely manner, and findings appear to be supported by the evidence. Further, the penalties imposed appear reasonable relative to the conduct being sanctioned and are of an amount likely to deter further violations.
· Trade practice violations accounted for fines of $1,563,000 and suspensions of almost one and one-half years against 26 members, two clerks, and three firms.
· Two members were ordered to pay restitution in the amount of $85,425 to disadvantaged customers.
The Division has no recommendations at this time.
IV. SURVEILLANCE OF MARKET ACTIVITY- SECTION 5a(a)(8) AND COMMISSION REGULATION1.51(a)(1)
A. Market Surveillance Department
The Market Surveillance Department (“MSD”) has 10 full-time employees and a consultant.3 The MSD staff is headed by the Senior Director, who has managerial responsibility for the overall operation of the department. The Senior Director reports to the Senior Vice President of Regulatory Affairs, who is responsible for all compliance activities conducted by Market Regulation, including trade practice, market surveillance and financial oversight.4
Three managers, the Director, and two product managers report to the Senior Director. The Director supervises three surveillance analysts, including one senior analyst. 5 These analysts are responsible for monitoring all financial contracts (i.e., interest rate and equity index products). A product manager and a senior analyst monitor all currency products, and one product manager and two analysts monitor all agricultural products. Managers and staff have considerable industry and Exchange experience, ranging from one and a half to 16 years. The MSD appears adequately staffed to perform its self-regulatory duties.
Analysts use the department's Market Surveillance Guidelines (“Guidelines”) as a manual for training and reference purposes.6 The Guidelines include a Market Regulation organizational chart, an overview of market surveillance activities, and sections on data collection, data analysis, and disciplinary actions. There are four appendices to the Guidelines, which include sample reports and screens from the Exchange’s large trader database, position limit exemption applications, contract specifications, daily price limits, speculative position limits, position accountability thresholds, and questions and answers regarding exchange of futures for physicals ("EFP") transactions.
The Guidelines, however, do not include a detailed description of the procedures employed by MSD staff to select EFP transactions for review, such as it does for possible speculative limit violations. The Guidelines contain only a brief and general discussion of the Cash for Futures Report, which analysts use to monitor EFPs. In addition, the Guidelines do not provide any guidance with respect to Exchange procedures for conducting position accountability reviews, which have been in effect at the CME since 1992. Accordingly, the procedures and parameters used for enforcing both EFP and accountability rules should be articulated in the MSD’s Guidelines.
B. Prices, Volume, Open Interest, and Market News
On a daily basis, the MSD staff review price movements, volume and open interest in all Exchange-traded contracts. On-line quotation systems, combined with computer-generated reports, greatly enhance staff’s ability to conduct several types of analyses of these data quickly and efficiently. In addition, staff work closely with the Exchange’s Market Information Systems Department to enhance on-line capabilities as needed. Price quotes are monitored throughout the day via the Exchange’s in-house quotation system, “Mercquote.” Mercquote is an on-line, real-time quotation system directly tied into the price quotation boards on the Exchange’s trading floors. The system allows staff to identify and monitor unusual price changes on a real-time basis. Mercquote also displays intra- and inter-commodity spread quotations and prices from external sources, such as futures and options prices at the Chicago Board of Trade and cash prices from the U.S. Department of Agriculture (“USDA”).
MSD staff use the Commitment Report for a detailed analysis of open interest. This report lists open interest by commodity and contract month. Within each contract month, the report is divided into customer, house, and combined customer and house positions for each clearing member. Each of the three positions is then divided into gross long and short positions, with the net change of positions from the previous business day also shown.7 The report is primarily used to identify potential concentrations of positions at one or more clearing firms. The report also is used to monitor the level of open interest in a contract as it approaches last trading day to help determine whether the contract is liquidating in an orderly manner.
In addition, Daily Information Bulletins, produced by the CME Statistics Department, are used extensively by MSD staff.8 These bulletins, which reflect various market data for the previous day’s trading session, provide a ready source of futures price data, as well as information relating to the underlying cash markets.9 The bulletins also contain volume and open interest statistics and the daily high, low, and settlement prices for each future and option contract. Analysts also use a historical statistical database to monitor open interest and volume. The database allows historical comparisons to be conducted to help analyze the relative liquidity of each market.
Finally, staff collects and analyzes market information and news on a daily basis. Analysts use a number of financial news reporting services to monitor economic statistics and news reports to determine the various influences on the markets. Newspapers and industry publications also provide valuable market and price information. MSD staff also receive market information from trading floor sources and periodically conduct field trips, also called "hedge visits." The purpose of hedge visits is to obtain feedback necessary for a better understanding of the market participants’ needs and to establish new contacts and lines of communication, while also solidifying relationships with existing contacts. Six hedge visits were conducted during the target period, each of which was memorialized in a memorandum. The memoranda typically included the location of the meeting, the names of individuals present and, with one exception, a brief summary of the topics discussed. 10
C. Large Trader Reporting System
The daily reports of large trader positions, required to be provided to the Exchange under CME Rule 8.17, form the foundation of the CME’s Large Trader Reporting System (“LTRS”). Rule 8.17 requires clearing members to report daily any position that at the close of trading is greater than or equal to the reportable position levels (gross long or short) established by the Exchange for each contract.11 Extensive reportable trader information is used by MSD analysts in the performance of their daily surveillance activities.
Analysts may access LTRS data through a series of computer reports and on-line screen applications that analyze large trader activity according to predetermined sorts.12 For example, an analyst can access a report that sorts large trader data by reportable trader across multiple clearing firms or by a clearing firm across commodities. One large trader report routinely used by staff is the Book Report, which is sorted by commodity and contract month, as well as by clearing firm, account number, account title, and position.13 The report indicates each reportable account’s current position, the previous day’s position, and the change between the two, and provides MSD staff with a useful tool for monitoring position limit violations and concentrations of positions among related accounts. Analysts also review the Book Report daily for occurrences of unusually large position changes and unusual trading activity.
Other LTRS reports used daily are the Watch/Account Reports, which provide reportable position information ranked by size for each contract month and for all months combined.14 Each account number contained within the large trader system may be assigned up to six individual “watch numbers” and more than one account can be assigned the same watch number. These data enable analysts to monitor groups of related accounts at one clearing firm, or at multiple firms, in order to detect potential concentrations of positions as they are developing.15
D. Contract Expirations
1. Heightened Surveillance
In addition to the above-described surveillance, which is continuous throughout the life of a contract, the Exchange intensifies surveillance with respect to the next deferred contract month and, more particularly, the spot month, as these contracts approach liquidation. Heightened surveillance generally begins just prior to first notice day in the agricultural markets and about a month before the spot month in the financial markets. This surveillance is focused on closely monitoring cash and futures prices, spread and basis relationships, size and ownership of deliverable supply, size of large trader positions relative to the total open interest and deliverable supply, and the positions of other large traders. In the weeks immediately preceding a contract expiration, MSD staff meets daily. Otherwise, staff meets on an as needed basis to discuss potential problems or other market situations which may prevent an orderly liquidation.
The Exchange also places major emphasis on the monitoring of “scale down” or spot month position limits, delivery intentions, position adjustments, and transfer trades. With respect to spot month limits, market participants are required to reduce their spot month positions to applicable position limits during the last days of trading of an expiring contract.16 The Exchange’s scale down policy was adopted to prevent any trader from carrying a position which, by virtue of its sheer size, could have a negative impact on the orderly liquidation of a contract. Staff primarily use two reports to monitor compliance with spot month limits, the aforementioned Book Report and the Account Position by Contract Month Report, one of the six Watch/Account reports.
The Blotter Report, produced by the Exchange Clearinghouse, is used by MSD staff to monitor deliveries. The report is essentially a chronology of long positions, sorted by firm and trade date.17 Specifically, MSD staff use the report to determine which firms and traders may be in position to receive deliveries, a significant factor in those commodities where deliverable supply may be limited. The report is also used to identify situations where a trader might use the delivery process, or the taking of deliveries, to influence prices during a contract’s expiration.
The Position Adjustment Report and the Transfer Report are used to monitor adjustments to positions and transfer trades. The Position Adjustment Report indicates an adjustment to a firm’s open positions with the Clearinghouse, made necessary when a clearing member incorrectly reports its position.18 Position adjustments may affect changes in open interest, and the report enables MSD staff to monitor the increases or decreases in open positions which are not accounted for by regular trading volume. The Transfer Report allows analysts to monitor position transfers from one account to another, either within the same firm or from one firm to another.19 Analysts use this report to monitor the movement of large positions from one firm to another, and to identify any positions transferred that may have resulted in a change of ownership, in possible violation of the open outcry requirement of Commission Regulation 1.38.20
2. Expiration Summary Files
During the target period, the Exchange initiated procedures for the routine preparation of Expiration Summary Files (“ESFs”) that document the Exchange’s surveillance actions taken with regard to expiring contracts. The Division examined five ESFs prepared during the target period to assess the adequacy and documentation of those surveillance procedures. The five ESF’s examined were prepared for the following contracts: September 1997 S&P 500, June 1998 Live Cattle, June 1998 Japanese Yen, June 1998 Eurodollar, and July 1998 Lumber.
Most of the information contained in the ESFs related to data gathered on the last trading day. The ESFs did not contain documentation of surveillance activities conducted during the expiring month, including contacts with major market participants or cash market trade sources. For example, the ESFs for Live Cattle and Lumber contained analyses for the last trading day of cash prices, bases, and spread relationships, along with documentation of large trader positions, their market share, and any possible concentration concerns. The Live Cattle ESF also contained a memorandum that provided a synopsis of the contract expiration, a listing of deliveries by clearing firm, cash stock information, and documentation of trader interviews that were conducted subsequent to contract expiration.21 The Live Cattle ESF did not indicate that any trade or major market participant interviews were conducted prior to expiration. Similarly, the price analyses and large trader and clearing firm position data included in the ESFs for index and financial contracts generally covered information only for the last trading day. These ESFs also did not contain documentation of any interviews. These interviews should provide MSD staff with important insights into hedging and cross-hedging strategies, underlying cash market activity, liquidation intentions, and other information that may be of import to ensure an orderly expiration. The information obtained should be articulated in memoranda retained in the respective ESF.
E. Enforcement of Speculative Position Limits and Exemptions
1. Speculative Limit Violations
The MSD also is responsible for enforcing the CME’s speculative position limit rules. Analysts review the Position Limit Report daily to detect positions in excess of limits, and to review large trader activity for indications of accounts that should be aggregated for speculative limit purposes. 22 The report lists accounts that are near or over speculative position limits. If an account or group of aggregated accounts is over the limit, the clearing firm(s) is contacted and instructed to reduce the position or to have the account owner apply for a speculative position limit exemption, if eligible.
During the target period, 28 speculative limit investigations were closed, 23 of which involved agricultural markets.23 Two of the investigations were opened prior to the target period and 26 were opened during the target period. On average, each investigation was open for 39 days, well within the four-month requirement of Commission Regulation 8.06.24 Staff determined that no violation had occurred in two investigations; granted hedge exemptions in conjunction with two investigations; issued warning letters in 24 investigations;25 and issued a cease and desist order against a local in one investigation, which was subsequently rescinded by unanimous vote of the Business Conduct Committee (“BCC”).26
Division staff reviewed seven of the 28 closed speculative limit investigations for adequacy. In each investigation, the position appears to have been reduced or an exemption application submitted in a timely manner. The Division found one violation, however, which was not identified by the MSD until a week after it was identifiable on Exchange computer reports. In addition, over the week-long period, the account, a large hedge fund, increased its position in Nikkei Stock Index Average futures by 200 contracts, further exceeding the 5,000 contract position limit.27
2. Speculative Positions Limit Exemptions
MSD staff also is responsible for reviewing and processing speculative position limit exemption applications. Pursuant to Exchange rule, speculative limit exemptions may be granted for bona fide hedges, risk management positions, arbitrage/inter-commodity spread positions, option-option and option-future spreads, and independently controlled positions.28 A separate exemption application must be completed for each agricultural commodity or approved inter-commodity spread for which an exemption is sought.29
No trader is allowed to exceed a speculative position limit in an agricultural commodity until he or she has filed the appropriate application and received Exchange approval. Traders in financial markets, except stock indexes, are permitted to exceed the limits for several days prior to filing an application--five business days for new applicants and ten business days for traders who want to increase an existing exemption.30 A trader intending to exceed speculative position limits in stock index futures may request verbal approval prior to exceeding such limits. If the request is granted, the application must be filed promptly thereafter.
Agricultural hedge exemptions are granted on a calendar-year basis. The exemptions must be renewed yearly, normally in the fall. As of October 1997, the Exchange had granted exemptions to 41 entities in at least one agricultural commodity, only a few of which were spread exemptions. Financial hedge exemptions must be renewed every other year. As of October 1997, the Exchange had granted exemptions to 46 entities in at least one financial commodity, 15 of which were independently controlled position exemptions. Division staff reviewed hedge exemption files for six entities. The files were well documented, except for one, which did not contain a justification for the exemption or a hedge exemption application. 31 The five remaining files included bona fide hedge and spread exemptions granted in livestock contracts and lumber. The Division found that three of the hedge exemption request files included completed exemption applications and adequate justifications. Each of those files also contained an MSD spreadsheet calculation comparing monthly cash capacity and requested exemption levels, as indicated in the applications.32 Two spread exemption request files did not include completed exemption applications, although the documentation was otherwise sufficient to justify the request. The Exchange should ensure that all hedge exemption files contain completed exemption applications and supported justifications for the exemption.
3. Position Accountability
Since January 14, 1992, position accountability rules have been in place for Eurodollar and major currency contracts. On August 7, 1995, the rules were extended to include the LIBOR contract. In place of absolute position limits, the accountability rules mandate levels, or thresholds, at which large traders may be required to respond to special requests by the Exchange for information relating to their positions. Specifically, the accountability rules provide that any trader who exceeds the former speculative position limits will be required to “provide, in a timely fashion, upon request by the Exchange, information regarding the nature of the position, trading strategy, and hedging information if applicable."33
Pursuant to Exchange procedures, a position accountability review is initiated when contact with either the account owner or clearing firm(s) carrying the position(s) is made by telephone or in writing. A Summary of Position Accountability Action form ("Action Sheet"), which among other things, includes a summary of telephone conversations held and written responses received, is completed for each account or aggregated group of accounts exceeding the accountability level. 34 As of March 1998, each position accountability review is assigned a number that is entered into a log. The new logging procedure has made it easier for MSD staff to monitor the status of position accountability reviews and to determine the need for additional follow-up.
A total of 32 position accountability reviews were opened during the target period.35 The Division randomly selected eight reviews for in-depth analysis.36 The Division found that MSD staff did not always contact, by telephone or in writing, the account holder. In seven of the eight reviews examined, MSD staff contacted either compliance staff or other personnel of the firm carrying the account, rather than the account holder. When practicable, the account holder should be contacted in the first instance. The Division also found one instance in which the Exchange did not obtain sufficient information concerning the nature of the position or the trading strategy underlying the position. In that instance, MSD staff asked a firm a question regarding the nature of a Eurodollar futures position, the underlying cash position, if any, and the ratio of futures to cash, if applicable. The firm gave a very non-specific response, and the Exchange conducted no further probing.37
The Division also found that of the 14 position accountability reviews entered into the log during the target period (i.e., those opened on or after March 23, 1998), seven were open for lengthy periods of time before required information was gathered. On average, each review was open for 98 days, a prolonged period of time given the potential market impact that a position in excess of accountability levels may have.38
The Exchange has two rules authorizing EFP transactions: CME Rule 538--Transfer of Spot for Futures, and CME Rule 719--Transfer of Cash for Futures after Termination of Contract. CME Rule 538 permits EFPs during the course of trading of the futures contract, while CME Rule 719 authorizes EFP transactions after expiration of a contract.39 All EFPs must be authorized by the customer, recorded on a trading card or order ticket by both parties to the transaction and, following execution, be confirmed to the customer and submitted to an Exchange employee at the relevant quadrant's pulpit for posting on the trading floor.40 CME Rule 538 requires that clearing members and brokers maintain full documentation of each EFP transaction. Parties to an EFP executed pursuant to CME Rule 719 must also file with the Clearinghouse all documentation necessary to verify the nature of the transaction.41
During the target period, a total of 6,925,521 contracts, representing approximately four percent of total CME volume, were executed via EFPs. Ninety-five percent of the EFPs were transacted in the Exchange’s currency contracts, representing 26 percent of total currency volume.42 Almost all of the remaining five percent of EFP volume was transacted in equity index products, mostly in the S&P 500 contract, with an even smaller percentage of EFPs transacted in interest rate and agricultural markets. More specifically, 328,641 equity index contracts, 5,160 agricultural contracts, and 987 interest rate contracts were transacted via EFPs.43
MSD staff uses the Cash-For-Futures Monthly Summary report to monitor EFP transactions.44 The report shows EFP volume relative to total volume by commodity sector. Each month, staff readily can determine what percentage of total volume was in the form of EFPs in any particular contract, or across all contracts; identify the firm that clears the most EFPs in any month in any particular contract or in all contracts combined; and compare EFP volume by sector to the previous two months or prior year. The MSD also spot checks EFPs to identify those that may have unusual characteristics, such that they warrant investigation.45
A total of 11 EFP investigations were opened during the target period, four each involving currency and equity index contracts, two involving agricultural contracts, and one involving interest rates. Seven EFP investigations were closed during the target period. Of the seven, each took an average of 77 days to complete, well within the four-month requirement of Commission Regulation 8.06. For the purpose of evaluating the adequacy of Exchange EFP investigations, the Division examined four of the seven closed investigations. Three of the investigations were closed during the target period, and one was opened during, and closed after, the target period. 46 Generally, the EFP investigations were thorough and well documented. Most importantly, in each of the four investigations, the change of ownership of the cash component was appropriately verified.
The Division notes one EFP review in which it believes additional analysis should have been conducted.47 Specifically, the subject South African Rand EFPs were reviewed because they consisted of two transactions at the same quantity and the same price, indicating a possible three-party EFP. One participant was common to both trades, the trades apparently were executed within 30 minutes of each other, and both trades were transitory.48 MSD staff obtained appropriate documentation from the clearing firms to confirm that the trades were executed separately and concluded that the trades did not violate Exchange rules. However, MSD staff could have used this opportunity to contact the parties to the EFP to obtain information about the nature of or motivation behind the transactions in what was then a new contract.
Exclusive of speculative limit, position accountability, and EFP investigations, MSD staff closed 11 other investigations during the target period. These involved complaints concerning settlement prices, trading ahead, freshening of long positions to avoid deliveries, simultaneous buys and sells, aggregation analyses, and reviews of volatile trading days. Division staff reviewed six representative investigations for adequacy, one of which was opened during, and closed after, the target period.49 The Division found that these investigations generally did not include interviews of relevant parties to the subject transactions, such as account holders or executing floor brokers, nor adequate explanations of the analyses conducted and conclusions reached.
For example, in one investigation, staff reviewed trading activity in the June 1998 Russian Ruble futures contract cleared through a particular firm in which staff suspected prearranged trading among certain accounts.50 The investigation closeout memorandum does not note the volume of trades in question. The memorandum also does not identify the suspect accounts, although daily account statements in the file contain the names of the account holders. More importantly, there is no indication of how the daily account statements and order tickets obtained relate to the conclusion that no prearranged trading occurred; there is no comparative analyses with respect to the volume of trades by the subject accounts on the particular day versus other days, or to the total volume in the contract; and there is no indication of staff interviews of account owners or relevant floor brokers.
The Division identified other investigations in which it appears that the relevant parties were not interviewed. One of the two investigations was initiated as a review of apparent simultaneous buys and sells in the October 1997 Live Cattle futures contract by a single account owner at two clearing firms.51 MSD staff concluded that simultaneous buying and selling had probably occurred, presumably an attempt to freshen open long positions to avoid delivery. Nevertheless, the investigation was closed, citing a lack of "unquestionable proof," and warning letters were issued. In addition to there being no evidence of interviews, the investigation file did not contain sufficient explanation as to the type of proof missing or why the case was not referred to the Market Regulation Department for further investigation.
The other investigation was opened in response to a member’s large spread position in May/July 1998 Frozen Pork Belly futures.52 The MSD did not contact the trader at the time the trader held the troublesome position in an attempt to ascertain the nature of the large position or the trader’s accessibility to the cash market. Rather, the MSD monitored the trader’s much smaller subsequent position in the July/August 1998 spread, anticipating tight deliverable supply and a volatile cash market during the July expiration.
The Exchange generally has an adequate market surveillance program. Surveillance is focused on the two nearest delivery months and, in particular, on the spot month. Supply and demand statistics, futures and cash prices and spread relationships, volume and open interest, deliverable supplies and delivery intentions, and spot month speculative position limits all are closely monitored as a contract approaches expiration. The Exchange’s Large Trader Reporting System produces on-line and hard-copy reports that are used by MSD staff to monitor large positions and enforce speculative position limit rules. The Exchange also has in place adequate procedures to monitor speculative limit exemptions, position accountability thresholds, and EFPs.
The Division believes that the CME can further enhance its market surveillance program by contacting account holders directly, when practicable, rather than the carrying clearing firm’s compliance department or other personnel, when seeking timely information concerning the nature of positions that have exceeded accountability thresholds. The Exchange should also make further inquiry, where appropriate, with respect to obtaining all necessary information concerning the nature of, and trading strategy underlying, a position that reaches an accountability level. In this manner, MSD staff will be in a position to secure the most accurate and useful information concerning the positions held. The Exchange also should document its interviews of large market participants conducted during the expiring month, even in those situations where expiration problems may not be immediately evident. The interviews should provide staff with important insights into hedging and cross-hedging strategies, underlying cash market activity, and liquidation intentions, all of which should be documented in the respective ESF. In addition, ESFs should include documentation of expiring month surveillance activities conducted prior to the last trading day.
The Division also found that most market surveillance reviews were completed expeditiously, however, several position accountability reviews should have been completed in a more timely fashion. Finally, the Market Surveillance Guidelines do not include a detailed description of the procedures employed by MSD staff to identify and investigate suspicious EFPs, and do not provide any guidance with respect to Exchange procedures for monitoring position accountability levels.
Based on the foregoing, the Division recommends that the Exchange:
· Implement the following enhancements to its market surveillance program: (1) document interviews with major market participants, including information concerning trading strategies and intentions; (2) contact account holders directly, where practicable, when making position accountability inquiries and obtain and document all necessary information; and (3) augment Expiration Summary Files with documentation of expiring month surveillance activities that take place prior to the last trading day.
· Take steps to improve the timeliness of accountability reviews, and include procedures for monitoring EFPs and position accountability thresholds in its Market Surveillance Guidelines.
V. AUDIT TRAIL COMPONENTS - ORDER TICKETS AND TRADING CARDS-COMMISSION REGULATION 1.35(a-1)(2)-(4) AND 1.35(d)
Pursuant to Commission Regulation 1.35(a-1)(2), each contract market member or its designated person receiving a customer’s order on the floor must prepare a written record of the order in nonerasable ink, including the account identification and order number. The member then must timestamp the order with the entry time to reflect the date and time, to the nearest minute, that it is transmitted to or received on the exchange floor. When the execution price is reported from the floor, the order must be timestamped again, pursuant to Commission Regulation 1.35(a-1)(4), to reflect the exit time.
Commission Regulation 1.35(d) requires that trading members record information for all transactions on trading cards or other records, including the member’s name, opposite member’s identification, clearing member’s name, date, execution time, commodity, future, quantity, price and delivery month. Further, members recording purchases and sales on trading cards must record such purchases and sales in nonerasable ink, in exact chronological order of execution, on sequential lines of the trading card without skipping lines between trades, and must cross out any remaining lines on the trading card. Trades made during the exchange’s opening and closing periods also must be separately identified.
In addition, Commission Regulation 1.35(d) requires that trading cards contain preprinted identification information and sequence numbers to distinguish one member’s cards from another’s, to permit the sequencing of cards, and to differentiate each card prepared by a member from other such cards for no less than a one-week period. Trading cards also must be submitted to the exchange or a clearing firm within 15 minutes of designated trading intervals not to exceed 30 minutes beginning with the opening of each trading session, and each member must use a new trading card at the beginning of each 30-minute interval.53
In order to evaluate member compliance with these audit trail requirements, the Division examined the results of the CME’s routine back office audits of member firms and conducted an independent review of randomly selected samples of trading cards and order tickets.
A. Back Office Audits
The CME generally conducts back office audits of each clearing firm for compliance with Computerized Trade Reconstruction (“CTR”) related recordkeeping requirements with respect to order tickets and trading cards at least once a year.54 However, firms with a large number of deficiencies uncovered in previous audits may be reviewed more frequently.
Back office audits are conducted by Market Regulation Department data analysts. The data analysts follow a questionnaire and a checklist to determine whether trading documents satisfy requisite recordkeeping standards.55 Specifically, the analysts examine original floor order tickets, presequenced trading cards used for the recordation of personal trades (“personal trading cards”), and trading cards with manually-recorded customer type indicator (“CTI”) 3 trade execution times (“CTI 3 trading cards”),56 along with the firm’s trade register, for compliance with audit trail recordkeeping requirements and to determine the accuracy of the recorded information.57
In response to a Division recommendation made in the 1995 Review, the Exchange has increased the number of trading documents reviewed during back office audits.58 With respect to order tickets, the Exchange examines a minimum of 20 to 30 percent of all customer orders cleared through a firm for a selected date. If the firm cleared trades recorded on no more than 50 trading cards and 50 customer orders, the Exchange will attempt to review all of the orders and cards. The Exchange uses a similar process for selecting CTI 3 trading cards. The sample size of personal trading cards chosen for review depends on the number of members who cleared trades through the firm on the particular date. Generally, the Exchange audits a minimum of ten personal trading cards for each member who cleared trades through the firm. In addition, if a particular member demonstrated unsatisfactory recordkeeping compliance during the preceding Exchange audit of the firm, the sample of trading cards reviewed for that member is at least doubled. This new trading document selection procedure significantly increases the likelihood that all Exchange members are reviewed for recordkeeping compliance at least once a year and also has significantly increased the number of trading documents examined.59
Once a back office audit is completed, the Exchange may send the clearing firm one of three types of deficiency letters. In addition, depending upon the degree of the identified deficiencies and the firm’s past recordkeeping compliance record, the CTR Committee may issue a fine not exceeding $5,000.60 Although the CTR Committee may issue a fine, there is no Exchange rule requiring a fine. If the deficiencies found during an audit involve an individual member who executes trades cleared by the subject firm, the member also is sent a deficiency letter.61 Finally, if Exchange staff uncover potential substantive trading violations in the course of reviewing trading documents, those findings are integrated into the Exchange’s routine trade practice surveillance program through the initiation of an investigation.
During the target period, the Exchange conducted a total of 71 back office audits of its active clearing member firms, with seven of these firms being audited twice. As a result of these audits, 11 firms were fined a total of $31,000 by the CTR Committee and 55 firm deficiency letters were issued, 28 of which required responses with proposed remedial action. In addition, the Exchange sent 320 member deficiency letters to 308 individual members.62
As a supplement to its back office audits, the Exchange has expanded its automated CTR enforcement program to track certain errors in trade time and sequencing data and to provide feedback to members and clearing firms through reports that reflect daily and month-to-date performance.63 For individual members, the Exchange monitors the following: (1) bracketing errors, (2) trade sequencing errors on personal trading cards, (3) errors in the reporting of execution times (for CTI 3 trades and certain other proprietary trades), and (4) trades at prices not found in the time and sales register. With regard to clearing firms, the Exchange monitors order ticket timestamping accuracy errors. Clearing firm collection and timestamping of trading cards cannot be tracked by the CTR enforcement program because trading card exit timestamp data are not entered into the Exchange’s imputed trade timing system.
Members whose CTR enforcement program error rates exceed a certain percentage threshold are subject to disciplinary action. Specifically, a member is issued two warning letters followed by a CTR Committee review/hearing at which the member may be fined up to $5,000 any time there have been three monthly violations for the same error within a rolling six-month period.64 However, similar to the Exchange’s deficiency letter process, there is no rule requiring that the CTR Committee impose a fine. During the target period, the CTR enforcement program generated 1,518 warning letters and 211 notices of CTR Committee review to individual members. In addition, 73 individuals were required to appear at CTR Committee hearings in which the Committee fined 33 members a total of $39,000. Further, 25 clearing firms were sent warning letters and 14 firms were sent notices of CTR Committee review. Of these 14 clearing firms, 13 were ordered to appear before the CTR Committee, which fined 12 firms a total of $37,000 for repeated timestamping violations.
1. Order Tickets
The Division’s review of the Exchange’s back office audits conducted during the target period disclosed that the Exchange examined a total of 7,407 order tickets for compliance with the account identification and timestamping requirements of Commission Regulation 1.35(a-1)(2)(i) and (4). The Exchange found that 7,405 (99.97 percent) of the 7,407 order tickets reflected account numbers, and that 7,267 order tickets (98 percent) included both an entry and exit timestamp. In addition, 6,599 order tickets (89 percent) reflected accurate entry into clearing of entry and exit timestamps by clearing firms.
Division staff conducted an independent review of 354 order tickets for compliance with the above regulations and found a similarly high rate of compliance.65 Account numbers were recorded on all of the 354 order tickets reviewed.66 The Division also found that 348 (98 percent) of the 354 order tickets contained the appropriate entry and exit timestamps. Of the six orders that were missing timestamps, two did not contain an entry timestamp and four did not contain an exit timestamp. In addition, 343 order tickets (97 percent) reflected accurate entry into clearing of exit and entry timestamps by clearing firms.
2. Trading Cards
The Exchange also examined 6,761 personal trading cards and 1,455 CTI 3 trading cards during the course of the 71 back office audits conducted during the target period. The Exchange found that 1,237 personal trading cards (18 percent) and 212 CTI 3 trading cards (15 percent) were not collected and timestamped by the clearing member firm within the required collection time period. The Exchange also found 107 CTI 3 trading cards (seven percent) on which the executing broker failed to indicate an execution time.
The Division conducted an independent review of 425 trading cards, which included 398 personal trading cards and 27 CTI 3 trading cards, for compliance with Commission Regulation 1.35(d).67 The Division found that all 398 of the personal trading cards contained pre-printed identification information and sequence numbers and listed opposite brokers. Forty-eight (12 percent) of the personal trading cards did not include a date. The Division found a high level of compliance regarding the requirements that there be no skipped lines between trades on trading cards and that all unused lines be marked through. Specifically, 392 (99 percent) of the 398 personal trading cards reflected no skipped lines between trades and 368 cards (93 percent) satisfied the requirement that the remaining lines on the trading card be marked through following the last recorded execution. In addition, 383 personal trading cards (96 percent) indicated the underlying commodity traded and 392 (99 percent) indicated the contract month. However, 226 of the personal trading cards (57 percent) did not indicate the clearing firm.
Although all 27 of the CTI 3 trading cards examined included trade execution times, 12 CTI 3 trading cards (44 percent) failed to indicate the clearing firm. The Division’s review also disclosed that six CTI 3 trading cards (22 percent) did not list the underlying commodity. The Division found that all of the trading cards were recorded in noneraseable ink.
Finally, Division staff examined the 398 personal trading cards and 27 CTI 3 trading cards for compliance with the requirement that cards be collected within 15 minutes following each 30-minute trading interval and be timestamped to the nearest minute following collection. The Division’s independent review, similar to the back office audits conducted by the Exchange, indicated that Exchange members must improve their compliance with trading card timestamping and collection requirements. Of the 398 personal trading cards, 55 cards (14 percent) did not contain a collection timestamp. In addition, 70 of the personal trading cards (18 percent) were collected and timestamped late. Of the 27 CTI 3 trading cards used to record manual execution times, one of the cards (four percent) did not contain a collection timestamp and seven of the cards (26 percent) were not collected and timestamped within the requisite time period. Thus, 133 (31 percent) of the 425 trading cards examined did not comply with timestamping and collection requirements.
B. Conclusions and Recommendations
The Division found that the Exchange maintains an adequate program for conducting back office audits to review clearing firms’ and members’ compliance with order ticket and trading card recordkeeping requirements. During the target period, the Exchange audited most of its active clearing firms at least once and audited seven firms twice. Since the 1995 Review, the Exchange has modified its process for selecting order tickets, personal trading cards, and CTI 3 trading cards to be reviewed during the course of a back office audit. Not only has this new procedure significantly increased the number of trading documents examined, it significantly increases the likelihood that all Exchange members are reviewed at least once a year for recordkeeping compliance.
As a result of the 71 back office audits conducted during the target period, 55 firms were issued firm deficiency letters, 26 of which required responses with proposed remedial action, and 11 firms were fined a total of $31,000. In addition, 320 member deficiency letters were issued to 308 individual members. The Exchange’s automated CTR enforcement program, which also identifies certain recordkeeping errors, resulted in a total of 1,543 warning letters, 225 notices of CTR Committee review, and $76,000 in fines. Notwithstanding the issuance of these fines, which were imposed after hearings by the CTR Committee, the Exchange’s recordkeeping enforcement program does not include a summary fining schedule.
The Exchange’s back office audits and the Division’s independent review of order tickets and trading cards indicate that members have a high level of compliance with respect to order ticket account identification and timestamping requirements. Nonetheless, the Exchange should take action to improve member compliance with a number of trading card recordkeeping standards. The Division’s independent review of 398 personal trading cards and 27 CTI 3 trading cards disclosed that 12 percent of the personal trading cards did not reflect the trade date, 57 percent of the personal trading cards and 44 percent of the CTI 3 trading cards did not include the clearing firm, and 22 percent of the CTI 3 trading cards did not include the underlying commodity. In addition, the Division found that 31 percent of the 425 trading cards examined failed to comply with timestamping and collection requirements.
Based on the foregoing, the Division recommends that the Exchange should:
· Augment its deficiency letter process and CTR enforcement program by implementing a summary fining schedule, or otherwise modify its programs appropriately, to increase member compliance with trading card recordkeeping requirements.
· Take appropriate action to ensure that trading cards reflect the trade date, clearing firm, and underlying commodity, and are timely collected and timestamped.
VI. TRADE PRACTICE SURVEILLANCE – SECTIONS 5a(8) AND 5a(b) AND COMMISSION REGULATIONS 1.51(a)(1), (2), (4), (5) AND (6)
Section 5a(a)(8) of the Act requires each exchange to enforce the bylaws, rules, regulations, and resolutions made or issued by it, the governing board or any committee. Section 5a(b) of the Act requires each exchange to maintain and to use a system to monitor trading to detect and deter violations of the exchange’s rules committed in the making of trades. Under Section 5a(b)(1), such a system must include, among other things, trade practice surveillance systems capable of reviewing, and used to review, trade data in order to detect violations committed in making trades and executing customer orders; floor surveillance; and the commitment of resources necessary for a trade monitoring system to be effective in detecting and deterring trade practice violations, including adequate staff to develop and prosecute disciplinary actions.
In addition, Commission Regulation 1.51 has long required that each exchange exercise due diligence in maintaining a continuing program for the surveillance of trading practices on the floor of the exchange; for the investigation of customer complaints and other alleged or apparent violations of the exchange bylaws, rules, regulations and resolutions; and for such other surveillance, record examination, and investigation as is necessary to enforce exchange bylaws, rules, regulations, and resolutions.
The CME’s trade practice surveillance program is administered by the Market Regulation Department. The Market Regulation Department, which is comprised of 43 individuals, is responsible for detecting, investigating, and prosecuting trading violations.68
The Market Regulation Department is led by the Senior Vice President of Regulatory Affairs, whose management team includes a Vice President of Market Regulation, two Senior Directors, one Director, and five managers.69 The remaining trade practice surveillance staff is divided into compliance systems staff, trading floor investigators, daily investigators, general investigators, regulatory program investigators, data analysts, and administrative support staff. The Exchange employs four trading floor investigators, six daily investigators, eight general investigators, and three regulatory program investigators. All Exchange investigators are further classified as “senior investigator,” “experienced investigator,” or “investigator,” depending upon their assigned level of responsibilities.
Compliance systems staff provide data processing support for investigative activities by providing the customized computer programming necessary to generate and analyze specific trade data, and develop applications and databases for data review. Trading floor investigators conduct physical surveillance on the Exchange’s two trading floors throughout each trading session to identify possible trading abuses. Daily investigators analyze computerized exception reports and utilize the Exchange’s relational database to identify potential violations to be further addressed in a general investigation. Although general investigators are responsible for conducting full-scale investigations, including the gathering and analysis of relevant documents and interviews of pertinent members, in some larger investigations, daily investigators remain involved until the investigation’s conclusion. General investigators also are responsible for preparing investigation reports and presenting evidence at disciplinary proceedings. Market Regulation investigators monitor compliance with specific Exchange rules regarding dual trading, trading within broker associations, and outtrade assignments.70 The regulatory program investigators also monitor for compliance with the Exchange’s “top step rule.”71 Finally, data analysts are responsible for conducting the Exchange’s back office audits.72
In sum, the Division believes that the Exchange commits sufficient resources to hiring and maintaining an adequate trade practice surveillance staff, which includes an experienced management team, to develop investigations and prosecute disciplinary matters.
B. Investigation Procedures
The Exchange’s daily investigators are assigned to monitor particular contract markets. With respect to open outcry markets that also are traded on Globex2, daily investigators are responsible for monitoring both the open outcry and the electronic markets.73 In this connection, daily investigators review trade data, including exception reports, to look for patterns of abusive trade practices. If a daily investigator identifies suspicious trading activity or unusual trading activity, the matter is discussed with a direct supervisor to determine whether a pre-investigation should be opened. A pre-investigation will be opened if a determination is made that Market Regulation will commit resources to a matter. The Exchange calls such a pre-investigation a “General Investigation” (“GI”). Once a daily investigator has completed a GI, a memorandum is prepared describing the issues and the investigator’s conclusions. If a determination is made to refer the GI to a general investigator for a full-scope investigation, a referral form with summary information is prepared.
Once a GI is referred to a general investigator, the general investigator will perform such tasks as determining the scope of the investigation, requesting and analyzing additional trading documents, analyzing members’ profit and loss, and conducting interviews. The general investigator also may work with a compliance systems analyst to create customized queries that generate and analyze certain trade data in a specific manner. Once all of the gathered information is analyzed to determine whether there is evidence of wrongdoing, a closeout memorandum or investigation report is prepared and reviewed by three levels of supervisors.74 Closeout memoranda and investigation reports summarize the reason an investigation was opened, the relevant facts, and include a conclusion and recommendation. All GIs and investigations are tracked by the Exchange’s FoxPro database.75
The CME employs four full-time trading floor investigators to conduct visual floor surveillance throughout the trading day.76 In addition to monitoring all of the trading pits, trading floor investigators communicate with daily and general investigators regarding their observations and any pertinent information obtained while observing the trading floor. Trading floor investigators also monitor the trading activity of specific members in response to requests from daily investigators, who may have identified potential violations regarding particular members from exception reports, or in response to requests from general investigators, who may be conducting a full-scope investigation of particular members. Further, there is always one trading floor investigator observing the side-by-side trading of the S&P 500 E-Mini electronic market and the S&P 500 open outcry market.
Trading floor investigators are authorized to issue charges against individuals for trading infractions set forth in CME Rule 514.77 These infractions include, among others, a bid or offer out of line with the market, price infractions, failure to confirm a transaction, and unbusinesslike conduct. Generally, a hearing is held by the Pit Committee or Pit Supervisory Committee within three days of such a charge.78 During the target period, fines totaling $164,200 were imposed against 72 individuals for CME Rule 514 infractions.
The CME is the sole domestic futures exchange to integrate video camera surveillance into its trade monitoring system. The Exchange has been using video camera surveillance since 1990. Two video camera systems currently operate on the Exchange’s trading floor. The first system, Video Trade Resolution (“VTR”), is a videologging system that records all trading and desk activity in the interest rate and equities quadrants. During the target period, the Exchange operated 44 fixed position analog VTR cameras in the interest rate quadrant. Subsequent to the target period, the Exchange placed 43 digital VTR cameras in the equities quadrant.79 Although VTR is primarily used by members for trade dispute resolution, VTR videotapes and digital recordings also can be used by Market Regulation staff for investigations, if approval is obtained from the Exchange President. Unless a request is made to save a recording, VTR interest rate quadrant videotapes are erased the second day following the trade date and equities quadrant digital recordings are erased the fourth day following the trade date.80
The Exchange’s second video system, called “video surveillance,” is used solely in connection with investigations. This system includes 17 professional grade cameras that have pan, tilt, and zoom capabilities.81 In order to use this system, staff must describe to the Exchange President or, in his absence, the Executive Vice President, the investigation for which video surveillance is being requested.
During the target period, the Exchange President approved all 64 of the Market Regulation Department’s requests to access VTR tapes or use the video surveillance system. The suspected trade violations included prearranged trading, violation of the Exchange’s top step rule, and trading outside of the pit. Three video camera surveillance cases that settled during the target period resulted in eight members being fined a total of $700,000, with five of the members also being suspended for a total of 235 days.82
The Division believes that video camera surveillance continues to be a valuable adjunct to traditional surveillance methods in the detection and prosecution of trading violations.
E. Automated Computer Surveillance
During the second quarter of 1998, the Exchange modified its Automated Trade Surveillance (“ATS”) system to enhance the manner in which data are stored and viewed. The new ATS system is an array of Windows-based applications that operate in a client-server environment. In addition to original ATS functionality, the enhanced system includes relational database structures containing trade data; position information; individual, firm, and broker association information; and information pertaining to account numbers.
The new ATS system has expanded the Exchange’s electronic surveillance beyond exception reports to encourage investigators to review trading activity in an innovative manner that is still evolving. It provides users with more flexibility than that previously available through the older ATS system by allowing users to manipulate, move, and sort data on their desktop computers and to download data into spreadsheets. The new ATS system also has expanded the array of trade attributions that can be selected, as well as the method of data selection. For example, the new ATS system provides users with a Windows-based application to analyze members’ profits and losses and create ad hoc queries. Ad hoc queries are useful in detecting some trading violations which otherwise may not be detected.83 These sophisticated functions provide users with the capability to isolate groups of potential trade violations with very specific characteristics without the need for re-analysis.
Exception reports are still an important tool in the Exchange’s electronic surveillance system. Under the new ATS system, exception reports are stored and viewed in the system’s Virtual Detection System (“VDS”) component. The trade data for VDS, which dates back to January 1998, are supplied by the Exchange’s clearing system, Clearing 21. If earlier data are needed, they can be downloaded into the system. The VDS exception reports, which generally are reviewed at least weekly, include the Market Analysis Report,84 the Accommodating Broker Trades Report,85 the Trading Ahead of Customer Orders Report,86 the Broker Direct Trading Opposite Customer Orders Report and the Broker Indirect Trading Opposite Customer Orders Report,87 the Direct Account Wash Trades and Multiple Account Wash Trades Report,88 the Outtrade Analysis Report,89 and the Indirect Trading Against With Collaborator Report.90
Because Globex2 trade data are not included in the VDS database, VDS does not include Globex2 exception reports. Rather, Cobol programs run against Globex2 trade tapes to generate Globex2 exception reports which are then stored in a CD-ROM optical disc system. Globex2 exception reports include several reports that are very similar to the open outcry exception reports. These include the Globex User Direct Trades Opposite Customer Orders Report and the Globex Indirect Trades Opposite Customer Orders Report, the Globex Single Account Wash Trades and Multiple Account Wash Trades Report, and the Globex Indirect Trading Opposite Customer Orders With Collaborator Report.
The Globex Activity Trading Ahead of Customers Report is quite different than its open outcry counterpart in that it not only searches for traditional trading ahead, but also searches for bids and offers ahead of customers. Effective June 1999, an additional report was created that integrated trade data from the Exchange’s open outcry and Globex2 side-by-side markets.91 With this addition, the report compares all trades executed for a broker’s personal account, whether filled by the broker or someone else in either open outcry or the Globex2 trading environment, with customer orders filled by the broker within a two-minute window.
The Globex Monitoring for Pre-Execution Report is an exception report that is unique to Globex2. The CME requires that Globex2 customer orders be exposed to the market for 15 seconds (futures) or 30 seconds (options) before the same firm can enter an opposite order. This report reviews the trading of a firm against its customers’ orders and displays all violations of this rule.
F. Timeliness and Adequacy of Investigations
The Division found that the Exchange’s investigations generally were completed in a timely manner.92 Of the 324 trade practice investigations closed during the target period, including 91 opened prior to the start of the period, 194 (60 percent) were completed in four months or less. Another 53 investigations (16 percent) were closed within four to six months, 55 (17 percent) were closed within six months to one year, and 22 (seven percent) were open more than one year.93 Of the 233 investigations opened and closed during the target period, 175 (75 percent) were completed within four months, 40 (17 percent) were closed within four and six months, and 18 (eight percent) were closed within six months and one year.
All 91 investigations that were opened prior to the target period were closed by the end of the target period, including seven that were referred to a disciplinary committee. Of these 91 investigations, 19 (20 percent) were completed within four months, 13 (14 percent) were closed between four and six months, 37 (41 percent) were closed between six months and one year, and 22 (24 percent) had been open for longer than one year.
The Division examined 81 investigations closed during the target period and generally found that those open longer than six months were justifiably open for an extended length of time. These investigations involved complex fact patterns requiring numerous interviews and document requests, and several were expanded beyond their original scope. More specifically, the Division examined 11 of the 22 investigations that were open longer than a year prior to being closed. In addition to involving complex fact patterns requiring extensive document analysis, these investigations also required profit and loss analyses and/or video analyses. The Division’s review further indicated that after examining originally requested documents, staff frequently pursued additional leads requiring further document requests and analysis. Seven of these 11 investigations resulted in substantial fines being imposed during the target period.94
Division staff reviewed 81 of the 310 investigations opened by the Market Regulation Department during the target period. The sample reviewed included, among others, investigations relating to customer complaints, prearranged trading, violation of the Exchange’s dual trading restriction, trading ahead, broker association violations, misuse of error accounts, and Globex2 violations. The Division found that although investigations were conducted across all contract markets, a majority of investigations were conducted in interest rate and currency contracts, which together account for a large percentage of the Exchange’s trading volume.
Exchange staff generally conducted appropriate analyses and thorough investigations. The Division found that both closeout memoranda and investigation reports adequately described the details of an investigation, including how it was initiated, the facts developed during the course of an investigation, and the investigator’s conclusions and recommendations.
Although all of the files examined by the Division included pertinent underlying trading documents and either a closeout memorandum or an investigation report, the Division found that investigation files did not comply with Exchange procedures concerning file maintenance.95 For example, only one of the files examined by the Division included a “record of action sheet.” Exchange procedure requires that such sheets be prepared indicating phone conversations and other investigation-related actions not otherwise reflected in a letter or separate memorandum. Some files did include an investigation progress log tracking the investigation’s development.96 In addition, the Exchange requires that once an investigation is closed, all interview tapes be stored in tape cabinets.97 Toward that end, Exchange procedure further requires that a memorandum itemizing the tapes associated with an investigation be placed with the investigation file’s correspondence and memoranda. Although closeout memoranda and investigation reports generally included summaries of witness interviews, the Division did not find any memoranda itemizing interview tapes in the files it examined.
Finally, the Division reviewed three investigations in which the Market Regulation Department closed the investigations with no action or a warning letter, but recommended further monitoring of the members involved.98 The Division found no evidence of continued monitoring in the files.
G. Conclusions and Recommendations
The Division found that the Exchange maintains an adequate trade practice surveillance program through the use of visual floor surveillance, video surveillance, and automated computer surveillance. Trade practice surveillance staff are led by an experienced management team and successfully develop investigations and prosecute disciplinary matters. The Division further found that trade practice investigations were thorough and well analyzed. In addition, investigations generally were completed in a timely manner. Those investigations remaining open beyond four months typically involved complex fact patterns, videotape analysis, numerous requests for documents, and numerous interviews. Seven of the trade practice investigations closed during the target period resulted in the Exchange imposing significant penalties, as discussed in Section VII.C.
The Division also found that investigation files were not maintained in accordance with Exchange procedures. Specifically, only one of the files examined by the Division included a record of action sheet documenting telephone conversations and other investigation-related actions not otherwise reflected in a letter or separate memorandum. Some files did include investigation progress logs indicating the actions and date of actions taken in developing the investigation. Record of action sheets and investigation progress logs are valuable tools for managers and Commission staff if the need arises to review the progress of an investigation. Furthermore, if an investigator assigned to a particular investigation leaves the Exchange prior to the investigation’s conclusion, it would be very time consuming for another investigator or a manager to reconstruct the investigation’s progress. In addition, none of the files reviewed by the Division contained a memorandum itemizing interview tapes associated with an investigation. This is an important document because interview tapes are not stored with closed investigation files but are kept in a designated cabinet.
The Division’s review also disclosed three investigations in which a matter was closed with no action or a warning letter, but with a recommendation of continued monitoring of the
members involved. The Division was unable to find any evidence that the Exchange continued to monitor the members’ trading activity.
Based on the foregoing, the Division recommends that the Exchange:
· Ensure that investigators, in accordance with CME file maintenance procedures, complete record of action sheets, when required, for each investigation or maintain an investigation progress log indicating all significant actions, and the dates of such actions, taken in developing an investigation. In addition, investigators should prepare a memorandum itemizing the interview tapes associated with a particular investigation prior to their storage in a separate area.
· Document follow-up monitoring activities of members when such monitoring is recommended in a closeout memorandum.
VII. DISCIPLINARY ACTIONS – SECTION 5a(b) AND COMMISSION REGULATION 1.51(a)(7)
Under Section 5a(b) of the Act, an exchange’s trade monitoring system must include appropriate disciplinary actions and assess meaningful penalties against violators. In addition, Commission Regulation 1.51(a)(7) requires that each exchange use due diligence in maintaining a continuing affirmative action program which results in prompt, effective disciplinary action for violations of exchange rules. When reviewing disciplinary programs, the Division considers, among other factors, the support for findings made in disciplinary actions, the adequacy of sanctions imposed, and the timeliness of the disciplinary process.99 The Division also assesses compliance with Commission Regulations 8.09 and 8.17, which require, respectively, that disciplinary committees review investigation reports in a timely manner and issue either a notice of charges or a written decision stating the reasons why no further action will be taken, and that hearings be convened promptly after reasonable notice.
A. Disciplinary Committees
The Exchange has three primary disciplinary committees, the Probable Cause Committee (“PCC”), the Business Conduct Committee (“BCC”) and the Floor Practices Committee (“FPC”).100 As discussed below, the PCC reviews most investigations referred by the Market Regulation Department.101 If the PCC determines to issue charges, the case generally is assigned to either the BCC or the FPC.
The BCC, which is responsible for conducting investigations and hearings regarding the business conduct of members, is divided into Agricultural and Financial divisions.102 The BCC may, among other things, impose fines not exceeding $100,000 per violation, plus the amount of any benefit received as a result of the violative action; order liquidation of open contracts in the member’s proprietary and/or customers’ accounts necessary to insure the integrity of Exchange contracts or to insure an orderly and liquid market; prescribe limitations on member positions; suspend membership privileges for up to one year; and order customer restitution. If the BCC determines that a case is of major importance or might warrant a penalty in excess of its own authority, it will refer the case to the Board of Directors (“Board”) for a hearing and decision. Generally, such cases are heard by a Special Hearing Committee (“SHC”) of the Board.103
The FPC, which is responsible for investigating and deciding matters pertaining to floor practices and trading ethics, is divided into Agricultural, Financial and Options divisions.104 FPC hearings generally are conducted by the FPC Chairman and heard by a full FPC panel. However, appeals of Pit Committee or Pit Supervision Committee decisions made pursuant to CME Rule 415 and hearings with respect to multiple violations of CME Rule 513 (conduct, apparel, and badges), are heard by the FPC Chairman and a panel of five FPC members. The FPC may, among other things, place a member on probation; impose fines not exceeding $50,000 per violation, plus the amount of any benefit received as a result of the violative action; suspend membership privileges for up to six months; and order customer restitution.105
All members selected to serve on an Exchange disciplinary committee must be approved by the Board. In addition, each panel conducting a hearing must include sufficient different membership interests so as to ensure fairness and prevent special treatment or preference for any person. With respect to conflicts of interest, no person may serve on a hearing body considering a specific matter if that person has any direct financial, personal, or other interest in the matter under consideration. In addition, any person who has participated in any prior stage of the disciplinary process is not eligible to serve in a higher decisional capacity for the same proceeding. Furthermore, any person who, within the prior three years, has been found to have committed, or entered into a settlement agreement finding that he or she committed, a disqualifying disciplinary offense, is prohibited from serving on any of the bodies involved in the disciplinary process.106
If the Vice-President of Market Regulation has reasonable cause to believe that a rule violation has occurred, an investigation report is prepared and delivered to the Chairman of the PCC.107 Within 30 days of receiving an investigation report accepted as complete, the PCC must determine whether a reasonable basis exists for issuance of charges based upon violation of Exchange rules. Based on the report, the PCC may issue a warning letter, direct that Market Regulation serve a member with a Notice of Charges, or determine that a reasonable basis for a rule violation does not exist.108
PCC decisions to issue a warning letter are primarily based on the gravity of the offense and whether it involves a clear violation of CME’s rules. Warning letters do not represent either a finding of a rule violation or impose a penalty.109 If charges are issued, the PCC refers the matter to one of the Exchange’s disciplinary committees or a SHC of the Board for a hearing and decision. In addition, the Market Regulation Department will attempt to settle the case. Respondents may agree to settle a case without either admitting or denying charged rule violations and agree upon a penalty to be imposed by a disciplinary committee. Proposed settlements are presented to the assigned disciplinary committee for approval. If the settlement is approved, the committee files a written decision specifying the Exchange rules alleged to have been violated, a statement that the respondent has accepted the penalty without admission or denial, and the penalty to be imposed.110 Finally, if a case is not settled, a disciplinary hearing is scheduled.
Prior to a disciplinary hearing, the respondent may examine all evidence which is to be relied upon by the Market Regulation Department in presenting its case, or is relevant to the charges. Respondents may be represented by legal counsel and are permitted to appear and make oral presentations before the committee. After the hearing is concluded, the hearing body determines guilt or innocence. The hearing committee Chairman then provides a written report of findings to Market Regulation, the PCC Chairman, and the respondent. The report must include the following: the Notice of Charges; the answer to charges, if any; a summary of evidence produced at the hearing; and a statement of findings regarding each charge, specific rule violations, and penalties and their effective dates.111
A respondent found guilty of an offense, or who is otherwise aggrieved by a decision of the Vice President of Market Regulation or a disciplinary committee, may appeal to the Board within ten days of any such decision.112 Unless a respondent demonstrates good cause, appellate hearings are strictly limited to the record of the prior disciplinary proceeding. The Board may set aside, modify, or amend the decision if it determines that the decision was arbitrary or not in accordance with the Exchange rules; exceeded the committee’s authority or jurisdiction; was made without observance of required procedures; or was unsupported by substantial evidence or facts. The Board’s decision is final.
C. Sanctions Imposed
To assess the penalties imposed by the Exchange, the Division reviewed Exchange disciplinary committee minutes, Regulation 9.11 disciplinary action notices received from the Exchange reflecting disciplinary actions taken during the target period, and all related Exchange disciplinary files. During the target period, the Exchange imposed fines totaling $1,865,200 against 135 individual members, member firms, and clerks. This amount includes fines for various trade practice, recordkeeping, and conduct violations. Trade practice violations accounted for $1,563,000 in fines and suspensions totaling almost one and a half years against 26 members, two clerks, and three firms for trade practice violations.113 In addition, two members were ordered to pay restitution totaling $85,425 to disadvantaged customers. The Market Regulation Department also issued 252 warning letters.
During the target period, the PCC and/or the Board reviewed eight cases referred by the Market Regulation Department.114 Generally, the penalties assessed were part of a settlement agreement. However, one case was heard and decided by a SHC panel. Two of the cases resulted in the Exchange, among other things, fining two members $500,000 each. In the first case, a member found to be dual trading through his error account while on the top step of the S&P 500 pit, in violation of CME Rule 555, was fined $500,000, suspended for six months, and ordered to pay $61,175 in customer restitution.115 The second case involved four members engaged in a scheme that included noncompetitive, prearranged, and accommodation trading. One member was fined $500,000, suspended for six months, and ordered to pay $24,250 in restitution to customers. The second member was fined $35,000 and suspended for 20 days; the third member was fined $40,000 and suspended for 15 days; and the fourth member, a clerk, was fined $40,000 and suspended for five days.116
In one case, it appeared that the Exchange considered a member’s past disciplinary history in imposing a $300,000 fine and suspending the member for three months. The Exchange found that the member had engaged in speculative trading through his error account from the top step of the S&P 500 pit, knowingly mischaracterized those trades as errors, and traded opposite his customer orders in violation of CME Rule 555. Although the Exchange found no financial harm to customers, the SHC, in accepting a settlement agreement, noted that the trading community was disadvantaged. The member had previously been fined $12,500 in 1996 for a similar violation and had been fined $30,000 and suspended for one month in 1989 for disclosing customer orders.117
The five remaining trade practice disciplinary cases involved conduct that included trading in restricted contracts, noncompetitive trading, an improper EFP transaction, and disclosing a customer order. Settlement agreements resulted in the Exchange imposing fines totaling $125,000 and one 15-day suspension against six members, two firms and two clerks.118
In sum, the CME continues to issue well-considered and significant sanctions which should serve to deter future violations.
D. Timeliness of Disciplinary Procedures
Commission Regulation 8.09 requires that an exchange disciplinary committee promptly review each investigation report and, if the committee determines that additional investigation or evidence is needed, promptly direct the enforcement staff to conduct further investigation. Within 30 days of receiving a completed investigation report, an exchange disciplinary committee must either (1) determine that no reasonable basis exists for finding a violation or that prosecution is otherwise unwarranted, and direct that no further action be taken, or (2) determine that a reasonable basis exists for finding a violation which should be adjudicated and direct that the alleged violator be served with a Notice of Charges. Regulation 8.09 further provides that if a disciplinary committee determines that no reasonable basis exists for finding a violation and directs that no further action be taken, such determination “must be in writing and contain a brief statement setting forth the reasons therefor.”
During the target period the PCC met four times and reviewed 15 cases, including the eight investigation reports referred by Market Regulation.119 The PCC made a determination as to whether to charge a member on the same day it formally reviewed a matter. It referred nine matters to disciplinary committees or the Board for hearings. Thus, the PCC acted well within the 30-day time period prescribed in Commission Regulation 8.09.
The Division reviewed the length of time which elapsed between the date that the PCC determined to issue a Notice of Charges and the date of a hearing or settlement. For those cases that resulted in settlement agreements after the PCC directed that charges be issued, the elapsed time between the PCC’s determination and a disciplinary committee’s acceptance of a settlement offer ranged from one to 13 months, with an average time period of approximately seven months. The one case that resulted in a SHC hearing and decision also was handled promptly. The hearing was held six months following the PCC’s determination to issue charges, and the SHC issued its written decision four days following the hearing.
E. Conclusions and Recommendations
Based upon its review, the Division found that the Exchange maintains an effective disciplinary program. The PCC promptly determines whether to issue charges, and cases are promptly referred to disciplinary committees. Disciplinary proceedings are generally held in a timely manner. During the target period, the Exchange assessed $1,563,000 in fines and imposed suspensions totaling almost one and a half years for trade practice violations of an egregious nature. In addition, members were ordered to pay $85,425 in customer restitution. The penalties imposed appear reasonable relative to the conduct being sanctioned and appear to take into account members’ past disciplinary histories.
Accordingly, the Division has no recommendations with respect to the Exchange’s disciplinary program at this time.
1 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange’s overall compliance capabilities for the period under review. Such reviews deal only with programs directly addressed in the review and do not assess all programs. The Division’s analyses, conclusions, and recommendations are based, in large part, upon the Division’s evaluation of a sample of investigatory cases and other exchange documents. This evaluation process, in some instances, identifies specific deficiencies in particular exchange investigations or methods but is not designed to uncover all instances in which an exchange does not address effectively all exchange rule violations or other deficiencies. Neither is such a review intended to go beyond the quality of the exchange’s self-regulatory systems to include direct surveillance of the market, although some direct testing is performed as a measure of quality control.
2 Pursuant to Section 8e(a) of the Act, the Division conducts a rule enforcement review of an exchange's trade monitoring system every two years, to the extent practicable. The Division had deferred initiating a rule enforcement review of the CME since 1995 because the Commission had been actively examining the Exchange's trade monitoring system as a result of the Exchange's pending dual trading petition. Although the petition remains under consideration, the Division subsequently determined that it was appropriate to initiate the current review of the Exchange's core compliance programs. A copy of the 1995 Review can be found in Appendix 1.
3 The consultant, who was a retired CME MSD employee with expertise in warehouse issues, ceased acting as a consultant as of January 1, 1999, subsequent to the target period. The Market Surveillance Department is part of the Exchange’s Division of Market Regulation (“Market Regulation”).
4 Market Regulation includes the Market Surveillance Department and the Market Regulation Department. The Market Regulation Department administers the Exchange’s trade practice surveillance program. See Section VI. for a detailed description of the Exchange’s trade practice surveillance program.
5 Each senior analyst has at least three years of CME experience.
6 A copy of the Guidelines, which were last updated during the summer of 1998, can be found in Appendix 2.
7 A copy of the Commitment Report can be found in Appendix 3.
8 A copy of a Daily Information Bulletin can be found in Appendix 4.
9 Cash market information includes livestock and meat prices from the USDA, U.S. Treasury Bill auction results, and foreign exchange data for currencies.
10 In the one exception, the intended purpose of the hedge visit was “to see how a hog plant operated, and to discuss the hog industry, focusing on reporting slaughter numbers and futures market usage.” However, none of these topics were discussed in the memorandum. Copies of this and other sample hedge visit memoranda can be found in Appendix 5.
11 For example, the minimum level at which positions must be reported for Eurodollars is 850 contracts. A list of all CME reportable levels can be found in Appendix 6.
12 The LTRS maintains six months of large trader data on-line.
13 A copy of the Book Report can be found in Appendix 7.
14 There is a series of six Watch/Account Reports, which replaced the Rank by Size Report previously used. Copies of these reports can be found in Appendix 8.
15 The CME is currently upgrading its LTRS. The upgrades will permit greater flexibility, perhaps most notably, providing analysts with the ability to customize sorts of large trader data instead of using predetermined sorts. An analyst will be able to sort these data based on any selected fields or criteria and manipulate these data at his or her desktop computer. The transition to the enhanced system is scheduled to take place toward year-end 1999.
16 For example, the position limit in live cattle is 1,200 contracts, long or short, in any contract month. The limit is reduced to 600 contracts, long or short, in the expiring contract month following the first Friday of the spot month. When five trading days remain, the limit is further reduced to 300 contracts, long or short.
17 The Blotter Report is generated only for expiring contracts and is used by the Clearinghouse for the assignment of deliveries. The Clearinghouse assigns deliveries on the basis of the first delivery going to the holder of the oldest long position. A copy of the Blotter Report can be found in Appendix 9.
18 A copy of the Position Adjustment Report can be found in Appendix 10.
19 A copy of the Transfer Report can be found in Appendix 11.
20 Exchange rules allow for the transfer of existing positions from one account or clearing firm to another where no change of ownership is involved. Transfer trades may not be used to liquidate an open position by circumventing the open outcry requirement of Regulation 1.38.
21 The interviews, which were conducted to obtain market information and opinions from major issuers of deliveries, included discussions of delivery procedures, then-recent changes to contract specifications, delivery intentions, and trading strategies.
22 A copy of the Position Limit Report can be found in Appendix 12.
23 The 28 speculative limit investigations included the following: 13 Live Cattle investigations, 4 Feeder Cattle investigations, 3 S&P 500 investigations, 3 Pork Belly investigations, one Lean Hogs investigation, one Milk investigation, one Euroyen investigation, one Nikkei 100 Index investigation, and one Lumber investigation.
24 Commission Regulation 8.06 requires that an investigation be completed within four months, except when significant reason exists to extend it beyond that time period.
25 Pursuant to CME Rule 443.A., a staff warning letter is issued to first-time speculative limit violators. Another violation within 12 months of the warning letter results in a cease and desist order and a possible fine.
26 In this matter, the local "forgot" to reduce his position in April 1998 Live Cattle, in accordance with Exchange’s scale-down requirements, due to an early holiday closing. The local, who had been issued a warning letter during the previous 12-month period for a speculative limit violation, was issued a cease and desist order. The local appealed to the BCC. The MSD then recommended that the cease and desist order be rescinded, noting the local's diligence and promptness in trying to rectify his speculative position limit violation. Given that this was a second violation, it may have been more appropriate, from a deterrent standpoint, for the BCC to have upheld the order.
27 Investigation No. 98-5834-MS. There is no indication in the file as to the reason this violation was not detected earlier. Once detected, the matter was resolved in seven days by the application for, and approval of, a hedge exemption.
28 CME Rule 543. Entities eligible for independently controlled position exemptions include commodity pool operators and commodity trading advisors that authorize an independent account controller to control all trading decisions for positions they hold directly or indirectly, but without day-to-day direction. The aggregate position held or controlled by each such account controller may not exceed the speculative position limits.
29 In general, each exemption application asks the hedger or spreader to specify, in futures equivalents, the maximum number of contracts, long and short, sought for each future month and for all months combined. The Exchange grants each exemption in futures-equivalent form, allowing any combination of futures and options in the hedging or spreading strategy, as long as the total futures-equivalent position does not exceed the granted exemption level.
30 All International Monetary Market and Index and Option Market contracts except for lumber, gasoline, crude oil, and options on cattle and hogs are considered to be financial contracts.
31 This exemption, which was requested by letter, was granted to a large investment bank. The bank requested a one-time exemption from spot month scale down limits in Mexican Pesos. According to MSD staff, information respecting the justification was obtained and confirmed via a telephone conversation, but was not memorialized for the file.
32 MSD staff currently is creating a "hedge database" for agricultural commodities which will incorporate these calculations and include any changes submitted during the year. The database is expected to be operational in October 1999.
33 See e.g., CME Rule 3902.D (Eurodollars).
34 Subsequent to the initial contact, each account or group of accounts is contacted annually, unless interim communication has occurred, to ascertain whether material changes affecting the account have occurred. In Eurodollars, the initial contact is made at the 10,000-contract former speculative limit level; the annual update occurs only when an account’s position exceeds 50,000 contracts. A copy of an Action Sheet can be found in Appendix 13.
35 Eighteen position accountability investigations were initiated between August 1, 1997 and March 22, 1998, prior to the time these investigations were included in the log. Fourteen accountability reviews were opened and included in the log on or after March 23, 1998. Ten of the 14, for which detailed summary log information is readily available, were conducted in the Eurodollar market, three in LIBOR, and one in Deutsche Marks.
36 The investigations reviewed included Investigation Nos. 98-5556-MS, 98-5570-MS, 98-5786-MS, 98-5847-MS, and four unnumbered investigations, two each involving hedge funds and banks.
37 Investigation No. 98-5570-MS. Specifically, the firm replied that either the information was not tracked by its "system" or that the information was "extremely proprietary." The firm did volunteer that speculative positions were not carried, and that 95 percent of the Eurodollar position was generated by the firm’s interest rate products group.
38 One review remained open for almost seven months.
39 Under CME Rule 538, an exchange of actual ("spot") commodities for futures contracts requires: (1) a buyer of the spot (seller of the future) or a seller of the spot (buyer of the future) to have the commodity in his or her possession; (2) the purchase and sale of the futures contract simultaneous to the sale and purchase of an equal quantity of the spot; (3) a mutually agreed upon price; and (4) the reporting of the transaction to the Exchange's Division of Market Regulation. EFPs executed pursuant to CME Rule 719, in addition to the above requirements, are subject to the approval of the Exchange President; however, this approval has been delegated to the Exchange clearinghouse.
40 In order for clearing members to be reasonably certain that their customers can meet all of the requirements for EFP trading, in particular, the spot or cash commodity portion of the transaction, the Exchange has advised clearing members to ascertain that the customers for whom such trades will be executed have established a relationship with a firm making EFP markets. This allows firms to clearly identify the customer as a counterparty to the spot side portion of the EFP trade on the spot side documentation.
41 EFP documentation is defined in Commission Regulation 1.35 (a-2) (4) as “those documents customarily generated in accordance with cash market practices which demonstrate the existence and nature of the underlying cash transactions, including, but not limited to, contracts, confirmation statements, telex printouts, invoices, and warehouse receipts or other documents of title.”
42 This represents a significant increase from the eight percent of total EFP currency volume found during the 1993 Review.
43 In November 1995, the Commission approved an amendment to CME Rule 538, which prohibits Eurodollar EFPs beyond the second-listed quarterly month in the March, June, September, December cycle. This rule eliminated the use of synthetic TED (Treasury Bill versus Eurodollar) spreads offered by inter-dealer brokers of Treasury securities. The synthetic TED spread product allowed the simultaneous purchase and sale of multi-sided cash and futures strips using CME’s EFP mechanism. Opportunities to transact Eurodollar EFPs are also limited by the small number of cash equivalents that can be delivered against an EFP. In this regard, U.S Treasury instruments, Eurodollar time deposits, and Collateralized Mortgage Obligations ("CMOs") are acceptable for delivery, provided that their maturities match that of the futures side of the EFP.
44 A copy of the Cash-For-Futures Monthly Summary Report can be found in Appendix 14.
45 For example, an EFP transaction between two locals is generally viewed as suspicious because locals tend to be less likely to have access to cash market facilities. An EFP transacted by an account with whom the MSD staff is unfamiliar, a particularly large transaction, or an EFP which takes longer than usual to clear might also be reviewed. In addition, notwithstanding CME Rule 538, which permits an EFP to be transacted at any mutually agreed upon price, an EFP might be examined if it is executed at a price significantly different from the market price.
46 These are Investigation Nos. 98-5703-MS, IQ-97-24 and IQ-97-28, and 98-5619-MS, respectively.
47 Investigation No. 98-5619-MS.
48 A “transitory” EFP occurs when a trader purchases a cash commodity and immediately resells it to the person from whom it was purchased in exchange for a long futures position (or, conversely, when a trader sells the cash commodity and repurchases it, together with a short futures position). The Division is currently exploring regulatory approaches to certain EFPs, particularly contingent EFPs. In that regard, the Division also plans to discuss transitory EFPs.
49 The investigations reviewed included Investigation Nos. 98-5558, 98-5776, 98–5785-MS, IQ-97-25, 97-26, 97-27, and 97–29.
50 Investigation No. 98-5785-MS.
51 Investigation No. IQ-97-26/27. The account owner also was the subject of at least two speculative position limit investigations during the target period.
52 Investigation No. 98-5776-MS.
53 CME Rule 536 requires that members record all personal trades in sequence on pre-numbered sequenced trading cards. The Exchange does not require that a broker’s personal trades and customer trades be recorded sequentially on a single trading document. Customer trades are recorded on order tickets.
54 CTR is the name of the Exchange’s imputed trade timing system. Accurate recordkeeping data is essential in order for CTR to derive accurate and verifiable trade times. The Exchange’s CTR Committee is responsible for reviewing and enforcing member compliance with recordkeeping rules. See CME Rule 421. CTR was the Exchange’s original imputed trade timing system. In October 1995, the Exchange significantly redesigned CTR and renamed it Regulatory Trade Timing System. The Exchange, however, did not change the name of the committee responsible for enforcing member compliance with recordkeeping requirements.
55 Copies of the questionnaire and checklist are included in Appendix 15.
56 CTI is a numerical code used to identify the source of trades as follows: CTI 1 designates a trade by a member for his or her personal account or an account for which he or she has discretion; CTI 2 is a trade for his or her clearing member’s house account; CTI 3 is a trade for another member present on the floor or an account controlled by such other member; and CTI 4 is a trade for any other type of customer.
With certain exceptions, a member placing (“initiating”) a verbal CTI 3 order with another member on the floor also must record the order and time of placement on a presequenced trading card. The member who executes the oral order must record the time of execution on a non-presequenced trading card or other document (“endorsement card”) and return that card to the initiating member. The initiating member then is required to submit both the presequenced trading card reflecting the trade initiation and the endorsement card to his or her clearing member. See CME Rule 536D.1.
57 Separately, Market Regulation’s Audit Department conducts routine biennial audits of Exchange clearing firm members. As part of these audits, Audit Department staff tracks, for selected trades, data from the order ticket through the clearing process to the ultimate customer’s account statement.
58 The Division found in the 1995 Review that under the Exchange’s trading document selection procedures, a data analyst would select a sample of approximately 50 personal trading cards, 50 customer floor orders, and 50 CTI 3 trading cards. Because back office audits are based upon records obtained from clearing firms, without specificity as to the members to be reviewed, there were instances when one member’s trading documents were audited more than once while another member’s documents were not audited at all. In addition, under these selection procedures, the audit of a member’s trading documents could have consisted of as little as one trading record.
59 The Division found in the 1995 Review that, for the target period then under review, the Exchange reviewed 5,122 customer orders and 2,000 personal trading cards. During the present target period, the Exchange examined 7,407 customer orders and 6,761 personal trading cards.
60 The first type of deficiency letter, issued to those firms with minimal deficiencies and a good history of recordkeeping compliance, simply advises of the deficiencies found and encourages continued compliance. The second type, for those firms with more errors (usually a deficiency exceeding ten percent) and a less exemplary audit record, advises of the deficiencies found, asks the firm to explain in writing the steps taken to correct the problems, and informs the firm of the possibility of an appearance before, and action by, the CTR Committee. A different version of this letter, sent to firms whose current audit shows some lapse from previous satisfactory audits, is signed by the CTR Committee Chairman and encourages the firm to remedy the problems noted. The third type, issued to firms with poor audit results and a history of substandard compliance, advises that the CTR Committee will conduct a summary review of the back office audit, that a fine could be issued based on the findings, and requests that a firm representative meet with the CTR Committee to discuss the matter. Samples of these letters are included in Appendix 16.
61 If the same deficiency is detected in a second audit, a second notice is sent to the member. A third deficiency detected within 24 months is brought to the attention of the CTR Committee Chairman for possible scheduling before the CTR Committee.
62 The most common deficiencies identified for clearing firms included the following: failure to collect documents within the prescribed time, failure to submit to clearing accurate entry and exit timestamps, and failure to submit to clearing accurate customer type indicator codes. With respect to individual member deficiencies, the most common problems cited included members’ failure to record the time of execution for CTI 3 orders and failure to record accurate time brackets.
63 Prior to January 1996, the Exchange’s CTR enforcement program only addressed member’s bracketing errors. The Division recommended in the 1995 Review that the Exchange apply its bracketing accuracy regime, which involved two warning letters followed by a referral to the CTR Committee, to other Commission Regulation 1.35 trading document recordkeeping requirements.
64 During the target period, the monthly threshold error rates established by the Exchange were: (1) six percent for bracket errors; (2) seven percent for personal trading card sequencing errors; (3) eight percent for CTI 3 execution time errors; (4) for quotes not found on the time and sales register, five or more missing price quotes for futures and ten or more for options; and (5) eight percent for clearing firm timestamping accuracy errors if the firm cleared 1,000 or more transactions per month.
65 The Division’s examination included 183 order tickets executed in Deutsche Mark futures, 161 order tickets executed in Feeder Cattle futures, and five orders executed in S&P Midcap 400 futures from one clearing firm on June 8 and 9, 1998; and five order tickets executed in Eurodollar futures from another clearing firm on the same date.
66 However, 14 order tickets reviewed by the Division showed a different account number than that entered into the Exchange’s trade register. Ten of the 14 orders were in Feeder Cattle futures and the trade register indicated the same account number for all ten of the orders, although the order tickets reflected different account numbers.
The Division’s standard practice when conducting a floor order ticket review for compliance with the provisions of Regulation 1.35(a-1)(2)(i) is to examine order tickets for the presence of symbols and numbers entered as account identifiers and order ticket numbers. These reviews are limited to identifying recordkeeping deficiencies that are clear on the face of the documents and are not intended to determine the relationship between the numbers or symbols on the order tickets and other account documentation.
67 With respect to personal trading cards, the Division’s examined 25 cards for trades executed in Deutsche Mark futures and 59 cards for trades executed in Three-month Euroyen futures obtained from one clearing firm on July 30, 1997; and 56 cards executed in Deutsche Mark futures, 80 cards executed in Lean Hog futures, 51 cards executed in NASDAQ 100 futures, 29 cards executed in Feeder Cattle futures, and 98 cards executed in Eurodollar futures obtained from two clearing firms on June 8 and 9, 1998. The Division also examined 27 CTI 3 trading cards obtained from the three clearing firms, including 23 cards used to record trades in Eurodollar futures, two cards used to record trades in Lean Hog futures, and one card each used to record trades in NASDAQ 100 futures and Three-month Euroyen futures.
68 The Division’s analysis of the CME’s trade practice surveillance staff went beyond the target period and is intended to present a clear picture of the Exchange’s trade practice surveillance staff as of August 31, 1999. A Market Regulation organizational chart can be found in Appendix 17.
69 The Senior Vice President of Regulatory Affairs has served in this position for the past eight years. Prior to this appointment, he worked an additional 16 years at the Exchange in various capacities, including two years as Vice President of Market Regulation, three years as Vice President of Market Surveillance, and six years as a Market Regulation Director. The Vice President of Market Regulation has 19 years of Exchange compliance experience. Prior to assuming his current position, he served as a Market Regulation Senior Director. The two Senior Directors have combined CME compliance experience of 40 years, one with 18 years of experience and the other with 22 years of experience. One of these Senior Directors also worked for five and a half years in the Commission’s Division of Enforcement before joining the Exchange. The other Senior Director had eight years of CME trading floor experience prior to joining Market Regulation. The Director has 12 years of CME compliance experience and the five mangers have a combined total of 44 years of compliance experience, ranging from five years to 13 and a half years.
70 CME Rule 552, with certain exceptions, restricts dual trading in those contracts with an average monthly volume of 10,000 contracts or more. CME Rule 515.E. establishes limits on the percentage of personal and customer trading between members of broker associations with which a member is affiliated. CME Rule 527 provides that a floor broker’s error account can be assigned as the opposite side of a customer’s trade when such trade has been confirmed to the customer and has resulted in an unresolvable outtrade. In such instance, the customer is given a fill at the confirmed price.
71 CME Rule 555 (“top step rule”) restricts members while standing on the top step of a trading pit from trading for their own account in a dual trading-restricted contract month.
72 See Section V.A.
73 The Exchange believes that assigning daily investigators to particular markets provides them with a unique opportunity to develop detailed knowledge of members trading in a particular market and the customers using those markets.
74 If a determination is made that there is sufficient evidence of a rule violation and that the case will be referred to a disciplinary committee, an investigation report is prepared. If a case is closed with a determination that Market Regulation will issue a warning letter, or close the investigation without further action, a closeout memorandum is prepared.
75 FoxPro tracks the activities performed by Market Regulation staff and also tracks actions with respect to Exchange disciplinary cases. The FoxPro investigation log includes information regarding, among other things, the date an investigation is opened; the complainant, if any; the potential violation and a brief description; incident dates; applicable rules; and the date an investigation is closed. FoxPro disciplinary information includes the dates of disciplinary hearings; the members that are charged; fines imposed; suspensions, including suspension start and end dates; settlement agreement information; amounts of customer restitution, if ordered; and effective dates of disciplinary actions. Market Regulation has designed and is testing a Windows-based database to replace FoxPro.
76 All of the trading floor investigators are former Exchange members.
77 The authority for trading floor investigators to issue such charges stems from CME Rule 415.A. Under this rule, Pit Committee and Pit Supervisory Committee members also are authorized to issue charges for Rule 514 trading infractions.
78 If the Pit Committee finds the individual guilty of committing the infraction, a fine not exceeding $2500 is issued for the first offense. A second offense within one year will result in a fine between $500 and $4,000, and a third offense within one year will result in a fine between $1,000 and $5,000. The Pit Supervision Committee may fine up to $10,000 for any infraction.
79 Videologging in the equities quadrant, commenced on August 6, 1999. The equities quadrant includes all S&P products, the NASDAQ 100 Index, Russell 2000 Stock Price Index, and Nikkei 225 Stock futures and options. Unlike the analog system which records on videotapes, the digital system records on computer drives. Neither the analog or digital VTR system provide audio capabilities.
80 Market Regulation staff can request that a VTR videotape or digital recording be preserved prior to receiving approval to use such tape.
81 The Exchange has placed five cameras each in the currency and interest rate quadrants, four cameras in the agricultural quadrant, and three cameras in the equities quadrant. The cameras’ sophisticated functions allow for overlapping coverage and additional camera angles when needed.
82 Investigation No. 96-4336 was closed prior to the target period and Investigation Nos. 96-4173 and 96-3766 were closed during the target period. See Section VII.C. for a discussion of the disciplinary cases.
91 The side-by-side markets are the S&P 500 and S&P 500 E-Mini, the E-Mini NASDAQ 100 and NASDAQ 100 Index, and the open outcry Eurodollar and Globex2 Eurodollar. This cut of the report also is available on the open outcry Trading Ahead of Customers Report.
92 Commission Regulation 8.06 requires that an investigation be completed within four months, except when significant reason exists to extend it beyond that timeframe. Significant reasons may include the complexity of the matter, as well as the number of documents required to be analyzed in order to properly determine if a rule violation occurred. For purposes of this review, once a number had been assigned to a matter, including a GI, Division staff considered the matter as an investigation. Thus, GI investigations that were closed without being referred to a general investigator also are included in these timeliness statistics.
93 These investigations included 53 investigations regarding violation of the Exchange’s dual trading restriction, CME Rule 552. Of these 53 investigations, 50 (94 percent) were closed in less than four months and three (six percent) were closed in four to six months. The Exchange found that the vast majority of these investigations involved recorkeeping errors, such as failure to list or register an error account or failure to reflect an error account or the reason for an error on a card, rather than trade practice infringements. If these trades had been properly documented, they would have been considered permissible exceptions under the Exchange’s dual trading restriction.
94 See Section VII.C. for a more detailed description of these disciplinary actions.
95 The Exchange’s Procedural Manual includes a February 15, 1990 memorandum setting forth the requirements for case file maintenance. A copy of this memorandum can be found in Appendix 18.
96 Although Exchange procedure does not require that investigators maintain investigation progress logs, the Division believes that such logs are useful tools for reconstructing investigations.
97 All interviews conducted by general investigators are tape recorded.
98 Investigation Nos. 97-5348, 98-5547, 98-5656.
99 Contract Market Rule Enforcement Program Guideline No. 2, 1 Comm. Fut. L. Rep. (CCH) ¶ 6430 (May 13, 1975).
100 CME also has a number of other disciplinary committees with specialized jurisdiction. The Pit Committee has jurisdiction over all pit infractions. This includes supervising opening and closing ranges and overseeing and enforcing price changes. The Pit Committee also has the authority to remove unauthorized persons from the pit. CME Rule 406. The Broker Association Committee conducts investigations and holds hearings regarding broker association matters. CME Rule 300. The CTR Committee is responsible for matters relating to non-serious audit trail violations that are not part of a larger scheme to engage in abusive trading activity. See Section V. and CME Rule 421. The Commodity Representative/Customer Complaint Committee has jurisdiction to enforce Exchange rules relating to the conduct of commodity representatives and any related conduct of a clearing member, member, or employee of a clearing member or member. CME Rule 404. The Clearing House Committee has jurisdiction over determining the qualifications of an applicant for status as a clearing member. CME Rule 403.
101 The PCC consists of two eight-member panels. Each panel conducting a proceeding also must include a non-Exchange member. CME Rule 407.
102 The Agricultural division is further divided into two panels, each consisting of 11 members and a non-Exchange member. The Financial division is similarly divided into two panels, each consisting of nine members and a non-Exchange member. In addition, one non-member Director serves as a non-voting member on each panel in both divisions.
103 See CME Rule 411. Similarly, if the FPC believes that a potential violation may exceed its authority, it may refer a case to the BCC (which has greater fining authority) or the Board. CME Rule 414. The Vice President of Market Regulation or the PCC Chairman also may refer a case to the Board if there is reasonable cause to believe that a rule violation is of sufficient importance to warrant a direct Board hearing. CME Rule 408.
Whenever an original hearing is scheduled to be held before the Board, the Board determines whether the case will be heard by the full Board or by a SHC. If the Board determines that the case is to be heard by a SHC, the Chairman of the Board selects four Directors, one of whom must be a non-Exchange member, to serve on the SHC panel. CME Rule 410.
104 Each of these divisions is further divided into three panels of eight members and one non-Exchange member.
105 CME Rule 414.
106 See CME Rules 402, 405, 409, and 300.C., respectively.
107 If an investigation involves matters under the jurisdiction of the Pit Committee, CTR Committee, Broker Association Committee, Clearing House Committee, or Commodity Representative/Customer Complaint Committee, the PCC will not review the case.
108 CME Rule 408.B. Generally, the PCC makes a determination the same day that it meets to review a report. If the PCC directs that a member be charged, the Notice of Charges must indicate the rule that the respondent is alleged to have violated, describe the conduct, and advise the member of his rights, including the opportunity to submit a written answer to the charge within 10 days of receipt of the notice. The Notice of Charges further advises the respondent of the committee before which the case will be heard and the time and place for the hearing. A respondent may waive his right to a hearing within 10 days of receipt of the Notice of Charges. A respondent’s failure to file a written answer is not considered an admission or denial. CME Rule 408.C. and D.
109 The Market Regulation Department also may, upon appropriate findings, either issue a warning letter to the member under investigation or recommend that the PCC issue a warning letter. CME Rule 408.A.
110 CME Rule 408.E.
111 CME Rule 409.
112 Respondents may not appeal a monetary sanction of $1000 or less. CME Rule 417. In addition, Pit Committee and Pit Supervision Committee decisions are appealed to the FPC. See CME Rule 415D.
113 The $1,563,000 of trade practice violation fines included $23,000 assessed by the Broker Association Committee against 14 individuals and a trio of broker association principals fined as a single entity.
114 Seven of these eight cases resulted from investigations that were closed during the target period.
115 Case No. 96-4188 was the case heard by the SHC during the target period. On April 13, 1999, the National Futures Association (“NFA”) issued an Order to restricting the member’s floor broker registration, effective May 13, 1999.
116 Case No. 96-3766. This was the first disciplinary action taken by the CME against any of the four members. On March 11, 1999, the NFA issued a notice of intent to restrict the floor broker registrations of the four members.
117 Case No. 96-3812. On April 13, 1999, the NFA issued a notice of intent to restrict the member’s floor broker registration.
118 Case Nos. 96-4161, 96-4173, 96-4336, 96-4509, and 98-5589.
119 The other cases reviewed by the PCC involved account mismanagement, decorum/attire, and various other matters.