For Public Release
RULE ENFORCEMENT REVIEW
OF THE MARKET SURVEILLANCE PROGRAM
AT THE COMEX DIVISION OF THE
NEW YORK MERCANTILE EXCHANGE
I. Introduction- Purpose and Scope
The Division of Trading and Markets ("Division") has completed a limited-scope rule enforcement review of the market surveillance program of the COMEX division ("COMEX" or "Exchange") of the New York Mercantile Exchange ("NYMEX"). The purpose of this review was to evaluate COMEX's market surveillance rule enforcement program for compliance with Section 5a(a)(8) of the Commodity Exchange Act ("Act") and Commission Regulation 1.51(a)(1).1 This review covers the period from January 1, 1996 to January 1, 1997 ("target period").
COMEX’s market surveillance procedures, which are essentially identical in practice and staff to the NYMEX division’s, were last reviewed as part of a rule enforcement review of NYMEX on July 25, 1996 ("1996 Review"). In the 1996 Review, with respect to market surveillance, the Division recommended that NYMEX enhance its recordkeeping by recording on its market surveillance inquiry log sheets the initiation and closing dates of inquiries, which it has done.2
During a visit to COMEX in March 1997, Division staff conducted tape-recorded interviews with senior COMEX Market Surveillance Department ("MSD") staff.3 The Division returned to COMEX in April and June 1997 to obtain additional documents and to discuss further market surveillance procedures with Exchange staff.
The Division also conducted a review of pertinent Exchange documents, including, among other things:
The Division provided the Exchange with the opportunity to review and comment on a draft of this report on March 12, 1998. Division staff held an exit conference with Exchange staff on March 17, 1998 to discuss the report’s findings and recommendations.
III. Findings and Recommendations
- The Exchange maintains an adequate market surveillance program for identifying indications of possible congestion or other market situations conducive to possible price distortion, and for ensuring the orderly liquidation of expiring contracts. The MSD appears adequately staffed and experienced to carry out its daily surveillance program, which includes, among other things, the review of prices, volume, open interest, large trader and clearing member positions, and supply and demand data.
- The Exchange has adequate procedures for reviewing speculative limit hedge exemption applications and for monitoring accounts that exceed position accountability thresholds. The Exchange also reviews exemptions and accountability levels regularly to ensure that they are appropriate for market participants.
- The Exchange’s Control Committee does not convene often enough during potentially problematic contract expirations. During the target period, the Control Committee met on only five occasions: one meeting each for the March, May, June, October, and December 1996 copper expirations.
- The Exchange’s investigation into the possible manipulation of the June 1996 copper future was too narrow in scope and should have been expanded to encompass significantly more trading and cash market activity, and to focus more on the basic elements of price manipulation. The Exchange focused its analysis of trading activity on the question of whether the largest long was a buyer or seller on two days near contract expiration, notwithstanding that the largest long in the market, who also controlled a significant amount of copper warehouse stocks, held similar positions in several contract months, and a very large position in the June future leading up to its expiration.
- The Exchange has a routine procedure for reviewing selected exchange of futures for physicals ("EFP") transactions to determine whether they are bona fide. However, 17 of 28 EFP files reviewed by the Division did not contain depository receipts or other documentation evidencing conclusively that a change of ownership of the cash commodity has occurred. In addition, one of two "contingent" EFP files in the Division’s sample did not contain sufficient evidence of the time of execution to determine whether the EFP was transacted during COMEX trading hours, which is prohibited by Exchange rule. The Exchange also examined several offsetting EFPs in which a clearing member was on both sides of equal and opposite EFPs for its customers.
- The Exchange’s Control Committee should convene more frequently during potentially problematic contract expirations.
- The Exchange should ensure that investigations of possible price manipulation encompass a sufficient scope of market activity given the time frame of a participant’s possible market dominance, and include, at a minimum, a thorough analysis of price artificiality, market dominance, and intent to manipulate.
- The Exchange should improve its EFP inquiries by consistently obtaining depository receipts or other documentation to conclusively evidence that a change of ownership of the cash commodity has occurred, and by reviewing contingent EFPs more closely to determine whether the EFPs occurred outside of the Exchange’s regular trading hours, in conformity with COMEX rules. In addition, the Exchange should further analyze the bona fides of those EFPs it reviewed that involved the same clearing member on both sides of equal and opposite EFPs for its customers, and provide that analysis to the Division within 90 days.
IV. Surveillance of Market Activity- Section 5a(a)(8) and Commission Regulation 1.51(a)(1)
Commission Regulation 1.51(a)(1) requires each contract market to maintain a program of continuing surveillance of market activity for indications of possible congestion or other market situations conducive to possible price distortion and for securing compliance with all of its rules. The purpose of the program is to detect adverse market situations before markets have been disrupted. An effective program includes monitoring price movements and spread relationships, volume and open interest, clearing member positions, large trader positions, deliverable supplies, and market news and rumors. In addition, each exchange must have a program for the enforcement of speculative position limits for futures and options, as required by Commission Regulation 1.61. The Division found that COMEX has an adequate program for continuously monitoring daily market activity and for enforcing its rules concerning speculative position limits and position accountability thresholds.5
A. Market Surveillance Staffing
The MSD is a section of the Compliance Department. During the target period, the MSD consisted of 15 persons, including the Director of Market Surveillance ("Director").6 There are three units in the MSD:
- The Market Surveillance Unit, which consists of a Manager, a Supervisor, six analysts, and three clerks.
- The Cash Market Operations Unit, which consists of a Manager and an analyst.
- The Harbor Operations Unit, which consists solely of a Manager.7
The three unit managers report to the Director, who in turn reports to the Vice President of Compliance. The Director is regularly given market briefings by each unit manager and, in turn, regularly briefs the Vice President of Compliance on surveillance matters. The Director will immediately advise Exchange senior staff of circumstances that could threaten market liquidity or jeopardize an orderly contract liquidation.
The Manager of the Market Surveillance Unit ("MSU"), together with the Supervisor, is responsible for day-to-day supervision of the unit. Each day, the Supervisor and analysts provide the Manager with information concerning, among other things, the largest market participants, futures and cash prices, and supply/demand statistics. The Manager provides guidance to MSU staff with respect to following up on potential market disruptions and rule violations. The Supervisor oversees the analysts and clerks and ensures that they complete their assignments promptly and accurately. He also maintains the inquiry logs and the minutes of Control Committee meetings, and ensures the accuracy of the large trader database.
The analysts review computer runs daily to monitor speculative position limits and position accountability thresholds. Each analyst is assigned one or more commodities and is responsible for monitoring all aspects of those commodities, including EFPs. They also prepare materials for presentation to the respective Control Committee, which is responsible for correcting any circumstances that interfere or might interfere with the normal functioning of the market.8 If an analyst discovers an apparent violation, the analyst conducts an inquiry. An inquiry does not go to the investigation level until MSD staff has done background work and discusses its findings with Compliance Counsel. Investigation reports are prepared only when a matter has investigation status; they are not prepared for inquiries. Completed investigation reports are referred to Compliance Counsel, who decides whether the case should be forwarded to the Business Conduct Committee ("BCC") for possible charges.9 MSU clerks enter and monitor the accuracy and completeness of large trader data submitted by clearing members and omnibus accounts, and process EFP data. Finally, the Manager of the Cash Market Operations Unit, with the assistance of an analyst, reviews all hedge exemption applications and position accountability forms filed with the Exchange to ensure their accuracy and completeness.
The entire MSD meets weekly to discuss and review each commodity. The purpose of these meetings is to keep the Director and his staff abreast of market developments. In addition, MSD staff meets weekly with the Research Department. The purpose of these meetings is to exchange information about the commodities traded on COMEX (and NYMEX). Because the Research Department has employees with extensive experience in the metals industry, MSD views these meetings as a valuable source of information.
The MSD appears sufficiently staffed and experienced to carry out its daily surveillance activities. The Director has been with the Exchange for ten years; the Manager of the Market Surveillance Unit has been with the Exchange for nine years; the Manager of the Cash Market Operations Unit has been with the Exchange for ten years and with a major oil company for 25 years; and the Supervisor of the Market Surveillance Unit has 14 years industry experience, two with the Exchange.In addition, the Exchange’s MS Manual is used as a training tool for newemployees, and is an effective reference for MSD staff. The MS Manual describes,among other things, procedures to be followed by MSD staff when performing their daily surveillance duties; computer reports used in market surveillance, their purposes, and how to analyze them; procedures for conducting inquiries and for analyzing cash markets; and preparations for Control Committee meetings.
The Division found, however, that the MS Manual should be clarified with respect to the differences between speculative position limits and position accountability levels. The MS Manual discusses "accountability level violations," although a market participant cannot violate the Exchange’s Position Accountability rule, Rule 4.48, by exceeding the accountability level. A participant can only violate the rule by not furnishing the Exchange with requested information about the size and nature of a position or any other information pertinent to the position that the Exchange may request. Similarly, the MS Manual refers to "accountability exemptions" when exemptions are not given with regard to accountability levels.10 These technical corrections should be made to the Manual by clarifying the distinctions between speculative position limits and position accountability levels in the Manual, and by amending its Rule 4.47(d) to reflect the fact that market participants do not apply for "exemptions" from accountability levels.
B. Routine Surveillance of Market Activity
COMEX lists contracts in gold, silver, copper, and Eurotop 100 futures and options. Volume in the Eurotop futures and option contracts is minimal. On a daily basis, the MSD prepares and reviews spreadsheets that contain data on volume, open interest, settlement prices, futures price changes, cash market prices, price differentials, and data on available supply and demand. The MSD also monitors clearing member and individual large trader positions, delivery intentions, and market information reported by news services and major trade publications, including Reuters, Telerate, Metal Bulletin, and Platt's Metals Weekly.
MSD analysts maintain continuous contact with the industry, including warehouses, to assess supply and demand factors, and to understand the reasons participants are using the market and the nature of their trading strategies. When a COMEX contract becomes the spot month, the MSD emphasizes delivery intentions in its contacts with traders and clearing members. In particular, the MSD requests that clearing members verbally certify that their customers with short positions are able to make delivery. MSD staff continues to monitor the contract expiration through the last trading day, obtaining and reviewing updated delivery and position information, and maintaining a dialogue with Commission surveillance staff when appropriate. After an expiration, the MSD monitors the delivery process to ensure that delivery instructions are submitted in a timely manner, and that deliveries proceed according to COMEX rules and procedures.
The Exchange's Control Committee usually meets two weeks prior to a contract’s expiration. However, the frequency of Control Committee meetings depends on the nature of the contract liquidation. The Committee may meet several times a month if there is a potential problem with an expiration or, if a contract is liquidating in an orderly manner, it may not meet at all. For example, during the target period, five Control Committee meetings were held for copper futures; one meeting each for the March, May, June, October and December 1996 expirations, while none were held for gold or silver. At Control Committee meetings, the MSD presents the ten largest long and short position holders11 and their delivery intentions, along with other relevant data, including open interest, volume, price information, spread differentials, deliverable supply statistics, cash market data, comparable historical data, and any other information that may affect the contract expiration.
The Division believes that given the low level of COMEX copper stocks, the concentration on the long side of both cash and futures, and the large backwardation in the market, at a minimum, the Control Committee should have convened during the January expiration, and that there should have been additional meetings during the June expiration. The January 1996 copper expiration was characterized by a dominant long participant, low COMEX stocks and approximately a five cent/pound backwardation on the last trading day. The June expiration was characterized by the same dominant long, and a large and continuous backwardation during its last four days. In fact, the backwardation of 13.95 cents/pound on the last trading day of the June contract was the largest since the April 1990 future.12 In addition, a large commercial participant was the largest long trader and owned most of the COMEX stocks during both expirations. Although, based on a review of the Exchange’s files, MSD staff had continuing contacts over the period with the large trader to ascertain its intentions, the copper Control Committee formally convened only once to discuss the June expiration, and that was before the opening on the last trading day, June 26th. The Committee did not meet at all for the January contract.
Finally, the Division found that the Exchange’s market surveillance recordkeeping practices were satisfactory. Specifically, the MSD prepares and maintains a "control file" for each contract expiration. The file generally includes the minutes of Control Committee meetings, notes of telephone conversations with market participants, and the aforementioned data and materials regarding the expiring future. The Division reviewed 21 control files from the target period, and found that each contained appropriate data and information.
C. Large Trader Reporting System
Pursuant to COMEX Rule 4.46(c), all COMEX clearing members, omnibus accounts, and foreign brokers are required to identify separately for each business day on which a position is reportable "the reportable position as well as the position in all delivery months of futures contracts for that commodity and in all expirations of options for that commodity, by strike price." These data must be filed with COMEX daily by 8:00 a.m. Reports are filed almost exclusively by computer-to-computer transmission. In order to monitor reportable positions in omnibus accounts, the MSD has developed an Omnibus Reporting Agreement13 that is modeled on the NYMEX version. Initially, the MSD works through the carrying clearing member to ensure that the omnibus account files the agreement with COMEX and is aware of its reporting obligations. Afterwards, the MSD deals directly with the omnibus account, even if it is a non-member. Should the omnibus account fail to report, the MSD will then contact the clearing member.14
Once reportable positions have been entered into the Large Trader Reporting System, the system generates various reports that are used to detect reporting violations, and violations of speculative position and hedge exemption limits.15 The reports are also used to monitor position accountability levels. MSD staff generally runs the large trader reports by 8:30 a.m., and the first batch, the Early Warning reports that identify accounts potentially over speculative or hedge exemption limits, is usually available for analysis by 9:30 or 10:00 a.m. An analyst may view a report on his computer screen or examine it in hard copy form.
To identify clearing members and omnibus accounts that may be reporting large trader data incorrectly, COMEX generates daily the "Unreported Exception Report" and the "Unmentioned Exception Report" for futures and options.16 The term "unreported" refers to clearing members and this report shows the difference between a clearing member's commitments and the reportable positions it has reported. "Unmentioned" refers to omnibus accounts and this report shows the difference between the positions reported by the omnibus account and those actually held open at the clearing member for the omnibus account.
COMEX Rule 4.46(c) also requires a carrying clearing member promptly to file a facsimile of CFTC Form 10217 with COMEX after an account becomes reportable. If necessary, MSD clerks will contact the clearing member before the form is filed to identify the account. When a trader becomes reportable, the MSD assigns an identification number until it can identify the trader by obtaining a CFTC Form 102 or by calling the carrying clearing member. Once the MSD identifies the trader, the Large Trader Reporting System will aggregate his positions at multiple clearing members, if such positions exist and are reportable. For entities that are apparently affiliated, the MSD assigns a group identification number and the system aggregates the positions of all the affiliates. The MSD will consult a number of sources before it aggregates trading entities, including CFTC Forms 102, new account forms at clearing members and futures commission merchants, industry references that discuss commercial entities, and occasionally CFTC Forms 4018 and Dun & Bradstreet. The computer reports generated will identify both the aggregate entity and the individual entities that make up the aggregate.
Each day, MSD staff reviews reports relevant to large traders, speculative position limits, and position accountability levels. Two important subsets of these reports are Early Warning and Ranking reports, which enable the analyst to detect potential position limit violations.19 The reports are:
Early Warning reports:
- "SPOT MONTH-CUSTOMER NET POSITION LIMIT REPORT": A list of customers and groups whose spot-month futures positions exceed the speculative position limit or their respective hedge exemption limits.
- "ANY/ALL MONTH NET POSITION LIMIT EXEMPTION REPORT": A list of customers and groups whose any-month or combined all-months futures-equivalent positions exceed the speculative position limit, their respective hedge exemption limits, or their respective all-months accountability levels. Positions are listed by net futures position, by net options futures-equivalent, and by net futures-equivalent.
- "CUSTOMER GROSS POSITION LIMIT-OPTIONS": A list by calls and puts of all customers and groups whose all-months gross options positions exceed accountability levels or the customer's or group's expanded accountability levels.
- "SPOT-CUSTOMER NET FUTURES EQUIVALENTS REPORT": A list, by all commodities for which an option contract is traded, of all customers and groups whose current delivery month net futures-equivalent positions exceed the speculative position limit or their respective hedge limits.
- "FUTURES OPEN INTEREST EXCEPTION REPORT," "OPTIONS OPEN INTEREST EXCEPTION REPORT": A list of customers and groups whose positions in futures or options exceed a predetermined percentage of the open interest for either any one month or all months combined.
- "CUSTOMER FUTURES EQUIVALENTS RANKING-SPOT MONTH," "CUSTOMER FUTURES EQUIVALENTS RANKING-ALL MONTHS:" Produced if the futures contract has a corresponding option contract. The reports list, for the spot month and all months, all reportable traders and groups in descending order according to their futures-equivalent positions.
- "FUTURES CUSTOMER POSITION RANKING-BY CONTRACT," "ALL MONTHS CUSTOMER POSITION RANKING REPORT," "CUSTOMER OPTIONS POSITION RANKING-BY UNDERLYING CONTRACT," "ALL MONTH CUSTOMER OPTIONS POSITION RANKING REPORT": For futures and options, these daily reports list gross long and gross short positions for all reportable customers and groups for each contract month and for all months aggregated. Although gross long and gross short positions are listed, accounts are ranked in descending order by their net positions. These reports enable the analyst to identify customers or groups with a large percentage of open interest, concentration of open interest by several customers or groups, and accounts that are approaching the speculative limits or their hedge limits.
D. Enforcement of Speculative Position and Hedge Exemption Limits, and Position Accountability Levels
1. Position Limits and Hedge Exemptions
COMEX Rule 4.47(b) prohibits a party from holding or controlling net futures equivalent positions in the spot month which exceed the levels established by COMEX.20 COMEX differs from NYMEX in that its contracts have speculative position limits only in their spot months.21 Similarly, Rule 4.47(b), together with Rule 4.48 ("position Accountability"), establishes net futures equivalent levels for position accountability. A market participant holding a position exclusively in a spot month is subject to a speculative position limit. A market participant who holds a position solely in the back months is subject to a position accountability level,22 while a participant who holds positions in both the spot and back months is subject to both a speculative position limit and a position accountability level. To determine the size of a position, COMEX nets long and short futures positions, and converts option positions to their futures equivalents.23
In addition, COMEX Rule 4.47(h) provides for exemptions from spot month speculative position limits for bona fide hedges, independently controlled positions, spread and arbitrage positions, and commodity swap transactions. An applicant for a spot month exemption must file a "COMEX Hedge Notice and Application For Exemptions From Position Limits" form ("Exemption Application").24 In addition to information and documentation concerning the commercial operations and financial status of the applicant, the form requests information concerning the risk management structure in an applicant's firm, the personnel responsible for supervision of the risk management/trading department, the positions it maintains on other regulated exchanges, its off-exchange derivative positions, the applicant's swap exposure, if any, and a description of the internal controls employed in the oversight of an applicant's risk management program. The applicant also must affirm that the transactions represent bona fide hedges. An Exemption Application must be filed and granted before the position can be increased. That is, no retroactive hedge exemptions are permitted at COMEX.25
The Exemption Applications are reviewed by the Cash Market Operations Unit, which validates the applicant's hedging requirements. The Exchange grants hedge exemptions separately for long and short positions for each commodity. The exemption usually lasts for a year; within that year, the exemption "rolls over" into the next expiration of that commodity. After a year, the applicant files a new Exemption Application and the MSD reviews it. Nevertheless, pursuant to Rule 4.47(k), the Exchange maintains the right to revoke, modify, or place limitations on an exemption.
On a monthly basis, COMEX generates a hedge exemption register which lists for each commodity all entities granted an exemption, the details of the exemption, and the expiration date of the exemption. A hedge exemption file is maintained for each applicant. The file contains the applicant's Exemption Application, financial data, work papers, and a letter informing the applicant whether the request for an exemption was granted or denied.
During the target period, applicants requested ten bona fide hedge exemptions. The Division reviewed all ten hedge exemption files and found that they contained the appropriate data and information necessary for the MSD to determine whether to grant or deny the applicant's request.26 The MSD approved nine exemptions and denied one. The denial letter cited "market conditions in the copper futures contract which do not support increases in trading position limits at this time, as any increase would pose a threat of undue concentration with an adverse impact on liquidity."
2. Position Accountability Levels
When a hedge or speculative account exceeds the initial accountability level, the MSD sends that account a "position Accountability Report" to complete. The report asks for an array of information about the account.27 Based on the account's response and liquidity and open interest considerations, the MSD will decide whether the account should be permitted to maintain its position. If so, MSD staff, the Director of Market Surveillance, the Vice President of Compliance, and ultimately, the Senior Vice President for Regulatory Affairs & Operations, will establish a new accountability level for that account. In the event that the account reaches the new accountability level (referred to as the "call-back" level), the procedure is repeated; i.e., the MSD forwards the account another "position Accountability Report" for completion and determines the next accountability level. If the MSD believes that open interest or liquidity or the account's financial resources are not sufficient to support the position, the MSD cannot unilaterally instruct the account to reduce its position. Rather, the President or his designee may request, and the Board or, upon delegation, the Control Committee, may order the reduction of positions.28
The second and third accountability levels are generally double and triple the initial level, respectively. If an account's position increases shortly after it has filed a "position Accountability Report," the MSD does not obtain another report because the information filed should not have changed significantly. Furthermore, the MSD can still contact any market participant at any time if market conditions so warrant. The MSD does an annual review of accountability thresholds. If a market participant's position reaches an expanded level within 12 months, it is required to provide a current "position Accountability Form." Twelve months after the most recent expanded level is established, the threshold automatically reverts to the original level of 7,500 contracts for gold and silver and 6,000 contracts for copper.
During the review period, the MSD requested and received "position Accountability Reports" from 27 market participants that had exceeded initial or expanded accountability levels. In each instance, the account was granted an expanded limit. The Division reviewed ten of these reports and found that COMEX received and examined appropriate information concerning the nature of the positions.29
V. Enforcement of Exchange EFP Rules30
COMEX Rule 4.36 ("Exchanges for Physicals")31 permits an exchange of physical commodities for futures contracts provided that the transaction meets the following requirements:
A. Initiation of EFP Inquiries
EFP trades are posted on the floor of the Exchange and are cleared in the same manner as regular trades except that the records of the Exchange and clearing members must clearly identify the trades as EFPs. In addition, each clearing member representing the buyer and the seller must submit a report form to the Exchange identifying the parties to the EFP, the details of the transaction, and a statement that the EFP will result in a change of ownership of the cash commodity.
The Exchange monitors compliance with Rule 4.36 by initiating an inquiry into EFPs that appear suspect. Suspect EFPs are generally those that involve an unusually large number of contracts; those that are transacted between participants who have no prior EFP history; those that involve non-commercial customers, including floor members; or those that have the same buyer and seller. All EFPs are listed on a computer report which is reviewed by MSD monthly. If a review of that report reveals no suspect EFPs, the MSD, nonetheless, randomly selects at least two EFPs per month for routine examination.
MSD staff enters each inquiry on an EFP log,33 and sends a letter to the respective clearing members, requesting that they provide cash-side documentation supporting the bona fides of the EFP. Cash-side documentation requested by the MSD includes commodity statements, order tickets, telexes and/or other communications, confirmation of deliveries, and confirmation of receipt or payment of funds for the physical commodity. If the inquiry finds that an EFP is potentially non-bona fide, the MSD prepares an investigation report for the review and approval of the Vice President of Compliance, in consultation with Compliance Counsel. As stated earlier, the preparation of an investigation report is what distinguishes an investigation from an inquiry. The Vice President then determines whether to issue a staff warning letter or refer the parties to the BCC for possible disciplinary action.
B. Adequacy of Inquiries
During the target period, MSD staff completed 77 EFP inquiries. Of these, 21 were initiated as a result of an April 30, 1996 Division referral regarding certain gold EFPs.34 The Division’s referral resulted from a review of gold EFPs which appeared suspicious because of either their size, the manner in which they were cleared (i.e., both sides were for house accounts of the same clearing member), or the fact that they were offset by equal and opposite EFP transactions on the same day with one clearing member acting as principal in separate EFPs opposite two of its customers. Although none of the 77 inquiries resulted in an investigation, one EFP was deemed non-bona fide. In that inquiry, # SI-4-96, warning letters were issued to a member firm and its carrying clearing member. Warning letters were issued because, in the Exchange’s view, the member firm mistakenly executed an EFP between two customer accounts with the same beneficial owner in order to transfer positions from one account to the other, rather than using a permissible office trade to effect the transfer.
The Division reviewed 28 of the 77 inquiry files, including the 21 gold inquiries from the Division’s referral, five silver inquiries, and two copper inquiries. The Division found that several of the gold EFP files35 and one of the silver inquiries did not contain depository receipts or other documentation conclusively evidencing a change of ownership of the cash commodity, and that one of two contingent EFP files did not contain adequate information to determine whether the EFP was transacted outside of COMEX trading hours. In addition, the Division found several EFPs in which an FCM, with apparently no price risk, entered into equal and opposite EFPs with two of its customers whereby the FCM’s EFPs, when taken together, raise a question as to the bona fides of the FCM’s involvement in the EFPs. The remaining inquiries in gold, silver and copper were conducted in a thorough manner.
1. Contingent EFPs
As stated above, COMEX Rule 4.36 prohibits contingent EFPs during COMEX trading hours.36 Therefore, establishing the execution time is critical when the MSD evaluates the bona fides of contingent EFPs. Two of the 28 EFP files reviewed by the Division involved contingent EFPs. In one of the two files, it appears that the MSD did not have sufficient documentation to determine the time of the EFP transaction.
Specifically, in file SI-1-96, Customer A bought one March ‘96 Comex silver futures contract at $5.2850 and sold 5,000 ounces of silver bullion at $5.23 through Clearing Member X. Customer B sold one March ‘96 Comex silver futures contract at $5.2850 and purchased 5,000 ounces of silver bullion at $5.23, also through Clearing Member X. This EFP was contingent upon Customer A also purchasing 5,000 ounces of silver from Customer B so that both customers could offset the cash portion of their EFPs.
The one order ticket in the file is for the buyer of the futures contracts (Customer A) and is time-stamped 3:44 p.m., after the close of silver trading. The MSD apparently assumed that this was the time of execution. However, the order ticket also contains the pre-printed legend "DO NOT EXECUTE," which typically indicates that the order is a duplicate and has already been executed. Therefore, it appears that the MSD may not have requested or examined the original order ticket to determine conclusively the correct time that the EFP was executed.
Accordingly, notwithstanding that there were only two contingent EFPs in the Division’s sample, the Division recommends that the MSD use all available data to determine the time of execution of a contingent EFP.
2. Offsetting EFPs
With respect to EFPs offset by equal and opposite transactions with one clearing member acting as principal on both sides opposite two of its customers, the Division noted in its referral at least one COMEX clearing member that was "between" two of its customer accounts in this manner on at least six occasions. That is, the clearing member executed one EFP with an account wherein it bought futures and sold cash, then executed a second EFP with another account wherein it sold the identical number of futures contracts and bought the identical amount of cash commodity. The cash and futures components of both EFPs were executed at identical prices, in effect, leaving the clearing member flat with respect to its participation in the two EFPs, and the two customer accounts transacting an EFP opposite each other.37
For example, COMEX clearing member [ ] executed EFPs with [ ] on January 3, 1996. In the first EFP, [ ] bought 330 February '96 COMEX gold contracts @ 396.00 and sold 33,000 ounces of January 5, 1996 gold, loco London, @ 394.75; [ ] sold 330 February '96 COMEX gold contracts @ 396.00 and bought 33,000 ounces of January 5, 1996 gold, loco London, @ 394.75. In the second EFP, [ ] sold 330 February '96 COMEX gold contracts @ 396.00 and purchased 33,000 ounces of January 5, 1996 gold, loco London, @ 394.75; [ ] bought 330 February '96 COMEX gold contracts @ 396.00 and sold 33,000 ounces of January 5, 1996 gold, loco London, @ 394.75.38
The Division recognizes that EFP transactions allow a certain flexibility in pricing and enable users to minimize transactional risk, which is the difference between cash and futures prices (also called the "basis"). Nonetheless, these types of EFPs at least raise a question with regard to the bona fides of the clearing member’s involvement. It appears that in at least six instances [ ] may have been exposed to no price risk in executing these EFPs. Although it appears that these transactions resulted in the transfer of cash commodity from one customer, through the clearing member, to the other customer, [ ] does not appear to have had a resulting cash or futures position. In this context, [ ] participation raises a question as to whether the transactions were in the nature of possible wash sales. The Exchange, therefore, should further analyze the bona fides of [ ] involvement in these EFPs, and provide that analysis to the Division within 90 days.
3. Evidence of Change of Ownership
The Division found that in 17 of the 28 files it reviewed, there were no documents that demonstrated conclusively a change of title to the cash commodity. The files contained cash ledgers showing debits and credits on account statements and wire transfer confirmations, but generally nothing in the nature of a depository receipt, invoice or other document that would conclusively show a change of ownership. Pursuant to COMEX Rule 4.36, an EFP consists of simultaneous futures and cash transactions. In order for an EFP to be bona fide, there must be a change of ownership of the cash commodity, including those EFPs that net each other out. For example, many COMEX EFP participants are commercial accounts that deal extensively in gold and silver. Because they may execute many EFPs over the course of a day, these accounts will be both buyers and sellers of the cash commodity. These EFPs must also have a cash component with a legitimate change of ownership.
Accordingly, the Division recommends that the MSD ensure that it obtains conclusive documentary evidence that a change of ownership of the cash commodity has occurred.
VI. Market Surveillance Inquiries and Investigations
During the target period, the Exchange initiated 79 market surveillance inquiries and one investigation. As stated earlier, 77 inquiries involved EFPs and resulted in one warning letter. In addition, one inquiry, a CFTC referral from the Division of Economic Analysis ("DEA"), involved inaccurate position reporting in gold options and resulted in a warning letter, and the other inquiry involved a violation of copper speculative limits, and also resulted in a warning letter. The Division agrees that warning letters were appropriate in these instances.
The single investigation opened by the MSD during the target period involved the possible manipulation of the June 1996 copper futures contract by a commercial entity.39 The Exchange initiated its investigation after the June ‘96/July ‘96 spread widened from two cents June under July to 14 cents June over July. The investigation was the joint effort of the Trade Practice and Market Surveillance Units. The Trade Practice Unit analyzed the orders that the trader sent to the trading floor; the MSD sought to determine whether the trader created an artificial price. Upon completion of its investigation, the Exchange determined that there was no reasonable basis to conclude that the commercial entity manipulated or attempted to create an artificial price in the June 1996 copper future.
The Division reviewed the Exchange’s investigation file and found that the investigation was too narrow in scope and should have been expanded to encompass significantly more trading and cash market activity. The Exchange’s investigation of the trading in June copper covered the period of May 17-June 26, 1996, but focused on only two days: June 21 and 26, the latter being the last trading day of the contract. These two dates were selected by the Exchange because of the price volatility present on those days and the large price inversion between the June and July contracts. The Exchange matched the Price Change Register against the commercial trader's orders on those dates, and found that the market rallied while the trader's sell orders were active. The Exchange cited this behavior in reaching the conclusion that there was no reasonable basis to believe that the trader could not have manipulated the market on those days, nor on any other date during May and June 1996.
The Exchange did not examine a more expansive time period to determine what effect, if any, the trader’s prolonged dominance as a long in the cash and futures markets in contract months leading up to the June expiration may have had on the market price. Moreover, the two days that the Exchange selected for its manipulation analysis represented days on which the large position holder was a significant seller, either liquidating June contracts outright or rolling long June contracts into July by selling the June/July spread. The Exchange should have analyzed the large trader’s trading strategy in the context of its apparent prolonged market dominance and whether there was evidence of an intent to manipulate copper futures prices.40
The Division found that the Exchange’s inquiries were generally completed within the four-month requirement of Commission Regulation 8.06.41 With the exception of the copper investigation and the 21 EFP inquiries emanating from the Division’s referral, which were complex in nature and involved large numbers of transactions and clearing members, the average time to completion of the remaining 58 inquiries was approximately 83 days. Eleven of the 58 inquiries took more than 120 days to complete, and the investigation required approximately 13 months to complete.
With respect to the EFP referral, the Division granted several extensions of time to the Exchange to respond to the Division’s referral due to the large number of transactions involved, and the various clearing members from whom the Exchange would need to request and receive documentation. Although the Division has articulated its concerns regarding the documentation requested in the Exchange’s review of these EFPs,42 the Exchange completed the inquiries and advised the Division of their results in a relatively timely manner given the magnitude of the referral, i.e., within six to eight months from the date of the referral.
Finally, subject to provisos discussed above concerning certain of the EFP inquiries, the Division found that the MSD generally conducted its inquiries adequately and obtained the necessary documentation. The Division found that the files contained relevant correspondence and pertinent documentation including, where applicable, copies of clearing house records, computer reports, documents relating to futures trades, cash transaction documentation, work papers, warning and advisory letters, and a summary log sheet.
VII. Conclusions and Recommendations
The Division found that COMEX maintains an adequate market surveillance program for identifying indications of possible congestion or other market situations conducive to possible price distortion, and ensuring the orderly liquidation of expiring contracts. The Exchange's MSD is sufficiently staffed and experienced to carry out its daily surveillance program, which includes, among other things, the review of prices, volume, open interest, spread relationships, cash markets, large trader and clearing member positions, and supply and demand data.
In addition, COMEX generates computer reports that help the MSD to monitor reporting requirements, reportable traders (including those in omnibus accounts), speculative position limits, and position accountability levels. The Exchange also has adequate procedures for reviewing hedge exemption applications and for monitoring accounts that exceed accountability thresholds. Further, COMEX reviews exemptions and accountability levels regularly to ensure that they are appropriate for market participants.
The Division also found, however, that the Exchange’s Control Committee does not convene often enough during potentially problematic expirations. During the target period, the Control Committee met on only five occasions: one meeting each for the March, May, June, October, and December 1996 copper expirations. Given the low level of copper stocks, the concentration on the long side of both cash and futures, and the large backwardation in the market, at a minimum, there should have been meetings held during the January expiration (no meetings were held) and additional meetings during the June expiration.
With respect to EFPs, the Division found that COMEX investigates selected EFP transactions to determine whether they are bona fide. Suspect EFPs are generally those that involve an unusually large number of contracts; those that are transacted between participants who have no prior EFP history; those that involve non-commercial customers, including floor members; or those that have the same buyer and seller. All EFPs are listed on a computer report which is reviewed by MSD monthly. If a review of that report reveals no suspect EFPs, the MSD, nonetheless, randomly selects at least two EFPs per month for routine examination.
The documentation that the MSD requests from clearing members with respect to evaluating the bona fides of an EFP may include commodity statements, order tickets, telexes and/or other communications, and confirmations of payment for the physical commodity. However, the Division finds that further documentary evidence, i.e., depository receipts or other documentation, should be obtained to determine conclusively a change in the ownership of the cash commodity. In addition, in determining whether a contingent EFP was transacted outside of COMEX trading hours, as required by Exchange rule, the Exchange should use all available data to establish the time that the EFP was transacted. Further, EFPs involving an FCM’s house account opposite two of its customers in two equal and opposite EFPs raise a question as to the FCM’s involvement in the transactions.
Finally, the Exchange’s market surveillance inquiries were generally completed within the four-month requirement of Commission Regulation 8.06. With the exception of the copper manipulation investigation and the 21 EFP inquiries emanating from the Division’s referral, which were complex in nature and involved large numbers of transactions and clearing members, the average time to completion of the remaining 58 inquiries was approximately 83 days. The Division found, however, that the copper investigation was too narrow in scope and should have been expanded to encompass significantly more trading and cash market activity. In addition, the Exchange should have examined the largest trader’s trading strategy in the context of price artificiality given its apparent market dominance in the June contract, and in contracts leading up to the June expiration.
Therefore, based on the foregoing, the Division recommends that the Exchange:
1. Convene Control Committee meetings more frequently during potentially problematic contract expirations.
2. Ensure that investigations of possible price manipulation encompass a sufficient scope of market activity given the time frame of a participant’s possible market dominance, and include, at a minimum, a thorough analysis of price artificiality, market dominance, and intent to manipulate.
3. Consistently obtain depository receipts or other documentation during EFP inquiries to evidence conclusively that a change of ownership of the cash commodity has occurred, and by reviewing contingent EFPs more closely to determine whether the EFPs occurred outside of the Exchange’s regular trading hours, in conformity with COMEX rules. In addition, the Exchange should further analyze the bona fides of those EFPs it reviewed that involved the same clearing member on both sides of equal and opposite EFPs for its customers, and provide that analysis to the Division within 90 days.
1 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange's overall compliance capabilities for the target period under review. These reviews deal only with the programs directly assessed in the reviews and do not assess all programs. The analyses, conclusions and recommendations are based, in large part, on the evaluation of a sample of investigatory cases and other documents. This evaluation process, in some instances, identifies specific deficiencies in particular exchange investigations or methods, but it is not designed to uncover all instances in which an exchange does not address effectively all exchange rule violations or other deficiencies. Neither are such reviews 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 The most recent evaluation of COMEX’s trade monitoring system, including its trade practice surveillance, disciplinary and audit trail programs, was contained in the Division’s April 25, 1997 memorandum to the Commission concerning the Exchange’s petition for exemption from the dual trading prohibition of Commission Regulation 155.5. The Commission granted COMEX an unconditional exemption from the dual trading prohibition of Regulation 155.5 on May 6, 1997. A rule enforcement review of the Exchange’s trade practice and disciplinary programs is currently in progress.
3 The transcript of this interview can be found in Appendix 1, and is hereinafter cited as "Transcript."
4 A copy of the MS Manual can be found in Appendix 2.
5 Position accountability thresholds are those levels at which a trader becomes accountable to the Exchange for its positions and must provide the Exchange with requested information concerning, among other things, the size and nature of the position, and the trading strategy involved in the position. See pp. 17-21, infra, for a discussion of speculative position limits and position accountability levels.
6 The January 15, 1997 Organizational Chart and the job descriptions for MSD personnel comprise Appendix 3.
7 Although the MSD services both the NYMEX and COMEX divisions, the Harbor Operations Unit is concerned solely with NYMEX energy products, and therefore is not discussed in this report.
8 The 1996/97 Control Committee consists of 11 Exchange members (70% from NYMEX and 30% from COMEX): a chairman, vice chairman, and nine other members, with three-member subcommittees responsible for monitoring each commodity traded at the Exchange. Subcommittee members generally do not trade in the markets they oversee. However, if a subcommittee member is holding a position in the market that he or she oversees at the time of any committee deliberations, that member must disclose that position to the Exchange’s General Counsel for a determination as to whether the member should recuse himself from the meetings. COMEX/ NYMEX Rule 3.17 ("Control Committee") addresses the Control Committee.
9 See Transcript, page 67.
10 For example, see pp. 18, 19, 21, and 23 of the MS Manual in Appendix 4.
11 The names of market participants are coded to ensure their confidentiality and the Committee's objectivity. However, a Control Committee member has the right to know the identity of a market participant and MSD staff will reveal the name upon request. Furthermore, the Committee may call market participants to appear before it.
12 [ ]
13 The Omnibus Reporting Agreement is a letter signed by an authorized representative of an omnibus account who confirms that the omnibus account will report daily all customers that own or control positions that equal or exceed COMEX customer reporting levels. The Exchange sends the agreement to the omnibus account in a package that also contains the following: an EFP Reporting Agreement, a CFTC Form 102, COMEX Forms 101 for futures and options, a form to be completed when a carried account executes an EFP, specification requirements for computer-to-computer transmission, and copies of COMEX Rules 4.36 ("Exchanges for Physicals") and 4.46 ("Reporting Requirements"). A copy of the agreement and other materials in the package can be found in Appendix 5.
14 COMEX Rule 4.46(c)(3) states in pertinent part: "If an omnibus account or foreign broker fails to file such reports when and as required, the clearing member at which the accounts are cleared shall be required to submit the information with respect to the constituent accounts."
15 The Large Trader Reporting System is a collection of about 30 reports derived from CFTC Form 101 data submitted to the Exchange by clearing members and omnibus accounts. A listing and samples of reports available through the Large Trader Reporting System may be found in the Market Surveillance Procedures Manual in Appendix 6.
16 Copies of Exception Reports can be found in Appendix 7.
17 The CFTC Form 102 ("Identification of Special Accounts") identifies reportable futures and options traders and includes information on account ownership and control.
18 Form 40 ("Statement of Reporting Trader") must be filed with the CFTC by reportable traders pursuant to terms set forth in Regulation 18.04. The reporting entity identifies the accounts it controls and the accounts that control it.
19 Copies of Early Warning and Ranking reports can be found in Appendix 8. These reports are part of the Large Trader Reporting System.
20 The maximum number of futures contracts, options on such futures contracts, or any combination thereof which any person may hold or control for the spot month is as follows: gold, 3,000; silver, 1,500; and copper, 2,500. There is no spot-month limit for the Eurotop 100 index, but the volume for this contract is minimal.
21 The spot month limit is effective as of the close of business on the second to last business day of the calendar month preceding the delivery month. See COMEX Rule 4.47(b).
22 Initial position accountability levels are as follows: gold, 7,500 contracts; silver, 7,500 contracts; copper, 6,000 contracts; and Eurotop, 10,000 contracts.
23 COMEX Rules 4.47(b) and (c).
24 A copy of an Exemption Application can be found in Appendix 9.
25 Rule 4.47(g)(2).
26 Copies of three of these exemption files can be found at Appendix 10.
27 In addition to the name and address of the filer, the report requests the following information: the names, titles and telephone numbers of the personnel authorized to trade COMEX futures and option contracts for the commodity that exceeds the accountability level; a list of all the filer's affiliated organizations; a copy of the filer's most current audited financial statement; an explanation of the filer's hedging, arbitrage or speculative trading activity; a description of the risk assessment policies and procedures in place at the firm, including testing for extraordinary price volatility; and the signature of an officer of the applicant firm or one of its duly authorized representatives.
28 COMEX Rule 4.48(1) .
29 Copies of the "position Accountability Reports" examined by the Division may be found at Appendix 11.
30 The Division notes that the Commission, on January 26, 1998, published a Concept Release in the Federal Register concerning the regulation of noncompetitive transactions, including EFPs, executed on or subject to the rules of an exchange. See 63 FR 3708 (January 26, 1998). In doing so, the Commission determined to seek comments on whether the existing regulatory structure should be revised to provide additional guidance concerning standards governing noncompetitive transactions. Among other things, the Commission is seeking input on the appropriate scope of regulatory requirements concerning reporting and recordkeeping, disclosure, internal controls, transparency and the prevention of fraud and manipulation. The Commission intends to consider carefully any comments it receives in determining whether any further regulatory action is necessary. Therefore, what constitutes a bona fide EFP may be further articulated by the Commission.
31 A copy of COMEX Rule 4.36 may be found at Appendix 12.
32 Rule 4.36 defines a contingent EFP as:
...an EFP involving the transfer of a physical commodity which is contingent upon the consummation of an additional cash commodity transaction offsetting the cash commodity component of the EFP. For example, a trader may purchase the cash commodity upon condition that he can immediately resell it to the person from whom it was purchased in exchange for a long futures position (or, conversely, the trader may sell the cash commodity and repurchase it together with a short futures position) by means of an EFP. Alternatively, a trader may transact an EFP with one party as a condition to entering into a cash commodity transaction with another party, which will liquidate the cash commodity component of the EFP.
An Exchange interpretation of Rule 4.36, entitled The Interpretation of the Board of Governors of Commodity Exchange, Inc. Regarding Exchanges of Futures for Physicals ("EFP Interpretation") states, among other things, that the COMEX Board bars contingent EFPs "during COMEX's business hours at any time that COMEX offers trading in its contracts, unless trading in a market is halted, such as during a physical emergency." The Division points out that the EFP Interpretation does not expressly address contingent EFPs which may occur outside of business hours. In approving the EFP Interpretation, by letter dated January 5, 1994, the Commission emphasized that "approval of the Exchange’s prohibition on contingent EFPs during COMEX trading hours should not be construed to permit by implication non-bona fide EFPs executed during non-trading hours." Notably, also, see footnote 39, infra, which indicates that the rules of only two other exchanges expressly address contingent EFPs.
To date, the Commission has neither promulgated governing standards nor a definition of contingent EFPs. The issue of the propriety of contingent EFPs generally will be addressed in the context of the Commission’s Concept Release. In particular, with respect to determining the bona fides of contingent EFPs, the Release solicited comments concerning the appropriate criteria for determining whether an EFP is contingent.
33 The log shows the EFP trade date, the date the inquiry was initiated, the parties involved, details of the trades, and a summary of the cash transaction. Sample copies of EFP logs may be found at Appendix 13.
34 The Division’s referral letter for Referral 96-E03, and the Exchange's response letters can be found in Appendix 14.
35 COMEX inquiry files corresponding to the CFTC Referral 96-E03 are Appendix 15.
36 NYMEX and Chicago Board of Trade ("CBT") rules also prohibit certain contingent EFPs. NYMEX Rule 6.21 requires non-commercial EFP participants to demonstrate that each EFP executed is not contingent upon a contemporaneous offsetting cash transaction, and CBT Notice to members dated May 22, 1990 requires any person transacting an EFP executed within one day of an offsetting cash transaction to demonstrate that the EFP was not contingent upon that cash transaction.
37 See COMEX files GC-4-96 and GC-4a-96, GC-5-96 and GC-5a-96, GC-8-96 and GC-8a-96, GC-9-96 and GC-9a-96, GC-10-96 and GC-10a-96, GC-12-96 and GC-12a-96 in Appendices 16 and 17. In particular, the second part of Appendix 17 juxtaposes the offsetting EFPs so that their results are more easily observed.
38 See inquiry files GC-4-96 and GC-4a-96 in Appendices 16 and 17.
39 The commercial entity in question was acquired by another metals dealer in May 1997 and is no longer in operation.
40 [ ] A copy of the Exchange’s June copper investigation report can be found in Appendix 18.
41 Commission Regulation 8.06 requires that an investigation be completed within four months, except when significant reason exists to extend it beyond that time frame.
42 See discussion at pp. 28-29, supra.