RULE ENFORCEMENT REVIEW
COFFEE, SUGAR & COCOA EXCHANGE, INC.
I. INTRODUCTION – PURPOSE AND SCOPE
The Division of Trading and Markets ("Division") has completed a rule enforcement review of the self-regulatory programs of the Coffee, Sugar & Cocoa Exchange, Inc. ("CSCE" or "Exchange"), a subsidiary of the Board of Trade of the City of New York (“NYBOT”).1 The purpose of this review was to evaluate the Exchange's market surveillance, trade practice surveillance, and disciplinary action programs for compliance with Section 5a(a)(8) of the Commodity Exchange Act ("Act") and Commission Regulation 1.51.2 The Division recently evaluated the Exchange's audit trail, trade practice surveillance, and disciplinary programs as part of its review of the Exchange's petition for exemption from the dual trading prohibition contained in Section 4j(a) of the Act and Commission Regulation 155.5. The Commission granted the Exchange's petition by Order dated December 23, 1998.3 In granting the Order, the Commission concluded that the Exchange's floor surveillance, audit trail, recordkeeping, surveillance, and disciplinary programs satisfied the requisite standards set forth in the Act to detect and deter dual trading-related abuses.4 The Commission further found that the Exchange committed sufficient resources to be effective in detecting and deterring violations by, among other things, maintaining an adequate staff to investigate and to prosecute disciplinary actions.
This review covers the period of October 1, 1997 to September 30, 1998 ("target period"). The Division's previous rule enforcement review of the Exchange's compliance program was presented to the Commission on September 30, 1996 ("1996 Review").5 In the 1996 Review, the Division found that CSCE generally had adequate market surveillance, audit trail, trade practice surveillance, and disciplinary programs. However, the Division made six recommendations to CSCE to further enhance its market surveillance, trade practice surveillance, and disciplinary action programs. With respect to market surveillance, the Division recommended that the Exchange disapprove cash and carry exemptions from spot month speculative position limits that are excessively large relative to deliverable stocks or the total delivery capacity on the expiring contract, notify non-member customers of behavior inconsistent with market surveillance-related rules, and incorporate into the Market Surveillance Procedures Manual its current procedures for reviewing hedge exemption requests for swaps and for monitoring cash-and-carry exemptions. The Division made two recommendations regarding the Exchange’s disciplinary program: modify the Litigation Log to include information about investigations that are referred to, but are later dismissed by, the Business Conduct Committee, and issue meaningful sanctions against members who disregard the directions of the market caller with respect to suspensions of trading during the opening/closing call. The Division also recommended that CSCE require staff to record all floor surveillance activities in the Exchange’s floor surveillance log. The Exchange responded appropriately to the Division’s recommendations.
During an on-site visit to the Exchange, Division staff interviewed senior Compliance Department (“Compliance”) officials, including the Vice President(s) and the Senior Manager.6 The Division also conducted a review of Exchange documents that included, among others, the following:
· Computer reports and other documentation used routinely in the conduct of trade practice surveillance and market surveillance;
· Selected trade practice investigation, market surveillance, and disciplinary action files;7
· Trade practice investigation, market surveillance, disciplinary action, and floor surveillance logs;
· Minutes of meetings of the disciplinary committees held during the target period; and
· Compliance manuals and guidelines.
The Division provided the Exchange with the opportunity to review and comment on a draft of this report on September 8, 1999. On October 5, 1999, Division staff conducted an exit conference with CSCE officials to discuss the report’s findings and recommendations.
III. CURRENT FINDINGS AND RECOMMENDATIONS
A. Market Surveillance
· The Exchange maintains an adequate 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 regularly contacts trade sources and large market participants to keep abreast of cash market developments and delivery intentions.
· The Exchange’s computerized large trader reporting system is an effective tool for monitoring the positions of large traders, aggregating related accounts, and detecting potential speculative position limit or hedge exemption limits. The Exchange monitors accounts that have used their exemptions to ensure that these accounts are meeting the exemption’s terms.
· Several market surveillance-related investigations were not completed in a timely manner. Although a majority of investigations were completed within the four-month requirement of Commission Regulation 8.06(b), there were reporting, speculative limit, and Against Actuals investigations that were open for excessive periods of time. No action was taken on Against Actuals investigations for a substantial period of time due to the prolonged absence of the sole analyst responsible for such investigations.
· The Exchange contacts traders that approach and/or exceed speculative position or hedge exemption limits, and normally will directly contact any such non-members. However, the Exchange does not consistently document contact with non-members who have violated speculative limits.
· The Exchange should improve the timeliness of its market surveillance-related investigations, and limit the impact of the absence of an analyst upon the progress of an investigation by cross-training staff.
· The Exchange should ensure that notification of all non-members who violate speculative position or hedge exemption limits is documented.
B. Trade Practice Surveillance Program
· The Exchange generally maintains an adequate trade practice surveillance program. The Exchange’s investigations, including those initiated in response to customer complaints, were generally thorough and well documented.
· The Exchange conducts computerized surveillance of its markets to detect possible trading abuses by its members and opens an adequate number of investigations based on trading sequences identified in the course of such surveillance, as well as on information obtained from other sources.
· The Exchange completes its trade practice-related investigations in a timely manner and only holds investigations open beyond four months where justified by factors such as the involvement of multiple parties and complex fact patterns.
· The Exchange concluded 110 trade practice investigations during the target period. Of the 52 investigations examined by the Division, two were closed without further action where the Division believes the evidence warranted referral to the Business Conduct Committee for its consideration. In its reports for these investigations, which involved possible accommodation trading, Compliance did not adequately discuss its calculations of brokers’ profits and losses.
· The Exchange could enhance its routine trade surveillance program by expanding reviews to include examination of all of relevant members’ original trading documents on the days that suspect trades occurred and by examining relevant members’ trading activity over an increased period of time through automated or other means.
· The Exchange did not refer to Commission staff its finding of possible conduct that violated the Act by an Exchange non-member firm over which the Exchange lacked jurisdiction.
· The Exchange did not ensure that senior Compliance staff sign and date its investigation reports upon completion and approval.
· Compliance should present to the Business Conduct Committee possible accommodation trading investigations in which trading pattern evidence supports the conclusion that a reasonable basis exists to find Exchange rules may have been violated, and should discuss in its investigation reports its calculations of brokers’ profits and losses.
· When Compliance identifies suspect trades in the course of routine reviews, it should expand those reviews to include examination of all of relevant members’ original trading records on the day(s) that suspect trades occurred and examine the members’ trading activity, through automated or other means, over a period of time that is sufficient to detect patterns of trading that are similar to those identified by the surveillance review or that indicate other possible Exchange rule violations.
· The Exchange should refer to the Commission cases in which it finds that a non-member may have engaged in conduct that violated provisions of the Act or the Commission’s regulations.
· Compliance should ensure that investigation reports are signed and dated by senior Compliance staff upon completion and review.
C. Disciplinary Program
· The Exchange generally maintains an adequate disciplinary program. Disciplinary matters are promptly referred to disciplinary committees, findings in cases that proceed for further action appear to be supported by the evidence, penalties generally appear reasonable relative to the conduct being sanctioned, and disciplinary action is taken in a reasonably timely manner.
· Penalties imposed by the Exchange, most of which resulted from settlement agreements, included fines totaling $126,700. Of this fine total, $63,950 (51 percent) was issued in cases involving trade practice and/or floor trading offenses. A number of these cases also involved violations of recordkeeping provisions.
· The Division found one case in which the findings appear to be supported by the evidence but the Business Conduct Committee did not issue charges, and another case that it believes resulted in insufficient sanctions upon appeal.
· The Exchange’s Litigation Log contained information that was incomplete and/or inaccurate.
· The Business Conduct Committee and Appeals Committee should issue meaningful sanctions against members in all instances in which findings are supported by the evidence.
· The Exchange should take steps to ensure that information is entered into the Litigation Log in a complete, accurate, and timely manner.
IV. MARKET SURVEILLANCE - SECTION 5a(a)(8) AND COMMISSION REGULATION 1.51(a)(1)
Commission Regulation 1.51(a)(1) requires each contract market to maintain a market surveillance program to identify possible congestion or other market situations conducive to possible price distortion. The purpose of the market surveillance program is to detect adverse situations in the markets as they develop and before the 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.
A. Routine Market Surveillance Activities
The Market Surveillance Department (“MSD”) monitors trading daily in order to detect potential price distortions and market congestion. 8 It uses the Internet, wire services, and the Exchange’s reporting system to examine open interest, volume, price movements, price relationships, market news, deliveries, physical supplies, and other factors that may affect market activity. The MSD also monitors large trader positions daily to ensure compliance with speculative and hedge exemption position limits. Further, the MSD regularly contacts trade sources and large market participants to keep informed of cash market developments and delivery intentions.
To ensure orderly liquidations, the MSD intensifies surveillance during contract expirations. The MSD begins its enhanced surveillance approximately three weeks before the first notice day for Coffee and Cocoa, and approximately three weeks before the nearby Sugar #11 month becomes the spot month. The staff focuses on position concentrations as well as the relationship between open interest and deliverable supplies. The MSD also gathers information about cash markets and any other factors that may affect an orderly liquidation. It contacts holders of large positions to ascertain their intentions with respect to making or taking delivery. Two weeks before reduced position limits for the notice period and last trading month take effect, the MSD sends reminder letters to traders whose current positions would violate those limits.
It is the MSD’s responsibility to keep the Exchange’s Control Committees abreast of market conditions prior to and during delivery periods. Control Committees direct market surveillance activities with respect to all commodities. They have the authority to obtain position information and to investigate and take action in any situation that may jeopardize the functioning of the Exchange. 9
The Exchange’s Control Committees for Coffee and Cocoa meet at least one week before first notice day. The Sugar #11 Control Committee meets at least one week before the first trading day of the spot month. Before a scheduled meeting, the MSD provides the Control Committee with a package of surveillance materials which includes a coded report on the largest traders, spread relationships, current open interest, and minutes from the last meeting. Although Control Committees meet at least once for any given expiration, they may meet more frequently if market conditions so require.
The MSD maintains expiration files for Coffee, Cocoa, and Sugar #11, the Exchange’s most heavily traded contracts. 10 These files typically include minutes from Control Committee meetings, coded weekly large trader reports,11 open interest charts, spot month or last trading month exemptions, notes and memoranda concerning discussions with large market participants, trader intentions and stocks data.
B. Large Trader Reporting System
The CSCE’s computerized large trader reporting system, the Speculative Limits Information Management (“SLIMS”) system, maintains account identification files and information on futures and option positions, delivery notices, and Against Actuals (“AA”) transactions12 for traders with reportable positions.13 All CSCE clearing members, non-member futures commission merchants (“FCMs”), and foreign brokers must give the MSD daily position data for all reportable futures on Commission 01 Large Trader Reports. At the MSD’s request, clearing members must furnish copies of CFTC Form 102 that identify traders first reaching reportable levels.14
Timely and accurate reporting of reportable futures and options positions is critical to the success of the Exchange’s market surveillance program. Once position data have been entered into SLIMS, the system generates reports that are used to detect speculative position limit violations and for general market surveillance purposes. MSD staff view these reports on SLIMS screens and also use several hard copy reports. Some of the SLIMS screens used by MSD staff are the “Display Account Record Screen,” which allows the user to select and display a specific account’s records, including the name of the aggregate to which the account may belong; the “Account Detail Screen,” which provides a listing of all accounts held by traders who use more than one clearing member; the “Aggregate Detail Screen,” which provides a listing of aggregates and accounts included within each aggregate, as well as the clearing member where each account is carried; and the “Reportable Futures Positions by Account and by Member Reports,” which display position information for all accounts or selected accounts, and for clearing members.
During the target period, the MSD referred three possible reporting violations to the Compliance Department for investigation.15 Investigation 98-21 was closed with no reason found to take action, investigation 97-86 resulted in the issuance of an information letter, and investigation 97-103 resulted in warning letters to three firms. In addition, the MSD referred two instances of failure to provide the Exchange with a CFTC Form 102. Compliance investigation 98-63 resulted in the issuance of a warning letter and investigation 98-65 was closed with no reason to take action.
C. Enforcement of Speculative Position Limits and Hedge Exemptions
1. Exemptions from Speculative Position Limits
The Exchange’s rules concerning speculative limits set forth the maximum number of net futures-equivalent contracts (futures and options) which any one person may own or control on the same side of the market without an exemption approved by the Exchange. These speculative limits cover all months in the contract (“all net month” or “all month” limit), any one month (“single month” limit), the notice periods for Coffee and Cocoa (“notice period” limit), and the last trading month for Sugar #11 (“last trading month” limit).16 The Exchange may grant four types of exemptions from speculative position limits: (1) bona fide hedge (Rule 13.06); (2) arbitrage and straddle (Rule 13.07); (3) independently controlled position (Rule 13.08); and (4) swap exposure. Single month limits do not apply to the notice period and last trading month, which have smaller limits.17
The MSD reviews exemption requests and makes recommendations to a panel consisting of the Vice President/Chief Economist, and the President.18 Staff considers the size of the requested position with respect to open interest, the principal business and occupation of the account owner, the account’s historical level of futures trading, the account’s assets and obligations in the physical market, and any other information the staff considers relevant to the reduction of risk.19
More specifically, when evaluating a request for an arbitrage and straddle exemption, staff considers the trader’s futures position relative to its deferred futures positions on the CSCE or equivalent positions on other exchanges, the prevailing spread level, and warehouse stocks. Within five business days of the submission of a completed request, the MSD informs the applicant in writing whether the exemption has been granted, partially granted, or denied. The MSD sends letters confirming approved exemptions together with a copy to be signed by an officer or partner of the member firm and returned to the MSD.
Most arbitrage and straddle exemptions are of the “cash-and-carry” variety. In fact, during the target period, all arbitrage and straddle exemptions granted were cash-and-carry. A cash-and-carry exemption enables a trader to take delivery in the near month and redeliver the same product in a deferred month at a profit.20 Historically, traders have applied for cash-and-carry exemptions during the notice periods in Coffee and Cocoa; cash-and-carry exemptions have never been applied for in Sugar.21 When requesting a cash-and-carry exemption, an applicant must provide its cost of carry and the quantity of stocks in Exchange-licensed warehouses that it already owns. The Exchange does not permit a trader to put on a spread position at a differential that is less than its cost of carry.22
In the 1996 Review, the Division recommended that the Exchange should not approve cash-and-carry exemptions that are excessively large relative to deliverable stocks or the total delivery capacity on the expiring contract. In that review, the Division noted that in several Cocoa and Coffee expirations, it appeared that long positions held by traders granted large cash-and-carry exemptions may have been an important factor in affecting futures price-spread relationships during the notice period.23 The Division’s concern was that these large cash-and-carry exemptions could result in undue market concentration and thereby present the potential for a disorderly liquidation.
In response to the 1996 Review, the Exchange has modified its procedures for granting cash-and-carry exemptions. Rather than granting the exemption and allowing the market to resolve any potential expiration problems, the MSD now analyzes the state of the market, gathers information concerning deliverable stocks, and asks market participants about their delivery intentions. Further, the MSD now grants cash-and-carry exemptions in stages, at specified spread levels, and expands them over time. The MSD also ensures that persons who receive a cash-and-carry exemption execute spread transactions at the specified differentials. 24 Finally, the Exchange has incorporated procedures for reviewing and monitoring cash-and-carry exemptions into its MS Manual, as recommended in the 1996 Review.
With regard to swap exposure exemptions, commercial traders apply for these when they need to hedge swap transactions with equivalent futures contracts. Applicants must provide the swap quantity, contra-party type (commercial or noncommercial), and a general description of the swap, including the termination date of the transaction.25 When requesting an independently controlled position exemption, an applicant must demonstrate the independence of the account controllers and provide notarized affidavits to that effect. Once an applicant has established the account controllers’ independence, the Exchange will assign position limits for the firms that are based on the number of independent account controllers.26 Lastly, when reviewing notice period and last-trading-month exemptions, the MSD places greater emphasis on current cash and futures commitments, delivery intentions, and deliverable supply. The MSD must receive a written request for a notice period exemption no later than five business days before first notice day in Coffee and Cocoa, or five business days before the first day of the last trading month in Sugar #11.27
Division staff requested exemption requests for 18 randomly selected traders during the target period. As a result, the Division reviewed 26 exemption requests and 13 letters confirming the renewal of overall and/or single month exemptions. In some cases, the MSD recommended and the Exchange granted only part of a requested hedge exemption based on information provided by the applicant or the lack of such information. MSD files document its efforts to obtain additional information from applicants. For example, in the case of one Sugar trader who wished to expand a last-trading-month exemption, the Exchange requested copies of physical contracts to verify the need for a larger bona fide hedge exemption. Other applicants reduced their original exemption requests after discussions with the Exchange. The selected exemption files, which were well documented, indicated that the Exchange diligently reviewed exemption requests and appeared to grant exemptions at appropriate levels.
All net month and single month hedge exemptions are reviewed annually by MSD staff during the fourth quarter to ensure that outstanding exemption levels still reflect the nature and scope of the exemption holder’s business. The Exchange sends a letter to each exemption holder asking it to resubmit an exemption request if any material change has occurred in its business. The holder may maintain its current exemption by signing, dating, and returning the letter. The MSD revokes the exemptions of holders that do not respond. The Exchange reviewed existing all month and single month exemptions in the fourth quarter of 1997. 28
2. Monitoring Position Limits and Hedge Exemptions
The Exchange uses SLIMS to monitor positions and to detect possible speculative position limit or hedge exemption violations. The “Futures Speculative Limit Violations Screen” allows the MSD to request a report of traders whose positions equal or exceed speculative position limits on a futures-equivalent basis. The SLIMS system automatically aggregates accounts based on the MSD’s data input regarding account ownership and control, and compares traders’ futures-equivalent positions with relevant speculative position limits or their exemption limits.29
The MSD also uses a SLIMS screen daily that identifies traders that are at or above 80 percent of position limits. The MSD telephones or faxes these traders to remind them that they are approaching position limits and that they may need to apply for an exemption or an expansion of a current exemption, if appropriate. In addition, two weeks before notice period or last-trading-month limits take effect, the MSD sends reminder letters to all traders whose positions equal or exceed those limits. As soon as the MSD identifies a speculative position or hedge exemption violation, it telephones the trader and instructs him to reduce his position within 24 hours.30
In the 1996 Review, the Division recommended that the Exchange notify non-member customers, either directly by letter to the customer, through the customer’s clearing firm, or by other means, when a customer’s behavior is inconsistent with market surveillance-related rules, such as exceeding the Exchange’s speculative position limits. In the current review, the Division found that the MSD normally notifies non-member customers, either directly or through clearing members, that their positions are approaching and/or violating position limits. However, contacts with non-members to inform them of possible Exchange rule violations have not been documented consistently. There were four speculative limit violations involving non-members that were referred to the Exchange by Commission staff.31 Three of these lacked documentation regarding the notification of the non-member. It was clear in only one instance that the non-member was contacted directly by the Exchange. In the remaining instances, there was no record of the non-member being informed of the speculative limit violation by either their clearing member or the Exchange. Documenting the notification of non-members whose behavior is inconsistent with market surveillance-related rules, such as exceeding the Exchange’s speculative limits or non-bona fide AAs, as discussed below, becomes increasingly important in cases where a non-member uses more than one clearing member or if a non-member continues to violate Exchange rules.
During the target period, Commission staff referred a total of seven possible speculative limit violations to the MSD. The MSD subsequently referred five of the seven referrals, as well as two additional potential speculative limit violations, to the Compliance Department for further investigation. The two referrals that the MSD did not refer to Compliance dealt with possible violations by non-member customers. In the first violation, a firm violated its all-month speculative limit by establishing new option positions. The MSD contacted the firm, which reduced its position that same day. In the second possible violation, a non-member clearing through several FCMs exceeded its speculative limit in the last-trading-month. One of the carrying FCMs was referred to Compliance because it apparently failed to provide the Exchange with accurate information concerning control of the trader’s accounts, thereby rendering the MSD unable to detect the apparent violation.32
Of the remaining five referrals that the MSD referred to Compliance, two involved possible position limit violations at one FCM by non-members. In of one these, the FCM notified the Exchange that a customer had violated speculative limits in the March 1998 Coffee contract and attempted to correct the situation the same day the position was established. The position was reduced the next day. Compliance did not open an investigation because “at no time did the FCM or its customer intend to violate the limit; and the size of their customer’s violation was considered relatively small.”33 In the second matter, Compliance investigated a non-member’s last-trading-month speculative limit violation in March 1998 Sugar #11 and issued a warning letter to the FCM carrying the position.
D. Against Actuals (AA) Transactions
The Compliance Department was responsible for reviewing AA transactions for most of the target period, from October 1, 1997 to July 1998. In July 1998, the MSD assumed this function, assigning one analyst solely to examine the bona fides of AA transactions. Responsibility for reviewing AAs was given to the MSD because it is more familiar with market participants who transact AAs and therefore can provide more effective and efficient surveillance of AAs.
The Compliance Department and the MSD conducted monthly reviews of AAs during the target period. The Compliance Department examined an average of ten AAs per month for the nine monthly reviews it conducted; the MSD examined an average of eight per month for its three monthly reviews. Generally, AAs are selected for review if the same clearing member and customer type indicator appear on both sides, if the price is out of line with the commodity at the time the AA was done,34 if the clearing members are executing AAs for the first time or execute them rarely, or if the number of AAs are substantially more than normally executed by the clearing member.
An investigator who is assigned an AA review requests the relevant documents and commercial contracts from the clearing firms involved. The investigator then examines the contracts to determine whether there are different parties on each side of the transaction, using information provided on copies of CFTC Form 40s, if necessary.35 In addition, the cash component of the AA is examined to verify that it approximates the size of the corresponding futures transaction. If the same non-member customer and the same clearing firm are on both sides of an AA, the MSD will refer the matter to Compliance for investigation of possible wash trades. This is because the clearing member knew or should have known that the same person was on both sides of the transaction.
The Compliance Department opened nine routine AA Reviews during the target period. One led to a warning letter, seven were closed with no action taken, and one remained open at the end of the target period. The MSD opened three routine AA reviews during the target period. All three were closed with no action taken. The Division examined all of the Exchange’s AA Compliance reviews and one of the MSD reviews for adequacy. The reviews were generally thorough and well-documented, the accounts involved had different beneficial owners or were under separate control, and there was evidence of a change in ownership of the physical commodity. The files contained cash-side documentation, including telexes and/or other communications between parties, confirmation of deliveries, and confirmation of receipt of funds for the physical commodity. The one warning letter was issued as a result of a member firm’s failure to provide customer omnibus account statements, commercial contracts and a price-fix letter.36
E. Timeliness & Adequacy of Market Surveillance Reviews/Investigations 37
During the target period, Compliance opened 18 market surveillance-related reviews/investigations. Nine involved reviews of AA transactions, three were Commission referrals, three involved reporting violations, one involved a contract expiration, and two involved speculative limit violations. Of the 18 reviews/investigations, 12 (67 percent) were completed within the four-month requirement of Commission Regulation 8.06, and one remained open at the close of the target period. Of the five (28 percent) that required more than 120 days to complete, one involved a reporting violation (open 184 days), one involved the reporting of false information (open 169 days), two involved AA transactions (open 142 and 331 days), and one involved a speculative limit violation (open 150 days).
Six reviews/investigations were opened prior to the target period and closed during the target period. Of these six, three were closed within the four-month requirement of Commission Regulation 8.06, and three required more than 120 days to complete, remaining open for 148, 169, and 175 days. Three reviews/investigations of AA transactions were initiated by the MSD. Of these three, one was completed within 120 days, one in 182 days, and one in 192 days. Investigations which were open well in excess of 120 days should have been completed in a more timely manner. The reporting and speculative limit investigations were open an excessive period of time, particularly in light of the generally straightforward nature of such investigations. With regard to AA investigations, Exchange staff explained that the AA analyst was out for a substantial period of time and no action was taken on AA matters during the analyst’s absence. The Exchange should prepare for such occurrences by cross training staff. In this manner, the absence of one specialized analyst will not impede unduly the completion of investigations.
The Division examined 16 of the 24 market surveillance-related review/investigation files and one of the three MSD AA reviews for adequacy. The reviews/investigations were generally thorough, well analyzed, and contained appropriate documents necessary to determine whether exchange rules had been violated.38
F. Conclusions and Recommendations
The Exchange maintains an adequate 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 reviews daily prices, volume, open interest, and spread relationships. Further, the Exchange regularly contacts trade sources and large market participants to keep abreast of cash market developments and delivery intentions.
The Exchange’s computerized large trader reporting system, SLIMS, is an effective tool for monitoring the positions of large traders, aggregating related accounts, and detecting potential speculative position limit or hedge exemption limit violations. In addition, MSD staff generally contacts non-members who have not been granted an exemption when they approach and/or exceed speculative limits. However, contacts with non-members to inform them of such violations have not been documented consistently. The Exchange also monitors accounts that have used their exemptions to ensure that these accounts are meeting the exemption’s terms.
Toward the end of the target period, the responsibility for monitoring AAs was transferred from the Compliance Department to the MSD. The MSD, as did the Compliance Department, conducts monthly reviews of AAs and selects unusual AAs for further investigation. The Division found that the Exchange’s market surveillance reviews and investigations, including AAs, were generally thorough, well analyzed and contained appropriate documentation. Exchange market surveillance-related investigations, however, should be completed in a more timely manner. Although a majority of investigations were completed within the four-month requirement of Commission Regulation 8.06(b), there were several investigations, including reporting and speculative limit investigations, that were open for excessive periods of time. Exchange staff explained that several AA investigations were open for lengthy periods because the analyst responsible for those investigations was out for a substantial period of time, and no action was taken on these matters during the analyst’s absence. To avoid this situation, the Exchange should improve the cross training of its staff. In this manner, the absence of one specialized analyst will not impede unduly the completion of investigations.
Based on the foregoing, the Division recommends that the Exchange:
· Improve the timeliness of its market surveillance-related investigations, and limit the impact of the absence of an analyst upon the progress of an investigation, by cross-training staff.
· Ensure that notification of all non-members who violate speculative position or hedge exemption limits is documented.
V. TRADE PRACTICE SURVEILLANCE – SECTIONS 5a(a)(8) AND 5a(b) AND COMMISSION REGULATIONS 1.51(a)(2), (4), (5) AND (6)
Section 5a(a)(8) of the Act requires each exchange to enforce all bylaws, rules, regulations and resolutions made or issued by it or by the governing board or any committee. Section 5a(b) of the Act requires each contract market to maintain and use a system to monitor trading to detect and deter violations of the contract market’s rules committed in the making of trades. Under Section 5a(b)(1), such a system must include 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; trade practice surveillance systems capable of reviewing, and used to review, trade data to detect violations committed in making trades; and floor surveillance.
In addition, Commission Regulation 1.51 has long required that each exchange use 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.
A. Compliance Staff
As part of the merger of CSCE with the New York Cotton Exchange (“NYCE”) to form the New York Board of Trade (“NYBOT”) in 1998, the self-regulatory staffs of the two exchanges were merged into one department, which is responsible for detecting, investigating, and prosecuting potential trading violations. Compliance is directed by the Vice President39 whose staff includes two Senior Managers, four Managers (one of whom also functions as a Special Investigator), 12 Investigators, and three Compliance Assistants.40
The Vice President ultimately determines whether evidence found in investigations is sufficient to support recommendations that investigations be referred to a disciplinary committee. The two Senior Managers report to the Vice President and supervise the Managers and Investigators. Senior Managers also assist the Vice President in evaluating disciplinary recommendations. The four Managers each supervise a team of three Investigators who are responsible for reviewing computerized trade surveillance reports, conducting floor surveillance, reviewing recordkeeping and audit trail practices, and investigating potential violations either detected in the course of these activities or referred by other sources, such as customers, members, and the Commission. Compliance Assistants perform primarily administrative and clerical functions.
The Division believes, for the purposes of the commitment of resources provision of Section 5a(b)(1)(E) of the Act, that the Exchange has adequate staff to develop investigations and prosecute disciplinary matters.
B. Floor Surveillance
In order to detect trading violations, Compliance staff routinely observes trading in each contract market on the open and close, at one random time during the trading day (the “float” period), and when special market conditions warrant. Once on the floor to conduct floor surveillance, a staff member typically remains to observe trading for 25 to 60 minutes, depending on market conditions.
Since the 1996 Review, the Exchange has enhanced its floor observation program.41 Each CSCE investigator has undergone intensive floor observation training, including participation in a mock trading session and a two-week floor surveillance assignment to one trading ring where, working with designated floor supervisors, he or she learned to understand the trade execution process in that ring. After this training period, each investigator rejoined the regular floor surveillance rotation schedule. The Exchange places new investigators into this training program as they are hired.42
After observing trading, staff records various information in the Exchange’s Floor Surveillance Log. In an effort to create a more legible and practical record of surveillance activities, in April 1998, Compliance staff changed the amount and type of information that is recorded in this log during the target period.43 The Division examined the Exchange’s Floor Surveillance Log to determine whether surveillance was conducted for the open, the close, and for random periods of time in the following markets each trading day: Coffee, Sugar, Cocoa, and dairy futures44 contracts and the option contracts on Coffee, Sugar, and Cocoa futures. During the period of October 1, 1997 through January 12, 1998, the Compliance Department did not record in its log any surveillance of trading in the Exchange’s dairy contracts.45 Also, during the period of October 1, 1997 through March 31, 1998, Compliance staff frequently did not record evidence of floor surveillance of its options markets.46 From April 1, 1998 through the end of the target period, however, the Exchange’s revised and improved Floor Surveillance Log reflects virtually complete coverage of all markets during all scheduled surveillance periods.47
The Exchange maintains an adequate floor surveillance program.48 Using the Floor Surveillance Log, the Division was able to confirm that during the target period investigators conducted daily floor surveillance in its three most active futures markets. The Division could not confirm the same for dairy futures and options on Coffee, Sugar, and Cocoa. Nevertheless, modifications made by the Exchange to its Floor Surveillance Log in April 1998 resulted in the recording of information that allowed the Division to confirm that virtually all scheduled surveillance was appropriately conducted during the last six months of the target period.
C. Computer-Assisted Surveillance
The Exchange uses its computerized surveillance system, the Compliance Analysis Review System (“CARS II”) as its primary means of detecting and investigating trade practice abuses. CARS II provides the Compliance staff with direct access to all data that can be used to match trades, including price change register (“time and sales”), trade register, Audit Trail System (“ATS”), and Trade Input Processing System (“TIPS”) data.49 Trade data are downloaded into the CARS II server each evening by the Exchange’s Market Information Services Department (“MIS”). Investigators can access this data, which is stored on-line for two years with tape backup, from their personal computers on the day following the trade date.
Although CARS II produces various standardized reports that isolate particular data for analysis,50 its primary function is to permit investigators to create customized reports that identify specific trading activity and to filter and sort material.51 In this regard, Compliance staff has created reports that, among other things, isolate possible instances of crosstrades involving accounts in which the executing broker or an affiliated broker has an interest and crosstrades involving accounts owned by the same principal.52
In addition to CARS II reports, Compliance staff uses a number of standardized reports provided by MIS. Each day, MIS creates the Accommodation Trading Report, which identifies possible direct and indirect trading against customer orders, the Trading Ahead Report (Broker Version), the Clearing Member Trading Ahead Report, the Broker Association Trading Ahead Report, and the Compliance Department Broker Group report.53 MIS also produces each day the Mechanical Adjustment Report, which displays instances where changes made to previously keypunched TIPS data, such as clearing member or price, produce possibly improper crosstrades or trades that are significantly different from the original transactions.
Monthly, MIS produces summaries of the data contained in its daily reports. These summary reports provide the basis for Compliance’s monthly Trading Ahead and Accommodation Trading reviews. Flagged trades from each daily report are stored in a computer file and, at month’s end, MIS prints out a report for Compliance that provides the monthly totals for each broker, clearing member, and broker association. Senior Compliance staff determines whether to open a review based upon the number of flagged trades and whether a review of the reported member is already ongoing. These procedures are essentially the same as those found to have been followed by Compliance during the 1996 Review.54
Since the 1996 Review, CSCE has developed an additional review. In response to the Division’s recommendations in its 1996 Horizontal Rule Enforcement Review of Times and Sales Procedures, the Exchange developed the Time and Sales Corrections Review to isolate price corrections made to time and sales that are not in accordance with applicable Exchange rules.55 Staff compares these corrections with data in the CARS II database and appropriate trading records to determine if: (a) the floor committee member approving the change, or one of his associated brokers, had any interest in having the correction made; (b) the broker requesting the change, or one of his associated brokers, benefited from having the correction made; or (c) the correction corresponds to the price trends existing in the market at the time.
D. Routine Reviews
Compliance conducts reviews of the various computer reports described above on a daily, monthly, quarterly, thrice-yearly, or twice-yearly basis.56 The Exchange conducts daily reviews of its Crosstrade, Mechanical Adjustment, and Unmatched Trade Reports.57 During the target period, the Exchange opened ten investigations based on review of the Crosstrade Reports and two investigations based on review of the Unmatched Trade Reports.
As described above, Compliance conducts monthly reviews of the Trading Ahead and Accommodation Trading Reports. Upon review of the monthly summary reports, senior Compliance staff determines whether a member should be investigated based on the number of Trading Ahead or Accommodation Trading exceptions in which he or she appeared during the previous month.58 Initially, the investigation involves review of the daily Trading Ahead and Accommodation Trading exception reports that contain the trade data corresponding to the exceptions indicated in the summary report. Compliance staff then selects from those reports specific trade dates for which to conduct review of original documents. This determination is based on their view of the relative strength of the exceptions. During the target period, the Exchange opened 31 investigations based on the monthly Trading Ahead reviews and one investigation based on the monthly Accommodation Trading reviews.
Each quarter, Compliance conducts reviews of spread trading, corrections made to time and sales, and the entry of members’ trading cards into TIPS. During the target period, the Exchange opened four reviews based on spread trading, two reviews based on time and sales corrections, and two reviews based on trading card entries.
Three times each year, the Exchange conducts Order Ticket Reviews and Trading Card Reviews, and two times each year the Exchange conducts ATS, Last Trading Day, and Transfer Trade reviews. During the target period, the Exchange opened three Order Ticket Reviews, three Trading Card Reviews, and two ATS Reviews. The Exchange also opened three Last Trading Day Reviews and two Transfer Trade Reviews.
E. Adequacy and Timeliness of Investigations
During the course of each investigation, investigators review CARS II and other computerized reports relating to the activity in question, obtain relevant original trading documents and account statements, and interview investigation subjects or other persons who may have relevant information.59 If, during the course of an investigation, evidence is found indicating violations other than those upon which the investigation is focused, Compliance’s stated policy is to expand the scope of the investigation to include review of those possible additional violations rather than to initiate a separate investigation.60
At the conclusion of each investigation, Compliance staff prepares an investigation report (“IR”) describing the nature, source, and findings of the investigation and stating staff’s recommendation for further action, if appropriate, or reasons for closing the investigation without taking further action.61 In the event that staff determines to present an investigation to the BCC, another version of the IR is prepared that specifically addresses the findings with respect to rule violations relevant to the particular subjects to be prosecuted before the committee.62
Ninety-nine investigations were opened during the target period, including 72 that were internally generated by the Compliance Department. Of the internally-generated investigations, 64 were initiated through review of routine computerized surveillance reports and eight were developed based on reviews of order ticket, trading card, and ATS procedures. Of the remaining 27 investigations, seven were opened based on customer complaints; two were initiated because of member complaints and/or referrals; and 18 were based on referrals from other Exchange departments. One hundred and ten investigations were closed during the target period.63 Eighteen of these resulted in the referral of members to the BCC for disciplinary action. Twenty-six investigations resulted in the issuance of Staff Warning Letters.64 Another eight investigations resulted in the referral of one or more involved members to the BCC as well as the issuance of Staff Warning Letters to one or more other members. Fifty-eight investigations were closed with no further action recommended.
The Division reviewed the adequacy of 52 of the 110 investigations closed during the target period, including all 13 of those closed investigations that involved customer complaints.65 The files reviewed included, among others, investigations of possible trading ahead, accommodation, and other noncompetitive trading that were opened based on information obtained from a variety of sources.66 The Division found that the vast majority of the Exchange’s investigations were generally thorough and contained relevant documentation that included copies of daily and monthly account statements, order tickets, trading cards, time and sales registers, correspondence, computerized exception reports, staff-prepared trade reconstruction worksheets, interview notes and transcripts, and other relevant documents. However, deficiencies were noted in several investigations, as described below.
a. Scope of Reviews and Investigations
Division staff found that the Exchange’s routine Trading Ahead and Accommodation Trading Reviews are adequate to detect instances of potential Exchange rule violations. Nevertheless, Compliance, when investigating a suspected sequence of trades indicated by an exception report, examines only trading records relating to the specific trades identified. In addition, Compliance limits its reviews to the particular days in question and to the particular trading cards used during the bracket periods on those days during which the identified trades occurred.67 The Division believes reviews could be enhanced by including involved members’ trading over a broader timeframe. Specifically, when a member’s trading records for a given day are obtained in connection with an investigation of this kind, the entire day’s records should be examined. Often, information relating to the trades in question could be found on seemingly unrelated cards.68 Such information could be crucial in providing physical evidence to support allegations of wrongdoing that otherwise may only be indicated by statistical data.
Further, the Exchange either should review the DBRs or adopt more focused automated reviews of members identified in exception reports over an increased period of time. These measures could be useful in developing a familiarity with members’ trading styles, habits, and frequent counterparties at or around the time of indicated sequences. Expanded review also could be useful in detecting additional sequences of trades that are similar to those identified in exception reports but are too small themselves to be detected by the exception reports. In addition, such extended review could reveal other anomalous trading activity that exception reports might otherwise miss and that could either contribute to a better understanding of the sequences under investigation or reveal other possibly violative trading.
b. Failure to Bring Investigations to the Business Conduct Committee
In two instances, Compliance staff did not present to the BCC investigations that, based on the Division’s review of the relevant IRs, revealed indicia of rule violations. Specifically, in Investigations 96-85 and 97-104, there was pattern evidence of possible accommodation trading.69 However, Compliance concluded that the subject trade sequences did not involve accommodation trading and did not present them to the BCC.70 Commission Regulation 8.07 requires that an exchange's enforcement staff submit a written investigation report to a disciplinary committee if, after an investigation, it determines that "a reasonable basis exists for finding a violation." The Division does not agree with Compliance’s conclusion in these two cases that this standard was not met.
Investigation 96-85 focused on members of a broker association who, based on floor observation and surveillance reports, appeared to use a local as an accommodator to cross indirectly their personal accounts with their customers’ orders. Compliance determined that the alleged accommodating local profited from seven of ten subject sequences.71 Compliance staff nevertheless concluded that nine of the ten sequences did not benefit the local, reasoning that he left eight of the sequences with “additional positions” that he held, and later offset, at risk. Compliance also concluded that the local lost money in the ninth sequence.72 Compliance’s determination that the local left many of these sequences with additional positions appeared to be based on its view that any positions held before the subject sequences were offset and then reestablished by the allegedly prearranged pairs of trades on opposite sides of the market. This, evidently, was Compliance’s view even where the round-turn trades were executed within the same minute and the local entered and exited the sequence with the same net market position.73 With respect to these sequences, Compliance reasoned that the local’s subsequent liquidation of the “additional” positions opposite uninvolved members was evidence that the positions taken from the allegedly prearranged sequences were held at risk. In none of these instances, however, did Compliance discuss in the IR the timing of the local’s subsequent liquidations and resulting profits or losses in order to support this conclusion.
Further, Compliance analyzed the benefits of prearranged trading to the accommodating local in terms of profits and losses, but it did not discuss the financial benefits of such trading to the brokers in the text of the IR. Rather, Compliance implied that the only benefit brokers could derive from indirectly crossing their personal accounts with their customers’ orders through an accommodator is to obtain fills for their customers’ orders.74 It is the Division’s view that brokers also use accommodators to make riskless personal trades opposite customer orders at prices favorable to themselves, and not merely to obtain order execution.75 Although Compliance did not discuss broker profits as a motive for accommodation trading in the text, Compliance described each sequence and, in most instances, calculated the profits made or losses incurred by the involved brokers in an appendix to the IR. Based on Compliance’s trade reconstructions, brokers in this case appeared to cross indirectly either their personal accounts or the accounts of their associates with customer orders in eight of the ten sequences, profiting from seven of them and losing money in only one sequence.76 The Division considers this to be an important fact that could contribute to a reasonable basis to find a rule violation occurred.77
Compliance’s IR for the second investigation, 97-104, did not include detailed descriptions of the ten trading sequences reviewed in that case, and so the Division was unable to scrutinize it with the same particularity as Investigation 96-85.78 Nevertheless, as in Investigation 96-85, Compliance’s rationale for not pursuing disciplinary action appeared inadequate in light of the pattern evidence upon which the investigation was based. In 97-104, Compliance investigated ten instances in which two brokers executed substantially contemporaneous offsetting pairs of trades that effected indirect crosstrades between one or the other’s personal account with his own customers' orders. Compliance concluded that the subject trades did not indicate accommodation trading because: (1) the average amount of time that could have elapsed between the offsetting trades in each sequence (2 minutes and 40 seconds) was too large to indicate accommodation trades, (2) the brokers traded with other members between the subject trades in eight sequences, (3) in three sequences the offsetting trades were of unequal sizes, and (4) the brokers were left with positions after five sequences.
Division staff does not agree that these factors alone, viewed either individually or collectively, sufficiently diminish the appearance of a pattern of prearranged or noncompetitive trades in this case. First, the stated average time difference between offsetting trades is insufficient to counter the appearance that these were noncompetitive or prearranged trades. The large time differentials that Compliance indicated could have passed between the offsetting trades represent the maximum time that could have passed between the trades, while the actual time differentials could have been much smaller. Second, the fact that intervening trades were executed within each sequence, particularly within such limited timeframes, does not indicate that the subject trades were executed competitively. Third, the unequal sizes of offsetting trades do not necessarily indicate that those trades were unrelated, but could merely reflect the splitting of profits between the involved brokers, as could the differences in prices between the offsetting trades. Finally, just as discussed above in connection with Investigation 96-85, the positions held by the brokers after each sequence could represent positions they held prior to the sequences and should not necessarily be considered in calculating profits and losses or in evaluating whether the round turn trades were meant to offset one another as a unit.
The Division also found that the IR did not contain any profit or loss calculations Compliance may have made with respect to this investigation, and notes that such information should be considered relevant in determining whether a reasonable basis exists to believe subjects engaged in accommodation trading. Specifically, if Compliance found that the subject members did not profit in some or all of the sequences, Compliance should have stated that fact in support of its conclusion. In the absence of such a relevant mitigating factor, the Division believes, based on the facts presented in Compliance’s IR, that this investigation should have been presented to the BCC.
Even if thorough investigations produce no additional supporting evidence, Compliance should, absent a finding of equally compelling exculpatory evidence, permit the BCC to decide how much weight, if any, to give trading pattern evidence that it discovers. If, on the other hand, Compliance’s investigation reveals exculpatory evidence that sufficiently counters the appearance of rule violations, it should present and discuss that evidence in its IR in support of its conclusion not to forward the investigation to the BCC. In the investigations described above, the Division believes that the body of facts, both incriminating and exculpatory, discussed in the IRs provide, on balance, adequate bases for finding rule violations occurred that should have been presented to a finder of fact.79
c. Failure to Refer Violations of the Act to the Commission
In one investigation, although Compliance concluded that an Exchange non-member firm engaged in conduct that violated the Act, the Exchange did not refer the matter to the Commission for investigation. In Investigation 97-74, Compliance conducted a review of multiple crosstrades by a particular broker association that cleared with the same clearing member firm on both sides. The investigation revealed that although the firm on both sides was the same, in all but two crosstrades the ultimate customers were different. However, in two crosstrades both sides cleared to the same customer account. Compliance found that the non-member firm placing the order for execution caused the improper crosstrade to be entered. As the Exchange has no disciplinary authority over non-member firms, Compliance staff recommended that no further action be taken and that the investigation be closed. As the Division has stated in several previous exchange rule enforcement reviews, it is an exchange’s responsibility to refer such instances to the Commission.
The Division found that the Exchange’s investigations generally were completed in a timely manner in accordance with Commission Regulation 8.06. Based on CSCE’s Compliance Case Log, the Exchange closed 110 investigations during the target period, including 36 opened prior to the target period and 74 opened during the target period. Of the 110 closed investigations, 81 (74 percent) were closed within the four month period set forth in Regulation 8.06. An additional 15 investigations (14 percent) were closed between four and six months after initiation, and another 12 investigations (11 percent) were closed between six months and one year after initiation. Two investigations were closed more than one year after initiation.80
The Exchange opened 99 investigations during the target period, of which, as stated above, 74 were closed during the target period. Of the 25 investigations opened during the target period that remained open at the end of the period, 13 had been open for four months or less, seven had been open for between four and six months, and five had been open for between six months and one year.
During the target period, the Exchange initiated seven investigations based on customer complaints and completed five of them by the close of the target period. Of the five completed investigations, three involved alleged bad fills or unfilled orders and two involved disputed prices in time and sales. Four of the completed investigations were closed in less than four months and the fifth investigation remained open for almost one year due to the failure of the subject broker to produce requested original trading records. The two customer-initiated investigations that remained open at the end of the target period had been opened for approximately four months and five months, respectively. Generally, the investigations of the customer complaints that were concluded during the target period were timely, thorough, and well documented.
The Division’s review of CSCE’s investigation files revealed that Compliance does not date its investigation reports upon completion. The Division previously noted this fact during the 1996 Review and stated that dating investigation reports would provide a more complete case record and would allow the Division to confirm that investigations are promptly closed following their completion.81 The Exchange, during that review’s exit conference, agreed to date its investigation reports upon completion.82 The Division reiterates its views regarding the usefulness of closing dates on IRs, and further recommends that senior Compliance staff sign and date IRs when they review and approve them.
F. Conclusions and Recommendations
The Division found that the Exchange generally maintains an adequate trade practice surveillance program. For the most part, the Exchange’s investigations, including those initiated in response to customer complaints, were thorough, well documented, and completed in a timely manner. Interviews of members were conducted where appropriate, investigation files contained relevant documentation, and most investigation reports complied with the content requirements of Commission Regulation 8.07.
However, Compliance determined not to refer two accommodation trading investigations to the BCC despite finding evidence that, on balance, provides a reasonable basis to believe that Exchange rules were violated. Also, in these two investigations, Compliance did not adequately discuss certain relevant facts in the IRs. In another case, the Exchange failed to report to the Commission a violation of the Act by an Exchange non-member firm over which the Exchange lacked jurisdiction. Further, the Division found that the Exchange, when conducting routine surveillance reviews, such as Trading Ahead and Accommodation Trading, should augment its program by reviewing targeted members’ trading over an expanded period of time and reviewing additional possibly relevant original documents.
Finally, the Exchange does not date its IRs upon completion, despite its previous commitment to do so. As a result, examination of an investigation case file alone does not, in many cases, reveal when an investigation was concluded.
Based on its review, the Division recommends that the Exchange:
· Present to the Business Conduct Committee for its consideration possible accommodation trading investigations in which trading pattern evidence supports the conclusion that a reasonable basis exists to find Exchange rules may have been violated, and discuss in its investigation reports its calculations of brokers’ profits and losses.
· Expand routine reviews to include examination of all relevant members’ original trading records on the day(s) that suspect trades occurred and examine the members’ trading over a period of time that is sufficient to detect patterns of trading that are similar to those identified by the surveillance review or that indicate other possible rule violations.
· Refer to the Commission all cases in which it finds that a non-member may have engaged in conduct that violated provisions of the Act or the Commission’s regulations.
· Ensure that investigation reports are signed and dated by senior Compliance staff upon completion and review.
VI. 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 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 that 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 procedures.83 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.84
B. Sanctions Imposed
The Division reviewed the Exchange's list of disciplinary actions taken, various disciplinary committee minutes, and the Regulation 9.11 disciplinary action notices received from the Exchange reflecting disciplinary actions taken during the 12-month target period.85 During that period, the Exchange took disciplinary action in 32 cases, disciplining a total of 30 different individual members and five member firms.86
Penalties imposed by the CSCE, most of which resulted from settlement agreements, included fines totaling $126,700.87 Of this fine total, $63,950 (51 percent) was issued in cases involving trade practice and/or floor trading offenses. A number of these cases also involved violations of recordkeeping provisions.88
Some of the largest sanctions were assessed in a case in which three members were charged with engaging in noncompetitive and accommodation trading amongst each other, in addition to misallocating trades and committing recordkeeping violations.89 The Exchange ultimately entered into settlement agreements with each member, assessing fines of $13,550, $10,650, and $10,000, and issuing cease and desist orders to all three.
The Division reviewed one case that it believes resulted in insufficient sanctions. The case involved two members charged with engaging in noncompetitive and accommodation trading with each other, as well as trading card submission and recordkeeping violations.90 The BCC Panel found the members guilty of accommodation trading and failure to trade by open outcry and assessed fines of $15,000 to Member A and $10,000 to Member B and issued cease and desist orders to each member. Member A was fined an additional $2500 for trade reporting and recordkeeping violations.
On appeal, the Appeals Committee found that there was insufficient evidence to support a guilty finding on the charge of failure to trade by open outcry, and only enough evidence to find the members guilty on 11 out of 13 counts of accommodation trading. Consequently, the Committee reduced the fines to $5000 each, amended the cease and desist orders, and left unchanged the $2500 fine for reporting and recordkeeping violations. The Committee's rationale was that Member B was guilty of only half of the violations found by the BCC Panel (accommodation trading but not failure to trade by open outcry), and in only 11 of the 13 trading instances. Thus, the Committee determined that his fine should be reduced by half. Since Member B was only guilty of half of the violations, and “since the Hearing Panel gave no reason why [Member A] should be fined more than [Member B] for the accommodation trading violations," Member A’s fine was reduced from $15,000 to $5,000.
In concluding that the facts found by the BCC Panel supported the determination that the members engaged in accommodation trading but did not “sustain any inference” that the trades were not made at open outcry, the Appeals Committee asserted that "[t]rading can constitute accommodation trading whether or not it is executed by open outcry."91 The Committee also stated that “even if there is sufficient evidence to sustain a finding of accommodation trading, it does not follow from that finding alone that the trading was not done at open outcry.” Furthermore, the Committee pointed to the characterization of the members’ actions as "non-competitive trading"92 to infer that such trading does not violate Floor Trading Rule 3.03(a)(i) because that rule does not refer to noncompetitive trading but, rather, requires that trading be done by open outcry. The Division does not believe that a prearranged, noncompetitive trade executed in the pit to accommodate another member could be properly described as having been executed at open outcry. Facts sufficient to establish accommodation trading, which is by definition noncompetitive, should always be sufficient to prove a failure to trade by open outcry. Open outcry trading presumes open and competitive execution of trades.93
The Division also questions the Committee’s determination to reduce the fine by half for Member B because he was “only guilty of half of the violations.” This decision suggests that the Appeals Committee believes that accommodation trading and failure to trade by open outcry warrant identical disciplinary sanctions, notwithstanding the differing larger sanctions assessed originally by the BCC Panel. The Division is also concerned with the Committee’s decision to reduce the fine assessed to Member A, the broker whose customer orders were being accommodated, to a level equal to that of Member B. It is not inappropriate to levy different fines on members who are party to the same rule violations, particularly when one of the members is a broker and the violations committed were directly related to his or her handling of customer orders.
With respect to the support for findings made in disciplinary actions, the Division reviewed another case, arising out of a customer complaint, in which the findings appeared to be supported by the evidence but the BCC Panel decided not to pursue any disciplinary action.94 In that case, a customer's sell order was filled, but the transaction subsequently was cancelled when the time and sales prints were cancelled. The broker then sold at a higher price for his personal account before refilling the order for the customer at the same (lower) price as the cancelled order, creating the appearance of trading ahead. The member was charged with violation of Floor Trading Rule 3.10(b) (executing a sale for his own account while holding an executable sell order for the same futures contract). The BCC found credible the broker's explanation that at the time of the personal trade, it was in dispute whether the lower prints of time and sales would be cancelled. Although this view appears to be supported by a review of the time and sales corrections records, the broker wrote his personal trade and the refilling customer trade over the original trades filling the order on the same trading card. It appears unlikely that he would have done this unless he already knew those trades to have been voided.
The Division also believes that the Exchange may not have adequately sanctioned one member who committed numerous rule violations during the target period. The member was disciplined three times during the target period for violations of trading or recordkeeping rules that included the following: Membership Rule 1.13(5) (conduct detrimental to the best interests of the Exchange; Disciplinary Rule 26.03) (failure to provide Information for investigations); Membership Rule 1.13(4)) (failure to furnish information or furnishing false information); Membership Rule 1.19(a) (improper supervision of employees); and Floor Trading Rule 3.03(a)(i) (failure to trade by open outcry). For these violations, he received fines of $2000, $1250, and 14,000.95 He was also issued three warning letters during the target period for recordkeeping violations.96
The member has a similar record with respect to decorum and attire offenses. During the target period, the member was suspended from membership for 15 days and ordered to cease and desist in one case,97 was fined $10,000, suspended from trading for seven days, and ordered to cease and desist in a second case98 and, as of the end of the target period, is awaiting a BCC Panel hearing on charges in yet another case.99 A member who consistently violates Exchange rules should be subject to severe disciplinary sanctions in order to deter future rule violations.
In addition to the cases discussed above, the Exchange took disciplinary action in seven other trade practice cases against nine individual members and one member firm during the target period. The fines issued in trade practice cases ranged from $250 to $13,550. The most serious offenses found to have been committed in these cases included the following: prearranged trades, wash sales, improper allocation of trades, improper execution of cross trades, failure to trade by open outcry, and trading ahead. The Exchange also issued $25,750 in fines against 11 different individual members and one member firm in cases solely involving floor recordkeeping violations.100 The largest fine issued for such violations was the $14,000 fine assessed against the recidivist member discussed above.
C. 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, 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.101 Regulation 8.09 further provides that if a disciplinary committee finds no reasonable basis for concluding that a violation occurred and directs that no further action be taken, such determination "must be in writing and contain a brief statement setting forth the reasons therefor."
Exchange staff indicated that BCC panel members generally are provided with copies of Compliance's investigation reports approximately one week prior to a BCC subcommittee meeting.102 A review of the Exchange's Litigation Log indicates that, for purposes of the prompt review of investigation reports as specified by Commission Regulation 8.09, the BCC Panel generally made a determination as to whether a rule violation may have occurred at that first meeting. In addition, the BCC Panel generally issued a proposed settlement to the subject member or member firm within one to five days of the initial meeting.
The Division also reviewed the amount of time that elapsed between the date the notice of charges was issued by a BCC Panel and the date of the disciplinary hearing. In conducting its review, the Division relied upon dates provided in the Exchange's Litigation Log. This log correctly provides hearing dates for three cases involving five members. In those matters, the length of time which elapsed between issuance of charges and a disciplinary committee hearing ranged from 103 days to 224 days, with an average time period 168 days. This represents an improvement over the findings of the 1996 Review, during which the Division found that the average span was 204 days, with the lower limit of the range at 12 days.103
During the Division’s review of the Exchange’s disciplinary procedures, several erroneous entries and omissions were noted in the Exchange’s Litigation Log.104 Specifically, the log did not reflect the final penalties in two instances.105 In addition, there were three instances where incorrect dates were entered,106 two instances of incorrect fine amounts,107 and three cases in which developments occurring two to six months prior to the end of the target period had yet to be entered into the Litigation Log.108 Finally, the disposition for one case entered in the log indicates that a hearing was held and the members were fined as a result of that hearing. In fact, the members agreed to accept settlement offers on the day before the scheduled hearing.109 The Division believes that the Exchange should take steps to ensure that information entered in the Litigation Log is complete and accurate.
D. Conclusions and Recommendations
Based upon its review, the Division found that the Exchange generally maintains an adequate disciplinary program. Disciplinary matters are promptly referred to disciplinary committees, findings in cases that proceed for further action appear to be supported by the evidence, penalties generally appear reasonable relative to the conduct being sanctioned, and disciplinary action is taken in a reasonably timely manner.
However, the Division found one case in which the findings appear to be supported by the evidence but the BCC dismissed the charges and one case that it believes resulted in insufficient sanctions on appeal. Also, based upon its review of several cases involving the same member, the Division believes that the Exchange should impose severe disciplinary sanctions upon members who consistently violate Exchange rules. Finally, some information entered in the Exchange’s Litigation Log was incomplete and/or inaccurate.
Therefore, based on the foregoing, the Division recommends that:
· The Business Conduct Committee and Appeals Committee should issue meaningful sanctions against members in all instances in which findings are supported by the evidence.
· The Exchange should take steps to ensure that information is entered into the Litigation Log in a complete, accurate, and timely manner.
1 On December 22, 1997, the memberships of the CSCE and the New York Cotton Exchange ("NYCE'') voted to merge and form the NYBOT. The merger was approved by the Commission on April 24, 1998, and initially closed on June 10, 1998. See Memorandum of the Division regarding the Proposed Merger of Coffee, Sugar and Cocoa Exchange, Inc. and New York Cotton Exchange (April 21, 1998).
2 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. These 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.
3 63 FR 71896 (December 30, 1998); 64 FR 1876 (January 12, 1999) (corrections).
4 Commission staff’s examination of the Exchange’s surveillance and disciplinary programs did not include review of individual investigation and disciplinary case files, as it does for a rule enforcement review.
5 A copy of the 1996 Review can be found in Appendix 1.
6 Transcript of November 30, 1998 interview with senior CSCE and NYBOT Compliance staff, hereinafter cited as "Transcript, p. __." The complete transcript can be found in Appendix 2.
7 Division staff reviewed all disciplinary action files for trade practice-related cases that became final during the target period. With respect to other disciplinary cases and investigations reviewed, a combination of random sampling and judgment was used by Division staff in selecting files for review.
8 See Attachment 1 for a description of market surveillance personnel responsibilities.
9 A Control Committee consists of the Exchange President and nine other persons who are not members of the Board of Managers and need not be members of the Exchange. All committee members are “from the trade;” however, they may not be “identified with the commodity” whose committee they serve. A person is identified with a commodity if he is employed or engaged in a business which produces, processes, uses or deals in the commodity, or trades the commodity on behalf of himself or any proprietary account of his firm or employer. The President is not a voting member. CSCE Rule 2.05.
10 The MSD also monitors low-volume contracts daily, such as Sugar #14 and dairy contracts, but does not maintain expiration files for them.
11 Each week, staff prepares reports for the Chief Economist that summarize the top five traders in each commodity.
12 Exchanges of futures for physicals, or “EFPs,” are referred to as AAs at the CSCE. The Exchange’s program for monitoring AAs is discussed at pp. 21-23.
13 See Attachment 2 for a brief description of SLIMS; see Appendix 3 for SLIMS Functional Specifications.
14 The CFTC Form 102 (“Identification of Special Accounts”) identifies reportable futures and option traders and includes information on account ownership and control.
15 The Compliance Department’s Investigation Log can be found in Appendix 4.
16 Exchange Rules 13.02, 13.03, and 13.05 specify position limits in terms of futures equivalent contracts for Coffee, Sugar #11, and Cocoa, respectively.
17 Applicants file for bona fide hedge exemptions, straddle/arbitrage exemptions, and swap exposure exemptions by using two forms: the “Single and Net All Months Exemption Request Form” or the “Notice Period or Last Trading Month Exemption Request Form.” Copies of these forms can be found in Appendix 5. Applicants request independently controlled positions pursuant to the directives in Rule 13.08. All exemption requests must carry the signature of an officer or partner of a member firm. A non-member cannot apply directly to the Exchange for an exemption; a member must file an application on behalf of its non-member customer.
18 The MSD prepares a summary which includes the firm’s relevant futures and options positions, open interest, the firm’s delivery intentions (if any), and the MSD’s recommendation.
19 The MSD maintains an Exemption Log that shows, for all exemptions requested, the applicant, commodity, type of exemption, date granted, and limits requested and granted. The MSD also has a computerized file, the “Hedge Exemption File Listing,” which lists by commodity each firm that has been granted a single month and/or an all-net month exemption. This file includes applicant, exemption type, date granted, and size of long and/or short limit. A sample Exemption Log and Hedge Exemption File Listing can be found in Appendix 5.
20 In carrying-charge markets, deliverable stocks are usually adequate and prices are higher for successive expiration months. Traders may request cash-and-carry exemptions when the spread between the expiring contract and next delivery month exceeds carrying charges (primarily storage, interest, and insurance). Thus, a trader who has purchased the near month and sold the deferred month may profit by taking delivery and redelivering the next month.
21 The application for this type of exemption states that the applicant must “provide the minimum spread (points) at which the firm will enter into a straddle position and which would result in an economic profit for the firm.” The application, as well as the letter granting the exemption, also notes that all long positions in the nearest futures month must be liquidated before the nearest futures month is at a premium to the deferred month. When the spread between the two futures is close to zero, the MSD contacts accounts with cash-and-carry exemptions to remind them that positions in the near month must be liquidated before the near month is more expensive than the deferred month.
22 If current long positions were put on before the exemption was granted at a wider spread, those positions must be liquidated and reestablished at least at the cost of carry.
23 See 1996 Review, pp. 16-17.
24 The Exchange granted six cash-and-carry exemptions for three Cocoa notice periods during the target period.
25 The application notes that if the exemption is granted, all positions in the nearest futures month must be liquidated before first notice day of the expiring Coffee or Cocoa contract and before the first day of the spot month of the expiring Sugar #11 contract. The MSD may grant swap exposure exemptions for up to two times the speculative position limit; however, traders who are granted these exemptions typically do not hold such large positions. Pursuant to the Division’s recommendation in the 1996 Review, the Exchange has added procedures for reviewing hedge exemption requests for swap exposure to its MS Manual.
26 In this regard, the Market Surveillance Manual states, “staff is guided by the Board of Managers’ view that such vehicles should be allowed a position limit that is a multiple of the speculative position limit, based on the number of independent account controllers trading the account.” The MSD treats the addition or departure of a controller as an event that requires reevaluation of position limits. Appendix 5 contains an example of an exemption requested and granted for an account that is commonly owned but independently controlled.
27 Occasionally, the Vice President/Chief Economist or the President may grant provisional exemptions. For example, a trader whose position is approaching or exceeds current limits may request an exemption or an expansion of limits by telephoning one of the persons listed above and orally providing all information set forth in the relevant exemption form. If the exemption is granted, the applicant must provide supporting documentation within 24 hours of the verbal request.
28 Appendix 5 contains selected letters in which applicants request and the Exchange grants hedge exemption renewals.
29 In order to calculate futures-equivalent positions, SLIMS combines accounts’ daily futures positions with accounts’ option positions as of each Tuesday on a delta-adjusted basis. Deltas used to adjust accounts’ positions are updated daily.
30 If a trader violated his position limit due to unforeseen increases in his bona fide hedging needs, the MSD does not consider this a violation provided that: (1) the trader files an exemption request within five business days of the date the limit was exceeded; and (2) the Exchange grants the exemption.
31 The MSD refers the member firm carrying the account that has exceeded the speculative limit or exempted level to the Compliance Department for investigation and possible disciplinary action. The Exchange has determined that it does not have jurisdiction over non-member customers and therefore lacks the authority to send warning letters regarding position limit violations to such customers. The four Commission referrals (97-CSCE-3; 98-CSCE-1; 98-CSCE-2; and 98-CSCE-6) were combined by the Exchange into two investigations: 98-17 and 98-65.
32 The Exchange took no action in this matter after finding that the trader’s accounts were not aggregated due to a reporting misunderstanding and the position limit violation was relatively small. Refer to Compliance Investigation 98-65 in Appendix 4.
33 See Exchange response to CFTC referral 98-CSCE-2 in Appendix 4.
34Pursuant to CSCE Rule 3.06, Cocoa AAs must be transacted at the current market price during the trading session; Coffee and Sugar AAs do not have to be done at the current market price.
35 Form 40 (“Statement of Reporting Trader”) must be filed with the CFTC by reportable traders pursuant to the terms set forth in Regulation 18.04 under the Act. The report contains account identifying information.
36 See Compliance Investigation, number 98-33, in Appendix 4.
37 Compliance initiates a “review” without any evidence or suspicion that an Exchange rule has been violated. A review is a “spot-check” for potential violations. Numerous market participants and transactions may be examined. Compliance opens an “investigation” when it appears that a member or other person within the Exchange’s jurisdiction has violated Exchange rules, either as a result of a review or other source.
38 Copies of the investigation reports from files examined by the Division may be found at Appendix 4.
39 The position of Vice President was occupied by two persons during the target period. The current Vice President has served in this position since July 1998, when the compliance departments of CSCE and NYCE were combined. Prior to that time, he served as Vice President of Compliance at NYCE and has a total of over 17 years of compliance experience. The former Vice President of Compliance for CSCE served in that position from June 1994 through June 1998, and has over 20 years of compliance experience. A description of the functions, responsibilities, and experience of Compliance personnel as of the end of the target period can be found in Appendix 6.
40 During the target period, Compliance experienced a period of high employee turnover. As a result, six Investigator positions were vacant at the time of the Division’s on-site visit pending responses from candidates to whom offers of employment had been made. Five of the six positions were filled by January 1999. Also, after the target period, the Exchange hired an additional Senior Manager of Special Investigations.
41 During the 1996 Review, the Division found that although investigators conducted daily surveillance, they failed to record regularly all periods of surveillance scheduled for all trading rings. Specifically, investigators were not required to record surveillance of the dairy markets or surveillance conducted during float periods, a procedure the Division recommended that the Exchange modify. The sample log sheets examined by the Division during the current review indicated that, during the target period, the Exchange gradually improved its performance in this area by, among other things, redesigning its Floor Surveillance Log. Copies of the sample floor surveillance log sheets may be found in Appendix 7.
42 Transcript, pp. 86-87.
43 From the beginning of the target period through March 31, 1998, the Exchange included in its log: (1) names of staff members conducting surveillance, (2) the date, (3) the time surveillance began and ended, (4) the market observed, and (5) the price quote spread for the various futures months and option series traded. Since April 1, 1998, through the end of the target period, the Exchange has used a revised log format that includes general remarks by staff regarding notable events rather than pricing data and causes a new page to be used to record log entries for each day.
44 The Exchange’s dairy markets, which trade in the afternoon and include cheddar cheese, non-fat dry milk, and milk, typically are low-volume markets.
45 Surveillance of the dairy markets was not noted on any of the 23 trading days reflected in the log for the month of October 1997, and is noted on only 12 of the 19 trading days reflected in the log for February 1998. On 4 of the 12 days in February 1998 for which dairy surveillance was noted in the log, one or more of the surveillance periods either were missed or not recorded.
46 Surveillance of the Exchange’s options markets was noted on only 10 of the 19 trading days reflected in the log for October 1997, and on all but one of those 10 days at least one surveillance period either was missed or not recorded. The February 1998 log indicates options market floor surveillance was conducted on all 19 trading days, however, one or more surveillance periods either were missed or not recorded on 11 of these days.
47 A comprehensive review of the Exchange’s May 1998 Floor Surveillance Log indicated only the following deficiencies during the course of that month’s 20 trading days: (1) one surveillance period in Cocoa futures was either missed or not recorded on three days, (2) no options surveillance was recorded on one day, and (3) one surveillance period was missed in Coffee futures and in the dairy ring on one day. A review of the subsequent months’ log sheets indicated that this relatively high level of coverage was consistently maintained throughout the remainder of the target period.
48 During the target period one case was opened as a result of floor surveillance. This case remained open as of the end of the target period.
49 ATS is the Exchange’s automated trade time reconstruction system. It uses trade and sequencing data entered by both buyers and sellers (or their clerks) for customer and proprietary trades, including trading card and line order entry sequence numbers, manually recorded execution times, time and sales data, and bracket period codes to impute trade execution times. TIPS is the system into which members input trade data for matching and clearing. For a more detailed description of TIPS and ATS, see 1996 Review, Attachments C and D, respectively.
50 These standardized reports include the Extended Trade Review, Trading Card Review, Daily Broker Recap (“DBR”), and Time and Price Function. While some of these reports were originally designed to ease the transition to CARS II from CARS I, the Exchange’s previous, less versatile automated trade surveillance system, investigators continue to use them as needed during the course of investigations. The DBR lists, for each broker, the details of all trades executed on a given day. Descriptions of the other reports as well as samples of all of these reports are included in Appendix 8.
51 For example, an investigator can design a report displaying all trading between two brokers for a selected date. To narrow further the focus of the report, the investigator then can filter the data to view only those trades executed during a chosen time period and sort the data to arrange the trades in a particular fashion, such as by price.
52 These reports include the Unmatched Trade Review, Broker/CTI Review, Broker/Opposite Broker CTI Review, Member/CTI Review, Time and Sales Insert/Customer Complaint Review, and the Straddle Report. A description of each of these reports as well as samples of these reports are included in Appendix 9.
53 Appendix 10 contains a detailed explanation of how MIS processes the trading ahead and accommodation trading programs and a detailed explanation of the MIS summary reports. Samples of the MIS summary reports also can be found in Appendix 10.
54 During the 1996 Review, the Division noted that the frequency of Accommodation Trading reviews had been increased from quarterly to monthly, and the frequency of Trading Ahead reviews had been increased from bi-monthly to monthly in response to a recommendation made by the Division during its 1993 rule enforcement review. See 1996 Review, pp. 52-53.
55Compliance staff examines corrections that: (1) exceed the time permitted for price corrections, (2) were made by the floor committee member who approved the greatest number of corrections in a given time period, (3) were requested by the broker asking for the greatest number of corrections in a given time period, or (4) involved the high or low at the time the correction was made.
56 Most reviews consist simply of examining the computer-generated exception reports described above and do not result in the initiation of investigations.
57 These routine reviews are structured such that reports for each day are reviewed, but on a weekly basis. Each investigator is assigned, on a rotating basis, one type of review each week. See Transcript, pp. 138-140.
58 An investigation is not necessarily opened every month as a result of the Trading Ahead and other reviews. Should senior Compliance staff determine that the summary report for a given month contains insufficient indicia of patterns or significant individual instances of potential violations, the review would be terminated and no investigation would be opened.
59 As noted in the 1996 Review, CSCE tapes all interviews. These tapes are transcribed only in those cases where statements made during an interview are relied upon in taking disciplinary action. Transcript, pp. 182-183.
60 Transcript, pp. 145-152.
61 Commission Regulation 8.07 requires, among other things, that IRs contain the reason the investigation was initiated, a summary of the complaint, if any, the relevant facts, the enforcement staff’s conclusions, and a recommendation as to whether a disciplinary committee should proceed with the matter.
62 Investigations are recorded in the Exchange’s Compliance Case Log. The log, included in Appendix 4, contains such information as case number, investigator assigned, date opened, dated closed, total days open, whether the investigation focused on individual members or member firms, investigation type, investigation source, and disposition.
63 Many of the 110 closed investigations involved multiple parties.
64 The Exchange issues two types of warning letters. Staff Warning Letters are issued by Compliance and require ratification by the BCC. BCC Warning Letters are issued by the BCC.
65 The Division also obtained the investigation reports for all 110 closed investigations. Additionally, Division staff reviewed 11 investigation files that were closed prior to the target period because these files corresponded to disciplinary cases that became final actions during the target period.
66 Division staff selected a sample of investigations that included a variety of subject matter and Compliance recommendations and comprised a representative sample.
67 Transcript, pp. 121-122.
68 For example, information relating to disclosed orders or prearranged trades may be noted in margins of other cards as reminders of positions to be offset, or quantities and prices of other, seemingly unrelated, trades could be altered in connection with suspect trades.
69 Accommodation trading is a practice whereby a broker enters into a set of two or more wholly or partially offsetting trades opposite another broker or trader, known in such cases as an "accommodator," where one or more trades involve the execution of the broker's customer orders opposite the accommodator's personal account, and the offsetting trade or trades involve both members' personal accounts. The net result of such trade sets is the indirect crossing of the broker's personal account with his customers' orders. Accommodation trading is considered noncompetitive because, although the offsetting trades may be recorded as occurring at different times, they are considered to have been executed contingent upon one another and therefore prearranged. Prearrangement of trades is inconsistent with Commission Regulation 1.38(a), which requires that all trades "shall be executed openly and competitively by open outcry . . . or by other equally open and competitive methods, in the trading pit or ring[.]"
Pattern evidence indicating this form of prearranged or noncompetitive trading is based on factors that include the timing and quantities of, common parties to, and profits derived from sequences of offsetting trades and the number and frequency of such sequences among a given set of exchange members.
70 A variety of recordkeeping violations were found to have been committed by members involved in Investigation 96-85, that Compliance did refer to the BCC for further action. A copy of the IR for this investigation can be found in Appendix 4.
71 With respect to the three remaining sequences, Compliance found that the local neither profited nor lost money in two sequences and lost money in one sequence.
Compliance used the First-In-First-Out (“FIFO”) method to calculate these profits and losses. FIFO involves calculating a member’s profit or loss from a subject trade by offsetting it against the earliest trade the member executed on the opposite side of the market that created a position which remained open at the time of the subject trade’s execution. Alternatively, if the member had no open positions, the subject trade would be offset by the next trade he or she executed on the opposite side of the market.
The Division believes that FIFO is not, in all circumstances, the most appropriate method for calculating profits and losses from alleged prearranged and noncompetitive trading sequences. Use of FIFO could cause an otherwise profitable sequence of two offsetting prearranged trades to be separately evaluated as one unprofitable trade (based on earlier positions), and another trade that resulted in an open position. Parties frequently “trade around” established positions and exit such prearranged trading sequences with the exact same market positions they had initially. When a broker engages in a sequence of offsetting prearranged trades, he or she generally considers the value of those trades vis-à-vis one another.
The Division believes, therefore, that to the extent possible, profits and losses from trades that are part of a suspected prearranged or noncompetitive sequence first should be calculated by considering the trades as offsetting one another. FIFO could then properly be applied to any remaining positions.
72Compliance acknowledged that the local profited from the one remaining sequence without incurring additional at-risk positions. However, as indicated below, the Division disagrees with Compliance that this was the only profitable sequence in this case.
73 The Division’s review of this case revealed that five of the ten round turns were timed as executed within one minute and another three were executed within two minutes. Of these eight sequences, five were comprised of equal sized buy and sell trades. Of the remaining two sequences, one consisted of two equal sized round-turn trade pairs completed within two minutes and fifteen seconds. It was this one sequence that Compliance acknowledged as being entirely beneficial to the local, although in the Division’s view it appears indistinguishable from the five other offsetting round-turn sequences. In the remaining sequence, trade times could not be established because no time and sales prints of the relevant trade prices existed for the bracket period indicated on the members’ cards.
74 Compliance stated in the IR that it “could not define a pattern of trading in which [the local] frequently took the other side of [the broker association]’s customer orders, so that the . . . brokers got their customer orders executed, and then received a reciprocal trade from the . . . brokers in order for [the local] to profit or incur no risk.”
75 Typically, a broker profits from indirect crosstrades at the expense of his customer by either trading ahead of an order, or increasing the size of a previously executed trade with an accommodator, on the same side of the market as an executable customer order and then engaging in two wholly or partially offsetting trades with an accommodator indirectly crossing the broker’s personal account with all or part of the customer order. In completing such a sequence, the broker profits from the difference in prices between his first personal trade and his offsetting personal trade indirectly filling the customer order. Often, but not always, the accommodator profits from small agreed upon price differences among the offsetting prearranged trades.
76 Compliance used FIFO and the brokers’ P&S statements to make these profit calculations and therefore, as with the local’s profits, based them in part on prior and subsequent trades without noting either the timeframe or opposite party to those trades.
77 In another Investigation (95-40) that was completed prior to the target period but became a final disciplinary action during the target period, accommodation trading was found where two affiliated brokers used an accommodating local to trade their own accounts indirectly opposite their customer orders. In that case, broker profits were referenced briefly in the text of the IR, but were not discussed as a substantive factor in concluding that the violations occurred. Only in three of eight sequence reconstructions, included as an appendix to the IR, did Compliance discuss broker profits. In two of the reconstructions, the brokers appeared to offset their positions gained from indirect crosstrades via straddle trades that involved the same delivery month as a component. In one of the two instances, Compliance determined that no profit was made because the prices assigned to the legs of the straddle caused the relevant leg to be offset by the outright trade done noncompetitively at the same price. In this way, the broker may simply have disguised his profit by switching his improperly gained position into another delivery month. In neither of these two sequences was the eventual liquidation of the spread trade’s other leg discussed.
78 A copy of the IR for Investigation 97-104 is included in Appendix 4.
79 At the Division’s exit conference with CSCE staff for this Review, Compliance presented various facts that were found during these investigations that were not discussed specifically in the IRs. While these facts would have added some support for Compliance’s conclusions, the Division does not believe that those additional facts ultimately defeat all reasonable bases for finding rule violations in these investigations.
80 Investigations 96-85 and 96-132 were open for 526 days and 349 days, respectively. Investigation 96-85 focused on six members involved in multiple complex fact patterns that required extensive analysis. Investigation 96-132 concerned the unauthorized delivery of physical commodities and involved examination of parties, witnesses, and records of types not typically involved in Exchange trade practice investigations. The Division believes the complexity of these investigations reasonably justifies the extraordinary length of time over which they were conducted.
81 Currently, the dates investigations were closed can consistently be found only in CSCE’s Compliance Case Log.
82 See 1996 Review, p. 58, n. 92.
83 Contract Market Rule Enforcement Program Guideline No. 2, 1 Comm. Fut. Rep. (CCH) ¶ 6430 (May 13, 1975).
84 CSCE’s primary disciplinary committee, the BCC, is composed of two subcommittees that sit alternately for probable cause hearings, ratifications, and formal hearings. Decisions appealed from the BCC are heard by the Appeals Committee. A description of CSCE's disciplinary committees and procedures can be found in Attachment 6.
85 Division staff reviewed the investigation files for all trade practice investigations resulting in disciplinary action that became final during the target period.
86 Three members were disciplined twice and one member was disciplined five times. These numbers include two members who were disciplined in three cases for decorum and attire violations.
87 This total includes a $10,000 fine levied as a result of decorum and attire offenses. Decorum and attire violations also resulted in three suspensions from membership of varying lengths, totaling 92 days. The fine total does not include a total of $1837 in customer restitution ordered in five cases in which the Exchange determined that customers were harmed.
88 On the day before the beginning of the target period, a disciplinary action in which two members were each fined $32,000 and suspended for 90 days became final. If these fines were included in the totals for the target period, the total fine amount would be $190,700, of which $127,950 (67 percent) was issued in cases involving trade practice offenses. These totals are comparable to those found by the Division in the 1996 Review: fines totaling $178,775, of which $118,200 (66 percent) was issued in cases involving trade practice and/or floor trading offenses.
89 95-40. The members were charged with violating Floor Trading Rule 3.03(a)(i) (failure to trade by open outcry) and Membership Rule 1.13(11) (wash sale, accommodation trade, fictitious sale, or prearranged trade), as well as recordkeeping and other rules.
90 95-97. These members also were charged with violating Floor Trading Rule 3.03(a)(i) and Membership Rule 1.13(11), as well as recordkeeping and other rules.
91 For a detailed definition of accommodation trading, see note 69, infra.
92 The Notice of Charges alleged that the respondents violated Floor Trading Rule 3.03(a)(i) by engaging in noncompetitive trading.
93 See The CFTC Glossary: A Layman's Guide to the Language of the Futures Industry, at 1 (CFTC Jan. 1997). ("Accommodation Trading: Noncompetitive trading entered into by a trader, usually to assist another with illegal trades."). This definition is often cited in opinions. See, e.g., In the Matter of Solomon Mayer, 1998 WL 39411, *31 at fn12; In the Matter of Joel J. Fetchenhier, 1997 WL 232135, *13 at fn12; Sundheimer v. CFTC, 688 F.2d 150, 152 (2d Cir. 1982).
95 97-47/97-72; 97-60A; 97-105/97-110/98-09. He was also disciplined once prior to the target period for trade practice offenses. On February 27, 1995, the member was fined $800 as part of a settlement agreement with respect to charges that included improper allocation of trades, failure to report a trade, and recordkeeping violations.
96 Two of the warning letters were issued by Compliance and one was issued by the BCC.
97 HR 1.
100 Three members were fined twice.
101 A notice of charges is the equivalent of the Exchange's complaint and states the alleged conduct the member committed, the corresponding rule violation, any predetermined penalty, and the member's rights with respect to a hearing. Commission Regulation 8.11.
102 Transcript, p.192.
103 In that review, two primary sources for the elapsed time were identified: Compliance staff was occupied with conducting Commission-directed audit trail testing and the Exchange had an ongoing difficulty in convening a hearing panel to hear a particular case. In order to remedy the latter problem, the Exchange restructured its disciplinary committees. See Attachment 3.
104 A copy of the Litigation Log can be found in Appendix 11. A copy of the BCC Log, which reflects actions taken with respect to cases heard by the BCC, also can be found in Appendix 11.
105 95-96, which involved the recidivist member discussed above and 95-97, which involved an appeal.
10696-85, 97-106, and 97-108.
10795-13. Two members were disciplined in this case. The Litigation Log reflects that each member was fined $62,000 when the actual amount of the fine was $32,000 each.
108 97-96, 97-105/97-110, and 98-38.