TO: The Commission
FROM: The Division of Trading and Markets
RE: FutureCom, LTD. Proposed Application for Designation as a Contract Market for Automated Trading over the Internet of Cash-Settled Live Cattle Futures and Options Contracts.
RECOMMENDATION: That the Commission approve the proposed designation application of FutureCom, LTD. and proposed Bylaw Sections 1.1-1.27; 2.1-2.7; 3.1-3.4; 4.1-4.16; 5.1-5.6; 6.1-6.16; and 7.1-7.2 and issue the attached Order designating FutureCom, LTD. as a contract market for automated trading over the internet of cash-settled live cattle futures and options contracts
CONSULTED: Division of Economic Analysis
Office of General Counsel
Division of Enforcement
Office of the Executive Director
STAFF CONTACT: Lois J. Gregory (x5483)
Table of Contents
II. PROCEDURAL HISTORY
B. Financial and Other Requirements
C. System Entry
E. FutureCom Account Agreement
1. General Legal Provisions
2. Clearing and Fees Consent
3. Margin, Default and Liquidation
4. Position Limits
5. Electronic Services
6. Limitation of Liability
VI. ORDER ENTRY AND EXECUTION
VII. CLEARING AND SETTLEMENT
VIII. COMPLIANCE AND SURVEILLANCE
IX. EMERGENCY PROCEDURES
X. SYSTEM SECURITY, VULNERABILITY AND OPERATIONAL ISSUES
XI. PUBLIC COMMENTS ON THE PROPOSAL
By letters and submissions dated January 17, 1997 through February 2, 2000, FutureCom, LTD. (“FutureCom”), a Texas Limited Partnership, submitted an application to the Commission pursuant to Section 6 of the Commodity Exchange Act (“Act”) for designation as a contract market in cash-settled live cattle futures and options contracts, along with proposed Bylaw Sections 1.1-1.27, 2.1-2.7, 3.1-3.4, 4.1-4.16, 5.1-5.6, 6.1-6.16, and 7.1-7.2.
FutureCom has not been designated previously as a contract market for any contract and would be an entirely new exchange. FutureCom would be unique among currently operating contract markets in four primary ways. First, it would be the first internet-based contract market. Second, it would not be a member-owned exchange, but would be operated by its owner-developers with the objective of earning a profit.1 Third, every FutureCom member would also be a clearing member. Although members and non-members could be authorized to place orders on the system on behalf of members, they would not be holding margin funds for those trades.2 All FutureCom members’ funds would be held in one separately and specially titled pooled account at the clearing bank.3 Fourth, FutureCom would require initial margin to support any new position of any member to be on deposit with the clearing bank before the order could be accepted by the computer system for execution.
II. Procedural History
The Commission published a Federal Register notice requesting comments on the proposed application on January 31, 1997 (62 FR 4730), and again on November 24, 1997 (62 FR 62566). Both comment periods were for sixty days.4 A total of thirty comment letters were received in response to both notices. Twenty-four of them were supportive and six of them were non-supportive.
The one-year statutory time period for consideration of FutureCom’s application has been stayed on three separate occasions because FutureCom’s application lacked sufficient information for evaluation by Commission staff. Stays were lifted upon the applicant providing information staff needed to continue in its evaluation of the application. A stay imposed on April 15, 1997 was lifted on May 13, 1997 and a stay imposed on June 20, 1997 was lifted on November 18, 1997. The last stay, imposed on March 23, 1998, was lifted by letter dated January 19, 2000. Commission staff has conducted two-on site visits to FutureCom headquarters in Amarillo, Texas as part of its review of the FutureCom application.
As proposed, FutureCom would be an automated exchange that would operate entirely over the internet through member connection via either FutureCom’s secure server or electronic mail communication. Trading hours would be from 9:00 a.m. to 1:00 p.m., Central Standard Time (“CST”), Monday through Friday (except for national bank holidays). The Exchange would be governed by a ten-member Board of Directors, two of whom would be public directors, and all of whom would be appointed by FutureCom’s developer. FutureCom would be operated initially by a staff of ten persons each of whom would be responsible for certain aspects of Exchange operations, support, and service.
To be accepted as a member, an individual or organization would have to apply to FutureCom and meet strict creditworthiness and other standards. Based on the financial information in each application, a member would be assigned to one of five membership levels which would, in turn, dictate its specific margin requirements and position limits.
Upon accessing FutureCom’s website, approved members would have to enter a password and ID number in order to connect with FutureCom’s secure server. Orders that were entered into the system would be matched in accordance with FutureCom’s pre-established trade-matching algorithm by a computer-run program. FutureCom would transmit trade confirmations, variation margin calls, and other communications to its members by electronic mail. FutureCom contends that since human intervention into ongoing operations would be minimal, the system would generate a superior audit trail which would be used in implementing the Exchange’s trade practice and other surveillance programs. FutureCom has contracted to have the National Futures Association (“NFA”) perform financial surveillance and other audit functions on behalf of the Exchange with respect to its members who are Commission registrants.
Trading and clearing would be integrated and highly automated. FutureCom’s clearing operations would take place through its clearing bank, the First National Bank of Amarillo, Texas. No member could establish a new position unless it had sufficient initial margin in its FutureCom account at the clearing bank. Each trading day, after the Exchange closed, the FutureCom system would automatically mark-to-market all open positions and send to the clearing bank the various collections and payments made on behalf of, and the resulting balances in, each member’s account. FutureCom staff would monitor account balances during the trading day and make intra-day margin calls as deemed necessary. All the members’ accounts together would comprise FutureCom’s pooled account at the clearing bank. FutureCom would not deposit any funds into that account, nor would it be used for payment of FutureCom’s operating expenses.
Margin calls would be issued automatically to each member by electronic mail. The clearing bank would initiate the transfer of funds from members’ personal bank accounts to the FutureCom pooled account at the clearing bank. All of the information required to be sent and received throughout the clearing process would be done by the system with little or no human intervention. If a member did not meet a margin call, the system would recognize the deficiency and automatically alert FutureCom staff. FutureCom staff would liquidate all the positions in the defaulted account at the beginning of the next trading session in a manner which minimized losses in the account.
Members of the public responding to the Commission’s request for comment stated, among other things, that FutureCom would provide a much-needed additional futures contract to the industry and that an internet-based exchange would provide advantages for traders that other exchanges could not provide, such as low cost execution, real-time account information, and easy accessibility. Critical commenters expressed, among other things, a high degree of concern over certain issues regarding the use of the internet as a basis for trading futures and the capacity of FutureCom to perform the clearing function and carry out adequate trade practice and other surveillance programs.
This Memorandum also discusses the mechanics of the clearing system; the financial safeguards underpinning the operations of the Exchange; the proposed trade practice, market and financial surveillance programs of FutureCom; the governance structure of the Exchange; the conditions for access to the Exchange; the manner in which orders would be executed; the system’s security, vulnerability, and capacity; and other operational issues.
The Division of Economic Analysis will discuss the terms and conditions and the economic justification for the proposed cash-settled live cattle futures and option contracts in a separate Memorandum to the Commission.
Accompanying the Memoranda are two Orders which the Commission would issue in designating FutureCom as a contract market in cash-settled live cattle futures contracts and in option contracts on those futures contracts. These Orders contain the conditions FutureCom must meet to become designated, to remain designated, and to begin operations.
B. Applicability of Commodity Exchange Act and Commission Regulations
FutureCom would be both a contract market and self-regulatory organization and would be subject to the regulatory framework that applies to contract markets under the Act. The regulatory provisions that apply to exchanges in their capacity as contract markets include those governing the handling and treatment of customer funds, records of orders and executions, maintenance of a program for enforcing rules, disciplinary procedures, position limits, trading standards, registration of broker associations, and arbitration.
Provisions that apply to exchanges as self-regulatory organizations include those pertaining to minimum financial requirements for certain members, use of material non-public information, and eligibility for and composition of the governing board and major disciplinary committees.
Due to the automated nature and structure of FutureCom and its attendant lack of a physical trading floor, a number of the regulatory provisions that would otherwise apply to contract markets do not apply to FutureCom. For example, the requirement of Commission Regulation 1.35(f) that each contract market provide for the identification of floor brokers, traders, and clearing members by use of a distinctive, non-variable designation for each is not applicable to FutureCom. The Exchange would not have to comply with this requirement as it would not have a trading floor upon which FutureCom members would congregate. In addition, all members would be clearing members.
In discussing the various aspects of the proposed operations of FutureCom, this Memorandum will assess how FutureCom would be able to operate in a manner consistent with the Act and the Commission’s regulations and would otherwise meet all the requirements to be designated as a contract market. Attached to this Memorandum as Appendix A is a chart which specifically cites how FutureCom would address each provision of the Commission's regulations that applies to contract markets. For those provisions of the regulations requiring FutureCom to take or not take certain steps or procedures, FutureCom has submitted in each instance an affirmative representation.
A. Structure and Ownership of FutureCom
FutureCom is a Texas limited partnership.5
REDACTED MATERIAL SUBJECT TO CONFIDENTIAL TREATMENT
Unlike currently operating exchanges, FutureCom would not be owned by its members. Neither the Act nor the Commission’s regulations, however, mandate any particular form of organization for a futures exchange. Division staff has analyzed FutureCom’s ownership structure, the relationships within that structure, and possibilities of abuse of power or information that would be inconsistent with the Act or the Commission’s regulations. In order to address this situation, FutureCom represents that neither Texas Beef nor any of the partners that own Texas Beef will become members of FutureCom or otherwise trade on the Exchange. If Texas Beef or its partners later determined to become members of the Exchange, they would do so only in accordance with procedures that had been submitted to the Commission for review.6 FutureCom also would have rules governing members who possess material, non-public information. These rules would meet the requirements of Commission Regulation 1.59.7
B. The Board of Directors
The affairs of FutureCom would be managed by its Board of Directors which would also oversee the business conduct of its members. FutureCom Bylaw 1.1 authorizes the FutureCom Board to establish classifications of membership and the qualifications that an applicant must meet. The Board also is authorized to amend the Bylaws and to adopt other rules and interpretations that are deemed necessary or appropriate.
The Bylaws provide that there will be no fewer than nine nor more than thirteen members of the Board. FutureCom anticipates that its initial Board will consist of ten members. The directors of the Board will be appointed by the General Partner of all of the Texas Beef Group of integrated companies to serve for a term of one year or until the director’s successor has been appointed, whichever occurs later.8
Although the FutureCom Board of Directors will be chosen by FutureCom’s general partner, FutureCom represents that the members of the Board would be expected to exercise the same independent judgment that members of any Board of Directors are expected to exercise. Pursuant to FutureCom Bylaw 1.10, directors may only be removed for cause. Moreover, as required by Section 5a(a)(14)(B) of the Act and Commission Regulation 1.64, at least 20% of the members of the Board of Directors would be public representatives. Although the governing structure and organization of FutureCom is very similar to that of other exchanges, FutureCom points out that it would not, in contrast to other exchanges, be member-owned. It would be owned by its developers and operated for the objective of making a profit for its owners.9 Any rule change adopted by the Board of Directors would, of course, would be subject to review by the Commission.
Commission regulations under the Act set forth requirements regarding service on, and composition of, the governing board of a self-regulatory organization. For instance, Regulation 1.63 requires an exchange to prohibit persons from serving on its governing body if they have, among other things, been found guilty of a disciplinary offense within the last three years, been suspended from trading on any contract market, had their registration revoked within the past three years, or been suspended from serving on a governing board under federal securities laws. FutureCom Bylaw Section 1.2(c) would satisfy this regulation by requiring that no individual may serve on the Board of Directors if he or she is subject to any disqualification under Commission Regulation 1.63(b).
Commission Regulation 1.64 requires each exchange to maintain in effect standards and procedures with respect to the composition of its governing board. These standards must ensure that 20% or more of the regular voting members of the Board are persons who are knowledgeable about futures trading and, among other things, are not members or employees of the exchange. At least ten percent of the Board must be comprised of persons representing farmers, producers, merchants, or exporters of commodities. The Board must also represent a diversity of the membership interests at the exchange.
FutureCom Bylaw 1.2(b) meets this requirement by mandating that at least 20% of the members of the Board be “public directors.” FutureCom represents that at least 10% of the Board members will be farmers or beef producers or exporters. As required by subsection (d) of Regulation 1.64, FutureCom, within 30 days following the date the individuals have been appointed to the Board, will submit to the Commission a list of the Board members, the membership interests they represent, and a description of how the members meet the compositional requirements of Regulation 1.64.
The Board would have regular and special meetings preceded by notice to the directors, although the Board could also take action without a meeting by electronic mail consent of all the directors. At any meeting at which a quorum was present,10 the act of a majority of the directors present would be an act of the Board. In the event of an emergency, as defined in FutureCom Bylaw 1.9, the Board may, upon a vote of two-thirds of its members at a meeting at which a quorum was present, place a temporary emergency rule into immediate effect, without prior Commission approval and without compliance with the non-emergency rule review provisions of Section 5a(a)(12)(A) of the Act and Commission Regulation 1.41. Bylaw 1.9 incorporates the requirements of Commission Regulation 1.41(f) governing exchange temporary emergency rules. (See Appendix A, page 5.)
As required by Regulation 1.69, FutureCom’s Bylaw 1.16 provides that no member of the Board may vote on any matter in which the named party in interest is the Board member or his employer, employee, or any other person that has a business, employment, or family relationship with the Board member that would warrant abstention. No Board member may vote on an action that would not be submitted to the Commission for prior approval if the member knowingly had a direct or substantial interest in the result of the vote, based on positions held either personally or at an affiliated firm. Consistent with Regulation 1.69, Bylaw Section 1.16 establishes procedures for determining whether a member must abstain from deliberating or voting in any particular matter.
FutureCom would have two committees to assist and advise the Board in conducting Exchange affairs. Although the FutureCom Board of Directors would have the ultimate authority in managing FutureCom’s operations, an Executive Committee would be empowered to conduct the routine day-to-day affairs which might require prompt decision making and flexibility. FutureCom’s developer believes it would be highly impractical, if not impossible, for the full Board to fulfill this function. Accordingly, FutureCom Bylaw 1.14 establishes a five-person Executive Committee to manage the Exchange on a daily basis. The Executive Committee would consist of the Chairman of the Board (Mr. O’Brien), the President of the Exchange (David Huseman), and three other directors appointed by the Board.
Like Bylaw 1.2(b), Bylaw 1.14 requires 20% of the members of the Executive Committee to be public directors as that term is defined. Therefore, the Executive Committee, in addition to being drawn from a body that meets the Commission’s compositional requirements, would separately meet the compositional requirements of Regulation 1.64. (See Appendix A, page 9.)11 The Executive Committee may not authorize distributions, fill vacancies on the Board or any committee, elect or remove officers, fix the compensation of any member of the Executive Committee, or amend, alter, repeal, or take action inconsistent with any resolution or action of the Board of Directors, when the resolution or action provides by its terms that it shall not be amended, altered or repealed by action of a committee. Executive Committee members, like members of all FutureCom committees, would serve for a term of one year or until their successors have been appointed. The FutureCom Board has veto power over anything the Executive Committee decides and thus retains ultimate authority over the affairs of FutureCom.
FutureCom also would have an Advisory Committee comprised of eight individuals who are FutureCom members, or representatives of member firms, appointed by the Chairman of the Board and approved by the full Board. The Advisory Committee may not have Board of Director members as committee members. The Advisory Committee would advise and make recommendations to the Board with respect to all aspects of the business and operation of FutureCom.12 The Committee would not be entitled to vote on any substantive matter. Proposed Bylaw 1.15 would require the Advisory Committee to meet compositional requirements similar to those contained in Commission Regulation 1.64.
The Board of Directors could create and utilize other committees. As with FutureCom’s Executive Committee, the Board would retain ultimate veto power over the action of any created committee that it created.
The FutureCom Board would appoint a President, Secretary and Treasurer who would fulfill the duties of these offices as described in the Bylaws and as determined by the Board. They would serve at the pleasure of the Board and may be removed at any time. The Bylaws provide for indemnification of officers, directors, and others who become parties to legal proceedings as a result of the person being a director, officer, or employee or agent of FutureCom. FutureCom will not, however, indemnify its officials for civil monetary penalties imposed by the Commission under Section 6b of the Act.13
FutureCom’s Bylaws also address the use of material, non-public information by any officers or directors in accordance with the requirements of Commission Regulation 1.59. (See Appendix A, page 7).
No person could access the FutureCom trading system other than a member or person authorized to act as an intermediary on behalf of a member.14 In order to become a member, a person must apply and be approved by FutureCom. Prior to becoming designated as a contract market, FutureCom will have in place a Board Resolution which warrants that all solicitations made by FutureCom for memberships will conform to NFA Compliance Rule 2-29, as appropriate.
Although any member of the public would be able to access the general FutureCom website over the internet, persons would not be able to access the website’s order-entry functionality without entering their personal password, user ID number, and account number. These procedures should enable FutureCom to monitor and control access to its trading system and particularly to prevent access by unauthorized users via the internet.
Each approved member would be assigned to one of five membership classes. The Bylaws provide that membership in FutureCom is available to individuals and organizations that satisfy the minimum financial requirements established for the membership class for which the individual or organization has applied and that are otherwise found to be qualified for membership in FutureCom. Each applicant for membership as a member organization must designate an individual who would be authorized to represent the organization. Every member also would be a clearing member of FutureCom.
B. Financial and Other Requirements
Position limits for FutureCom members would be set in accordance with each members’ “membership class.” There would be separate position limits for each contract month and for the period ten days prior to expiration of a contract. Each membership class would have the following minimum financial requirements:
Class 1 Members: must maintain net worth in excess of $50 million and have annual income exceeding $20 million.
Class 2 Members: must maintain net worth in excess of $20 million and have annual income exceeding $5 million.
Class 3 Members: must maintain net worth in excess of $1 million and have annual income exceeding $500,000.
Class 4 Members: must maintain net worth in excess of $200,000 and have annual income of at least $100,000.
Class 5 Members: would not be subject to any minimum financial requirements, but would be required to have their FutureCom transactions guaranteed by a person that has been approved as either a Class 1 or Class 2 member of the Exchange.15
Each applicant must submit to FutureCom any pertinent information requested by the Exchange. Each applicant would undergo a credit and background check which must prove satisfactory to the Board. FutureCom staff would compare the names of all applicants for membership in the Exchange, and their principals, with the names on the administrative and reparations sanctions in effect list maintained by the Commission and available on the Commission’s internet site and would reject any applicant who appeared on that list. The Board of Directors would review all applications for membership and may approve, deny, or condition an application as the Board sees fit for the protection of the other members of FutureCom.
C. System Entry
Upon approval for membership, FutureCom would assign the new member a user ID number, an account number, and a password. The member would have to use all of these codes to gain entrance to the secure FutureCom trading site server. Members obtain access through the internet on their own personal computers. Valid codes would be necessary to execute transactions on FutureCom as well as to access any information in the member’s account. Each member would be responsible for the selection of an internet access provider and an alternative access provider.
All communications between FutureCom and its members, including confirmations of all transactions executed for or on behalf of the member’s account, margin calls and all other information regarding the member’s account, would be transmitted by electronic mail. The Exchange would require all members to confirm a valid electronic mail account with the FutureCom mail server. Each member would be responsible for promptly viewing, and if required, responding to all electronic mail. Member meetings also would be held by electronic mail.
E. FutureCom Account Agreement
Many of the requirements for members contained in the Bylaws are also found in the FutureCom Account Agreement, an agreement each member must sign before accessing FutureCom for trading purposes. The Agreement covers many general legal contractual provisions, and other FutureCom-specific provisions such as a consent to the clearing arrangement, margin and default provisions, position limits, an electronic services agreement, trading fees, FutureCom’s limitation of liability, order entry and matching rules, duty to notify of changed financial condition, termination of a member’s account, agreement to arbitrate, and other matters.
FutureCom’s Account Agreement also contains provisions similar to those in agreements entered into between clearing members and currently operating exchanges.16 This includes agreement that members are subject to all the rules of the Exchange, that the members authorize the Exchange to provide required information to the Commission, and that members represent that entering into the agreement does not violate the members’ own charter, Bylaws, or partnership agreement, if applicable. The FutureCom Account Agreement would be executed electronically but each member also would be required to execute a separate version of the full agreement in hardcopy. Other major provisions and sections of the Account Agreement are discussed in the section below and elsewhere.
1. General Legal Provisions
This first section of the Account Agreement imposes several responsibilities and obligations on members. Among other matters, the Agreement provides for joint and several liability if there is more than one member or named person in an account.17 In such cases, each individual would jointly and severally agree that he or she has the authority to enter orders, to receive notices, confirmations and other communications, to contribute margin and to receive funds without notice being given to the other joint account holder.
The Agreement authorizes FutureCom to follow the instructions of any party who authorizes a new account application. In this regard, FutureCom would have no duty to inquire into the purpose or propriety of a demand for delivery of securities or funds in connection with a FutureCom account. Likewise, FutureCom also would not be liable in the event of conflicting instructions with respect to one account.
Each applicant must agree to be responsible for receiving, reviewing, and responding to electronic mail, which would be FutureCom’s sole method of verifying transactional information. All trades would be subject to the rules of FutureCom, the Commission’s regulations and any other applicable federal or state law.
2. Clearing and Fees Consent
Pursuant to the Account Agreement, each member would consent to the custodial and clearing services provided by FutureCom. When authorized by the member, FutureCom would execute electronic debits or credits to the member’s separate bank account established for this purpose at the First National Bank of Amarillo. FutureCom would set trading fees according to the profile of each member as to expected volume, experience, and financial worth. The fees would be set forth in the Agreement separately for futures, spreads and options. Fees would be deducted from the member’s account at the time a trade was executed.
The only other charges a member could incur would be charges associated with the electronic transfer of funds from the member’s bank account to the FutureCom pooled account at the clearing bank for various purposes, such as depositing initial margin or meeting variation margin calls. The fees would be charged to the member’s account at the time the transfer was processed. FutureCom would not impose clearing fees.18
3. Margin, Default and Liquidation
Each member must agree that available funds for initial margin for any order must be on deposit in the pooled account at the clearing bank before any transaction could be executed. Minimum maintenance margin of at least 1.5 times the maximum allowed daily price move of the contract traded would be required and FutureCom could liquidate any trade not settled according to the terms of a margin call.19 Failure to meet a margin call would be considered a default and all the member’s positions would be liquidated at the beginning of the next trading session in a manner to minimize losses to the account. Monies transmitted to FutureCom by members would first be applied to the member’s outstanding margin calls and could not be used to support new positions until all margin calls had been satisfied. FutureCom may liquidate any securities accepted as margin in the event of a failure to meet a margin call or if the position was liquidated and the sale was necessary to satisfy remaining obligations to the Exchange.
The only securities acceptable as margin for trading on FutureCom would be U.S. Government Treasury obligations. These would be maintained in a separate custodial account at the clearing bank.20
4. Position Limits
The FutureCom Account Agreement between FutureCom and each member would set forth the position limits specific to that particular member based on the member’s membership classification and other factors specific to the member. The Agreement would list position limits for each contract month and for the period ten days prior to expiration.
5. Electronic Services
Members must agree to provisions intended to address various operational aspects of the electronic FutureCom system. As account owners, members agree to protect their system access codes and to inform the Exchange of any inadvertent disclosure of the codes. All transaction and trading information would be transmitted by electronic mail. FutureCom would not be deemed to have received an order until it sent the member an assigned order number which was designated at the completion of the order entry routine.
FutureCom would not be responsible for the member’s internet service provider, the internet system or access to FutureCom’s server. Members would be responsible for their internet access options. The Exchange does not warrant any order entry, quote, or order execution speed to any member. In fact, the Exchange would disclose that response times would vary according to the traffic on the internet at any particular time. FutureCom would close the Exchange if it determined that internet services or any of the electronic systems were impaired sufficiently so as to harm trading on the Exchange, or FutureCom’s servers were incapable of managing the orders. The procedures for closing the Exchange are discussed in more detail in Section IX., below.
Each member must agree that if the member failed to notify FutureCom within 24 hours of a mistake on the part of the Exchange in handling or processing a transaction, FutureCom would not be responsible. FutureCom would provide a Help Desk which could assist a member in entering an order by telephone. This service would be for a fee as posted on the public folders of the Exchange’s website. All calls to the order entry desk would be recorded and FutureCom would only be responsible for errors that violated the order instructions given by the member.
6. Limitation of Liability
Each FutureCom member must agree that he or she understands that trading on the internet involves many interrelated components which may be subject to faults, failures, malfunctions, and other impacts that could adversely affect the ability to trade. The Account Agreement states that FutureCom would not be responsible or liable for any failure to execute orders as intended. Failures may be caused by interruption or disruption of the power supply or phone lines, or by natural disasters or other causes. Trading also may be subject to disruption from hardware or software failures anywhere on the internet connection including the client or host computers. FutureCom further notes that nothing in their statement limiting its liability is intended to limit the liability of any person as may be provided in the Act or the Commission’s regulations or as a result of willful or wanton misconduct or fraud. With respect to orders sent to the Help Desk, as stated, the Account Agreement would provide that FutureCom would only be responsible for errors that violated the order instructions given by members. These provisions are consistent with the Act and are substantively identical to limitation of liability provisions previously approved by the Commission.21
Each member must agree to arbitrate any disputes that might arise as a result of transacting business on FutureCom.22 Each member would agree that the arbitration would be binding. Any dispute, controversy or claim between members arising out of or relating to transactions on FutureCom may be submitted to arbitration in Amarillo, Texas, before a panel of three arbitrators. Each member would select one arbitrator. These two arbitrators together would then select a third. All arbitrators must be knowledgeable in futures trading or the regulation of such trading. All member arbitration proceedings would be conducted in accordance with the rules of the American Arbitration Association. The decision of the arbitrators would be final, and judgment upon any decision rendered could be entered in any court, state or federal, having jurisdiction. Unless the arbitrators found that one of the parties acted in bad faith, each party would pay its own expenses, and the expenses of arbitration would be equally divided between the parties. American Arbitration Association procedural requirements satisfy Part 180 of the Commission’s regulations and their minimum requirements for fair and equitable arbitration proceedings.23
FutureCom would reserve the right to terminate a member’s Account Agreement at any time for any reason. Such termination would not affect the obligations or liabilities of the parties incurred or arising from transactions initiated under the Agreement prior to the termination, including the provisions regarding arbitration which would survive any termination of the Agreement. Upon termination, it would be the member’s responsibility to issue instructions with regard to assets held at FutureCom. Unless and until FutureCom received the member’s instructions, FutureCom would not be under any obligation to take any action with regard to the member’s assets. The member also would be responsible for any transaction costs associated with instructions, including commissions and related costs.
In addition to the FutureCom Account Agreement, a member would not be permitted to enter into and execute an order through FutureCom until the member had acknowledged receipt of the Risk Disclosure Statement prepared by FutureCom. Part One of the Statement contains the risk disclosure prescribed by Commission regulations and describes the risks inherent in trading on futures and options on futures contracts generally, wherever traded. Part Two describes certain risks that are unique to trading on electronic exchanges in general, and on FutureCom, in particular.
Part Two states that trading on FutureCom may not be appropriate for all parties and that FutureCom is different from conventional futures exchanges in a number of important respects. The disclosure informs members that they would be responsible for protecting system access information and for the costs of any losses incurred on any trades made using that information. The disclosure reminds members that an order would not be accepted for execution unless initial margin was on deposit and that all orders would be deemed to have settled and cleared immediately upon execution on the Exchange. If a margin call was not met, FutureCom would automatically liquidate the member’s account by creating a market order(s) that would offset the member’s positions and enter them in a manner designed to minimize losses. Members would be responsible for receiving and responding to any electronic mail from the Exchange.
Part Two of the Risk Disclosure Statement also makes clear that FutureCom would not be responsible for a member’s inability to enter or cancel an order due to the temporary disruption or failure of the computer-based component systems maintained by FutureCom. The disclosure describes various conditions which could affect the ability of a member to trade and reminds the member that he or she accepts the risk that, if the member is unable to trade on FutureCom or capacity to trade is impaired, the value of the member’s portfolio may be adversely affected. The Statement also describes situations involving system disruption or failure for which FutureCom officials could close the Exchange or take other emergency action.24
FutureCom expects that most members will enter all of their own orders into the system and that members would not typically use another person to enter their orders. However, as mentioned, FutureCom members may authorize other persons, intermediaries, to enter orders into the system on their behalf. Members might use an intermediary, for example, if they are not comfortable using computers or if they desire to trade at a time when access to a computer was not possible.
Intermediaries would be able to enter discretionary or non-discretionary orders on behalf of FutureCom members using the intermediary’s user ID number and password, and the member’s account number. FutureCom member intermediaries would be subject to heightened scrutiny under FutureCom’s trade practice surveillance procedures which specifically require compliance staff to create a report which would identify instances in which any member-intermediary may have traded ahead of the member.25 An intermediary would never handle the funds of the FutureCom member for which the intermediary is entering orders.26
With limited exception, all intermediaries must be FutureCom members. FutureCom would have to approve the appointment of any non-member as an intermediary. The Exchange may approve a non-FutureCom member that was a Commission registrant (for example, a CTA) as an intermediary, or in some cases, approve a non-member, non-Commission registrant when the intermediary has an existing business or personal relationship with the FutureCom member that is unrelated to futures trading; for example, a spouse of a member. In this case, the intermediary would be required to consent to FutureCom’s jurisdiction with respect to all activity on the FutureCom system.27
The Exchange prefers and anticipates requiring that most, if not all, appointed intermediaries would be both FutureCom members and Commission registrants and that it would be the rare instance in which that was not the case. As a Commission registrant an intermediary would be a member of the NFA and be subject to NFA oversight in accordance with an agreement between FutureCom and NFA for NFA to perform the DSRO functions of financial and recordkeeping surveillance.28
An intermediary would not be able to enter orders for multiple accounts. The intermediary would have to exit the secure portion of the FutureCom website and then log on again using the same ID number and password, but the account number for the next account, if any, for which the intermediary was authorized to enter orders.29
As a Commission registrant, an intermediary would have to comply with the Commission’s relevant recordkeeping regulations - Regulation 1.35 for FCMs and IBs and Regulation 4.33 for CTAs. The Exchange believes that the electronic nature of its system would enable intermediaries to take advantage of the Commission’s advisory concerning an alternative method of compliance with the written record requirements of Regulation 1.35.30 The advisory declares that the written record requirements of Regulation 1.35 will be deemed satisfied, subject to certain conditions, by an electronic system that generates particular records for orders entered into it.
Under FutureCom Bylaws,31 members who allow a Commission registrant intermediary to enter orders could arbitrate claims against the intermediary at NFA in accordance with NFA’s current arbitration procedures. Since typical intermediaries would be Commission registrant members of FutureCom, they would be subject to NFA’s sales practice and financial surveillance programs. As such, they would be required to distribute to customers a list of organizations that are qualified to conduct customer arbitration proceedings. Such list must include a registered futures association (i.e., NFA, the only registered futures association at this time). Furthermore, NFA is required to accept any demands for arbitration against a registrant NFA member arising out of a futures-related dispute under Section 2 of NFA’s Code of Arbitration. Since arbitration proceedings conducted at NFA comply with Commission regulations, FutureCom members employing a typical intermediary to enter orders on their behalf would be able to arbitrate disputes with that intermediary under procedures that meet Commission standards. Cases in which an intermediary that entered orders on behalf of a FutureCom member was not a FutureCom member and not a CTA or otherwise registered with the NFA could still be subject to arbitration at FutureCom, if the member elected, as such intermediary would have consented to FutureCom’s jurisdiction under FutureCom Bylaws.
VI. Order Entry and Execution
FutureCom members and intermediaries would enter orders for their accounts and the Exchange would maintain an electronic record of those entries. Members would be financially responsible for all of their orders. Once an order was entered, the system would re-display the details of the order to the party who entered the order and request that the originator affirmatively confirm that all the order information was correct and should be made final. Final orders would be entered into the system and immediately be eligible for matching. The FutureCom system is designed to match trades on a strict price/time priority basis, meaning that resting orders at a given price would be filled in the sequence in which they were entered into the system.32 Pursuant to the FutureCom Account Agreement, members agree to be bound by the order once executed. Each member would be responsible for disclosing to FutureCom prior to order entry the name of any party the member desired to authorize to enter orders on FutureCom on the member’s behalf.33
B. Types of Orders
The FutureCom system would accept the following types of orders; limit; market; stop; and market-if-touched (“MIT”). All orders could be entered either as day-only or “good until filled” (“GTF”). A day-only order would be canceled automatically if unfilled at the end of the day’s trading session, while the GTF designation would allow an order to remain eligible until matched or canceled. In either case, an order would stay open in accordance with its designated time limit even if the trader who entered it had exited the FutureCom website. There would be no default selection for order duration; a trader must select one option or the system would not accept his or her order.
1. Limit Orders
Limit orders specify a price at which a trader wishes to buy or sell, and would match only at the limit price or better. Limit orders may receive partial fills, and unfilled portions would remain open at the same price and for the same duration as was specified when the order was originally entered. These unfilled portions would retain the time priority of the original order. Limit orders would be filled on an “at or better” basis, so that a buy limit order that was entered at a price above the current best offer to sell, would be matched with all the outstanding sell limit orders in price/time priority until the limit price was reached, or the order was filled completely.
2. Market Orders
Market orders to buy (sell) would hit the best available limit offers (bids) in price/time order until the market order had been filled in its entirety, or until there were no more opposing limit orders against which it could be executed. If the latter occurred, i.e., if the market order had disposed of all orders on the opposite side of the market, then any unfilled portion of the market order would be canceled automatically. Similarly, the system would not accept a market order if there were no limit orders on the other side of the market against which it could be executed. Market orders cannot execute against each other. By nature, market orders either execute instantaneously or not at all, so traders do not specify a time duration for them.
3. Stop and MIT Orders
Stop and MIT orders would be treated identically, the only difference between them being that they would be entered on different sides of the market. (A sell stop is placed below the current market price, while a sell MIT is placed above it, and the reverse is true for buy orders.) Stop orders are generally employed to stop losses, while MIT orders are used in the same fashion as limit orders. Stops and MITs are much more likely to be executed in their entirety, because they would become market orders when triggered. This means, however, that they could be executed at a price worse than the trigger price. Conversely, limit orders cannot be executed at a price worse than the limit, but for this reason may not be filled completely when the limit price was reached.
Both stop and MIT orders would be entered at a particular stop price, and when the market traded at or through that price, the stop or MIT order would become a market order and execute immediately against whatever opposite orders were available, in their order of priority. Unlike regular market orders, however, unfilled portions of triggered stop and MIT orders would not be canceled, but would remain open and be executed against the first limit orders entered on the opposite side of the market.34
C. Order Entry and Confirmation
All traders would access the FutureCom system via the internet by accessing the Exchange’s World Wide Web site. Although portions of the website would be accessible to the general public, access to trading pages necessary to conduct and review trading activity would require a FutureCom ID, password, and account number.35 When entering an order, a trader would first encounter a screen where he or she must indicate whether to buy, sell, or spread, and what contract to trade. If a buy or sell order was selected, the trader would then be presented with an order entry screen and a display of the current best five bids and offers in the front month of the contract selected. This display could be modified by the trader to show the best five for any listed month of that contract. On the order entry screen the trader must enter his or her desired contract quantity, contract month, order type (market, limit, stop, or MIT), price (except in the case of market orders), and the time limit (day only or GTF). For spread orders, a trader must select the number of contracts, time limit, the buy and sell months, the desired price differential, and whether the premium will be for the buy or sell month.36
If any of the required information was not entered, the system would reject the order and inform the trader what was missing. If the form was complete when submitted, the system would then display a page showing the terms of the order, as well as the trader’s account balance, the initial margin required for the order, the commission that would be charged, and the account equity remaining available for trading. This would provide the trader with an opportunity to review the terms of an order before it was entered. If the trader wished to revise the order, he or she could return to the order form by pressing the “Back” button on his or her browser. If the trader entered the order as is, the system would display a confirmation page showing the same information, plus the notice “Order Successfully Entered” and an order number assigned by the system.
Once logged on to the system, traders on FutureCom could only enter orders for the account associated with the user ID entered during the log-in. In most cases, this would presumably be the trader’s personal account. However, an Exchange member may authorize an intermediary to enter orders on behalf of the member.37
When a trade was matched by FutureCom’s trading system, a notice of fill would be sent immediately to each trader via electronic mail, showing the order number, price, time of fill, and quantity. Traders could also check the status of their orders on the Exchange website using the Open Orders screen, which would show all of their active unfilled orders, or the Open Positions screen, which would show all open positions (including offsetting positions which have not been matched and formally closed).38 Additionally, the Closed Position History screen would allow traders to examine their last six months of trading activity (except for currently open positions), displaying each trade in a group with the one(s) against which it subsequently was offset. Nowhere in the FutureCom system would it be possible for a trader to discover the identity of the trader or traders on the other side of his or her transaction.
D. Opening Price Procedure
The FutureCom system would employ a procedure to determine an opening price for each trading session. It should be emphasized that the opening price would simply be an indicator to traders of where the market was – what other traders bid or asked before the market opened. The opening price would not be binding in any way and would not necessarily be the price at which trades entered before the trading session start time (9:00 a.m., CST) would be matched at the beginning of the trading session (also referred to as “the open”).39
For the live cattle contract, the initial contract that FutureCom proposes to list, the trading system would begin each session by reviewing all limit orders entered into the system since the close of the preceding trading session, and ascertaining the price at which the largest number of contracts could be matched (i.e., the “equilibrium price”). This would be the opening price. Its determination is illustrated in the following example:
Example: Assume the market opens at 9:00 a.m. and the following limit orders were entered before that time as shown:
• Trader A’s offer of 1 entered at 72.05 at 8:35 would match with Trader B’s bid of 1 entered at 72.05 at 8:40
• Trader D’s bid for 3 at 72.10 entered at 8:50 would match with 3 of Trader C’s offer of 4 at 72.10 entered at 8:45.
• The opening or equilibrium price would be 72.10 as that would be the price at which the largest number of contracts, three, could be matched at the open.
In determining the opening or equilibrium price, if there were two or more prices with equal largest volumes, then those prices would be averaged to determine the opening price. If no trades could be matched before the open, then the opening or equilibrium price would be the arithmetic mean between the best pre-open bid and offer on the contract in question.
If no orders were received by the Exchange between the close of one trading session and the opening of the subsequent one, then the closing price for the first session would be the opening price for the second. In the event that a closing price was not established for that first session, then the opening price for the following session would be the “Five Day Weighted Average Price.” This price would be calculated by the Exchange using data from the U.S. Department of Agriculture’s “Five Area Weighted Average Report” for live cattle, and according to a formula described in Appendix 1 to the FutureCom Bylaws.
The opening price on the very first trading day for each live cattle contract month would be the settlement price from the previous trading session for the contract month immediately preceding the unopened contract month. If no such settlement price was calculated, then the opening price would be the Five Day Weighted Average Price for the previous day.
After the opening price was established, the market would open. At the open, orders that had been entered before 9:00 a.m., CST would be immediately matched according to the normal trade-matching rules, with one exception. At the open, limit orders which overlapped in price (bids higher than outstanding offers, or offers lower than outstanding bids) would be matched at a price halfway between the bid and offer. FutureCom states that since limit orders are executed on an “at or better than” basis it would serve as a reward to those who entered a pre-open limit order prior in time to the entry of the opposite pre-open limit order to execute at a price halfway between the two when the orders overlap. This should encourage the entry of more pre-open limit orders which would assist in developing an accurate opening price. (By contrast, overlapping limit orders entered after the open would be matched at the price of the first order entered in accordance with the normal priority rules.) The opening price calculations would not involve market orders which, although they may have been entered prior to the open, would not be processed until immediately after the open, in order of time priority. At the open, all, some, or none of the pre-open entered orders could get matched at that time.
E. Trade Matching
The FutureCom servers would maintain a “book” of open orders to be executed in accordance with the system’s trade-matching algorithm. The algorithm would apply to all trades in the system, including those matched at the open, and, as stated, would follow a price/time priority rule.40
1. Limit Orders
The price/time priority of the FutureCom trade-matching algorithm means simply that trades would be matched at the best available price, and orders at that price would be filled in the same sequence in which they were entered into the system. The following example, Example #1, illustrates this matching rule as applied to limit orders:
Assume limit bids and offers were placed at the following prices, times, and quantities:
Further assume that at 9:03 Trader D enters a limit offer at 72.00 for 4 contracts. The FutureCom system would execute the following transactions:
• Trader D’s limit offer of 4 would be executed at 72.00 or better. Following the rules of price/time priority, Trader C’s bid for 1 contract at the highest price, 72.10, would be matched against Trader D’s limit offer of 4 contracts.
• Trader B’s bid for 2 contracts at 72.05 would be matched against the remaining 3 contracts of Trader D’s offer
• One of Trader A’s bid of 3 contracts at 72.00 would be matched against the remaining contract of Trader D’s limit offer.41 Although Trader A’s bid would meet the terms of the limit offer (at 72.00 or better), and has time priority, it does not have price priority, and would be the last to be matched.
2. Market Orders
Market orders would be executed against the best available limit orders on the other side of the market in price/time sequence until they were filled, or until there were no more opposing orders left, as shown here in Example #2:
Assume limit offers were placed at the following prices, times, and quantities:
Next, assume that at 10:04 Trader E enters a market order to buy 3 contracts. The FutureCom system would execute the following transactions:
• Trader E’s market order is matched with the pending offers according to their price priority. Accordingly, Trader E’s order to buy 3 contracts is first matched against Trader D’s offer of 1 contract at 71.85
• It is then matched next against Trader C’s offer of 1 contract at 71.90
• It is then matched against one of Trader B’s offer of 2 contracts at 71.95, even though each of these offers was entered after Trader A’s offer of 3 contracts for 72.00.42
3. Stop Orders
To be executable under FutureCom’s trade-matching algorithm, stop orders must be triggered by a trade executed at the stop price. A triggered stop order turns into a market order. The following example, Example #3, illustrates the triggering and execution of a stop order:
Assume that at 11:00 Trader A enters the following sell stop order43 into the system:
Further assume that between 11:01 and 11:05, Traders B, C, D, E and F enter the following limit bid orders:
The FutureCom system would execute the following transactions:
• Trader A’s stop offer of 6 contracts at 71.90 entered at 11:00 is triggered and turns into a market order when the trade between Trader E and F was executed at the stop price of 71.90 at 11:05.
• Once the stop offer becomes an executable market order the rules of price/time priority apply. Accordingly, Trader A’s offer will be executed at 11:05 for 6 contracts against Trader D at 71.85.44
4. MIT Orders
To be executable under FutureCom’s trade-matching algorithm, MIT orders also must be triggered by a trade executed at the MIT price. Like a triggered stop order, a triggered MIT order turns into a market order. The final example, Example #4, illustrates the triggering and matching of an MIT order:
Assume that at 12:00 Trader A enters the following MIT buy order45 into the system:
Further assume that between 12:04 and 12:07, Traders B, C, D and E enter the following limit bid orders:
The FutureCom system would execute the following transactions:
• Trader A’s MIT bid order of 4 contracts at 71.85 entered at 12:00 is triggered and turns into a market order when the trade between Trader D and E was executed at the MIT price at 12:07.
• Trader A’s bid will be executed against the remaining 2 of Trader D’s limit offer of 3 at 71.85, Trader C’s limit offer of 1 at 71.90, and 1 of the 2 of Trader B’s offer for 2 contracts at 71.95.46
If more than one stop or MIT order were entered at the same price and the stop or MIT orders were triggered, the stop or MIT order that was entered first47 would be filled first, and the stop or MIT order entered second in time would be filled next, and so on. There would be no allocation of fills among different MIT orders entered at the same price.
All types of orders other than market orders could receive partial fills, in which case the unexecuted portion of the order would remain in the system, retaining its time priority. With market orders, the unexecutable portions would be canceled immediately, thus market orders on FutureCom operate just like orders with a “fill or kill” qualifier attached. Unexecuted portions of triggered stop and MIT orders, however, would remain open as market orders, and would therefore execute against the next opposing limit order entered into the system.48 Unexecuted portions of triggered stop and MIT orders would remain in the system rather than being automatically canceled, as would unfilled portions of market orders, because stop and MIT orders can be used as tools by traders in lieu of watching the market, which is not always feasible, for the appropriate market situation in which to buy or sell. If unexecuted portions of triggered stop and MIT orders were canceled, the use of these types of orders for this purpose would be adversely affected.
It should be noted that orders would be matched sequentially in the FutureCom system; an order would not be matched until the system had completed matching the order directly ahead of it in priority rank. This means, among other things, that if the matching of one trade were to cause a resting stop or MIT order to convert to a market order, the triggering of that stop or MIT would not affect the execution of the first trade in any way. The triggered order would not be processed until the triggering order was completely matched.
F. Spread Transactions
There would be no separate market for spread orders at FutureCom; the legs of spread orders would be matched separately and simultaneously against straight buy and sell orders for the appropriate contracts. When a trader entered a spread trade, he or she would specify the quantity, what the buy month was, what the sell month was, what the differential should be, and whether the premium should go to the buy or sell month. Each leg of the spread would be treated as a separate order and each would have to be matched separately, but simultaneously, for the spread order to be executed. Spread orders could be specified to be GTF or good for that day only.
Mechanically, the system would list the sell leg of a spread as a limit offer at a price equal to the currently existing best limit bid in the spread’s sell month. The buy side of the spread would be listed as a limit bid at a price equal to the sell leg’s offer plus the price differential (when the premium was to the buy month), or minus the differential (when the premium was to the sell month). The bid for the buy leg would move in tandem with the sell leg offer as the latter followed the currently existing best limit bid of the sell month. Therefore, when the buy side of a spread matched with an offer, the sell side would be matched simultaneously with the already existing bid, and the spread would be executed.
For example, assume a spread order indicated that a premium of .20 should go to the sell month leg. The buy order would be placed as a limit bid at a price which equaled the current best limit bid price of the sell leg month, minus the differential. Assuming the best currently existing limit bid price of the sell leg month was 72.00, the sell leg of the spread would be placed as a limit offer at 72.00 and the buy leg would be placed as a limit bid at 71.80 (72.00 - .20). The limit offer of the sell leg would change as it followed the currently best limit bid in the sell month until the buy leg matched with an offer as it moved in tandem with the sell leg.
To illustrate, assume, in the example, that the limit offer of the sell leg (which is the same price as the best currently existing limit bid price of the sell leg) moved to 72.10. The buy leg limit bid would automatically move to 71.90 (72.10-.20). Assuming an offer was entered or already existed that matched the buy bid of 71.90, the spread would then execute as both legs could execute independently and would do so simultaneously.
G. Modification and Cancellation of Resting Orders
The FutureCom system would allow traders to modify or cancel any unexecuted (or “resting”) orders they have entered. This would be done via the Open Orders screen, which displays all of a trader’s unfilled orders in chronological sequence, indicating the order number; date and time entered; contract and month; buy, sell, or spread; limit, stop, or premium price; quantity; and time limit. From this screen, orders may be canceled entirely, or modified via a Change Order screen at which the price of a resting order can be modified. The modified order, however, would lose its time priority and be sent to the end of the queue like any new order. As the Change Order screen would only allow changes to the price of an order, any other modifications to an order’s terms must be made by canceling it and entering a new order.
H. Offsetting or Closing Positions
Once an order has been accepted into the system and matched with another order pursuant to the system’s trade-matching algorithm, a member may close or offset a position with another of the trader’s open, filled orders. Offsetting positions would be held open on FutureCom, until a member affirmatively closes a position by offsetting it with another offsetting open position in the system.49 The right half of FutureCom’s order entry screen would be dedicated to “closing an order.”50
After selecting the option to close a order, the screen would show a list of open, filled orders that could be closed, if chosen. After selecting a position to be closed, the system would ask which order should be used to close the chosen position and list the available possibilities. Upon the selection of an order to close a position, the system would display a confirmation page indicating by order number which position had been closed with which order. A similar procedure would be used to partially close a position. After a position was closed or partially closed, the trader’s account balance would reflect the financial result of the offset.
FutureCom members would receive most of the same type of information that is available to traders in open outcry pits. FutureCom believes that this flow of information should enhance the liquidity of contracts trading on the system. A FutureCom member who was working on his or her order entry screen would see a display of the current best five bids and offers in the front month of the contract selected. This display also could be changed to show the best five bids and offers for any listed month of that particular contract. This is the same level of transparency as the CME’s Globex trading system, but a greater level of transparency than the CBT’s Project A electronic trading system which displays only the current best bid and best offer.
The FutureCom system would not disclose to a trader the identity of the trader or traders on the other side of his or her transactions. FutureCom members should be able to make an assessment regarding the depth of market participation and the degree of participation by other traders at least equal to the assessment traders can make on the Globex, Project A, and NYMEX ACCESS trading systems. FutureCom would disseminate real-time market quotes for free on pages of its website that would be accessible to the general public.
J. Open and Competitive Nature of the System
The Division believes that the procedures described above for FutureCom order entry and execution and the opening of trading would not be inconsistent with the Act and the Commission’s regulations. Commission Regulation 1.38 explicitly requires open and competitive execution; however its language also makes clear that there is more than one means of open and competitive trading.
The Division believes that FutureCom would provide for competitive trading within the meaning of Regulation 1.38. FutureCom’s trade-matching algorithm would operate according to the same underlying theory of the trade-matching algorithm for the Globex trading system, the Project A trading system, and the NYMEX ACCESS system: trades would be conducted through a competitive auction process pursuant to an algorithm which would apply non-discretionary rules of priority, under which orders at the best prices would be executed first and under which new orders could obtain priority simply by bettering the current best bid or offer. FutureCom’s trade-matching rules would reward aggressive market behavior which is intended to add liquidity and foster participation by approved members in its markets.
K. Exchange of Futures for Physicals
FutureCom members would be able to execute exchanges of futures for physicals (“EFPs”) over the FutureCom trading system. FutureCom Bylaw 4.13 allows parties to execute EFPs at mutually agreed upon prices; provided, that: (1) at least one side of the transaction is priced within the daily price limits for the commodity; (2) both transaction parties are members of FutureCom; and (3) both parties have on deposit with the Exchange the necessary initial margin with respect to the futures portions of the EFP. All EFPs must be reported immediately to FutureCom which would make the appropriate adjustments to the parties’ open positions. FutureCom members would not be permitted to exceed their established position limits by entering into EFPs.
Consistent with Commission Regulation 1.35(a-2)(3), FutureCom Bylaw 4.4 requires that members provide documentation of cash transactions that underlie EFP transactions upon the Exchange’s request.51
VII. Clearing and Settlement
FutureCom would integrate trading and clearing. All traders must be members of the Exchange and all members would be clearing members. Therefore, all traders on FutureCom would be self-clearing.
Each trader would be required to deposit margin in an account maintained by the Exchange at its settlement bank, the First National Bank of Amarillo, before an order would be accepted. Initial margins, submitted in cash or qualified securities,52 may be wired, mailed, or electronically transferred. Subsequent orders would require sufficient available margins in the trading account prior to the acceptance of the orders.
Initial margin for live cattle futures would be between $1,200 and $1,500 per contract. The precise level of initial margin would be established by FutureCom based upon each member’s trading level and creditworthiness.53
For each member, minimum maintenance margin would at all times be maintained at a level at least 1.5 times the daily price fluctuation. Maintenance margin would be based upon three factors: an analysis of the market volatility and market conditions; competitive forces; and emergency events. To analyze market volatility, FutureCom would employ the SPAN method of determining market risk54 and examine other factors to evaluate market conditions. Maintenance margin has been initially established by FutureCom at $1,000, to be collected in increments of $500.55
Under its clearing procedures, the Exchange would have the discretion to make intraday margin calls during periods of unusual volatility or due to a member’s particular financial situation.56 Under emergency conditions, FutureCom could close the Exchange in order to collect margins before resuming trading. An emergency in this context would be defined by FutureCom as the existence of price sensitive information that in the view of FutureCom officials could move prices greater than 10%.57
Trading on the Exchange would take place each day, Monday through Friday, beginning at 9:00 a.m., CST and closing at 1:00 p.m., CST.58 Immediately after the close, FutureCom would determine the settlement price for each contract in accordance with Section 8.3(f) of the Bylaws. By 1:15 p.m. FutureCom would have all positions marked to the settlement price and would adjust traders’ account balances accordingly. At 1:30 p.m., FutureCom would issue margin calls to traders whose account balances had fallen below the maintenance margin level. Payment on margin calls would be due, essentially, in 24 hours.59
FutureCom would maintain with its settlement bank, the First National Bank of Amarillo, a clearing account holding all the funds on deposit with the Exchange. These funds would be pooled and managed by a bank trust officer.60 FutureCom would provide the clearing bank the daily changes to the traders’ accounts and complete clearing and balancing information shortly after 1:00 p.m. each day. The standard settlement procedures are set forth in a Cash Settlement Agreement between FutureCom and the settlement bank, First National Bank of Amarillo.
Notices to traders of margin deficiencies would be delivered by electronic mail and would set forth the relevant details of the margin call.61 The information provided would include: the account owner; the amount of the call; the time of the call; date due; time due (in collected funds); and the current available trading equity adjusted for unrealized profit or loss.
Traders would have the responsibility to ensure the funds were delivered to the settlement bank by the time specified on the notice.62 FutureCom would immediately know of any defaults on any margin calls. FutureCom represents that all delinquent accounts, defined as accounts failing to respond to margin calls by the date and time requirements, would be liquidated at the beginning of the next trading session. Market order(s) would be created by FutureCom staff that would be accepted by the system and would offset any open positions in that account once executed. The member would assume all responsibility for fees or other monies due to FutureCom resulting from closed positions. FutureCom staff would exercise discretion during the liquidation process to minimize losses to the account and FutureCom.
Most maintenance margin requests would be automatically processed by FutureCom with the member’s consent. Member accounts would be set up to allow FutureCom to debit automatically a trader’s account at either the clearing bank or another bank through electronic transfers of funds for amounts under $20,000; i.e., Automatic Clearing House (“ACH”) transactions.63 Maintenance margin calls above $20,000 would require wire transfer of the funds for same day collection.
Each member’s account information would be available to the member in real-time from the trading site using secure servers. Member account information would display the current month’s beginning balance, postings to the account for profits or losses for closed positions for the month, and unrealized profits or losses on open positions. Withdrawals and contributions for the period would be listed and members could query activity for any date range for the past year. The adjustments to the beginning balance would determine for each account the current balance of money available for trading.
C. Financial Safeguards
There are several components to the financial viability of FutureCom as a clearing organization and the soundness of its clearing operations.
If a member defaulted on a margin call, that margin would be delivered by FutureCom to the settlement bank on the day the default occurred, and thus no break in the clearing operations would take place. Daily accounting of the pool of monies on account with the clearing bank would be provided, and balances would be adjusted for any market moves, deposits, withdrawals, or defaults. The custodial officer at the clearing bank would verify that the account pool (i.e., the FutureCom pooled account of members’ funds used to secure FutureCom positions plus members’ excess funds on deposit)64 was in balance with FutureCom’s records on a daily basis.
Safeguards would be built into the trading system by virtue of the fact that the position limits and margin levels for each member would be tied to the trading level and the determined creditworthiness of that member. The FutureCom system is designed to prevent any member from actually entering into any transactions if it would cause the member to exceed his or her position limit. Also, the FutureCom system would prevent any member from entering an order to establish a new position if the member did not have on deposit adequate funds to meet the initial margin requirements for the new position. Procedurally, funds that were deposited in FutureCom’s pooled account at the clearing bank would be applied to the specific appropriate members’ current available equity balance in a sequence that would first satisfy all variation margin calls that had been issued to that point, and then be applied to support new positions. Therefore, it would not be possible for a member to establish a new position based on his or her current available equity balance while at the same time holding positions which had recently fallen in market value without first meeting the required maintenance margin for the devalued positions.
If a member entered an order and had insufficient margin to support it, or the filling of the order would cause the member to exceed his or her position limit, the system would not accept the order and would display a message informing the member of the reason for non-acceptance of the order.
FutureCom’s chief credit officer would review all member applications for creditworthiness and trading level assignments, as discussed in Section V., Access, above. At that time, decisions regarding minimum maintenance margins on futures and short options for a new account would be made by FutureCom officials and submitted to the Board of Directors for approval.65 FutureCom members would be required to maintain on deposit with FutureCom’s clearing bank sufficient U.S. cash (or Treasury obligations) to support their current positions in an amount commensurate with the required margin and position level of their membership classification. In addition, FutureCom members located outside of the U.S. also would be required to maintain additional funds at the clearing bank or another U.S. bank to support the continuing process of clearing for the members’ account. This means that non-U.S. resident FutureCom members would not have the option not to participate in the automatic transfer of funds program.66
Although FutureCom would not have a guaranty fund as other commodity exchanges do, it would provide a clearing guarantee and would maintain a reserve fund. The clearing guarantee would be supported by a minimum of $1,000,000 in the form of a segregated credit facility from Bank of America.67 Bank of America has agreed to extend the segregated credit facility until April 5, 2001. At that time, in order to continue operations, FutureCom must either obtain an extension of the credit facility or obtain a different credit facility or a letter of credit with an approved institution pursuant to terms approved by the Commission.
The minimum $1,000,000 amount would be available beginning on the first day of trading and thereafter for open interest in each listed contract up to 10,000 contracts. That amount would be increased by $100 for each unit increase of open interest in a listed contract on FutureCom. For example, if open interest for a contract was 10,001 contracts, the segregated facility amount would be $1,000,100; and for a contract with open interest of 80,000 contracts, the amount would be $8,000,000. FutureCom would obtain supplementary support in the form of additions to the segregated credit facility, or a letter of credit with Bank of America or another Commission-approved institution, in the event that open interest in a listed contract reached 65,000 contracts. The amount of open interest would be calculated quarterly and the credit facility would remain in force at the designated level throughout the quarter following the calculation date. In its December 23, 1999 letter, Bank of America represents that the sole recourse for repayment of any amounts advanced to FutureCom under the segregated credit facility would be against Texas Beef Group.68 Bank of America also represents that the facility would be free of encumbrances from the business or credit needs of Texas Beef Group.
FutureCom also would accrue a reserve fund at the clearing bank at the rate of $1.00 per contract cleared to be available against member defaults. This fund is not intended to accrue indefinitely, however. Although the specific dollar end figure for the fund has not been determined as of the date of this memorandum, FutureCom officials intend for the fund to accrue eventually to the greater of $3,000,00069 or an amount which, given the rate at which trading volume was increasing and other factors, would provide a significant upfront source of funds readily available to apply in a default situation and keep uninterrupted operations. Upon designation, Division staff will monitor the level of funds maintained in FutureCom’s accrued reserve fund.
Division staff has reviewed and evaluated a financial analysis spreadsheet provided by FutureCom which illustrates the application of the Exchange’s various available financial resources to default scenarios at varying levels of trading volume and open interest. In its analysis, FutureCom assumes a starting daily volume of 2,000 contracts, to grow by 500 contracts each quarter. FutureCom projects an open interest of five times the estimated daily volume.70 Therefore, in FutureCom’s analysis, open interest at the end of the first quarter would be approximately 10,000 contracts and would increase by approximately 2,500 contracts each quarter.
At the end of the first quarter of operations, based on an approximate daily volume of 2,000 contracts with 65 trading days in the quarter, the reserve fund would have accrued to approximately $130,000 (2,000 x 65). At this point, the segregated credit facility amount would be $1,000,000 and the total combined credit facility and reserve fund would be $1,130,000. FutureCom has offered an illustration of what would occur at two levels of default: defaults by a FutureCom member(s) holding 3% and 6% of the open interest.71 The analysis sets forth the dollar value of default under the conservative assumption that the market moves against the defaulter(s) in the amount of the daily price limit of $1.50 per contract and does so for three consecutive days.72 The analysis also conservatively assumes that all margin funds allocated to the defaulting member(s) in FutureCom’s pooled account had been fully applied and absorbed to his or her (their) account(s) prior to the beginning of the price limit drops in value.
After dropping $1.50 or $600 per contract,73 the dollar value of default of all the defaulting contracts would be $180,000.74 After another day of the market moving against the defaulter(s) in the amount of the daily price limit, this amount would be $360,000. After the third day, it would be $540,000. At a 6% default rate, these amounts would be $360,000, $720,000, and $1,080,000, respectively. With a combined segregated credit facility and reserve account of $1,130,000 at that point - the last trading day of the first quarter of trading - FutureCom would be able to cover the losses accrued in the worst case scenario and still have $50,000 remaining to draw on the segregated credit facility with Bank of America.
FutureCom’s financial analysis illustrates the dollar value of defaults and the combined resources available to it at each quarter of the first three years of operations, based on the same relative assumptions that are in place for the illustration of the first quarter. Based on its analysis, FutureCom would have sufficient resources to cover the dollar value of default at a 6% default rate with adverse price limit moves for three consecutive days.75
FutureCom also illustrates what would happen if the market experienced a major default almost as soon as operations started, or at least before the reserve fund was able to accrue anything other than a minimal amount. If daily volume were 2,000 contracts, the segregated credit facility would be $1,000,000. This amount would be sufficient to cover the loss accrued after two days of adverse price limit moves assuming a 6% market default.
In the event that losses from member defaults exceeded the FutureCom combined credit facility and reserve fund, the Bylaws and FutureCom Account Agreement provide for losses to be borne pro rata by all the members trading and clearing in the defaulted contract at the time of default. The pro-ration would be computed according to the number of outstanding open contracts held by each member on the day of the default. All recoveries would be allocated back to the members first. The recoveries from defaulting members would be allocated to the same trading and clearing group upon which it was drawn. The FutureCom Account and Clearing Agreement will disclose that the Bylaws provide for the members’ pro-rata sharing of loss resulting from a default in the event FutureCom’s resources are insufficient to cover such loss.
In sum, FutureCom’s viability as a clearing organization is based upon the existence of position limits and margin levels tied to the creditworthiness of members, FutureCom’s preparedness to step in immediately and contribute any defaulted margin so there would never be a break in the clearing operations, the segregated credit facility consisting of up to $8,000,000, the accrual of a reserve fund, the requirement that all traders located outside the U.S. have an account with FutureCom's clearing bank or another U.S. bank for the purposes of supporting their positions, and, as a last resort, the rules of the Exchange which provide for pro rata assessment against members. FutureCom has committed that it would have an outside independent audit of its clearing operations done every quarter. The results of this audit would be posted in public information folders that would be available electronically to all members.
3. Members’ Status
The Division believes that FutureCom’s financial safeguards should be adequate to ensure the continued operations of the Exchange in the event of significant member defaults. However, should FutureCom itself become insolvent, the Division also believes that members’ creditor status in relation to FutureCom would be no different than the status of clearing members with respect to currently existing commodity exchange clearing houses. In accordance with certain federal Bankruptcy Code provisions, this status should be the same as the status of FCM customers with respect to an insolvent FCM.
Under Section 761(2) of Subchapter IV of Chapter 7 – Liquidation, of the United States Code, FutureCom would be a “clearing organization.”76 Under Section 761(9)(d), FutureCom clearing members would be “customers” of a clearing organization77 and would include all FutureCom members since all FutureCom members must also be clearing members of FutureCom.78
Section 766(i)(2) provides that the trustee of a debtor clearing organization shall distribute member property ratably to customers on the basis of their allowed net equity claims. Thus, the members of FutureCom should have a priority over all claims against the clearing house or FutureCom (with the exception of certain administrative costs as provided by the Code).
D. Clearing Example
The following example illustrates how members’ balances in FutureCom’s pooled account at the clearing bank would reallocate based on the outcome of each trading day.
· FutureCom has 100 members
· Each member has $1,200 margin on deposit in the Exchange’s pooled account
· FutureCom pooled account has a balance of $120,000
Day 1: · 25 traders each buy one June live cattle at 72.00
· 25 other traders each sell one June live cattle at 72.0079
· The June contract closes that day at 73.00
At the end of Day 1, the “longs” are the “winners.” FutureCom would send the clearing bank an allocation notice resulting in the following adjustments to members’ account balances:
· Each long trader’s account balance would increase by $400 to $1,60080
· Each short trader’s account balance would decrease by $400 to $800
FutureCom’s maintenance margin is $1,000 to be deposited in $500 increments. Since each short trader’s account balance fell to $800, FutureCom would send each short trader a margin call for $500. Each long trader would have $400 available to draw as excess margin funds. Assuming all long traders make $400 withdrawals and each short trader meets his margin call, the FutureCom account would consist of $122,500.
Fifty of the original 100 traders would still have $1,200 in their accounts totaling $60,000. The 25 traders who were long would continue to have $1,200 in their accounts ($1,200 + $400 - $400 excess margin withdrawal = $1,200) totaling $30,000, and the remaining 25 traders who were short each have $1,300 in their accounts ($1,200 - $400 + $500 margin call = $1,300) totaling $32,500. $60,000 + $30,000 + $32,500 = $122,500.
Day 2: · Assume no members trade but the market moves down to 72.55
At the close of Day 2, the “shorts” are the “winners.” FutureCom would send an allocation notice to the clearing bank and the members’ accounts would be adjusted as follows:
· Each short trader’s account balance would increase by $180 to $1,480
· Each long trader’s account balance would decrease by $180 to $1,020
In the example, the market did not fall enough to trigger a margin call to maintain the minimum maintenance margin of $1,000 with respect to the long traders’ accounts. Assuming that no short traders withdrew excess margin, FutureCom’s pooled account balance would remain at $122,500 at the end of Day 2.
Day 3: · Assume no members trade but the market moves down by $1.50 per contract (which is the daily price range for the contract)
At the close of Day 3, the “shorts” are again the “winners.” FutureCom would send an allocation notice to the clearing bank and the members’ accounts would be adjusted as follows:
· Each short trader’s account balances would increase by $600 to $2,080
· Each long trader’s account balances would decrease by $600 to $420
In this example, the market move would trigger a margin call to each long trader for $1,000, or two $500 increments since one increment would only bring the margin level up to $920. Assuming that all of the short traders withdrew their $600 excess margin, FutureCom’s account balance would be $132,500 at the end of Day 3.
VIII. Compliance and Surveillance
Commission Regulation 1.51 requires that each contract market use due diligence in maintaining a continuing affirmative action program to secure compliance with various provisions of the Act, the Commission’s regulations, and the contract market’s own Bylaws. In order to meet the requirement, FutureCom represents that it intends to implement, or delegate its responsibility to implement, trade practice, market, and financial surveillance programs as described below. FutureCom also has a program pursuant to which it intends to conduct investigations and prosecute possible violations of its Bylaws or Commission regulations under the disciplinary procedures set forth in its Bylaws.81
Each of FutureCom’s computerized surveillance programs, described below, has been reviewed by Division staff and analyzed for potential effectiveness given the unique structure of FutureCom and the context in which it would operate.82 The programs, if implemented properly and as represented, should enable FutureCom to secure compliance by its members with the requirements of the Act and the Commission’s regulations. FutureCom represents that it will continue to develop specific strategies for detecting each trade practice violation that may be committed by members or intermediaries. Of course, FutureCom, as any contract market, would be subject to periodic rule enforcement reviews conducted by Commission staff. As part of FutureCom’s first rule enforcement review, FutureCom understands that Commission staff would examine carefully the development and implementation of FutureCom’s trade practice violation detection strategies.
A. Trade Practice Surveillance
FutureCom Bylaws require Exchange members to comply with the Act and the Commission’s regulations including Part 155 of the Commission’s regulations which lists trading standards applicable to floor broker members.83
At least initially, FutureCom’s Compliance Department would conduct trade practice surveillance. FutureCom asserts that the time required to analyze the various reports and investigate suspected irregularities should be significantly less than is required at the floor-based exchanges due to the superior quality of FutureCom’s audit trail which obviates the need for underlying documentation, such as order tickets and trading cards. Initially, therefore, FutureCom’s Compliance Department would be composed of a single compliance officer.84 This person however, would be able to obtain assistance from a well-qualified outside consultant to FutureCom whenever a matter required any further investigation.85 Further, as volume and open interest in contracts traded on FutureCom grows, FutureCom represents that it would add qualified staff.86
Pursuant to the program, FutureCom staff would generate reports from its computerized trade register and analyze them to identify transactions that may have been executed in violation of the Act, the Commission’s regulations, or FutureCom Bylaws. FutureCom represents that these reports would be generated and analyzed by a member of the Compliance Department at least weekly. FutureCom’s computerized surveillance system would not be limited to the use of pre-programmed exception reports. Because the data would be maintained in a relational database, FutureCom’s Compliance staff would also be able to conduct specialized queries of the data. Any apparent violations of the Bylaws, the Act or the Commission’s regulations detected by these exception reports would be further investigated.
Although FutureCom intends to generate other reports as experience indicates is necessary or appropriate, FutureCom staff would use Microsoft Access and/or SQL87 to conduct tailored inquiries to create the following initial specific surveillance reports.
1. Pre-Arranged Trading
FutureCom staff intend to conduct inquiries using Microsoft Access and/or SQL to create a report to identify instances in which members may have engaged in pre-arranged trading (“PAT Report”). The PAT Report would identify when any two members frequently entered offsetting orders at or about the same time and executed against each other.
2. Trading Ahead of Member Orders
FutureCom staff intend to conduct computer inquiries to create a report that would identify instances in which any FutureCom member that has been authorized by a member to enter orders on that member’s behalf, may have traded ahead of the member’s order (“TAC Report”). The TAC Report would identify instances in which an order for such registrant or AP was entered within 15 seconds prior to the time that a member’s order for the same or a related market was entered. This report can be tailored to show orders within 10, 20 or whatever number of seconds from each other the investigator believed was appropriate to detect this type of trade violation given particular trading and market circumstances.
3. Disclosing or Withholding Member Orders
FutureCom staff also intends to utilize a report that would identify instances in which any FutureCom member that had been authorized by another member to execute orders on such member’s behalf, may have disclosed or withheld member orders (“DWC Report”). The DWC Report would identify instances in which such member-intermediary repeatedly entered orders for one member within, for example, 15 seconds after an order in the same or a related contract had been entered by or on behalf of another member. This report also could be tailored to show orders within whatever number of seconds from each other the investigator believed was appropriate to detect this type of trade violation given particular trading and market circumstances.
4. Wash Trading
FutureCom staff also would create a report that would identify instances in which a member may have engaged in wash trading (“WT Report”). The WT Report would identify those instances in which a member entered into a series of purchase and sale transactions within a limited time period (generally, one trading day), which resulted in no change in the member’s open positions. Such inquiries would include all accounts in which such member had a beneficial interest.
5. Deliberately Triggering Stop Orders
FutureCom also would create a report that would identify instances in which a member could have deliberately set off a stop order (“TSO Report”). The TSO Report would identify those instances in which a member executed a trade that triggered a stop order and subsequently traded against that order. The successful and repeated triggering of others’ stop orders may be an indicator that an Exchange member with the knowledge, such as a member acting as an intermediary for another, is disclosing information about one or more traders’ orders to other traders.
B. Market Surveillance
FutureCom states that its planned market surveillance program will be an integral part of the FutureCom trading system. FutureCom compliance staff intends to review daily the positions of all Exchange members with net positions in futures and options in excess of a predetermined number of contracts88 and to monitor trading activity in expiring contracts. Staff also would be able to review member positions on a real-time basis if necessary.
In order to ensure that bids and offers for the live cattle futures contract are reflective of the forces of supply and demand, Exchange staff intends to compare the net open positions of members and the prices at which each member was either net long or net short with the Five Area Daily Weighted Average cash price for that day as reported by the USDA.
FutureCom staff intends to prepare a daily report for FutureCom’s Director of Compliance who would determine whether any action was warranted with respect to one or more members and, if appropriate, make a recommendation to the Exchange President. FutureCom states that the types of actions that may be taken with respect to one or more members would depend on the circumstances in a particular case. Examples of further action include requests for information on positions on other markets, requests for current financial statements, or an increase in margin requirements.
Staff of FutureCom also intend to prepare a “Market Movement Report” each day to be reviewed by the Director of Compliance. Alerts would be generated if the market made any of the following moves: (1) two consecutive days of limit moves in the same direction; (2) a three day cumulative price change of 8% or more; (3) a four day cumulative price change of 10% or more; (4) a five day cumulative price change of 12% or more; (5) or a ten day cumulative price change of 15% or more.89 Again, the Director of Compliance would decide if further action was necessary based on the previous day’s market movement.
C. Financial and Sales Practice Surveillance
FutureCom Bylaw 3.1 would require that each FutureCom member that was an FCM or IB must comply with the minimum financial and related reporting and recordkeeping requirements set forth in Commission Regulation 1.10, et. seq. Under Bylaw 3.1, any notice or written report that a member was required to file with the Commission under these regulations, specifically Regulation 1.12, must be filed concurrently with FutureCom’s Director of Compliance.90
FutureCom has contracted with NFA for NFA to conduct financial audits and otherwise monitor the financial condition of those FutureCom members that are registered FCMs or IBs. NFA would use its own financial surveillance and audit procedures and would notify FutureCom of any apparent violations of financial requirements discovered in the course of an audit.91
FutureCom Bylaw 3.4 would require that members maintain the minimum net worth requirements applicable to the member’s membership classification. A member must notify the Director of Compliance immediately whenever the member knows or should have known that its net worth is less than its minimum net worth requirement. Until the member is in compliance with all minimum financial requirements, the member may engage in transactions only for the purpose of closing open positions.
FutureCom would conduct financial surveillance for its members that were not Commission registrants, and thus not NFA members, by requiring them to submit annual financial statements and to notify FutureCom promptly of any significant change in their financial situation. FutureCom staff also would monitor on a daily basis the payment flow into the members’ margin accounts. If any problems were detected during the course of this Exchange staff could require a member to demonstrate immediate compliance with the applicable net worth requirements.
As indicated above, FutureCom members that were CTAs, FCMs and IBs (i.e., Commission registrants) would be able to act as intermediaries for other FutureCom members.92 FutureCom and NFA have contracted with NFA to conduct sales practice audits of those FCMs and IBs that are members of FutureCom.93 NFA would use its own audit procedures and would advise FutureCom of any apparent violations of FutureCom, NFA, or Commission rules. Thus, NFA would essentially assume FutureCom’s self-regulatory responsibilities under Commission Regulations 1.51(a)(3) and 1.52(c) with respect to the maintenance of appropriate books and records in connection with the dealing of futures and options. FutureCom has represented to the Commission that NFA believes that it would have sufficient resources to fulfill its duties to FutureCom as described under an agreement between the two.94
FCMs and IBs are required to create and maintain all the records prescribed by Commission Regulation 1.35, including, in particular, Regulation 1.35(a-1) which addresses order recordation. Records generated by an intermediary at FutureCom, whether an FCM, IB, or CTA, would be generated electronically by the order entry process. Accordingly, FutureCom intermediaries that were registered would automatically satisfy the requirements outlined in the Commission’s Advisory relating to “Alternative Methods of Compliance with the Written Record Requirements.”95
FutureCom’s Compliance Department would investigate all apparent violations of FutureCom Bylaws, the Act, and Commission regulations, including apparent trade practice violations. FutureCom’s proposed investigative procedures would be very similar to the procedures of other exchanges. An investigation would be initiated upon discovery or receipt of information that, in the opinion of the Director of Compliance, indicated a basis for finding that a violation had occurred. FutureCom would investigate all complaints from members that it received about other members or intermediaries who placed orders for the members.96
If, after reviewing the appropriate trade records, the Director of Compliance concluded that no apparent violation had occurred, the investigation would be closed. If the Director concluded that further inquiry was warranted, the relevant parties would be notified by electronic mail and would be requested to provide documents and other information about the transactions in question. The Director of Compliance would have the authority, pursuant to the membership agreement, to compel testimony, subpoena documents, and require statements under oath from any member or any member’s employee or agent.
FutureCom compliance staff would attempt to complete each investigation within 120 days after the matter was initiated.97 Upon completion, the Director would submit a written report to the Exchange’s Chairman, William O’Brien, indicating whether the Director believed that a trade practice violation had occurred and whether a disciplinary proceeding should be initiated.
The Chairman would review each report and, within 30 days, instruct the Director to serve a written complaint initiating a disciplinary proceeding if he believed a violation had occurred. The Chairman also could instruct the Director to refer the matter to the Commission or to another SRO for any action that organization deemed appropriate.
E. Disciplinary Procedures
FutureCom’s rules for disciplinary procedures are contained in Chapter VI of its Bylaws and are very similar to the disciplinary procedures of other exchanges. Upon the completion of an investigation and the determination to issue a complaint, service would be transmitted to the charged person by electronic mail. Consistent with Commission Regulation 8.11, the complaint would state each FutureCom Bylaw alleged to have been violated, and each act or practice that constituted the alleged violation(s). The complaint would advise the respondent that a written answer must be filed with FutureCom within 10 business days. Failure to answer would be deemed to be: (1) an admission of the averred facts and rule violation; and (2) a waiver of the respondent’s right to a hearing.98 A respondent may be represented by counsel at any stage of an investigation or disciplinary proceeding.
The disciplinary chapter of FutureCom’s Bylaws additionally provides procedures for each step of a full disciplinary action, including pre-hearing procedures, Hearing Committee procedures, the issuance of written decisions, the negotiation of settlement agreements, appeals of Hearing Committee decisions, and guidelines for penalties.
The Division believes that the proposed disciplinary procedures would be fair and would comply with Part 8 of the Commission’s regulations governing disciplinary actions of contract markets.
Contrary to the general industry practice, FutureCom’s disciplinary procedures would not permit the summary imposition of minor penalties. The Division notes, however, that Part 8 of the Commission’s regulations makes the adoption of summary action provisions optional on the part of each contract market. FutureCom believes that the automated nature of its trading system would nearly eliminate the opportunity for commission of the types of violations which are typically subject to summary fines, such as dress code, language, and other decorum offenses.
IX. Emergency Procedures
A. Physical Emergencies
FutureCom Bylaw 1.9 authorizes the Board of Directors and, in the case of certain physical emergencies, the Chairman or President of the Exchange, to place into immediate effect certain temporary emergency rules. FutureCom’s provisions fully comply with Commission Regulation 1.41(f)’s requirements regarding the implementation of temporary emergency rules.
Proposed FutureCom Bylaw 1.9 would define a physical emergency to include power failures and breakdowns of communication, computer or trading systems. The Exchange explains that each of these breakdowns would first come to the attention of the Exchange information technology staff which would determine the cause of the breakdown and whether the problem could be corrected promptly.
If the cause of the breakdown could not be determined or, if determined, could not be corrected promptly (i.e., within 15 minutes), technology staff would notify the Exchange’s Chairman. If the Chairman concluded that the breakdown prevented a significant number of Exchange members from conducting business, he would order the suspension of trading until the cause of the breakdown had been corrected.
B. Financial Emergencies
FutureCom states that its financial integrity is generally assured through Bylaw 5.2 which requires that the initial margin for any order must be on deposit with FutureCom before any transaction could be executed on behalf of a member. This requirement, combined with position and daily price limits, makes it unlikely that the default of one or more FutureCom members would be so great that the Exchange’s financial integrity would be compromised.
In the event of a possible or actual default by an Exchange member, FutureCom Bylaws would require the Director of Compliance to notify FutureCom’s Chairman immediately. The Chairman would consult with the Director of Compliance and determine whether the amount of the default threatened the financial integrity of FutureCom.99 The Chairman would call a special meeting of the Board whenever losses resulting from a default of one or more members exceeded, in the aggregate, $750,000.100 The Board would meet as soon as practicable, but in no event later than 24 hours following the call.
Promptly after the special meeting had been called and, if at all possible, prior to the meeting taking place, the Chairman would notify the Director of the Division of Trading and Markets or, in his or her absence, other Division staff, by telephone, of the purpose of the meeting and the possible decisions that could be made. If the Board, consistent with Bylaw 1.9, subsequently determined to suspend trading on FutureCom (or take any other temporary emergency action), the Chairman would notify Commission staff by telephone immediately.101
X. System Security, Vulnerability and Operational Issues
A. System Overview
The Commission’s Office of Information Resources Management (“OIRM”) staff has examined the FutureCom system for consistency with the IOSCO principles for screen-based trading systems. It is OIRM’s opinion that the FutureCom system either meets each IOSCO principle or, to the extent that the FutureCom system does not meet a principle, full disclosure of that fact would be a satisfactory substitute.
FutureCom would be a globally accessible internet-based electronic futures exchange. The electronic trading system that would support the FutureCom exchange employs a scalable architecture and modular design. Those characteristics would enable the system to be economically sized to support the small volume of trading expected initially and yet to be easily expanded to accommodate growth. The system consists of centralized servers and communications equipment. By virtue of its high-speed connection to the internet, the system could be accessed by any authorized user from a personal computer (“PC”) located anywhere in the world. Although there are some minimal requirements related to the PC hardware and software, those requirements are generic in nature and are easily satisfied. Use of the system will be facilitated by the familiarity of its browser interface and by online access to help information and technical support services.
REDACTED MATERIAL SUBJECT TO CONFIDENTIAL TREATMENT
FutureCom's security profile, as determined recently by a certified independent system auditor, indicates that it already does or plans to make appropriate use of these security features prior to launch.102
FutureCom would employ a variety of safeguards for its physical environment, including protection of its equipment from unauthorized access, fire, lightning and other power surges, power outages, water damage and improper temperature and humidity conditions. These safeguards include detection and notification systems and procedures, and automated shutdown capabilities. Although FutureCom does not maintain a disaster recovery site, a number of factors would facilitate the accomplishment of their disaster recovery plan, which is to reestablish the trading environment at an alternate location. Those factors include the small amount of equipment required to support the low initial volume of trading it expects and the fact that it maintains an inventory of essential spare equipment. In the event of a disaster that would require FutureCom to halt trading, detailed plans are in place to manage the notification and trade management processes related to forced shutdown and restart of the trading environment.
Since the FutureCom system would be accessed over the internet, the performance for system participants is subject to variance depending on the nature of the trader's internet connection and the volume of competing internet traffic. Based upon participation in mock trading by a number of Commission staff on a number of occasions and observations at the FutureCom site using a variety of internet connections, that variance is small, on the order of a few seconds. Nonetheless, the FutureCom Account Agreement includes a disclaimer notice that warns participants of the potential for variations in performance. With regard to capacity issues, FutureCom expects the initial volume of trading to be relatively low. Even after the system has gained acceptance in the marketplace, FutureCom does not expect the average daily volume during the first year to exceed 3,500 contracts per day, with peak levels of trading not expected to exceed 150 trades per minute. The current configuration of the system, which for the most part will be replaced prior to launch with faster equipment, was able to support peak levels in excess of 150 trades per minute.
FutureCom expects its trading system to evolve and change rapidly in conjunction with the rapid pace of change in the nature and use of the internet.
B. System Security and Data Integrity
The FutureCom system would use a number of security features to insure the integrity of the trading environment. These security features and specific guidelines for their effective use were documented and discussed with FutureCom staff during a recent security audit conducted by an independent firm. FutureCom has provided detailed documentation that supports its stated intention to comply with recommendations of that security audit that address the following system security and data integrity issues:103
(1) REDACTED INFORMATION SUBJECT TO CONFIDENTIAL TREATMENT
(2) Authentication of website identity through certification;
(3) REDACTED INFORMATION SUBJECT TO CONFIDENTIAL TREATMENT
(4) REDACTED INFORMATION SUBJECT TO CONFIDENTIAL TREATMENT
(5) Provision of a secure operating and physical environment through the use of physical and environmental monitoring and alarm systems and security screening of new and existing personnel.
Unlike electronic trading systems previously approved by the Commission, which all use closed private networks to provide access for traders, access to the FutureCom system would be provided by an open public network, the internet.
REDACTED INFORMATION SUBJECT TO CONFIDENTIAL TREATMENT
Notably, FutureCom would not provide physical security for the trading terminals. There are two reasons for this. First, unlike all other electronic systems for which exchanges have sought approval to date, the FutureCom system does not require that the use of the trading terminal be restricted to any particular set of operations. FutureCom would not limit system access to specific PCs nor would it install any software on PCs to restrict access to or use of those PCs. The only requirement by FutureCom with regard to the trading terminal is that it be equipped with web-browser software - either Microsoft's Explorer or Netscape, version 3 or higher. Second, since communication with the FutureCom system would be accomplished through the internet, the trader and his computer could be located anywhere. It would therefore not be possible for FutureCom to restrict the location of or the physical security controls over the trading terminals. These two factors clearly place the responsibility for providing physical security on the traders themselves, a fact that is emphasized in FutureCom's risk disclosure statement.
C. System Reliability and Disaster Recovery
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To protect against power outages, equipment in the data center is insulated from short-term power outages by Uninterruptible Power Supplies (“UPS”). That equipment would provide sufficient reserve power for an automated orderly shutdown of equipment in the event of a power failure. Such an orderly shutdown would enable operations staff to conduct a normal restart of the system once electrical power was again available.
In addition to the reliability of system components, system reliability would be provided by the activities of Data Center staff. Those employees would monitor the status of communications and network servers. In the event of a hardware or network problem, they would follow documented procedures for problem identification, reporting and recovery.
Data Center staff also would collect and review internal system resource data on a daily basis. Staff would analyze that data to insure that system capacity was adequate for actual trading activity. This preventive maintenance practice also would provide additional system reliability.
D. System Capacity and Performance
FutureCom has conservatively sized its initial system configuration to accommodate its expected small volume of trading at launch. During the last year, FutureCom has conducted several tests to demonstrate the capacity and performance of its system. The results of those tests support FutureCom's position that its system would be able to accommodate the initial volume of trading it expects to occur. The architecture of the system supports FutureCom's position that it would be able to scale the system to accommodate significant growth in volume.
REDACTED MATERIAL SUBJECT TO CONFIDENTIAL TREATMENT
XI. Public Comments on the Proposal
A. Summary of Comments
The Commission staff first published the FutureCom proposal for comment in a January 31, 1997 Federal Register notice.104 The Commission received a total of 23 comment letters, with 20 commenters favoring and three commenters opposing the application.
The majority of favorable comments were submitted by individuals and corporations in the cattle business. Positive letters also came from Abraham Trading Company, a CTA; Teel Curtis, a commodities broker; the Kansas Livestock Association; the National Cattlemen’s Beef Association; the Continental Grain Company; the Texas Cattle Feeders Association; and Teel R. Bivins, a Texas state senator. In general, these letters stressed that competition among futures exchanges is beneficial and that, accordingly, FutureCom’s application should be approved and allowed to compete with the CME’s live cattle contract. Several commenters mentioned that the CME contract has suffered from increased basis unpredictability, and that they would like to have the proposed FutureCom contract as an available alternative. A number of letters also contended that FutureCom’s proposal would bring lower transaction costs, an improved audit trail, and benefits from cash settlement.105
Critical letters were submitted by the CME, the Minneapolis Grain Exchange (“MGE”), and NYMEX. All expressed concern at the incompleteness and inadequacy of the proposed rules submitted by FutureCom. Each of the exchanges indicated that FutureCom should be held to the same high regulatory standards as all contract markets.
Following the receipt of additional materials and information from FutureCom, the Division of Trading and Markets, acting pursuant to delegated authority, published the proposal for a 30-day comment period on November 24, 1997.106
Seven comment letters were submitted in response to the second notice. Four supportive letters were submitted by the National Cattlemen’s Beef Association and the Kansas Livestock Association, two agricultural associations; Continental Grain Company, a grain feeding company; and Netglobe Transit, Inc., an information support services company. The CME, the CBT, and NYMEX each sent a letter that was critical of the proposal.
The favorable letters contended that FutureCom would: (1) provide an alternative risk management tool to the CME live cattle futures contract; (2) have the advantages of an internet-based exchange over traditional exchanges; and (3) have low transaction costs.
The unfavorable commenters all expressed the opinion that there still were not sufficient materials available to make a comprehensive comment.107 These commenters also expressed concern regarding, among other things, the use of the internet as a basis for a trading system; the capacity of the clearing organization to perform the clearing function; the financial capability of FutureCom adequately to support clearing operations, including concern regarding the lack of a guaranty fund; the lack of a well-staffed compliance department; and FutureCom’s ability to adequately monitor its markets.
B. Discussion of Commenters’ Concerns
The predominant unfavorable comment concerned the lack of materials available to serve as the basis for informed comment about the proposal. When the FutureCom proposal was first published in the Federal Register for public comment in January 1997, limited materials describing FutureCom’s proposal were available. Division staff assisted the applicant in understanding the initial requirements for designation and the continuing obligations and requirements applicable to any designated contract market. Since the second request for comment was published, FutureCom submitted materials sufficient to inform the public about the proposal.
Although subsequently FutureCom submitted additional material and revised the content of its proposal, there were periods when Division staff did not have sufficient material to continue meaningful evaluation of the application under the Act and the Commission’s regulations. Therefore, the statutorily-established one-year period for consideration of FutureCom’s application was stayed on three occasions.108 However, with the re-commencement of the review period on January 19, 2000, the Division believes that FutureCom has submitted sufficient evidence that it would be able to meet applicable requirements under the Act and the Commission’s regulations and otherwise be able to operate in a manner not inconsistent with applicable law.
The second most common negative comment regarding FutureCom’s application concerned fairness and pragmatic issues related to the use of the internet as a means for trading. Specifically, the critical commenters contended that there would be inherent inequities between market participants on an internet-based trading system given the uneven levels of service between different internet service providers.
As discussed in Section X. of this Memorandum, OIRM staff has examined the FutureCom system for consistency with the IOSCO principles for screen-based trading systems. As stated, it is OIRM’s opinion that the FutureCom system either meets each IOSCO principle or, to the extent that the FutureCom system does not meet a principle, full disclosure of that fact would be a satisfactory substitute.
As discussed, FutureCom’s risk disclosure statement would set forth all the possible risks of trading futures and options contracts over the internet. FutureCom contends that many individuals who may become FutureCom members would already have firsthand knowledge of the nature of various kinds of commercial activity, including purchasing and selling securities and other investments, over the internet and possible risks of participating in those activities. Indeed, the volume of market activity over the internet, including access to various markets and intermediaries to those markets, continues to increase rapidly.
Another area of critical comments pertained to the financial adequacy of the applicant and its ability to support clearing operations in the event of a major default of a group of members holding a relatively large number of open positions. As discussed in Part C. of Section VII. of this Memorandum, the Division believes that FutureCom would have adequate financial protections designed to support clearing operations in circumstances of extreme levels of membership default. These protections include: (1) position limits and margin levels tied to the creditworthiness of members; (2) the requirement that initial margin must be on deposit before an order can be accepted into the system;109 (3) a minimum $1,000,000 segregated credit facility in an amount that is staggered in relation to levels of open interest; and (4) a reserve fund which would accrue at the rate of $1.00 per contract cleared until the fund reached $3,000,000.
As discussed, FutureCom has provided Division staff with a detailed analysis of the financial strength of the Exchange and its ability to support the clearing function at varying levels of default and at varying levels of volume and open interest. Based on this analysis, the Division believes that FutureCom has satisfactorily demonstrated that it would be able adequately to support its clearing function even if many members cumulatively holding a significant percentage of open interest defaulted.
With respect to the concern of public commenters regarding the technological capacity of the clearing organization to perform the clearing function, Commission staff has, as discussed herein, visited the First National Bank of Amarillo, examined the facilities and met with Bank staff that would be running the clearing operations. Specifically, Commission staff: (1) viewed each step of the clearing cycle on the Bank’s computer systems; (2) verified the ability of FutureCom and the Bank to communicate in the manner intended and to carry out daily balancing procedures; (3) viewed the initiation of a sample ACH transaction and procedures in the case of insufficient funds; and (4) verified procedures covering the flow of margin funds to and from FutureCom members, the flow of daily trade settlement funds, the issuance and monitoring of responses to margin calls, procedures used to handle members’ defaults, accounting to members for funds deposited and disbursed, the handling and build-up of the reserve fund, and the flow of funds received from the segregated credit facility.
Several commenters indicated concern as to whether FutureCom would be able to monitor adequately its markets. As discussed herein, Division staff believes that FutureCom would be able to adequately monitor its markets due to the automated nature of the trading system, and the design of the Exchange’s market surveillance and financial surveillance programs. FutureCom’s market surveillance program generally would take place in real time, as would the Exchange’s financial surveillance of FutureCom members who were not registrants.
A final concern raised by a number of commenters was the ability of FutureCom to perform adequate trade practice surveillance. As described and discussed in Section IX., above, FutureCom subsequently has developed a trade practice surveillance program that Division staff believes is adequately designed to detect the majority of the types of violative behavior that could take place on the FutureCom system.
As discussed, FutureCom would have an initial staff of ten people to provide support and services for the Exchange. Although only one of these persons would initially be responsible for monitoring trading and reviewing computer reports to discover possible trade practice violations, FutureCom would add additional staff as work load increased commensurate with increases in the level of open interest at the Exchange. As discussed in Part A. of Section VIII. of this Memorandum, FutureCom commits that it would hire additional compliance staff when the Compliance Director began to devote more than 75% of his time to compliance responsibilities. FutureCom estimates that this would occur when open interest in live cattle futures contracts exceeded 20,000 contracts.
FutureCom’s trade practice surveillance program would be supported by an investigation and disciplinary program which would meet the fairness requirements of Part 8 of the Commission’s regulations and which would sanction the commission of trade practice violations as well as deter future commission of violations by other FutureCom members or would-be repeat offenders.
FutureCom also would be subject to ongoing oversight. In particular, there would be rule enforcement reviews periodically in which Division staff would determine whether the Exchange was adequately enforcing its rules. Should Division staff discover deficiencies in FutureCom’s surveillance or disciplinary program, staff would make recommendations for program changes.
Based on the foregoing, including the analysis of OIRM in Section X., the Division of Trading and Markets believes that the proposed application demonstrates that the Exchange meets all the requirements of the Act and the Commission’s regulations and would continue to comply with all the regulatory requirements during its ongoing operations. Accordingly, the Division of Trading and Markets recommends that the Commission approve FutureCom’s application, approve its proposed Bylaws 1.1-1.27, 2.1-2.7, 3.1-3.4, 4.1-4.16, 5.1-5.6, 6.1-6.16, and 7.1-7.2, and issue the attached Orders. One Order designates FutureCom as a contract market in cash-settled live cattle futures and the other in options on those futures.
This recommendation is limited solely to the proposal before the Commission. The attached proposed Orders set forth the conditions, both initial and ongoing, upon which the Commission’s grant of designation to FutureCom as a contract market and the commencement and ongoing operations of the Exchange should be based. These Orders contain specific conditions, based on FutureCom’s representations to the Commission, related to how FutureCom will operate its clearinghouse, the final stages of implementation of its electronic trading system, and other self-regulatory undertakings specific to FutureCom’s business plan. Thus, these conditions relate to the financial soundness and integrity of FutureCom, including the maintenance of a segregated credit facility with a Commission-approved institution pursuant to terms substantially identical to the terms of the current facility, that Texas Beef repay any amounts advanced against the credit facility, that FutureCom obtain additional financial support should it approach upper limits built into the initial credit facility formula, and the accrual and maintenance of an adequate reserve fund. The Order also conditions designation and ongoing operations on the procurement and third-party testing of all final system components and receipt of written approval on the test results from the Commission, on the development and refining of specific strategies to detect trade practice violations and otherwise implementing the surveillance program submitted to Commission staff, and entering into a signed agreement with NFA for NFA to perform financial and recordkeeping surveillance with respect to Commission-registrant members of FutureCom.
Also attached is a cover letter to transmit the Order to FutureCom. This letter reminds FutureCom of certain core obligations detailed in the Order and of certain requirements it must meet under the Act and the Commission’s regulations.
1 FutureCom is owned by a number of partnerships which in turn are owned by a number of individuals. Due to the percentage ownerships of these partnerships and the individuals who own them, the ultimate owner-developer of FutureCom is Mr. William H. O’Brien of the Texas Beef Group located in Amarillo, Texas. Although the Kansas City Board of Trade also is technically organized as a for-profit entity, that Exchange does not generally operate with the primary objective of generating a profit for its owner.
3 This arrangement should not put FutureCom clearing members at a disadvantage with respect to FutureCom should it become insolvent. Under the Federal bankruptcy code, clearing members of a commodity clearing organization should have the same status with respect to an insolvent clearing organization that futures commission merchant (“FCM”) customers would have with respect to an insolvent FCM. See Section 761 of Subchapter IV of Chapter 7 of the United States Code. For further discussion see Section VII.C.3. of this Memorandum.
11 Although FutureCom’s Bylaws require the Executive Committee to meet the compositional requirements of Commission Regulation 1.64, that regulation strictly applies only to the full Board of Directors and FutureCom is not legally required to meet the compositional requirements with respect to its Executive Committee. Having the committee meet these requirements, however, serves the same purpose as it would when applied to the full Board. Thus, this provision should assist FutureCom in insuring that the affairs of the Exchange are run in a fair and even-handed manner.
15 Of course, each member that is registered with the Commission as an FCM or introducing broker (“IB”) must also comply with the minimum financial and related reporting requirements set forth in the Commission’s regulations.
21 See CME Globex Rule 578 wherein CME remains liable for willful or wanton misconduct or fraud or violations of the Act or the Commission’s regulations and wherein any person acting as agent in entering orders remains liable for any act, incident or occurrence within their control.
22 Chapter VII of FutureCom’s Bylaws provides for member arbitration procedures. (See Appendix A, page 18.) Under FutureCom Bylaw 7.1, members who allow a Commission registrant intermediary to enter orders could arbitrate claims against the intermediary at NFA in accordance with NFA’s current arbitration procedures. See Section G., below.
26 Although an intermediary would never hold or handle member funds, a FutureCom member who otherwise maintained an account with an FCM may instruct the FCM to transfer margin payments from that account to the FutureCom pooled account and that FCM may also be acting as an intermediary for the member on FutureCom.
27 See FutureCom Bylaw Section 2.7 which provides that no member may authorize another person that is not a FutureCom member to act as intermediary except as the Board may permit. The Board would permit only non-members to act as intermediaries if they were either Commission registrants or consented to FutureCom’s jurisdiction under the section.
28 The FutureCom-NFA agreement would require FutureCom to compensate NFA for the costs incurred in performing SRO surveillance functions. For any intermediaries that were not FutureCom members but otherwise had NFA as their designated SRO, NFA would apportion the costs of surveillance between FutureCom and other applicable exchanges.
29 While these procedures would prevent the entry of bunched orders, FutureCom’s Bylaws would permit the bunching of orders in anticipation of the implementation of an as-yet undeveloped system enhancement which first would have to be submitted to and reviewed by the Commission. See Section VI. C. for general information regarding order entry and confirmation.
34 Since the market could only move the daily price limit (30 ticks or $600 per contract (see footnote 55)) up or down in one trading session, the unfilled portions of triggered MIT or Stop orders could not generally be picked off by relatively low or high bids or offers.
39 It would be possible, in fact, for multiple trades entered before the start of the trading session to be matched at the open, but with none at the official opening price. While the Division does not believe that this would impair trading on FutureCom, it should nonetheless be disclosed to traders. An explanation of this point is included in the FutureCom Account Agreement.
42 Trader A’s offer and the un-filled quantity of Trader B’s offer would remain in the system and be eligible for matching. If Trader E’s bid had only been partially filled, the remainder would have been canceled automatically.
43 A sell stop order typically is placed below the present market and is often used to limit losses on long futures positions. Sell stop orders also are used by some traders to initiate sell transactions when the market penetrates below support levels.
49 Commission Regulation 1.46 requires FCMs to offset certain orders of customers. This protects customers from FCMs who may want to delay letting the customer know he has lost money by keeping offsetting positions open rather then closing out an offsetting trade. However, Regulation 1.46 applies to the customer accounts of FCMs and each member of FutureCom would be its own clearing member and there would be no customers of FCMs. Further, since every FutureCom member could, in a matter of seconds, ascertain his or her current equity balance, including all gains and losses, realized and unrealized, at any time, the rationale behind Regulation 1.46 would not apply to traders on FutureCom. Therefore, non-FCM members of FutureCom would be able to close out positions at their discretion and there would be no inconsistency in this regard with Commission regulations. However, FCM members of FutureCom would have to offset positions in their FutureCom accounts in accordance with Regulation 1.46 as Regulation 1.3(k) specifically defines the term “customer” to include the owner of a proprietary account for purposes of Regulation 1.46. FutureCom Bylaw 4.11 requires any member of the Exchange registered with the Commission as an FCM to comply with Regulation 1.46. (Since Regulation 1.46 applies only to FCMs, the Regulation 1.3(k) definition of “customer” would not include non-FCM members for purposes of Regulation 1.46.)
50 This refers to closing out a position and not the modification or cancellation of an order that has been accepted into the system. A separate procedure discussed above is used to modify or cancel an order.
51 FutureCom could request any kind of documentation it deemed necessary to determine the bona fides of an EFP transaction including, but not limited to: contracts; confirmation statements; telex printouts; invoices; and warehouse receipts or other documents of title. These requirements would be at least as stringent as those of other exchanges with respect to the execution and documentation of EFPs. See Appendix A, page 3.
52 Variation margin must be paid in U.S. dollars but initial margin payments may be made in either U.S. dollars or U.S. Treasury obligations. Deposited Treasury obligations would be held by the clearing bank as custodian in accordance with the terms of a Custody Agreement between FutureCom and the First National Bank of Amarillo.
54 SPAN stands for Standard Portfolio Analysis of Risk and is a risk-based, portfolio approach system for calculating performance bond requirements developed by the CME. First used by CME in 1988, it is now used by many other exchanges and clearing organizations to compute minimum performance bond requirements for futures and options positions. SPAN constructs scenarios of contract price changes and volatility changes to determine what an entire portfolio might reasonably lose in one day. The amount of performance bond calculated should cover the largest of these calculated one-day losses. Margin on short option positions would also be calculated using the SPAN system.
55 The terms and conditions for the live cattle futures contract generally prohibit trading in any contract month at a price more than $0.0150 per pound above or below the previous day’s settlement price. Since one live cattle futures contract represents 40,000 pounds of live slaughter cattle, the daily price limit is $600 per contract. Maintenance margin for the contract of $1,000 is a little over 1.5 times the $600 daily price fluctuation limit.
56 FutureCom Bylaw Sections 5.3 and 5.4 provide that margin calls may be made at such times and in such amounts as the Board shall determine from time to time, and that a member shall be required to transfer funds necessary to meet a margin call within the time prescribed by the Exchange, respectively.
57 This would apply only in the last five trading days of the spot month when daily price limits are lifted. FutureCom staff state that in their experience in the cattle market, this is the most volatile period of trading. Procedures involved in closing the Exchange are discussed in Section X.
59 FutureCom will strongly encourage every member to participate in automatic transfer of funds and authorize the clearing bank to draw funds from an account of the member set up for this purpose. See Footnote 63 and accompanying text. One hour after FutureCom’s e-mail margin call message is sent to a member, the clearing bank would initiate the automatic funds transfer procedure for the amount of the margin call. Although it may take more than 24 hours in some circumstances for the funds to arrive at the clearing bank, once the process is initiated, it cannot be stopped, and the funds will arrive and are considered an asset to the recipient of the transfer until arrival. Further, recipients in this process, in this case, FutureCom and the clearing bank, would receive a notice within 24 hours regarding any account that had insufficient funds to fulfill the transfer. The receipt of such notice would constitute a default on a margin call. FutureCom may have flexible margin call deadlines for any members not participating in the automatic transfer program. Other alternatives, however, with the exception of U.S. mail, are not significantly slower and may even be faster than automatic transfers. Members who wished to transfer funds via check by U.S. mail would cause delays in their ability to put on new positions and otherwise trade on the FutureCom system. This method of funds transfer is, with the exception of establishing an account, expected to be the least likely method used. It is anticipated that most members would, in fact, keep excess margin deposited in the pooled account at the clearing bank at all times to support their ability to trade as desired on the system.
60 FutureCom Bylaws require every member that is required to be registered with the Commission as an FCM to comply with the Act and the Commission’s customer segregation regulations. FutureCom would hold funds in the FutureCom pooled account at the clearing bank. Each member would be self-clearing and the relationship between FutureCom and its members would be the same as that between, for example, the Board of Trade Clearing Corporation and its clearing members. See Section 4d of the Act. However, under federal bankruptcy law, the status of FutureCom members vis-a-vis FutureCom in the case of an insolvent FutureCom, should be the same as the status of a customer of an FCM with respect to an insolvent FCM. See Section VII. C. 3. for an analysis of this point.
61 Members would be responsible for maintaining accessible mail delivery accounts and responding to time-critical messages. FutureCom would have proof and time of receipt of a message and when a member had accessed the message.
63 The ACH System is a clearing house for settling any accounts between member banks accomplished through transfer of information via electronic transfers. The clearing bank would submit ACH instructions sent at 1:30 p.m. from FutureCom at 2:30 p.m. each business day to the Federal Reserve’s South Western Automated Clearing House System which is the system that applies to the geographical location of the clearing bank; the origin of the ACH instructions. Although ACH transfers can take, in some cases at the maximum, up to two days, FutureCom would receive advance notice of a denied ACH within 24 hours and before it would have become collected funds if honored. See Footnote 59.
64 It is expected that most members would maintain excess funds on deposit in the pooled margin account to increase their flexibility both to meet variation margin calls and to put on new positions when they wanted to do so.
69 At FutureCom’s best anticipated trading volume growth rate of 500 contracts per calendar quarter based on an initial volume of 2,000 contracts per day during the first quarter of trading, an estimated open interest of five times the daily trading volume, and an accrual rate of $1.00 per cleared contract, it would take approximately three full years to reach this level of accrued funds.
70 This is based on the CME’s live cattle contract’s open interest relative to volume, i.e., FutureCom found that on a historical basis, when CME volume in live cattle futures was approximately 20,000, CME’s open interest in live cattle futures was approximately 100,000 contracts.
71 Given the low levels of the few defaults that have taken place on currently existing exchanges, FutureCom’s two default assumptions of 3% and 6% of estimated open interest illustrated in their analysis are comparatively conservative estimates and thus provide for a relatively high degree of assurance of capacity to support the clearing function of FutureCom.
72 In reality, FutureCom would cover the losses generated by a defaulting member immediately. The analysis illustrates three days of price limit moves only to show what would have to happen in order to use most or all of the combined segregated credit facility and reserve funds available to FutureCom at the time.
75 For example, at the end of the fourth quarter of the second year of operations, at an estimated open interest of 27,500, the combined segregated credit facility and accrued reserve fund should total $4,700,000. The dollar value of the 6% market default would approximate $2,970,000, which would still leave $1,730,000 available to draw from the segregated credit facility. At the end of three years, at an estimated daily trading volume of 6,000, the combined resources available to FutureCom to support operations would total $6,510,000, the dollar value of defaulted contracts at a 6% default rate would total approximately $3,240,000, and $3,270,000 would be left for FutureCom to draw on the segregated credit facility until it was replenished by drawn proceeds being repaid by Texas Beef.
76 That section provides that a “clearing organization” is an organization that clears commodity contracts made on, or subject to, the rules of a contract market or board of trade. In the case of FutureCom this would be, like the CME, the Exchange itself, as no separate entity outside the Exchange would be the clearing organization.
77 That Section provides that a “customer” with respect to a clearing organization means a clearing member of such clearing organization that holds a claim against the clearing organization on account of cash or other property received by the clearing organization to margin a commodity contract in such clearing member’s proprietary account. FutureCom’s pooled account at the clearing bank, the First National Bank of Amarillo, will be held in an account managed pursuant to the terms of a Cash Settlement Agreement between FutureCom and the bank, and specially titled to indicate exactly what the account was for, how it would be applied, and the fact that it cannot be used for any other purpose.
78 These two Sections support the conclusion that FutureCom members’ property is “customer property.” That assertion is also directly supported by two other Sections which together provide for the terms “member property” and “customer property” to be legally synonymous for purposes of this Subchapter of the Code. Section 761(16) provides that “member property” means customer property held by or for the account of a debtor that is a clearing organization, from or for the proprietary account of a customer that is a clearing member of the debtor. Section 761(10) provides that “customer property” means cash or the property held by or for the account of the debtor from or for the account of a “customer’ (which, under Section 761(9)(d), is a clearing member). Thus, member property would be a type of customer property with respect to the bankruptcy of FutureCom as a clearing organization. Also, pursuant to its non-intermediated design in this context, FutureCom would literally never hold any customer property that was not also “member property.”
80 The minimum price increment for a FutureCom live cattle futures contract is 5 cents per hundred pounds or $20.00 per contract (each contract consisting of 40,000 pounds). In the example, the price moved $1.00 or 20 minimum price increments per hundred pounds resulting in a gain or loss of $400.00 per contract for each long or short trader, respectively.
82 For example, it is expected that many, if not most members, including those who otherwise maintain an account with an FCM, would enter transactions on FutureCom directly, thus greatly reducing or changing the manner in which many of the types of unlawful trade practices could occur. FutureCom Bylaw 2.7 prohibits any member from authorizing another person that is not a FutureCom member to enter and execute transactions for the member, except as the Board, in its sole discretion, may permit. In addition to any other requirements the Board may impose, the Board would not permit any non-FutureCom member to enter and execute transactions for a member of the Exchange unless such person was registered with the Commission, such as a CTA, FCM or IB and was an NFA member, or had agreed to comply with FutureCom Bylaws and consented to the jurisdiction of FutureCom with respect to such person’s activities on behalf of the member. See Section V.G., above. FutureCom member intermediaries also would be subject to heightened scrutiny under FutureCom’s trade practice surveillance procedures which specifically require compliance staff to create a report which would identify instances in which any member-intermediary may have traded ahead of the member. See next section, below.
83 Although FutureCom’s members would not act as floor brokers, Bylaw 4.15 would prohibit the same types of trade practices that are prohibited by Part 155. The Bylaws also require each member that is registered with the Commission as an FCM or IB to comply with Part 155. (See Appendix A, pages 15-17.)
84 Mr. David Huseman would serve as FutureCom’s compliance officer. Mr. Huseman has been an associated person (“AP”) and principal of Texas Beef Commodities Company, a registered introducing broker, since 1986, where he has been primarily responsible for supervision and compliance. Mr. Huseman has been responsible for the development of FutureCom’s trade practice and market surveillance program and would be one of an initial ten-person staff responsible for the various areas of Exchange operations.
85 If, upon analysis of the exception reports generated by FutureCom, Mr. Huseman concluded that further investigation of any particular matter was warranted, he would be assisted in his investigation by FutureCom’s outside counsel, Mr. Kevin Foley. Mr. Foley has nearly twenty years’ experience in the regulation of commodities and securities markets. He served as Chief Counsel to the Division of Trading and Markets from 1983 to 1987. In addition to his role as outside counsel to FutureCom, Mr. Foley has served as special counsel to the CBT in connection with an investigation of one of its member firms.
86 In this regard, if at any time the Exchange determined that Mr. Huseman was devoting 75% or more of his time to the analysis of exception reports, FutureCom represents that additional compliance staff would be hired and trained to support him. It is estimated that this would occur when open interest in the live cattle futures contract exceeded 20,000 contracts.
87 SQL stands for Structured Query Language. Microsoft Access and SQL are both software products FutureCom would use in administering its surveillance program. Microsoft Access is a database storage mechanism which stores and manipulates information. SQL is a software database tool used to help select records from a database.
88 Although this number has not yet been determined, FutureCom represents that it would set a level that would help the Exchange to assess whether any member or members were controlling a sufficient number of contracts in a manner that could affect the forces of supply and demand such that bid and offer prices could become distorted.
89 Market movements of these types in these percentages are not viewed by Exchange staff as an absolute indication that the market is behaving in a distorted fashion, but are viewed by Exchange staff to be the minimum level of activity which would warrant a closer look and analysis of the market at that time. These numbers were determined based on FutureCom staff’s experience and knowledge of the cattle markets. Once trading begins and the Exchange has actual experience with trading, the Exchange may determine to change these numbers.
92 Commission registrants or others that were not members of FutureCom would generally not be able to act as intermediaries for FutureCom members. FutureCom Bylaw 2.7 prohibits any member from authorizing another person that is not a FutureCom member to be an intermediary, except as the Board, in its sole discretion, may permit. This might include a spouse or a partner in a business unrelated to futures trading. See Section V.G. for discussion of the use of intermediaries on FutureCom.
93 For any intermediaries that were not FutureCom members but otherwise had NFA as their designated SRO, NFA would apportion the costs of surveillance between FutureCom and other applicable exchanges.
98 If a respondent waived his or her right to a hearing, the Compliance Department could submit testimony or other evidence to the FutureCom Hearing Committee which would hear the merits of the disciplinary case.
99 The size of the loss that would lead to this conclusion would depend on the facts and circumstances at the time, including consideration of the size of the Exchange reserve fund, which accrues at the rate of $1.00 per contract cleared. Initially, however, the Chairman would make such a determination if losses resulting from a default of one or more members would exceed, in the aggregate, $500,000. The Chairman would advise each member of the Board but not necessarily call a special meeting until the aggregate default exceeded $750,000. At this point, a meeting would be required.
100 The Division believes that these amounts are reasonable and appropriate given the amounts available from FutureCom’s segregated credit facility with Bank of America in relation to the open interest at the time of default and in relation to the total daily price limit moves of FutureCom’s initial cash-settled live cattle contract. In accordance with provisions of FutureCom Bylaw 1.4, the Chairman could also call a special meeting of the Board if three Board members requested a meeting.
101 Any suspension of trading would be lifted as soon as possible by FutureCom staff and all orders that had been entered into the system at the time of the suspension would be preserved unless the Exchange did not re-open on the same trading day. In this event, only GTF orders would be preserved (day orders having expired).
102 The auditor was AuditForce, a Dallas, Texas based professional services firm providing internal auditing, information technology auditing, and compliance services to organizations. Commission staff reviewed and made revisions to the proposal for review conducted by AuditForce and reviewed the report of the audit.
107 During the pendency of the comment period, FutureCom had filed requests to treat certain submissions about its computer system and other information as confidential. Accordingly, these materials were not available at that time for public review.
109 As mentioned previously, it is notable that any monies in FutureCom’s pooled account at the clearing bank would be applied first to the appropriate member’s current available equity balance in an order which will satisfy all outstanding variation margin calls at that point, before being applied to support any new positions.