The Division of Trading and Markets (“Division”) has completed a rule enforcement review of the market surveillance, trade practice surveillance, audit trail, and disciplinary programs of the Kansas City Board of Trade (“KCBT” or “Exchange”) for compliance with Sections 5a(a)(8) and 5a(b) of the Commodity Exchange Act (“Act”) and Commission Regulation 1.51.1 The review covers the period January 1 through December 31, 1999 (“target period”).2
In conducting its review, Division staff performed an on-site review of Exchange records in February 2000. The Division examined, among others, computer reports and other documentation used routinely in the conduct of trade practice surveillance and market surveillance; selected trade practice investigations, market surveillance investigation and disciplinary action files; trade timing accuracy reports and trading cards and order tickets from selected firms for selected dates; trade practice investigation, market surveillance, disciplinary, and floor surveillance logs; minutes of meetings of the disciplinary committees held during the target period; and compliance manuals and guidelines. In addition, Division staff interviewed officials of the Exchange’s Department of Audits and Investigations (“A&I” or “Compliance”), including the Vice President of Compliance, with respect to the operation of KCBT’s self-regulatory programs.3
The Division provided the Exchange an opportunity to review and comment on a draft of this report on August 24, 2000. On August 29, 2000, Division staff conducted an exit conference with KCBT officials to discuss the report’s findings and recommendations.
II. MARKET SURVEILLANCE - SECTION 5a(a)(8) AND COMMISSION REGULATION 1.51(a)(1)4
A. Routine Market Surveillance Activities
1. Volume and Open Interest
A&I monitors trading to detect potential market congestion and price distortions. The KCBT Clearing Corporation (“Clearing Corporation”) provides daily to A&I the “Open Share of Market Report” for each contract. This report shows each clearing member's gross long and short positions and market percentage, arranged from the largest to the smallest positions. Beginning on the last trading day of the preceding future, A&I records the largest positions and their respective clearing members on a computer spreadsheet for each contract and monitors those positions on a daily basis until contract expiration. A&I also calculates the cumulative percentage of total open interest held by those clearing members in the nearby month.
In addition, Exchange staff examines the “Volume and Open Interest by FCM Report” (“Volume and Open Interest Report”) for each contract on a daily basis. 5 The Volume and Open Interest Report contains pit trades, exchanges of futures for physicals ("EFPs"), transfer trades, option exercises, and ending gross long and short positions for all clearing members in all months. The report, which also includes codes that highlight for review any open position changes greater than the clearing member's daily volume, is reviewed for any significant change in open interest.6 A&I analyzes the significant changes to determine possible reasons for the change and any market impact. Staff contacts the respective clearing member if any questions remain as to whether the problem was resolved satisfactorily or further action is necessary.
The Division reviewed 30 random days during the target period and found seven instances, four in Wheat futures and three in Wheat options, in which A&I contacted clearing members to determine whether large increases or decreases in positions were properly resolved. A&I noted the amounts of the increases or decreases in the clearing members’ open positions, either in the margins of the Volume & Open Interest Report or on a separate sheet, and prepared brief memoranda of the explanations provided by clearing members. In six of the seven instances, large increases or decreases were the result of clearing members not obtaining offsetting positions for omnibus accounts before submitting open positions to the Clearing Corporation.
In the seventh instance, A&I opened a Special Investigation after a review of the Volume and Open Interest Report revealed that a clearing member had a large reduction in its Wheat option position, in excess of the daily volume on August 16, 1999.7 A&I found that this clearing member had been adding, rather than offsetting, its Wheat option positions, thereby overstating its total Wheat option position by 1,223 contracts on the previous day. During its investigation, A&I also discovered that the clearing member had been overstating its Wheat option position since June 8. Based on these findings, A&I referred the matter to the Complaint Committee. The clearing member agreed to a $1,223 fine.8
2. Price Changes and Inter-Market Relationships
A&I reviews daily price changes for KCBT contracts, as well as cumulative price changes dating back to expiration of the preceding contract. A&I also reviews the spread differential between the nearby and each deferred month. In addition, staff tracks the daily price movements of Wheat futures at the Chicago Board of Trade and Minneapolis Grain Exchange, and the spreads between those markets and the KCBT contract. Further, the price movements and spreads in the Mini Value Line futures are monitored against the Value Line Spot Index, S&P 500 future and spot indexes, New York Stock Exchange Composite Index future and spot indexes, and the Dow Jones future and spot indexes. The ISDEX futures and spot indexes also are monitored daily, as well as price movements and spreads for Western Natural Gas futures at KCBT and the New York Mercantile Exchange.9
By monitoring the daily and cumulative price changes, A&I is able to detect any price movements that are inconsistent with other exchanges, taking into account external factors such as weather, economic news, or domestic and foreign market crises. If A&I detects a significant difference in price relationships, it will investigate further to determine possible reasons for the difference and its impact on the market, particularly in the nearby month. No significant price discrepancies occurred during the target period.
3. Deliverable Supplies
The KCBT receives a “Daily Stock Report” from its 17 “regular elevators,” which shows the gross amount of wheat and other commodities either held in storage or for which warehouse receipts are held as of the previous day's close of business.10 The gross amount is posted on the trading floor each morning, along with the increase or decrease from the previous business day. The regular elevators also provide a “Weekly Deliverable Stocks Report,” which A&I uses to compare the daily and weekly numbers to determine if any discrepancies exist. If discrepancies are identified, A&I immediately reports them for follow-up to KCBT’s Senior Vice President. A&I also compiles the information and issues a report every Tuesday indicating the total deliverable grades, total non-deliverable grades, and total Commodity Credit Corporation (“CCC”) stocks for the Kansas City and Hutchinson elevators.11
A&I staff also review the Weekly Deliverable Stocks Reports, Daily Stock Reports, daily railroad receipts and shipments, and registered warehouse receipts, to verify the deliverable supply. In conjunction with this review, A&I contacts members with outstanding registered warehouse receipts to verify their status. If a clearing member does not report the cancellation of warehouse receipts, A&I will open an investigation into the matter. No such investigations were opened during the target period.
4. Heightened Surveillance of Contract Expirations
A&I's objective for each delivery month is to ensure orderly liquidations by increasing surveillance of open positions in expiring contracts near the end of the month. Starting a few days before the first notice day of a Wheat future, i.e., the last business day of the month preceding the delivery month, A&I monitors the house and customer positions held by each clearing member and prepares a spreadsheet for the three largest long and short position holders (and any other clearing members with positions of 100 contracts or more) and their respective percentage of open interest. A&I monitors these clearing members throughout the liquidation period until their position balances are zero.
On the first notice day of the Wheat future contract, A&I sends liquidation notice letters to clearing members reminding them of the delivery date and the last trading day of the expiring month. Throughout the liquidation month, A&I routinely asks clearing members and other positions holders about their intentions to make or take delivery and reminds them that an orderly liquidation is expected. In addition, A&I performs an "economic justification" test, calculating the difference between the cost to procure wheat through the delivery process and the cash market. Staff looks at current market prices and spread trading activity to determine which would be more economically feasible given current market conditions.
For Western Natural Gas futures, A&I sends liquidation letters to the clearing members with open positions one week prior to the last trading day. In addition, A&I ascertains whether the clearing members have transportation agreements on file. Clearing members must have a copy of the agreements on file before the last trading day.12 Because the Mini Value Line and ISDEX futures contracts are cash-settled, there are no delivery-related issues associated with their expiration and liquidation letters are typically not needed.
With respect to option contracts, A&I sends liquidation letters to clearing members with long in-the-money positions four days before the last trading day of the expiring option month.13 A&I receives a “Report of Exercises from the Clearing Corporation” that shows each option position that was exercised by the clearing member and opposite clearing member. A&I also receives an “Exercise Trade Register Report” when options are exercised on the previous business day. This report identifies the clearing member, premium, quantity bought and/or sold, and the dollar amount exercised. A&I reviews the Exercise Trade Register Report to ensure that the options were properly exercised, particularly those occurring on the last trading day. During the target period, all in-the-money options were exercised properly or automatically exercised.
A&I creates a file for each contract expiration that contains price-change spreadsheets, the largest long and short position holders, liquidation/open interest spreadsheets, copies of liquidation letters sent to clearing members, delivery notices and any underlying documents, in-the-money summaries, and Reports of Exercises. The Division reviewed all 37 expiration files for the target period, and found that they contained appropriate information and documents for each respective contract expiration. The Division did not find any material market surveillance issues on the days selected for review that required further action by A&I staff.
B. Large Trader Reporting System
A&I monitors reportable positions in Wheat, Mini Value Line, and ISDEX futures and options, and Western Natural Gas futures. Clearing members must submit open positions on CFTC Form 01 for each reportable customer and house position to A&I each morning by 9:00 a.m. A&I records any reportable positions on “Open Contracts of FCMs” sheets for each contract, which are categorized by clearing member and customer/house accounts. Wheat futures reportable positions are compiled by the Commission’s Kansas City office and are forwarded to the Exchange weekly. The Exchange monitors these positions for concentrations that may disrupt the market.
A&I verifies the accuracy of Form 01 information by comparing Form 01 reportable positions to the positions reported by clearing members on the Clearing Corporation’s Form 20.14 A&I contacts the relevant clearing member if any discrepancies exist.
Since the 1998 Review, the Exchange has changed its procedures for reporting weekly large trader option positions. In early 1999, the Commission assumed responsibility for collecting and reporting weekly option data submitted by all reporting firms. Prior to that time, clearing members submitted their reportable option positions weekly to the Clearing Corporation. The Commission compiles and produces reports of KCBT reportable position holders for KCBT contracts on a weekly basis. A&I receives a copy of these reports each week and uses them in its market surveillance program.
C. Enforcement of Speculative Position Limits and Hedge Exemptions
KCBT rules concerning speculative limits prescribe the maximum number of net futures-equivalent contracts (futures and options) which any one person or entity may own or control on the same side of the market without an approved exemption.15 A&I reviews clearing members' open positions for speculative limit violations daily as part of its review of Volume & Open Interest Reports. Also, as first notice day approaches, A&I will identify position holders who are near or over the spot-month limits. Clearing members or position holders will then be notified and instructed to take appropriate action to reduce their positions. A&I will continue to monitor these positions to ensure that they are reduced to required levels. If a position holder has filed for a speculative limit exemption, A&I will not take action. If a speculative limit exemption is not on file, A&I will request that an exemption be filed or that action be taken to reduce the position.
There were no positions in excess of KCBT's speculative limits during the target period.
D. Monitoring of EFP Transactions
KCBT rules allow transactions in futures made either in connection with EFPs or for the purpose of establishing the price of cash commodities.16 To enforce these rules, A&I examines EFPs daily as a part of its Time Audit Report ("TAR")17 review, looking for transactions with suspicious characteristics. In particular, A&I searches for EFPs in which both sides have the same clearing firm and account number, are unusually large, or are priced outside of the daily trading range. If any of these elements are identified, A&I will call the clearing member and/or account owner in an effort to determine whether the transaction was bona fide. During the target period, there were no EFPs deemed suspicious by A&I based upon the foregoing criteria.
In this connection, the Division conducted an independent review of Wheat EFPs on 16 days during the target period, and similarly did not find EFPs that appeared suspicious or otherwise warranted further investigation.
E. Conclusions and Recommendations
The Exchange maintains an adequate market surveillance program. The KCBT tracks daily price changes and spreads, and reviews the volume and open interest of its market participants. The Exchange also routinely contacts trade sources and large market participants to keep abreast of cash market activities and delivery intentions. Additionally, the Exchange has adequate procedures for monitoring reportable traders, enforcing its speculative position limit rules and resolutions, and for identifying suspicious EFPs for follow up.
Based on the foregoing, the Division has no recommendations in this area.
III. AUDIT TRAIL – SECTION 5a(b) AND COMMISSION REGULATION 1.35
A. Essential Trade Data and One-Minute Timing18
To capture essential trade data, Exchange members use two-sided trading cards, with buys on one side and sells on the other. Trade data are submitted by clearing firms to the Clearing Corporation throughout the day. All trades must be submitted for clearing within 60 minutes after each 30-minute trading period. The clearing system matches trades that agree on quantity, brokers, month, price, and clearing firms. Trades can be entered and errors can be corrected throughout the day, until each contract’s first reconciliation report is distributed to clearing firms, approximately 45 minutes to one hour after regular trading hours end. After that time, no trades from that day can be entered into the clearing system, and firms have two hours to correct any errors on trades already in the system. The Clearing Corporation provides A&I with a “Daily Out-Trade Audit Report” that contains a record of all unmatched trades, corrections, and busted trades from the previous trading day.19 The Division believes that KCBT’s audit trail system is able to capture essential data on trades, including data on unmatched trades and out-trades, as required by Section 5a(b)(1)(B) of the Act.
To satisfy the one-minute timing requirements of the Act and Commission regulations, the Exchange requires that both parties to a trade manually record the minute of trade execution on their trading cards.20 The time of execution and other recorded trade data are then entered into the Clearing Corporation’s trade matching system and compared to the Time and Sales Report to create the TAR, KCBT’s Commission Regulation 1.35(e) trade register. The TAR, also used by A&I to verify the accuracy of one-minute execution times recorded by members, includes trade times, execution prices, and indications of possible timing errors. There are six error codes that identify inaccurate trade execution times on the TAR: (1) Bought Side-No Trade; (2) Sold Side-No Trade; (3) No Quote at This Price (“No Quote”); (4) Time Out of Limits; (5) Bought Side-Untimed Trade; and (6) Sold Side-Untimed Trade. These codes are used by the Exchange to calculate and enforce its one-minute timing requirement.21
For purposes of this review, the Division requested that the Exchange provide data on the percentage of accuracy of its one-minute execution times for all contracts on two representative trade dates in each month of the target period. Because the Exchange treats No Quote errors as reporting errors rather than timing errors, the Division and the Exchange agreed that the Exchange would submit two sets of timing accuracy data for purposes of this review, one set counting No Quote errors as timing errors and another set excluding No Quote errors from the calculation.22
Exchange staff explained to the Division that No Quote errors are deemed reporting errors because generally they occur for one of two reasons: (1) a member failed to report a trade, or (2) the pit reporter missed the report of a trade. In reviewing the Exchange’s investigations, the Division found that members questioned regarding No Quote errors often alleged that they reported their trades but that the pit reporter failed to record them.23 Although the Exchange experienced high turnover with respect to pit reporters during the target period, it nevertheless remains members’ responsibility to ensure that their trades are reported and recorded. Indeed, KCBT Rule 1111.00 notes that members are responsible for ensuring that trades are made known to the pit reporter.
In response to recommendations made in previous rule enforcement reviews, the Exchange has implemented a summary disciplinary program for order ticket, trading card, and trade timing errors. This program includes issuance of reminder and warning letters prior to a member being referred to the Complaint Committee.24 Because the Exchange does not consider No Quote errors to be trading card errors (the member has recorded the trade time as required by KCBT Rule 1115.00) or trade timing errors, they fall outside of the Exchange’s summary disciplinary program and are dealt with by A&I on a case-by-case basis. In determining whether to issue a reminder or warning letter, or whether to refer the matter to the Complaint Committee, A&I weighs various factors such as the number of violations and the member’s prior history.
The Division found that A&I issued reminder letters to five members regarding No Quote errors identified in five routine TPIs conducted during the target period.25 The Division also found, however, ten TPIs in which A&I identified No Quote errors, but did not mention these errors in reminder letters or warning letters that were issued regarding other violations. For example, at the conclusion of one TPI, A&I issued a reminder letter to a member regarding seven untimed trades and 19 no trade errors, and a warning letter regarding various trading card errors. Although A&I had identified seven No Quote errors, those errors were not mentioned in either the reminder or warning letter.26
The Division recognizes that the Exchange’s practice of treating No Quote errors as reporting errors rather than timing errors does not impact significantly trade timing accuracy rates. Specifically, the Exchange’s one minute trade timing compliance rate dropped only from 96 percent to 94 percent when No Quote errors were deemed trade timing errors. However, members’ failure to ensure that trades are reported to and recorded by the pit reporter does call into question the accuracy and reliability of the Exchange’s Time and Sales Report. An accurate and reliable Time and Sales Report is not only essential for surveillance purposes, including trade reconstruction, but is essential for evidentiary purposes with respect to prosecuting disciplinary actions. The Division believes that the absence of specific guidelines for A&I to determine whether No Quote errors should result in a reminder letter or warning letter, or should be referred for disciplinary action, may contribute to this problem. Therefore, the Division recommends that the Exchange treat No Quote errors as trade timing errors subject to the Exchange’s summary disciplinary program. The Division believes that consistent enforcement of the Exchange’s trade reporting requirement should reduce the number of No Quote errors, and thereby, improve the accuracy and reliability of the Exchange’s Time and Sales Report.
B. Recordkeeping Compliance
To ensure compliance with Regulation 1.35 recordkeeping requirements, the Exchange conducts quarterly reviews of order tickets and trading cards (“audit trail reviews”) by randomly selecting a three-day period for review. Quarterly audit trail reviews alternate between “full-scope” and “limited-scope” reviews. Full-scope reviews are intended to encompass all Exchange members. Limited-scope reviews are used primarily to follow up on members who received reminder or warning letters, or who were referred to the Complaint Committee as a result of a prior review.
In order to evaluate members’ compliance with order ticket and trading card recordkeeping requirements, the Division examined the Exchange’s second full-scope audit trail review conducted during the target period. The Exchange’s review of order tickets typically involves all orders from the selected three-day period. Accordingly, A&I staff examined 1,421 orders from 19 firms as part of the full-scope review. A&I found that all of the order tickets it examined contained a pre-printed order number and account identification, and that 1,408 order tickets (99 percent) contained the requisite entry and exit timestamps.
The Exchange also inspected all trading cards from the same three-day period for compliance with trading card recordkeeping requirements and found similar high levels of recordkeeping compliance. Specifically, the Exchange found that 99 percent of the 3,237 trading cards reviewed were written in non-erasable ink, contained trades for one 30-minute interval, separately identified the open and close, had no skipped lines, and included the date, commodity, price, quantity, opposite floor member, put or call indicator (for option trades), pre-printed members’ identifications, and trading card sequence numbers. Additionally, 98 percent of the cards indicated the clearing FCM, had no unused lines that were not crossed out, and were submitted to a clearing member within 15 minutes of the appropriate 30-minute trading interval.
The Division’s examination of this audit trail review also revealed that the review was well documented, and that similar to the other audit trail reviews conducted during the target period, was completed in a timely manner.
C. Conclusions and Recommendations
The Division found that the Exchange’s audit trail system is able to capture essential data on trades, including data on unmatched trades and out trades. With regard to recordkeeping compliance, the Division found that the Exchange maintains an adequate program to ensure member compliance with the Commission’s trading card and order ticket content requirements. The Exchange reviews trading cards and order tickets during quarterly audit trail reviews. The Division examined one of the Exchange’s full-scope reviews and found that it was well-documented and completed in a timely fashion, and that members demonstrated a high level of compliance with order ticket and trading card recordkeeping requirements. Since the 1998 Review, the Exchange has implemented a summary disciplinary program for enforcing trade timing, order ticket, and trading card requirements.
The Division’s review of the one-minute trade execution times recorded by Exchange members during the target period found that the accuracy rate for those times was approximately 94 percent when No Quote errors were treated as timing errors and 96 percent when such errors were treated as reporting errors. The Exchange does not include No Quote errors in its trade timing calculations because it believes that No Quote errors are due generally to either a member not reporting a trade or the pit reporter missing a trade. The Division believes that the Exchange should treat No Quote errors as timing errors because members’ failure to ensure that trades are reported to and recorded by the pit reporter diminishes the accuracy and reliability of the Exchange’s Time and Sales Report, an essential tool for reconstructing trading activity and prosecuting trade practice violations. Treating No Quote errors as timing errors subject to the Exchange’s summary disciplinary program also should result in the consistent enforcement of the Exchange’s requirement that trades be reported to and recorded by the pit reporter.
Based on the foregoing, the Division recommends that the Exchange:
· Treat No Quote errors as trade timing errors subject to the Exchange’s summary disciplinary program.
IV. TRADE PRACTICE SURVEILLANCE – SECTIONS 5a(a)(8) AND 5a(b) AND COMMISSION REGULATIONS 1.51(a)(2), (4), (5) AND (6)27
A. Trade Practice Surveillance
1. Review of Daily Reports
A&I staff monitors trading practices by reviewing the TAR for each contract daily.28 The Exchange’s computer system identifies possible trade practice violations by performing certain edit functions based on predetermined parameters. All trades meeting the criteria of one or more parameters are flagged on the TAR with error codes. Possible violations noted on the TAR include trading ahead of a customer order, accommodation and wash trading, money passing, invalid spread trading, and improper cross trading. A&I determines on a case-by-case basis whether to open an investigation based upon activity identified by these error codes or if any particular member has an unusually high number of errors on a given day or during the month.29
A&I also reviews daily the “Time And Sales Verification Against Trades Report” which lists all unmatched quotes and unmatched trades. A&I staff check all unmatched quotes with the then-current market price and the daily high and low to ensure that erroneous price quotes were not disseminated to the public.30 In addition, A&I also reviews daily the “Give-up Average Price Residual Summary Report for Executing Firm” (“Give-up Report”). This report lists all trades filled by an executing clearing member that were transferred that day to give-up clearing members at the trade price or at an average price. The Give-up Report also includes the original trade executed in the pit at the original prices, and the subsequent transfer trade at the original price or at the average price with the residual amount.31 A&I examines average price/give-up orders of new clearing members to ensure that clerks are properly preparing and confirming average price information to customers, and checks that a written authorization, or “give-up agreement,” is on file for each participating clearing member.32
Division staff examined the TAR reviews conducted by A&I on 24 days over the course of the target period.33 The Division found that notations were handwritten on the TARs, indicating that the trades in question were reviewed, and that relevant trading documents were stapled to the reports. A&I staff typically noted information obtained from related order tickets and/or trading cards to verify whether a floor broker traded ahead of a customer’s order or whether a ring trade was executed properly.
The Exchange also conducts routine TPIs to monitor trading activity. A routine TPI is a review of a member’s trading activity for possible trading abuses over a designated period of time, typically three to five days.34 The Exchange performs one routine TPI on each active member every year. All routine TPIs are conducted without advance notice to members.
During a routine TPI, A&I reviews all of a member’s trades executed during the designated review period. In particular, all potential trade practice violations are examined, and relevant trading cards and order tickets are reviewed for recordkeeping compliance. A&I evaluates all potential violations that remain unresolved after supporting documents have been examined to determine whether a reasonable basis exists for finding that a violation occurred. When appropriate, A&I also will contact the member involved to discuss the facts of an investigation. If A&I determines that a reasonable basis exists, it will issue a reminder or warning letter, or refer the matter to the Exchange’s Complaint Committee for consideration of charges, depending upon the severity of the violation.
In addition to routine TPIs, the Exchange initiates Special Investigations when there is evidence indicating that a violation of Exchange rules may have occurred. Special Investigations are generally initiated from follow-up TPIs, investigations of unusual trading activity arising from floor surveillance, Commission or NFA referrals, and investigation of member or customer complaints. The Exchange’s quarterly audit trail reviews also are classified as Special Investigations.
3. Floor Surveillance
Floor surveillance is the third component of the Exchange’s trade practice surveillance program. A&I conducts floor surveillance on the open and close in each market, and at one randomly selected time in the middle of the day, usually for a 15 to 20 minute time period. A&I staff will stay on the floor longer if a market is exceptionally busy. Among other things, staff watches to see who is trading with whom, monitors spread differentials, and checks for possible disclosure of orders. During a delivery period, staff pays particular attention to firms with large positions to see whether they are increasing or decreasing their positions, and at what prices they are trading. A&I also watches to ensure that: (1) clerks are not soliciting business or engaging in other prohibited activities; (2) orders are written up and timestamped properly; and (3) trades are properly reported and checked.
The Exchange maintains a daily floor surveillance log which shows, for each market, the observer’s initials, date and time of surveillance, and any material observations. Actions taken by A&I as a result of observations made during floor surveillance are detailed in “Floor Surveillance Reports” and referenced in the log. Floor Surveillance Reports list the following information: (1) the staff member who conducted the surveillance; (2) the date and time of the observation; (3) the member or firm observed; (4) the possible violation; (5) any prior instances of similar conduct; (6) the action taken, including summaries of any conversations between A&I staff and members about the observed conduct; and (7) the Special Investigation number if the matter was examined further.
During the target period, A&I prepared seven Floor Surveillance Reports, two of which led to the opening of Special Investigations.35 The first of these Special Investigations involved two members who were recording trades when no trades had occurred. Following an investigation into the activity, the two members were referred to the Complaint Committee and ultimately fined $250 each.36 The second Special Investigation generated from floor surveillance involved a member trading while holding a telephone in the pit and resulted in the member receiving a warning letter.37
B. Adequacy and Timeliness of Investigations
During the target period, the above surveillance activities resulted in 58 investigations (43 TPIs and 15 Special Investigations). Two of the Special Investigations resulted from daily TAR review, two from floor surveillance, two from member complaints, and one from market surveillance. The eight remaining Special Investigations were the Exchange’s quarterly audit trail reviews.38
The Division conducted an in-depth review with respect to the adequacy of 26 investigations (17 TPIs and nine Special Investigations) and reviewed the investigation reports for the other 32 investigations conducted during the target period. The Division found that the investigations were generally thorough and well-documented, and that each file included an index of its contents, a summary of the investigation procedures (with the dates each step was completed), spreadsheets, work papers, summaries of interviews, letters notifying the subject member of the investigation and its results, and a copy of the investigation report.
In response to recommendations made in prior rule enforcement reviews, the Exchange has improved the manner and quality in which it documents staff’s analyses of facts. Specifically, investigation reports list facts supportive and facts not supportive of finding that a member violated a specific Exchange rule. The Division, however, identified several investigation reports in which A&I’s analyses and conclusions were unclear as to why A&I determined that the facts supportive of finding that a rule violation occurred were outweighed by facts A&I found not supportive.
For example, the investigation report for Investigation W9937 noted, among other things, two possible instances of accommodation trading. With respect to the facts supportive of finding accommodation trading, the investigation report listed for each potential instance the members trading; the contract and number of contracts bought and sold; the price and time; and the member’s profit, $25 in one instance and $50 in the other instance. In listing the facts not supportive of determining that a rule violation occurred, the investigation report listed time and sales information surrounding the questionable trades. A&I’s analysis noted for each instance the length of time between the trades, 33 seconds and one minute and 54 seconds, respectively, and that there was no other unusual activity associated with the trades. The investigation report’s conclusion concerning the possible instances of accommodation trading stated only that A&I “is of the opinion, based on the facts unsupportive of the issue, that no basis exists for finding a violation.” While the Division can surmise that A&I’s determination was somehow related to the time between the subject trades, the Division has no insight as to why A&I determined that the time between the trades supported a finding “that no basis exists for finding a violation.”39 Therefore, the Division recommends that when A&I completes an investigation and determines that no basis exists for finding a rule violation, the investigation report include an explanation that clearly and fully articulates A&I’s rationale for determining that the facts not supportive of finding that a rule violation occurred outweigh the facts supportive of such a finding.
The Division found that the Exchange’s investigations were completed in a timely manner. All of the 58 investigations opened during the target period were closed within the four-month requirement of Commission Regulation 8.06. Two investigations opened late in the target period were still open when the target period ended, but were subsequently closed within four months.
C. Conclusions and Recommendations
The Division found that the Exchange maintains an adequate trade practice surveillance program. Because of the Exchange’s relatively small pit population, A&I has a unique familiarity with members’ trading particularities and members’ normal trading activity such that anomalous trading is readily identified by daily review of the TAR, floor surveillance, and TPIs. The Division found that the Exchange’s investigations were generally thorough and completed in a timely manner. Members were interviewed when appropriate and investigation files contained relevant documentation. The Division found, however, several investigation reports that did not include sufficient explanation of staff’s conclusion that no basis existed for finding a rule violation. Specifically, these investigation reports did not contain a clear explanation of why A&I determined that the facts not supportive of finding that a rule violation occurred outweighed facts supportive of such a finding.
Based on the foregoing, the Division recommends that the Exchange:
· Ensure that when A&I concludes an investigation and determines that no basis exists for finding a rule violation, the respective investigation report include a complete and clear explanation of A&I’s rationale for determining that the facts not supportive of finding a rule violation outweigh those facts supportive of such a finding.
A. Sanctions Imposed
Pursuant to Exchange rules, the Complaint Committee is responsible for reviewing investigation reports referred by A&I and determining whether a notice of charges should be issued.41 During the target period, a total of six trade practice, recordkeeping, and market surveillance cases involving six individual members and one clearing firm were referred to the Complaint Committee. All six cases were subsequently settled and the penalties imposed totaled $3,423. In addition, a member firm was fined $7,500 for failing to file annual financial statements.42
Although the $3,423 is a small amount of fines for a 12-month period, the Division has identified no material deficiencies in the Exchange’s trade practice program that would suggest that the Exchange should have brought additional cases during the target period. However, as discussed below, the Division believes that the Exchange should impose more significant sanctions for substantive trading violations that are brought before a disciplinary committee.
Specifically, the lone case involving a substantive trading violation resulted in the imposition of $250 fines against two members for noncompetitive trading.43 The case involved two one-lot customer orders, and neither broker benefited personally. The minutes from the Complaint Committee meeting regarding this case state that, despite the fact that there was no customer complaint nor any personal benefit to either of the members, the committee believed that a notice of charges should be issued against both members. Although the Complaint Committee and the Business Conduct Committee (“BCC”) may have considered these facts in subsequently accepting a settlement agreement that fined each member only $250,44 the Division believes that a more substantial penalty should have been imposed considering that the violation involved customer orders and a substantive trading abuse. The Division further believes that a more meaningful penalty also would serve as an effective deterrent.45
The remaining portion of the $3,423 in penalties included a $1,223 fine levied against a clearing member for inaccurate reporting of open interest, and fines totaling $1,700 levied against four members for floor recordkeeping violations.46 A&I also issued 21 reminder letters and 15 warning letters during the target period for trade timing and recordkeeping violations.
B. Timeliness of Disciplinary Procedures
The Division found that the Complaint Committee reviewed investigation reports promptly after receiving them. KCBT Rules 1412.00 and 1413.00, which exceed the mandate of Commission Regulation 8.09, require that the Complaint Committee meet within ten business days of receiving an investigation report to consider the report, and determine within ten business days of the respective meeting whether to issue a notice of charges.47
The Complaint Committee met five times during the target period to review six investigation reports. In each instance, the Complaint Committee met within ten business days of receiving the investigation report, reached its decision on the day of the meeting, decided to issue a notice of charges, and issued such notice within ten business days following the meeting. All of the respondents submitted settlement offers within 21 days, and those offers were reviewed and accepted by both the Complaint Committee and the BCC within 23 days of their submission.
C. Conclusions and Recommendations
During the target period, a total of six trade practice, recordkeeping, and market surveillance cases were referred to the Complaint Committee and all six cases were subsequently settled. The fines levied in these cases against six individuals and one member firm totaled $3,432. In addition, A&I issued 21 reminder letters and 15 warning letters. Further, all disciplinary matters referred to the Complaint Committee during the target period were resolved in a timely manner.
The $3,432 in fines imposed during the target period included two $250 fines imposed against two members for noncompetitive trading. The subject trade involved two customer orders. Although neither member personally benefited, the Division believes that substantive trading abuses merit a larger sanction to address the seriousness of the violation, especially when customer orders are involved, and to serve as an effective deterrent.
Based on the foregoing, the Division recommends that the Exchange:
§ Impose penalties for substantive trading violations of an amount that is significant enough to address the seriousness of the violation and to serve as an effective deterrent.
TIMING ERROR CODES
Bought Side-No Trade (“B-NT”)
When scanning for timing errors, the computer begins by comparing the time recorded by the buyer to the time and sales listing. If no trade is indicated on time and sales at the time recorded by the buyer, the computer scans one minute preceding and one minute following the buyer’s time. If the price as reported on the trading card is not reported as a trade during the three-minute period, the trade is error coded as B-NT.
Sold Side-No Trade (“S-NT”)
The system follows the same procedure for the selling member, comparing the seller’s recorded time to the prices recorded in time and sales. If no trade is indicated on time and sales during the three-minute period, the trade is error coded as S-NT.
No Quote at This Price (“No Quote”)
The computer also combines the B-NT and S-NT searches. If neither the buyer’s nor the seller’s prices occur during the three-minute periods surrounding the times recorded on their trading cards, the trade is error coded No Quote.
Time Out of Limits (“TOL”)
After scanning for errors against time and sales, the computer checks the buyer’s time against the seller’s time. If both times have been marked as correct by the system but there are more than two minutes between the bought and sold side times, the trade is error coded TOL.
Bought Side-Untimed Trade (“B-UT”)
If the buyer fails to record a time for a trade on his or her trading card, the trade is error coded B-UT.
Sold Side-Untimed Trade (“S-UT”)
If the seller fails to record a time for a trade on his or her trading card, the trade is error coded B-UT.
1 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange’s compliance capabilities for the period under review. Such reviews deal only with programs directly addressed in the review and do not assess all programs. The Division’s analyses, conclusions, and recommendations are based, in large part, upon the Division’s evaluation of a sample of investigatory cases and other exchange documents. This evaluation process, in some instances, identifies specific deficiencies in particular exchange investigations or methods, but is not designed to uncover all instances in which an exchange does not address effectively exchange rule violations or other deficiencies. Neither is such a review intended to go beyond the quality of the exchange’s self-regulatory systems to include direct surveillance of the market, although some direct testing is performed as a measure of quality control.
2 The Division’s last rule enforcement review of the Exchange’s compliance program was presented to the Commission on September 29, 1998 (“1998 Review”). In the 1998 Review, the Division found that the Exchange generally had adequate market surveillance, audit trail, trade practice surveillance, and disciplinary programs. However, with respect to the Exchange’s trade practice surveillance and disciplinary programs, the Division recommended that the Exchange: (1) ensure that all investigation reports contain a clear articulation of staff’s rationale for not pursuing further possible accommodation trades and other trade practice violations discovered during routine trade practice investigations; (2) indicate the source of all investigations on its investigation logs; and (3) impose monetary and/or other sanctions on members who repeatedly violate the same or similar Exchange rules. A similar recommendation with respect to investigation reports articulating clearly staff’s rationale for determining that the facts supportive of finding that a rule violation occurred are outweighed by facts not supportive of such a finding is made in the current review. A copy of the 1998 Review can be found in Appendix 1.
3 A complete transcript of the February 2, 2000 interview can be found in Appendix 2.
4 Commission Regulation 1.51(a)(1) requires each contract market to maintain a market surveillance program to identify possible congestion or other market situations conducive to possible price distortion. The purpose of the market surveillance program is to detect adverse situations in the market as they develop and before the markets have been disrupted. An effective program includes monitoring price movements and spread relationships, volume and open interest, clearing member positions, large trader positions, deliverable supplies, and market news and rumors. In addition, each exchange must have a program for the enforcement of speculative position limits for futures and options, as required by Commission Regulation 150.5.
5 The contracts traded during the target period were Wheat futures and options, Value Line futures, Mini Value Line futures and options, Western Natural Gas futures, and Internet Stock Index (“ISDEX”) futures and options. Following the target period, upon expiration of the March 2000 contract, the Value Line contract was delisted. The Mini Value Line futures and options continue to trade.
6 A significant change includes an abrupt increase or decrease in the total open interest in any clearing member’s positions or an abrupt switch from a long to a short position, or vice versa.
7 Investigation SP9908. The Exchange’s Special Investigations are conducted in the same manner as routine Trade Practice Investigations (“TPI”), described in Section IV.A.2. below, except that they are not generated from routine surveillance activities. Rather, A&I opens a Special Investigation if, for example, a complaint is received from any source, staff detects unusual trading activities or market conditions, or significant problems are detected during a routine TPI.
8 This was the lone market surveillance investigation opened during the target period. An examination of the file indicated that the investigation was conducted in a timely manner (15 days), and that it was thorough and well documented.
9 In June 1999, the Exchange began trading ISDEX futures, which are based on a composite of internet-based stocks.
10 Regular elevators are those elevators that have satisfied the Exchange’s requirements for facilities, capacity, location, and financing, and have been approved for delivery of hard red winter wheat against the futures contract.
11 The CCC, a government-owned entity affiliated with the United States Department of Agriculture, assists farmers and offers price support programs, foreign sales programs, and export credit programs for agricultural commodities.
12 KCBT Rule 2733.00 requires each clearing member to obtain from each customer holding a short or long contract in the expiring month a copy of a signed transportation service agreement with a pipeline serving the Waha delivery point at least ten business days prior to the last trading day of the expiring contract. For any long or short position established fewer than ten business days before the last trading day, a clearing member must obtain a written transportation service agreement by the close of business on the following day.
13 A&I requires clearing members to sign and date all liquidation letters, acknowledging that they have received the notification. The purpose of the letter is to remind clearing members that, pursuant to KCBT Rules 2515.03, 2615.01, and 2818.06, in-the-money option positions will be exercised automatically unless instructions to the contrary are delivered to the Clearing Corporation by 4:00 p.m. the day the letter is received.
14 Form 20 is a gross-position report submitted daily by each clearing member which shows, by commodity and delivery month, all open contracts carried over from the previous business day, the contracts bought and sold during the current business day, and all open positions at the close of business. Effective May 2000, clearing members began submitting their open positions to the Clearing Corporation electronically. KCBT has created an intranet to give members access to Clearing Corporation and Exchange information.
15 Exchange rules and resolutions governing speculative position limits are KCBT Rule 2415.02 (Mini Value Line futures), KCBT Rule 3517.00 (ISDEX futures and options), RES 26-2621.00-1 (Mini Value Line options), and RES 27-2714.00-1 (Western Natural Gas futures). With respect to Wheat futures and options, the Exchange has adopted the federal speculative limits set forth in Commission Regulation 150.2. Commission surveillance staff and A&I share information as needed.
16 See KCBT Rule 1128.00 (allowing EFP transactions), KCBT Rule 1128.01 (specifying EFP clearing requirements), and KCBT Rule 1128.02 (requiring the production of EFP documentation upon request).
17 See Section III.A. for a description of the TAR.
18 To capture essential trade data, as required under Section 5a(b)(1) of the Act, KCBT Rule 1115.00 requires each member to promptly record on a trading card all trade executions for customer and personal accounts upon the purchase or sale of any contract. The trading card must contain the member’s trading initials, clearing member code, date, execution time to the nearest minute, quantity, commodity, contract month, price, opposite member and opposite clearing member, as well as strike price and put/call indicator for option contracts.
Section 5a(b)(2) of the Act requires that the audit trail system of each contract market accurately record the times of trades in increments of no more than one minute and the sequence of trades for each floor trader and broker. In addition, Commission Regulation 1.35(g) requires that trade execution times be obtained and stated in increments of no more than one minute on an exchange’s trade register.
19 There are effectively no out-trades at the Exchange because all trades that remain unmatched at the end of the trading day are busted by the Clearing Corporation. Busted trades that are resolved before the opening on the following day are called “as of” trades. The trade date for an as of trade is the date of the original trade, not the date when the trade is resolved and cleared. A&I reviews all as of trades by comparing the trade price to the previous day’s Time and Sales Report.
20 KCBT Rule 1115.00.
21 A description of these codes may be found in Attachment A.
22 A No Quote error appears on the TAR when a trade, as reported by both the buyer and the seller, does not appear on the Time and Sales Report within one minute of the time recorded by the two parties. The Exchange examines members’ trade timing compliance in detail during routine TPIs. See section IV.A.2. below for a complete description of the Exchange’s TPI program.
23 See, e.g., Investigation W9905 and Investigation W9921. With respect to TPIs, the letter appearing prior to an investigation number refers to the contract that the member who was the subject of the investigation was trading. For example, a “W” before an investigation number denotes that the member was trading Wheat.
24 KCBT Rule 1406.00 provides A&I with the authority to issue a warning letter to a member under investigation, with a copy to the Complaint Committee. Exchange staff explained to the Division that although it has a summary disciplinary program for audit trail violations, staff exercise some discretion in its implementation. For example, if a member has a trade timing, order ticket, or trading card deficiency level ranging between five and ten percent, a reminder letter would be issued. If the member’s deficiency level exceeds ten percent, a warning letter would be issued. However, if a member received a warning letter for a deficiency exceeding ten percent and during the next review A&I discovered a deficiency level of six percent, A&I would likely issue another warning letter rather than referring the member to the Complaint Committee because the person had demonstrated some improvement.
25 Investigation IS9901 (one No Quote error); Investigation W9919 (one No Quote error); Investigation W9915 (seven No Quote errors); Investigation W9928 (seven No Quote errors); and Investigation W9914 (eight No Quote errors). Three of the reminder letters also noted other violations such as invalid spread trades, no trade errors, possible unmarked spreads, and failure to draw a line through the remaining lines of a trading card. None of the investigation files or reminder letters indicated that the members had a prior history of No Quote errors.
26 The nine other TPIs identified by the Division with facts similar to Investigation W9935 included Investigation NG9901 (three No Quote errors not included in warning letter); Investigation W9903 (eight No Quote errors not included in reminder letter); Investigation W9911 (six No Quote errors not included in reminder letter); Investigation W9921 (four No Quote errors not included in warning letter; Investigation W9922 (one No Quote error not included in warning letter); Investigation W9929 (two No Quote errors not included in reminder letter); Investigation W9931 (three No Quote errors not included in reminder letter); Investigation W9932 (two No Quote errors not included in reminder letter); and Investigation W9936 (three No Quote errors not included in reminder or warning letter).
27 Section 5a(a)(8) of the Act requires each exchange to enforce all bylaws, rules, regulations, and resolutions made or issued by it or by the governing board or any committee. Section 5a(b) of the Act requires each contract market to maintain and use a system to monitor trading to detect and deter violations of the contract market’s rules committed in making the trades. Under Section 5a(b)(1), such a system must include the commitment of resources necessary for a trade monitoring system to be effective in detecting and deterring trade practice violations, including adequate staff to develop and prosecute disciplinary actions; trade practice surveillance systems capable of reviewing and used to review trade data to detect violations committed in making trades; and floor surveillance.
In addition, Commission Regulation 1.51 requires that each exchange use due diligence in maintaining a continuing program for the surveillance of trading practices on the floor of the exchange; for the investigation of customer complaints and other alleged or apparent violations of the exchange bylaws, rules, regulations, and resolutions; and for such other surveillance, record examination, and investigation as is necessary to enforce exchange bylaws, rules, regulations, and resolutions.
28 During the target period, A&I’s staff included the Vice President of Compliance, the Assistant Vice President of Compliance (who also served as the lead investigator), a part-time investigator, and a bookkeeper. The part-time investigator resigned in April 2000 and the Exchange does not intend to hire a replacement. The Exchange has represented that this should not affect the number of investigations performed or the timeliness of investigations because, if needed, the Vice President of Compliance will conduct investigations in addition to his other duties. Thus, the Division believes that the loss of A&I’s part-time investigator should not adversely impact the Exchange’s trade practice surveillance program. The Division further believes that the Exchange has an adequate size staff to develop investigations and prosecute disciplinary actions.
29 The Exchange’s error codes and related parameters have not changed since the 1998 Review, nor have the procedures for A&I’s daily review of the TAR, ring slips, and other trading activity reports. Ring slips are written records of permissible cross trades prepared by the pit reporter at the time of trade execution.
30 A&I examines the TAR for possible explanations of unmatched quotes that may be related to timing, spread, or trade practice errors identified on the Time and Sales Verification Against Trades Report.
31 The residual is the amount left over after the average price is calculated and rounded to the nearest price increment and must be paid to the customer. KCBT Rule 1120.02(d).
32 KCBT Rule 1120.00 requires that an agreement between the two respective parties be on file with the Exchange prior to executing give-ups.
33 These were the same days as those used to calculate the one-minute trade timing accuracy rate, i.e., two days per month for each month of the target period. See Section III.A. above.
34 The number of days covered by a routine TPI depends on the volume of trading done by the member being reviewed. A&I generally examines a minimum of 100 trades per member.
35 With respect to the conduct observed in the other five matters, A&I spoke with the members engaged in the questionable conduct and reminded those members of the related rule requirements. Generally, A&I will open a Special Investigation based on activity observed during floor surveillance if the member observed has been warned previously regarding the same conduct or if A&I was suspicious of the members’ trading activity prior to the observation.
36 Investigation SP9907. As discussed below in Section V.A., the Division believes that a more significant sanction should have been imposed for this trading violation.
37 Investigation SP9902. KCBT Rule 1177.00 prohibits brokers and traders from holding and using telephones while standing in a trading pit.
38 For each audit trail review, the Exchange opens two Special Investigations, one for order tickets and one for trading cards.
39 Similarly, the Division examined several other investigation reports that, with respect to potential instances of accommodation trading, appeared to rely on the length of time between questionable trades and the fact that there were no other unusual circumstances associated with the trades in concluding that no basis existed for finding a rule violation. See Investigation NG9901, Investigation IS9901, Investigation W9902, and Investigation W9938. In these particular investigations the length of time between the questionable trades ranged from six seconds to one minute and 53 seconds. The profit to the respective members ranged from $12.50 to $200.
40 Under Section 5a(b) of the Act, an exchange’s trade monitoring system must include appropriate disciplinary actions and meaningful penalties against violators. In addition, Commission Regulation 1.51(a)(7) requires that each exchange use due diligence in maintaining a continuing affirmative action program that results in prompt, effective disciplinary action for violations of exchange rules. When reviewing disciplinary programs, the Division considers, among other factors, the support for findings made in disciplinary actions, the adequacy of sanctions imposed, and the timeliness of procedures. The Division also assesses compliance with Commission Regulations 8.09 and 8.17, which require, respectively, that disciplinary committees review investigation reports in a timely manner and issue either a notice of charges or a written decision stating the reasons why no further action will be taken, and that hearings be convened promptly after reasonable notice.
41 KCBT Rule 1410.00.
42 The firm subsequently withdrew its membership.
43 Investigation SP9907.
44 KCBT Rule 1416.00 provides that the Complaint Committee may receive and consider offers of settlement. If the Complaint Committee accepts and approves a settlement, the offer of settlement must be forwarded to the BCC for final acceptance and approval.
45 In fact, on May 30, 2000, Division staff observed the same two members execute another possible noncompetitive trade together and referred the matter to A&I for further investigation. A&I believed that there only was enough evidence to refer one of the members to the Complaint Committee. Specifically, this member traded against a customer order for his personal account. On July 6, 2000, the member made a settlement offer of $2,500 which was accepted by the Complaint Committee and the BCC, effective August 9, 2000.
46 The recordkeeping penalties resulted from the following investigations: (1) Investigation SP9904 (member fined $250); (2) Investigation W9924 (member fined $350); (3) Investigation W9832 (member fined $500); and (4) Investigation V9812 (member fined $600).
47 Commission Regulation 8.09 requires that an exchange disciplinary committee promptly review each investigation report and, if the committee determines that additional evidence is necessary, promptly direct the enforcement staff to conduct further investigation. Within 30 days of receiving a completed investigation report, an exchange disciplinary committee must also either: (1) determine that no reasonable basis exists for finding a violation, or that prosecution is otherwise unwarranted, and direct that no further action be taken; or (2) determine that a reasonable basis exists for finding a violation which should be adjudicated, and direct that the alleged violator be served with a notice of charges.