For Public Release
Rule Enforcement Review
of the Market Surveillance Program
at the New York Cotton Exchange
I. Introduction- Purpose and Scope
The Division of Trading and Markets ("Division"), in consultation with the Division of Economic Analysis ("DEA"), has completed a limited-scope rule enforcement review of the market surveillance program of the New York Cotton Exchange, including the Citrus Associates, the FINEX Division, and the New York Futures Exchange, Inc. ("NYFE"), a wholly-owned subsidiary (hereinafter referred to collectively as "NYCE" or "Exchange"). The purpose of the review was to evaluate the Exchange’s market surveillance program for compliance with Sections 5a(a)(8) of the Commodity Exchange Act ("Act") and Commission Regulation 1.51 (a)(1). The review covered the period February 1, 1996 to February 1, 1997 ("target period").1
The Division’s prior rule enforcement review of the Exchange’s market surveillance program was dated January 26, 1993 ("1993 Review").2 The 1993 Review was also a limited-scope review that focused solely on market surveillance. In that review, the Division found that NYCE generally had an adequate market surveillance program for the daily monitoring of market activity to ensure orderly liquidations of expiring contracts. However, the Division recommended that the program be enhanced by (1) more closely integrating the surveillance of its FINEX contracts into its routine market surveillance program; (2) developing written market surveillance procedures; (3) granting long and short speculative position limit exemptions that are justified by appropriately documented cash market positions; (4) documenting more completely hedge exemption files; (5) selecting a meaningful number of exchange of futures for physicals ("EFP") transactions for routine review to evaluate the bona fides of those EFPs; and (6) improving its methods for detection of large trader reporting violations. Following several discussions and correspondence with the Division, the Exchange responded affirmatively to each of the Division’s recommendations.3
During on-site visits to the Exchange in May 1997, Division and DEA staff tape-recorded interviews with Exchange Market Surveillance Department ("MSD") staff.4 The Division also conducted a review of pertinent Exchange documents that included, among other things, the following:
- Computer reports and other documentation used routinely in the conduct of market surveillance;
- Contract expiration files;
- Market surveillance inquiry and investigation files;
- Speculative limit hedge exemption files; and
- NYCE’s Market Surveillance Manual and guidelines.
The Division provided the Exchange with the opportunity to review and comment on a draft of this report on February 9, 1998. Division staff held an exit conference with Exchange staff on February 12, 1998 to discuss the report’s findings and recommendations.
III. Current Findings and Recommendations
- The MSD’s staffing levels are insufficient to monitor effectively the number of markets traded on the Exchange, and to conduct other routine surveillance activities, including the review of selected EFPs to assess the bona fides of those transactions. No EFPs were reviewed during the target period due to low staffing levels.
- The Exchange has improved its large trader reporting system by using software packages to monitor and better analyze reportable position information. The MSD can retrieve reportable position and account identifying information based on specifically selected criteria through the use of the Exchange’s on-line market surveillance system, and a customized software query program.
- Market surveillance inquiries concerning possible reporting and speculative limit violations were conducted by MSD staff in a timely manner and were generally well documented.
- The Exchange does not give adequate consideration to whether requested speculative limit exemptions are too large relative to the liquidity available in a market, and there were several instances where updated exemption applications were not obtained by the Exchange in a timely manner. In addition, the Exchange does not have an automated report that compares exemption levels to existing positions.
- The Exchange does not maintain any market surveillance logs that reflect the progress of MSD inquiries, or the status of hedge exemption applications and the level of exemptions approved. The Exchange’s files, however, do include this information.
- The Division found one MSD inquiry involving a possible speculative limit violation that it believes should have been referred to the Compliance Department for further investigation, and two inquiries into reporting problems that should have resulted in at least the issuance of warning letters.
- The Exchange should increase the size of its market surveillance staff commensurate with the growth in the number of markets now traded at the Exchange so that all requisite surveillance activities, including the routine review of selected EFPs, can be conducted.
- The Exchange should give additional weight to whether requested speculative limit exemptions are too large relative to the liquidity available in a market, particularly in the spot month; automate the monitoring of position data relative to approved hedge exemption levels to detect more readily traders whose positions may exceed their exemptions; and be more diligent in updating hedge exemption applications.
- The Exchange should consistently refer significant reporting and speculative limit violations to the Compliance Department for possible issuance of staff warning letters or other action.
- The Exchange should improve its ability to monitor the progress of market surveillance inquiries, referrals to the Compliance Department, and the status of hedge exemption applications by developing automated logs for each category.
IV. Surveillance of Market Activity- Commission Regulation 1.51(a)(1)
Commission Regulation 1.51(a)(1) requires each contract market to maintain a market surveillance program to identify possible congestion or other market situations conducive to possible price distortion. The purpose of the market surveillance program is to detect adverse situations in the markets as they develop and before the markets have been disrupted. An effective program includes monitoring price movements and spread relationships, volume and open interest, clearing member positions, large trader positions, deliverable supplies, and market news and rumors. In addition, each exchange must have a program for the enforcement of speculative position limits for futures and options, as required by Commission Regulation 1.61.
A. MSD Staffing Levels
The Division found that MSD staffing levels are not adequate to monitor effectively the increased number of markets traded on the Exchange since the 1993 Review, and to perform other routine surveillance activities, including the review of EFP transactions.5 During the 1993 Review period, the MSD was staffed by five people: the Vice President of Market Surveillance, the Director of Market Surveillance, two market analysts, and one economist. At that time, these staffers were responsible for monitoring six markets: cotton, frozen concentrated orange juice ("FCOJ"), U.S. Dollar Index, European Currency Unit, and Two- and Five-Year Treasury Notes. Each of these markets trades futures and options, except the Two-Year Treasury Notes, which trades only futures.
Since that time, NYCE acquired the New York Futures Exchange ("NYFE") in 1993, and expanded its FINEX currency trading with the opening of a complementary trading floor in Dublin, Ireland in 1994. NYFE trades futures and options on the NYSE Composite Index, CRB /Bridge Index, and PSE Tech 100 Index, and the Dublin floor trades FINEX’s U.S. Dollar Index contract and several foreign currency and cross-rate contracts, including the Deutsche Mark/French Franc, Deutsche Mark/Japanese Yen, Deutsche Mark/British Pound, Deutsche Mark/Spanish Peseta, British Pound/Japanese Yen, British Pound/Swiss Franc, Australian Dollar/U.S. Dollar, New Zealand Dollar/U.S. Dollar, Canadian Dollar/U.S. Dollar, and U.S. Dollar/South African Rand. Thus, there are an additional 16 markets that MSD staff must monitor, or almost a 200 percent increase, since the 1993 Review period.
Notwithstanding the growth in the number of contracts traded at the Exchange over the past several years, the MSD staff has not grown. In fact, for virtually the entire target period, only two people were directly involved in performing daily market surveillance activities: the Director of Market Surveillance and one market analyst. The Director monitored FCOJ, potatoes and all FINEX markets, and the analyst monitored cotton and all NYFE contracts. The Vice President of Market Surveillance and Special Projects was assigned to work on special projects for seven months during the target period, while the second analyst and economist, who were on staff during the 1993 Review period, left their positions and were not replaced with full-time employees.
Toward the end of the current target period, in January 1997, the Exchange assigned its Warehouse and Delivery Secretary, and later, its Director of Marketing, who is an economist, to assist the MSD on a part-time basis. The former was assigned responsibility for monitoring the FCOJ and potato markets, relieving the Director of those duties, and the latter performs technical analysis of the agricultural markets and is responsible for publication of the Weekly Cotton Trade Report.6 The Warehouse and Delivery Secretary and the Director of Marketing also have other significant responsibilities in their primary positions, and spend approximately 50 and 30 percent of their work week, respectively, on MSD activities. In addition, the Vice President of Market Surveillance and Special Projects devotes approximately 50 percent of his time to special projects.7
The Division recognizes that the Exchange is attempting to operate its compliance programs in the most cost-effective manner. However, the Division believes that the MSD is not currently staffed adequately to carry out its self-regulatory responsibilities effectively in this area. In this regard, the requirement in Commission Regulation 1.51(a) that each exchange must maintain a "continuing affirmative action program of rule enforcement" means that each exchange has the obligation of having a suitable staff actively and continuously looking for possible violations of its rules, including those relating to market surveillance.8 In doing so, it is the obligation of every exchange to make whatever modifications in its self-regulatory programs as are necessary to enable it to maintain adequately an enforcement program which will protect the public interest.9 Since the number of markets traded on the Exchange has increased to a level that justifies additional MSD personnel, the Division expects appropriate changes in the size of the staff devoted to market surveillance.10
B. Routine Monitoring of Expiring Contracts
On a daily basis, the MSD monitors, among other things, clearing member and large trader positions, deliverable supplies, delivery intentions, price, volume and open interest data, and market information reported by news services and major trade publications, including Knight-Ridder, and the Florida Citrus Reporter. MSD staff have ready access to computer resources that allow them to follow intra-day and inter-day price movements. Staff also analyze spread price relationships, with particular emphasis placed on the comparison of cash to nearby futures and nearby futures to the next deferred futures contract. In addition, MSD staff make frequent use of computer technologies to analyze these and other data in various tabular and chart formats.
1. Agricultural Markets
The Exchange’s surveillance program focuses on the spot and nearby futures contracts in its agricultural markets. Within 40 days prior to the last trading day in the spot month, MSD staff compile in a "Control Committee Booklet" detailed information on stocks and open interest, spread values, settlement prices, cash versus futures prices, and large trader positions and their percentage share of open interest. At agricultural Control Committee meetings, the booklets are given to the respective Committee members, who are responsible for monitoring contract expirations and guiding staff in resolving potential problem liquidations.11 The Control Committees usually commence meetings a few days prior to first notice day, or sooner, if MSD staff identifies a potential liquidation problem. The frequency of the Control Committee meetings is dependent upon the potential for disorderly liquidations. At a minimum, Control Committees meet with the Director of Market Surveillance at least once during an expiration period to review booklets and other surveillance information, and meet as frequently as necessary during potentially problematic expirations.
The NYCE program for the monitoring of market participants in the spot month relies heavily on MSD verbal contacts with clearing members and traders regarding their trading and delivery intentions. In this connection, as first notice day approaches, MSD staff begin placing calls to participants to ascertain their intentions, and to remind them of their positions and the time remaining to expiration. Calls to hedgers are begun prior to first notice day; calls to speculators are initiated on, or about, first notice day. When necessary, the Exchange obtains this information by contacting the customer’s FCM, who acts as an intermediary in gathering the information.
As expiration draws near, staff is involved in analyzing market surveillance data with greater frequency and in ascertaining whether the participants are carrying out their stated delivery and trading intentions. In addition, the MSD prepares daily reports on the speculative/hedge composition of its markets, in which net changes in positions are charted and analyzed. These "Spec-Hedge Reports" are prepared for all Exchange-traded commodities, and consolidated reports for cotton and FCOJ are released to the public on a weekly basis.
The MSD also prepares "expiration diaries" for agricultural commodities.12 These diaries, which become part of the Control Committee Booklets, generally contain information on supply and demand statistics, price movements, and the details of telephone or other contacts with traders, clearing members, Exchange members, and Commission staff. The market surveillance diary for the spot month is usually initiated a few days after the expiration of the previous month and is maintained through the expiration of the contract. Files containing these data and minutes of any Control Committee meetings are maintained by the MSD. The Division reviewed four agricultural expiration files for adequacy and completeness; May and November 1996 FCOJ, December 1996 cotton, and January 1997 potatoes, and found that each contained the appropriate information and documentation.
For example, the November 1996 FCOJ expiration, which was a difficult market situation during the target period that the MSD handled adequately, was well documented. That expiration was characterized by conditions of tight deliverable supplies, as was evidenced by a sharply inverted November 1996/January 1997 spread differential, and reports of cash prices for prompt delivery trading several cents per pound above the nearby futures price. Further adding to the difficulty of the expiration was high open interest with very little liquidation until the last trading day, and large positions controlled by two commercial entities on opposite sides of the market. The file indicated that MSD staff closely monitored the expiration of this future and called participants and FCMs on a timely basis to gather pertinent information. Specifically, the MSD obtained, among other things, delivery and trading intentions from several large and small traders (and in some instances the reasons behind those intentions), the existence and specifics of liquidating orders, and the status of EFP negotiations. Additionally, staff reminded the two commercial participants controlling the largest long and short positions of their obligations to maintain an orderly liquidation.
The November 1996 FCOJ future expired in an orderly manner. On November 8, 1996, the last trading day, the November/January price spread settled at a 965-point inversion, 325 points lower than its previous day’s level of 1290 points. Open interest decreased by 2,242 lots to 1,591 contracts, as both the largest long and short in the market liquidated a large number of contracts by EFPs and offsetting trades. The 1,591 contracts left open were settled by deliveries.
2. Financial Markets
Surveillance of financial contracts traded on FINEX and in Dublin is carried out in a slightly different manner. Since availability of deliverable supply generally is not a concern for cash settled index contracts and for financial instruments that are in plentiful supply, MSD staff appropriately focus their attention on clearing member and large trader position information. In addition, most of the trading volume in FINEX contracts is in the spot month. As a result, the MSD almost exclusively concentrates its surveillance on that month, rather than on the spot and deferred months, as it does for agricultural contracts. Further, the FINEX Control Committees do not need to meet on as regular a basis as do the agricultural Control Committees. Otherwise, the same statistical information retained for the agricultural markets are retained for the financial markets.
These data are maintained in expiration files. The Division reviewed two FINEX expiration files, the June 1996 U.S. Dollar Index and June 1996 Five-Year T-Note expirations, and found that they also were well documented. Specifically, the files contained documents that reflect MSD-analyzed charts, spread relationships, open interest, moving averages, settlement prices, market information reported by Knight Ridder, and several large trader reports. For example, the Spot Intentions Report lists all accounts that are reportable on the current day and the previous day. For each reportable account, the report shows the gross position for both days, changes in positions, percentage of open interest held by the reportable account on either side of the market, and whether the account is designated as a speculative or hedge account. Another position report found in the files was the Open Interest Daily Comparison Report, which is generated for all commodities, including those on FINEX, on a daily basis. This report lists, for each clearing member, the gross long and gross short open positions carried in the expiring contract on the current and previous day.13
C. Large Trader Reporting and Speculative Position Limits
1. Large Trader Reporting
Exchange rules require clearing members to provide the MSD with daily Series 01 position data for all reportable traders by 9:30 a.m. each day. Non-clearing FCMs and foreign brokers originating omnibus accounts are required to file large trader data once a week. Using these data, the Board of Trade Clearing Corporation ("BOTCC"), which processes large trader position and identifying information for NYCE, provides the Exchange with various large trader reports for futures and options. The MSD uses these reports on a daily basis to monitor large position holders and to enforce speculative position limits.
For example, the Large Trader Position Report-Futures and Large Trader Position Report-Options are generated for each commodity on a daily basis. These reports list all accounts that have reportable positions in futures and options.14 An Exchange index code is assigned the first time a trader becomes reportable and this code is assigned to affiliated entities for aggregation purposes. By referencing traders’ reported positions to the Exchange index code, traders’ positions carried at different clearing members and positions of all affiliated entities can be aggregated for speculative limit enforcement purposes. These reports allow MSD staff to review reportable positions by Exchange index code or by clearing member.
2. Speculative Position Limits
Pursuant to Commission Regulation 1.61, Exchange rules prohibit a trader from holding or controlling net futures positions that exceed speculative limits established by the Exchange. There are separate position limits for the spot month, any one month, and all months combined. The Exchange has improved its program for identifying potential violations of these rules by utilizing software packages to monitor and better analyze reportable position data. In this regard, the MSD can retrieve reportable position and account identifying information based on specifically selected criteria through the use of the Exchange’s on-line market surveillance system, and a customized software query program. A variety of query functions allow the MSD staff to prepare different sorts of BOTCC-provided data by a number of variables for both futures and options. For example, the MSD is now able to rank futures equivalent position data in descending order by gross or net positions or by percentage of open interest.15
In addition, MSD staff review on a daily basis large trader reports that are generated by the BOTCC for each commodity. For example, the MSD reviews the "Transaction Summary Report," which reflects, by clearing member, a comparison of the number of large traders reported on the current day and the previous day.16 Because daily position changes in reportable accounts must be reported, this enables the market analyst, prior to processing the data, to identify clearing members that may not be reporting completely their large trader data. Other reports produced daily for each commodity include: (1) the Open Interest Reporting vs. Large Trader Report, which lists instances where a clearing member shows a reportable level of open interest in a particular month for futures or options but where there are no large trader positions reported by the clearing member;17 (2) Futures and Options Gross Position/Large Trader Exception Reports, which list instances where a clearing member’s large trader data exceed gross futures or options open interest for that clearing member, indicating potential reporting errors;18 (3) Spot Month Positions Report, which shows all traders whose current delivery month net futures position equals 75% or more of the speculative position limit for the current delivery month; and (4) Single Month Position In Excess of 75% of Limit in Futures Equivalent Report, which lists all traders whose single month net futures equivalent position equals 75% or more of the speculative position limit for any one month. These reports alert MSD staff to speculative traders and hedgers whose positions are close to or over speculative position limits.19 If staff finds possible violations of speculative limit rules as a result of their review of these reports, they refer them to the Compliance Department for further investigation.
Although the Exchange has refined its speculative limit enforcement program through improved automation, the Division believes that further improvements are needed. Specifically, the Exchange should complete its ongoing effort to place approved hedge exemption levels into a computer file to allow for an automated comparison of approved hedge exemption levels to existing positions. Currently, the MSD manually compares positions on the above-mentioned Spot and Single Month position reports, which reflect all positions close to or above the speculative limit, to the hedger’s exempted level. Additionally, the Exchange should begin collecting data for traders who carry reportable futures positions through omnibus accounts on a daily basis. Currently, reportable futures positions for omnibus accounts are reported on a weekly basis. More frequent collection of these data would allow the Exchange to closely monitor these traders’ positions for compliance with speculative position limits and for market surveillance purposes generally.20
3. Exemptions from Speculative Limits
Exchange rules provide for exemptions from speculative position limits for bona fide hedgers. An applicant for an exemption must file an Exemption Application form with the Exchange.21 Retroactive hedge exemptions are permitted, provided that a proper Exemption Application is furnished to the Exchange no more than 10 business days after a position exceeding the limits is established. The applications are reviewed by the Director of Market Surveillance.22 In determining whether to grant an exemption, the Director considers, among other things, the potential impact of the requested exemption on the market relative to open interest and deliverable stocks, and the cash market information set forth on the application. A hedge exemption file is maintained by the MSD for each applicant, which typically contains an Exemption Application, letters requesting updated information, and a letter informing the applicant whether the request for an exemption was granted, modified or denied.
In reviewing these files, the Division found instances where it believes the Exchange should have given additional weight to whether requested exemption levels are too large relative to the liquidity available in the market, particularly in the spot month. Specifically, over the course of the target period, open interest on the day prior to a contract becoming the spot month in FCOJ averaged 2,244 contracts. Notwithstanding this relatively low open interest, the Exchange had previously approved a spot month exemption of 5,000 long and 10,000 short to one hedger, and 3,000 long or short to another hedger. In addition, four days prior to the November 1996 FCOJ contract becoming the spot month, the latter hedger, holding a long position of 4,078 contracts, requested an increase in its spot month exemption to 5,000 contracts. The Exchange approved the request in large part, granting an exemption of 4,111 contracts.
The additional exemption was granted based on the premise that it would have been detrimental to the market to have had the hedger, who held the majority of the open positions on the long side of the market, liquidate down to its exempted spot month level of 3,000 contracts on the day prior to the November FCOJ future becoming the spot month. The Exchange also granted the exemption contingent upon the receipt of documentation evidencing the firm’s need for FCOJ and efforts to obtain juice on the cash market, and futures price levels at which the firm reported it would liquidate its position. However, the increased exemption allowed the entity to carry an extraordinarily large long position into the last trading day, which raised the possibility of a disorderly liquidation. It appears that these exemptions were too large relative to the number of contracts that were normally open during the spot month and the number of deliveries made.
In these instances, the Exchange should consider granting "tiered" or "graduated" exemptions, whereby large exemptions are granted as needed, but are lowered in stages to amounts appropriate to the market situation. These exemptions will have the effect of allowing a trader to reduce gradually a large position, and at the same time help to assure that the liquidation of an expiring future progresses in an orderly manner.
The Division also found a number of instances during the target period where Exemption Applications, which are updated every 18 months, were not obtained by the Exchange in a timely manner. For example, the Division found an instance where a trader, who is typically one of the largest participants in the FCOJ market, had not filed an updated Exemption Application for almost three years. Similarly, at the end of the target period, two other traders’ exemptions had not been updated in more than 18 months. One trader’s exemption had not been updated for about three and one half years, and the second trader’s exemption had not been updated for about two years. In addition, the Division noted that approval letters for updated hedge exemptions for seven traders during the target period were sent from 26 to 29 months after their prior updated exemptions were approved.23
Finally, the Division found that the Exchange does not maintain a log indicating exemption-related activities conducted by the MSD. The Division believes that an automated log will allow the Exchange to monitor traders who are not responding to Exchange requests pertaining to exemptions so that follow-up actions, including termination of exemption privileges, can be taken in an expeditious manner. The automated log should include, among other things, the date of any previous exemptions, any outstanding requests for exemption applications and the dates of associated requests for supplemental information, the date that those responses are due, and the date the information is actually received.
D. Market Surveillance Inquiries and Investigations
The MSD opens inquiries into suspected rule violations brought to its attention by Commission or member referral, or identified as a result of its routine review of various computer reports. If, upon initial inquiry, the MSD finds reason to believe that a rule violation may have occurred, the inquiry is referred to the Compliance Department, where it is converted to an investigation and pursued further. During the review period, the MSD initiated 10 inquiries, three of which were referred to the Compliance Department. Six inquiries involved possible FINEX and FCOJ large trader reporting violations; two involved possible violations of FCOJ speculative position limit rules; one involved a possible violation of FCOJ rules regarding offsetting spot month positions during the notice period; and one involved possible filing of inaccurate Cotton/FCOJ Spec/Hedge Reports.
Seven of the 10 inquiries were completed within the four-month requirement of Commission Regulation 8.06. Five were closed within one month; one within two months; and one within four months. However, the three market surveillance inquiries that were referred to the Compliance Department for further investigation were open in that department for unduly long periods of time considering their lack of complexity. Two of the three, #96-057 and #96-058, resulted from DEA referrals. Investigation #96-057 involved a failure to file an updated Form 102 and a potential speculative limit violation in FCOJ futures, and #96-058 involved inaccurate reporting of position data in FCOJ futures. The former investigation was open for approximately 18 months, and the latter investigation, which was referred by the MSD to Compliance on June 12, 1996, remains open. The third investigation, #96-074, involved the filing of inaccurate Cotton/FCOJ Spec/Hedge Reports and was open for nine months.24
The Division found that inquiries were adequately conducted by MSD staff and that files were generally well documented. The files contained relevant correspondence and pertinent documentation, including copies of various memos, computer printouts with notations, and a close-out memorandum. The one inquiry that was not sufficiently documented was a DEA referral opened prior to and closed during the target period that involved improper reporting of a significant number of cotton option positions by an FCM. The incorrect reporting that was investigated resulted in inaccurate option positions being provided to the CFTC by the Exchange. The MSD promptly brought this reporting error to the FCM’s attention and obtained corrected position information. In its inquiry file, the MSD noted that it had advised the firm in question that the Exchange would conduct an audit of its position reporting as a follow-up measure to assure that it was complying with applicable reporting requirements. Although the MSD’s close-out memo stated that no substantial further reporting problems by the firm had occurred, there was no documentation in the file to substantiate that a follow-up audit had been conducted. In fact, the inquiry file contained a memorandum indicating that the same firm had subsequently reported inaccurate clearing position data in cotton options. According to the memorandum, the incorrect reporting apparently resulted in inaccurate open interest. The file did not provide adequate documentation as to the specifics of this matter. Although it is therefore difficult to assess the seriousness of the latter reporting violation, the Division believes that the initial reporting violation was serious enough to be referred to Compliance for the possible issuance of a warning letter to the FCM. Finally, this inquiry was not completed in a timely manner, taking approximately 15 months to complete.
The Division also found that the MSD does not maintain a log of inquiries, CFTC referrals, and matters that are referred to Compliance and converted to investigations. This made it difficult for the Division to confirm the actual number of inquiries handled by the MSD during the target period, and to calculate the length of time inquiries were open. However, based on the documentation in each file, the Division was able to evaluate the timeliness of the inquiries. Therefore, similar to the Division’s recommendation, supra, with respect to the implementation of a speculative limit exemption log, the Division recommends that the Exchange also develop an automated log that lists and tracks all MSD inquiries so that the Division and the Exchange can readily monitor their progress.
E. Monitoring the Bona Fides of EFP Transactions
NYCE Trading Rule 1.02(f)(5), Citrus Associates Trading Rule 5(e)(5), and FINEX Trading Rule 1.05-B(e)(5) provide for EFP transactions. All Exchange EFPs require a futures and cash commodity transaction that involves a change of ownership of the cash commodity between the parties, wherein the seller of the futures position is the buyer of the cash position and the buyer of the futures position is the seller of the cash position. During the target period, EFPs totaled 319,517 contracts, or approximately eight percent of total trading volume of 4,091,103 contracts. Approximately 80 percent of the EFP volume occurred in FINEX currency and cross currency contracts, with those ranging from 15 percent of trading volume in the U.S. Dollar/Japanese Yen contract to 68 percent of volume in the Deutsche Mark/Swedish Krona contract.25
EFPs are cleared in the same manner as regular trades, except that the records of the transaction must clearly identify the trades as EFPs. The executing broker reports the EFP to a designated Exchange employee at the trading pit rostrum. The employee then fills out a Floor Sheet, identifying the clearing members, brokers, price, volume and contract month involved in the EFP.26 The Floor Sheet information is recorded at the rostrum and the price, volume, and month are recorded on the Exchange’s time and sales record. Plies of this sheet are then forwarded to the MSD for recordkeeping and surveillance purposes and to the Commodity Clearing Corporation ("CCC"), the Exchange’s clearing house, for its records. EFPs transacted during trading hours are immediately reported at the pit rostrum; those executed during non-trading hours are reported at the rostrum as soon as possible during the next trading session.
Clearing members submit the required clearing information for each EFP into the CCC’s clearing system. The CCC then provides each clearing member with a computer run listing their matched EFPs. Each clearing member representing the buyer and seller must submit this run to the Exchange, identifying the actual parties to the EFP and their account numbers. Upon receipt of this information, the MSD enters the account identification into their surveillance computer system.
In the 1993 Review, the Division found that the Exchange did not have a routine program for reviewing the bona fides of EFPs. The Division found that the only EFPs that the Exchange reviewed were those referred to it by Commission staff. Consequently, the Division recommended that the Exchange should select, based on criteria established by the Exchange, a relatively meaningful number of EFPs for review to determine whether they are bona fide transactions. In response to this recommendation, the Exchange agreed to develop a procedure whereby the MSD would review those EFPs that are significantly larger than the customer’s historical norm, or are larger than the contract’s reportable level but are not reflected in the large trader report.27 This review would include a request for the underlying cash transaction documentation.
Over the course of the current target period, however, the Exchange did not conduct any EFP reviews. As a result, no EFPs were subjected to an MSD examination to determine the bona fides of those transactions. According to the Director of Market Surveillance, the reason for this was not that there were no EFPs that satisfied their stated criteria for review, but rather that he did not have staff available to conduct the reviews. As stated earlier, pursuant to Commission Guideline No. 2, each exchange has an affirmative responsibility under the Commission’s regulations to have a suitable staff actively and continuously looking for possible violations of its rules. Given the large volume of currency and cross currency EFPs transacted on the Exchange, it is incumbent upon the Exchange to maintain an effective program for monitoring the bona fides of these and other EFPs. The complete absence of a program in this area during the target period underscores the Division’s concern regarding MSD staffing levels.28
F. Market Surveillance Disciplinary Actions
There were no disciplinary actions taken, or staff warning letters issued, relative to market surveillance rules during the target period. The Division, however, found one inquiry that it believes should have been forwarded by MSD staff to Compliance for further investigation and possible disciplinary action, and two inquiries that should have resulted at least in the issuance of staff warning letters.
In the first inquiry, which emanated from a DEA referral, the combined position of two commercial firms exceeded the any one month speculative limit in the July 1996 FCOJ future. Although the accounts were under the control of a common trader, the positions in the accounts were not aggregated by the Exchange, and neither firm had been granted an exemption from the speculative limits.29 The Exchange contended that it was unaware of the apparent violation because the FCM carrying one of the firms had not filed an updated CFTC Form 102 with the Exchange reflecting that both accounts were under common control and ownership.30 The MSD referred the apparent failure of the FCM to file an updated Form 102 to Compliance for further investigation, but did not refer the possible speculative limit violation.
With respect to the speculative limit, the MSD solicited and granted an exemption to the firms from the applicable limit in excess of the initial position speculative limit violation. However, this exemption was sought more than two months after the firms’ combined position had exceeded the speculative limit. Citrus Associates of the New York Cotton Exchange Rule 64(a) requires that traders file for an exemption within 10 business days after a trader’s position exceeds a position limit. Given the length of time that the firms’ position was over the speculative limit, the Division believes that the MSD should have also referred this possible violation to Compliance for further investigation and possible disciplinary action.
One of the inquiries where the Division believes at least a staff warning letter was appropriate involved the failure of an FCM to report to the clearinghouse the closing out of positions of a customer omnibus account. This inaccurate reporting took place in two Five-Year Treasury Note futures on a single trade date and led to significant overstatements in the open interest statistics reported by the Exchange for those futures. The MSD closed this matter with no action taken based on the rationale that delays in receiving close-out instructions from an omnibus account to an FCM are not unusual, and the fact that the FCM did not have a history of inaccurate reporting of open positions. However, the Division believes that since the reporting error resulted in a very large overstatement of published open interest, it should have been referred to Compliance for, at least, the issuance of a warning letter to the offending FCM. Similarly, the Division believes that the cotton option reporting inquiry that resulted in the improper reporting of a significant number of cotton option positions by an FCM to the Exchange, discussed at pp. 21-22, supra, should also have been referred to Compliance for at least the issuance of a warning letter.
G. Conclusions and Recommendations
The Division found that the MSD’s staffing levels are insufficient to monitor effectively the number of markets traded on the Exchange, and to conduct other routine surveillance activities, including the review of EFPs to determine the bona fides of those transactions. In this regard, there were no EFPs reviewed by the Exchange during the target period. Notwithstanding the growth in the number of markets it trades over the past several years, the Exchange has not increased the size of its MSD staff. In fact, for virtually the entire target period of this Review, only two people were directly involved in performing daily market surveillance activities: the Director of Market Surveillance and one market analyst. Although these two individuals adequately monitored the one potentially difficult market expiration during the target period, the November 1996 FCOJ contract, the Division believes that additional staff are necessary to carry out effectively the broad range of responsibilities attendant to an adequate market surveillance program.
The Division’s staffing concerns are heightened by the fact that the Exchange did not review any EFPs during the target period. Given the large volume of currency and cross currency EFPs transacted on the Exchange, it is incumbent upon the Exchange to maintain an effective program for monitoring the bona fides of these and other EFPs.
The Division also found that the Exchange has improved its large trader reporting system by using software packages to monitor and better analyze reportable position information. The MSD can retrieve reportable position and account identifying information based on specifically selected criteria through the use of the Exchange’s on-line market surveillance system, and a customized software query program. A variety of query functions allow the MSD staff to prepare different sorts of data by a number of variables for both futures and options. For example, the MSD is now able to rank futures equivalent position data in descending order by gross or net positions or by percentage of open interest. MSD staff also review various large trader reports on a daily basis to monitor for potential violations of the Exchange’s speculative position limit rules.
Although the Exchange has improved its speculative limit enforcement program through improved automation, the Division believes that further enhancements are needed. Specifically, the Exchange should give added consideration to whether requested exemption levels are too large relative to the liquidity in a market when reviewing hedge exemption requests, particularly in the spot month, and complete its ongoing efforts to automate the comparison of granted exemption levels to existing positions. Further, the Exchange should be more diligent in updating its hedge exemptions every 18 months. The Division found instances where hedge exemption applications had not been updated for several years.
In addition, the Division found that market surveillance inquiries were conducted by MSD staff in a timely manner and were generally well documented. However, the Division found three market surveillance inquiries that were referred to the Compliance Department and converted to investigations that were open in that department for unduly long periods of time. The Division also found that the Exchange does not maintain a log of MSD inquiries, or those inquiries that are referred to Compliance and converted to investigations. Nor does the MSD maintain a log of hedge exemptions granted and the staff activity related to those exemptions. These logs would permit Commission and Exchange staff to readily monitor the progress of all MSD inquiries, and the status of hedge exemption applications.
Finally, no disciplinary actions were taken, or warning letters issued, relative to market surveillance rules during the target period. The Division, however, found one potential violation of speculative position limit rules which it believes should have been referred to Compliance for investigation and possible disciplinary action, and two instances where at least staff warning letters should have been issued.
Based on the foregoing, the Division recommends that the Exchange:
- Increase the size of its market surveillance staff commensurate with the growth in the number of markets now traded at the Exchange so that all requisite surveillance activities, including the routine review of selected EFPs, can be conducted;
- Give additional weight to whether requested speculative limit exemption levels are too large relative to the liquidity available in a market, particularly in the spot month; automate the monitoring of position data relative to approved hedge exemption levels to more readily detect traders whose positions may exceed their exemptions; and be more diligent in updating hedge exemption applications;
- Consistently refer significant reporting and speculative limit violations to the Compliance Department for possible issuance of staff warning letters or other action; and
- Improve its ability to monitor the progress of market surveillance inquiries, referrals to the Compliance Department, and the status of hedge exemption applications by developing automated logs for each category.
1 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange’s overall compliance capabilities for the target period under review. Such reviews deal only with the programs directly addressed in the reviews and do not assess all programs. The Division’s analysis, conclusions, and recommendations are based, in large part, upon the Division’s evaluation of a sample of investigatory cases and other documents. This evaluation process, in some instances, identifies specific deficiencies in particular exchange investigations or methods, but is not designed to uncover all instances in which an exchange does not address effectively all exchange rule violations or other deficiencies. Neither is such a review intended to go beyond the quality of the exchange’s self-regulatory systems to include direct surveillance of the market, although some direct testing is performed as a matter of quality control.
2 A copy of the 1993 Review can be found in Appendix 1. The Division notes that an exchange’s market surveillance compliance program does not fall within the scope of Section 8e(a) of the Act, which requires that at least every two years, to the extent practicable, the Commission shall assess whether the "trade monitoring system" of each exchange satisfies Section 5a(b). Section 5a(b) , among other things, sets forth the necessary components of an exchange’s system for monitoring for potential trading abuses and does not include market surveillance-related activities. A rule enforcement review of NYCE’s trade monitoring system, including its trade practice surveillance and disciplinary programs, is currently ongoing.
3 See February 17, 1993 letter from Joel M. Bassoff, Compliance Counsel, NYCE, to Andrea M. Corcoran, Director, Division of Trading and Markets; April 7, 1993 letter from Alan L. Seifert, Deputy Director, Division of Trading and Markets to Joel M. Bassoff; May 3, 1993 letter from Joel M. Bassoff to Alan L. Seifert; July 22, 1993 letter from Stephen Braverman, Associate Director, Division of Trading and Markets to Joel M. Bassoff; and August 5, 1993 letter from Joel M. Bassoff to Stephen Braverman. A copy of each of these letters can be found in Appendix 2.
4 Transcripts of interviews with William J. O’Brien, Director of Market Surveillance; Terrence Miller, Vice President of Market Surveillance and Special Projects; and Dennis Murray, Market Analyst, can be found in Appendix 3.
5 For a full discussion of the Exchange’s program for reviewing EFPs, see pp. 23-25, infra.
6 The Weekly Cotton Trade Report contains, among other things, changes in cotton outstanding in the government loan program; price, volume, and open interest in cotton futures; and changes in certified cotton stocks. A copy of the report can be found in Appendix 4.
7 Although the MSD is understaffed, the current staff is experienced. The Vice President has been with the Exchange for 17 years; the Director, 19 years; the market analyst, 16 years; the Director of Marketing, 10 years; and the Warehouse and Delivery Secretary, 12 years.
8 See Commission Guideline No. 2, Contract Market Rule Enforcement Program, Comm. Fut. L. Rep. (CCH)§6430 at 6213 (CFTC May 13, 1975).
10 Based on a January 21, 1998 discussion with a senior Exchange official, it is the Division’s understanding that the Exchange, in the immediate future, intends to hire one additional staffer for the MSD, and transfer another employee to that department. One will function as a market analyst and one, among other things, will review EFPs and monitor reportable omnibus account positions. The Exchange also intends to have its Chief Economist spend two to three hours a day conducting surveillance of financial futures and options. Separately, on December 22, 1997, the memberships of both the NYCE and Coffee, Sugar & Cocoa Exchange voted to merge and form the Board of Trade of the City Of New York. Although the exact timing of the merger is uncertain, the Division recognizes that its recommendation concerning MSD staffing levels at NYCE may also be affected by the impending merger of the two exchanges and personnel changes that may flow from that merger.
11 Control Committees consist of three Exchange members, one of whom is a chairman, who are not members of the Board of Managers. The Control Committees are generally comprised of members who do not trade in the market they oversee. However, if a committee member is holding a position in the market that he or she oversees at the time of any committee deliberations, that member must disclose such position to the MSD and can not participate in such meetings.
12 A sample copy of an expiration diary can be found in Appendix 5.
13 Copies of the Open Interest Daily Comparison Report and the Spot Intentions Report can be found in Appendix 6.
14 Copies of the Large Trader Position Reports for Futures and Options can be found in Appendix 7.
15 Examples of ranking reports by gross or net position or by percentage of open interest are found in Appendix 8.
16 A copy of the Transaction Summary Report can be found in Appendix 9.
17 A copy of the Open Interest Reporting vs. Large Trader Report can be found in Appendix 10.
18 Copies of Gross Position/Large Trader reports can be found in Appendix 11.
19 Copies of the Spot Month Positions and Single Month Positions in Excess of 75% of Limit in Futures Equivalent reports can be found in Appendix 12.
20 The Exchange has recently advised DEA that it has notified its clearing members that effective February 2, 1998, reportable omnibus account positions for both futures and options must be reported to the Exchange on a daily basis. The Exchange also advised DEA that it was programming its system to incorporate a comparison of existing positions to approved hedge exemption levels. See the Exchange’s letter of January 12, 1998 from Terry Miller to John Mielke, which can be found in Appendix 13.
21 A copy of the Exemption Application can be found in Appendix 14.
22 At the February 12, 1998 exit conference to discuss the reports findings, the Exchange advised the Division that as of September 1997, the Exemption Applications are being reviewed by the Vice President of Market Surveillance and Special Projects and the Warehouse and Delivery Secretary, rather than the Director of Market Surveillance.
23 In its January 12, 1998 letter to John Mielke, the Exchange represented that as of January 8, 1998, it had completed a review of updated applications for all traders whose previous exemptions were over 18 months old.
24 None of the matters closed during the target period resulted in warning letters or disciplinary actions. Investigation #96-057 was closed by Compliance on November 24, 1997, subsequent to the target period, and resulted in warning letters being issued to two clearing members for failing to amend Form 102s. See pp. 26-27, infra, for a full discussion of the Exchange’s market surveillance-related disciplinary program.
25 According to an Exchange economist, the high percentage of EFPs in currencies and cross currencies may be attributable to forex traders preferring to use EFPs to initiate and liquidate futures positions because of the relatively low futures volume in these markets and the higher cash market volume. Thus, using EFPs may allow forex traders to hedge their positions on the futures markets with less price uncertainty and less counterparty risk. In addition, as an absolute number, the volume of EFPs is not large. For example, on January 20, 1998, volume in the British Pound/Deutsche Mark futures contract was 516, and volume in the Deutsche Mark/Swedish Krona futures contract was 351. On that same date, 430 EFPs were transacted in the British Pound/Deutsche Mark contract and 254 were transacted in the Deutsche Mark/Swedish Krona contract.
26 A copy of a Floor Sheet can be found in Appendix 15.
27 See May 3, 1993 letter from Joel M. Bassoff to Alan L. Seifert at p 3. This letter can be found in Appendix 2.
28 According to the Director, EFP reviews were recommenced in August 1997. At that time, the Exchange initiated reviews of six EFPs; three in cross currencies, and one each in U.S. Dollar Index, FCOJ, and cotton. Due to staffing shortages, these reviews are being conducted by the Director himself. As of January 21, 1998, none of these reviews had been completed. However, to reiterate, the Exchange has represented that it is taking immediate action to increase the size of the MSD staff, which should relieve the Director of this task, and alleviate the staffing problem. See n. 10 at p. 9, supra.
29 The positions of these entities were being aggregated for speculative limit purposes by the Commission’s surveillance staff based on representations of common ownership made on one of the firms’ CFTC Forms 40.
30 The firms used separate FCMs, and the positions at each FCM did not exceed the speculative limit at any time.