[Federal Register: January 26, 1998 (Volume 63, Number 16)]
[Notices]
[Page 3708-3721]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr26ja98-32]
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COMMODITY FUTURES TRADING COMMISSION
Regulation of Noncompetitive Transactions Executed on or Subject
to the Rules of a Contract Market
AGENCY: Commodity Futures Trading Commission.
ACTION: Concept release.
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SUMMARY: The Commodity Futures Trading Commission ("CFTC" or
"Commission") is reevaluating its approach to the regulation of
noncompetitive transactions executed on or subject to the rules of a
contract market. Accordingly, the Commission is soliciting comments on
a broad range of questions concerning the oversight of transactions
involving (i) the exchange of futures contracts for, or in connection
with, cash commodities, (ii) other noncompetitive transactions, and
(iii) the use of execution facilities for noncompetitive transactions.
Following the receipt of public comments, the Commission will determine
whether rulemaking is appropriate.
DATES: Comments must be received on or before March 27, 1998.
ADDRESSES: Interested persons should submit their written data, views,
and opinions to Jean A. Webb, Secretary of the Commission, Commodity
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street
N.W., Washington, D.C. 20581. In addition, comments may be sent by
facsimile transmission to facsimile number (202) 418-5221 or by
electronic mail to [email protected]. Reference should be made to
"Regulation of Noncompetitive Transactions Executed on or Subject to
the Rules of a Contract Market." Certain related materials described
herein are available for inspection at the Office of the Secretariat at
the above address. Copies of these materials also may be obtained
through the Office of the Secretariat at the above address or by
telephoning (202) 418-5100.
FOR FURTHER INFORMATION CONTACT: Rebecca Creed, Attorney, at (202) 418-
5493, Division of Trading and Markets, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street N.W., Washington,
D.C. 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Statutory and Regulatory Provisions
B. Purpose of This Release
C. Overview
II. Standards Governing EFP Transactions
A. Background
1. Historic Uses of EFPs
2. Current EFP Volume
3. Current Oversight of EFPs
B. Elements of a Bona Fide EFP
1. Relationship of the Instruments
(a) Qualitative Correlation
(b) Quantitative Correlation
(c) Request for Comments
2. Relationship of the Parties
(a) Separate Parties
(b) String Trades
[[Page 3709]]
(c) Request for Comments
3. Nature of the Transaction
(a) Exchanges of Futures Contracts for Cash Commodities
(b) Futures Leg Requirements
(c) Cash Leg Requirements
(d) Transitory EFPs
(e) Contingent EFPs
(f) Request for Comments
4. Price of the Transaction
(a) Current Requirements
(b) Request for Comments
C. Other Regulatory Requirements Governing EFPs
1. Reporting and Recordkeeping
(a) Current Requirements
(b) Request for Comments
2. Disclosure
(a) Current Requirements
(b) Request for Comments
3. Internal Controls
(a) Current Requirements
(b) Request for Comments
4. Transparency
(a) Current Requirements
(b) Request for Comments
III. Other Noncompetitive Transactions Executed on or Subject to the
Rules of a Contract Market
A. Types of Eligible Transactions
1. Exchanges of Futures for Swaps
(a) The New York Mercantile Exchange Proposal
(b) Request for Comments
2. Exchanges of Options for Physicals
(a) Background
(b) Request for Comments
3. Alternative Execution Procedures
(a) Current Procedures
(1) Contract Market Large Order Procedures
(2) Section 4(c) Contract Market Transactions
(3) Securities Market Block Trading Procedures
(b) Potential Procedures
(c) Request for Comments
B. Qualifying Standards
1. The Need for Standards
2. Request for Comments
C. Continuing Regulatory Requirements
1. The Need for Requirements
2. Request for Comments
IV. Execution Facilities for Noncompetitive Transactions Executed on
or Subject to the Rules of a Contract Market
A. Current, Proposed and Potential Facilities
1. Interdealer Brokers
2. The Chicago Board Brokerage
3. Potential Facilities for Transactions Other Than EFPs
B. Qualifying Standards
1. Current Requirements
2. Request for Comments
V. Summary of Request for Comments
I. Introduction
A. Statutory and Regulatory Provisions
Section 4(a) of the Commodity Exchange Act ("Act") makes it
unlawful for any person to enter into a contract for the purchase or
sale of a commodity for future delivery "unless such transaction is
conducted on or subject to the rules of a board of trade which has been
designated by the Commission as a 'contract market' for such
commodity." <SUP>1</SUP> Although Congress has indicated that trading
on contract markets be conducted generally in an open and competitive
manner, it also has recognized the need for certain, limited exceptions
to that requirement. Section 4c(a) of the Act prohibits various types
of noncompetitively executed transactions but provides an exception for
transfer trades, office trades, and exchanges of futures for physicals
("EFPs") that are executed in accordance with contract market rules
that have been approved by the Commission. <SUP>2</SUP> With reference
to these statutory provisions, the Senate Committee on Agriculture and
Forestry stated:
\1\ 7 U.S.C. 6(a). As discussed below, Section 4(c) of the Act,
7 U.S.C. 6(c), vests the Commission with certain exemptive authority
subject to specified qualifying criteria.
\2\ 7 U.S.C. 6c(a).
Both the Commodity Exchange Act and the rules and regulations of
the commodity exchanges require that futures transactions be
executed openly in a competitive manner.
* * * * *
Certain carefully prescribed exceptions to competitive trading
are allowed, but they do not nullify the general requirement of open
and competitive trading.
The purpose of this requirement is to ensure that all trades are
executed at competitive prices and that all trades are focused into
the centralized marketplace to participate in the competitive
determination of the price of futures contracts. This system also
provides ready access to the market for all orders and results in a
continuous flow of price information. <SUP>3</SUP>
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\3\ Report of the Senate Committee on Agriculture and Forestry,
S. Rep. No. 1131, 93rd Cong., 2d Sess. 16 (1974).
Consistent with this policy, Commission Regulation 1.38(a) requires
that contract market rules providing for the execution of
noncompetitive transactions must be submitted to the Commission for
approval. Commission Regulation 1.38(b) requires all noncompetitive
transactions as well as all related orders, records, and memoranda to
be identified and marked. Regulation 1.38 was adopted pursuant to
Sections 4b and 8a(5) of the Act. <SUP>4</SUP> Section 8a(5) authorizes
the Commission to "make and promulgate such rules and regulations as,
in the judgment of the Commission, are reasonably necessary to
effectuate any of the provisions or to accomplish any of the purposes
of this Act."
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\4\ 7 U.S.C. 6b and 12a(5).
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B. Purpose of This Release
The purpose of this release is to solicit comments on whether the
regulatory structure governing noncompetitive transactions executed on
or subject to the rules of a contract market should be modified in
light of recent developments in the marketplace. The impetus for this
action comes from several sources, including the following.
First, ten years have passed since the Division of Trading and
Markets ("Division") conducted a comprehensive study of
EFPs.<SUP>5</SUP> During this time, the use of EFPs has continued to
grow and evolve.
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\5\ Report of the Division of Trading and Markets: Exchanges of
Futures for Physicals (October 1987) ("EFP Report"). This document
provides a detailed discussion on the history, use and regulation of
EFPs. Interested parties may obtain a copy of the EFP Report by
contacting the Commission's Office of the Secretariat at the address
noted above.
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Second, several organizations have developed computerized systems
for basis trading of U.S. Treasury securities. Essentially, a basis
trade involves the simultaneous acquisition of positions in actual
Treasury securities and in offsetting futures contracts. Venues for
basis trading simplify the trading process by enabling traders to
obtain both cash and futures positions in a single transaction which is
reported to a contract market as an EFP.
Third, the New York Mercantile Exchange ("NYMEX") has sought
Commission approval for a proposed rule that would permit the exchange
of futures contracts for, or in connection with, swap agreements ("EFS
transactions").<SUP>6</SUP> This proposal would establish provisions
for EFS transactions that are parallel to, but separate from, those
governing EFP transactions. Thus, an EFS transaction would follow the
form of an EFP except that a swap agreement would be substituted for
the physical component.
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\6\ Interested parties may obtain a copy of the NYMEX proposal
permitting EFS transactions by contacting the Commission's Office of
the Secretariat at the address noted above.
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Fourth, the Chicago Board of Trade ("CBT"), through counsel,
requested the Division of Economic Analysis to agree not to recommend
that the Commission take any enforcement action against the CBT, its
members or market participants in connection with the CBT's proposed
implementation of a one-year pilot program facilitating the off-
exchange transfer of futures contracts in agricultural products in
exchange for related over-the-counter agricultural options.<SUP>7</SUP>
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\7\ The Division of Economic Analysis staff advised counsel
that, in light of the Commission's ongoing consideration of
agricultural trade options in connection with its advance notice of
proposed rulemaking, 62 FR 31375 (June 9, 1997), it was not
currently appropriate to consider this request. The Commission has
subsequently proposed removing the prohibition against off-exchange
trade options on the enumerated agricultural commodities pursuant to
a three-year pilot program. Trade Options on the Enumerated
Agricultural Commodities, 62 FR 59624 (Nov. 4, 1997).
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[[Page 3710]]
Finally, recent legislative proposals contemplate the establishment
of separate, professional markets.<SUP>8</SUP> The Commission wishes to
explore whether it is possible to achieve some of the objectives of
these proposals by expanding the boundaries of permissible
noncompetitive trading on existing contract markets. In contrast to the
legislative proposals, a revised structure governing noncompetitive
transactions could act as an adjunct rather than as an alternative to
existing regulated markets. Such an approach might improve the
usefulness and efficiency of existing markets for institutional or
professional users but with a reduced risk of market fragmentation.
Thus, carefully designed revisions to the regulatory structure
governing noncompetitive transactions could have a procompetitive
effect.
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\8\ See, e.g., S. 257, 105th Cong., 1st Sess. Sec. 6 (1997).
Part 36 of the Commission's regulations adopts certain
exemptions under a pilot program for separate, professional markets.
Included among the exemptions is a provision exempting certain
noncompetitive trading subject to the rules of a professional
market. However, no contract market has filed a proposal with the
Commission pursuant to Part 36.
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C. Overview
For the foregoing reasons, the Commission has determined to seek
comments on whether the existing regulatory structure should be revised
to provide additional guidance concerning standards governing
noncompetitive transactions executed on or subject to the rules of a
contract market. In scope, the Commission's request includes
transactions that currently are permitted, such as EFPs, as well as
transactions that are not currently permitted, such as EFS transactions
or block trades. Of course, if the Commission were to revise its
regulatory structure relating to noncompetitive transactions, the
choice of whether to permit these types of transactions on a particular
contract market would remain, in the first instance, with that contract
market.
In general, the Commission is soliciting comments on the following
questions:
(1) Should the standards articulated in the EFP Report be
codified in the Commission's regulations and/or refined in any way?
(2) Should other types of noncompetitive transactions, such as
EFS transactions or block trades, be permitted to be executed on or
subject to the rules of a contract market and, if so, what standards
should apply to these transactions?
(3) What standards should be applicable to execution facilities
for noncompetitive transactions executed on or subject to the rules
of a contract market?
More specific questions addressing particular aspects of these topics
are posed in the relevant sections of this release. A consolidated list
of questions is set forth at the conclusion. The Commission recognizes,
however, that its identification of the issues may not be exhaustive
and therefore invites comments on other aspects of these topics even if
not expressly set out below.
The Commission is asking these questions for the dual purpose of
giving notice of its consideration of these issues and of obtaining
input before proceeding with any specific initiatives. Commenters
should set forth with particularity the bases for their views. After
receiving input, the Commission will endeavor to strike an appropriate
balance among the relevant concerns.
II. Standards Governing EFP Transactions
A. Background
1. Historic Uses of EFPs
An EFP involves simultaneous transactions in the futures and cash
commodity markets. The futures market transaction consists of a
noncompetitive transfer of a futures position between the parties to
the EFP. Thus, one party buys the physical commodity and simultaneously
sells (or gives up long) futures contracts while the other party sells
the physical commodity and simultaneously buys (or receives long)
futures contracts. Subject to applicable contract market rules, the
quantity and price of the futures and cash commodity to be exchanged as
well as other terms are negotiated privately by the parties rather than
being executed openly and competitively on a contract market. Depending
on the pre-existing market positions of EFP counterparties, an EFP
transaction can create, transfer, or extinguish futures positions.
The EFP exception currently contained in Section 4c(a) of the Act
first appeared in H.R. 12287, which was introduced in 1932. The report
of the House Committee on Agriculture accompanying that bill indicates
that this exception was intended to permit the continuation of what was
described as an accepted commercial practice:
Transactions involving the exchange of cash commodities for
futures in accordance with exchange rules applying to such exchanges
are exempted, even though they take the form of office trades, it
being understood that the exchange of cash commodities for futures
is a common and necessary practice.<SUP>9</SUP>
\9\ Commodity Short Selling, H.R. Rep. No. 1551, 72d Cong., 1st
Sess. 3 (1932).
The EFP exception was ultimately adopted with the enactment of the
Commodity Exchange Act in 1936. None of the amendments to Section 4c(a)
since that time provides further guidance as to the scope of
permissible EFP transactions.<SUP>10</SUP>
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\10\ See Commodity Futures Trading Commission Act of 1974, Pub.
L. No. 93-463, 88 Stat. 1389 (substituted the Commission for the
Secretary of Agriculture and deleted state law preservation clause);
Futures Trading Act of 1978, Pub. L. No. 95-405, 92 Stat. 865
(required contract market rules permitting EFPs to be approved by
the Commission); Futures Trading Act of 1982, Pub. L. No. 97-444, 96
Stat. 2294 (exempted transactions in foreign currency options traded
on a national securities exchange from coverage of the Commodity
Exchange Act).
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As discussed in detail in the EFP Report, the use of EFPs has
evolved to include practices not contemplated at the time Section 4c(a)
originally was enacted. Indeed, financial futures contracts, which now
dominate futures trading at some exchanges, did not exist at the time
the EFP exception was adopted. In the EFP Report, the Division
concluded that it appeared appropriate to interpret Section 4c(a) to
accommodate some of these practices, many of which arise out of trading
practices in various cash markets and which accomplish a variety of
commercial purposes. <SUP>11</SUP> However, the Division also stated
that the historical context in which the EFP exception first was
enacted and the statutory language of Section 4c(a) itself necessarily
imply certain limits on the permissible scope of EFP transactions as an
exception to the general requirement of competitive execution.
<SUP>12</SUP>
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\11\ EFP Report at 144-145.
\12\ Id. at 26. For example, the Division has expressed its
opinion that the EFP "exemption was not designed to create an
avenue for traders to use EFP transactions to accomplish what they
could not otherwise legitimately do, that is, wash trades,
accommodation trades, fictitious sales, or illegal off-exchange
transactions." Report of the Division of Trading and Markets:
Volume Investors Corporation 59 n. 54 (July 1985).
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2. Current EFP Volume
A comparison of statistical data regarding the level of EFP
activity between the late 1980s (when the EFP Report was published) and
recent years shows that EFP activity, in many major markets, has
continued to grow. The following table summarizes such data for
selected contracts between 1986 and 1996.
[[Page 3711]]
Table 1.--EFPs as a Percent of Trading Volume in Selected Contracts
1986--1996 \13\
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Contract Market 1986 1996
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CBT Wheat............................................. 2.32 2.35
KCBT Wheat............................................ 15.61 10.87
MGE Wheat............................................. 24.72 15.31
CBT Corn.............................................. 8.14 6.81
CBT Soybeans.......................................... 5.42 4.57
CBT Soybean Oil....................................... 6.52 4.89
CBT Soybean Meal...................................... 7.89 7.95
CME Live Cattle....................................... 0.06 0.04
CSC Coffee "C"...................................... 1.48 4.10
CSC Sugar #11......................................... 3.86 4.69
CSC Cocoa............................................. 6.24 3.17
CBT Treasury Bonds.................................... 0.75 5.00
CBT Treasury Notes.................................... 1.23 4.59
CME Japanese Yen...................................... 7.32 16.11
CME British Pound..................................... 7.76 21.53
CME Deutsche Mark..................................... 6.12 16.81
CME Swiss Franc....................................... 5.96 13.79
COMEX Gold............................................ 7.46 9.05
COMEX Silver.......................................... 3.46 5.04
NYMEX Crude Oil....................................... 3.60 2.67
NYMEX Heating Oil #2.................................. 1.90 6.66
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\13\ The data shown in Table 1 is for calendar year 1986 and 1996.
As the table shows, EFP activity as a share of trading volume has
been relatively stable in traditional agricultural markets and has
declined in some cases. The trend for financial futures contracts has
been just the opposite, with EFP activity continuing to increase, in
some cases dramatically.
3. Current Oversight of EFPs
EFP transactions are currently subject to oversight through a
variety of sources, including: (i) the Commission's review of contract
market rules governing such transactions; (ii) the Commission's
reporting and recordkeeping requirements; (iii) contract markets'
enforcement of their own rules; (iv) the Commission's rule enforcement
review program; and (v) the Commission's own enforcement program.
B. Elements of a Bona Fide EFP
The EFP Report described EFP practices in selected markets,
analyzed the legislative and regulatory framework surrounding EFPs, and
reviewed the contract market rules and interpretations that govern
them. The EFP Report suggested possible criteria to be examined by
contract markets in evaluating whether a particular EFP transaction is
eligible for the Section 4c(a) exception. In particular, the Division
enumerated three essential elements of a bona fide EFP as follows: (i)
a futures transaction and a cash transaction which are integrally
related; (ii) an "exchange" of futures contracts for cash commodity,
where the cash commodity contract provides for the transfer of
ownership of the cash commodity to the cash buyer upon performance of
the terms of the contract, with delivery to take place within a
reasonable time thereafter in accordance with prevailing cash market
practice; and (iii) separate parties to the EFP, where the accounts
involved have different beneficial ownership or are under separate
control.<SUP>14</SUP>
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\14\ EFP Report at 146-150.
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In addition, the Division developed a non-exclusive list of other
indicia to assist contract markets in determining whether the essential
elements of a bona fide EFP have been satisfied. These include: (i) the
degree of price correlation between the futures and cash legs of the
EFP; (ii) the prices of the futures and cash legs of the EFP and their
relationship to the prevailing prices in their respective markets;
(iii) whether the cash seller has possession, the right to possession,
or the right to future possession of the cash commodity prior to the
execution of the EFP; (iv) the cash seller's ability to perform on his
delivery obligation in the absence of prior possession of the cash
commodity, i.e., the cash seller's access to the cash market; and (v)
whether the cash buyer acquires title to the cash
commodity.<SUP>15</SUP>
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\15\ Id. at 150-151.
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These elements can be analyzed in terms of four categories: (i) the
relationship of the instruments; (ii) the relationship of the parties;
(iii) the nature of the transaction; and (iv) the price of the
transaction. The following discussion summarizes the elements and
indicia of a bona fide EFP as set forth by the Division in the EFP
Report. As noted above, the Commission is soliciting comments on
whether these standards should be codified in the Commission's
regulations and/or refined in any way.
1. Relationship of the Instruments
(a) Qualitative Correlation. In the EFP Report, the Division
determined that the futures and cash legs of a bona fide EFP should be
correlated with each other, both qualitatively and
quantitatively.<SUP>16</SUP> Qualitative correlation clearly exists
when the cash commodity satisfies the delivery specifications of the
associated futures contract. However, when the cash commodity is not
deliverable against the relevant futures contract, questions arise as
to its acceptability as the cash leg. While some contract markets focus
on whether the cash commodity is the economic equivalent of, or is
derived from, the particular commodity specified in the futures
contract, others also consider the price relationship between the cash
and futures legs of the transaction.
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\16\ Id. at 152-160.
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In the EFP Report, the Division concluded that the cash commodity
should have a reliable and demonstrable price relationship with the
futures contract involved in the EFP.<SUP>17</SUP> The cash leg should
exhibit price movement that historically has paralleled the price
movement of the futures contract, with the cash and futures prices
typically moving in the same direction and at consistent relative rates
of change. Although perfect price correlation is not required, a
"strong correlation" should exist. Otherwise, the parties are at risk
that the basis or price differential between the cash and futures legs
will change significantly prior to the conclusion of the EFP, thus
adversely affecting the utility of the transaction itself. The lack of
a strong correlation may indicate that the parties' motive for the EFP
was to circumvent the regulatory requirements of the Act or the
Commission's regulations, such as the requirement of open and
competitive execution, rather than to conduct a commercially
appropriate transaction. The Division also concluded that hedgeable
commodities are appropriate cash legs for EFPs.<SUP>18</SUP>
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\17\ Id. at 155.
\18\ Id. at 157.
The Division referred to Administrative Determination 239,
issued by the Commodity Exchange Authority on December 16, 1974,
which advised that, "[i]f a commodity, product or by-product is
hedgeable under the Act, it may be exchanged for futures. If it is
not hedgeable, it may not be exchanged." See generally 17 CFR
1.3(z) (defines bona fide hedging transactions and positions);
Clarification of Certain Aspects of the Hedging Definition, 52 FR
27195 (July 20, 1987).
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In the EFP Report, the Division noted that statistical correlation
coefficients <SUP>19</SUP> have been used to justify specific EFPs
involving stock index futures contracts either before or after the
transaction was consummated.<SUP>20</SUP> The Division also recommended
that contract markets publicize their determinations regarding the
acceptability of particular commodities as the cash leg of an EFP in
order to provide more guidance to the market users of these
transactions.<SUP>21</SUP>
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\19\ A correlation coefficient measures the degree to which the
movements of two variables are related. Here the variables consist
of the price of the futures contracts and the price of the cash
commodity.
\20\ EFP Report at 158.
\21\ Id. at 159.
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(b) Quantitative Correlation.
For quantitative correlation to exist, the Division determined that
the cash commodity position should be approximately equal in quantity
or dollar value to the futures position and that appropriate hedge
ratios may be
[[Page 3712]]
used to create such dollar equivalency.<SUP>22</SUP> Again, the absence
of such equivalency may indicate a motive to circumvent some
requirement of the Act or the Commission's regulations rather than to
conduct a commercially appropriate transaction.
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\22\ Id. at 159-160.
For example, if the futures position established by the EFP
transaction represents 50,000 bushels of corn, then the associated
cash leg should also equal approximately 50,000 bushels of corn.
With respect to the use of appropriate hedge ratios to create dollar
equivalency, traders might cross-hedge a 182-day T-bill by using
more than one 91-day T-bill futures contract since the risk exposure
on the principal amount of the T-bill increases the higher the
duration of the security. Other instruments with differing
maturities and yields would require different ratios.
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(c) Request for Comments. The Commission is soliciting comments on
the following questions:
(4) How should the "strong price correlation" standard
articulated in the EFP Report be implemented?
(5) Should the Commission require contract markets to adopt a
minimum statistical correlation coefficient to be used in assessing
the acceptability of a particular cash commodity for use as the cash
leg of an EFP?
(6) If a minimum correlation coefficient is required, should
this coefficient apply to all EFPs, or should it be adjusted to
account for the different commodities involved in EFPs?
(7) What is the appropriate type and scope of guidance contract
markets should be required to provide to the general public
concerning the acceptability of particular commodities as the cash
leg of an EFP?
2. Relationship of the Parties
(a) Separate Parties. In the EFP Report, the Division concluded
that a bona fide EFP must be executed between separate
parties.<SUP>23</SUP> Determining if separate parties are involved in a
particular transaction in turn depends upon whether the accounts have
different beneficial owners or are under separate control. This
standard permits separate profit centers of a futures commission
merchant ("FCM") to engage in EFPs with each other in order to
accomplish their trading strategies and to fulfill their business
needs.
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\23\ Id. at 147, 149-150.
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(b) String Trades. In the EFP Report, the Division discussed a
method of effecting an EFP transaction in the grain markets called a
"pass-through" or "string trade." <SUP>24</SUP> Under this method,
the two parties to the EFP each have cash commodity contracts with a
different party or parties which require them to buy/sell the cash
commodity and sell/buy the corresponding futures contract in order to
set the price for the cash transaction. All of the parties in the
string have complementary cash commitments and corresponding
obligations to buy or sell futures contracts to the next party in the
string. Instead of executing a series of EFP transactions in which the
intermediate futures positions transferred among the parties would net
out for the common parties, the first and last parties in the string
execute a single EFP and the other mutually exclusive futures
obligations are canceled.<SUP>25</SUP>
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\24\ Id. at 47, 148 n. 173.
\25\ For example, party A has agreed to sell grain to and buy
futures contracts from party B. Meanwhile, party B has agreed to
sell grain to and buy futures contracts from party C. When C is
ready to sell futures contracts to B in order to fix the price of
their cash transaction, B directs C to execute the futures trade
with A instead, thus satisfying B's obligation to sell futures
contracts to A. Thus, A and C execute an EFP in which C sells
futures contracts to A, but there is no corresponding cash
transaction between A and C. In the absence of this string trade,
parties A and B and parties B and C must execute separate EFP
transactions consistent with their contractual obligations. Thus,
the string trade serves to match the mutually exclusive futures
obligations so that only one EFP is reported to the contract market.
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(c) Request for Comments. The Commission is soliciting comments on
the following questions:
(8) What is the appropriate scope of the separate parties
requirement?
(9) Should the Commission address string trades as that practice
is described in the EFP Report and, if so, how?
3. Nature of the Transaction
(a) Exchanges of Futures Contracts for Cash Commodities. As
discussed previously, Section 4c(a) of the Act excepts EFPs from the
prohibition against various types of noncompetitively executed
transactions. A bona fide EFP must involve an "exchange" of futures
contracts for cash commodity in which both legs of the transaction
entail actual economic risk.
(b) Futures Leg Requirements. The futures leg of the EFP must be
reported to and cleared by a contract market clearing organization.
Therefore, it is subject to the same margin obligations, both original
and variation, as any other exchange-traded futures transaction. If the
futures leg were netted off-exchange, this conduct might constitute
bucketing in violation of Section 4b(a) of the Act.<SUP>26</SUP>
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\26\ 7 U.S.C. 6b.
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(c) Cash Leg Requirements. In the EFP Report, the Division
concluded that the cash commodity contract must impose a real
obligation to transfer ownership of the cash commodity from the cash
seller to the cash buyer upon performance of the terms of the contract,
with delivery taking place within a reasonable time thereafter in
accordance with prevailing cash market practice.<SUP>27</SUP> The
Division further asserted that, although the cash commodity contract
must contemplate the making and taking of delivery of the cash
commodity, the parties may, subject to the terms of the contract and
the principles of contract law, individually transfer their contractual
rights or obligations with respect to the cash commodity to a third
party or may offset these positions or obligations prior to
delivery.<SUP>28</SUP>
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\27\ EFP Report at 146.
\28\ Id. at 149. For example, under this approach, a third party
could assume the seller's obligation to deliver the cash commodity,
or the cash seller could contract to purchase the cash commodity
from the third party and direct that delivery be made to the cash
buyer in the EFP.
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In the EFP Report, the Division discussed several factors to be
considered in analyzing the parties' intent with respect to the
transfer of cash commodity, including: (i) the ability of the cash
seller to make delivery and of the cash buyer to take delivery of the
cash commodity; (ii) the level of creditworthiness required of the cash
seller and buyer; (iii) the form and terms of the cash commodity
contract; (iv) the documentation underlying the transfer of cash
commodity from the cash seller to the cash buyer; and (v) whether the
cash buyer acquires an enforceable claim on the title to the cash
commodity.<SUP>29</SUP>
---------------------------------------------------------------------------
\29\ Id. at 179-192, 196.
---------------------------------------------------------------------------
The Division expressed the view that the cash seller is not
required to have possession, or the right to possession, of the cash
commodity in order to undertake a contractual obligation to deliver it
in the future by way of an EFP.<SUP>30</SUP> Nevertheless, the lack of:
(i) possession, (ii) the right to possession, or (iii) access to the
cash market may indicate that the parties lacked the requisite intent
to execute a cash transaction in the first place. This would raise
doubts about the legitimacy of the EFP. Similarly, evidence that the
cash buyer was unable to accept delivery of the cash commodity may
indicate that the parties never intended to execute the cash leg of the
EFP. An examination of the documents underlying the cash transaction,
including the form and the terms of the cash commodity contract,
confirmation statements, and documents evidencing title, in light of
the state law governing transfers of ownership is especially useful in
determining the parties' intent.
---------------------------------------------------------------------------
\30\ Id. at 181.
---------------------------------------------------------------------------
In determining whether there has been, or will be, an actual
transfer of ownership of the cash commodity, the critical inquiry is
whether the buyer of the cash commodity has acquired or will acquire,
upon completion of performance under the contract, title to the cash
commodity associated with the
[[Page 3713]]
EFP.<SUP>31</SUP> In this regard, the Division stated that the cash
commodity contract may contemplate an immediate transfer of title or a
transfer of title at some subsequent time.<SUP>32</SUP> Regardless of
when title passes, however, delivery of the cash commodity should occur
within a reasonable period of time in accordance with normal industry
practice involving comparable cash market transactions. If delivery did
not occur, the transaction would need to be scrutinized, the reasons
for failure identified, and a determination made as to whether the EFP
is bona fide.
---------------------------------------------------------------------------
\31\ Id. at 185-186.
\32\ Id. at 186.
---------------------------------------------------------------------------
(d) Transitory EFPs. In the EFP Report, the Division expressed
concern about a practice, then occurring frequently in the gold and
foreign currency markets, involving both an EFP and an offsetting cash
commodity transfer.<SUP>33</SUP> For example, party A purchases the
cash commodity from party B and then engages in an EFP whereby A sells
the cash commodity back to B and receives a long futures position. As a
result of this integrated transaction, the parties acquire futures
positions but end up with the same cash market position as they had
before the transaction. These transactions are sometimes referred to as
transitory EFPs. In such cases, questions arise as to whether there has
been a bona fide "exchange" of the cash commodity as is required by
Section 4c(a) of the Act.
---------------------------------------------------------------------------
\33\ Id. at 192-193.
---------------------------------------------------------------------------
The Division concluded that, in reviewing transitory EFPs, the EFP
and the cash commodity transfer should be examined both separately and
as an integrated transaction.<SUP>34</SUP> The parties must incur
actual economic risk in both legs of the EFP and in the cash commodity
transfer, and the EFP itself must otherwise be bona fide.
---------------------------------------------------------------------------
\34\ Id. at 195.
---------------------------------------------------------------------------
The predominant consideration is whether the cash commodity
transfer can stand on its own as a commercially appropriate
transaction, with no obligation on either party to carry out the
EFP.<SUP>35</SUP> One indication is whether the terms and structure of
the cash commodity transfer are substantially the same in all material
respects as other cash transactions in that market or more specifically
for those particular participants. For example, if the price of the
cash commodity is determined differently or if a lower level of
capitalization is required of the buyer than would otherwise be the
case, then the cash commodity transfer may not be genuine. Another
indication is whether the buyer acquires title to the cash commodity in
accordance with customary cash market practices.
---------------------------------------------------------------------------
\35\ Id. Evidence that the cash commodity transfer is severable
from the EFP is necessary, but not sufficient, to establish the
legitimacy of the integrated transaction. As noted above, the EFP
itself must be bona fide.
---------------------------------------------------------------------------
Additional issues to be considered in evaluating whether the
integrated transaction is bona fide include: (i) The timing of the cash
commodity transfer and the EFP; (ii) whether the same parties have
executed a number of integrated transactions in which the cash
commodity transfer never occurs independently of the EFP; (iii) whether
there have been a series of transactions in which the same cash
commodity is transferred repeatedly between the same parties, resulting
in the liquidation of a futures position much larger than the exchanged
cash commodity which ultimately remains with the original owner; and
(iv) the relationship between the parties and their patterns of
dealings, including evidence of money passes between them.<SUP>36</SUP>
---------------------------------------------------------------------------
\36\ Id. at 200-201.
---------------------------------------------------------------------------
(e) Contingent EFPs. Contingent EFPs are an impermissible subset of
transitory EFPs. The existence of conditions tying the cash commodity
transfer and the EFP together may indicate that the transactions are
not severable but are contingent upon each other.<SUP>37</SUP> A cash
commodity transfer which cannot stand on its own may indicate that
there was no actual economic risk in the initial cash transfer and may
raise concerns about whether the EFP involved an "exchange" of
futures contracts for cash commodity as is required by Section 4c(a) of
the Act.
---------------------------------------------------------------------------
\37\ Id. at 198.
---------------------------------------------------------------------------
(f) Request for Comments. The Commission is soliciting comments on
the following questions:
(10) What criteria are appropriate for judging whether the
futures leg of an EFP is bona fide?
(11) What criteria are appropriate for judging whether the cash
leg of an EFP is bona fide?
(12) What criteria are appropriate for determining whether a
transitory EFP is bona fide?
(13) What criteria are appropriate for determining whether an
EFP is contingent?
4. Price of the Transaction
(a) Current Requirements. As discussed previously, because EFPs are
executed noncompetitively off-exchange, the prices of both the futures
and cash legs are determined by mutual agreement of the parties. In the
EFP Report, the Division concluded that the price differential between
the futures and cash legs should reflect commercial realities and that
at least one leg of the transaction should be priced at the prevailing
market.<SUP>38</SUP> Although pricing one leg of the EFP significantly
away from the market may be justified by commercial
necessity,<SUP>39</SUP> the Division expressed its concern that such
aberrant pricing can be used to shift substantial sums of cash from one
party to another or to allocate gains and losses between the futures
and cash sides of the EFP.<SUP>40</SUP> Moreover, when both legs of an
EFP are priced away from the market, the transaction may not be
commercially appropriate, particularly when one party could obtain
better prices for the futures and cash legs in another available
market. In the EFP Report, the Division urged contract markets to
determine whether the pricing of a particular EFP is supported by a
business purpose.<SUP>41</SUP>
---------------------------------------------------------------------------
\38\ Id. at 174-175.
\39\ The Division identified several such examples in the EFP
Report including meeting a margin call, taking advantage of expected
foreign exchange fluctuations, and complying with internal inventory
policies. Id. at 169-173.
\40\ Id. at 169.
\41\ Id. at 175.
---------------------------------------------------------------------------
(b) Request for Comments. The Commission is soliciting comments on
the following questions:
(14) Should the Commission require both the futures and cash
legs of an EFP to be priced within the daily range of their current
respective markets, should it require only one leg of an EFP to be
priced within its daily range, or should it impose no restrictions
on the price of either leg of an EFP?
(15) Should the Commission require contract markets to obtain
documentation regarding the business purpose underlying the pricing
of an EFP?
C. Other Regulatory Requirements Governing EFPs
1. Reporting and Recordkeeping
(a) Current Requirements Under the Commission's current regulations
EFPs are subject to broad reporting and recordkeeping requirements.
Commission Regulation 1.35(a) generally requires every FCM, introducing
broker ("IB"), and contract market member to keep full, complete and
systematic records of all transactions relating to its business of
dealing in commodity futures, commodity options, and cash commodities,
to retain such records for a period of five years, and to produce them
upon request of the Commission or the Department of Justice. Commission
Regulation 1.38(b) requires every person handling, executing, clearing,
or carrying EFPs to identify all related documents by appropriate
symbol or designation. Similarly, under Commission Regulation 1.35(e),
each
[[Page 3714]]
contract market must maintain a record showing, by appropriate and
uniform symbols, any transaction which is made noncompetitively in
accordance with written rules of the contract market. Commission
Regulation 1.35(a-2) requires FCMs, IBs, and other contract market
members to ask their customers for documentation of the cash leg of an
EFP upon request of the contract market, the Commission, or the
Department of Justice and upon receipt to provide the documentation to
the requesting body; requires customers to create, retain, and produce
such documentation directly to the requesting body; and requires that
all contract markets adopt, as necessary, corresponding rules requiring
its members to provide the documentation to the contract market.
Under Part 16 of the Commission's regulations, each contract market
must report the total quantity of futures contracts bought or sold in
connection with EFPs to the Commission by clearing member and must
publish the total quantity of EFPs executed on any given business day.
Part 17 of the Commission's regulations requires FCMs, members of
contract markets, and foreign brokers to report to the Commission the
quantity of EFPs executed in each special account on the day it has a
reportable futures position as well as on the first day the account is
no longer reportable. Commission Regulation 18.05 requires each trader
holding or controlling a reportable futures position ("large trader")
to keep records of all futures and cash commodity positions and
transactions. Finally, the Commission may issue a special call under
Regulation 21.03(e)(1)(iii) to FCMs, IBs, or customers that requires
information about EFPs to be submitted for the particular commodity,
contract market, and delivery months named in the call.
(b) Request for Comments. The Commission is soliciting comments on
the following question:
(16) Are the current reporting and recordkeeping requirements
relating to EFPs adequate?
2. Disclosure
(a) Current Requirements. Commission Regulation 1.55(a)(1)
prohibits an FCM or IB from opening a commodity futures account for any
customer unless the FCM or IB first provides the customer with a
written risk disclosure statement prepared by or approved by the
Commission and receives a signed acknowledgment from the customer that
he or she has received and understood this statement.<SUP>42</SUP> This
risk disclosure statement, as set forth in Commission Regulation
1.55(b), does not specifically address EFPs. However, Commission
Regulation 1.55(f) makes clear that compliance with the specific
disclosure requirements of Regulation 1.55 does not relieve an FCM or
IB from any other disclosure obligation it may have under applicable
law. These disclosure obligations arise under Section 4b of the Act as
well as under state and common law and require an FCM or IB to provide
its customers with all material information relating to a transaction,
including information relating to the risks involved in entering a
particular transaction.<SUP>43</SUP>
---------------------------------------------------------------------------
\42\ The Commission is currently proposing to amend Regulation
1.55 so that FCMs and IBs would no longer be required to furnish the
specified written risk disclosure statement to certain categories of
financially accredited customers or to obtain written
acknowledgments of receipt of the risk disclosure statement before
opening a commodity futures account for these customers. In
addition, the Commission is currently proposing amendments to
relieve FCMs and IBs from requirements to furnish disclosure
statements to these financially accredited customers pertaining to
foreign futures or foreign options (Regulation 30.6(a)), domestic
exchange-traded commodity options (Regulation 33.7(a)), customers
whose accounts are transferred to another FCM or IB other than at
the customer's request (Regulation 1.65(a)(3)), and the treatment in
bankruptcy of non-cash margin held by an FCM (Regulation 190.10(c)).
Distribution of Risk Disclosure Statements by Futures Commission
Merchants and Introducing Brokers, 62 FR 47612 (Sept. 10, 1997).
\43\ Id. at 47614.
---------------------------------------------------------------------------
The Commission seeks to ensure full and fair disclosure of the
requirements of and risks inherent in EFPs. Only when customers have
complete information regarding EFPs can they effectively evaluate
whether such transactions are consistent with their financial goals.
The Commission believes that some guidance as to the form and content
of disclosure concerning EFPs may be appropriate.
(b) Request for Comments. The Commission is soliciting comments on
the following questions:
(17) What should be the form and content of disclosure
concerning EFPs?
(18) Should the form and content of disclosure vary according to
the commercial sophistication of the EFP participant similar to the
Commission's proposed amendment to Regulation 1.55?
(19) Should the Commission explicitly require that customers
must be informed that an EFP is executed noncompetitively, that it
involves a cash transaction, and that their FCM might take the
opposite side of the EFP?
(20) Should the Commission explicitly require Commission
registrants to obtain customer consent before executing an EFP on
the customer's behalf?
3. Internal Controls
(a) Current Requirements. Commission Regulation 166.3 generally
requires all Commission registrants, except associated persons who have
no supervisory duties, to "diligently supervise the handling by its
partners, officers, employees and agents * * * of all commodity
interest accounts carried, operated, advised or introduced by the
registrant and all other activities * * * relating to its business as a
Commission registrant." One basic purpose of the rule is to protect
customers by ensuring that their dealings with employees of Commission
registrants will be reviewed and overseen by other officials in the
firm.<SUP>44</SUP> Although Commission Regulation 166.3 currently
applies to EFPs, the Commission believes that some guidance as to the
types of internal controls that Commission registrants should be
required to maintain may be appropriate.
---------------------------------------------------------------------------
\44\ Adoption of Customer Protection Rules, 43 FR 31886, 31889
(July 24, 1978).
---------------------------------------------------------------------------
(b) Request for Comments. The Commission is soliciting comments on
the following question:
(21) What internal controls are appropriate for Commission
registrants to ensure compliance with regulatory requirements
concerning the essential elements of bona fide EFPs, reporting and
recordkeeping, and disclosure?
4. Transparency
(a) Current Requirements. The current reporting requirements for
EFPs are outlined above. Exchanges do not require, and generally do not
have a mechanism for providing, timely information about EFP bids,
offers, and transactions.
(b) Request for Comments. The Commission is soliciting comments on
the following questions:
(22) Do existing price reporting standards provide adequate
transparency concerning EFPs to the marketplace and, if not, are
there alternative methods of achieving improved price transparency?
(23) Should the Commission require contract markets to publicize
information about bids and offers, as well as consummated EFP
transactions?
III. Other Noncompetitive Transactions Executed on or Subject to
the Rules of a Contract Market
A. Types of Eligible Transactions
Although EFPs have raised many issues and concerns, they have
proven to be useful commercial tools. As noted above, the Commission
seeks to explore whether there are other types of noncompetitive
transactions that also could enhance the usefulness of
[[Page 3715]]
designated contract markets without compromising necessary regulatory
safeguards. The Commission has identified three potential candidates:
(i) EFS transactions; (ii) exchanges of options for physicals
("EOPs"); and (iii) block trades. The Commission welcomes the
identification by commenters of any other potential types of
transactions.
1. Exchanges of Futures for Swaps
(a) The New York Mercantile Exchange Proposal. As noted, the NYMEX
has applied to the Commission for approval of a rule that would permit
the execution of EFS transactions. As proposed by the NYMEX, EFS
transactions would involve the noncompetitive exchange of futures
contracts for separately negotiated swap agreements. In this respect,
the proposal would establish for EFS transactions provisions that are
parallel to, but separate from, those governing EFP transactions.
<SUP>45</SUP> Thus, an EFS transaction would follow the structural form
of an EFP transaction except that a swap agreement would be substituted
for the physical component of the transaction. <SUP>46</SUP>
---------------------------------------------------------------------------
\45\ As noted above, pursuant to Section 4c(a) of the Act, EFPs
are explicitly permitted as an exception to the usual open and
competitive execution requirements established by the Act, but only
to the extent provided for by contract market rules approved by the
Commission. Also as noted, Commission Regulation 1.38(a) authorizes
noncompetitive transactions if executed in accordance with contract
market rules that have received Commission approval. All domestic
commodity exchanges permit the execution of EFP transactions,
although there is some variation among exchange rules.
\46\ In general, a simplified swap agreement may be
characterized as an agreement between two parties to exchange a
series of cash flows measured by different interest rates, exchange
rates, or prices, with payments calculated by reference to a
principal base (or notional amount). See Policy Statement Concerning
Swap Transactions, 54 FR 30695 (July 21, 1989). Part 35 of the
Commission's Regulations defines swap agreements by reference to the
Bankruptcy Code. See 17 CFR 35.1(b)(1).
---------------------------------------------------------------------------
Under the NYMEX proposal, the swap component of the EFS transaction
must comply with the requirements of Part 35 of the Commission's
regulations or with the Commission's 1989 Policy Statement concerning
cash-settled swap transactions or must otherwise qualify for or fall
within other exemptions or jurisdictional exclusions under the Act or
Commission regulations. This initiative represents the first proposal
the Commission has received for approval of EFS transactions.
The NYMEX states that the rule proposal in part responds to the
substantial growth that has occurred in the swaps market during recent
years. In this respect, the NYMEX asserts that swap transactions,
though not "physical" in the traditional sense, subject market
participants to the same type of price risk. Thus, the NYMEX claims
that the proposal could aid in linking the on-exchange futures and off-
exchange swap markets.
The NYMEX believes that allowing EFS transactions would increase
market efficiency and enhance the use of the exchange as a risk
transfer medium. Specifically, the NYMEX believes that both traditional
market users and swap dealers (banks, trading companies, and energy
companies) would benefit from the availability of EFS transactions. By
a similar line of reasoning, the NYMEX notes that commodity swap
instruments continue to play an increasingly important role in
providing a risk management function in crude oil and other markets, in
part because they can be individually tailored to a user's commercial
needs and thereby reduce substantially the presence of basis risk.
Because of this, the NYMEX concludes that permitting EFS transactions
would reduce basis risk for NYMEX market participants, enhance
competition among exchange and over-the-counter markets, and facilitate
greater usage of NYMEX as a centralized market.
The NYMEX affirms that it has not identified any evidence
suggesting that adoption of the proposal would harm existing liquidity
in NYMEX markets. Moreover, the NYMEX concludes that the rule proposal
would make the liquidity present in NYMEX energy markets accessible to
swap market participants via the EFS process. Additionally, the NYMEX
identifies the ability of swap participants to close out futures
positions more readily, as the underlying futures contracts approach
expiration, and thus utilize the exchange in managing price risk
associated with swap market transactions as a potential benefit of the
proposal.
The NYMEX also views the financial safeguards of the on-exchange
trading environment as potentially beneficial, and attractive to, swap
market participants. The NYMEX concludes that access to these financial
safeguards, including those associated with the position limit and
margining systems, either for purposes of creating or extinguishing
swap agreements, would enable swap market participants to enhance the
credit quality of swap positions. Thus, in summary, the NYMEX concludes
that several benefits would accrue to market participants from adoption
of the proposed rule, including improvements in liquidity and price
transparency, and reductions in basis and credit risk.
(b) Request for Comments. The Commission is soliciting comments on
the following questions:
(24) What are the economic reasons firms might have for engaging
in EFS transactions and what benefits might accrue thereunder,
including the potential benefits to domestic futures markets, to
over-the-counter markets, and to financial markets generally?
(25) What are the potential costs or risks of permitting EFS
transactions, particularly with respect to the effect on price
discovery, risk transfer, and the competitive character of "on-
exchange" transactions?
(26) Should the Commission approve the NYMEX rule proposal
permitting EFS transactions?
(27) Should EFS transactions be limited to particular markets,
participants or types of transactions?
(28) Should special provisions be established to ameliorate any
competitive costs or otherwise safeguard the competitive conditions
of the on-exchange market?
2. Exchanges of Options for Physicals
(a) Background. The EFP Report included an examination of
EOPs.<SUP>47</SUP> The Division noted that the statutory sections
governing options trading, Sections 4c(b) and 4c(c) of the
Act,<SUP>48</SUP> do not provide for the extension of the Section 4c(a)
exception for EFPs to options. The Division acknowledged that
Regulation 1.38 provides for the execution of noncompetitive
transactions pursuant to Commission-approved contract market rules and,
on that basis, concluded that EOP transactions could potentially fall
within the noncompetitive trade exception found in that regulation.
---------------------------------------------------------------------------
\47\ EFP Report at 235-240.
\48\ 7 USC 6c(b) and 6c(c).
---------------------------------------------------------------------------
The EFP Report's investigation of contract market rules found that
most were silent on the question of whether EOP transactions were
acceptable, with only the Chicago Mercantile Exchange ("CME") rules
expressly prohibiting EOP transactions.<SUP>49</SUP> Although the Amex
Commodities Corporation ("ACC") adopted a rule permitting
EOPs,<SUP>50</SUP> it subsequently withdrew that rule, apparently prior
to the execution of any EOP transactions.
---------------------------------------------------------------------------
\49\ CME Rule 538.
\50\ ACC Rule 908.
---------------------------------------------------------------------------
The Division staff that prepared the EFP Report were unable to
discover any instances in which an option on a futures contract was
exchanged for a cash commodity, and the Commission is not aware that
any of these transactions have occurred since the publication of the
report. The Division observed that the absence of these transactions
could be due to the fact that market participants had not yet been able
to design a plan to execute EOPs, perhaps
[[Page 3716]]
because of difficulty in establishing an appropriate basis relationship
between the option and the cash commodity.
The EFP Report indicated that commentary from contract market
officials and market participants on the EOP issue was divided. Some
commenters objected on the basis that an option does not involve a
delivery commitment. However, others indicated that EOPs could be
appropriate in some circumstances. These commenters indicated that an
EOP might be appropriate for the grantor of an option, who has a
delivery commitment upon exercise, or in the case of a deep-in-the-
money option, which as a practical matter appears to be the equivalent
of a futures position. One commenter stated that EOPs were conceptually
viable but that the instability associated with option deltas (and
therefore option value) could create great risk for a person accepting
an option in exchange for a cash commodity. This commenter also
indicated that, assuming this risk was reflected in the price, EOP
transactions could be very expensive.
(b) Request for Comments. The Commission is soliciting comments on
the following questions:
(29) Are EOPs viable and do these transactions offer genuine
risk management benefits?
(30) If so, should EOPs be permitted, and should there be
limitations on EOPs that reflect the particular risk characteristics
of options?
3. Alternative Execution Procedures
(a) Current Procedures. (1) Contract Market Large Order Procedures.
The Commission has approved several contract market rules that
establish alternative execution procedures for certain transactions.
These procedures generally preserve the competitive forces available on
a centralized market and thereby comply with the "open and
competitive" requirement of Commission Regulation 1.38(a).
The CME, the New York Cotton Exchange ("NYCE") and the New York
Futures Exchange ("NYFE") have adopted similar procedures providing
for the execution of large orders.<SUP>51</SUP> These procedures may be
used only upon customer request or if the large order bid or offer is
the best price available to satisfy the terms of the order. A member
makes a request for a large order bid and/or offer in the appropriate
trading area. Responding members may make bids and/or offers at, above
or below the current prevailing bid or offer in the underlying market
for regular size orders. Only the best bid and/or offer shall prevail,
and the large order must be filled on an all-or-none basis. The large
order execution price does not trigger conditional orders in the
underlying market, such as stop or limit orders.
---------------------------------------------------------------------------
\51\ CME Rule 521 ("All-Or-None Transactions"); NYCE Rule
1.10-B ("Block Order Execution"); NYFE Rule 312 ("Block Order
Execution").
The CME all-or-none procedures apply to a variety of products,
including currency futures, South African Rand options, 28-day
Mexican TIIE futures, 91-day Mexican CETES futures, Brady Bond
futures, IPC futures, Three-month Eurodollar futures bundle
combinations, 13-week U.S. Treasury Bill futures, British Pound/
Deutsche Mark and Deutsche Mark/Japanese Yen futures, and Argentine
Par Bond futures. The minimum contract size eligible for execution
under these procedures ranges from 20 contracts to 100 contracts.
The NYCE limits its block order execution procedures to transactions
involving 50 or more FINEX futures or futures spreads, options
spreads or futures/options combinations in the same contract. The
NYFE limits its block order execution procedures to transactions
involving 15 or more NYSE Large Composites, 30 or more NYSE
Composite Index or 50 or more CRB futures or options, futures
spreads, options spreads or futures/options combinations in the same
contract.
---------------------------------------------------------------------------
The NYCE and NYFE expressly prohibit an initiating floor broker
from bundling customer orders to meet the minimum contract size
required for eligibility under the large order execution procedures,
but allow a responding broker to bundle customer limit orders and to
add orders from his or her own account to match the quantity of futures
or options in the large order request. Under the CME all-or-none
procedures, both the initiating floor broker and the responding floor
broker may bundle customer orders to meet the minimum contract size as
long as the customers specifically request execution under these
procedures or the all-or-none bid or offer is the best price available
to satisfy the terms of the orders. Although cross trades are not
permitted at the NYCE and NYFE under these procedures, they are
permitted at the CME. Large order transactions executed at all three
exchanges must be reported to a designated Exchange official who
records and publishes the quantity and prices separately from reports
of transactions in the regular market.
The CME also has adopted separate large order execution ("LOX")
procedures for transactions involving 300 or more futures contracts in
the Standard & Poor's 500 Stock Price Index or the Nikkei Stock
Average.<SUP>52</SUP> These procedures, which include the pre-execution
solicitation of interest and discussion of price, have only been used
once in the several years they have been available.
---------------------------------------------------------------------------
\52\ CME Rule 549.
---------------------------------------------------------------------------
The CME also has adopted request for size ("RFS") quotations for
the GLOBEX system. These procedures supplement the GLOBEX request for
quote ("RFQ") procedures. As originally configured, RFQ messages were
distributed without any contract quantity indication. Thus, the
adoption of RFS procedures permits requests for large size transactions
for all contracts traded through GLOBEX, subject to a minimum threshold
quantity for RFS quotations of 100 contracts.<SUP>53</SUP>
---------------------------------------------------------------------------
\53\ The CME recently lowered the minimum threshold quantity for
RFS quotations for currency futures traded through GLOBEX to 50
contracts.
---------------------------------------------------------------------------
(2) Section 4(c) Contract Market Transactions. As noted previously,
Section 4(c) of the Act vests the Commission with certain exemptive
authority from the general requirement that all futures transactions
must be executed on designated contract markets, subject to specified
qualifying criteria. Part 36 of the Commission's regulations adopts
certain exemptions under a pilot program for the establishment of
separate professional markets which would have less restrictive
requirements governing trading, reporting, and risk disclosure for
eligible transactions than are applicable to current contract markets.
Subject to certain recordkeeping and audit trail requirements, Part 36
procedures provide for the execution of noncompetitive transactions,
regardless of size. In addition, these transactions are limited to
certain Commission registrants and sophisticated and/or institutional
traders which meet certain minimum asset requirements, including banks,
trust companies, savings associations, credit unions, investment
companies, commodity pools, certain business associations, employee
benefit plans, government entities, broker-dealers, FCMs, floor
brokers, floor traders, and certain other natural persons. A contract
market may adopt trading rules permitting the execution of Part 36
transactions using any combination of noncompetitive execution
procedures and competitive on-floor trading procedures.
No contract market has filed a proposal with the Commission
pursuant to Section 4(c) and Part 36. Significantly, Part 36 only
permits noncompetitive executions in specially-designated, stand-alone,
professional markets. In contrast, the other noncompetitive trading
methods discussed in this release are adjuncts to regular trading on or
subject to the rules of a contract market.
(3) Securities Market Block Trading Procedures. Block trading in
securities markets differs substantially from that on Commission
designated contract
[[Page 3717]]
markets. Blocks may be traded on securities exchanges, in over-the-
counter securities markets, or through "principal-to-principal" trade
execution venues. In the securities industry, a block trade is commonly
defined as a transaction involving 10,000 or more shares or a quantity
of stock having a market value greater than or equal to $200,000. In
recent years, block trading in securities markets has increased as a
percentage of reported trading volume.<SUP>54</SUP>
---------------------------------------------------------------------------
\54\ In 1996, block trading on the New York Stock Exchange
comprised 55.9% of the exchange's reported volume, or 2,348,457
transactions accounting for 58.5 billion shares. New York Stock
Exchange Fact Book 1996, at 16 (May 1997).
---------------------------------------------------------------------------
The New York Stock Exchange ("NYSE") and the Chicago Board
Options Exchange ("CBOE") have rules providing for block
trading.<SUP>55</SUP> A customer desiring to trade a block of NYSE-
listed stocks contacts a block trader. Depending on the block trader's
assessment of market demand and supply, the block trader may notify the
Specialist of the pending block trade.<SUP>56</SUP> If notified, the
Specialist may indicate an interest in participating in the block. The
block trader then must decide whether to "position" the entire block
by serving as the counterparty or "shop the block" by seeking
customers to take the other side of the trade. The block trader may
also combine these strategies by positioning part of the block and
seeking customers for the remaining shares. Upon agreement of a price
for the block,<SUP>57</SUP> the block order is transmitted to the NYSE
floor for crossing against the block trader's house account or against
other customer orders as arranged in "shopping the block."
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\55\ NYSE Rule 127; CBOE Rule 6.9.
\56\ NYSE Rule 127(a).
\57\ When positioning a block, the block trader quotes a
tentative price for the stock to the block customer, and the
customer may tentatively accept this price. Barring an extreme and
unexpected movement in the price of the stock, the customer may be
reasonably assured of execution at the quoted price.
When a block trader "shops a block," the trader contacts one
or more potential customers to take the opposite side of the block
at a specified price. The block trader might be willing to negotiate
this price depending on how interested other investors are in
participating in the block. The block trader continues to "shop the
block" until he or she has a sufficient quantity of orders for the
opposite side at a single price. At this point, the block trader
returns to the block customer and confirms the customer's interest
in the block transaction at the negotiated price, also known as the
"clean-up" price.
---------------------------------------------------------------------------
Block orders crossed on the NYSE floor must comply with NYSE rules,
including the following. Block orders within the current market
quotation must first be offered publicly at a price higher than the
member's bid by the minimum variation applicable to that stock so that
the trading crowd may participate in the block at that publicly offered
price, before the member may proceed with the cross
transaction.<SUP>58</SUP> Block orders crossed outside the current
market quotation must be disclosed to the Specialist.<SUP>59</SUP>
Where the member is holding agency orders on both sides of the market,
he or she must probe the market to determine whether more stock would
be lost than is reasonable under the circumstances to orders in the
crowd.<SUP>60</SUP> Where the member is serving as the counterparty of
the block and where all or any portion of the block establishes or
increases his or her position, the member must fill all limit orders at
the post for the clean-up price or better at the clean-up price, before
any amount may be retained for the member's account.<SUP>61</SUP> As an
anti-manipulation safeguard, when a member holds any part of a long
position in a stock in its trading account as a result of a block trade
it completed with a customer, the member is precluded from effecting
certain transactions in this stock on the same trading day in which the
block trade was executed.<SUP>62</SUP>
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\58\ NYSE Rule 76.
\59\ NYSE Rule 127(b).
\60\ NYSE Rule 127(c). If the member representing the block
orders decides that the amount of stock that would be lost is not
excessive, then he or she announces the clean-up price to the crowd
and fills at such price all agency limit orders at the post for the
clean-up price or better. The member then crosses the remaining
block orders at the clean-up price.
If the member decides that the amount of stock that would be
lost is excessive, then he or she either may return to the block
customers to negotiate a new clean-up price or may limit
participation in the block by members at the post. The member limits
participation merely by informing the crowd that they cannot
participate freely in the block. After such an announcement, the
member follows the crossing procedures set forth in NYSE Rule 76 and
makes a bid and offer for the full amount of the block. A
"reasonable" time must elapse before the cross is completed in
order to provide the crowd, including the Specialist, the
opportunity to execute superior priced bids or offers to provide
price improvement. Thereafter, the member crosses the orders for the
remaining shares at the clean-up price. The member is not required
to fill at the clean-up price orders limited to the clean-up price
or better. The block is entitled to priority at the proposed clean-
up price.
\61\ NYSE Rule 127(d)(1).
\62\ NYSE Rule 97.
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At the CBOE, a member or member organization may solicit another
member, member organization, non-member customer or broker-dealer
("solicited person") to take the opposite side of a large-sized order
("original order").<SUP>63</SUP> The member representing the original
order must disclose the terms and conditions of that order to the
trading crowd before it can be executed.<SUP>64</SUP>
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\63\ CBOE Rule 6.9. CBOE Rule 6.9 specifically allows solicited
transactions by "a member or member organization representing an
order respecting an option traded on the Exchange * * * including a
spread, combination, or straddle order as defined in Rule 6.53 and a
stock-option order as defined in Rule 1.1(ii)."
\64\ CBOE Rule 6.9(d). However, the member is not required to
announce to the trading crowd that another person has been solicited
to participate in the order. The initiating member simply must
disclose all the terms and conditions of the original order and any
modifications to the trading crowd.
---------------------------------------------------------------------------
In order to promote disclosure at the inception of the solicitation
period and to encourage solicited persons to bid or offer at prices
that improve the current market, the CBOE rule establishes a series of
priority principles for these solicited transactions. Priority depends
upon whether the original order is disclosed throughout the
solicitation period, whether the solicited order improves the best bid
or offer in the crowd and whether the solicited order matches the
original order's limit.
If the terms and conditions of the original order are disclosed to
the trading crowd prior to any solicitation and the order is
continuously represented in the crowd throughout the solicitation
process, then the following rules apply. If the solicited order matches
the original order's limit and improves the best bid or offer in the
trading crowd, then the solicited order has priority over the crowd and
may trade with the original order at the improved bid or offered price
subject to the customer limit order book priorities set forth in CBOE
Rule 6.45.<SUP>65</SUP> If the solicited order does not match the
original order's limit, but improves the best bid or offer in the crowd
and the original order is subsequently modified to match the solicited
order's bid or offer, then the terms of the original order, as
modified, must be disclosed to the trading crowd. The crowd has
priority to trade with the modified original order before this order
may be crossed with the solicited order.<SUP>66</SUP> If the solicited
order does not match the original order's limit and meets but does not
improve the best bid or offer in the trading crowd and the original
order is subsequently modified to match the solicited order's bid or
offer, then the trading crowd has priority to trade with
[[Page 3718]]
the modified original order at the best bid or offered price subject to
the customer limit order book priorities.<SUP>67</SUP> Finally, where
the terms and conditions of the original order have not been disclosed
in advance of the solicitation, the trading crowd has priority to trade
with the original order at the best bid or offered price subject to the
customer limit order book priorities before the original order may be
crossed with the solicited order. <SUP>68</SUP>
---------------------------------------------------------------------------
\65\ CBOE Rule 6.9(a).
Under CBOE Rule 6.45, the highest bid or lowest offer has
priority. Where two or more bids (offers) for the same option
contract represent the highest (lowest) price, the bid (offer) that
is displayed in the customer limit order book shall have priority
over any other bid at the post. If two or more bids (offers)
represent the highest (lowest) price and the customer limit order
book is not involved, then priority is determined according to the
sequence in which the bids (offers) were made.
The procedures set forth in CBOE Rule 6.74 govern the crossing
of original orders with solicited orders, except when the solicited
party has priority as is the case under CBOE Rule 6.9(a).
\66\ CBOE Rule 6.9(b).
\67\ CBOE Rule 6.9(c).
\68\ CBOE Rule 6.9(d).
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CBOE members and their associated persons who have knowledge of all
the material terms and conditions of an imminent, undisclosed solicited
transaction are prohibited from certain trading in an option of the
same class that is the subject of the solicited transaction, the
underlying security or any related instrument. That prohibition is in
effect until the original order and any modifications are disclosed to
the trading crowd or until the solicited transaction can no longer
reasonably be considered imminent in view of the passage of time since
the solicitation.<SUP>69</SUP>
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\69\ CBOE Rule 6.9(e). This trading restriction applies to the
solicited party as well as to any other member or associated person
who has knowledge of all the material terms and conditions of both
the original and solicited orders, including the price.
---------------------------------------------------------------------------
Block trading also is carried out on regional securities exchanges
and in over-the-counter securities markets. The procedures governing
block trades in these markets are generally less complex than those
applicable at the NYSE. Block trades for stocks listed on regional
exchanges are negotiated off-floor and in most cases must be crossed on
the floor of the exchange. Moreover, traders generally do not have to
accommodate limit orders. Over-the-counter block trades are arranged by
a block trader who then crosses the resulting orders.
Another venue for securities block trading involves "principal-to-
principal" systems. Generally, block customers directly enter trade
quantities and bid/ask prices into a computerized system, which matches
the orders according to the availability of bids and offers at matching
prices. In addition, block customers may execute block trades
themselves, off-exchange, without the assistance of a broker or block
trader.
(b) Potential Procedures. Certain participants in the futures
markets have suggested that the competitive execution requirements
under the Commission's regulations be relaxed to permit block trading
procedures similar to those in the securities exchange and over-the-
counter markets. As noted previously, the proviso to Commission
Regulation 1.38(a) permits noncompetitive transactions if executed
pursuant to contract market rules that have been approved by the
Commission.
One of the purposes of this release is to investigate whether there
are alternative, noncompetitive execution procedures that would further
the policies and purposes of the Act. If so, the Commission seeks to
determine the extent to which these procedures could be structured to
serve the purposes of market participants while not sacrificing
customer protection. The procedures might be limited according to order
size, class of participant, contract, or some other category. In
addition, the Commission seeks to determine the extent to which the
procedures would be, and should be, similar to securities market
procedures.
The following examples, while not exhaustive, illustrate the range
of possibilities. The least significant modification of current open
and competitive procedures would expressly permit market participants
to alert potential counterparties of their interest in trading in a
particular market at a particular time. Actual execution would occur
pursuant to existing competitive procedures.
A more significant departure from current procedures would permit
market participants to divulge not only a general interest in trading
but also specific information about quantity and price to potential
counterparties. Again, actual execution would occur competitively. This
might be analogous to the practice of "shopping the block" in
securities markets.
A further variation would permit negotiation between market
participants. This would permit some degree of prearrangement although
the execution price would to some extent remain subject to prices in
the competitive market.
Yet another variation would adjust execution procedures to confer a
degree of priority on particular orders that they might not attain in
the open and competitive process. Such priority could be conferred, for
example, on certain retail orders or on certain marketmaker orders.
Finally, market participants could be permitted to execute certain
transactions bilaterally, away from the centralized marketplace, and
simply report them to the exchange and clearing house. This would be
similar to the way EFPs are handled currently.
Each of these alternatives potentially raises concerns, including,
among others:
the impact on price discovery;
the impact on liquidity;
the potential for manipulation; and
the potential for mispricing, frontrunning, or other customer fraud.
Any proposed procedure would have to address such concerns. The
need for safeguards is discussed further below.
(c) Request for Comments. The Commission is soliciting comments on
the following questions:
(31) Should alternative, noncompetitive execution procedures be
permitted on or subject to the rules of a contract market?
(32) If so, how should these procedures be structured to address
regulatory concerns?
(33) Should these procedures be limited by order size,
participant class, contract, or some other criteria?
(34) Can adequate safeguards be devised in connection with these
procedures to prevent manipulation?
(35) Can adequate safeguards be devised in connection with these
procedures to prevent fraud?
B. Qualifying Standards
1. The Need for Standards
The preceding discussion identifies particular types of
transactions that might be appropriate for noncompetitive execution,
such as EFS transactions or block trades. The common thread connecting
these types of transactions with one another and with EFPs is their
potential ability to fulfill some particularized need of market
participants that the traditional open and competitive execution
methods cannot fulfill as well. Congress has implicitly found with
respect to EFPs that, at least under some circumstances, they provide
certain benefits although their pricing and execution occurs outside of
the centralized, open and competitive marketplace. To permit other
types of noncompetitive transactions, the Commission would have to make
a similar finding. For example, a contract market seeking approval of
new procedures could address the effect of the proposal on the contract
market's usefulness as a vehicle for price discovery and risk transfer.
If the proposal had the potential to affect those functions adversely,
the contract market could try to demonstrate countervailing benefits.
The contract market also could address, pursuant to Section 15 of the
Act,<SUP>70</SUP> whether its proposal was the least anticompetitive
means of achieving its objective. Moreover, a contract market might
show that these transactions are structured in such a way as to
complement the competitive market, not to supplant it.
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\70\ 7 U.S.C. 19.
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[[Page 3719]]
2. Request for Comments
The Commission seeks input on the general qualifying standards that
should govern a proposal's eligibility for approval and how compliance
with such standards would be demonstrated. The Commission is soliciting
comments on the following questions:
(36) What are the appropriate qualifying standards for
noncompetitive transactions concerning:
(a) the effect on the usefulness of a designated futures contract as
a hedging mechanism?
(b) the effect on the price discovery function of a designated
futures contract?
(c) the effect on the level of financial integrity in a designated
contract market?
(d) the effect on the level of customer protection in a designated
contract market?
(37) Should access to noncompetitive transactions be limited to
commercials or sophisticated investors?
(38) Should noncompetitive transactions be subject to contract
market rules?
(39) Are there other appropriate qualifying standards?
C. Continuing Regulatory Requirements
1. The Need for Requirements
As discussed above, in addition to determining whether an EFP is
bona fide, there is a need for appropriate regulatory oversight in
areas such as reporting and recordkeeping, disclosure, and internal
controls. Similar considerations apply to other types of noncompetitive
transactions.
2. Request for Comments
The Commission seeks input on any additional requirements that
should apply to a potential noncompetitive transaction, once it is
determined that the transaction meets basic eligibility standards. To
that end, the Commission has identified the following areas where it
appears that additional qualifying requirements would be required in
order to maintain systemic integrity and to provide guidance to self-
regulatory entities. The Commission seeks input both as to whether the
prospective requirement is necessary and, if so, how the requirement
could be structured to provide a meaningful test. The Commission is
soliciting comments on the following questions:
(40) What are the appropriate standards to ensure that
noncompetitive transactions are bona fide and meet basic qualifying
requirements on an ongoing basis?
(41) What are the appropriate reporting and recordkeeping
requirements applicable to these transactions?
(42) What are the appropriate disclosure requirements applicable
to these transactions?
(43) What are the appropriate internal controls applicable to
these transactions?
(44) What are the appropriate safeguards to maintain an adequate
level of transparency?
(45) What are the appropriate safeguards to prevent
manipulation?
(46) What are the appropriate safeguards to prevent fraud?
IV. Execution Facilities for Noncompetitive Transactions Executed
on or Subject to the Rules of a Contract Market
A. Current, Proposed and Potential Facilities
As noted in the Introduction, several organizations have developed
execution facilities for transactions that are executed off-exchange
and reported to contract markets as EFPs. As with the procedures
discussed in the previous section, these facilities expand the
opportunity for market participants to engage in the negotiation of
transactions off the floor of the exchange. It appears, however, that
there are significant structural differences between these facilities
and traditional methods for the execution of EFPs. The latter generally
appear to take a bilateral, over-the-counter approach to the
negotiation of trades.
Unlike traditional approaches, these execution facilities provide a
formal market environment for the negotiation and arrangement of
transactions, are typically operated by third parties, and may be
beyond the operational and regulatory purview of contract markets to
some extent. In this respect, however, the Commission also recognizes
that these facilities perhaps should be characterized as noncompetitive
only in the sense that the transactions executed thereon are completed
outside of designated contract markets. Thus, unlike the execution
procedures on a contract market, the execution procedures on one of
these facilities have not been formally reviewed and approved by the
Commission for compliance with the open and competitive requirements of
the Act and other statutory requirements. The Commission acknowledges
that an execution facility's centralized structure may provide a market
environment that facilitates the competitive execution of transactions
and also may provide competitive benefits for the underlying contract
markets.
This section includes a discussion of existing facilities, proposed
facilities, and potential facilities and presumes that the futures leg
of the transaction is reported to and cleared by an existing contract
market clearing organization. Generally, the request for comments
relative to this section seeks input as to whether the regulatory
environment applicable to such transactions continues to be appropriate
in light of the growth and evolution of activity on such facilities or
whether some form of additional oversight is needed. As more fully set
out below, the Commission's request for comments also seeks input on
the appropriate form of any prospective regulatory actions applicable
to these facilities.
1. Interdealer Brokers
There are six major interdealer brokers in the cash U.S. Treasury
securities market.<SUP>71</SUP> All or most offer basis trading
facilities. As noted above, a basis trade involves the simultaneous
acquisition of positions in actual Treasury securities and in
offsetting futures contracts. Transactions through these facilities
must meet minimum trade sizes as well as other qualifying requirements.
---------------------------------------------------------------------------
\71\ The six are Cantor Fitzgerald, Liberty, RMJ, Tullet &
Tokyo, Garban, and Hilliard & Farber.
---------------------------------------------------------------------------
It appears that at least a minimal level of transparency is
maintained for basis trading on these facilities, although it is not
clear whether that level is completely adequate. Information on these
basis trades is obtained through reports published over screen-based
news reporting services, such as Govpx or Bloomberg. The screens are
anonymous, except that firms may be identified for basis trade
quotations.
It also appears that these firms restrict their activities to
dealing only with primary dealers and other large institutional
entities. The interdealer brokers do not reveal counterparty names, and
anonymity is thereby maintained. Trades generally are cleared through
the Government Securities Clearing Corporation ("GSCC"), and
anonymity is maintained even after a trade is consummated. GSCC nets
the cash market legs of the basis trades.
2. The Chicago Board Brokerage
The CBT is developing a computerized system for, among other
things, basis trading of U.S. Treasury securities. The system will be
operated by the Chicago Board Brokerage ("CBB"), a subsidiary of the
CBT, which is registered with the Securities and Exchange Commission
("SEC") as a broker/dealer.
Pricing of basis trades on the CBB system will be carried out
according to a standardized formula. The futures leg will be assigned a
price equal to the last sale price for the futures contract. The cash
Treasury leg will be assigned a price according to the basis spread
relative to the price of the futures leg. The price of the cash
Treasury leg also will be adjusted to account for
[[Page 3720]]
differences between the coupon rate of the actual Treasury security and
the standardized 8 percent coupon rate of the futures contract. The
cash leg will be cleared through the Clearing Corporation for Options
and Securities ("CCOS"), a subsidiary of the Board of Trade Clearing
Corporation ("BOTCC") which is registered as a clearing agency with
the SEC. The futures leg will be cleared through the CBT and BOTCC
pursuant to rules governing EFP transactions.
3. Potential Facilities for Transactions Other Than EFPs
The interdealer brokers and the CBB are facilities for the
execution of EFPs. If the Commission were to permit other types of
noncompetitive trading, such as block trading, facilities might be
established for the execution of those types of transactions. For
example, a computerized, bulletin board system might be established in
connection with the execution of blocks. The Commission, of course,
before approving relevant contract market rules, would have the
opportunity to review procedures relating to these trades. Nonetheless,
as discussed below, the Commission is requesting comments as to the
appropriate form of regulatory oversight for these facilities.
B. Qualifying Standards
1. Current Requirements
Basis trades executed through these facilities currently are
subject to the same regulatory requirements as any other EFP
transaction. The Commission's oversight of these facilities does not
differ in any way from its oversight of the EFP markets generally. The
Commission is concerned that the nature of the transactions executed on
these facilities and the environment in which they are executed may
differ enough from the nature of traditional EFPs as to warrant
differing regulatory treatment. Indeed, it could be argued that some of
these facilities have evolved to the extent that they are functionally
the equivalent of designated contract markets.
2. Request for Comments
The Commission seeks input on the regulatory structure appropriate
for these execution facilities. At a threshold level, this area of
inquiry seeks comments on whether the existing regulatory structure
appears adequate as currently organized and administered. To the extent
that a commenter believes the current approach is adequate, a
supporting rationale should be set forth. To the extent that a
commenter believes the current approach is deficient, the Commission
seeks comments identifying the nature of the deficiency and whether new
guidelines or standards are required. Where a commenter believes that
new regulatory initiatives are required, the Commission seeks comments
on the form and nature of any such initiatives. Any such comments
should include a supporting rationale.
Specifically, the Commission is soliciting comments on the
following questions:
(47) What characteristics distinguish execution facilities for
EFPs from contract markets?
(48) Is the current regulatory approach concerning these
facilities adequate?
(49) If not, what modifications are appropriate?
(50) If execution facilities were established for noncompetitive
transactions other than EFPs, how, if at all, should the regulatory
approach that would apply to those facilities vary from that
currently applicable to contract markets?
(51) Should execution facilities for EFPs and other
noncompetitive transactions that are operated by non-contract
markets be subject to oversight by the relevant contract market?
(52) Should these facilities limit access to commercials or
sophisticated investors?
(53) Should these facilities be subject to procedures to prevent
manipulation?
(54) Should these facilities be subject to procedures to prevent
fraud?
(55) Should these facilities be subject to procedures to ensure
that transactions executed thereon are bona fide?
(56) Should these facilities be subject to procedures to provide
for market transparency?
(57) Should these facilities be subject to procedures related to
reporting and recordkeeping?
V. Summary of Request for Comments
After reviewing the comments, the Commission will determine whether
rulemaking or other action is appropriate. Commenters are invited to
discuss the broad range of concepts and approaches described in this
release. The Commission specifically invites commenters to compare the
advantages and disadvantages of the possible changes discussed above
with those of the existing regulatory framework. In addition to
responding to the specific questions presented, the Commission
encourages commenters to submit any other relevant information. In sum,
the Commission is soliciting comments on the following questions:
Overview
(1) Should the standards articulated in the EFP Report be
codified in the Commission's regulations and/or refined in any way?
(2) Should other types of noncompetitive transactions, such as
EFS transactions or block trades, be permitted to be executed on or
subject to the rules of a contract market and, if so, what standards
should apply to these transactions?
(3) What standards should be applicable to execution facilities
for noncompetitive transactions executed on or subject to the rules
of a contract market?
Elements of a Bona Fide EFP: Relationship of the Instruments
(4) How should the "strong price correlation" standard
articulated in the EFP Report be implemented?
(5) Should the Commission require contract markets to adopt a
minimum statistical correlation coefficient to be used in assessing
the acceptability of a particular cash commodity for use as the cash
leg of an EFP?
(6) If a minimum correlation coefficient is required, should
this coefficient apply to all EFPs, or should it be adjusted to
account for the different commodities involved in EFPs?
(7) What is the appropriate type and scope of guidance contract
markets should be required to provide to the general public
concerning the acceptability of particular commodities as the cash
leg of an EFP?
Elements of a Bona Fide EFP: Relationship of the Parties
(8) What is the appropriate scope of the separate parties
requirement?
(9) Should the Commission address string trades as that practice
is described in the EFP Report and, if so, how?
Elements of a Bona Fide EFP: Nature of the Transaction
(10) What criteria are appropriate for judging whether the
futures leg of an EFP is bona fide?
(11) What criteria are appropriate for judging whether the cash
leg of an EFP is bona fide?
(12) What criteria are appropriate for determining whether a
transitory EFP is bona fide?
(13) What criteria are appropriate for determining whether an
EFP is contingent?
Elements of a Bona Fide EFP: Price of the Transaction
(14) Should the Commission require both the futures and cash
legs of an EFP to be priced within the daily range of their current
respective markets, should it require only one leg of an EFP to be
priced within its daily range, or should it impose no restrictions
on the price of either leg of an EFP?
(15) Should the Commission require contract markets to obtain
documentation regarding the business purpose underlying the pricing
of an EFP?
Other Regulatory Requirements Governing EFPs: Reporting and
Recordkeeping
(16) Are the current reporting and recordkeeping requirements
relating to EFPs adequate?
[[Page 3721]]
Other Regulatory Requirements Governing EFPs: Disclosure
(17) What should be the form and content of disclosure
concerning EFPs?
(18) Should the form and content of disclosure vary according to
the commercial sophistication of the EFP participant similar to the
Commission's proposed amendment to Regulation 1.55?
(19) Should the Commission explicitly require that customers
must be informed that an EFP is executed noncompetitively, that it
involves a cash transaction, and that their FCM might take the
opposite side of the EFP?
(20) Should the Commission explicitly require Commission
registrants to obtain customer consent before executing an EFP on
the customer's behalf?
Other Regulatory Requirements Governing EFPs: Internal Controls
(21) What internal controls are appropriate for Commission
registrants to ensure compliance with regulatory requirements
concerning the essential elements of bona fide EFPs, reporting and
recordkeeping, and disclosure?
Other Regulatory Requirements Governing EFPs: Transparency
(22) Do existing price reporting standards provide adequate
transparency concerning EFPs to the marketplace and, if not, are
there alternative methods of achieving improved price transparency?
(23) Should the Commission require contract markets to publicize
information about bids and offers, as well as consummated EFP
transactions?
Types of Eligible Transactions: Exchanges of Futures for Swaps
(24) What are the economic reasons firms might have for engaging
in EFS transactions and what benefits might accrue thereunder,
including the potential benefits to domestic futures markets, to
over-the-counter markets, and to financial markets generally?
(25) What are the potential costs or risks of permitting EFS
transactions, particularly with respect to the effect on price
discovery, risk transfer, and the competitive character of "on-
exchange" transactions?
(26) Should the Commission approve the NYMEX rule proposal
permitting EFS transactions?
(27) Should EFS transactions be limited to particular markets,
participants or types of transactions?
(28) Should special provisions be established to ameliorate any
competitive costs or otherwise safeguard the competitive conditions
of the on-exchange market?
Types of Eligible Transactions: Exchanges of Options for Physicals
(29) Are EOPs viable and do these transactions offer genuine
risk management benefits?
(30) If so, should EOPs be permitted, and should there be
limitations on EOPs that reflect the particular risk characteristics
of options?
Types of Eligible Transactions: Alternative Execution Procedures
(31) Should alternative, noncompetitive execution procedures be
permitted on or subject to the rules of a contract market?
(32) If so, how should these procedures be structured to address
regulatory concerns?
(33) Should these procedures be limited by order size,
participant class, contract, or some other criteria?
(34) Can adequate safeguards be devised in connection with these
procedures to prevent manipulation?
(35) Can adequate safeguards be devised in connection with these
procedures to prevent fraud?
Qualifying Standards
(36) What are the appropriate qualifying standards for
noncompetitive transactions concerning:
(a) the effect on the usefulness of a designated futures contract as
a hedging mechanism?
(b) the effect on the price discovery function of a designated
futures contract?
(c) the effect on the level of financial integrity in a designated
contract market?
(d) the effect on the level of customer protection in a designated
contract market?
(37) Should access to noncompetitive transactions be limited to
commercials or sophisticated investors?
(38) Should noncompetitive transactions be subject to contract
market rules?
(39) Are there other appropriate qualifying standards?
Continuing Regulatory Requirements
(40) What are the appropriate standards to ensure that
noncompetitive transactions are bona fide and meet basic qualifying
requirements on an ongoing basis?
(41) What are the appropriate reporting and recordkeeping
requirements applicable to these transactions?
(42) What are the appropriate disclosure requirements applicable
to these transactions?
(43) What are the appropriate internal controls applicable to
these transactions?
(44) What are the appropriate safeguards to maintain an adequate
level of transparency?
(45) What are the appropriate safeguards to prevent
manipulation?
(46) What are the appropriate safeguards to prevent fraud?
Execution Facilities for Noncompetitive Transactions Executed on or
Subject to the Rules of a Contract Market: Qualifying Standards
(47) What characteristics distinguish execution facilities for
EFPs from contract markets?
(48) Is the current regulatory approach concerning these
facilities adequate?
(49) If not, what modifications are appropriate?
(50) If execution facilities were established for noncompetitive
transactions other than EFPs, how, if at all, should the regulatory
approach that would apply to those facilities vary from that
currently applicable to contract markets?
(51) Should execution facilities for EFPs and other
noncompetitive transactions that are operated by non-contract
markets be subject to oversight by the relevant contract market?
(52) Should these facilities limit access to commercials or
sophisticated investors?
(53) Should these facilities be subject to procedures to prevent
manipulation?
(54) Should these facilities be subject to procedures to prevent
fraud?
(55) Should these facilities be subject to procedures to ensure
that transactions executed thereon are bona fide?
(56) Should these facilities be subject to procedures to provide
for market transparency?
(57) Should these facilities be subject to procedures related to
reporting and recordkeeping?
Issued in Washington, DC, on January 16, 1998.
Jean A. Webb,
Secretary.
[FR Doc. 98-1672 Filed 1-23-98; 8:45 am]
BILLING CODE 6351-01-P
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