Review of the
Financial and Sales Practice Compliance Program
of the
Chicago Mercantile Exchange
Commodity Futures Trading Commission
Division of Trading and Markets
September 1998
I. Introduction
This is a report of the Division of Trading and Markets' ("Division") review of the design and execution of the audit, financial and sales practice compliance program ("program") of the Chicago Mercantile Exchange ("CME"). The Division�s review covered the period January 1, 1996 through June 30, 1998. The Division also conducted an interim review for the period January 1, 1996 through April 30, 1997 which focused on the CME's compliance with the Commission's segregation requirements with respect to customer funds deposited with the CME's Clearing House.
This review is part of the Division's ongoing program of reviews, which have been conducted periodically for many years, to assess the design and overall effectiveness of self-regulatory organization ("SRO") rule enforcement programs. The reviews are intended to identify specific deficiencies in the execution of established procedures or areas that could be improved or enhanced.
In conducting its review, the Division employs techniques which rely heavily on the sampling of audit workpapers, files, records, and other documents prepared and retained by the SRO being reviewed, as well as interviews of SRO staff. The success of a review depends in large measure on the willing cooperation of SRO management and staff, and the completeness and accuracy of the documentation and representations provided by SRO management in support of its Program. Therefore, a review will not necessarily uncover every program failure or identify every needed improvement.
The Division conducted this full-scope review through a series of interim reviews performed over the course of the review period. The Division conducts interim reviews of an SRO�s program in order to maintain ongoing contact and familiarity with the status of the relevant SRO�s financial rule and sales practice enforcement programs. Any significant findings discovered by the Division during an interim review are brought to the SRO's attention at the time they are found in order to initiate prompt corrective action. In preparing the formal written report of its oversight activities, the Division draws upon the results of all of the interim reviews conducted since the last formal written report.
Current Findings
The Division found that the CME Program is well designed, that its audit staff generally execute their duties thoroughly and that the Program complies with applicable regulatory requirements. The Division has no major recommendations for the enhancement of the CME Program. (When minor recommendations are developed, they are made on a staff-to-staff basis during the course of the review work.)
III. Follow-up on Prior Recommendation
During the current review, Division staff followed up on a recommendation made in its prior September 1995 report on CME's Program. The Division found CME had taken appropriate action in response to the following recommendation in the 1995 report:
Surveillance Activities During Major Market Moves Should Be Routinely Documented
During major market moves, the CME Clearing House may request the Audit Department to follow up at clearing member firms regarding large positions held and the collection of related margins from customers. The recommendation stated that documentation of this process would be helpful to the Division, as well as to CME management, in reviewing the Clearing House's and the Audit Department's surveillance activities. Thus, the Division recommended that documentation of these activities be prepared and retained.
Current Status of Recommendation
Shortly after issuing the September 1995 recommendation, Division staff examined the "Risk Log" prepared by CME�s Risk Control Department. The "Risk Log" contains documentation of key events and correspondence resulting from CME�s financial surveillance. CME�s Audit Department also prepares a "Special Review/Issue Reference Log" which, together with memoranda and other documentation, supports CME�s follow-up activities relating to financial surveillance. As part of the current examination, Division staff examined these logs and found that CME continued to document surveillance activities it had taken in response to major market moves and other follow-up activities.
IV. Scope and Purpose of the Review
The Division reviewed various elements of CME's Program to ascertain whether it met pertinent regulatory requirements and to identify areas where enhancements could be made. The Division interviewed officials of the CME and reviewed:
documents regarding compliance by CME with the Commission's segregation requirements for customers' funds deposited as performance bond with its clearing house;
audit reports and selected audit workpapers for full and limited scope financial and sales practice audits conducted by CME;
records of CME�s receipt and analyses of electronically filed financial reports;
CME�s procedures for approving subordinated loan agreements;
new risk-based capital requirements and changes made to CME�s surveillance over short-option positions;
written programs and supporting guides, manuals and procedures;
staffing levels, qualifications, experience, independence, turnover, supervision and training;
ongoing financial surveillance, risk assessment policies and procedures, monitoring of markets, inter-SRO coordination and information sharing and review of financial reports;
disciplinary actions, imposition of sanctions and committee minutes; and
actions on prior recommendations.
In conducting the review, the Division's auditors sought to identify audits or financial statement reviews which would be illustrative of the effectiveness of CME's Program. Thus, they selected audits based on problems they were aware of in recordkeeping, net capital or segregation as a result of reviewing financial reports, early warning notices and CME audit reports.
V. Background
A. Regulatory Basis for the Program
CME�s Program is operated pursuant to the requirements of the Commodity Exchange Act ("Act"), applicable Commission regulations and interpretive guidance. Commission regulation 1.51 requires each contract market to use due diligence in maintaining a continuing affirmative action program to secure compliance with various provisions of the Act and with the contract market's bylaws, rules and regulations, which the contract market is required by the Act to enforce. Commission regulation 1.52 requires an SRO to adopt and conduct surveillance of minimum financial requirements, which must be no less stringent than those contained in the Commission's regulations. The Division's Financial and Segregation Interpretation No. 4-1 ("Interpretation No. 4-1") provides guidance as to how an SRO should conduct its program. A 1993 addendum to Interpretation No. 4-1 provides guidance regarding the sales practice portion of an SRO's Program. Addendum B to Interpretation No. 4-1 provides guidance on coordinating SRO financial rule enforcement programs over firms that are registered with the Commission as FCMs and with the Securities and Exchange Commission ("SEC") as broker-dealers.
All futures SROs, including CME, are participants in a joint audit plan that has been approved by the Commission pursuant to regulation 1.52(g) to assure efficient coverage and to reduce duplication of audits. The plan is operated under the auspices of the "Joint Audit Committee" (JAC). The JAC was formed specifically for the purpose of coordinating the commodities industry sales practice and financial surveillance programs. Its membership is comprised of all of the commodities SROs. The arrangements under the joint audit plan ensure that FCMs who are members of more than one SRO are subject to routine periodic audit by only one SRO. Each FCM has an SRO designated by the JAC as being responsible for routine in-field audit and financial surveillance activities over that firm. Such SRO is referred to as the FCM's designated SRO ("DSRO"). In the event a DSRO discovers an apparent violation of a Commission rule or the rule of another SRO, the matter will be referred to the relevant SRO or to the Commission for appropriate follow-up and possible action.
B. The Chicago Mercantile Exchange and its Clearing House
CME�s Clearing House is an operating division of the CME; all rights, obligations and/or liabilities of the Clearing House are also those of the CME. The Clearing House Division has four departments: the Clearing House Department; the Audit Department; the Risk Control Department; and the Risk Management Development Group.
CME traded 159.9 million futures and 40.7 million options contracts during 1997, and 141.6 million futures and 35.4 million options contracts during 1996.
Following are some operational elements and programs which are unique to CME:
GLOBEX2
In September 1998, CME expects to fully implement GLOBEX2 as a complete replacement for the existing GLOBEX electronic trading system that CME had developed with Reuters. The new platform was developed for CME by the Paris Stock Exchange, SBF, and its subsidiary, GL Consultants, and is used by a number of securities exchanges in Europe and elsewhere. GLOBEX2 will operate in a manner similar to the old system, but it will have greater functionality for market users, including allowing them to enter a wider range of order types, such as stop, limit, and market if touched orders. The products traded and the trading hours will remain the same; however, CME intends to use the system to trade some products virtually 24 hours a day. GLOBEX2 will provide interfacing to numerous other exchanges� electronic trading systems.
SIMEX
CME�s Mutual Offset System ("MOS") allows CME and Singapore International Monetary Exchange ("SIMEX") members to establish and offset positions in Eurodollar and Euroyen futures contracts at the other exchange. During CME trading hours, CME members act as agents for SIMEX members; during SIMEX trading hours, SIMEX members act as agents for CME members. To trade at the partner exchange, members of each exchange establish relationships with one or more members of the other exchange. As of December 31, 1997, 60 CME members had a clearing relationship with one or more SIMEX members.
The average monthly MOS volume for 1997 was 441,108 contracts. Open interest as of December 31, 1997 was 50,662.
Cross-Margining
The cross-margining system allows certain joint or affiliated CME/OCC/CCC (Chicago Mercantile Exchange/Options Clearing Corporation/Commodity Clearing Corporation) clearing members and their "market professional" customers to receive performance bond credit for certain broad-based equity index futures, options on futures, and options contracts. To use the cross-margining system, the qualified clearing member must establish a cross-margin member account at the CME and either OCC or CCC (or both). Public customers are not eligible for the cross-margining program.
CME had twelve clearing members participating in cross-margining as of February 28, 1998. Six trade exclusively for their own accounts ("house origin"); four clear trades exclusively for market professionals ("customer origin"); and two handle both customer and house cross-margin accounts.
The average daily savings in margin for February was $60.1 million for house origin accounts and $26.9 million for customer origin accounts. The margin requirements were 74% and 63% lower, respectively, as compared to the margin that would be required if cross-margining agreements were not in place.
GFX Corporation
GFX Corporation ("GFX") is a wholly-owned subsidiary of the CME. GFX buys and sells CME foreign currency futures contracts using the GLOBEX electronic trading system to enhance liquidity on CME's currency markets on Globex.
In 1997, CME�s GFX traders executed 76,410 transactions for a total of 390,509 contracts. Division staff noted that the transactions executed on GLOBEX were in CME�s foreign currency contracts. CME has indicated that during 1997, all exposures were either fully hedged or closed out at the end of each day.
As of December 31, 1997, GFX had 19 employees, consisting of a Managing Director, five operations staff, one marketing staff, two risk staff and ten traders.
CLEARING 21
CLEARING 21 was developed jointly by the CME and the New York Mercantile Exchange (NYMEX). Clearing member firms have been using elements of CLEARING 21 since implementation began in 1994. CLEARING 21 represented a change from a batch processing environment to an online or near real-time system. It processes trades and tracks positions continuously. Users have up-to-the-second data on trades, positions, money and risk available at all times. Clearing members can now have the tools to manage risk on a real-time basis.
C. Audit Department Staffing, Organization, and Training
The Audit Department Director and the Director of Systems Development report to the Audit Department's Vice-President, who in turn reports to the President of CME�s Clearing House. The Audit Department Director supervises the everyday operations of the audit staff, directs the audits of member firms and carries out special projects of a financial nature. The Director of Systems Development and his staff provide data processing assistance to the Audit Department, including development of CME's electronic financial report filing and analysis systems (WinJammer, STS and RSR Express) and other surveillance and analysis tools.
Staff auditors and managers are all college graduates, who either have an accounting degree or at least 27 semester hours of accounting. This accounting requirement also qualifies them to sit for the certified public accountant ("CPA") examination. At March 31, 1998, eight of CME's audit staff were CPAs, while another three had conditionally passed parts of the examination.
CME conducts an initial two-week training period for new auditors which includes: 1) training manuals and audit guides; 2) information about exchange and audit department procedures; 3) instruction about the commodity business and commodity accounting; 4) instruction in audit workpaper preparation; and 5) instruction on how to review 1-FR and Financial and Operational Combined Uniform Single Report ("FOCUS") financial statements.
After the initial training, new auditors receive on-the-job training and are instructed in the use of the Computer Assisted Auditing software, which CME�s programmers developed for staff�s use in preparing audit workpapers for full and limited scope examinations. Managers are encouraged to take supervisory training and auditors are encouraged to take communication and writing courses. The exchange provides ongoing continuing education and training for all staff, including a tuition reimbursement program.
Commission regulation 1.59 prohibits an SRO's employees from disclosing material and non-public information to any other person, except in the course of their duties, and from trading, either directly or indirectly, any commodity interest based on such information. CME Rule 255 limits CME employees' outside employment, and prohibits trading, accepting gifts valued at more than $25, disclosure of non-public information and ownership of an exchange membership. Every CME employee annually signs an acknowledgment that they understand and are complying with Rule 255.
The Division found that CME�s Audit Department staff generally has low experience levels because the staff turnover rate has been high in recent years. As of December 31, 1994, CME's 23 auditors had an overall average experience of 3.9 years. At March 31, 1998, the average experience for CME's 17 auditors decreased by 25%, to 2.9 years, largely due to staff turnover. The number of audit staff "on-board" also declined by 25%. The Audit Director, Managers, and Supervisor are included in this average because they continue to assist in carrying out audit work. The staff is generally well-qualified, but the Division notes that in-depth experience is somewhat lacking on the part of a majority of the staff because of turnover, as compared to prior years. However, the Division found that due to factors noted below, the impact upon the quality of the program has been minimized:
CME's audit managers are spending more time in the field with staff auditors.
CME has completed several audit cycles of its FCMs, whose staffs are now very familiar with recordkeeping and other regulatory requirements. Generally, FCMs have corrected problems found in CME's earlier audits.
CME recently has begun to use computers to a greater extent in its audit work, which allows staff to conduct audits and other surveillance activities more efficiently. For example, Computer Assisted Auditing software greatly simplifies creating and organizing audit workpapers.
CME and CBT developed WinJammer, an electronic financial reporting system to allow their member firms to file financial reports electronically. CME developed the RSR Express software to automate much of the review process. The software automatically examines the FCM's financial report, targeting adverse balances and trends for further staff review.
CME's firm profile database, as well as CME's history of audit and financial findings from surveillance over member firms, allows audit staff to more effectively set the scope of their examinations.
The number of firms for which CME had DSRO responsibility remained largely unchanged during the period from December 1994 to March 31, 1998: 34 FCMs as of December 31, 1994, compared to 35 FCMs as of March 31, 1998. Division staff verified that during calendar years 1995, 1996 and 1997, CME started and completed each of its audits within the time-frame guidelines established in Interpretation No. 4-1. CME�s other surveillance work, such as desk reviews of financial statements, has also been carried out as required. The Division also noted that CME has been able to fully staff problem situations at member firms anytime it was necessary. Based on the Division's examination of CME's timing and execution of its Program, there is no indication that recent staff reductions and turnover in CME's Audit Department, in both management and staff positions, have negatively impacted CME's ability to carry-out its surveillance activities, but the Division will continue to monitor CME�s staffing levels.
The Division found that the quality and timeliness of CME's financial surveillance, in-field audits, and other surveillance activities generally met regulatory requirements.
D. Monitoring FCM�s Year 2000 Compliance Programs
The Division has been monitoring CME�s year 2000 preparedness activities with respect to the FCMs for which CME is the DSRO. In this connection, the CME Audit Department is participating in the JAC year 2000 project, which is a coordinated effort to assess and monitor all FCMs and other major registrants for year 2000 preparedness. As part of this project, early in the year, CME mailed JAC�s "Year 2000 Compliance Questionnaire" to all of the FCMs for which it is the DSRO. Since the mailing, CME has received responses and conducted review and follow-up actions on all of the firms for which CME is the DSRO. In addition, CME plans to review and update the questionnaire responses with each member-FCM during each FCM's next annual audit. Because FCMs are audited annually, on-site review of each questionnaire response will be accomplished for all FCMs well before the arrival of the year 2000.
VI. Audit Department Program Areas
CME�s Audit Department reports to the Clearing House President. Much of its daily work involves direct audits of member firms or review of member firms� financial reports. Routine risk management surveillance is carried out by the Clearing House, which occasionally asks audit department staff for assistance in obtaining additional information about a firm or its customers.
A. In-Field Audits (Financial, Sales Practice and Compliance) - Full and Limited Scope
Division staff reviewed CME�s execution of its in-field examination program for the period January 1, 1995 through July 15, 1998 to evaluate CME's compliance with the Division's Financial and Segregation Interpretation No. 4-1 and related addendum.
Division staff reviewed all audit reports which CME issued during the 3 � year period from January 1, 1995 until July 15, 1998. As of July 15, 1998, CME had two full scope and three limited scope audits open; however, none of the audits was more than five months old from the start of audit fieldwork.
Following is a summary of CME�s in-field audit reports which Division staff reviewed:
����������
| Audit Report Dated | � Full Scope | Limited Scope | Special Review | Total |
| 1995 | 19 | 15 | 0 | 34 |
| 1996 | 14 | 22 | 0 | 36 |
| 1997 | 22 | 19 | 2 | 43 |
| 1998 (thru 7-15) | 7 | 14 | 0 | 21 |
| Total | 62 | 70 | 2 | 134 |
Many of CME�s audit reports are "clean" in that they do not contain audit findings. CME�s staff frequently discusses and resolves minor discrepancies with a firm�s personnel prior to concluding audit fieldwork; these discrepancies are not documented in CME�s audit report. CME uses its written audit reports to communicate only the more material or repetitive findings to the member firm. The data on material findings is as follows:
| Audit Report Dated | Total Audits | Findings | No Findings | % without� Findings |
| 1995 | 34 | 11 | 23 | 68% |
| 1996 | 36 | 20 | 16 | 44% |
| 1997 | 43 | 10 | 33 | 77% |
| 1998 (thru 7-15) | 21 | 6 | 15 | 71% |
| Total | 134 | 47 | 87 | 65% |
Division staff�s review of audit workpapers and audit reports did not identify any instances where CME failed to include in its audit report a material finding.
Coordination between Commodities and Securities SROs
Addendum B to Division Interpretation No. 4-1 provides a basis for commodity and securities regulators to coordinate their examination of dually registered firms. The Division selected for its review several audits performed by CME of dually registered FCM broker/dealers. Fourteen of the 32 CME DSRO member-FCMs in 1998 were registered as both FCMs with the Commission and as securities broker/dealers with the SEC or had memberships on securities exchanges and, thus, were subject to audit programs of both commodities and securities SROs. Division staff found that CME routinely communicated and shared audit scopes and results with securities-side designated examination authorities, thereby allowing each regulator to more efficiently carry out their examinations.
Review of CME�s Audit Workpapers
Division staff reviewed seven full scope audits, seven limited scope audits and two special scope reviews. As a result of prior reviews, Division staff determined that CME�s "in town" audits generally met the requirements of Interpretation No. 4-1. Therefore, to determine whether the quality of CME�s out of town audits was comparable to that of the "in-town" audits, Division staff selected for review eight CME full and limited scope audits of four FCMs located in New York City. The FCMs were large securities broker-dealers. Division staff also selected for review CME�s examination of a firm affected by the market correction of late October 1997, and a new CME firm whose futures business was predominately cross-margin accounts carried for professional traders.
The Division�s review of the sixteen audits disclosed that CME�s Program and its execution thereof met the requirements of the Division�s Interpretation No. 4-1 and the Addenda as follows:
Division staff found CME conducted its audits using JAC�s written audit programs; all audits were conducted on a surprise basis; CME started audit field work within two months of the audit "as of" date; and CME�s audits were made as of the most recent month-end net capital computation date. CME completed all in-field audits within five months of the start of audit fieldwork.
CME�s workpapers contain documentation that the scope setting process was adequate for CME to determine that its member-FCMs were complying with the Commission�s and CME�s net capital, segregation, recordkeeping and reporting requirements. For audits of securities broker-dealers, CME�s workpapers contain documentation of CME�s correspondence with securities regulators.
Division staff noted no differences in the quality of out-of-town audits versus local audits. The out-of-town audits contained comparable amounts of testing as the local audits; all material questionable items encountered during the audits were investigated; and sufficient evidence was obtained to support the conclusions in the audit reports.
Documentation of CME�s Examination of Current Segregation and Secured Amounts Records
Commission rules require that daily segregation and secured amount records be prepared by noon of the following business day. Division staff found during its review of CME�s audit workpapers that in the course of an audit, CME tested whether member-FCMs are preparing their daily segregation and secured amount records as required by Commission rules.
In the workpapers, CME audit staff described specific segregation record dates which they tested, and concluded that the segregation records were prepared on a current basis. While Division staff have no basis to believe that CME did not examine the most current segregation record which should have been prepared when the examination was conducted, the workpapers do not document the date the audit work was performed. The sign-off date on the audit workpapers only reflects the last date the audit work could have been performed, which in most instances is several days after the segregation records should have been examined. CME audit management staff agreed to remind in-field audit staff to describe in the audit workpapers the exact date they examined daily segregation records so that it clearly shows they examined the most current daily records.
Sales Practice Audits
The Sales Practice and Compliance Addendum to Interpretation No. 4-1 requires that a sales practice audit be performed in conjunction with the FCM�s biennial full scope financial audit and that each SRO have procedures that address criteria for extending audit activities to branches and Guaranteed Introducing Brokers ("GIBs"), when warranted. Division staff�s review of CME�s full scope audits found that CME was executing the JAC Branch Office-GIB Sales Practice Program on each full scope audit. As a part of the full scope audit, CME staff also reviewed the internal audits which FCMs are required to perform of their branches and GIBs.
Division staff reviewed the factors that CME considers when determining whether to expand its audit activities to branch offices and GIBs, and noted they appear reasonable. CME reviews NFA�s audit reports for guaranteed IBs or branch offices to determine whether to expand its sales practice audits to include an FCM�s other GIBs or branch offices. CME�s criteria for extending sales practice audit activities also includes consideration of the number of customer complaints, excessive trading volume at the Branch or GIB relative to other sales outlets, significant deficiencies noted in prior NFA Sales Practice Audits, misleading sales promotional material, discretionary orders not being properly identified, and any instance where CME has found the FCM�s sales practice procedures for monitoring branches and GIBs to be inadequate. Based on the review of CME�s customer complaints, Division staff found no instance where CME should have more closely examined a branch office or GIB, but did not do so.
During the review period, CME conducted a sales practice audit as a part of each of the sixty-two full scope audits. CME expanded the scope of its sales practice examinations at two FCMs, and closely examined twelve GIBs and two branch offices. The expanded scope audits were triggered because CME found a significant number of customer complaints and large trading volume relative to other GIBs, and because an NFA audit report disclosed significant deficiencies. CME expanded the scope of another sales practice audit because the sales practice portion of CME�s audit revealed that the FCM�s procedures for monitoring branch offices and GIBs were not adequate.
CME found that one branch office was improperly bunching order tickets. CME sent the FCM a letter asking it to take corrective action at its branch office. CME also found one FCM using radio promotional material which was misleading. CME instructed the FCM to stop using the misleading commercial. The misleading promotional material resulted in the $25,000 fine noted in the Disciplinary Actions section of this report.
Division staff also reviewed the sales practice portion of CME�s full scope audit of an FCM which had a large retail customer base. The audit did not result in an expansion of sales practice audit activity to branch offices or GIBs. Division staff�s review of the testing of branch office and GIB activity found that CME�s work appeared to be adequate and supported CME�s conclusion that an expansion of sales practice audit activity was not warranted.
CME�s sales practice audit work is in compliance with the Sales Practice and Compliance Addendum to Interpretation No. 4-1.
B. Review of Financial Reports
Division staff reviewed CME's records related to its review of financial reports filed by member firms during the period June 30, 1996 through December 31, 1997. The review was to determine if CME's surveillance program for reviewing reports was in compliance with the Division's Interpretation No. 4-1, which requires an SRO: (1) to conduct a preliminary review of financial reports within two days after receipt, and to identify and report any instance of undersegregation or undercapitalization and (2) to complete within six weeks (eight weeks for certified reports) from the time a report is received a final resolution of any discrepancies disclosed by a detailed review of the report. Interpretation 4-1 also requires DSROs to have minimum review procedures which include but are not limited to determining that balances cross-check between statements within the report, comparing the report under review with reports previously filed and integrating the review of reports with other aspects of the financial surveillance program.
CME's time-frame for reviewing reports is more strict than the requirements of Interpretation 4-1. Preliminary reviews of financial reports are conducted within one business day of receipt. Final reviews of financial reports must be completed within three weeks of receipt.
During July 1996, CME began conducting reviews of financial reports through an internally developed, personal computer-based system known as RSR Express ("RSR"). Processing financial reports using RSR subjects the reports to comprehensive edit and logic checks. RSR immediately identifies and issues an "alert" when any electronically filed financial report indicates that the filing FCM failed to meet minimum net capital requirements, was undersegregated or under its secured amount requirement, or had one of several reportable events. RSR and a companion program known as STS track the date the financial report was received, the date it was processed, the names of the reviewers of the financial report and the dates the financial report was reviewed.
CME generated a table of RSR information reflecting key information for all statements received and reviewed during the period June 30, 1996 through December 31, 1997. Division staff reviewed the table and supporting financial reports and found that CME started its preliminary review of financial reports within one business day after receipt, commenced reviews for all reports within two weeks of the receipt, and completed those reviews within three weeks of the receipt.
Division staff also reviewed sixteen financial reports previously reviewed by CME. The sample of reports revealed that each review contained edits and cross-checks required in Interpretation 4-1. The quality of CME's review was good. The Division found that when necessary, CME staff gathered additional information necessary to complete the review, including reviewing prior filings, reviewing recent in-field examination workpapers, and contacting firm personnel to obtain additional information.
CME managers indicated that auditors, for several reasons, may sign-off on a review a day or more after actually completing the review and after the deadline for completing it. To accommodate this practice, CME�s auditors are able to "sign-off" on the statement review and show a "sign-off" date that is earlier than the date the review is actually signed. Division staff noted that when this situation arises, CME�s auditors receive a prompt noting the sign-off date is later than the deadline for completing the review. In response to the Division�s concerns, CME expanded the prompt, which now reads:
The Signoff Date you entered is greater than the Required Signoff Date. Make sure that you have documented the reason for the late signoff. Do you want to continue with the signoff?
The Division believes that the expanded prompt is sufficient.
C. Subordinated Debt
Commission and CME rules require that CME must approve all subordination agreements before an FCM can exclude such debt from liabilities in determining net capital. CME also must approve subordinated loan prepayments and amendments to the agreements. In addition, member firms must notify CME of all drawdowns and prepayments on revolving cash agreements and all instances where loan repayments are suspended because of capital insufficiency. CME does not have to approve drawdowns made under revolving agreements (because CME approves the original, blanket agreement). However, CME does approve prepayments made to revolving agreements as required by Commission rules.
As of June 30, 1998, twenty-six firms for which CME had DSRO responsibility had entered into 130 subordination agreements, amounting to $7.3 billion. Twenty-four of the twenty-six FCMs had $4.8 billion in outstanding subordinated loans as of June 30, 1998. The Division�s review found that CME reviews and approves most standard subordinated loan agreements within one day of receipt.
D. Disciplinary Actions
The Division reviewed CME's disciplinary actions taken as a result of CME�s audits or financial surveillance during the period January 1, 1995 through December 31, 1997 to determine if the CME was adequately enforcing its own rules by promptly imposing appropriate disciplinary actions against its members for apparent serious violations of CME's rules. Division staff also reviewed committee minutes for each CME Committee that has the authority to take disciplinary actions against CME members for violations of CME�s rules. Staff reviewed minutes from CME�s Board of Director meetings, as well as various disciplinary committees and sub-committees of the CME Clearing House.
Members of any disciplinary committee who have an apparent conflict of interest in any matter brought before the committee are required to recuse themselves from any discussion of, and voting on possible sanctions against, firms with which they are affiliated. Division staff�s review of the various committee minutes disclosed numerous instances where members left deliberations concerning companies with which they were affiliated.
The Audit Department presents every full scope audit report to the Clearing House Finance Sub-Committee ("FSC"). The FSC has given the Audit Department discretion to close limited scope reviews which contain no violation of CME�s rules. The FSC can issue reminder letters, letters of warning, and for more serious violations, issue formal charges against the firm, which may result in a fine or other disciplinary action.
The Division found that CME's audit staff promptly refers matters to the FSC for disciplinary action. In addition, most referrals only took a few days from the time the Audit Department presented the audit report to the FSC to the time the FSC made a decision about the findings.
Division staff�s review of CME's FSC Disciplinary Logs prepared for the period January 1, 1995 through December 31, 1997 disclosed 42 disciplinary actions involving 55 violations of CME's rules brought against 20 member firms. FSC issued 29 letters of warning ("LOWs") to 19 firms to address serious or repeat violations and four reminder letters ("RL") to four firms regarding more minor infractions. The FSC and the Hearing Sub-Committee, which hears matters on appeal from other committees, levied seven fines totaling $101,000 against six firms.
The largest fine, $50,000, was levied by the FSC against a firm for recurring violations involving general compliance, current books and records, segregation and net capital violations and/or problems. The FSC also fined the firm an additional $25,000 for a sales practice violation related to using a misleading radio promotion.
Of the 55 rule violations found, 44 resulted from 26 CME audits. The other 11 violations resulted from other facets of CME's surveillance programs. Division staff did not identify any Audit Department finding where FSC failed to take appropriate action. Of the seven monetary fines assessed by the FSC against the six firms, (two to the same firm) it took an average of 29 days from the time staff recommendations were brought to the FSC to the time FSC made a final decision on the matter.
Division staff determined that CME was adequately enforcing its rules by promptly taking appropriate actions against its members for violations of CME�s rules.
E. Notifications of Significant Events
Division staff reviewed the CME's policies and procedures pertaining to notices and communications filed with the Commission concerning member-FCMs� violations of the Commission�s regulations for the period January 1, 1996 through December 31, 1997. In many instances, CME found rule violations during its in-field examination, and instructed the member firm to file notice with the Commission as required by the regulations. CME only directly reports to the Commission serious violations or instances where the firm has not notified the Commission of a violation.
The purpose of the review was to determine whether the CME was adequately following the Commission's Regulations and Interpretation No. 4-1 by promptly notifying the CFTC of reportable events or violations of CFTC regulations occurring at its member-FCMs. Reportable events pertain to violations in the following areas: segregation, net capital, being below early warning levels, access to records, non-current books and records, material inadequacy in internal controls, and various other violations.
Number and Types of Notifications
Commission staff keeps logs of special notices received from FCMs, CPAs, and DSROs. Between January 1, 1996 and December 31, 1997, the Commission�s New York and Chicago regional offices received 131 notices regarding reportable events from CME DSRO FCMs (two notices reported two reportable events). The notices document 133 reportable events, such as a firm�s net capital falling below its early warning level, or non-current books and records. Where follow-up action was needed, Commission staff contacted the FCM and\or CME�s staff to determine the facts surrounding the reportable event, and to determine that appropriate corrective action had been taken.
The 133 reportable events related to the following areas:
Net Capital �������������������� 109
Segregation ���������������������� 5
Material Inadequacy��������� 3
Below Early Warning�������� 2
Other Reportable Events 14
Total �������������������������������� 133
Many of the notifications related to net capital were made when an FCM�s adjusted net capital declined by more than 20% from net capital as earlier reported to the Commission. One FCM/broker dealer notified the CFTC's New York office thirty-one times that its tentative net capital declined more than 20% from net capital last reported to the Commission. The decline in net capital was due to net capital charges for repo/reverse repo transactions and did not reflect a permanent impairment of the FCM's capital. In each instance the firm remained properly capitalized.
Membership Withdrawals
During the review period CME reported to the Commission 17 instances where member firms withdrew their CME membership. Notification is required by Commission regulation 1.52 ( j ). CME reported that each FCM was in good standing at the time they withdrew; none withdrew because of net capital or compliance problems.
CME Notifications of Rule Violations
Commission regulation 1.12(e) provides that whenever any SRO learns that a member registrant has failed to file a notice or written report required by regulation 1.12, the SRO must immediately report such failure to the Commission. CME notifies the Division whenever it finds any clearing member-FCM which has not reported to the Commission, as required by regulation 1.12, that its net capital has fallen below its minimum requirement or early warning reporting level, that the FCM member has failed to maintain current books and records, or other reportable events.
One example of CME�s notification occurred on November 4, 1997, when one of CME�s Audit Supervisors alerted Division staff to an unreported violation and instructed the FCM to report immediately to the Commission that it had been undersegregated and undersecured on various days in August 1997 and previously. The Division staff found no instance where CME failed to notify the Commission of an unreported violation.
CME Sharing of Financial Information
CME is DSRO for five FCMs for which it shares financial information with foreign regulators in accordance with Financial Information Sharing Memorandum of Understanding ("FISMOU") agreements. The Division found that CME�s audit department routinely sends foreign regulators a financial statement coversheet, which summarizes key financial data from those FCMs� latest financial reports. CME also alerts foreign regulators whether the firm was required to make any special notifications of events pursuant to Commission regulation 1.12, and whether the firm�s high risk ratio has exceeded JAC�s established high risk guidelines. The ratio highlights any firm whose ratio of funds carried for customers exceeds net capital by more than 16:1.
F. CME�s Risk-Based Capital Requirements
Effective January 1, 1998, CME adopted a new, risk-based capital requirement.
CME�s former minimum net capital requirement was computed as:
The greater of (a) $2 million, (b) six percent of customer segregation and secured amount required for the net capital computation plus six percent of non-customer (excluding proprietary) risk maintenance margin/performance bond requirements, or (c) SEC�s early warning net capital requirement.
The computation was changed to:
The greater of (a) $2 million, (b) 10% of domestic and foreign domiciled customer and 4% of non-customer (excluding proprietary) risk maintenance margin/performance bond requirements for all domestic and foreign futures and options on futures; or (c) CFTC or SEC�s minimum net capital requirement. The Division recently granted a request to reduce the formula from 10% to 8%, effective August 31, 1998.
CME believes the change to a risk-based minimum net capital requirement has three benefits:
(1) The risk-based capital requirement includes accounts of foreign domiciled customers trading foreign markets and accounts in a deficit position that were excluded from the prior capital calculation;
(2) Firms are not penalized when customers retain excess margin in their trading account; and
(3) Margin/Performance Bond Requirements are a better measurement of an FCM�s need for net capital than the amount of equity carried in a customer�s account.
Division staff reviewed CME�s late-1997 analysis of the effect the rule change would have on the minimum net capital requirement of member-FCMs. Under the new rules, approximately fifteen firms must maintain at least CME�s $2 million minimum requirement. This number was unchanged after implementation of the new rule. Staff found that broker/dealers whose minimum net capital requirement had been computed using SEC�s early warning level were now computing their requirement using SEC�s minimum net capital requirement. The average decrease in net capital for thirteen firms was from $278 million to $114 million, or about 59 percent. The remaining clearing firms� minimum net capital increased or decreased on a firm-by-firm basis, for a net reduction in minimum capital of approximately 10 percent. The average minimum requirement for these firms decreased from $26.8 million to $24.1 million.
VII. Clearing House Risk Management and Surveillance
A. Background
CME manages financial risks resulting from its clearance of commodity transactions through a combination of (i) rules imposed on members, (ii) clearance and margining polices and procedures established by the clearing house and (iii) ongoing market and member surveillance by staff. Following is a brief description of some of the many program and risk management elements in place at CME:
Risk Management Team
CME's program involves what it calls "exception risk management reporting," which enables the Risk Management Team ("Team") to identify, isolate, and focus in on potentially problem firms. CME's Team consists of the senior management of the Audit, Clearing, Legal, Market Regulation, Research, and Membership Departments. The Team meets on Monday mornings to discuss current developments that could impact the financial integrity of the Clearing House. For each meeting, the Team targets a particular CME clearing member firm for a more in-depth review, which includes the nature of its business, its management, business affiliations and any special risks associated with that firm. The purpose of this exercise is to improve the staff's familiarity with the firms for which they are responsible.
Financial Surveillance during Major Market Moves
CME staff monitors contract prices throughout the day. When a contract moves across its significant price move level (also called major market move level), CME staff commences enhanced surveillance. CME defines a major market move as a price move which results in a change in the value of a commodity that is at least 75% of CME's performance bond requirement for that contract, except for the S&P 500 contract, where CME doesn�t use the 75% guideline. For the S&P 500 contract, CME closely evaluates the nature and extent of any price moves against a firm�s and its largest customers� positions.
During a major market move, CME identifies losing market positions held by clearing member firms or specific large traders. The Clearing House, Market Regulation, and Audit Department share their information, and coordinate follow-up action necessary to determine whether a clearing member has been financially affected.
Stress Testing
The CME routinely performs a pro-forma analysis to determine which of its clearing member firms would be most affected by large market moves in commodities where these firms carry significant positions. Before a potential market move has occurred and during market moves, CME compares a firm's overnight positions against historical and hypothetical adverse market moves for potential negative cash flows for the firm. This allows the CME to determine if the firm is a potential problem firm during major market moves.
Daily, CME staff stress tests member firms' customer and house positions with approximately eight different scenarios. The scenarios include market moves in both directions and market moves up to circuit breaker levels. The output from the stress test reflects the reevaluation of the futures and options positions. The totals of the reevaluated positions is compared to the collateral from the member firm held by CME. The difference between the reevaluated positions and collateral CME calls "GAP". The stress test results are sorted in sequence of largest "GAP".
Monthly, CME staff analyze the impact a major market move would have on clearing member customer and house futures and options positions in stock index, interest rate and currency futures contracts. Quarterly, CME staff coordinate stress testing with the Options Clearing Corporation. CME also stress tests individual clearing members� portfolios to evaluate the impact of eliminating inter-commodity spreading, and stress test positions of the largest customers as reported in CME�s large trader reporting system. CME has stress tested clearing member positions using hypothetical price moves as large as 1 1/2 times the largest move which occurred in the past ten years.
In May of 1998, CME stress tested member firm positions with a 200 point downward move in the S&P 500. CME contacted the firms most affected by the hypothetical move, and requested and received information as to how the firms would cover the settlement payments to the CME Clearing House.
Logs of Special CME Surveillance Activities
Division staff determined that CME�s Clearing House is maintaining a log of major market moves and concerns about various FCMs. Division staff also noted that CME�s Audit Department was maintaining a log of issues and problems that are referred to it by other CME Departments and SROs. For instance, the CME Clearing House logs recorded instances where the CME was monitoring the trading activity of a large foreign trader who maintained an account at more than one FCM. Division staff also noted documentation reflecting instances where CME�s Clearing House contacted CME�s Audit Department regarding customer and house origin losses at another FCM.
Tolerance Levels
A key element in CME's surveillance program is monitoring the magnitude of cash flows between the Clearing House and an individual firm, using the specific "tolerance levels" that CME has established for each clearing member. These tolerance levels are absolute dollar levels of cash flow between a CME clearing member firm and the Clearing House which CME would consider to be unusually large for that particular firm on a given day. CME establishes a tolerance level for a clearing member's proprietary and customer origin trading based on inter-departmental knowledge of the firm and its operations and past cash flow history.
Over time, a firm's history of settlement payments forms a basis for identifying high risk situations before they reach a critical state and aid the Clearing House's President and senior staff in setting CME's tolerance levels. The setting of each firm's tolerance level (an absolute dollar amount) is a somewhat subjective process and is intended to be a tool or trigger to initiate an inquiry by CME staff. The amount is not intended to represent a threshold above which the Clearing House lacks confidence in a firm's ability to meet its obligations. CME assumes that firms can meet settlement obligations in amounts up to 400% of their tolerance levels without straining credit relationships with their settlement banks. CME revises the tolerance levels at least quarterly and when it identifies new or changed risk factors. Risk factors, which are identified by the Audit, Clearing House, and Market Surveillance Departments, might arise from financial reporting, results of in-field audits, recognition of changes in a clearing member's back office personnel, off-the-record discussions with settlement bank staff, market conditions, information available in the marketplace, media reports on financial or other risk conditions, complaints or other factors.
Under CME's procedures, all performance bond calls and variation settlement payments which exceed established tolerance levels require an inquiry by CME staff and a written explanation or report by the CME staff member. If a clearing member's settlement payment exceeds its tolerance level by 100% or more, Clearing House staff are required to alert an officer of the Clearing House, no matter what time of day or night it is discovered. Such a situation would also prompt an immediate call to the firm and its settlement bank.
Market positions, updated to the current trading session's latest trade match, are marked to the market at a given time, and CME arrives at an intra-day cash flow estimate for each clearing member firm. Clearing House staff compares the intra-day cash flow estimates for each clearing member to the CME established tolerance levels. When CME's estimated cash flows exceeds the firm's tolerance level, the Clearing House works with both the Audit Department and Market Surveillance, and with the Clearing Member Firm and its Settlement Bank, if necessary, to determine the source of the cash flow and plan any additional risk management steps that may be required. If CME's cash flow analysis indicates significant payments, it makes further projections of potential losses based on hypothetical prices. Cash flows are projected and compared to each clearing member's adjusted net capital.
High Risk/Watch List
CME places clearing member firms, which it determines to be "high risk" on its "Watch List". CME�s staff carefully monitors these firm's pay/collects (intra-day and end-of-day), margin calls, position concentrations, trade clearing, option activities, and delivery obligations, and immediately report unusual items to senior management. Typical reasons for being on the Watch List include:
The firm is new, and is placed on the list for a period ranging from three months to a year;
The firm has capital problems or CME has reason to believe that the firm is in danger of falling below CME's net capital requirements;
The firm has operational difficulties, including the loss of key personnel;
There are management changes at the firm;
The firm has evidenced an inability to adhere to CME operational policies;
The firm has experienced capital fluctuations due to large market maker haircuts, which arise from the firm's securities business; and
The firm has had large pay/collects.
At December 31, 1997, CME had seven firms on its Watch List. One was being monitored because of proprietary trading, the others were monitored because of large fluctuations in SEC market maker haircuts or other audit-related issues.
Parent Guarantees
CME's Rule 901.L. requires each person or entity owning 5% or more of the clearing member to guarantee unconditionally to the CME obligations of the clearing member arising out of non-customer and proprietary accounts carried by the clearing member. These parent guarantees provide assurance that obligations arising out of trades made and positions held by owners of clearing members are promptly discharged.
CME's Clearing House Committee has granted exemptions from the rule, provided the exemption would not jeopardize the financial integrity of the Exchange. CME has prohibited some firms from trading in the house origin and limited other firm's house origin trading so as not to exceed a specific margin requirement.
As of June 30, 1998, CME had parent guarantees from 61 of its 73 clearing members. The remaining 12 members were exempt for the following reasons:
Eight had adjusted net capital ("ANC") greater than $300 million,
CME granted an exemption to one firm provided it maintain ANC in excess of $200 million, and
three had no house origin trading.
Clearing House Security Deposit Requirements
The Clearing House requires a security deposit from each clearing member as an additional financial safeguard for the protection of the exchange and its clearing members. The deposit is based upon the member's volume of contracts traded and its historical risk performance. The amounts deposited augment performance bond margin and are an additional reserve against losses resulting from a clearing member's default on its obligations to the Clearing House. The amount of each clearing member's security deposit requirement is recalculated quarterly. As of December 31, 1997, the total amount of security deposits required from CME's clearing members was approximately $112.8 million. The Clearing House actually held deposits of approximately $142 million.
Interest Earning Facility ("IEF")
On February 27, 1997, the CME instituted a program to allow CME's clearing members to voluntarily invest their customer and/or house performance bond deposits at the Clearing House in "ownership" units of two companies which CME set up to implement IEF. The companies are known as IEF Customer Segregated Funds, L.L.C. and IEF Proprietary Funds, L.L.C. CME is the manager of each company and a major bank serves as investment advisor and custodian for the assets in the companies.
Under the IEF program, performance bond cash and settlement funds which participating clearing firms deposit with the Clearing House are pooled and invested in U.S. Treasury bills, U.S. Treasury notes, U.S. Treasury strips, and in reverse repurchase agreements collateralized by the government securities noted above. CME established two separate accounts with a major bank, one for customer funds and the other for proprietary funds (IEF Customer Segregated Funds, L.L.C. and IEF Proprietary Funds, L.L.C., respectively).
As of May 29, 1998, fifteen firms were participating in IEF with customer funds and five participated with proprietary origin funds. The IEF investment as of May 29, 1998 was $237.4 million customer segregated funds, which included CME funds of $10,711. Proprietary IEF deposits totaled $96.6 million, which included $4.8 million in clearing member security deposits.
B. Segregation of Customers' Funds
This rule enforcement review of CME included a review of its Clearing House's compliance with Commission rules requiring segregation of customer funds. The requirement to segregate the commodity margin funds of public customers is imposed not only on all futures commission merchants that hold such funds, but also on each commodity exchange/clearing house where an FCM deposits such funds to margin customers' positions carried on such markets.
Section 4d(2) of the CEAct and regulations 1.20(b) and 1.26(b) require a clearing organization to separately account for and segregate all customer commodity and option funds received from and accruing to members of the clearing organization. A clearing organization cannot hold, use or dispose of such customer funds to such commodity or option customer. CME's rule 825, Securities, provides that a clearing member must designate whether securities are to be maintained as performance bond for its customers' trades or its house trades, and the securities will be held for that account. CME's rule 971 addresses segregation and secured amount requirements for clearing members which requires all clearing members to comply with the requirements set forth in CFTC regulations 1.20 through 1.30, 1.32, and 30.7.
Division staff found that, as of December 31, 1997, in accordance with the Commission's segregation rules Section 4d(2) of the CEAct and regulations 1.20(b) and 1.26(b), the Clearing House held and properly segregated funds belonging to regular customers, as well as funds belonging to cross-margin customers.
At June 30, 1998, the CME Clearing House held the following non-segregated house and house cross-margin funds and segregated customers' and customers' cross margin funds received from its clearing members:
Summary of Customer and House Performance Bond Deposits
As of June 30, 1998
|
Customer |
House |
||||||
|
Dollar |
% |
Dollar |
% |
||||
| CASH (USD EQUIVALENT) |
$ 13,606,584 |
0.17 |
$ 23,164,643 |
0.61 |
|||
| LETTERS OF CREDIT |
395,450,000 |
4.97 |
488,780,000 |
12.96 |
|||
| IEF |
301,218,485 |
3.79 |
71,867,015 |
1.91 |
|||
| US T-BILLS |
4,046,981,842 |
50.91 |
1,702,591,474 |
45.15 |
|||
| US T-NOTES |
2,262,845,438 |
28.47 |
913,661,621 |
24.23 |
|||
| US T-BONDS |
824,998,355 |
10.38 |
531,124,173 |
14.08 |
|||
| FHLB |
5,665,235 |
0.07 |
0 |
0 |
|||
| FHLMC |
78,842,900 |
0.99 |
0 |
0 |
|||
| FNMA |
2,846,869 |
0.04 |
0 |
0 |
|||
| STOCK |
0 |
37,690,800 |
1.00 |
||||
| CANADIAN GOVT DEBT (USD EQUIVALENT) |
16,978,869 |
0.21 |
2,438,088 |
0.06 |
|||
|
Total |
$ 7,949,434,577 |
100% |
$3,771,317,814 |
100% |
|||
|
Cross Margin Performance Bond |
|||||||
|
Customer |
House |
||||||
|
Dollar |
% |
Dollar |
% |
||||
| CASH (USD EQUIVALENT) |
$ 83,364 |
0.05 |
$ 5,321,920 |
6.11 |
|||
| LETTERS OF CREDIT |
305,000 |
0.17 |
33,567,500 |
38.52 |
|||
| US T-BILLS |
100,853,411 |
57.62 |
35,758,431 |
41.03 |
|||
| US T-NOTES |
73,788,935 |
42.16 |
12,499,644 |
14.34 |
|||
|
Total |
$ 175,030,710 |
100% |
$ 87,147,495 |
100% |
|||
�
C. Circuit Breakers and Price Limits on CME�s S&P 500 Contract
In April 1998 the Commission approved new circuit breaker levels for futures contracts traded on several commodity futures exchanges. Circuit breakers are pre-established price limits and trading halts which prohibit trading at prices below specified levels from the close of the specified contract or index from the previous business day.
The NYSE and the CME review their circuit breaker levels on a quarterly calendar basis, and adjust them as necessary. The first day of each new quarter, CME resets its S&P 500 circuit breaker price limits to be approximately equivalent to 10 percent and 20 percent of the average of the daily closing prices in the current primary futures contract during the preceding calendar month. For the S&P 500 contract, the 10 percent limit is computed as 10 percent of that average, rounded down to a multiple of 10 index points. CME�s 20 percent limit is twice the 10 percent limit.
NYSE resets its point levels quarterly at 10, 20, and 30 percent of the DJIA by using the DJIA average closing values of the previous month, rounded to the nearest 50 points. Point levels will be adjusted on January 1, April 1,
July 1, and October 1.
The following circuit breaker levels are effective for the calendar quarter ending September 30, 1998.
NYSE CME
10% 900 points 110 points
20% 1,750 points 220 points
30% 2,650 points market closed
A 10 percent (110 point) decline in the S&P 500 contract would equal $27,500 per contract; a 20 per cent decline would be $55,000. CME�s S&P 500 margin requirements, at July 31, 1998 were $15,563 initial and $12,450 for maintenance for speculative positions.
D. Short Option Surveillance Enhancements
On October 27, 1997, the DJIA experienced a record decline of 554 points. On this same day the CME's equity index contract, the S&P 500, declined 70 points. CME found one of its clearing members was undersegregated on October 27 and 28, 1997 and under CME capital requirements on October 28 and 29, 1997 as a result of this decline and a margin default by a major customer. The undersegregation violation and violation of CME�s net capital requirement were primarily due to deficits resulting from short option positions of this defaulting customer. The positions were in deep out-of-the-money S&P 500 put options.
Prior to October 1997, CME did not sort its large trader short option information by gross position. Instead, CME used to survey short option positions on a futures-equivalent basis, which was not effective at the time in highlighting that customer as a risk. Since that time, CME has made useful enhancements to its short option surveillance program, which were described in a letter to the Commission dated January 26, 1998. The primary enhancement is the sorting of large trader data by largest gross short option position. In addition, CME has increased its SPAN margin requirements for deep out-of-the-money short option positions SPAN now builds in implied volatility for each strike price for each contract month. Previously, all of the strike prices in the same contract month contained the same implied volatility. Division staff tested the procedures noted in the letter and discussed the procedures in a meeting with CME staff and found the procedures to be adequate.
E. Flex Style Options
The CME permits trading in Put and Call Flexible Options ("Flex Options") on the S& P 500 Stock Index Futures. These Put and Call Options do not have the same underlying futures contract, strike price, exercise style, and expiration date as standard listed options. They have a unique, non-standard strike price and expiration date, agreed to by the two parties that created the trade. Flexible Options are flexible as to exercise and may be specified to have either American-style expiration (i.e., any business day the option is traded ) or European-style expiration (i.e., only the day the option expires ). Trading in a flexible options contract is initiated through a Request For Quote ( RFQ ), which is sent to the regular options pit on the exchange floor. The minimum size for requesting a quote and/or trading in a flexible option series is 50 contracts, where each contract represents an option to buy, in the case of the call, or to sell, in the case of the put, one S&P 500 Stock Price Index futures contract. Respondents to a RFQ must be willing to trade at least 50 contracts and, once established, a position is closed out through a RFQ. Open interest in flexible options as of June 12, 1998 consisted of 9,811 American�style calls, 50,036 American-style puts and 175 European-style puts.
The CME has recently authorized trading in Flex Options on other Stock Indexes: the S&Ps Mid-Cap-400, the Nikkei 225 Stock Average, the Russell 2000 Stock Price Index, the Major Market Index, the S&P 500/BARRA Growth Index, the S&P 500/BARRA Value Index, the NASDAQ 100 Index, and the IPC Stock Index. The CME has also recently authorized trading in Flex Options on various agricultural commodities: Live Cattle, Feeder Cattle, Lean Hogs, Frozen Pork Bellies, Fresh Pork Bellies, Butter, and Cheddar Cheese
Flex-style options are different than standard listed options in that two parties agree to a unique strike price and expiration date of the option. The customer referred to earlier in this report, in the section "Short Option Surveillance Enhancement", held significant positions in both standard and flex style S&P 500 options. On October 28, 1997, the customer�s clearing firm began liquidating the customer�s options positions. On October 28, 1997, trading in the S&P 500 contract was very active as the DJIA fluctuated in a several hundred point range. That customer�s October 28, 1997, daily account statements show that the clearing firm was able to liquidate the customer�s standard S&P 500 option positions; however, the flex-style option positions were not liquidated. Because of the unique characteristics of the flex style options it appears that the clearing firm may have had trouble liquidating those positions.
Division staff discussed with CME the apparent lack of liquidity in flex options in a volatile market. As a result, CME has expanded the number of standard options strike prices in the S&P 500 contracts. CME staff believes that flex style option expiration dates and strike prices are now closer to standard terms for expiration dates and strike prices, so that liquidity in flex options should be improved.
VIII. CONCLUSION
The Division concluded that CME�s design and execution of its financial and sales practice compliance program for FCMs and IBs complies with applicable regulatory standards. Audit findings were adequately documented in CME�s audit reports and workpapers, and the overall quality of the audit workpapers in documenting the execution of the program was generally good. The Division has no major recommendations for enhancement of CME�s program.