[Federal Register: July 1, 2004 (Volume 69, Number 126)]
[Proposed Rules]
[Page 39880-39886]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr01jy04-35]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1 and 38
Execution of Transactions: Regulation 1.38 and Guidance on Core
Principle 9
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rules.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is proposing a number of amendments to its rules concerning
trading off the centralized market, including the addition of guidance
on contract market block trading rules. The Commission is proposing
these rule amendments and requesting comment as part of its continuing
efforts to update its regulations in light of the Commodity Futures
Modernization Act of 2000 (``CFMA'').
DATES: Comments must be received by August 30, 2004.
ADDRESSES: Comments should be sent to the Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington,
DC 20581, attention: Office of the Secretariat. Comments may be sent by
facsimile transmission to 202-418-5521 or, by e-mail to
secretary@cftc.gov. Reference should be made to ``Proposed Rules for
Trading Off the Centralized Market.'' Comments may also be submitted by
connecting to the Federal eRulemaking Portal at http://www.regulations.gov
and following comment submission instructions.
FOR FURTHER INFORMATION CONTACT: Riva Spear Adriance, Associate Deputy
Director for Market Review, Division of Market Oversight, Commodity
Futures Trading Commission, Three Lafayette Center, 1155 21st Street,
NW., Washington, DC 20581. Telephone 202-418-5494; e-mail
radriance@cftc.gov.
SUPPLEMENTARY INFORMATION:
I. Background
Commission Regulation Section 1.38 (17 CFR 1.38) sets forth a
requirement that all purchases and sales of a commodity for future
delivery or a commodity option on or subject to the rules of a
designated contract market (``DCM'') should be executed by open and
competitive methods. This ``open and competitive'' requirement is
modified by a proviso that allows transactions to be executed in a
``non-competitive'' manner if the transaction is in compliance with DCM
rules specifically providing for the non-competitive execution of such
transactions, and such rules have been submitted to, and approved by,
the Commission.
Since Regulation 1.38 was promulgated,\1\ the CFMA was enacted.\2\
Federal regulation of commodity futures and option markets was
significantly changed by the CFMA, which replaced ``one-size-fits-all''
regulation with broad, flexible core principles.\3\ At the same time,
the CFMA modified Section 3 of the Act, such that the purpose of the
Act is now, among other things, ``to deter and prevent price
manipulation or any other disruptions to market integrity; to ensure
the financial integrity of all transactions subject to this Act and the
avoidance of systemic risk; to protect all market participants from
fraudulent or other abusive sales practices and misuses of customer
assets * * *'' \4\ The CFMA also specifically expanded the types of
transactions that could lawfully be executed off the centralized
market. Specifically, the CFMA permits DCMs to establish trading rules
that: (1) Authorize the exchange of futures for swaps; or (2) allow a
futures commission merchant, acting as principal or agent, to enter
into or confirm the execution of a contract for the purchase or sale of
a commodity for future delivery if the contract is reported, recorded,
or cleared in accordance with the rules of a contract market or
derivatives clearing organization.\5\
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\1\ Regulation 1.38 was originally adopted in 1953 by the
Commodity Exchange Authority, the predecessor of the Commission. See
18 FR 176 (Jan. 19, 1953). For subsequent amendments, see 31 FR 5054
(Mar. 29, 1966), 41 FR 3191 (Jan. 21, 1976, eff. Feb. 20, 1976), and
46 FR 54500 (Nov. 3, 1981, eff. Dec. 3, 1981).
\2\ Pub. L. 106-554, 114 Stat. 2763 (2000). Under the CFMA, such
rules may be effected by the certification procedures set forth in
section 5c(c) of the Act and 40.6 of the Commission's regulations.
\3\ The CFMA was intended, in part, ``to promote innovation for
futures and derivatives.'' See Sec. 2 of the CFMA. It was also
intended ``to reduce systemic risk,'' and ``to transform the role of
the [Commission] to oversight of the futures markets.'' Id.
\4\ 7 U.S.C. 5 (2000).
\5\ See section 7(b)(3) of the Act.
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[[Page 39881]]
The Commission promulgated regulations implementing provisions of
the CFMA relating to trading facilities in 2001, which established
procedures relating to trading facilities, interpreted certain of the
CFMA's provisions and provided guidance on compliance with various of
its requirements.\6\ Later, the Commission promulgated amendments to
those regulations in response to issues that had arisen in
administering the rules, noting that the Commission would consider
``additional amendments to the rules implementing the CFMA based upon
further administrative experience.'' \7\ Consistent with that
rationale, the Commission now proposes to amend: (i) Commission
Regulation 1.38; and (ii) Commission guidance concerning Core Principle
9 as it relates to Commission Regulation 1.38, to include changes that
the Commission believes necessary based upon its experience
administering those provisions.\8\
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\6\ See 66 FR 14262 (Mar. 9, 2001) and 66 FR 42256 (Aug. 10,
2001).
\7\ See 67 FR 20702 (Apr. 26, 2002) and 67 FR 62873 (Oct. 9,
2002).
\8\ Core Principle 9 (7 U.S.C. 5(d)(9) (Execution of
transactions) states that ``The board of trade shall provide a
competitive, open, and efficient market and mechanism for executing
transactions.''
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II. Discussion of the Proposed Rule Amendment and Guidance
A. Proposed Amendments to Regulation 1.38
At the time that the Commission promulgated its first rules
implementing the CFMA, it retained Regulation 1.38 as applicable to
DCMs. The Commission now proposes to rearrange and amend Regulation
1.38 in light of further consideration of the implications of the CFMA
and administrative experience. The proposed amendments simplify the
text and update the requirements of Regulation 1.38, including language
specifically expanding types of transactions that may lawfully be
executed off of a DCM's centralized market in accordance with the CFMA.
For instance, the Act, as amended by the CFMA, specifically allows
the exchange of futures for swaps,\9\ and since the CFMA was enacted,
several DCMs have adopted rules that allow the exchange of futures for
swaps,\10\ or for another derivatives position.\11\ The Commission is
proposing, therefore, to update the language of Regulation 1.38 by
substituting the phrase ``the exchange of futures for a commodity or
for a derivatives position'' for the phrase ``the exchange of futures
for cash commodities or the exchange of futures in connection with cash
commodity transactions.'' \12\ Furthermore, as the CFMA implemented the
rule certification procedures of Section 5c(c)(1) of the Act,\13\ the
proposed changes to Regulation 1.38 would add transactions carried out
pursuant to certified rules to the transactions that are allowed to be
executed away from the centralized market.\14\
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\9\ See section 5(b)(3) of the Act (7 U.S.C. 7(b)(3)).
\10\ See, e.g. (Chicago Board of Trade (``CBOT'') Rule 444.04,
INET Futures Exchange, LLC (``INET'') Rule 606, Merchants Exchange
(``ME'') Rule 418(b), New York Board of Trade (``NYBOT'') Rule 4.13,
New York Mercantile Exchange, Inc. (``NYMEX'') Rule 6.21A and U.S.
Futures Exchange, LLC (``USFE'') Rule 417.
\11\ See, e.g., (i) rules allowing the exchange of futures for
options NQLX LLC Futures Exchange (``NQLX'') Rule 420 (Exchange for
Physical Trades) and USFE Rule 418 (Volatility (``VOLA'') Trading
Facility--Exchange of Futures for Options)); (ii) rules allowing for
the exchange of futures over-the-counter (``OTC'') derivatives
(Kansas City Board of Trade (``KCBT'') Rule 1129 (Exchange For Risk
(``EFR'') Transactions) and CBOT Rule 444.06 (Exchange of Futures
for, or in Connection with, OTC Agricultural Option Transactions));
and (iii) rules allowing the exchange of futures for any derivative,
by-product or related product (NYMEX Rule 6.21 (Exchange of Futures
for, or in Connection with, Product).
\12\ The Commission observes that although this language retains
the phrase ``futures for [a] commodity,'' it does not retain the
phrase ``in connection with [a] commodity.'' The Commission also
notes that the phrase ``exchange of futures for a commodity or for a
derivatives position'' does not include elements of these exchanges.
Instead, essential elements of bona fide exchange of futures trades
have been provided in the guidance to Core Principle 9 below. See
infra section III.B.4. See also proposed Appendix B(9)(b)(2)(iii) to
Part 38.
\13\ Under section 5c(c)(1) of the Act as amended by the CFMA,
DCMs are allowed to implement any new rule or rule amendment, except
for material changes to enumerated agricultural products, by
providing a written certification to the Commission that the new
rule, or rule amendment complies with this Act and the Commission's
regulations.
\14\ See proposed Regulation 1.38(b). Current Regulation 1.38
limits transactions that can be executed away from the centralized
market to those transactions carried out pursuant to rules approved
by the Commission.
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B. Amendments to Guidance on Core Principle 9
The Commission proposes to rearrange and amend its guidance for
compliance with Core Principle 9 in light of consideration of the
implications of the CFMA and further administrative experience. The
proposed guidance separates guidance provided for DCM transactions on
the centralized market from guidance provided for DCM transactions off
the centralized market. The current proposal also provides more
detailed information concerning acceptable practices regarding the
execution of transactions off the centralized market. Specifically,
given the Commission's growing experience with markets in which block
trades are permitted, this release proposes amending the guidance to
provide more detail regarding acceptable block trading rules.
Additionally, the proposed guidance describes under what circumstances
the exchange rules can permit arm's length block trades between
affiliated parties.
1. General Guidance
Current Commission Regulation 1.38(b) provides that every person
handling, executing, clearing, or carrying trades, transactions or
positions that are not competitively executed, must identify and mark
by appropriate symbol or designation all such transactions or contracts
and all associated orders, records, and memoranda. As well as updating
the language of Regulation 1.38(b), the proposed amendments add this
requirement to the guidance under Core Principle 9, to provide
consolidated guidance regarding recordkeeping practices pertaining to
transactions off the centralized market.
The guidance for Core Principle 9 also addresses the testing and
review of automated trading systems. Currently, the guidance states
that acceptable testing of automated systems should be ``objective,''
and calls for the provision of ``objective'' test results.\15\ The
proposed guidance would also call for the provision to the Commission
of test results of any ``non-objective'' testing carried out by or for
a DCM (i.e., in-house reviews) regarding the system functioning
capacity or security of any automated trading systems. Although the
results of ``non-objective'' testing would be of more limited use, the
Commission believes that test results of any ``non-objective'' testing
carried out by or for the DCM should also be provided to the
Commission.
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\15\ Appendix B (a)(1)(iii) and (b)(1)(ii)(B), both to Part 38.
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2. Block Trade Rules
The Commission is proposing to provide guidance to DCMs with
respect to their rules for block transactions. The guidance provides
block trade standards that would be acceptable to the Commission. These
acceptable block trade standards adopt elements of block trade rules
previously approved by the Commission. For example, under proposed
Appendix B(9)(b)(2)(ii)(B) to Part 38, block trade parties generally
are required to be eligible contract participants (``ECPs''), although
commodity trading advisors (``CTA'') and investment advisors having
over $25 million in assets under management \16\ are allowed to carry
out
[[Page 39882]]
block trades for non-ECP customers. The Commission originally approved
a comparable requirement in CX and Chicago Mercantile Exchange
(``CME'') block-trading rules.\17\
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\16\ Including foreign persons performing equivalent roles.
\17\ See CX Rule 305-A and CME Rule 523. CX's and CME's original
block trade rules both called for the CTA or investment advisor to
have $50 million in assets under management. Subsequently, CME
submitted a rule change that lowered the amount of assets required
to be under management to $25 million for CTAs and investment
advisors. This requirement is currently found in CME, CBOE Futures
Exchange (``CFE''), CBOT, NYBOT, OneChicago Futures Exchange
(``OCX'') and USFE block trading rules (Rules: 523(I), 415(a)(ii),
331.05(c), 4.31, 417(ii) and 415(b); all respectively). Although
BTEX trading operations have been suspended, its block trading rules
also included this requirement. This requirement is not included in
NQLX and INET block trading rules (Rules 419(a) and 704(a),
respectively), as those rules limit block trades to members and
wholesale customers.
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Under proposed Appendix B(9)(b)(2)(ii)(A) to Part 38, a DCM must
determine a minimum size for block transactions. An acceptable minimum
size would be no smaller than the customary size of large transactions
in any relevant markets.\18\ Aggregation of orders for different
accounts in order to satisfy the minimum size requirement would be
prohibited except in appropriate circumstances.\19\ Under the proposal,
the aggregation of orders would be acceptable only if done by certain
registered persons having discretion to trade customer accounts.\20\
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\18\ See proposed Appendix B(9)(b)(2)(ii)(A) to Part 38.
\19\ See proposed Appendix B(9)(b)(2)(ii)(C) to Part 38.
\20\ Appropriate registered persons include a CTA registered
pursuant to section 4m of the Act, or a principal thereof, including
any investment advisor who satisfies the criteria of Sec.
4.7(a)(2)(v) of this chapter, or a foreign person performing a
similar role or function and subject as such to foreign regulation,
where such CTA, investment advisor or foreign person has more than
$25,000,000 in total assets under management. This requirement is
currently found in CME, CBOT, CFE, NYBOT, OCX and USFE block trading
rules ((Rules: 523(I), 331.05(c), 415(a)(ii), 4.31(a)(i), 417(ii)
and 415(f); all respectively)). BTEX and CX block trading rules also
included this requirement. INET Rule 704(c) and NQLX Rule 419(c)(2)
each include a similar rule that allows aggregation only for
advisers with discretion over multiple discretionary accounts of
appropriate customers (``wholesale customers'' or ``block trader''
respectively).
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A majority of exchanges that permit block trading prohibit persons
from effecting block trades on behalf of customers unless the person
receives a customer's explicit instruction or prior consent to do
so.\21\ The proposed guidance incorporates this prohibition as an
acceptable practice.
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\21\ See CME Rule 526(C), CFE Rule 415(a)(i), CBOT Rule
331.05(a), NYBOT Rule 4.31(a)(ii)(A), OCX Rule 417(a)(i), and USFE
Rule 415(c). BTEX's block trading rules also tracked this
requirement.
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Under the proposed guidance, acceptable block trade rules would
require parties to, and members facilitating, a block trade to keep
appropriate records.\22\ Appropriate block trade records would comply
with the requirements of Core Principle 10 and Core Principle 17.
Records kept in accordance with the requirements of Statement No. 133
(``Accounting for Derivative Instruments and Hedging Activities''),
issued by the Financial Accounting Standards Board (``FASB''), would be
satisfactory.\23\ Acceptable block trade rules would require that block
orders be recorded by the member and time-stamped with both the time
the order was received by the member and the time the order was
executed. This guidance is based on CME and USFE block trading rules
that have been approved by the Commission.\24\ When requested during an
investigation, parties to, and members facilitating, a block trade
should provide records to document that the block trade is executed in
accordance with contract market rules.
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\22\ Proposed Appendix B(9)(b)(2)(ii)(E) to Part 38.
\23\ FASB Statement No. 133 provides guidance on the use of
accounting for corporate hedge activity involving derivative
transactions. The statement includes guidance on documenting the
hedging relationship.
\24\ Rules 536.A and 415(c), respectively. BTEX block trading
rules also tracked this requirement.
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Proposed Appendix B(9)(b)(2)(ii)(F) to Part 38 requires reporting
of the block trade to the DCM within a reasonable period of time once
the transaction is executed. Reporting periods previously approved by
the Commission, when executed under comparable circumstances, would be
considered reasonable time periods for reporting a block transaction to
the DCM.\25\
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\25\ Currently, NYBOT block trading rule requires reporting of
block trades within two minutes. See Rule 4.31(a)(v). CBOT, CME
(generally), and INET rules require reporting of a block trade
within five minutes, although CME allows 15 minutes for reporting
block trades in Eurodollars. See Rules 331.05(d), 526.F., and
704(e)(iv), respectively. NQLX rules require reporting of a block
trade to the DCM within eight minutes. See Rule 419(g)(2). The OCX
rule, in comparison, requires that parties report the block trade
``without delay'' and also prohibits carrying out offsetting trades
until after the block trade has been reported to and disseminated by
the exchange. See Rules 417(e) and (f). Finally, the USFE rule
requires that the block trade buyer enter the details of the block
trade into the USFE trading system immediately upon agreement to
enter into the trade, to which the seller must respond within 15
minutes confirming the block transaction on the electronic trading
system. See Rule 415(h). By the seller's confirmation of the block
transaction on the trading system, USFE is immediately, and
automatically, notified of the block trade.
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The proposed guidance also identifies publication of block trade
details by DCMs immediately upon receipt of block trade reports as an
acceptable practice.\26\ This proposed acceptable practice would also
require the DCM to identify block trades on its trade register.\27\
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\26\ Proposed Appendix B(9)(b)(2)(ii)(G) to Part 38. See also,
CME, CFE, CBOT, INET, NYBOT, OCX and USFE block trading rules. This
is also an element of compliance with Designation Criterion 3 (Fair
and Equitable Trading) and Core Principle 8 (Daily Publication of
Trading Information).
\27\ Proposed Appendix B(9)(b)(2)(ii)(H) to Part 38.
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Under the proposed guidance, acceptable block trade rules would
require that the block trades be at a price that is fair and
reasonable.\28\ Consideration of whether a block transaction price is
fair and reasonable could take into account: (i) The size of the block;
and (ii) the price and size of other trades in any relevant markets at
the applicable time, or the circumstances of the market or the parties
to the block trade.\29\ Relevant markets could include, without
limitation, the DCM itself, the underlying cash markets and/or other
related futures markets.
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\28\ Proposed Appendix B(9)(b)(2)(ii)(I) to Part 38.
\29\ A similar ``fair and reasonable'' price parameter is found
in Commission memoranda on block trading, in versions of Part 38
regulations adopted prior to the passage of the CFMA (see 65 FR
77962, see also 65 FR 82272 (withdrawing regulations due to
enactment of the CFMA)) as well as current CBOT, CFE, CME, and NYBOT
block trading rules, Rules 331.05(b), 415(c), 526.D., 4.31(a)(iii),
respectively.
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If a DCM rule requiring a fair and reasonable price included the
``circumstances'' of the parties or of the market within its
parameters, a block trade participant could execute a block transaction
at a price that was away from the market provided that the participant
retained documentation to demonstrate that the price was indeed fair
and reasonable under the participant's legitimate trading objectives or
the market's particular circumstances. Analysis of whether a block
trade price outside the bid/ask spread or prices of contemporaneous
transactions in the futures market is fair and reasonable, however,
should consider how the block trade price reflects commercial
realities. A price that is away from any market may raise suspicion
concerning the legitimacy of the trade.
As a result, inclusion of the ``circumstances'' of the parties or
of the market within the parameters of the fair and reasonable price
guidance provides flexibility to market participants while allowing the
DCM to later review the price of the block trade, as the exchange would
have the ability to obtain trade participant documentation if
necessary.
3. Block Trades Between Affiliated Parties
Under the proposed guidance, acceptable block trade rules would
[[Page 39883]]
require that block trades be arm's length transactions.\30\ For
exchanges that desire to allow block trading between affiliated
parties, however, the proposed Appendix B(9)(b)(2)(ii)(J) to Part 38,
would also provide guidance on acceptable rules for affiliate block
trades, which when carried out consistent with the guidance would be
presumed to be arm's length transactions. Specifically, the proposed
guidance provides that block transactions between parties that have an
arm's length organizational structure will be presumed to be at arm's
length. Under the guidance, an ``arm's length organizational
structure'' is one in which the counterparties (whether affiliated or
not), each have a separate account controller, with its own
responsibility to review and evaluate the terms and conditions and the
potential risks and benefits of prospective transactions.
Alternatively, block transactions between affiliated parties will be
presumed to be at arm's length if they are executed during trading
hours and are carried out at an arm's length price, as provided by the
guidance.\31\
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\30\ Proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
\31\ See proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
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In addition to the requirements previously discussed, acceptable
DCM rules for affiliate block trades would require: (i) Execution
during the contract's trading hours; (ii) transaction prices that fall
within the bid/ask spread on electronic trading systems or prices of
contemporaneous related trading floor transactions, although if the
contract does not have a bid/ask spread or any floor transactions at
the time of the block transaction, then the contemporaneous bid/ask
spread or price of transactions on related futures or cash markets
could be used; and (iii) identification of the trade on the order
ticket and to the DCM as a trade that was between affiliated parties.
The proposed price parameters for affiliate block trades (a
prevailing bid-ask spread or price of contemporaneous related floor
transactions) would be a narrower subset of the fair and reasonable
price parameter proposed for block trades between parties that are not
affiliated.\32\ Block transactions between affiliated parties raise
concerns that such block trades may be susceptible to abuse. Under the
Commission's proposal, only block trade prices between affiliated
parties that fall within a price parameter using concrete prices
(contemporaneous bid-ask spread or prices in contemporaneous market(s))
would be assumed to be at arm's length. Such a pricing parameter
provides an objective method for determining whether the price of an
affiliated party block trade was fairly negotiated and absent any
pricing abuse, and, consequently, warranting a presumption that the
block trade was carried out at arm's length.
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\32\ See proposed Appendices B(9)(b)(2)(ii)(J)(2) and
B(9)(b)(2)(ii)(I) to Part 38.
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The Commission expects that the proposed guidance will benefit DCMs
that are interested in allowing affiliate block transactions, as well
as participants that desire to take advantage of such rules as the
guidance provides participants with alternative means to comply with
the requirement that block transactions be carried out at arm's
length.\33\ Affiliate block trades that are not carried out according
to this guidance could be subject to greater scrutiny. Such scrutiny
would not be based on a presumption of illegitimacy, but on lack of
information about the trade. Firms that execute affiliate block
transactions outside of the guidance, therefore, should preserve
records (in addition to those they are required to keep in any event)
in order to answer any questions regarding the trade.
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\33\ See proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
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4. Exchange of Futures for a Commodity or for a Derivatives Position
The essential elements of bona fide exchange of futures trades have
been provided in the guidance to Core Principle 9 below.\34\ The
elements proposed are found in current contract market EFP, EFS, EFR
and EFO rules and are based on the essential elements for bona fide
EFPs detailed in the 1987 EFP Report prepared by the Commission's then
Division of Trading and Markets.\35\ The elements include separate but
integrally related transactions, an actual transfer of ownership of the
commodity or derivatives position, and both legs transacted between the
same two parties. The Commission notes that the determination whether
an actual transfer of ownership has occurred will depend upon the facts
and circumstances of each transaction. In each instance where an
exchange of futures for a commodity or for a derivatives position is
linked to another offsetting transaction, the particular facts and
circumstances may warrant a determination that there was not an actual
ownership transfer of each leg of the commodity or derivatives
position.
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\34\ See proposed Appendix B(9)(b)(2)(iii) to Part 38.
\35\ See generally, Division of Trading and Markets, Report on
Exchanges of Futures for Physicals (1987). See also, CBOT Rules
444.01, 444.01B, 444.04 and 444.06; CBOE Rule 414; CME Rule 538;
INET Rules 705 and 706; KCBT Rules 1128.00, 1128.02, 1129.00, and
1129.02; ME Rule 418; MGE Rule 719; NQLX Rule 420; NYBOT Rules 4.12
and 4.13, NYMEX Rules 6.21, 6.21A and 6.21E, and OCX Rule 416.
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IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act \36\ requires federal agencies, in
proposing rules, to consider the impact of those rules on small
businesses. The rule amendments adopted herein will affect DCMs, FCMs,
CTAs and large traders. The Commission has previously established
certain definitions of ``small entities'' to be used by the Commission
in evaluating the impact of its rules on small entities in accordance
with the RFA.\37\ The Commission has previously determined that
DCMs,\38\ registered FCMs,\39\ and large traders \40\ are not small
entities for the purpose of the RFA. With respect to CTAs, the
Commission has determined to evaluate within the context of a
particular rule proposal whether CTAs would be considered ``small
entities'' for purposes of the Regulatory Flexibility Act and, if so,
to analyze the economic impact on the affected entities of any such
rule at that time.\41\ The Commission believes that the instant
proposed rules will not place any new burdens on entities that would be
affected hereunder, and the Commission does not expect the proposed
amendments to cause persons to change their current methods of doing
business in most cases. This is because requirements under the instant
proposal, if adopted, would be similar to most existing DCM
requirements.
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\36\ 5 U.S.C. 601 et seq.
\37\ 47 FR 18618-21 (Apr. 30, 1982).
\38\ Id. at 18618-19.
\39\ Id. at 18619-20.
\40\ Id. at 18620.
\41\ 47 FR at 18618, 18620.
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Accordingly, the Commission does not expect the rules, as proposed
herein, to have a significant economic impact on a substantial number
of small entities. Therefore, the Chairman, on behalf of the
Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the
proposed amendments will not have a significant economic impact on a
substantial number of small entities. The Commission invites the public
to comment on this finding and on its proposed determination that the
trading facilities covered by these rules would not be small entities
for purposes of the Regulatory Flexibility Act.
[[Page 39884]]
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 imposes certain requirements on
federal agencies (including the Commission) in connection with their
conducting or sponsoring any collection of information as defined by
the PRA. The proposed rule amendments do not require a new collection
of information on the part of any entities subject to these rules.
Accordingly, for purposes of the Paperwork Reduction Act of 1995, the
Commission certifies that these rule amendments do not impose any new
reporting or recordkeeping requirements.
C. Cost-Benefit Analysis
Section 15 of the Act, as amended by section 119 of the CFMA,
requires the Commission to consider the costs and benefits of its
action before issuing a new regulation. The Commission understands
that, by its terms, Section 15 does not require the Commission to
quantify the costs and benefits of a new regulation or to determine
whether the benefits of the proposed regulation outweigh its costs. Nor
does it require that each proposed regulation be analyzed in isolation
when that regulation is a component of a larger package of regulations
or of rule revisions. Rather, section 15 simply requires the Commission
to ``consider the costs and benefits'' of its action.
Section 15(a) further specifies that costs and benefits shall be
evaluated in light of five broad areas of market and public concern:
protection of market participants and the public; efficiency,
competitiveness, and financial integrity of futures markets; price
discovery; sound risk management practices; and other public interest
considerations. Accordingly, the Commission could, in its discretion,
give greater weight to any one of the five enumerated areas of concern
and could, in its discretion, determine that, notwithstanding its
costs, a particular regulation was necessary or appropriate to protect
the public interest, to effectuate any of the provisions, or to
accomplish any of the purposes of the Act.
The proposed amendments constitute a package of amendments to
Regulation 1.38 and to guidance that the Commission originally
promulgated to implement the CFMA. The amendments are proposed in light
of past experience with the implementation of the CFMA, and are
intended to facilitate increased flexibility and consistency. Some
sections of the proposed amendments merely clarify or make explicit
past Commission decisions concerning transactions off the centralized
market.
As most provisions incorporate rules previously approved by the
Commission, the proposed amendments would not, in most cases, impose
new costs on DCMs or market participants. Most current DCM rules
already meet the acceptable practices proposed, furthermore, these
amendments incorporate standards that the Commission has previously
determined protect market participants and the public,\42\ the
financial integrity or price discovery function of the markets, and
sound risk management practices. Moreover, the additional clarification
of acceptable practices provides a benefit to markets and market
participants. In addition, the amendments are expected to benefit
efficiency and competition by providing more detailed guidance as to
acceptable means of meeting the applicable designation criteria and
core principles, allowing a greater degree of legal certainty to the
markets and market participants.
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\42\ See, e.g. proposed Appendix B(9)(b)(2)(ii)(B) to Part 38.
See also, supra notes 14-15 and accompanying text.
---------------------------------------------------------------------------
After considering the five factors enumerated in the Act, the
Commission has determined to propose the rules and rule amendments set
forth below. The Commission invites public comment on its application
of the cost-benefit provision. Commenters also are invited to submit
any data that they may have quantifying the costs and benefits of the
proposed rules with their comment letters.
List of Subjects in 17 CFR Parts 1 and 38
Block transactions, Commodity futures, Contract markets,
Transactions off the centralized market, Reporting and recordkeeping
requirements.
In consideration of the foregoing, the Commission hereby proposes
to amend Chapter I of Title 17 of the Code of Federal Regulations as
follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 continues to read as follows:
Authority: 7 U.S.C.
2. Section 1.38 is proposed to be revised to read as follows:
Sec. 1.38 Execution of transactions.
(a) Transactions on the centralized market. All purchases and sales
of any commodity for future delivery, and of any commodity option, on
or subject to the rules of a contract market, shall be executed openly
and competitively by open outcry, or posting of bids and offers, or by
other equally open and competitive methods, in a place provided by the
contract market, during the regular hours prescribed by the contract
market for trading in such commodity or commodity option.
(b) Trades off the centralized market; requirements.
Notwithstanding paragraph (a) of this section, transactions may be
executed away from a centralized market, including by transfer trades,
office trades, block trades, or trades involving the exchange of
futures for a commodity or for a derivatives position, if transacted in
accordance with written rules of a contract market that provide for
execution away from the centralized market and that have been certified
to or approved by the Commission. Every person handling, executing,
clearing, or carrying the trades, transactions or positions described
in this paragraph shall comply with the rules of the appropriate
contract market and derivatives clearing organization, including to
identify and mark by appropriate symbol or designation all such
transactions or contracts and all orders, records, and memoranda
pertaining thereto.
PART 38--DESIGNATED CONTRACT MARKETS
3. The authority section for Part 38 continues to read as follows:
Authority: 7 U.S.C. 2, 5, 6, 6c, 7 and 12a, as amended by the
Commodity Futures Modernization Act of 2000, Appendix E of Pub. L.
106-554, 114 Stat. 2763 (2000).
4. In Appendix B to Part 38 Core Principle 9 is proposed to be
revised to read as follows:
Appendix B to Part 38--Guidance on, and Acceptable Practices in,
Compliance With Core Principles
* * * * *
Core Principle 9 of section 5(d) of the Act: EXECUTION OF
TRANSACTIONS--The board of trade shall provide a competitive, open,
and efficient market and mechanism for executing transactions.
(a) Application guidance--(1) Transactions on the centralized
market. (i) All purchases and sales of any commodity for future
delivery, and of any commodity option, on or subject to the rules of
a contract market shall be executed openly and competitively by open
outcry, or posting of bids and offers, or by other equally open and
competitive methods, in a place provided by the contract market,
during the regular hours prescribed by the contract market for
trading in such commodity or commodity option.
(ii) A competitive and open market and mechanism for executing
transactions includes a board of trade's methodology for entering
orders and executing transactions.
[[Page 39885]]
(iii) Appropriate objective testing and review of a contract
market's automated systems should occur initially and periodically
to ensure proper system functioning, adequate capacity and security.
A designated contract market's analysis of its automated system
shall address compliance with appropriate principles for the
oversight of automated systems, ensuring proper system
functionality, adequate capacity and security.
(2) Transactions off the centralized market. (i) Transactions
may be executed off the centralized market if transacted in
accordance with written rules of a contract market that have been
certified to or approved by the Commission and that specifically
provide for execution of such transactions away from the centralized
market.
(ii) Every person handling, executing, clearing, or carrying the
trades, transactions or positions that are not executed on the
centralized market, including transfer trades, office trades, block
trades, or trades involving the exchange of futures for a commodity
or for a derivatives position, shall comply with the rules of the
applicable designated contract market and derivatives clearing
organization.
(iii) A designated contract market that determines to allow
trades off the centralized market shall ensure that such trading
does not operate in a manner that compromises the integrity of
prices or price discovery on the centralized market.
(b) Acceptable practices--(1) Matters relating to trade
execution facilities. (i) General provisions. [Reserved]
(ii) Electronic trading systems. (A) The guidelines issued by
the International Organization of Securities Commissions (IOSCO) in
1990 (which have been referred to as the ``Principles for Screen-
Based Trading Systems''), and adopted by the Commission on November
21, 1990 (55 FR 48670), as supplemented in October 2000, are
appropriate guidelines for a designated contract market to apply to
electronic trading systems.
(B) Any objective testing and review of the system should be
performed by a qualified independent professional. A professional
that is a certified member of the Information Systems Audit and
Control Association experienced in the industry is an example of an
acceptable party to carry out testing and review of an electronic
trading system.
(C) Information gathered by analysis, oversight, or any program
of testing and review of any automated systems regarding system
functioning, capacity and security must be made available to the
Commission upon request.
(iii) Pit trading. [Reserved]
(2) Transactions off the centralized market--(i) General
provisions. (A) Types of allowable trades off the centralized
market.--Acceptable transactions off the centralized market include:
transfer trades, office trades, block trades, or trades involving
the exchange of futures for a commodity or for a derivatives
position, if transacted in accordance with written rules of a
contract market appropriately providing for execution away from the
centralized market, that have been certified to or approved by the
Commission.
(B) Reporting. Acceptable contract market rules would require
reporting of transactions off the centralized market to the contract
market within a reasonable period of time.
(C) Publication. Acceptable contract market rules would require
the contract market to publicize details about transactions off the
centralized market immediately upon the receipt of the transaction
report.
(D) Trade register. Acceptable contract market rules would
require the contract market to identify transactions off the
centralized market on its trade register.
(E) Recordkeeping. Acceptable contract market rules would
require parties to, and members facilitating, transactions off the
centralized market to keep appropriate records. Appropriate records
for transactions off the centralized market would comply with Core
Principle 10 and Core Principle 17.
(F) Identification of trades. Section 1.38(b) of this chapter
establishes the guidance regarding the identification of all trades
off the centralized market. It requires contract market rules to
require every person handling, executing, clearing, or carrying
trades, transactions or positions that are executed off the
centralized market, including transfer trades, office trades, block
trades or trades involving the exchange of futures for a commodity
or for a derivatives position, to identify and mark by appropriate
symbol or designation all such transactions or contracts and all
orders, records, and memoranda pertaining thereto.
(ii) Block transactions. (A) Include an acceptable minimum block
size. An acceptable minimum block size would be no smaller than the
customary size of large transactions in any relevant markets. A
``large'' transaction is one that may affect the quality of the
transaction price due to the significant impact of such a large
order on the centralized market. An acceptable minimum block size,
for example, would be a transaction size that is greater than 90
percent of the trades in a relevant market. The relevant market
should be the subject futures or options market, any related
derivatives market, and/or the underlying cash market, as
appropriate. If a contract market chooses to allow block
participants to meet the minimum block size requirement by
aggregating the component legs of a spread or combination position
executed as a block trade, the acceptable size for each leg should
be the size of a large transaction in the relevant market (that is,
a size that is greater than 90 percent of the trades in the relevant
market). For markets where transaction data in the relevant
market(s) are unavailable, inadequate to conduct an analysis, or for
markets where there is no underlying cash market, an acceptable
minimum block size should be set initially at 100 contracts and
adjusted thereafter as transaction data in the relevant market(s)
become available.
(B) Restrict access to appropriate parties. Acceptable block
trade parties would be eligible contract participants. However,
contract market rules could also allow a commodity trading advisor
registered pursuant to section 4m of the Act, or a principal
thereof, including any investment advisor who satisfied the criteria
of Sec. 4.7(a)(2)(v) of this chapter, or a foreign person
performing a similar role or function and subject as such to foreign
regulation, to transact block trades for customers who are not
eligible contract participants, if such commodity trading advisor,
investment advisor or foreign person has total assets under
management that exceed $25,000,000.
(C) Aggregation of orders. Acceptable contract market rules
would prohibit aggregation of orders for different accounts in order
to satisfy the minimum size requirement except in appropriate
circumstances. Aggregation of orders for different accounts in order
to satisfy the minimum size requirement would be acceptable if done
by a commodity trading advisor registered pursuant to section 4m of
the Act, or a principal thereof, including any investment advisor
who satisfies the criteria of Sec. 4.7(a)(2)(v) of this chapter, or
a foreign person performing a similar role or function and subject
as such to foreign regulation, where such commodity trading advisor,
investment advisor or foreign person has more than $25,000,000 in
total assets under management.
(D) Acting for a customer. Acceptable contract market rules
would prohibit a person from effecting a block trade on behalf of a
customer, unless the person has received an instruction or prior
consent to do so from the customer;
(E) Recordkeeping. Acceptable contract market rules would
require parties to, and members facilitating, a block trade to keep
appropriate records. Appropriate block trade records would comply
with Core Principle 10 and Core Principle 17. Records kept in
accordance with the requirements of FASB Statement No. 133
(``Accounting for Derivative Instruments and Hedging Activities'')
would be acceptable records. Block trade orders must be recorded by
the member and time-stamped with both the time the order was placed
and the time the order was executed, and must indicate when block
trades are between affiliated parties. When requested during an
investigation, parties to, and members facilitating, a block trade
shall provide records to document that the block trade is executed
in conformance with contract market rules.
(F) Reporting. Acceptable contract market rules would require
reporting of the block trade to the contract market within a
reasonable period of time. Reporting periods previously approved by
the Commission would be considered reasonable time periods for
reporting a block transaction to the contract market once the
transaction is executed.
(G) Publication. Acceptable contract market rules would require
the contract market to publicize details about the block trade
immediately upon its being reported to the contract market.
(H) Identification of trades. Acceptable contract market rules
would require the contract market to identify block trades as such
on its trade register, and to identify when block trades are between
affiliated parties.
(I) Pricing. Acceptable contract market rules would require that
the block trades be
[[Page 39886]]
at a price that is fair and reasonable. Consideration of whether a
block transaction price is fair and reasonable could take into
account: (i) The size of the block; and (ii) the price and size of
other trades in any relevant markets at the applicable time, and the
circumstances of the market or the parties to the block trade.
Relevant markets could include, without limitation, the contract
market itself, the underlying cash markets and/or other related
futures markets. If a contract market rule requiring a fair and
reasonable price includes the ``circumstances'' of the parties or of
the market within its parameters, a block trade participant could
execute a block transaction at a price that was away from the market
provided that the participant retains documentation to demonstrate
that the price was indeed fair and reasonable under the
participant's or market's particular circumstances.
(J) Arm's length transactions. Acceptable contract market rules
would require that block trades be arm's length transactions. The
following block trades will be presumed to be carried out at ``arm's
length'' (1) Block trades transacted between separate counterparties
(whether affiliated or not), where each counterparty has a separate
account controller with its own responsibility to review and
evaluate the terms and conditions and the potential risks and
benefits of prospective transactions would be presumed to be carried
out at ``arm's length;'' and (2) Block trades between affiliated
parties if transacted under contract market rules that require,
along with the requirements of paragraphs (b)(2)(i)(A)-(H) of this
appendix: (i) execution during the contract's trading hours; and
(ii) transaction prices that fall within the bid/ask spread on
electronic trading systems or prices of contemporaneous related
trading floor transactions, however, if the contract does not have a
bid/ask spread or any floor transactions at the time of the block
transaction, then the contemporaneous bid/ask spread or price of
transactions on related futures or cash markets could be used.
(iii) Exchange of futures for a commodity or for a derivatives
position. Acceptable contract market rules for exchange of futures
for a commodity or for a derivatives position would require that
such trades include the following elements:
(A) Separate but integrally related transactions, involving (1)
the same or a related commodity; (2) price correlation of legs; and
(3) quantitative equivalence;
(B) A buyer of futures who is the seller of the corresponding
commodity or derivatives position and a seller of futures who is the
buyer of the corresponding commodity or derivatives position; and
(C) An actual transfer of ownership, involving (1) separate
parties; (2) possession, right of possession, or right to future
possession of each leg prior to the trade; (3) an ability to
perform; and (4) a transfer of title.
(iv) Office trades. [Reserved]
(v) Transfer trades. [Reserved]
* * * * *
Issued in Washington, DC, on June 24, 2004, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 04-14815 Filed 6-30-04; 8:45 am]
BILLING CODE 6357-01-P