[Federal Register Volume 60, Number 190 (Monday, October 2, 1995)]
[Rules and Regulations]
[Pages 51323-51346]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-23940]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 36
Section 4(c) Contract Market Transactions
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rules.
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SUMMARY: Pursuant to section 4(c) of the Commodity Exchange Act, the
Commission is promulgating final rules to exempt certain contract
market transactions from specified requirements of the Commodity
Exchange Act, 7 U.S.C. 1 et seq. (``CEA'' or ``Act''), and Commission
regulations thereunder. The Commission proposed these rules after
considering the public comments on petitions for exemptive relief
submitted by the Chicago Mercantile Exchange (``CME'') and by the Board
of Trade of the City of Chicago (``CBT'').
Based upon its consideration of the comments received in response
to its Notice of Proposed Rulemaking, and upon its independent
analysis, the Commission is promulgating final rules establishing a
three-year pilot program to permit certain transactions to trade on
section 4(c) contract markets exempt from specified requirements of the
Act and Commission rules. The Commission believes that permitting, on a
pilot basis, the trading of this new class of contract market
transaction, which can be offered only to specified categories of
individuals or entities, is in the public interest.
The final rules will permit these exchange-traded products greater
flexibility in competing with foreign exchange-traded products and with
both foreign and domestic over-the-counter transactions, while
maintaining basic customer protection, financial integrity and other
protections associated with trading in an exchange environment. In
particular, new Part 36 permits greater flexibility with respect to
trading rules (section 36.3); listing of transactions (section 36.4);
reporting requirements
[[Page 51324]]
(section 36.5); registration requirements (section 36.36) and risk
disclosure (section 36.7). It also reserves the anti-manipulation
prohibitions in the Act and Commission Rule 33.9 and provides for anti-
fraud prohibitions in addition to those otherwise applicable to section
4(c) contract market transactions under the Act and Commission Rule
33.10.
Finally, although the Commission requested comment relating to the
advisability of making certain conforming changes to its Part 35
Exemption of Swap Agreements, the Commission has determined to make no
changes herein to Part 35.
EFFECTIVE DATE: November 1, 1995.
FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel,
Division of Economic Analysis; Alan L. Seifert, Deputy Director, or
Lawrence B. Patent, Associate Chief Counsel, Division of Trading and
Markets; or Ellyn S. Roth, Attorney, Office of the General Counsel;
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, N.W., Washington, D.C. 20581, (202) 418-5260, 418-5450, and
418-5120, respectively.
SUPPLEMENTARY INFORMATION:
I. Statutory Background
The Futures Trading Practices Act of 1992, P.L. No. 102-546
(October 28, 1992) (``1992 Act''), added new subsections (c) and (d) to
section 4 of the Act. These new provisions authorize the Commission, by
rule, regulation, or order, to exempt any agreement, contract or
transaction, or class thereof, when entered into between ``appropriate
persons'' from the exchange-trading, or any other, requirement of the
Act other than section 2(a)(1)(B), 7 U.S.C. 2.1 Before granting
such an exemption, the Commission must determine that its action would
be consistent with the public interest and would not have a material
adverse effect on the ability of the Commission to discharge its
regulatory responsibilities or of any contract market to discharge its
self-regulatory responsibilities under the Act.2
\1\ Section 2(a)(1)(A) of the Act grants the Commission
exclusive jurisdiction over ``accounts, agreements (including any
transaction which is of the character of * * * an `option' * * * ),
and transactions involving contracts of sale of a commodity for
future delivery traded or executed on a contract market * * * or any
other board of trade, exchange, or market. * * * '' 7 U.S.C. 2. The
CEA and Commission regulations require that transactions in
commodity futures contracts and commodity option contracts, with
narrowly defined exceptions, occur on or subject to the rules of
contract markets designated by the Commission.
Specifically, Section 4(c)(1), 7 U.S.C. 6(c)(1), provides:
In order to promote responsible economic or financial innovation
and fair competition, the Commission by rule, regulation, or order,
after notice and opportunity for hearing, may (on its own initiative
or on application of any person, including any board of trade
designated as a contract market for transactions for future delivery
in any commodity under section 5 of this Act) exempt any agreement,
contract, or transaction (or class thereof) that is otherwise
subject to subsection (a) (including any person or class of persons
offering, entering into, rendering advice or rendering other
services with respect to, the agreement, contract, or transaction),
either unconditionally or on stated terms or conditions or for
stated periods and either retroactively or prospectively, or both,
from any of the requirements of subsection (a), or from any other
provision of this Act (except Section 2(a)(1)(B)), if the Commission
determines that the exemption would be consistent with the public
interest.
\2\ Specifically, Section 4(c)(2), 7 U.S.C. 6(c)(2), states:
The Commission shall not grant any exemption under paragraph (1)
from any of the requirements of subsection (a) unless the Commission
determines that--
(A) The requirement should not be applied to the agreement,
contract, or transaction for which the exemption is sought and that
the exemption would be consistent with the public interest and the
purposes of this Act; and
(B) the agreement, contract, or transaction--
(i) will be entered into solely between appropriate persons; and
(ii) will not have a material adverse effect on the ability of
the Commission or any contract market to discharge its regulatory or
self-regulatory duties under this Act.
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II. The Petitions for Exemptive Relief
On August 16, 1993, the Commission published in the Federal
Register notice of, and a request for comment on, petitions for
exemption under section 4(c) of the Act submitted by the CME and the
CBT.3 As detailed in that Federal Register notice, the CME sought
an exemption from most of the provisions of the Act and Commission
regulations with regard to the purchase and sale of its Rolling
SpotTM futures and options contracts. The CBT's petition,
submitted on June 30, 1993 (``section 4(c) petition''), and
subsequently joined by the New York Mercantile Exchange
(``NYMEX''),4 requested that the Commission establish a
``professional trading market exemption'' from most of the provisions
of the Act and regulations for trading in any instrument of the CBT and
other boards of trade, including those designated previously as
contract markets by the Commission. Under both petitions, trading in
exempted instruments would have been limited to certain participants,
and trades would have been cleared through an exchange clearing system
approved by the Commission.
\3\ 58 FR 43414 (Aug. 16, 1993); 58 FR 44402 (Aug. 20, 1993)
(correction); 58 FR 52948 (Oct. 13, 1993) (extension of comment
period to Dec. 15, 1993).
\4\ By letter dated September 20, 1994, subsequent to the close
of the comment period, the NYMEX joined in the CBT's petition.
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The substance of the comments on the petitions is discussed in the
Notice of Proposed Rulemaking, 59 FR 54139 at 54140-54141 (Oct. 28,
1994). The CBT, as part of its comments responding to the Notice of
Proposed Rulemaking, offered several amendments to its section 4(c)
petition. Of these, the most notable would limit the transactions
eligible for exemptive relief to ``swap agreements'' as defined by
Commission Rule 35.1(b).5
\5\ See Comment letter of the Board of Trade of the City of
Chicago, dated December 13, 1994.
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III. The Proposed Rules
In light of the comments received on the exchange petitions, and
based on its own analysis, the Commission proposed a new Part 36 of its
rules.6 The proposed rules would establish a pilot program to
provide more streamlined procedures for listing new exchange-traded
products and greater flexibility in the trading procedures for those
products, the offer and sale of which would be limited to specified
categories of individuals or entities. In addition, the proposed rules
would provide greater flexibility to qualified market users in certain
areas, particularly relating to registration and account opening
procedures.
\6\ 59 FR 54139 (Oct. 28, 1994); 59 FR 64359 (Dec. 14, 1994)
(extension of comment period to January 31, 1995).
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A. Duration and Scope of Exemption
The Commission proposed to implement these rules under the
framework of a three-year pilot program, providing the exchanges and
the Commission an opportunity to test whether actual trading under the
proposed rules, in fact, was, and remained, in the public interest, and
to determine the effect of such trading on the integrity of the
marketplace as a whole. The Commission specifically requested comment
on the concept and feasibility of such a pilot program. Given the pilot
nature of this program, the Commission also proposed that the exemption
could be revoked at any time, following notice and an opportunity for
hearing, upon a determination that the continued operation of the
exemption was no longer consistent with the public interest.
With regard to the scope of the exemption, proposed section 36.1(b)
provided that boards of trade listing section 4(c) contract market
transactions for trading would be deemed to be ``contract markets''
which must comply with all provisions of the Act and
[[Page 51325]]
Commission regulations, except for those provisions which are
``specifically inconsistent'' with the proposed rules. Transactions in
these instruments were proposed to be limited to ``eligible
participants,'' the definition of which was based upon the list of
``appropriate persons'' set forth in section 4(c)(3) (A) through (J) of
the Act, with certain revisions tailored to this particular market and
reflecting the Commission's experience in applying similar concepts in
the context of other exemptions. In this regard, the Commission asked
commenters to address the issue of whether certain of the proposed
revisions should be applied to the Commission's previously-granted
exemption under Part 35,7as well.
\7\ Part 35 of the Commission's rules exempts swap agreements,
as defined in Section 35.1(b), from,
all provisions of the Act (except * * * Sections 2(a)(1)(B), 4b,
and 4o of the Act and Sec. 32.9 of this chapter * * *, and the
provisions of Sections 6(c) and 9(a)(2) of the Act to the extent
these provisions prohibit manipulation of the market price of any
commodity in interstate commerce or for future delivery on or
subject to the rules of any contract market), provided the following
terms and conditions are met:
(a) the swap agreement is entered into solely between eligible
swap participants * * * ;
(b) the swap agreement is not part of a fungible class of
agreements that are standardized * * * ;
(c) the creditworthiness of any party having an actual or
potential obligation under the swap agreement would be a material
consideration * * * ; and
(d) the swap agreement is not entered into and traded on or
through a multilateral transaction execution facility.
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Proposed section 36.2 limited the potential breadth of the
exemption, specifying that section 4(c) contract market transactions
must be: (1) cash-settled, or that delivery be by ``means other than
the transfer or receipt of any commodity, except a major foreign
currency;'' (2) cleared through a clearing organization subject to
Commission oversight; and, (3) based on commodities other than the
agricultural commodities enumerated in section 1a of the Act, except
for a broad-based index thereof. Proposed section 36.2(a)(4) further
would have limited section 4(c) contract market transactions to those
transactions which could ``reasonably be distinguished'' based upon the
contract's hedging function or pricing function from futures or option
contracts already designated by the Commission at the time of
application to trade a section 4(c) contract market transaction.8
Finally, any transaction subject to section 2(a)(1)(B) of the Act, 7
U.S.C. 2, including stock index futures contracts, was proposed to be
excluded from the scope of the exemptive rules.
\8\ As proposed, Section 36.2(a)(4) specifically identified the
following as eligible Section 4(c) contract market transactions:
flexible commodity options (which trade under contract market option
rules, but are not separately designated); contracts in foreign
currency known as Rolling SpotTM Contracts; five- and ten-year
interest rate swaps contracts; and foreign currency forward futures
contracts and options thereon.
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B. Trading Rules and Procedures
Section 36.3 proposed to permit section 4(c) contract markets
greater flexibility in trading procedures and systems and to establish
a streamlined procedure for Commission review of the contract market
rules implementing those procedures. As proposed, section 36.3 would
have permitted significant flexibility for trading procedures and
systems. In particular, by permitting upstairs or other forms of off-
floor execution if certain broad criteria were met, the proposed rule
departed profoundly from current regulatory constraints. The limiting
criteria included: meeting certain Commission recordkeeping and audit
trail requirements; maintaining customer protection standards under
Commission Rules 155.2, 155.3, and 155.4, to the extent applicable;
providing for post-trade transparency of the transactions, including
specified reporting requirements identifying section 4(c) contract
market transactions from non-section 4(c) contract market transactions;
and clearing such transactions on the same schedule as products traded
on non-section 4(c) contract markets. Further, any submission made
under the proposed rule would have been required to describe fully the
contract market procedures and systems to assure compliance with
sections 4b and 4c(a) of the Act, which prohibit the abuse of customer
orders. Such abuses include frontrunning customer orders, misuse of
information, wash sales and fictitious trades. Procedurally, the
Commission proposed that such trading rules be submitted for its review
prior to being put into effect. Absent notification to the contrary,
these rules would become effective ten days after receipt.
C. Listing Procedures
The Commission proposed that section 4(c) contract market
transactions be listed for trading ten days after submission to the
Commission of their terms and conditions, unless the Commission
notified the board of trade in writing during that period that the
transactions did not meet the conditions specified by the rules. In
that event, the terms and conditions of the transaction would be
subject to the usual rule approval procedures under section
5a(a)(12)(A) of the Act.
D. Reporting Requirements
The Commission proposed that, in lieu of its current reporting
requirements under Parts 16-19 of its rules, section 4(c) contract
markets, futures commission merchants (``FCMs''), and large traders
comply with reporting requirements specifically geared toward these
markets. Most notably, in addition to publishing daily information on
total open interest, transactions, and prices for each commodity or
type of contract, the Commission proposed that section 4(c) contract
markets provide open interest and transaction information for each
clearing member similar to that required under current Rule 16.00.
However, although required to be maintained in a manner that is readily
accessible, contract markets would be required to supply information
concerning large traders conducting section 4(c) contract market
transactions only on call by the Commission. The actual frequency of
those reports would be determined based upon market developments.
E. Special Temporary License, Registration or Principal Listing
Procedures; Risk Disclosure Requirements
The Commission also proposed, in section 36.6, to allow special
registration procedures for persons associated with an FCM or
introducing broker (``IB'') whose activities were limited to
instruments specified by the Commission in an Appendix to Part 36.
These special procedures would be established upon the petition of a
contract market and under approved procedures of the National Futures
Association (``NFA''). The Commission noted in the Notice of Proposed
Rulemaking that particular areas of flexibility in the registration
process might include the waiver of NFA's fingerprint requirement and
acceptance of alternative proficiency tests. With regard to risk
disclosure, the Commission proposed, when accounts for section 4(c)
contract market transactions were opened, allowing the use of
disclosure statements appropriate to a customer's expertise and
financial capacity and tailored to a particular product. This
disclosure requirement would have replaced the basic risk disclosure
statements generally required when opening accounts. See, e.g.,
Commission Rules 1.55, 1.65, 33.7, and 190.10.
[[Page 51326]]
F. Fraud and Manipulation in Connection With Section 4(c) Contract
Market Transactions
Finally, the Commission proposed that section 4(c) contract market
transactions be subject to the anti-fraud proscriptions of sections
4b(a) and 4o of the Act, those provisions of sections 6(c), 6(d), and
9(a) of the Act that prohibit price manipulation, and Commission Rules
33.9 and 33.10, which prohibit fraudulent conduct and price
manipulation in connection with commodity option transactions. The
Commission also proposed to include in Part 36 a free-standing anti-
fraud rule modeled after Commission Rule 33.10, the anti-fraud rule
applicable to exchange-traded commodity options, and requested comment
on the need for a free-standing anti-manipulation rule. In this regard,
the Commission specifically requested comment on whether such stand-
alone anti-fraud and anti-manipulation rules were appropriate and
whether the swaps exemption also should be amended to include similar
rules.
IV. Comments Received
The Commission received 34 comment letters from 29 different
commenters 9 in response to its Notice of Proposed Rulemaking. The
commenters included: four futures exchanges; two clearing
organizations; a securities exchange; seven trade associations; four
federal regulatory agencies; a Commission Administrative Law Judge;
three bar association committees; two industry lawyers; three
investment firms; and two other futures professionals.
\9\ Morgan Stanley & Co., Inc. (``Morgan Stanley''), the
Securities and Exchange Commission (``SEC''), and the Futures
Industry Association (``FIA'') each sent two letters, one on Part 36
and one on Part 35; the CBT sent three.
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The comments carefully analyzed the proposed rules and many
responded to the specific questions raised by the Commission. The vast
majority of the commenters favored the general concept of the proposed
rules, although many recommended clarifications, revisions or
modifications to particular provisions. Several industry associations,
a state bar association subcommittee, and others, in supporting the
proposal, opined that introducing these changes through the framework
of a pilot program would be a prudent step toward accommodating and
meeting changes that are occurring in the traditional markets.
In this regard, one commenter noted that this proposal is
consistent with the Commission's sustained efforts to enhance the
competitiveness of the U.S. futures markets. A second commenter noted
favorably that the proposal recognizes that certain sophisticated
market participants, although enjoying the benefits and enhanced safety
of exchange trading, do not necessarily require the full panoply of
protections and regulatory provisions.
Significantly, the NYMEX, a futures exchange which joined in the
original CBT section 4(c) petition, stated its belief that the
structure of the program set forth by the Commission generally strikes
the correct balance for establishing an exempt exchange-style market.
In its view,
[s]everal of the areas from which the Commission declined to
grant exemptive relief are areas that * * * require regulation in
the context of an exchange-traded marketplace, where participants
are brought together in a blind-match system and the clearinghouse
provides the ultimate source of credit and financial backing.
Other commenters, including, in particular, the other futures
exchanges which commented on the proposal, were of the opinion that the
Commission did not go far enough in extending relief under the proposed
rules, particularly in light of the restrictions on market access. The
CME commented, in particular, that the proposed scope of the exemption
was too narrow to allow U.S. futures exchanges to compete effectively
against over-the-counter (``OTC'') markets and foreign futures
exchanges.
One commenter, a commodity trading advisor (``CTA''), urged the
Commission to consider expanding the proposed relief to reduce any
unwarranted regulatory costs that might be imposed on an exchange-style
swaps trading and clearing facility. A futures industry trade
association noted that the proposed Part 36 rules would provide relief
predominately in the relatively narrow context of trading practices,
and recommended that the Commission consider implementing broader
exemptive relief for institutional users of the futures markets.
Finally, certain government regulators commenting on the proposed
rules, although generally urging caution, recognized that a pilot
program was an appropriate framework for proceeding. In particular, the
Board of Governors of the Federal Reserve System (``Federal Reserve
Board'' or ``Board'') noted that it supported the Commission's use of
its authority to grant exemptions to classes of products and market
participants for which many of the Act's requirements are unnecessary
or burdensome. The Board further stated, however, that exemptions of
the breadth contemplated by the exchange petitions could have
unintended effects on market integrity, and urged the Commission to
take a cautious approach in applying its exemptive authority to
exchange-traded instruments.
The Securities and Exchange Commission (``SEC'') also urged
caution, stating that although the SEC would not support every element
of proposed Part 36, a pilot program would offer the Commission an
opportunity to evaluate the entire Part 36 approach in a controlled
environment. The United States Department of Labor (``Department of
Labor'') stressed that, although the Department of Labor believed that
the exemption, as proposed, raises several issues regarding ERISA plan
investment in the exempted transactions, by purchasing contracts
covered by this exemption rather than over-the-counter (OTC) contracts,
plan fiduciaries may secure additional protection for plan assets. The
Pilot program would offer several of the advantages of OTC
transactions, while operating in an exchange-type environment with its
clearinghouse function, transparent pricing, reporting requirements,
daily settlement, heightened liquidity and reduced credit risk.
In general, although opinion was divided between those commenters
who urged caution in proceeding and those who urged the Commission to
provide greater regulatory relief, few, if any, were of the opinion
that the Commission should refrain from according some form of the
proposed relief to markets that limit access to eligible participants.
Based upon the agreement of the commenters that the proposed
exemption's general direction was correct, the Commission is
promulgating final rules adding a new Part 36. These final rules
establish a three-year pilot program to permit limited-access contract
markets which have differing regulatory requirements, tailored to the
nature of the market's participants. However, based upon its careful
consideration of all of the comments received, and particularly in
light of the many comments received raising technical issues or making
specific recommendations regarding various of the proposed rules, the
Commission has determined to make various modifications to the proposed
rules. These specific modifications are highlighted below, along with a
discussion of the corresponding public comment.
[[Page 51327]]
V. Final Rules
A. Duration and Scope of Exemption
1. Pilot Program
A key feature of the Commission's proposal was its implementation
as a three-year pilot program, beginning when the first contract trades
pursuant to these rules. See Proposed section 36.1(a). The Commission
noted that a pilot program would provide an opportunity to test the
operation of the exemption, determine the effect of section 4(c)
contract market transactions on the integrity of the marketplace as a
whole, and determine whether continued trading under the exemption
would be in the public interest. The Commission further noted in the
Notice of Proposed Rulemaking that it and other agencies had
successfully used the concept of a pilot program. For example, the
Commission used a pilot program to reintroduce exchange-traded
commodity options.10
\10\ 46 FR 54500 (Nov. 3, 1981).
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Most commenters supported the concept of implementing the Part 36
exemption provisions on a trial basis. Many agreed with the
Commission's reasoning that a pilot program would allow the exchanges
to test the operation of the exemption, while also allowing the
Commission to assess the impact of the exemption on the operation of
the markets as a whole. Some commenters stated that, in light of the
legitimate potential regulatory concerns in exempting exchange-traded
transactions from substantive provisions of the Act, the use of a pilot
program would be an appropriate means of encouraging market innovation
without limiting the Commission's ability to add later limitations or
modifications as needed to maintain market integrity.
While generally endorsing the concept of a pilot program, several
commenters asked the Commission to clarify that ongoing trading
activity would not terminate automatically at the end of the three-year
period and to clarify the effect on outstanding section 4(c) contract
market transactions should it determine to terminate the pilot program.
These commenters noted that section 4(c) contract market transactions
could be listed for maturities of five years or longer. Market
participants, they reasoned, would not be comfortable trading these new
instruments if trading possibly could be suspended or terminated prior
to the instruments' maturity, leaving no opportunity to unwind open
positions. These commenters suggested that the Commission begin its
evaluation during the probationary three-year period to avoid any
potential disruptions in an established market, and, if the program
were not made permanent, provide a mechanism for a smooth transition
into the traditional contract market framework. Finally, one commenter
suggested that the Commission clarify the criteria it plans to use in
evaluating the success of the pilot program.
The Commission continues to believe that the introduction of
section 4(c) contract markets on a pilot basis is appropriate. As the
Commission stated previously, the trial nature of this program reflects
the Commission's belief that the exemption constitutes a significant
departure from the regulatory scheme under which futures and option
contracts have been trading for over 70 years. The pilot program will
enable the Commission to obtain market experience on which to base any
permanent program. A pilot program also will permit the Commission to
make modifications or adjustments consistent with the program's trading
and regulatory experience.
Since section 4(c) contract market transactions might have terms
providing for expiration beyond the end of the three-year pilot
program, the Commission agrees with the commenters' views on the need
for market certainty. Accordingly, the Commission plans to review the
program and whether to make it permanent well before the end of the
three-year pilot period. As part of its review, the Commission intends
to evaluate whether to extend or otherwise alter the exemptive relief
granted herein. The Commission also will consider whether to expand the
exemptive relief provided by these rules to other transactions or
markets. Any Commission decision to terminate the program will be based
on a finding that trading in section 4(c) contract market transactions
has adversely affected the ability of the Commission to discharge its
regulatory responsibilities or the ability of a contract market to
discharge its self-regulatory duties under the Act or that a permanent
program for such transactions would not be consistent with the public
interest and the purposes of the Act. Should the Commission determine
to terminate the program, all previously listed section 4(c) contract
market transactions would be permitted to continue trading until their
expiration; however, no new section 4(c) contract market transactions
with more distant expirations could be listed.
2. Scope of the Exemption
a. Scope of the Relief
The Commission set forth the proposed scope of the exemption with
respect to section 4(c) contract market transactions in proposed
section 36.1(b), stating that each board of trade on which such
transactions are traded would be deemed to be a contract market.11
As such, they would be required to comply with all provisions of the
Act and Commission rules, except for those provisions which are
``specifically inconsistent'' with Part 36.12
\11\ The Commission's proposal did not limit contract markets
eligible to provide a facility for trading in Section 4(c) contract
market transactions to current contract markets. New markets wishing
to offer a facility for such transactions would be required to
comply with those provisions of the Act and Commission rules
governing a board of trade seeking an initial designation as a
contract market. Accordingly, among other things, a prospective
Section 4(c) market must submit all rules relative to matters such
as governance, disciplinary and arbitration proceedings, and
financial requirements under the current provisions of Section
5a(a)(12) of the Act, 7 U.S.C. 7a(a)(12). 59 FR 54139, 54143, 54144.
\12\ 59 FR 54139, 54143, 54151.
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The three petitioning exchanges (CBT, CME and NYMEX) commented that
the structure of the proposed exemption created ambiguity with regard
to what was included within its scope. The CBT requested that the
Commission specify all of the statutory and regulatory provisions
superseded by Part 36. In contrast, NYMEX requested that the Commission
specify only those sections of the Act and Commission rules to which
the section 4(c) exemption would be inapplicable. At a minimum, the CBT
suggested that the word ``specifically'' be deleted from the phrase
``specifically inconsistent,'' stating that without that deletion,
market participants might be less able to ascertain what legal
requirements apply.
The Commission has considered carefully these comments and has
determined that the scope of the exemption is generally appropriate, as
proposed. If Part 36 does not specifically exempt section 4(c) contract
market transactions from a statutory or regulatory provision, there is
no exemption from that provision. However, the provisions of Part 36
govern the trading of section 4(c) contract market transactions in the
following specified areas: section 36.3 (trading rules); section 36.4
(listing of transactions); section 36.5 (reporting requirements);
section 36.6 (registration requirements); and section 36.7 (risk
disclosure). Also, section 36.9 provides for anti-fraud and anti-
manipulation prohibitions in addition to those
[[Page 51328]]
applicable to section 4(c) contract market transactions under the Act
and Commission Rules 33.9 and 33.10.13 All other provisions of the
Act and Commission rules, including those related to, among other
things, segregation of customer funds, adjusted net capital (except for
the capital requirements of certain IBs as discussed infra),
supervision, bankruptcy (see discussion infra), exchange emergency
actions, reparations proceedings and private rights of action, will
continue to apply.
\13\ The remainder of Part 36 sets forth the duration of the
exemption (36.1(a)), definitions for purposes of Part 36 (36.1(c)),
mandatory conditions and prohibited transactions (36.2) and a
procedure for suspension or revocation of the exemption (36.8).
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Nevertheless, the Commission, as discussed below, is modifying
section 36.3 to provide greater specificity with respect to the trading
procedures that are permissible under this exemptive relief. Moreover,
in responding to the public comment on the proposed rules, the
Commission has provided guidance on the scope and operation of the
exemption beyond that which was provided in the Notice of Proposed
Rulemaking.
b. Definitions
Several commenters held opposing views regarding the nature of the
instruments to be included within the proposed broad definition of
``section 4(c) contract market transaction,'' 14 In adopting Part
36, the Commission is exercising its authority under section 4(c) of
the Act, 7 U.S.C. 6(c), to exempt certain instruments and transactions
from certain provisions of the Act and Commission rules. Accordingly,
the proposed definition of ``section 4(c) contract market transaction''
is included to make clear that an election by a contract market to
trade an instrument on a section 4(c) contract market pursuant to the
Part 36 exemptive system will be deemed to be an election to submit
that instrument to the Act and Commission rules in accordance with this
Part.15
\14\ Proposed Section 36.1(c)(1) defined a ``Section 4(c)
contract market transaction'' as ``[a]ny agreement, contract, or
transaction (or class thereof) entered into on or subject to the
rules of a contract market in accordance with the provisions of this
Part, and that is executed by a member of the Section 4(c) contract
market that is an eligible participant for its own account, or a
futures commission merchant or floor broker for its own account or
on behalf of an eligible participant.''
\15\ Any instrument meeting the criteria of Part 36, except for
those specifically excluded thereunder, could be eligible to trade
under these rules. See H.R. Rep. No. 978, 102d Cong., 2d Sess. 82-83
(1992).
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In addition, an industry trade association expressed concern that
proposed section 36.1(b) may have created an ambiguity regarding the
treatment of these transactions under the United States Bankruptcy
Code. According to the commenter, the absence in proposed section
36.1(b) of the words ``designated as'' before the phrase ``a contract
market within the meaning of the Act'' could leave open to question the
applicability of the special protective provisions 16 of the
Bankruptcy Code with respect to commodity broker bankruptcies in the
context of section 4(c) contract market transactions.17
\16\ The commenter noted that these provisions are designed to
enhance the integrity of the futures markets by preventing the
trustee of an insolvent customer or FCM from, among other things,
(1) avoiding contractual obligations, (2) rescinding transfers of
margins and positions, or (3) impeding the liquidation of defaulted
contracts.
\17\ See 11 U.S.C. 761-766. Presumably, this conclusion could be
based upon the Commission's definition of ``commodity contract'' for
purposes of its Bankruptcy Rules, which incorporates by reference
Section 761(4) of the Bankruptcy Code. See, Commission Rule
190.01(g). The Bankruptcy Code defines ``commodity contract'' as a
``contract for the purchase or sale of a commodity for future
delivery on, or subject to the rules of, a contract market or board
of trade'' (11 U.S.C. 761(4) (A) and (D)) and defines a ``contract
market'' as a ``board of trade designated as a contract market by
the Commission under the Act.'' 11 U.S.C. 761(7) (emphasis added).
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The Commission intends that its Part 190 Bankruptcy Rules will
apply in the context of Part 36.18 To remove any perceived
ambiguity, the Commission is modifying the language of the final rule
as suggested by the commenter. Accordingly, the Commission is adding to
section 36.1(b) the words ``designated as'' before the phrase ``a
contract market within the meaning of the Act.''
\18\ See 59 FR 54139, 54144.
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c. Eligible Participants
As proposed, the definition of a ``section 4(c) contract market
transaction'' included the requirement that an agreement, contract, or
transaction be executed by, or on behalf of, an ``eligible
participant.'' Proposed section 36.1(c)(2) defined ``eligible
participant,'' by setting forth a list of those individuals and
entities permitted to trade section 4(c) contract market transactions.
This list, with several additions tailored to the operation and
structure of this particular market, was modeled on the list of
``appropriate persons'' set forth in section 4(c)(3) (A) through (J) of
the Act, and on the definition of ``eligible swap participant'' under
Part 35 of the Commission's Rules. However, as proposed, the definition
of ``eligible participant'' under Part 36 differed in several respects
from the definition of ``eligible swap participant'' under Part 35. The
proposed differences related to employee benefit plans, municipalities,
and certain types of investment vehicles. The Commission also sought
comment on whether the definition of ``eligible swap participant''
under Part 35 should be conformed to the proposed revisions. Many of
the comments focused on these proposed revisions, which are discussed
in greater detail below.
i. Employee Benefit Plans
As proposed, section 36.1(c)(2)(vii) would have limited employee
benefit plans eligible to participate in section 4(c) contract market
transactions to those subject to the Employee Retirement Income
Security Act of 1974 (``ERISA''), or similar foreign plans, with total
assets exceeding $5 million and (rather than the ``or'' provided in
section 4(c)(3)(G) of the Act and in section 35.1(b)(2)(vii)) whose
investment decisions were made by a bank, trust company, insurance
company, investment adviser (``IA'') under the Investment Advisers Act
of 1940, or a CTA under the Act.19 The Commission specifically
sought comment concerning whether there is an asset level for an
employee benefit plan which should qualify it as an eligible
participant irrespective of whether its investment decisions are made
by a bank, trust company, insurance company, IA or CTA and whether Part
36 should be conformed to Part 35 in this regard.
\19\ The Commission's proposed asset floor for an eligible
employee benefit plan in this context, $5 million, was five times
the $1 million asset floor for an employee benefit plan set forth in
section 4(c)(3)(G) of the Act, but the same as specified under the
Part 35 swaps exemption.
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Several commenters, including three exchanges, an industry trade
association and a bar association committee, stated the view that Part
36 should conform to the existing language of Part 35, so that those
currently eligible to participate in swap transactions also could
participate in section 4(c) contract market transactions. Moreover, the
Department of Labor and the FIA opposed this revision in the proposed
rule, reasoning that requiring an employee benefit plan to use a bank,
trust company, insurance company, IA or CTA to make its investment
decisions with respect to section 4(c) contract market transactions
would create burdens for large sophisticated plans that manage plan
assets in-house.
The Commission has carefully considered these comments in the
context of the Act and Part 35 and does not believe that it should be
more difficult for an employee benefit plan to
[[Page 51329]]
participate in a transaction under Part 36 than in an exempt swap
transaction under Part 35. In adopting section 36.1(c)(2)(vii),
therefore, the Commission is substituting the word ``or'' for the
proposal's ``and.'' Accordingly, employee benefit plans with total
assets exceeding $5 million will not be required to have their
investment decisions with respect to section 4(c) contract market
transactions made by a bank, trust company, insurance company, IA or
CTA.
The Department of Labor also objected to the level of the asset
floor set forth in proposed Rule 36.1(c)(2)(vii). Although it
recognized that this threshold is five times that set forth in section
4(c)(3)(G) of the Act, it stated its belief that $5 million is too low
a threshold to be an accurate gauge of sophistication or understanding
of complex financial instruments. The Department recommended that the
asset floor for an employee benefit plan be $50 million if an outside
investment advisor is used and $100 million, otherwise. The SEC,
without setting forth a specific dollar amount, also advocated a
substantially higher threshold.
The Commission has carefully considered these comments, but does
not believe that it is appropriate to make the threshold amount higher
for section 4(c) contract market transactions than for OTC transactions
exempted under Part 35. However, it should be emphasized that Rule
36.1(c)(2)(vii) sets forth minimum standards for eligibility. As the
administrator of ERISA, the Department of Labor can establish a higher,
controlling standard of eligibility for participation in section 4(c)
contract market transactions by employee benefit plans subject to
ERISA.20
\20\ An association representing state and local finance
officers requested clarification whether proposed Section
36.1(c)(2)(vii) included both private and public employee benefit
plans. In adopting Section 36.1(c)(2)(vii), the Commission notes
that the rule includes the phrase ``subject to ERISA.'' Because
ERISA does not cover public employee benefit plans, such plans are
not encompassed in Section 36.1(c)(2)(vii), but rather would be
included under Section 36.1(c)(2)(viii), as an instrumentality,
agency or department of a governmental entity or subdivision,
thereof. See note 22 infra.
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ii. Municipalities
In proposing section 36.1(c)(2)(viii), the Commission questioned
whether municipalities should be included as eligible participants and,
if so, whether any limitations on their participation would be
appropriate. All of those commenting on the issue, except for the SEC,
strongly supported the proposed inclusion of municipalities as eligible
participants without limitation. An association of state and local
government finance officials opined that, although certain government
entities have experienced trading losses, municipalities as a class are
no more or less sophisticated than other types of eligible
investors.21 Several commenters further reasoned that limitation
of the investment authority of municipalities is a function more
appropriately reserved to the various states. In contrast, the SEC
expressed concern that there are no qualifying standards for
municipalities, noting that municipalities are not included in the
definitions of ``qualified institutional buyer'' under SEC Rule 144A or
``accredited investor'' under SEC Regulation D.22
\21\ Orange County, California, recently suffered trading losses
of approximately $1.7 billion, primarily from transactions in
government securities and governmental agency obligations and
declared bankruptcy in December 1994. The commenter noted, in this
regard, that Orange County would have been considered a
sophisticated investor by any common measure.
\22\ 17 CFR 230.144A and 230.501(1995), respectively. However,
any plan established and maintained by a state, its political
subdivisions, or any agency or instrumentality of a state or its
political subdivisions, for the benefit of its employees, shall be
deemed a ``qualified institutional buyer'' if it owns at least $100
million in securities of issuers that are not affiliated with the
plan, and shall be deemed an ``accredited investor'' if it has total
assets in excess of $5 million. 17 CFR 230.144A(a)(1)(i)(D) and
230.501(a)(1)(1995), respectively.
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After carefully considering the comments, the Commission is
persuaded that, as a matter of state/Federal comity, it should continue
to refrain from precluding the participation of municipalities in
exempt transactions. This policy applies both to section 4(c) contract
market transactions and to exempt swap agreements under Part 35 of the
Commission's rules. Accordingly, the Commission is adopting section
36.1(c)(2)(viii) as proposed.
Nevertheless, the Commission has emphasized in several reports,
Congressional testimony and administrative proceedings, that all
institutions, including municipalities, need to establish and implement
strong internal controls and risk management practices with respect to
financial market transactions. The Commission also notes that
representatives of the President's Working Group on Financial Markets
23 have met with representatives of various state and local
government associations to discuss sharing and disseminating
information on appropriate investment guidelines for governmental
entities, and to promote their use. The Commission and its staff stand
ready to meet with such associations or any other appropriate entity to
pursue the development of such guidelines or to otherwise provide
information concerning risk management practices relevant to the
exchange markets subject to its supervision. The Commission also will
provide further guidance on the responsibilities of FCMs for
supervision of such accounts.
\23\ The Working Group includes the Secretary of the Department
of the Treasury and the Chairs of the Federal Reserve Board, the SEC
and the CFTC.
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iii. Other Entities
Proposed Part 36 specifying the list of eligible participants for
section 4(c) contract market transactions also included certain
technical or clarifying changes from that used in defining eligible
swap participants under Part 35. Many, if not all, commenters were of
the view, however, that conformity between the two exemptions should be
maintained, to the greatest degree possible. In light of these views,
the Commission, in adopting section 36.1(c)(2) has attempted to conform
the substance, and the language, of Part 36 to that of Part 35,
wherever possible. In a few instances, however, the final Part 36 rules
do not mirror precisely their counterparts in Part 35.
For example, as proposed, section 36.1(c)(2)(iv) required that to
be an eligible participant, investment companies be regulated under the
Investment Company Act of 1940 (``ICA'') or subject to foreign
regulation, provided that such investment company was not formed solely
for the purpose of constituting an eligible participant and has total
assets exceeding $5 million. This proposed rule differs from its Part
35 counterpart defining investment companies as eligible swap
participants by including a $5 million asset floor and by the language
requiring that the investment company be regulated under the ICA,
rather than subject to regulation.24
\24\ Compare proposed 36.1(c)(2)(iv) with Section 35.1(b)(iv).
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In adopting section 36.1(c)(2)(iv), the Commission has modified the
proposal to refer to investment companies subject to regulation under
the ICA, more closely conforming the provision to its Part 35
counterpart.25 This modification
[[Page 51330]]
will permit hedge funds,26 which although subject to the ICA are
generally excluded from regulation under it, to qualify as eligible
participants. The $5 million asset floor, however, which applies to
commodity pools under both Part 36 and Part 35,27 is being adopted
under section 36.1(c)(2)(iv).28 In all other respects the
substance of section 36.1(c)(2)(iv), as adopted, conforms to its
counterpart under Part 35.
\25\ The Commission is also adopting similar conforming changes
to the language of Section 36.1(c)(2)(v), relating to commodity
pools. Specifically, the language requiring that, to be an eligible
participant, a commodity pool be formed and operated by a person
regulated under the Act, is being modified to read subject to
regulation. The remaining conditions, that the commodity pool is not
formed solely for the purpose of constituting an eligible
participant and has total assets exceeding $5 million are already
consistent with Part 35, and are being adopted as proposed.
\26\ The term ``hedge fund'' is now commonly used to refer to a
wide array of private collective investment vehicles, usually
organized as limited partnerships and organized so as to avoid the
application of most securities laws.
\27\ See, 17 CFR 35.1(b)(2)(v) (1995).
\28\ The $5 million asset floor being adopted under Section
36.1(c)(2)(iv) will apply to hedge funds even though there is no
comparable requirement for eligibility under Part 35. The Commission
believes, however, that this slight difference in the definitions
will not disadvantage any hedge funds seeking to participate in
Section 4(c) contract market transactions and provides for
consistent treatment under Part 36 for commodity pools and hedge
funds with respect to the imposition of an asset floor.
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The provisions of proposed section 36.1(c)(2)(vi), which would
apply to a corporation, partnership, organization, trust, or other
entity, would have required that such an entity not be formed solely
for the purpose of constituting an eligible participant, and have
either (1) assets exceeding $10 million, or (2) a net worth of $1
million and that the transaction be entered into in connection with the
conduct of the entity's business or to manage the risk of an asset or
liability owned or incurred in the conduct of the entity's business or
reasonably likely to be owned or incurred in the conduct of its
business. The proposed Part 36 rule differed from the Part 35 provision
in two respects. First, proposed section 36.1(c)(2)(vi) did not include
a provision similar to that of section 35.1(b)(2)(vi), which permits
the entity to be an eligible swap participant by obtaining a guarantee
of the obligation of the party under the swap agreement in lieu of
meeting the $10 million asset test. However, because all section 4(c)
contract market transactions will be guaranteed by a clearing
organization, the ability to obtain a guarantee is not a measure of
counterparty creditworthiness, and hence the alternative guarantee test
of swap eligibility is inapplicable to section 4(c) contract market
transactions. Accordingly, the final Part 36 rule continues, as
proposed, to differ in this respect from Part 35.29
\29\ The proposed rules also differed from Part 35 to the extent
they did not impose specific financial requirements on floor brokers
and floor traders. Such requirements were not imposed based on the
Commission's understanding that any floor broker or floor trader
would, by necessity, be a member in good standing of the 4(c)
contact market whose transactions thereon would be guaranteed by an
exchange clearing member. The Commission's understanding in this
regard was confirmed by one exchange. A second exchange expressed
its view that exchange rules adequately address such financial
matters. Accordingly, at this time, the Commission sees no need to
impose explicit clearing member guarantee or financial requirements
on floor brokers and floor traders.
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The second difference between the proposed Part 36 rule and its
Part 35 counterpart was a clarification in section 36.1(c)(2)(vi) that
commodity pools, investment companies or hedge funds qualify for
exemptive relief under the specific eligibility provision applicable to
them, and not under the more general provision of subsection (vi). The
Commission's inclusion of the phrase ``other than a commodity pool or
other collective investment vehicle'' in proposed subsection (vi) was a
technical clarification, and was not intended as a substantive change
to the exemptive framework.
However, in order to maintain consistency between the language of
Parts 36 and 35 to the greatest degree possible, the Commission is not
including this additional, clarifying language in section
36.1(c)(2)(vi). Nevertheless, the Commission intends that to be deemed
an eligible participant in a section 4(c) contract market transaction,
an investment company or a hedge fund must qualify under section
36.1(c)(2)(iv), and a commodity pool must qualify under section
36.1(c)(2)(v). The Commission interprets Part 35 similarly, so that to
qualify as an eligible swap participant, an investment company or hedge
fund must meet the standards of section 35.1(b)(2)(iv), and a commodity
pool must meet the standards of section 35.1(b)(2)(v). These specific
provisions are the only avenues through which a commodity pool,
investment company or hedge fund can qualify as an eligible participant
for section 4(c) contract market transactions under Part 36, or as an
eligible swap participant under Part 35.30
\30\ Section 36.1(c)(2)(vi) cannot be used to abrogate the
limits on commodity pool or other collective investment vehicle
eligibility. Section 36.1(c)(2)(vi) (B) and (C) only apply to an
entity engaged in risk management or commercial conduct that has a
principal business other than serving as a passive investment
vehicle and is not intended to be available to passive investment
vehicles like commodity pools, investment companies or hedge funds.
See also, Section 35.1(b)(2)(vi)(C).
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B. Conditions on Transactions Which Are Included Under Part 36
As summarized above, transactions included within the proposed Part
36 exemption were required to meet a number of additional conditions.
Specifically, proposed section 36.2 required that section 4(c) contract
market transactions provide for cash settlement, be cleared through a
clearing organization, not involve domestic agricultural commodities,
not involve a previously designated futures or option contract, and not
involve futures or option contracts subject to the provisions of
section 2(a)(1)(B) of the Act. The comments submitted on each of these
conditions are discussed below.
1. Cash Settlement
The Coffee, Sugar & Cocoa Exchange, Inc. (``CSCE'') objected to the
requirement as proposed in section 36.2(a)(1) that the settlement or
delivery of section 4(c) contract market transactions be in cash or by
means other than transfer or receipt of a commodity. The CSCE opined
that requiring cash settlement would limit section 4(c) contract market
transactions to economically inferior contracts in those instances
where a physical delivery contract may be superior to a cash settled
contract. The CSCE further reasoned that because access to section 4(c)
contract markets is limited to sophisticated traders, who presumably
have greater familiarity with the procedures for making or taking
physical delivery, there is less reason to restrict the availability of
physical delivery contracts under the exemption.31
\31\ A commenter stated that a physical delivery commodity
futures contract, in fact, may require that certain documents,
rather than the actual commodity itself, be transferred at the time
of delivery. The commenter noted that these documents create a
subsequent contractual agreement to deliver the physical commodity
and therefore such contracts should be eligible to trade as Section
4(c) transactions. The Commission disagrees. Most ``physical
delivery'' contracts provide for the transfer of documents (e.g.,
warehouse receipts, shipping certificates, vault receipts, etc.) as
part of the delivery process. However, the ultimate satisfaction of
such contracts is by physical delivery of the commodity pursuant to
exchange-specified rules. Thus, the fact that documents are
transferred as a means of executing the delivery process does not
qualify such contracts for Section 4(c) transactions, because
settlement ultimately would not be in cash or means other than
transfer or receipt of a commodity, as required by Rule 36.2(a)(1).
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The Commission disagrees with this view. To the contrary, the
Commission notes that, in its experience, most surveillance problems
have arisen in the context of market congestion relating to the
delivery of physical commodities. Generally, in order to minimize the
possibility of market congestion or manipulation, the Commission
evaluates the adequacy of deliverable supplies and delivery procedures
during its review of contract market
[[Page 51331]]
applications for designation. Section 4(c) contracts, however, will not
be required to undergo such a review process. Accordingly, the
Commission believes that restricting eligible section 4(c) contract
market transactions to those that do not involve physical delivery of a
commodity is a prudent measure to mitigate concerns regarding the
delivery process and deliverable supplies. That is not to say, however,
that after gaining experience with the trading of section 4(c) contract
market transactions during the pilot program, the Commission will not
revisit this issue for all, or certain classes of, commodities.
The proposed limitation on the physical delivery of commodities on
section 4(c) contract market transactions did contain an exception for
the physical delivery of a ``major foreign currency.'' The CME
suggested that the restriction of this exception to ``major'' foreign
currencies should be removed from the final regulations. It reasoned
that the need for risk management by participants in markets for many
of the ``non-major'' currencies is as great, if not greater, than in
the major currency markets. In its view, the rule, at a minimum, should
be revised to clarify the meaning of ``major currency,'' a term
otherwise undefined in the proposed rules. The CME suggested that
``major'' currencies include all currencies for which there are no
legal impediments to delivery or cash settlement and in which a
sufficiently liquid spot market exists.
The Commission disagrees with the commenter that physical delivery
should be permitted on a section 4(c) contract market for any foreign
currency, no matter how thin its cash market. To the contrary, the cash
market for a foreign currency must be sufficiently liquid and unimpeded
by legal restraints to permit its ready delivery. Otherwise, the
contract would be susceptible to manipulation, price distortion or
default. Indeed, it was based upon this reasoning that the Commission
initially proposed to limit the exception to physical delivery of
``major foreign currencies.''
However, the Commission agrees that the proposed rule's use of the
undefined term ``major currency'' needs clarification. The final rule,
therefore, substitutes the descriptive criteria suggested by the
commenter for the term ``major currency.'' That is, physical delivery
is permitted in section 4(c) contract market transactions for foreign
currencies which have no legal impediment to such a delivery and for
which there exists a sufficiently liquid cash market.
2. Clearing and Related Financial Integrity Issues
a. Clearing
Because the exemption deems all section 4(c) contract markets to be
designated as contract markets, the Commission also proposed to require
that section 4(c) contract markets maintain a clearing facility subject
to Commission oversight, and that the rules of the clearing
organization be submitted to the Commission for approval pursuant to
section 5a(a)(12)(A) of the Act.32 The Philadelphia Stock Exchange
(``PHLX''), commented that the Commission should apply this requirement
``flexibly.'' According to the PHLX, the Commission should permit, for
example, transactions cleared by a registered securities clearing
agency pursuant to a comparable regulatory scheme.
\32\ The term ``contract market'' includes a clearing
organization that clears trades for the contract market. Commission
Rule 1.41(a)(3).
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As the Commission noted in its Notice of Proposed Rulemaking, in
proposing these rules it did not intend:
to limit contract markets in section 4(c) contract market
transactions to current contract markets or exchanges. In order to
qualify, such an entity would be treated similarly to a board of
trade seeking an initial designation as a contract market.
59 FR at 54144. Nevertheless, the Commission believes that all section
4(c) contract markets should be subject to direct Commission oversight
and enforcement of all of the self-regulator's rules, particularly
those regarding the financial integrity of the transactions.
Accordingly, although a clearing agency registered under a comparable
regulatory scheme such as that administered by the SEC would be
eligible to clear section 4(c) contract market transactions under Part
36, the entity would, nonetheless, also be required to qualify as a
clearing organization under the CEA and Commission rules, clear for a
board of trade which has been designated as a section 4(c) contract
market, and submit its rules for approval to the Commission pursuant to
section 5a(a)(12)(A) of the Act.
In addition to those questions relating to the clearing of section
4(c) contract market transactions,33 several commenters raised a
variety of issues relating to the financial integrity requirements
applicable to all designated contract markets. Under the proposed pilot
program, these financial integrity requirements would be applied to
section 4(c) contract markets. Commenters noted that the Commission did
not propose, in the context of this section 4(c) exemption, any
modifications to these requirements and requested various forms of
relief.
\33\ The CME suggested that the Commission permit the clearing
of Part 36 transactions on a faster schedule or otherwise in a more
innovative fashion than that provided for traditional designated
contract markets. This issue is discussed below, as it relates to
trading rules. As a general matter, however, the Commission believes
that, for all markets, whether traditional or exempt under Part 36,
an expeditious clearing system, by reducing the time during which
transactions are unsettled and the parties at risk, is crucial to
minimizing systemic risks. Accordingly, although Section 4(c)
transactions generally may be part of the same clearing regimen as
non-exempt transactions, nothing in the Part 36 rules would prohibit
faster or more innovative clearance of these instruments.
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b. Segregation of Customer Funds
For example, the CME, both in its petition and in its comments on
proposed Part 36, asserted that the requirement of Commission Rule 1.20
to segregate all customer funds is not necessary to ``the smooth and
safe functioning of the Rolling Spot Futures Contracts.'' 34
However, segregation of customer funds is a cornerstone of the
Commission's customer protection and financial integrity framework. In
light of its importance to safeguarding customer funds, the Commission
is not prepared to grant relief from the segregation requirement.
\34\ 58 FR 43424-25.
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The CBT requested that the Commission grant an exemption for
section 4(c) contract market transactions from Commission Rule 1.25,
which the CBT describes as a rule prohibiting an FCM from investing
customer funds in anything other than U.S. government
securities.35 The CBT views the permissible investments under Rule
1.25 as unduly restrictive and stated that there are other liquid
investments, such as corporate investment grade bonds, that would be
safe, appropriate investments of customer funds. The CBT stated that
exchanges should be allowed to determine how customer funds deposited
with an FCM in connection with trading on these exempt markets can be
invested.36
\35\ In fact, Rule 1.25 also permits customer funds to be
invested in certain municipal securities, subject to staff
interpretations that such investments must be liquid. Rule 1.25
provides in pertinent part that ``[n]o [FCM] and no clearing
organization shall invest customer funds except in obligations of
the United States, in general obligations of any State or any
political subdivision thereof, or in obligations fully guaranteed as
to principal and interest by the United States.'' See also CFTC
Interpretative Letter No. 86-21, [1986-1987 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para.23,266 (Sept. 17, 1986).
\36\ As an alternative to exemption from Rule 1.25, the CBT
suggested that the Commission specify an expanded range of
permissible investments of customer funds. If this approach were
adopted, the CBT believes it should be available with respect to all
funds deposited with an FCM by an eligible participant under Part
36, without regard to whether the customer is trading exempt or
traditional contracts.
[[Page 51332]]
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The Commission believes that it is inappropriate to grant the
requested relief from Rule 1.25 at this time. That rule derives from
the statutory limitations set forth in the final proviso of section
4d(2) of the Act. The investment limitations are intended to assure
that the pool of customers' funds remains safe, liquid and available
for distribution to customers on demand or, following an FCM's
bankruptcy, to facilitate transfers to another firm should that become
necessary.
The Commission envisions that customer funds related to section
4(c) contract market transactions will be commingled with other
customer funds in a combined pool of segregated funds and would be
treated as funds of customers involved in traditional futures contracts
in the event of an FCM's bankruptcy. Therefore, it is inappropriate and
impracticable to apply provisions different from the general provisions
of section 4d(2) of the Act and Commission Rules 1.20-1.30, 1.32 and
1.36 concerning segregation of customer funds to section 4(c) contract
market transactions. However, as a consequence of the failure of
Barings PLC, the Commission, joined by regulators and self-regulators
worldwide, currently is reviewing the safeguarding of customer funds,
both domestically and internationally, to determine if statutory or
regulatory changes are appropriate.
Two commenters also suggested that required subordination
agreements relating to customer funds held in foreign depositories be
limited. In 1988, the Division of Trading and Markets issued Financial
and Segregation Interpretation No. 12 to permit funds of United States-
domiciled customers to be segregated in foreign depositories subject to
conditions intended generally to prevent the dilution of customer funds
held in segregation in the United States in the event that an FCM
holding segregated funds offshore became bankrupt.37 Among other
requirements, the FCM must obtain a customer's authorization to deposit
its funds into a foreign depository. The customer also must agree in
writing that, in the event the FCM is placed in bankruptcy and there
are insufficient funds in a foreign currency to satisfy customer claims
in that currency, the customer will subordinate its claim attributable
to funds held offshore in that particular foreign currency to the
claims of customers whose funds are held in dollars or other foreign
currencies.
\37\ 53 FR 46911 (Nov. 21, 1988), reprinted in 1 Comm. Fut. L.
Rep. (CCH) para.7122. Prior to 1988, the Commission required
segregated funds to be held in the United States except for certain
funds of foreign-domiciled customers.
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Commenters also suggested that the Commission limit the
applicability of the subordination requirement of Interpretation No. 12
with respect to section 4(c) funds. Specifically, one commenter
suggested that a subordination agreement should be required only in
``cases where access to funds held in a foreign depository is subject
to potential restriction by foreign governmental authorities or
agencies.''
The Commission believes that there is no basis for applying a
different standard in requiring subordination of section 4(c) and non-
section 4(c) segregated funds. However, as noted above, the Commission
is reviewing this and other requirements contained in Interpretation
No. 12 in response to the recent collapse of Barings and to address
issues that have developed since Interpretation No. 12 was first
published.38 Any revision of the current safeguards for funds held
outside the United States on behalf of customers trading on futures
exchanges in the United States likely will be uniform across section
4(c) and non-section 4(c) contract markets.
\38\ For example, the Federal Reserve Board did not allow banks
in the U.S. to accept deposits denominated in foreign currencies
until January 1990.
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c. Margining of Customer and Proprietary Accounts
Two commenters raised issues regarding the margining of section
4(c) contract market transactions. One commenter recommended that the
Commission permit eligible participants initially to cross-margin
section 4(c) contracts, and subsequently to cross-margin section 4(c)
and non-section 4(c) contracts. Although the Commission has not
provided for cross-margining as part of this rulemaking, the Commission
would consider such a feature as part of the pilot program. In this
connection, the Commission notes that it has approved numerous cross-
margining plans for exchange trading, beginning in 1988. Accordingly,
the Commission encourages interested persons to submit a detailed
petition for such a plan during the course of the Part 36 pilot
program.
The second commenter suggested that the Commission allow ``futures-
style'' margining for option contracts. Futures-style margining would
permit the initial purchase of option contracts with a performance bond
or margin payment as currently permitted for futures contracts, rather
than with full payment of the option premium.
Commission Rule 33.4(a) requires payment of the full amount of each
option premium at the time the option is purchased. After that rule was
adopted, the issue of whether ``futures-style'' margining is also
appropriate for options was raised, culminating in publication in the
Federal Register of two petitions to repeal Rule 33.4(a)(2).39
Although a number of supportive comments were submitted, many also
opposed the concept. The pilot program for the trading of section 4(c)
contract market transactions presents an ideal opportunity to test
prudently, within the confines of a limited-access market, the
potential benefits and risks of futures-style margining. Accordingly,
the Commission has determined, in principle, to permit ``futures-
style'' margining for section 4(c) option transactions under the Part
36 pilot program, and will consider any such proposals submitted.
\39\ See 54 FR 11233 (March 17, 1989).
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Finally, an investment banking firm requested clarification of
several technical issues relating to financial integrity requirements.
Specifically, it inquired regarding the terms on which an FCM may
transfer excess funds 40 belonging to the same customer from an
account containing section 4(c) contract market transactions to an
account containing traditional contracts, e.g., whether a separate
signature is required. Because the Commission will treat customer funds
related to section 4(c) contract market transactions the same as those
of traditional futures contracts for segregation purposes, it would be
unnecessary to maintain separate accounts for section 4(c) and
traditional contracts of the same customer.
\40\ The commenter did not define the term ``excess funds.'' The
Commission uses the terms ``excess funds'' and ``free funds'' to
mean the amount by which the net liquidating equity in an account
exceeds the initial margin requirement for the positions in that
account.
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The commenter also expressed the view that although customer and
proprietary positions in section 4(c) contract market transactions
should be accounted for in the same fashion as in non-exempt futures
and option contracts, to the extent that positions in section 4(c)
contract market transactions may be margined differently than non-
exempt futures and options transactions, a different adjusted net
capital treatment might be appropriate. The Commission reiterates that
the general financial and segregation rules applicable to non-exempt
futures and
[[Page 51333]]
option contracts will apply in the same manner to section 4(c) contract
market transactions.41
\41\ For example, the same distinctions between customer and
proprietary transactions will apply for segregation and adjusted net
capital purposes, so that the amount of customer funds related to
Section 4(c) transactions will be included in the calculation of an
FCM's minimum adjusted net capital requirement. Proprietary
positions in such transactions will be subject to the same haircuts
as proprietary positions in traditional contracts when an FCM
computes its adjusted net capital. To the extent that Section 4(c)
contract market transactions result in more long-dated transactions
or in transactions with features, such as embedded options, which
are substantially different from customary futures contracts, the
Commission will reassess the continued efficacy of its capital
requirements and make appropriate adjustments. Separately, the
Commission may consider whether adjustments are appropriate in light
of responses to the SEC's concept release on capital. 58 FR 27486
(May 10, 1993). In addition, the Commission recently held a
roundtable on capital issues, generally.
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3. Excluded Commodities
The scope of the section 4(c) exemption was proposed to be further
limited by its inapplicability to transactions in certain, identified
commodities and by the general restriction that a section 4(c) contract
market transaction could not be offered for a contract previously
designated as a traditional contract market. Two commenters objected to
section 36.2(a)(3)'s proposed prohibition of section 4(c) contract
market transactions on specified domestic agricultural
commodities.42 The CME and the CSCE noted that the Commission did
not propose to prohibit section 4(c) trading in many other physical
commodities already trading as non-exempt futures and options, such as
sugar, coffee, copper, crude oil, lumber, and scrap metal. Any
distinction between these two classes of physical commodities,
according to the commenters, would be artificial.
\42\ The rule, however, does allow for Section 4(c) transactions
on a broad index of these enumerated commodities.
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The Commission disagrees. The commodities excluded from eligibility
under proposed section 36.2(a)(3) are those agricultural commodities
specifically enumerated in section 1a of the Act. The Commission is of
the opinion that these commodities share certain characteristics
relating to their underlying cash markets and the seasonality of their
production, which make different treatment appropriate. As the
Commission noted in the Notice of Proposed Rulemaking, the enumerated
agricultural commodities are treated differently, as a class, in other
contexts, as well. For example, the Commission directly administers
speculative position limits under Part 150 of its rules only for these
commodities. In light of the apparent ability of the currently
designated contract markets in these commodities to fulfill the price
basing and hedging needs of market users and the untested operation of
the Part 36 rules, the Commission believes that caution requires that
these commodities be excluded from the pilot program. The Commission
will reconsider this determination when it evaluates the success of the
pilot program.
The Commission also proposed to exclude any transaction subject to
section 2(a)(1)(B) of the Act, 7 U.S.C. 2, including stock index
futures contracts, from the scope of the exemptive rules.\43\ In
contrast to the SEC, which specifically concurred with this part of the
proposal, PHLX commented that:
\43\ See Proposed Section 36.2(a)(5). See also 59 FR at 54145.
nothing in the section 2(a)(1)(B) limitation on section 4(c)
[prevents] the Commission from permitting a securities exchange that
obtains a designation tailored to its special circumstances or a
contract market affiliate of a securities exchange to trade stock
index futures contracts or analogous products meeting the special
criteria for futures contracts on groups or indexes of securities in
a securities-style environment pursuant to the requirements of the
1934 Act, as long as the SEC has an opportunity to express its views
on such contracts in accordance with the provisions of section
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2(a)(1)(B).
Accordingly, PHLX asserted that the proposed exclusion of section
2(a)(1)(B) commodities was overly broad and should be narrowed or
deleted in the final rules and that these issues be addressed in the
context of individualized requests for exemptive relief.
Section 2(a)(1)(B) commodities raise particular issues in light of
the nature of the underlying cash market and the special procedures
that apply to designation of these commodities. Accordingly, the
Commission continues to believe that inclusion of these commodities in
a pilot program is inappropriate and has determined not to further
revise section 36.2(a)(5) at this time. The Commission may reconsider
the issue in the future, depending upon its regulatory experience.
More generally, the Commission proposed to limit section 4(c)
contract market transactions to transactions which do
not involve any commodity futures contract or commodity option for
which any board of trade has been designated by the Commission * * *
prior to its application to trade as a section 4(c) market
transaction, unless it can reasonably be distinguished * * * based
on its hedging function and/or pricing basis.44
\44\ Proposed Section 36.2(a)(4) is intended to address, among
other things, the concerns expressed by some commenters regarding
the problems of a two-tier marketplace. Although the CME and CBT
have indicated that they do not intend to trade the same contract on
both a Section 4(c) contract market and a traditional contract
market, this provision would prevent a Section 4(c) contract market
transaction from trading if the same traditional contract were
already trading on a contract market.
The Commission explained that it will base determinations as to
whether proposed section 4(c) contract market transactions can be
``reasonably distinguished'' from existing contracts on the same
considerations that it now applies in deciding whether proposed futures
and options contracts are treated as separate designation applications,
and provided several examples of instruments that are ``reasonably
distinguishable'' from existing contracts. 59 FR 54145.45
Nevertheless, several commenters complained that the Commission's
inclusion of examples of acceptable section 4(c) contract market
transactions is not adequate to prevent misapplication or
misinterpretation of the rule's terms. They suggested that the rule be
amended to set forth a brighter line delineating those transactions
which could be traded under Part 36.
\45\ In that regard, however, Section 36.2(a)(4) specifically
states that five- and ten-year interest swap futures and option
contracts, rolling spot and currency forward futures and option
contracts and flexible options may be listed as Section 4(c)
transactions.
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The Commission believes that further enumeration of specific
standards or commodity characteristics defining the universe of
permissible section 4(c) contract market transactions would
unnecessarily restrict the exchanges' and the Commission's flexibility
for innovation under the proposed rules. Because the universe of
eligible section 4(c) contract market transactions is so broad--
including a wide range of diverse tangible commodities, financial
instruments and indexes--a comprehensive listing of eligibility
standards likely would be incomplete, failing to address questions
regarding novel section 4(c) contract market transactions that may be
designed in the future. Moreover, a detailed listing of eligibility
requirements could have the unintended effect of excluding certain
types or classes of contracts or commodities from the exemption. For
these reasons, the Commission believes that a broad standard based on
two fundamental economic characteristics of futures contracts--their
hedging function or the basis on which they are priced--will provide
maximum flexibility to the exchanges in
[[Page 51334]]
developing new section 4(c) contract market transactions, while
maintaining the goal of the rule to avoid two-tiered, identical markets
trading under two differing regulatory regimes.46
\46\ One commenter specifically requested that the Commission
clarify whether a contract based on cash-settled North Sea crude oil
or a contract based on cash-settled West Texas Intermediate (WTI)
crude oil would be considered ``reasonably distinguished'' from the
existing light sweet crude oil futures contract which provides for
physical delivery of, and for which the pricing basis represents,
WTI. Regarding the former, North Sea crudes are distinct from WTI,
having different (albeit related) pricing characteristics, so that a
WTI-based crude oil contract may not meet the hedging needs of firms
having positions in North Sea crudes. Accordingly, Section 4(c)
transactions would be permitted for cash-settled North Sea crude
oil, since the hedging and pricing functions of these transactions
would be distinguished from the existing designated WTI-based crude
oil contract. In contrast, a cash-settled WTI crude oil contract
would not be permissible, since there should be no material
difference in the pricing basis of the contracts (both would reflect
the value of WTI crude oil at Cushing, OK) and the hedging uses
provided by each contract would be identical.
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On a related issue, the CME suggested that even if the Commission
concludes that the proposed standard separating exempt and non-exempt
markets were appropriate, the mere existence of a similar, previous
contract market designation is an overly-broad criterion. The comment
suggested that the prohibition should apply only to contracts that have
open interest at the time a Part 36 market proposes to list the section
4(c) transaction; otherwise, competing exchanges could stymie
innovation by obtaining traditional contract market designations for
markets which are never listed for trading.
The Commission agrees that this comment has merit. The Commission
intends that the above provision only limit the trading of two-tiered
markets, and does not intend for it to be a means of forestalling
competition. Accordingly, the Commission is modifying the restriction,
limiting the availability of the Part 36 exception only to contracts
that are trading at the time a board of trade proposes to list for
trading a section 4(c) contract market, rather than to all designated
contract markets. Traded contracts are those in which any transactions
occurred during the six complete consecutive calendar months preceding
the date of application to trade a section 4(c) contract market.47
\47\ The six-month period is consistent with the time period
specified in Commission Rule 5.2 for classifying designated contract
markets as ``dormant,'' after which Commission approval is required
to reactivate trading. However, the Commission is not including as a
condition for Section 4(c) eligibility, Rule 5.2's five-year grace
period, which commences at designation, during which a designated
market is exempt from being considered ``dormant.''
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4. Speculative Position Limits
Finally, an exchange commenter opined that the Commission should
exempt section 4(c) contract markets from the requirement under Rule
1.61 that they set and administer speculative position limits. The
commenter reasoned that enforcing speculative limits would serve little
purpose in light of the requirement that all section 4(c) contract
markets (except for foreign currencies) be cash-settled.
As the Commission articulated in the Notice of Proposed Rulemaking,
Commission Rule 1.61 already is applied quite flexibly, permitting the
exchanges to substitute various position accountability rules for
speculative position limits for many futures and option contracts.
However, commenters have argued forcefully that OTC markets and foreign
exchanges enjoy a competitive advantage by generally not providing for
any type of position accountability or position limit rules. The
Commission, nevertheless, continues to believe that these types of
rules provide the exchanges with a useful and flexible tool for
addressing market surveillance concerns.
In any event, based upon the continuing perception of some industry
sources that the existence of these rules on U.S. futures exchanges is
an actual source of competitive disadvantage, the Commission, by adding
a new subsection (b) to section 36.2, is exempting section 4(c)
contract markets from the requirements of Rule 1.61. However, the
decision of an exchange to discard this particular device from its
surveillance tool chest does not, in any way, diminish the exchange's
responsibilities under the Act to assure orderly markets. Accordingly,
exchanges remain free, as a matter of exchange discretion, to apply
position accountability or speculative position limit rules to section
4(c) contract markets.
C. Trading Rules and Procedures
1. The Proposed Rule
Proposed section 36.3 would have permitted a board of trade to
submit for Commission approval flexible trading procedures for section
4(c) contract market transactions which were not required to comply in
all respects with existing competitive trading requirements and other
trading standards relative to the exposure of orders and trades. The
proposal represented a substantial change in the principles underlying
the required method of trading futures and futures option contracts in
that it would have allowed the execution of section 4(c) contract
market transactions without exposing such transactions to competition
in the pit. The proposal would have permitted exchanges, under a pilot
program that would provide some relaxation in competitive trading
requirements for certain market participants, to develop new trading
procedures designed to address the needs of their increasingly
institutional market participants and to compete more aggressively with
the OTC market. The proposal also would have required exchange
compliance with certain regulatory safeguards in order to maintain
essential market and appropriate customer protection.
After reviewing the comments to proposed section 36.3 and customer
protection rules in other markets, the Commission has determined to
adopt section 36.3, modifying it from the proposal to address certain
comments. As adopted, section 36.3 provides a framework of safeguards
intended to set forth non-exclusive conditions for the execution of
section 4(c) contract market transactions. Section 36.3 would permit
expeditious review of exchange rules without prejudicing the ability of
the exchanges to request Commission approval of other procedures
pursuant to the usual rule approval procedures under section
5a(a)(12)(A) of the Act and Commission Rule 1.41(b). Effectively, the
Commission is establishing a framework of safeguards for transparent,
negotiated off-floor/ex-pit trading. Experience with the permitted
procedures may be required to determine whether other or different
limitations are necessary or whether the type of activity that should
be deemed to be in violation of the applicable anti-fraud rule should
be further specified. Therefore, the Commission intends to evaluate its
experience with contract market rules adopted under section 36.3 twelve
months after such rules become effective and to propose, if necessary,
modifications or limitations to the parameters for section 4(c) trading
rules set forth herein to address any market problems which it
observes.
Paragraph (a) of proposed section 36.3 provided that a board of
trade could submit for Commission approval section 4(c) contract market
trading rules to permit trading procedures for section 4(c) contract
market transactions that do not satisfy all of the requirements of
Commission Rules 1.38(a), 1.39, 155.2, 155.3 and 155.4. Paragraph
(b)(3) of the proposed regulation, however, required compliance with
Commission Rules 155.2, 155.3 and 155.4 to the extent applicable.
[[Page 51335]]
2. Specific Exemptive Relief
Two commenters requested that the Commission provide increased
specificity with regard to the kinds of transactions that could be
executed using section 4(c) contract market trading procedures.
Specifically, the FIA stated that it would be helpful ``if the
Commission would further set out the kinds of core trading practices it
believes would be acceptable in the exempt exchange markets.'' The CBT
stated that the ``proposal would be greatly improved if the agency
could provide some concrete idea of the kinds of procedures that would
be acceptable under the exemption.'' The CBT further recommended that
the Commission make explicit in its exemptive relief whether trading
opposite customer orders and matching trades between customers or
between customers and FCMs would be permitted.
The Commission believes that these comments have merit and has
modified the trading rules requirements to provide explicit relief in
the form of a safe harbor from the requirements of sections 4b(a)(iv),
4b(b) and 4c(a) of the Act, 7 U.S.C. 6b(a)(iv), 6b(b), and 6c(a), and
Commission Rules 1.38(a), 1.39, 155.2, 155.3 and 155.4 for section 4(c)
contract market transactions executed using ``special execution
procedures'' in accordance with exchange rules that meet certain
standards and are permitted to become effective by the Commission. For
section 4(c) contract market transactions, such special execution
procedures could permit noncompetitive bids, offers, negotiation and/or
execution of such orders and transactions.
Subject to the requirement that they satisfy certain specified
Commission recordkeeping and audit trail requirements, the Commission
would allow exchange rules providing special execution procedures to
become effective. These special procedures would permit a member to
trade for his own account opposite the account of another
member,48 permit an FCM or floor broker to take the opposite side
of a customer order for its own account, or permit the execution of
customer orders of different principals directly between customer
accounts.49 The Commission also would allow to become effective
exchange rules that permitted the execution of section 4(c) contract
market transactions using any combination of special execution
procedures and competitive on-floor trading procedures provided that
certain additional requirements were satisfied.50
\48\ Section 36.3(b).
\49\ Section 36.3(c).
\50\ Section 36.3(d). Any section 4(c) contract market
transactions executed competitively on-floor must comply with
applicable Commission regulations and exchange rules that currently
govern competitive on-floor trading.
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Exchanges also may submit for Commission review and approval,
pursuant to the usual rule approval procedures contained in section
5a(a)(12)(A) of the Act, and Commission Rule 1.41(b), other section
4(c) contract market rules which do not conform to the specific trading
standards set forth in section 36.3 and which do not satisfy the
requirements of the Act and Commission regulations with regard to
competitive trading requirements and other trading standards relative
to the exposure of orders and trades.
In this regard, the Commission has provided greater specificity to
give further content to the type of flexibility it intends to provide
the exchanges to adapt trading procedures to new products, technology
and market circumstances without sacrificing important customer and
market protections. For example, it is the Commission's belief that
boards of trade designated as section 4(c) contract markets could have
market makers with affirmative obligations, specialist systems, ``all
or nothing'' large-trader execution procedures and other trading
procedures currently not necessarily consistent with Rules 1.38 and
1.39. The Commission would, however, expect the exchanges to have
procedures to protect the integrity of pricing and to monitor
compliance with the conditions and limitations of the relief as set
forth herein, consistent with the affirmative obligations of exchanges
to enforce compliance with existing exchange and Commission rules.
a. Recordkeeping and Audit Trail Requirements
As previously stated, all transactions executed using special
execution procedures must satisfy certain recordkeeping and audit trail
requirements. Paragraph (e)(1) of section 36.3 requires that the
contract market provide for record maintenance and retention consistent
with Commission Rule 1.31. The audit trail for all transactions
executed using special execution procedures must meet the books and
records, trade register, trade timing, and contract market oversight
requirements of Rules 1.35(a), (e), (g) and (i), respectively.51
In addition, the recordkeeping requirements set forth in Commission
Rule 1.38(b), which requires the special identification of such
transactions, must be satisfied for all transactions executed using
special execution procedures. This is intended to permit identification
of such transactions as different from regular contract market
transactions for price discovery purposes.
\51\ In order to meet the trade timing requirement for
transactions executed using special execution procedures, the
contract market rule must specify that the actual time of execution
must be recorded and reported to the exchange immediately following
the execution.
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b. Customer Orders and Disclosure Requirements
Customer orders that could be executed using special execution
procedures, i.e., where the FCM or floor broker takes the opposite side
of a customer order for its own account or executes orders directly
between customer accounts of different principals, would be required to
satisfy certain recordkeeping and disclosure requirements in lieu of
those now set forth in Commission Rules 1.39, 155.2, 155.3 and 155.4,
but in addition to those required where members trade opposite each
other.
The exchanges' rules must prohibit the FCM or floor broker from
disclosing customer order information for purposes other than to
facilitate the execution of that order. The exchanges' rules also must
require that an FCM or floor broker provide certain disclosure to
affected customers. Before the FCM or floor broker executes the first
transaction using special execution procedures for a particular
customer, he must provide the customer with a description of such
procedures and, in particular, describe how such procedures differ from
competitive on-floor trading procedures. The Commission believes that
the FCM or floor broker should be required to make such disclosure to
the customer only once, prior to the first transaction executed under
such procedure for that customer, and that the disclosure should focus
primarily on the differences relative to the method of determining the
price at which the transaction is to be executed. Thus, although
permitting certain practices which currently are prohibited in the
exchange environment, these rules nevertheless will provide a greater
degree of regulatory protection than is the case for similar OTC
transactions.
FCMs and floor brokers executing customer orders also would be
required to satisfy certain audit trail and recordkeeping requirements
in that the FCM or floor broker must create and maintain a written
record, such as an office order ticket, reflecting each customer order.
The record must
[[Page 51336]]
include customer account identification, order number, time of order
receipt and, in addition, must include in the terms of the order, some
price-specific instruction provided by the customer.
The Commission is adding the requirement that the customer provide
some price-specific instructions or indications to assure that the
customer has had an opportunity to determine a price at which the
transaction should be executed, in that exchange markets, unlike OTC
markets, contemplate agency as well as principal-to-principal
transactions. The Commission notes that, unlike trading on most other
markets and the futures exchanges,52 there will be no published or
otherwise open or publicly, readily available bid or offer prices for
transactions executed using special execution procedures.53 The
only pricing data that would be publicly available to the customer is
the post-execution report of previous transactions, required to be
disseminated by paragraph (e)(2) of Rule 36.3.54
\52\ Trades executed directly between customers, in the
securities ``fourth market,'' do not have any price reporting or
other pricing requirements.
\53\ Unlike auction markets or markets with designated market
makers, prices for transactions using special execution procedures
would be determined through negotiation. Nonetheless, Exchange rules
could require that members maintain and disseminate bid and offer
prices.
\54\ Certain trades executed by affiliated investment companies,
however, have a pricing restriction imposed by Regulation 17a-7, 17
CFR Sec. 270.17a-7 (1995). Under this regulation, transactions that
are (1) at current market prices, (2) between certain affiliates,
and (3) reviewed by the affiliates' boards, are exempt from the
prohibition against affiliated investment company transactions
contained in Section 17 of the Investment Company Act of 1940.
Pension law also imposes some restrictions on transactions between
affiliated entities. The exchanges may want to impose their own
restrictions on the pricing of affiliated transactions in this
market in order to attract customers who operate under such
restrictions.
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Under these circumstances, the Commission believes that requiring
some price indication, rather than just specifying ``market price,''
for instance, provides a means to help the customer determine whether
the FCM or floor broker is fulfilling his fiduciary duty to exercise
due diligence in the execution of the customer's order. It also is
intended to improve the enforceability of section 36.9, which prohibits
fraud and manipulation in connection with section 4(c) contract market
transactions.
The customer-provided, price-specific information could take
various forms. A ``limit order'' or an order that contains a specific,
negotiated price at which the customer wants the order to be executed
may be examples of such information. A customer-provided maximum price
on a buy order or minimum price on a sell order also would fulfill the
requirement. In addition, where special execution procedures may be
used to fill large orders that cannot be filled in a single
transaction, thereby requiring partial executions at different times
and prices to obtain a complete fill, a customer-provided range of
acceptable prices at which transactions could be executed to fill the
order would meet the requirement.
In proposing section 36.3, the Commission indicated that
regulations for which exchange alternatives could be submitted include
the audit trail requirements of Commission Rule 1.35.55 A
Commission Administrative Law Judge urged the Commission not to amend
Commission Rule 1.35(a-1), which generally requires FCMs, introducing
brokers and contract market members to identify customer accounts upon
receipt before the trades are executed.56 According to this
commenter, ``[e]ven the most sophisticated clients will be unable to
protect their own interest if the Commission omits th[is] very tool
such clients would use to detect fraud.''
\55\ 59 FR at 54145.
\56\ This commenter also made a passing reference to Rule
1.35(a-2), but did not provide any further explanation.
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The Commission agrees that customer account identification can be
an important component in detecting customer abuse. The information
required to be recorded on the written record that must be created by
the FCM or floor broker for each section 4(c) contract market customer
order exceeds that required by Commission Rule 1.35(a-1). In addition
to account identification, order number and time of order receipt, the
written record must include the terms of the order, including, as
previously discussed, some price-specific instructions from the
customer.
c. Combination Transactions
Paragraph (d) of section 36.3 provides that if they meet certain
additional requirements, section 4(c) contract market rules could
permit transactions to be executed using a combination of special
execution procedures and competitive on-floor procedures. The exchange
could require, for example, that some, or all, of any section 4(c)
contract market transactions negotiated using special execution
procedures be exposed to the floor for execution.57 In this
regard, the CSCE commented
\57\ New York Stock Exchange (``NYSE'') Rule 76, which governs
cross trading, requires that a member who has set up a block trade
and is bringing it to the floor to be crossed first announce the
proposed bid, offer, and transaction size to the floor. The member
must then wait a reasonable amount of time to allow the ``crowd''
(including specialists) to trade against either side before
completing the transaction. In addition, NYSE Rule 127 provides that
members who bring block trades to the floor that are priced outside
current quotations must permit the crowd to participate in a portion
of the block. See also NYSE Rule 72, which provides priority to an
agency cross transaction where both orders consist of 25,000 shares
or more. See also SEC Release No. 34-35837 (June 12, 1995)(order
approving proposed NYSE rule changes that prevent members with
knowledge of block orders for execution after the close from
effecting transactions in that stock with the intention of reversing
the position by participating in the contra-side of the block trade
and that require members to establish and maintain procedures
reasonably designed to review block trading activities). that ``it
is inappropriate, in the case where transactions can occur both in
the pit and off the floor, to not require a potential trade to be
exposed to the pit.''
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The Commission believes, however, that the exchanges should be free
to develop approaches that would best serve the identified needs of
their customers consistent with the rule. In this connection, exchange
rules permitting the use of combined procedures would be required to
set forth the circumstances under which such transactions could or
should occur competitively on-floor, i.e., under what conditions, when,
and to what extent any portion of a section 4(c) contract market order
should be exposed to the pit.
Of course, each exchange will continue to have an affirmative
obligation under sections 5 and 5a of the Act and Commission Rules 1.51
and 1.52 to carry out a program for the enforcement of its rules
relating to the trading of section 4(c) contract market transactions.
This includes, in particular, those rules relating to special execution
procedures and the associated procedures that the exchange has in place
to address the maintenance of orderly markets which are free from fraud
and other abuses. As stated above, the Commission will evaluate its
experience with section 4(c) contract market transaction special
execution procedures after their implementation and determine whether
further specific guidance is necessary or appropriate.
In addition, exchange rules that permit section 4(c) contract
market transactions to be executed using any combination of special
execution procedures and competitive on-floor procedures must provide
that any transaction executed using special execution procedures must
be in compliance with the requirements of paragraphs (b) and (c) of
section 36.3, discussed above. As previously stated, any section 4(c)
contract market transaction executed competitively on-floor must comply
with applicable
[[Page 51337]]
Commission regulations and exchange rules that currently govern
competitive on-floor trading. Finally, an exchange rule that permits
transactions to be executed using such a combination of procedures must
include a specific prohibition against frontrunning between the on- and
off-floor markets.58
\58\ Commission staff reviewed frontrunning prohibitions on
other markets. See, e.g., NYSE/CME Joint Frontrunning Interpretation
(November 27, 1989)(prohibiting trading to take advantage of
material non-public information about a trade in the option, stock,
or stock index futures markets that can be expected to have a
favorable impact on the trading); SEC Release No. 34-27047 (July 19,
1989)(order approving proposed NYSE rule changes that relate to the
Joint CME/NYSE Frontrunning Interpretation); NASD Frontrunning
Policy (prohibiting trading to take advantage of material non-public
information about a trade in the option or stock markets that can be
expected to have a favorable impact on the trading); and NASD
Schedule G, Section 4(f)(1), Trading Practices (prohibiting members
from buying or selling securities while holding unexecuted market or
limit orders).
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Morgan Stanley, among others, commented that the Commission should
clarify the extent to which its relaxation of trading restrictions and,
in particular, the relaxation of restrictions on off-floor discussions
permitted under proposed section 36.3 is applicable to the execution of
positions in non-exempt futures or option contracts which are related
to section 4(c) contract market transactions. For example, although,
under proposed Rule 36.2(a)(4), an exchange would not be able to trade
identical section 4(c) and non-exempt futures or option contracts,
traders may seek to trade on spread relationships between exempt and
non-exempt 4(c) contracts.
The commenter suggested that the trading rules governing section
4(c) contract market transactions should be applicable in instances
where a trading strategy involves both exempt and non-exempt
transactions. The Commission disagrees. Where a trading strategy
involves transactions executed under both special execution procedures
and on-floor competitive procedures, the trader may not rely on its
safe harbor for special execution trading procedures to govern
both,59 although other exchange rules which address this situation
could be submitted for Commission consideration.
\59\ For example, in the case of a spread, the trader could
comply with the competitive on-floor trading procedures applicable
to the non-exempt portion of the spread for both sides, or the
trader could leg into the spread transaction using the particular
trading procedures which are available to each side of the spread.
In any event, the trader could not rely upon the existence of
special execution procedures as the basis for non-compliance with
the rules which are applicable to trading traditional designated
futures and option contracts.
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3. Price Transparency
As the Commission stated in proposing section 36.3, transactions
under this provision must be transparent.60 In that regard,
paragraph (e)(2) of section 36.3 requires the immediate post-execution
report of each purchase and sale transaction executed using special
execution procedures by the member specified by exchange rule and the
dissemination thereof. The required information includes, at a minimum,
price, quantity and contract. The Commission believes that the
dissemination of this information is critical for price basing purposes
and, therefore, has noted in paragraph (e)(2) of the regulation that
special execution transactions may be executed only during hours in
which such immediate post-execution dissemination of price basing
information is available.61 The Commission believes that the
exchanges should determine how best to structure their proposals so as
to assure the integrity of the prices set pursuant to special execution
procedures. The Commission wishes to provide the exchanges significant
flexibility to address this issue. In addition to other appropriate
steps, an exchange could establish a minimum transaction size or could
combine special execution procedures and on-floor procedures. The
Commission also believes that to fulfill their other self-regulatory
obligations, exchanges will have to define monitoring or other
surveillance procedures to ensure compliance with these transaction
reporting requirements.
\60\ 59 FR at 54147.
\61\ In proposing Rule 36.3, the Commission stated the
following: ``To the extent that a proposal for section 4(c) contract
market transactions might provide for trading when the exchange
floor is closed, the Commission would still require the immediate
report and dissemination of that transaction information.'' 59 FR at
54147.
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4. Clearing
Paragraph (b)(5) of proposed section 36.3 would require that
transactions be reported to clearing, and be cleared, on the same
schedule as trades subject to Commission Rules 1.38 and 1.39 or
otherwise be immediately reported to clearing. The CME commented that
the proposal, taken literally, ``would prohibit an exchange from using
a Part 36 product as a testing ground to develop faster and more
accurate procedures for clearing transactions.'' The Commission
believes that this comment has merit and, in paragraph (e)(3) of this
regulation, requires the report to clearing, and clearing, of each
special execution transaction as quickly as practicable, but in no
event later than that required for trades subject to Commission Rules
1.38 and 1.39.62
\62\ The section 4(c) contract market clearing organization
would have an affirmative duty under the Act and Commission
Regulations to enforce its rules, and would be subject to
recordkeeping, documentation, and other applicable requirements.
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5. Price Reporting for Block Trades
The Commission also requested comment on whether to require the
dissemination of separate pricing information for block trades.63
The FIA commented that ``an exchange submitting a proposed block
trading procedure should be afforded the alternatives of including a
separate price reporting system or explaining why one is not
appropriate or necessary to protect the public interest.'' The CME
commented that ``the requirement of a separate ticker for non-standard
trades would be both unnecessary and potentially burdensome.'' The
Commission has determined that the reporting and dissemination of
special execution transactions under existing reporting systems should
be satisfactory so long as special execution transactions are clearly
identified as such when reported and disseminated and such transactions
are executed only during hours when existing reporting systems are
available to make immediate post-execution dissemination. Of course,
exchanges may choose to operate a separate but comparable ticker for
section 4(c) contract market transactions.
\63\ As an example, the Commission noted that the NYSE and its
vendors maintain a separate ``block trade'' ticker which runs
throughout the day and reflects only the size and price of block
trades.
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6. Prohibition Against Fraud and Manipulation
Paragraph (c) of proposed section 36.3 would require that rules
submitted under this section describe the manner in which the rules or
procedures would assure compliance with the provisions of sections 4b
and 4c(a) of the Act prohibiting false reports, frontrunning, misuse of
information, fictitious sales, wash sales, and abuse of customer
orders. This paragraph has been replaced by paragraph (e)(4) of section
36.3.64 This new paragraph requires that rules submitted under
this section provide for compliance with section 36.9, which prohibits
fraud and manipulation in connection with section 4(c) contract market
transactions, except that any trade executed using special execution
procedures need not be executed in
[[Page 51338]]
compliance with section 4b(a)(iv) of the Act.
\64\ With regard to customer orders, paragraphs (c) and (d) of
the regulation provide more guidance as to what activity the
Commission would consider to be prohibited.
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Section 36.9 provides, among other things, that it shall be
unlawful to cheat, defraud or deceive or attempt to cheat, defraud or
deceive any other person or to willfully make any false report or
statement. The Commission believes that compliance with these
provisions, when combined with compliance with the other specific
customer protection provisions included in section 36.3, should provide
for appropriate customer protection safeguards. Rules submitted
pursuant to paragraph (c) of section 36.3, which would permit customer
order transactions to be executed using special execution procedures,
require a specific prohibition against the improper disclosure of
customer order information. Rules submitted pursuant to paragraph (d)
of Rule 36.3 which would permit transactions to be executed using
combined special execution and on-floor competitive procedures, require
a specific prohibition against frontrunning. Further, these safeguards
apply in a market already limited to specified eligible participants.
In addition, the Commission believes that it is important to
provide examples of trading activity that would be permissible and
activity that could constitute fraud and customer abuse in violation of
section 36.9. It would be permissible to engage in anticipatory
hedging. An FCM or floor broker would be allowed to cover when he took
the opposite side of a customer order. It would not be permissible for
an FCM or floor broker executing transactions using special execution
procedures to take the opposite side of a customer order when doing so
would deny the fill to another customer. For example, if an FCM or
floor broker were to receive matching buy and sell orders from
different customers, the FCM or floor broker should not take the
opposite side of one of the customer orders if doing so would result in
the inability to fill the order of the other customer. It also would
continue to be impermissible for an FCM or floor broker to trade ahead
of a customer order to the disadvantage of that order.65
\65\ With certain exceptions, trading ahead of customer orders
recently has been restricted in the OTC securities markets. On May
22, 1995, the SEC issued Securities Exchange Act Release No. 35751
(May 22, 1995), 60 FR 27997 (May 26, 1995), an order approving a
proposed rule change submitted by the National Association of
Securities Dealers, Inc., (``NASD'') relating to limit order
protection on NASDAQ. The rule change amended NASD's interpretation
to Article III, Section 1 of the NASD Rules of Fair Practice. The
interpretation generally provides that a member firm cannot accept a
limit order in a NASDAQ security from its own customer, or from a
customer of another member, and continue to trade that security for
its own account at prices that would satisfy the customer limit
order without filling that order at the limit order price or at a
price more favorable to the customer. Limit orders for retail
customers that involve 10,000 shares or more and a value of $100,000
or greater are exempt from this prohibition, as are limit orders of
any size for institutional accounts. The NASD Rules of Fair Practice
define an institutional account as an account of a bank, savings and
loan association, insurance company, or registered investment
company; a registered investment adviser; or any other entity
(whether a natural person, corporation, partnership, trust, or
otherwise) with total assets of at least $50 million. (``Release 34-
35751''). See also NYSE Rule 92 (limiting members' trading when they
hold an unexecuted customer order); NASD Schedule G, Section
4(f)(1), Trading Practices (prohibiting members from buying or
selling securities while holding unexecuted market or limit orders);
and CBOE Rule 6.73 (requiring a floor broker to handle an order
using due diligence to execute the order at the best price available
to him).
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7. Safe Harbor Provision
Paragraph (f) of section 36.3 enunciates the ``safe harbor''
provisions of the regulation. Transactions in exempt contracts executed
in compliance with special execution procedures contained in exchange
rules that are permitted to become effective shall not be deemed to be
in violation of sections 4b(a)(iv), 4b(b) or 4c(a) of the Act or
Commission Rules 1.38(a), 1.39, 155.2, 155.3 and 155.4. Transactions in
exempt contracts that are not executed in compliance with such exchange
rules shall be deemed to be in violation of section 36.3.
8. Procedures for Permitting Rules to Become Effective
Section 36.3 provides for expedited procedures under which section
4(c) contract market trading rules may be permitted to become
effective. Pursuant to paragraphs (g) (1) and (2) of the regulation,
section 4(c) contract market trading rules must be submitted to the
Commission for review prior to becoming effective. Such rules may
become effective ten days after receipt by the Commission unless the
Commission, within that ten-day period, notifies the submitter that the
proposal does not meet the conditions of this section. Pursuant to
paragraph (g)(4) of section 36.3, any subsequent proposed modifications
of such rules consistent with this section shall be subject to the same
expedited Commission review procedures. In the event that the trading
rules, or subsequent modifications thereof, are not permitted to become
effective, they shall be subject to the usual rule approval procedures
under section 5a(a)(12)(A) of the Act, 7 U.S.C. 7a(12), and Commission
Rule 1.41(b).
Paragraph (g)(3) of section 36.3 provides for expedited review of
certain large order execution procedures. If a contract market submits
for review large order execution procedures for section 4(c) contracts
which are substantially similar to procedures approved by the
Commission pursuant to Commission Rule 1.39 for non-section 4(c)
contracts, then such procedures shall be deemed effective upon
Commission receipt thereof.
Proposed exchange clearing and financial integrity rules are not
eligible for review under these expedited procedures and, thus, are
subject to the usual rule approval procedures under section
5a(a)(12)(A) of the Act, 7 U.S.C. 7a(12), and Commission Rule 1.41(b).
In addition, pursuant to paragraph (g)(5), exchanges may submit for
Commission review and approval, pursuant to the usual rule approval
procedures contained in section 5a(a)(12)(A) of the Act and Rule
1.41(b), other section 4(c) contract market rules which do not conform
to the specific trading standards set forth in section 36.3 and which
do not satisfy the requirements of the Act and Commission regulations.
D. Listing Procedures
The proposed rules specify a 10-day notification requirement prior
to listing new section 4(c) contract market transactions. Most
commenters supported the proposed 10-day notification requirement.
Several commenters further suggested that a 10-day period should apply
to all exchange-traded contracts or to certain categories of such
contracts, such as financial futures and options. One commenter stated
that the Commission should allow new section 4(c) contract market
transactions to become effective, and to begin trading, immediately
following the Commission's receipt of notice. This commenter further
noted that, if the Commission thereafter determines that trading in a
new section 4(c) transaction violates the listing standards in Rule
36.2, the Commission could take appropriate measures, suspending
trading without a prior adjudication, pending further review.
The Commission believes that a 10-day advance notification
requirement is appropriate. This limited period should allow
flexibility in listing new eligible products without impairing
exchanges' ability to respond rapidly to market situations. The
Commission will evaluate whether the notification period should be
eliminated or revised, and whether the 10-day notification provision
should be extended to certain non-section 4(c) contract market
transactions, when it evaluates trading experience under the pilot
program.
[[Page 51339]]
E. Reporting
Proposed section 36.5(f)(2) would require traders to provide to the
Commission information specified in Commission Rule 18.04 within one
business day following receipt of a special call. Commission Rule 18.04
relates to reports regarding a trader's positions and transactions in a
particular market as well as identifying, and other, information
contained on CFTC Form 40. One commenter questioned whether it is
realistic, and necessary, to expect such information to be furnished by
a large trader in that time frame. The commenter stated that it would
be preferable to rely upon the contract markets and FCMs to provide the
data in such a time-sensitive fashion, noting that a federal regulatory
requirement for recordkeeping by reportable traders would discourage
participation in section 4(c) contract market transactions.
As suggested by the commenter, the Commission normally would rely
on clearing member reports in conducting routine oversight of the
section 4(c) contract markets. However, the Commission believes that
the special call provisions in proposed Rule 36.5(f) are necessary in
order to preserve its ability to respond fully and flexibly to concerns
it may have regarding potential or developing market congestion,
disruptions or other anomalies in section 4(c) contract market
transactions. The Commission plans further to review its information
needs during the course of the pilot program, but notes that prompt
access to large-trader information also has been fundamental to its
effective response to market disruptions posed by financial problems at
firms holding large concentrations of positions.
F. Risk Disclosure, Temporary Licensing, and Dispute Resolution
1. Risk Disclosure
The Commission proposed, in section 36.7, to permit accounts to be
opened for section 4(c) contract market transactions without furnishing
an eligible participant with the basic risk disclosure statements
applicable generally to non-exempt futures and option contracts under
Commission Rules 1.55, 1.65, 33.7 and 190.10,66 or the
Commission's generic risk disclosure statement.67 In lieu of
requiring a specific statement or format, the proviso to proposed
section 36.7(a) would require an FCM or, in the case of an introduced
account, an IB, to furnish an eligible participant with disclosure
appropriate to the particular instrument and the eligible participant
prior to the eligible participant's entry into the first section 4(c)
contract market transaction involving a particular instrument.68
Proposed section 36.7(b) makes clear, however, that these provisions do
not relieve an FCM or IB from any other disclosure obligation it may
have under applicable law.69
\66\ The basic risk disclosure statements are intended to
provide a brief description of some of the risks attendant to
futures and options trading and are designed to be understood by all
customers.
\67\ 59 FR 34376 (July 5, 1994). This statement currently can be
used in the U.S., in the United Kingdom and in Ireland. Several
other jurisdictions are considering its adoption.
\68\ Because Section 4(c) contract market transactions may be
different from traditional futures and option contracts, and are
limited to the eligible participants specified in the rule, the
Commission expressed its belief in proposing Section 36.7 that it
may be preferable to substitute for standard disclosure statements,
such disclosure as may be appropriate to the customer's expertise
and financial capacity. See, 59 FR 54139, 54149-54150.
\69\ The Commission explained that this provision was included
as a reminder that Section 4b of the Act requires all material
information to be disclosed. 59 FR 54139, 54150 & n.47.
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Several commenters addressed this issue. The CBT stated that
proposed section 36.7 leaves to an FCM or IB the flexibility to
determine what level of risk disclosure is appropriate for eligible
participants, thereby freeing FCMs and IBs from having to provide the
CFTC-mandated disclosure forms to new customers, and reducing the
competitive advantage foreign firms now enjoy in the risk disclosure
area. NYMEX also supported proposed section 36.7 as a sensible approach
given the fact that the likely customers of the section 4(c) contract
market will be sophisticated entities.
Other commenters, however, expressed concerns about proposed
section 36.7. A futures industry association stated that because
persons who qualify as eligible participants in section 4(c) contract
market transactions are capable of obtaining whatever information they
need before engaging in such transactions, a specific requirement to
provide disclosure is unnecessary. It also expressed concern, however,
that customers would be bombarded with differing disclosure documents
that could become the basis of lawsuits or arbitration claims. Others
agreed that proposed section 36.7 might create uncertainty, increasing
the risk of litigation without decreasing the burden and volume of
disclosure. They urged the Commission to follow here an approach
similar to Commission Rule 4.7.
The CME recommended that to the extent that any disclosure is
required for eligible Part 36 participants, FCMs and IBs be given the
choice of using either a specially-prepared disclosure document or the
current generic, two-page disclosure statement available for non-exempt
products. Morgan Stanley suggested that FCMs and IBs would prefer a
safe harbor which required them to furnish the basic risk disclosure
statements that are currently generally required, supplemented as
specified by the section 4(c) contract market.
The Department of Labor noted that while the proposed Part 36 rules
would provide relief from providing certain disclosure requirements to
sophisticated investors, pension plan fiduciaries may nonetheless be
required by ERISA to request and obtain much of the otherwise required
information in order to meet their statutory obligations. The
Department further noted that to the extent such information is either
unavailable or difficult to obtain, pension plan investment in exempt
transactions may be adversely affected.
The Commission has carefully considered these comments and has
determined to adopt section 36.7 as proposed. The Commission believes
that this rule provides FCMs and IBs with sufficient flexibility
concerning risk disclosure with respect to section 4(c) contract market
transactions, yet still requires, in accordance with section 4b of the
Act, that all material information be disclosed. The Commission
believes this approach is consistent with that set forth in Rule 4.7.
For those FCMs and IBs seeking guidance in this area, the Commission
believes, as a general proposition, that providing the generic risk
disclosure statement approved in July 1994, together with any
additional risk disclosure developed by the contract market upon which
the section 4(c) contracts are traded, as required hereunder for
special execution procedures, would be appropriate.\70\
\70\ The Commission notes a general trend toward the use of
generic risk disclosure statements for newer products. For example,
the Framework For Voluntary Oversight published by the Derivatives
Policy Group in March 1995 includes on page 37 thereof a guideline
for professional intermediaries on generic risk disclosure which
states that ``[a] professional intermediary should consider
providing new nonprofessional counterparties with disclosure
statements generally identifying the principal risks associated with
OTC derivatives transactions and clarifying the nature of the
relationship between the professional intermediary and its
counterparties.''
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The Commission reiterates, however, that all material information
must be disclosed. Thus, the circumstances relating to a particular
instrument and customer should be considered by an FCM or IB. For
example, to the extent instruments are priced ex-pit, how
[[Page 51340]]
prices are obtained may be relevant in certain cases. This requirement
does not change existing requirements under sections 4b and 4o of the
Act. The Commission particularly notes that the primary relief accorded
to customers trading only in section 4(c) contract market transactions
is the waiver of the acknowledgment requirement otherwise applicable to
non-section 4(c) customers. This relief should materially facilitate
access to such transactions, particularly for offshore customers and
securities customers who are unaccustomed to acknowledging disclosures.
For business or internal control purposes, of course, firms would be
free to retain the acknowledgment procedure.
With respect to ERISA concerns, the Commission notes that section
36.7 does not relieve an FCM or IB from any other disclosure obligation
it may have under applicable law. Thus, to the extent ERISA
requirements pertain to a particular customer, the Commission's rules
should not inhibit an FCM or IB from making appropriate disclosures to
a pension plan fiduciary. Moreover, in contrast to privately created
trading vehicles or instruments, whose specialized characteristics can
be meaningfully disclosed only by their creators, information on the
mechanics of trading of section 4(c) contract market transactions will
be readily available from the listing exchange.
2. Limited Registrations
The Commission proposed section 36.6 to allow special temporary
license, registration or principal listing procedures to be available
to a person associated with an FCM or IB who limits his or her
activities under the Act to section 4(c) contract market transactions.
Proposed section 36.6 would require the person to certify that he or
she is licensed or otherwise authorized to do business and in good
standing with another federal financial regulatory authority or a
foreign financial regulatory authority with which the Commission has
comparability arrangements under the Part 30 rules, and is not subject
to a statutory disqualification from registration under section 8a(2)
of the Act. The Commission indicated that a contract market and NFA
could develop procedures applicable to these persons that would not
require submission of fingerprints and could provide for proficiency
testing requirements other than those generally applicable to
registrants under the Act.\71\
\71\ 59 FR 54139, 54149.
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Several commenters addressed the registration issue. The NFA, which
has been delegated a substantial portion of registration functions by
the Commission, although commending the Commission's desire to
streamline the proficiency testing and fingerprint requirements for
persons who limit activities to section 4(c) contract market
transactions and recognizing the need for flexibility, expressed the
concern that different registration procedures ultimately could be
time-consuming, confusing, and administratively cumbersome. The FIA
agreed, noting, in addition, that it would be difficult for the
industry to develop compliance procedures. The CME reasoned further,
that although such special procedures may be useful in the longrun,
initially they would be costly to develop and would apply to only a
small subset of the industry.
The FIA stated that it was unclear whether the CFTC was conferring
on the NFA the ability to waive proficiency testing completely for the
individuals involved in the sale of section 4(c) products or merely to
establish different tests for different people selling the same
product. In its view, requiring registration and full testing for
certain individuals involved in selling futures and exempt futures
products, yet requiring little or no testing for others, raised issues
of fairness and fair competition. The SEC expressed concern that
securities training for registered representatives of securities
broker-dealers may not be sufficient for purposes of participating in
section 4(c) contract market transactions, and stated that the
registration requirements should be designed to assure that those
licensed have sufficient training to participate in such transactions.
The CBT stated that the Commission should permit the same
unregistered sales force as is permitted to vend OTC swaps under Part
35 to market section 4(c) contract market transactions. Alternatively,
the CBT urged the Commission to grant limited registration to
individuals who intend to sell section 4(c) contract market
transactions upon a showing that the individual or his or her employer
is in good standing with another federal financial regulatory
authority, without requiring Commission registration for the sponsoring
employer.
The CBT further commented that proposed section 36.6 should be
expanded, in any event, because it applies only to associated persons
(``APs'') of an FCM or IB. Employees of non-FCMs or non-IBs, such as
securities broker-dealers or banks, would have to be sponsored by
entities other than their employers. The CBT stated that this would
unduly restrict the potential number of limited registrants able to
market section 4(c) contract market transactions and suggested, as a
remedy, the creation of a ``limited'' IB registration category for
securities broker-dealers or banks in good standing under their
respective federal regulatory schemes.\72\
\72\ Under this approach, a securities broker-dealer, for
example, could qualify as a ``limited IB'' to sponsor its own
employees for limited AP registration status under Part 36. The
securities broker-dealer would have direct supervisory
responsibility over its APs.
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The Commission disagrees with various commenters' recommendation to
delete registration requirements for section 4(c) contract market
transactions sales persons. Registration is a key element in an
effective regulatory and enforcement program. In addition, the
Commission believes that fitness checks and a proficiency testing,
training or experience requirement are necessary.
However, the Commission has determined to adopt the CBT's
alternative suggestion for a ``limited'' IB registration category. Rule
36.6 will allow entities to qualify for limited IB status if they are
in good standing with a federal financial regulator or a foreign
financial regulator. Banks and securities broker-dealers would be
eligible for this special treatment. Insurance companies would not be
eligible under Rule 36.6 because of the large number of state insurance
regulators and the diverse nature of the applicable regulations.
However, the Commission may be willing to entertain proposals developed
by contract markets and NFA to permit flexible procedures for insurance
company participation in section 4(c) contract market transactions.
As the Commission envisions the process, an entity would provide
the NFA with basic identifying information about the firm and its
principals and pay the appropriate processing fee. The applicant would
also certify that (1) it is in good standing with its other regulator,
(2) its principals have filed their fingerprints with the other
regulator, (3) neither it nor its principals are subject to statutory
disqualification from registration under section 8a(2) of the Act, (4)
it will restrict its activities under the Act to section 4(c) contract
market transactions, and (5) it will be liable for all acts, omissions
and failures, and responsible for the diligent supervision, of its APs,
employees and agents in connection with its activities as a limited IB
involving section 4(c) contract market transactions.\73\
\73\ Registration, of course, could continue to be denied,
conditioned, suspended, restricted or revoked under Sections 8a(3)
or 8a(4) of the Act, 7 U.S.C. 12a(3) or 12a(4).
[[Page 51341]]
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A firm would not need to submit fingerprints for its principals if
it provided similar information to its primary regulator and this
information were accessible to the Commission, nor would it be subject
to the minimum financial requirements applicable generally to
independent IBs provided it met the capital requirements of, and was
otherwise in good standing with, its primary regulator. The Commission
believes that the limited nature of an IB's activities, its
responsibility for its employees and good standing with another
financial regulator with such requirements permit waiver of the IB
financial requirements.\74\
\74\ Thus, such an IB would not need to raise its own capital or
enter into a guarantee agreement with an FCM as generally required
for IBs by Commission Rules 1.17(a)(1)(ii) and (a)(2)(ii),
respectively. The Commission believes this is consistent with a no-
action letter issued on December 1, 1994 by the Division of Trading
and Markets, wherein an IB that is a member of various U.K. futures
exchanges and a wholly-owned subsidiary of a U.S. FCM was permitted
to continue to introduce U.S. contract market transactions based on
substituted compliance with U.K. regulatory requirements in lieu of
a guarantee agreement under Commission Rule 1.10(j). The Division
based its position upon, among other things, the IB's status as a
registrant under the Act pursuant to which it is subject to CFTC
requirements including, but not limited to, registration, sales
practice and other conduct of business rules, recordkeeping,
reporting and anti-fraud provisions.
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Customers of a ``limited'' IB, like customers of a regular IB,
would be required to transmit funds for trading directly to an FCM,
which would carry all customer positions on a fully-disclosed
basis.\75\ The IB would be required to sponsor its salespersons, who
would be subject to a proficiency testing, training or experience
requirement, as discussed below. The NFA and the section 4(c) contract
markets would determine the specific format of the information to be
supplied to the NFA.\76\
\75\ Commission Rule 1.57, 17 CFR 1.57 (1995).
\76\ The CBT also stated that the term ``temporary,'' used in
proposed Section 36.6 could suggest impermanence or a transition
period until a final license would be obtained, and that the term
``limited'' more accurately depicts the registration status of those
APs eligible only to market Section 4(c) transactions. The
Commission agrees that, in light of its adoption of the provision
for limited IBs referred to above, it is also appropriate to refer
to APs confining their activities to Section 4(c) contract market
transactions as ``limited APs.'' The Commission notes that limited
APs may also be eligible for a temporary license during the period
that background checks are performed by the NFA.
With respect to testing requirements for limited APs, the NFA
could substitute participation in a training module developed by the
contract market offering the Section 4(c) transactions or an
experience requirement in lieu of the regular, generally applied
proficiency test. This is consistent with the Commission's previous
approval of NFA Registration Rules 401(b), (c), and (d), permitting
persons registered as general securities representatives who
restrict their activities under the Act to register as APs without
taking the generally required National Commodity Futures Examination
(``Series 3 test'') and permitting persons to register if they have
passed the regulatory portions of the Series 3 test and the test of
a foreign futures authority. The Commission expects that the
regulatory portions of the Series 3 test would be included in any
modified testing or training module developed for limited APs
referred to herein. Further, the Commission will entertain
applications to substitute training received in connection with
other regulatory requirements, or to recognize specialized ethics
training, in satisfaction of the training required under Commission
Rule 3.34.
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As discussed above, certain commenters viewed different
registration requirements for each section 4(c) product as potentially
administratively unwieldy. Similar concerns were expressed when the
Commission adopted Rule 3.12(j), upon which proposed section 36.6 was
modeled.\77\ Despite the fact that the Commission has permitted section
4(c) contract markets and the NFA, subject to Commission approval, the
discretion to vary registration procedures on a contract-by-contract
basis, the Commission believes that the special registration procedures
ideally would be substantially identical for the various section 4(c)
contracts, and that it would be preferable to implement uniform
procedures for all such contracts at the outset. As when the Commission
adopted Rule 3.12(j), a contract market seeking special registration
procedures with respect to persons limiting their activities to section
4(c) contract market transactions may consult and develop the
applicable procedures with the NFA and submit them for Commission
consideration in conjunction with the other submissions which must be
filed under this Part. Of course, if a particular contract market or
firm found administration of the alternative procedures too difficult,
it could follow the general provisions applicable to any IB or AP.\78\
\77\ See 57 FR 23136, 23141-23142 (June 2, 1992).
\78\ Persons following the registration procedures which are
generally applicable to transactions under the Act, as well as all
of those already registered under the Act, can be involved in the
offer and sale of Section 4(c) contract market transactions without
being subject to additional registration requirements.
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3. Dispute Resolution
As proposed, all of the provisions of the Act and Commission rules
concerning reparations and private rights of action will continue to
apply under Part 36. 59 FR at 54144. The CBT commented that section
4(c) contract market transactions should be exempt from Commission Rule
180.3(b)(6), 17 CFR 180.3(b)(6)(1995), which prescribes language that
must be included in any pre-dispute arbitration agreement between an
FCM and its customers. The prescribed language essentially notifies the
customer that, notwithstanding the agreement to arbitrate, the customer
can pursue a claim against the FCM through the Commission's reparations
forum.
The CBT reasoned that institutional customers do not need this
protection, ``either negotiat[ing] such rights or elect[ing] not to
sign the pre-dispute arbitration agreement.'' The NYMEX agreed, arguing
that the availability of the reparations forum was unnecessary because
disputes involving section 4(c) contract market transactions would be
``more than adequately addressed by existing exchange arbitration
procedures and comparable NFA procedures.''
The Commission has determined to retain the availability of
reparations as a forum for section 4(c) contract market transaction
participants as well as the notice provisions of Rule 180.3(b)(6).
Although section 4(c) contract market transactions will be entered into
by institutional or relatively ``sophisticated'' participants, the
reparations program was designed as an inexpensive forum where any
customer may seek redress for violations of the Act committed by
industry professionals registered with the Commission. The Commission
sees no reason to eliminate the availability of this dispute resolution
forum.
G. Anti-fraud and Anti-manipulation
The Commission proposed in section 36.9 to apply to section 4(c)
contract market transactions the proscriptions against fraud and
manipulation found in the Act,79 and Commission Rules 33.9(d) and
33.10, 17 CFR 33.9(d) and 33.10, which prohibit price manipulation and
fraud, respectively, in connection with commodity option transactions.
In addition, proposed section 36.9 included a stand-alone prohibition
of fraudulent misconduct in connection with section 4(c) contract
market transactions.
\79\ Specifically, proposed Section 36.9 applied to Section 4c
contract market transactions Sections 4b and 4o of the Act, 7 U.S.C.
6b and 6o, and those provisions of Sections 6(c), 6(d), and 9(a) of
the Act, 7 U.S.C. 9, 15, 13b and 13(a), that prohibit price
manipulation.
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Commenters expressed varying views on the need for a stand-alone
prohibition of fraud in connection with section 4(c) contract market
transactions. Some supported including in Part 36 an anti-fraud
provision separate and independent from the provisions of the Act and
Commission regulations that would, in any event, continue to apply.
Others, however,
[[Page 51342]]
asserted that the existing statutory anti-fraud provisions, i.e.,
sections 4b and 4o, would be adequate as applied to section 4(c)
contract market transactions, and questioned whether it was appropriate
in any event to include a stand-alone anti-fraud provision in Part 36.
In addition, many commenters noted that the text of proposed
section 36.9 could be construed as eliminating the scienter requirement
which has been held to exist in section 4b of the Act. These commenters
observed that the Commission had suggested no policy basis for
eliminating scienter as an element of fraud in connection with section
4(c) contract market transactions, thus imposing a lesser standard of
proof than applicable for futures transactions in general.
The Commission has concluded that a free-standing anti-fraud rule
for section 4(c) contract market transactions is appropriate. Effective
prohibition of fraud is a cornerstone of any fair and efficient market.
While section 4b of the Act provides an adequate tool to address fraud
in traditional futures contract trading, and section 4o adequately
addresses fraud in connection with commodity pool and trading advisor
activities, section 4(c) contract market transactions may involve
innovative trading methods and resources that the courts have not
addressed previously under the statutory provisions. The Commission is
aware of no reason why an additional, comprehensive prohibition of
fraud should not apply to section 4(c) contract market transactions
across the board. Under the rule as adopted, section 4(c) contract
market transactions would be subject to existing prohibitions of fraud
and manipulation whenever applicable and the specific prohibitions in
Rule 36.9.
However, the Commission agrees with commenters who questioned
whether it would be appropriate to have a disparity in scienter
requirements applicable to section 4(c) contract market transactions
and futures markets in general. Accordingly, section 36.9 as adopted
includes the term ``willfully'' in paragraphs (a)(2) and (3), providing
a scienter requirement in section 36.9 parallel to that of section
4b.80 In all other substantive respects, section 36.9 is being
adopted as proposed.81 The Commission notes that actions brought
under section 4o(1)(B) of the Act, whether involving section 4(c)
contract market transactions or other transactions subject to the
Commission's jurisdiction, would continue to be governed by existing
legal standards, which do not require proof of scienter.82
\80\ See Hammond v. Smith Barney, Harris Upham and Co., Inc.,
[1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) para.24,617
(CFTC March 1, 1990).
\81\ In a related matter, the Commission's proposal requested
comment on adopting a stand-alone prohibition of fraud in connection
with swap transactions exempt under Part 35 of the Commission's
rules. The Commission is not at this time adopting such a provision.
\82\ See Messer v. E.F.Hutton & Co., 847 F.2d 673, 679 (11th
Cir. 1988); CFTC v. Savage, 611 F.2d 270, 285 (9th Cir. 1979); and
In re Kolter, [1992-1994 Transfer Binder] Comm. Fut. L. Rep. (CCH)
para.26,262, at 42198 (CFTC Nov. 8, 1994).
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VI. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601 et seq.,
requires that agencies, in proposing rules, consider the impact of
those rules on small business. The Commission previously determined
that contract markets,83 futures commission merchants,84
registered commodity pool operators,85 and large traders 86
should not be considered ``small entities'' for purposes of the RFA.
The Chairman, on behalf of the Commission, previously certified that
the proposed rules would not have a significant economic impact on a
substantial number of small entities. 59 FR 54151.
\83\ 47 FR 18618 (April 30, 1982).
\84\ Id. at 18619.
\85\ Id.
\86\ Id. at 18620.
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In certifying pursuant to section 3(a) of the RFA that the proposed
addition to its rules of Part 36--Exemption of section 4(c) Contract
Market Transactions would not have a significant economic impact on a
substantial number of small entities, the Commission invited comments
from any firm which believed that the proposed rules, if adopted, would
have a significant economic impact on its activities. No such comments
were received.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1980, (``PRA'') 44 U.S.C. 3501 et
seq., 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. In compliance with the
PRA, the Commission previously submitted these rules in proposed form
and their associated information collection requirements to the Office
of Management and Budget. The Office of Management and Budget approved
the collection of information associated with these rules on Jan. 20,
1995, and assigned OMB control number 3038-0047 to the rules. The
burden associated with these specific final rules, is as follows:
Average burden hours per response: 2.88
Number of respondents: 300
Frequency of response: on occasion
Copies of the OMB approved information collection package associated
with this rule may be obtained from Jeff Hill, Office of Management and
Budget, Room 3220, NEOB, Washington, D.C. 20503, (202) 395-7340.
List of Subjects in 17 CFR Part 36
Commodity futures, Commodity options, Prohibited transactions.
In consideration of the foregoing, and pursuant to the authority
contained in the Commodity Exchange Act, and in particular, sections 2,
4, 4c, and 8a, 7 U.S.C. 2, 6, 6c, and 12a, as amended, the Commission
hereby adds Part 36 to Chapter I of Title 17 of the Code of Federal
Regulations as follows:
PART 36--EXEMPTION OF SECTION 4(c) CONTRACT MARKET TRANSACTIONS
Sec.
36.1 Exemption and definitions.
36.2 Trading of section 4(c) contract market transactions.
36.3 Section 4(c) contract market trading rules.
36.4 Listing of section 4(c) contract market transactions.
36.5 Reporting requirements.
36.6 Special procedures relating to registration and listing of
principals.
36.7 Risk disclosure.
36.8 Suspension or revocation of section 4(c) contract market
transaction exemption.
36.9 Fraud and manipulation in connection with section 4(c)
contract market transactions.
Authority: 7 U.S.C. 2, 6, 6c, and 12a.
Sec. 36.1 Exemption and definitions.
(a) Duration of Exemption. The provisions of this Part apply to any
section 4(c) contract market transaction entered into on or after
November 1, 1995. The provisions of this Part expire, and are no longer
valid as to any such transaction entered into on or after three years
following the date the first contract trades pursuant to this Part.
(b) Scope of Exemption. Each board of trade on which section 4(c)
contract market transactions are permitted to be traded pursuant to
this Part shall be deemed for such purposes to be designated as a
contract market within the meaning of the Act and, with respect to
section 4(c) contract market transactions, shall comply with and be
subject to all of the provisions of the Act and the Commission's
regulations
[[Page 51343]]
applicable to a contract market other than those provisions which are
specifically inconsistent with this Part, in which case the provisions
of this Part shall govern.
(c) Definitions. As used in this Part:
(1) ``Section 4(c) contract market transaction'' means:
Any agreement, contract, or transaction (or class thereof) entered
into on or subject to the rules of a contract market in accordance with
the provisions of this Part, and that is executed by a member of the
section 4(c) contract market that is an eligible participant for its
own account, or a futures commission merchant or floor broker for its
own account or on behalf of an eligible participant.
(2) ``Eligible Participant'' means:
(i) A bank or trust company;
(ii) A savings association or credit union;
(iii) An insurance company;
(iv) An investment company subject to regulation under the
Investment Company Act of 1940 (15 U.S.C. Sec. 80a-1, et seq.) or an
investment company performing a similar role or function subject as
such to foreign regulation, provided that such investment company or
foreign person is not formed solely for the purpose of constituting an
eligible participant and has total assets exceeding $5,000,000;
(v) A commodity pool formed and operated by a person subject to
regulation under the Act or a foreign person performing a similar role
or function subject as such to foreign regulation, provided that such
commodity pool or foreign person is not formed solely for the purpose
of constituting an eligible participant and has total assets exceeding
$5,000,000;
(vi) A corporation, partnership, proprietorship, organization,
trust, or other entity not formed solely for the purpose of
constituting an eligible participant (A) which has total assets
exceeding $10,000,000; or (B) which has a net worth of $1,000,000 and
enters into a section 4(c) contract market transaction in connection
with the conduct of its business; or (C) which has a net worth of
$1,000,000 and enters into a section 4(c) contract market transaction
to manage the risk of an asset or liability owned or incurred in the
conduct of its business or reasonably likely to be owned or incurred in
the conduct of its business;
(vii) An employee benefit plan subject to the Employee Retirement
Income Security Act of 1974 or a foreign person performing a similar
role or function subject as such to foreign regulation with total
assets exceeding $5,000,000 or whose investment decisions are made by a
bank, trust company, insurance company, investment adviser subject to
regulation under the Investment Advisers Act of 1940 (15 U.S.C.
Sec. 80b-1, et seq.), or a commodity trading advisor subject to
regulation under the Act;
(viii) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof, or
any multinational or supranational entity or any instrumentality,
agency, or department of any of the foregoing;
(ix) A broker-dealer subject to regulation under the Securities
Exchange Act of 1934 (15 U.S.C. Sec. 78a, et seq.) or a foreign person
performing a similar role or function subject as such to foreign
regulation, acting on its own behalf: Provided, however, that if such
broker-dealer is a natural person or proprietorship, the broker-dealer
must also meet the requirements of paragraph (c)(2)(vi) or (xi) of this
section;
(x) A futures commission merchant, floor broker, or floor trader
subject to regulation under the Act or a foreign person performing a
similar role or function subject as such to foreign regulation; or
(xi) Any natural person with total assets exceeding at least
$10,000,000.
(3) ``Section 4(c) contract market trading rules'' means: Contract
market rules prescribing trading procedures applicable only to section
4(c) contract market transactions.
(4) ``Terms and conditions'' has the same meaning as in
Sec. 1.41(a)(2) of this chapter.
Sec. 36.2 Trading of section 4(c) contract market transactions.
A section 4(c) contract market transaction may be traded pursuant
to the provisions of this Part provided the following conditions are
met:
(a) The section 4(c) contract market transaction:
(1) Provides that settlement or delivery shall be in cash (at a
cash settlement price that reflects the cash market for the underlying
commodity and is based on a price series that is reliable, publicly
available, and timely) or by means other than the transfer or receipt
of any commodity, except a foreign currency for which there is no legal
impediment to delivery and for which there exists a liquid cash market;
provided however, that the terms and conditions of such transaction are
in conformity with the underlying cash market (or, in the absence of
conformity, are necessary or appropriate) and that trading is not
readily susceptible to price manipulation, nor to causing or being used
in the manipulation of the price of any underlying commodity;
(2) Is cleared through a clearing organization subject to
Commission oversight;
(3) Except with respect to a broad-based index, does not involve
any, or the price of any, wheat, cotton, rice, corn, oats, barley, rye,
flaxseed, grain sorghums, millfeed, butter, eggs, onions, solanum
tuberousum (Irish potatoes), wool, wool tops, fats and oils (including
lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other
fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean
meal, livestock, livestock products, or frozen concentrated orange
juice;
(4) Does not involve any commodity futures contract or commodity
option contract in which there is any open interest and in which there
has been any trading on any board of trade during the six consecutive
complete calendar months preceding the date of application to trade as
a section 4(c) contract market transaction, unless the transaction can
reasonably be distinguished from any such futures contract or commodity
option contract based on its hedging function and/or pricing basis;
provided however, that (i) the five- and ten-year interest rate swaps
futures contracts, the Rolling Spot Contracts in foreign currency, and
the foreign currency forward futures contracts and options thereon, may
be traded as section 4(c) contract market transactions, and (ii) a
flexible commodity option may be listed as a section 4(c) contract
market transaction prior to listing such option for trading otherwise;
and
(5) Does not involve any contracts of sale (or options on such
contracts) subject to the provisions of section 2(a)(1)(B) of the Act,
including contracts for future delivery of a group or index of
securities (or any interest therein or based upon the value thereof).
(b) The contract market on which the section 4(c) contract market
transaction is traded need not satisfy the requirements of Sec. 1.61 of
this chapter.
(c) The contract market on which the section 4(c) contract market
transaction is traded or executed complies with the provisions of this
Part.
Sec. 36.3 Section 4(c) contract market trading rules.
A board of trade may submit for Commission review, pursuant to the
expedited procedures set forth in this paragraph, trading rules for
section 4(c) contract market transactions (``special execution
procedures'') that need not meet the requirements of sections
4b(a)(iv), 4b(b) and 4c(a) of the Act and
[[Page 51344]]
Sec. Sec. 1.38(a), 1.39, 155.2, 155.3 and 155.4 of this chapter,
provided that such section 4(c) contract market trading rules satisfy
the terms and conditions of this section.
(a) Definition. ``Special execution procedures'' means contract
market rules permitting noncompetitive bids, offers, negotiation, and/
or execution of orders and transactions.
(b) Special execution procedures that permit a member to trade for
his own account opposite the account of another member must provide for
an audit trail that meets the requirements of Sec. 1.35(a), (e), (g)
and (i) and Sec. 1.38(b) of this chapter.
(c) Special execution procedures that permit a futures commission
merchant or floor broker to take the opposite side of a customer order
for its own account or permit the execution of orders directly between
customer accounts of different principals must provide for an audit
trail that meets the requirements of paragraph (b) of this section and
that also requires a written record of each customer order which must
consist of customer account identification, terms of the order,
including price-specific instruction from the customer, order number,
and time of order receipt. No order shall be executed without price-
specific instruction from the customer. Procedures submitted under this
paragraph also must include a specific prohibition against disclosure
of customer order information other than to facilitate execution
thereof and a requirement that members provide to their customers, in
writing, prior to the initial execution for that customer of any
transaction using these procedures, a description of the special
execution procedures and, in particular, how they vary from on-floor
competitive trading procedures.
(d) Section 4(c) contract market trading rules that provide that
transactions may be executed using any combination of special execution
procedures and competitive on-floor trading procedures must set forth
the circumstances under which such transactions could occur
competitively on-floor, provided that any transaction executed using
special execution procedures be in compliance with paragraphs (b) and
(c) of this section, and include a specific prohibition against
frontrunning.
(e) Section 4(c) contract market trading rules also must provide
for the following:
(1) Record maintenance and retention in accordance with Sec. 1.31
of this chapter;
(2) The immediate post-execution report of each purchase and each
sale transaction and dissemination on the relevant market floor,
trading screen, and/or vendor service through the board of trade's
market quotation system of the price, quantity, and contract traded
pursuant to this section. Transactions may be executed pursuant to this
section only during hours in which such immediate post-execution
dissemination is available;
(3) The report to clearing, and clearing, of each transaction
concluded pursuant to this section as quickly as practicable, but in no
event later than required for trades subject to Secs. 1.38 and 1.39 of
this chapter; and
(4) Compliance with Sec. 36.9 of this Part, except that any trade
executed using special execution procedures in compliance with this
section need not be in compliance with section 4b(a)(iv) of the Act.
(f) (1) Transactions offered or entered into in compliance with
special execution procedures submitted to the Commission and permitted
to become effective pursuant to the terms of this Part shall not be
deemed to violate sections 4b(a) (iv), 4b(b), or 4c(a) of the Act or
Sec. Sec. 1.38(a), 1.39, 155.2, 155.3 or 155.4 of this chapter.
(2) No person shall offer or enter into any section 4(c) contract
market transaction, unless it meets all requirements of the applicable
special execution procedures submitted to the Commission and permitted
to become effective pursuant to the terms of this Part.
(g) Submission Procedures
(1) A board of trade seeking review of a section 4(c) contract
market trading rule shall furnish one copy of the information set forth
in paragraphs (b), (c) or (d) and (e) of this section, as applicable,
to the Commission at its Washington, D.C. headquarters. One copy shall
also be transmitted by the board of trade to the regional office of the
Commission having local jurisdiction over the board of trade. Each
submission shall be labeled as being submitted pursuant to this
section.
(2) Section 4(c) contract market trading rules submitted by the
contract market pursuant to this section shall become effective ten
days after receipt of the submission (or such earlier time as may be
determined by the Commission or its delegee) unless, within the ten-day
period, the Commission or its delegee notifies the board of trade in
writing that the submission does not meet the conditions of this
section. Upon such notification by the Commission or its delegee, the
submission will be subject to the usual procedures for rule approval
under section 5a(a)(12)(A) of the Act and Sec. 1.41(b) of this chapter.
(3) Notwithstanding the foregoing, if a contract market submits for
review pursuant to this paragraph large order execution procedures that
are substantially similar to procedures previously approved by the
Commission pursuant to Sec. 1.39 of this chapter for non-section 4(c)
contract market transactions, then such procedures shall be deemed
effective upon Commission receipt thereof.
(4) Once trading in a section 4(c) contract market transaction has
commenced, any modification to any approved section 4(c) contract
market trading rule must be submitted to the Commission for review
pursuant to the standards and procedures for section 4(c) contract
market trading rules set forth in this section.
(5) Other section 4(c) contract market trading rules, which do not
conform to the specific trading standards set forth herein and which do
not satisfy the requirements of the Act and Commission Rules, may be
submitted for Commission approval in accordance with section
5(a)(12)(A) of the Act and Sec. 1.41(b) of this chapter under the usual
timeframes.
Sec. 36.4 Listing of section 4(c) contract market transactions.
(a) A board of trade which has been initially designated as a
contract market and has otherwise met the requirements of sections 5
and 5a of the Act (other than section 5a(a)(12)(A)) seeking to permit
trading in a section 4(c) contract market transaction shall furnish to
the Commission at least ten days prior to its proposed effective date,
the rules setting forth the terms and conditions of the proposed
section 4(c) contract market transaction.
(b) The board of trade shall furnish one copy of the information
set forth in paragraph (a) of this section to the Commission at its
Washington, D.C. headquarters. One copy shall also be transmitted by
the board of trade to the regional office of the Commission having
local jurisdiction over the board of trade. Each submission shall be
labeled as being submitted pursuant to this Part.
(c) A board of trade which has been initially designated as a
contract market and has otherwise met the requirements of sections 5
and 5a of the Act (other than section 5a(a)(12)(A)) and which meets the
requirements of Sec. 36.2 shall be deemed to be designated as a
contract market in section 4(c) contract market transactions, the rules
submitted shall be deemed to be approved, and section 4(c) contract
market transactions may be
[[Page 51345]]
traded or executed thereon ten days after receipt of the submission
pursuant to this section unless, within the ten-day period, the
Commission or its delegee notifies the board of trade in writing that
the proposed transactions do not meet the requirements of Sec. 36.2.
Upon such notification by the Commission or its delegee, the submission
will be subject to the usual procedures for rule approval under section
5a(a)(12)(A) of the Act and Sec. 1.41(b) of this chapter.
(d) Any modification to the rules setting forth the terms and
conditions of a section 4(c) contract market transaction shall be
submitted to the Commission pursuant to the procedure set forth in this
section.
Sec. 36.5 Reporting requirements.
(a) The reporting requirements set forth in this section shall
govern section 4(c) contract market transactions in lieu of the
requirements of Parts 16, 17, 18, and 19 of this chapter.
(b) The provisions of Sec. 15.05 and Part 21 of this chapter shall
apply to section 4(c) contract market transactions as though they were
set forth herein and included specific references to eligible
participants.
(c) Reports by contract markets to the Commission. Each contract
market shall submit to the Commission in accordance with paragraph (d)
of this section the following information with respect to section 4(c)
contract market transactions by commodity or type of contract as
specified by the Commission:
(1) For each commodity or type of contract,
(i) The total gross open contracts at the end of the day covered by
the report,
(ii) Total transactions, by type of transaction, as specified by
the Commission, which occurred during the day covered by the report,
and
(iii) Prices, as specified by the Commission.
(2) For each clearing member by proprietary and customer account,
(i) The total of all long open contracts and the total of all short
open contracts carried at the end of the day covered by the report, and
(ii) The quantity of contracts transacted during the day covered by
the report, by type of transaction, as specified by the Commission.
(3) Large trader reports.
(i) Reportable positions. Reportable long and short positions of
traders as defined by contract market rules and approved by the
Commission, separately for each futures commission merchant or member
of the contract market.
(ii) Identification information. For each reportable position, the
information specified in Sec. 17.01(b)(1)-(b)(8) of this chapter.
(d) Form and manner of reporting; time and place of filing reports.
Unless otherwise approved by the Commission or its designee, each
contract market operating pursuant to this Part shall submit the
information required by paragraph (c) of this section as follows:
(1) A format and coding structure approved in writing by the
Commission or its designee on compatible data processing media as
defined in Part 15 of this chapter shall be used;
(2) The information contained in paragraphs (c)(1) and (c)(2) of
this section must be filed daily when the data are first available, but
not later than 3:00 p.m. on the business day following the day to which
the information pertains. The information contained in paragraph (c)(3)
must be filed on call by the Commission or its designee, at such times
as specified in the call.
(3) Except for dial-up transmissions, the information should be
submitted at the regional office of the Commission having local
jurisdiction with respect to such contract market.
(e) Reports by contract markets to the public. Each contract market
operating pursuant to this Part shall publish for each business day the
following information for section 4(c) contract market transactions by
commodity or type of contract as specified by the Commission:
(1) The total gross open contracts;
(2) The total number of transactions by transaction type as
specified by the Commission; and
(3) Prices, as specified by the Commission.
(f) Reports and maintenance of books and records by traders. Every
trader who owns, holds, or controls, or has held, owned, or controlled
a reportable position, as defined by contract market rules, in
contracts traded as section 4(c) contract market transactions shall:
(1) Keep books and records showing all details concerning all
positions and transactions with respect to section 4(c) contract market
transactions, all positions and transactions in any options traded
thereon, and all positions and transactions in the underlying
commodity, its products, and by-products and, in addition, commercial
activities that the trader hedges in the underlying commodity, and
shall upon request furnish to the Commission or the U.S. Department of
Justice any pertinent information concerning such positions,
transactions, or activities.
(2) File within one business day after a special call upon such
trader by the Commission or its designee the following:
(i) Reports showing positions and transactions on such contract
markets for the period of time that the trader held or controlled a
reportable position, and in a form and manner as instructed in the
call; and
(ii) The information specified in Sec. 18.04 of this chapter as
though it pertains to section 4(c) contract market transactions.
Sec. 36.6 Special procedures relating to registration and listing of
principals.
(a) Notwithstanding any other provision of law, any person shall be
granted a temporary license or registration as a limited introducing
broker if such person:
(1) Certifies that it:
(i) Is licensed or otherwise authorized to do business and is in
good standing with another federal financial regulatory authority or a
foreign financial regulatory authority with which the Commission has
comparability arrangements under Part 30 of this chapter and has
received Part 30 relief;
(ii) Has filed the fingerprints of its principals with such other
regulatory authority;
(iii) And its principals are not subject to a statutory
disqualification from registration under section 8a(2) of the Act;
(iv) Will restrict its activities subject to regulation under the
Act to section 4(c) contract market transactions; and
(v) Will be liable for all acts, omissions and failures, and
responsible for the supervision, of its associated persons, employees
and agents in connection with its activities as a limited introducing
broker involving section 4(c) contract market transactions; and
(2) Complies with any special temporary licensing or registration
procedures applicable to persons whose activities are limited to those
specified in paragraph (a)(1)(iv) of this section that have been
adopted by the National Futures Association and approved by the
Commission.
(3) A person whose activities are limited to those specified in
paragraph (a)(1)(iv) of this section shall not be subject to the
minimum financial requirements set forth in Sec. 1.17 of this chapter.
(b) Notwithstanding any other provision of law, any person
associated with a futures commission merchant, an introducing broker,
or a limited introducing broker described in paragraph (a) of this
section shall be granted a temporary license or registration to act in
the capacity of a limited associated person of such sponsor, or be
listed as a principal
[[Page 51346]]
thereof, if such person and such person's sponsor:
(1) Certifies that he:
(i) Is licensed or otherwise authorized to do business and in good
standing with another federal financial regulatory authority or a
foreign financial regulatory authority with which the Commission has
comparability arrangements under Part 30 of this chapter and the
sponsor, if applicable, has received Part 30 relief;
(ii) Has filed his fingerprints with such other regulatory
authority;
(iii) Is not subject to a statutory disqualification from
registration under section 8a(2) of the Act; and
(iv) Will restrict his activities subject to regulation under the
Act to section 4(c) contract market transactions; and
(2) Complies with any special temporary licensing, registration or
principal listing procedures applicable to persons whose activities are
limited to those specified in paragraph (b)(1)(iv) of this section that
have been adopted by the National Futures Association and approved by
the Commission.
Sec. 36.7 Risk disclosure.
(a) A futures commission merchant or, in the case of an introduced
account, an introducing broker, may open an account for a customer with
respect to an instrument governed by this Part without furnishing such
customer the disclosure statements required under Secs. 1.55, 1.65,
33.7, and 190.10 of this chapter: Provided, however, that the futures
commission merchant or, in the case of an introduced account, the
introducing broker, does furnish the customer, prior to the customer's
entry into the first section 4(c) contract market transaction with
respect to a particular instrument, with disclosure appropriate to the
particular instrument and the customer.
(b) This section does not relieve a futures commission merchant or
introducing broker from any other disclosure obligation it may have
under applicable law.
Sec. 36.8 Suspension or revocation of section 4(c) contract market
transaction exemption.
The Commission may, after notice and opportunity for a hearing,
suspend or revoke the exemption of any section 4(c) contract market
transaction if the Commission determines that the exemption is no
longer consistent with the public interest and the purposes of the Act.
Sec. 36.9 Fraud and manipulation in connection with section 4(c)
contract market transactions.
(a) Fraud. The requirements of sections 4b(a) and 4o of the Act and
Sec. 33.10 of this chapter shall apply to section 4(c) contract market
transactions. In any event, it shall be unlawful for any person,
directly or indirectly, in or in connection with an offer to enter
into, the entry into, the confirmation of the execution of, or the
maintenance of any transaction entered into pursuant to this Part--
(1) To cheat or defraud or attempt to cheat or defraud any other
person;
(2) Willfully to make or cause to be made to any other person any
false report or statement thereof or cause to be entered for any person
any false record thereof;
(3) Willfully to deceive or attempt to deceive any other person by
any means whatsoever.
(b) Manipulation. The requirements of sections 6(c), 6(d), and 9(a)
of the Act and Sec. 33.9(d) of this chapter shall apply to section 4(c)
contract market transactions.
Issued in Washington, D.C., this 21st day of September, 1995, by
the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 95-23940 Filed 9-29-95; 8:45 am]
BILLING CODE 6351-01-P
