3708 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

those U.S. CEP and CEP/Further

Manufactured (CEP/FM) sales compared

to sales in France through Ugine

Service. We included a CEP offset for all

sales in France which are compared

with CEP and CEP/FM sales in the

United States since the comparison of

home market sales to CEP sales is at a

different level of trade. We applied the

CEP offset to normal value or

constructed value, as appropriate.

Preliminary Results of Review

As a result of our review, we

preliminarily determine the weightedaverage dumping margins (in percent)

for the period January 1, 1996, through

December 31, 1996, to be as follows:

Manufacturer/exporter Margin

(percent)

Imphy/Ugine-Savoie .................. 10.51

Parties to the proceeding may request

disclosure within five days of the date

of publication of this notice. Any

interested party may request a hearing

within 10 days of publication. Any

hearing, if requested, will be held 44

days after the date of publication or the

first business day thereafter. Case briefs

and/or other written comments from

interested parties may be submitted not

later than 30 days after the date of

publication. Rebuttal briefs and

rebuttals to written comments, limited

to issues raised in those comments, may

be filed not later than 37 days after the

date of publication of this notice. The

Department will publish the final

results of this administrative review,

including its analysis of issues raised in

any written comments or at a hearing,

not later than 120 days after the date of

publication of this notice.

The Department shall determine, and

the U.S. Customs Service shall assess,

antidumping duties on all appropriate

entries. We have calculated importerspecific ad valorem duty assessment

rates based on the ratio of the total

amount of dumping margins calculated

for the examined sales made during the

POR to the total customs value of the

sales used to calculate those duties.

These rates will be assessed uniformly

on all entries of each particular importer

made during the POR. (This is

equivalent to dividing the total amount

of antidumping duties, which are

calculated by taking the difference

between statutory NV and statutory EP

or CEP, by the total statutory EP or CEP

value of the sales compared, and

adjusting the result by the average

difference between EP or CEP and

customs value for all merchandise

examined during the POR).

Furthermore, the following deposit

requirements will be effective for all

shipments of the subject merchandise

entered, or withdrawn from warehouse,

for consumption on or after the

publication date of the final results of

these administrative reviews, as

provided by section 751(a)(1) of the Act:

(1) The cash deposit rate for the

reviewed companies will be the rate

established in the final results of this

review (except that no deposit will be

required for firms with zero or de

minimis margins, i.e., margins less than

0.5 percent); (2) for previously reviewed

or investigated companies not listed

above, the cash deposit rate will

continue to be the company-specific rate

published for the most recent period; (3)

if the exporter is not a firm covered in

this review, a prior review, or the

original LTFV investigation, but the

manufacturer is, the cash deposit rate

will be the rate established for the most

recent period for the manufacturer of

the merchandise; and (4) the cash

deposit rate for all other manufacturers

or exporters will continue to be 24.51

percent, the ‘‘All Others’’ rate made

effective by the LTFV investigation.

These deposit requirements, when

imposed, shall remain in effect until

publication of the final results of the

next administrative reviews.

This notice also serves as a

preliminary reminder to importers of

their responsibility under 19 CFR

353.26 to file a certificate regarding the

reimbursement of antidumping duties

prior to liquidation of the relevant

entries during this review period.

Failure to comply with this requirement

could result in the Secretary’s

presumption that reimbursement of

antidumping duties occurred and the

subsequent assessment of double

antidumping duties.

These administrative reviews and

notice are in accordance with section

751(a)(1) of the Act (19 U.S.C.

1675(a)(1)) and 19 CFR 353.22(c)(5).

Dated: January 16, 1998.

Robert S. LaRussa,

Assistant Secretary for Import

Administration.

[FR Doc. 98–1806 Filed 1–23–98; 8:45 am]

BILLING CODE 3510–DS–P

COMMODITY FUTURES TRADING

COMMISSION

Regulation of Noncompetitive

Transactions Executed on or Subject

to the Rules of a Contract Market

AGENCY: Commodity Futures Trading

Commission.

ACTION: Concept release.

SUMMARY: The Commodity Futures

Trading Commission (‘‘CFTC’’ or

‘‘Commission’’) is reevaluating its

approach to the regulation of

noncompetitive transactions executed

on or subject to the rules of a contract

market. Accordingly, the Commission is

soliciting comments on a broad range of

questions concerning the oversight of

transactions involving (i) the exchange

of futures contracts for, or in connection

with, cash commodities, (ii) other

noncompetitive transactions, and (iii)

the use of execution facilities for

noncompetitive transactions. Following

the receipt of public comments, the

Commission will determine whether

rulemaking is appropriate.

DATES: Comments must be received on

or before March 27, 1998.

ADDRESSES: Interested persons should

submit their written data, views, and

opinions to Jean A. Webb, Secretary of

the Commission, Commodity Futures

Trading Commission, Three Lafayette

Centre, 1155 21st Street N.W.,

Washington, D.C. 20581. In addition,

comments may be sent by facsimile

transmission to facsimile number (202)

418–5221 or by electronic mail to

secretary@cftc.gov. Reference should be

made to ‘‘Regulation of Noncompetitive

Transactions Executed on or Subject to

the Rules of a Contract Market.’’ Certain

related materials described herein are

available for inspection at the Office of

the Secretariat at the above address.

Copies of these materials also may be

obtained through the Office of the

Secretariat at the above address or by

telephoning (202) 418–5100.

FOR FURTHER INFORMATION CONTACT:

Rebecca Creed, Attorney, at (202) 418–

5493, Division of Trading and Markets,

Commodity Futures Trading

Commission, Three Lafayette Centre,

1155 21st Street N.W., Washington, D.C.

20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Statutory and Regulatory Provisions

B. Purpose of This Release

C. Overview

II. Standards Governing EFP Transactions

A. Background

1. Historic Uses of EFPs

2. Current EFP Volume

3. Current Oversight of EFPs

B. Elements of a Bona Fide EFP

1. Relationship of the Instruments

(a) Qualitative Correlation

(b) Quantitative Correlation

(c) Request for Comments

2. Relationship of the Parties

(a) Separate Parties

(b) String Trades
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3709

1 7 U.S.C. 6(a). As discussed below, Section 4(c)

of the Act, 7 U.S.C. 6(c), vests the Commission with

certain exemptive authority subject to specified

qualifying criteria.

2 7 U.S.C. 6c(a).

3Report of the Senate Committee on Agriculture

and Forestry, S. Rep. No. 1131, 93rd Cong., 2d Sess.

16 (1974).

4 7 U.S.C. 6b and 12a(5).

5Report of the Division of Trading and Markets:

Exchanges of Futures for Physicals (October 1987)

(‘‘EFP Report’’). This document provides a detailed

discussion on the history, use and regulation of

EFPs. Interested parties may obtain a copy of the

EFP Report by contacting the Commission’s Office

of the Secretariat at the address noted above.

6 Interested parties may obtain a copy of the

NYMEX proposal permitting EFS transactions by

contacting the Commission’s Office of the

Secretariat at the address noted above.

7The Division of Economic Analysis staff advised

counsel that, in light of the Commission’s ongoing

consideration of agricultural trade options in

connection with its advance notice of proposed

rulemaking, 62 FR 31375 (June 9, 1997), it was not

currently appropriate to consider this request. The

Commission has subsequently proposed removing

Continued

(c) Request for Comments

3. Nature of the Transaction

(a) Exchanges of Futures Contracts for Cash

Commodities

(b) Futures Leg Requirements

(c) Cash Leg Requirements

(d) Transitory EFPs

(e) Contingent EFPs

(f) Request for Comments

4. Price of the Transaction

(a) Current Requirements

(b) Request for Comments

C. Other Regulatory Requirements

Governing EFPs

1. Reporting and Recordkeeping

(a) Current Requirements

(b) Request for Comments

2. Disclosure

(a) Current Requirements

(b) Request for Comments

3. Internal Controls

(a) Current Requirements

(b) Request for Comments

4. Transparency

(a) Current Requirements

(b) Request for Comments

III. Other Noncompetitive Transactions

Executed on or Subject to the Rules of a

Contract Market

A. Types of Eligible Transactions

1. Exchanges of Futures for Swaps

(a) The New York Mercantile Exchange

Proposal

(b) Request for Comments

2. Exchanges of Options for Physicals

(a) Background

(b) Request for Comments

3. Alternative Execution Procedures

(a) Current Procedures

(1) Contract Market Large Order Procedures

(2) Section 4(c) Contract Market

Transactions

(3) Securities Market Block Trading

Procedures

(b) Potential Procedures

(c) Request for Comments

B. Qualifying Standards

1. The Need for Standards

2. Request for Comments

C. Continuing Regulatory Requirements

1. The Need for Requirements

2. Request for Comments

IV. Execution Facilities for Noncompetitive

Transactions Executed on or Subject to

the Rules of a Contract Market

A. Current, Proposed and Potential

Facilities

1. Interdealer Brokers

2. The Chicago Board Brokerage

3. Potential Facilities for Transactions

Other Than EFPs

B. Qualifying Standards

1. Current Requirements

2. Request for Comments

V. Summary of Request for Comments

I. Introduction

A. Statutory and Regulatory Provisions

Section 4(a) of the Commodity

Exchange Act (‘‘Act’’) makes it unlawful

for any person to enter into a contract

for the purchase or sale of a commodity

for future delivery ‘‘unless such

transaction is conducted on or subject to

the rules of a board of trade which has

been designated by the Commission as

a ’contract market’ for such

commodity.’’ 1 Although Congress has

indicated that trading on contract

markets be conducted generally in an

open and competitive manner, it also

has recognized the need for certain,

limited exceptions to that requirement.

Section 4c(a) of the Act prohibits

various types of noncompetitively

executed transactions but provides an

exception for transfer trades, office

trades, and exchanges of futures for

physicals (‘‘EFPs’’) that are executed in

accordance with contract market rules

that have been approved by the

Commission. 2 With reference to these

statutory provisions, the Senate

Committee on Agriculture and Forestry

stated:

Both the Commodity Exchange Act and the

rules and regulations of the commodity

exchanges require that futures transactions be

executed openly in a competitive manner.

* * * * *

Certain carefully prescribed exceptions to

competitive trading are allowed, but they do

not nullify the general requirement of open

and competitive trading.

The purpose of this requirement is to

ensure that all trades are executed at

competitive prices and that all trades are

focused into the centralized marketplace to

participate in the competitive determination

of the price of futures contracts. This system

also provides ready access to the market for

all orders and results in a continuous flow of

price information. 3

Consistent with this policy,

Commission Regulation 1.38(a) requires

that contract market rules providing for

the execution of noncompetitive

transactions must be submitted to the

Commission for approval. Commission

Regulation 1.38(b) requires all

noncompetitive transactions as well as

all related orders, records, and

memoranda to be identified and

marked. Regulation 1.38 was adopted

pursuant to Sections 4b and 8a(5) of the

Act. 4 Section 8a(5) authorizes the

Commission to ‘‘make and promulgate

such rules and regulations as, in the

judgment of the Commission, are

reasonably necessary to effectuate any of

the provisions or to accomplish any of

the purposes of this Act.’’

B. Purpose of This Release

The purpose of this release is to

solicit comments on whether the

regulatory structure governing

noncompetitive transactions executed

on or subject to the rules of a contract

market should be modified in light of

recent developments in the marketplace.

The impetus for this action comes from

several sources, including the following.

First, ten years have passed since the

Division of Trading and Markets

(‘‘Division’’) conducted a

comprehensive study of EFPs.5 During

this time, the use of EFPs has continued

to grow and evolve.

Second, several organizations have

developed computerized systems for

basis trading of U.S. Treasury securities.

Essentially, a basis trade involves the

simultaneous acquisition of positions in

actual Treasury securities and in

offsetting futures contracts. Venues for

basis trading simplify the trading

process by enabling traders to obtain

both cash and futures positions in a

single transaction which is reported to

a contract market as an EFP.

Third, the New York Mercantile

Exchange (‘‘NYMEX’’) has sought

Commission approval for a proposed

rule that would permit the exchange of

futures contracts for, or in connection

with, swap agreements (‘‘EFS

transactions’’).6 This proposal would

establish provisions for EFS transactions

that are parallel to, but separate from,

those governing EFP transactions. Thus,

an EFS transaction would follow the

form of an EFP except that a swap

agreement would be substituted for the

physical component.

Fourth, the Chicago Board of Trade

(‘‘CBT’’), through counsel, requested the

Division of Economic Analysis to agree

not to recommend that the Commission

take any enforcement action against the

CBT, its members or market participants

in connection with the CBT’s proposed

implementation of a one-year pilot

program facilitating the off-exchange

transfer of futures contracts in

agricultural products in exchange for

related over-the-counter agricultural

options.7
3710 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

the prohibition against off-exchange trade options

on the enumerated agricultural commodities

pursuant to a three-year pilot program. Trade

Options on the Enumerated Agricultural

Commodities, 62 FR 59624 (Nov. 4, 1997).

8See, e.g., S. 257, 105th Cong., 1st Sess. § 6

(1997).

Part 36 of the Commission’s regulations adopts

certain exemptions under a pilot program for

separate, professional markets. Included among the

exemptions is a provision exempting certain

noncompetitive trading subject to the rules of a

professional market. However, no contract market

has filed a proposal with the Commission pursuant

to Part 36.

9Commodity Short Selling, H.R. Rep. No. 1551,

72d Cong., 1st Sess. 3 (1932).

10See Commodity Futures Trading Commission

Act of 1974, Pub. L. No. 93–463, 88 Stat. 1389

(substituted the Commission for the Secretary of

Agriculture and deleted state law preservation

clause); Futures Trading Act of 1978, Pub. L. No.

95–405, 92 Stat. 865 (required contract market rules

permitting EFPs to be approved by the

Commission); Futures Trading Act of 1982, Pub. L.

No. 97–444, 96 Stat. 2294 (exempted transactions in

foreign currency options traded on a national

securities exchange from coverage of the

Commodity Exchange Act).

11EFP Report at 144–145.

12 Id. at 26. For example, the Division has

expressed its opinion that the EFP ‘‘exemption was

not designed to create an avenue for traders to use

EFP transactions to accomplish what they could not

otherwise legitimately do, that is, wash trades,

accommodation trades, fictitious sales, or illegal offexchange transactions.’’ Report of the Division of

Trading and Markets: Volume Investors Corporation

59 n. 54 (July 1985).

Finally, recent legislative proposals

contemplate the establishment of

separate, professional markets.8 The

Commission wishes to explore whether

it is possible to achieve some of the

objectives of these proposals by

expanding the boundaries of

permissible noncompetitive trading on

existing contract markets. In contrast to

the legislative proposals, a revised

structure governing noncompetitive

transactions could act as an adjunct

rather than as an alternative to existing

regulated markets. Such an approach

might improve the usefulness and

efficiency of existing markets for

institutional or professional users but

with a reduced risk of market

fragmentation. Thus, carefully designed

revisions to the regulatory structure

governing noncompetitive transactions

could have a procompetitive effect.

C. Overview

For the foregoing reasons, the

Commission has determined to seek

comments on whether the existing

regulatory structure should be revised to

provide additional guidance concerning

standards governing noncompetitive

transactions executed on or subject to

the rules of a contract market. In scope,

the Commission’s request includes

transactions that currently are

permitted, such as EFPs, as well as

transactions that are not currently

permitted, such as EFS transactions or

block trades. Of course, if the

Commission were to revise its

regulatory structure relating to

noncompetitive transactions, the choice

of whether to permit these types of

transactions on a particular contract

market would remain, in the first

instance, with that contract market.

In general, the Commission is

soliciting comments on the following

questions:

(1) Should the standards articulated in the

EFP Report be codified in the Commission’s

regulations and/or refined in any way?

(2) Should other types of noncompetitive

transactions, such as EFS transactions or

block trades, be permitted to be executed on

or subject to the rules of a contract market

and, if so, what standards should apply to

these transactions?

(3) What standards should be applicable to

execution facilities for noncompetitive

transactions executed on or subject to the

rules of a contract market?

More specific questions addressing

particular aspects of these topics are

posed in the relevant sections of this

release. A consolidated list of questions

is set forth at the conclusion. The

Commission recognizes, however, that

its identification of the issues may not

be exhaustive and therefore invites

comments on other aspects of these

topics even if not expressly set out

below.

The Commission is asking these

questions for the dual purpose of giving

notice of its consideration of these

issues and of obtaining input before

proceeding with any specific initiatives.

Commenters should set forth with

particularity the bases for their views.

After receiving input, the Commission

will endeavor to strike an appropriate

balance among the relevant concerns.

II. Standards Governing EFP

Transactions

A. Background

1. Historic Uses of EFPs

An EFP involves simultaneous

transactions in the futures and cash

commodity markets. The futures market

transaction consists of a noncompetitive

transfer of a futures position between

the parties to the EFP. Thus, one party

buys the physical commodity and

simultaneously sells (or gives up long)

futures contracts while the other party

sells the physical commodity and

simultaneously buys (or receives long)

futures contracts. Subject to applicable

contract market rules, the quantity and

price of the futures and cash commodity

to be exchanged as well as other terms

are negotiated privately by the parties

rather than being executed openly and

competitively on a contract market.

Depending on the pre-existing market

positions of EFP counterparties, an EFP

transaction can create, transfer, or

extinguish futures positions.

The EFP exception currently

contained in Section 4c(a) of the Act

first appeared in H.R. 12287, which was

introduced in 1932. The report of the

House Committee on Agriculture

accompanying that bill indicates that

this exception was intended to permit

the continuation of what was described

as an accepted commercial practice:

Transactions involving the exchange of

cash commodities for futures in accordance

with exchange rules applying to such

exchanges are exempted, even though they

take the form of office trades, it being

understood that the exchange of cash

commodities for futures is a common and

necessary practice.9

The EFP exception was ultimately

adopted with the enactment of the

Commodity Exchange Act in 1936. None

of the amendments to Section 4c(a)

since that time provides further

guidance as to the scope of permissible

EFP transactions.10

As discussed in detail in the EFP

Report, the use of EFPs has evolved to

include practices not contemplated at

the time Section 4c(a) originally was

enacted. Indeed, financial futures

contracts, which now dominate futures

trading at some exchanges, did not exist

at the time the EFP exception was

adopted. In the EFP Report, the Division

concluded that it appeared appropriate

to interpret Section 4c(a) to

accommodate some of these practices,

many of which arise out of trading

practices in various cash markets and

which accomplish a variety of

commercial purposes. 11 However, the

Division also stated that the historical

context in which the EFP exception first

was enacted and the statutory language

of Section 4c(a) itself necessarily imply

certain limits on the permissible scope

of EFP transactions as an exception to

the general requirement of competitive

execution. 12

2. Current EFP Volume

A comparison of statistical data

regarding the level of EFP activity

between the late 1980s (when the EFP

Report was published) and recent years

shows that EFP activity, in many major

markets, has continued to grow. The

following table summarizes such data

for selected contracts between 1986 and

1996.
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3711

14 EFP Report at 146–150.

15 Id. at 150–151.

16 Id. at 152–160.

17 Id. at 155.

18 Id. at 157.

The Division referred to Administrative

Determination 239, issued by the Commodity

Exchange Authority on December 16, 1974, which

advised that, ‘‘[i]f a commodity, product or byproduct is hedgeable under the Act, it may be

exchanged for futures. If it is not hedgeable, it may

not be exchanged.’’ See generally 17 CFR 1.3(z)

(defines bona fide hedging transactions and

positions); Clarification of Certain Aspects of the

Hedging Definition, 52 FR 27195 (July 20, 1987).

19A correlation coefficient measures the degree to

which the movements of two variables are related.

Here the variables consist of the price of the futures

contracts and the price of the cash commodity.

20EFP Report at 158.

21 Id. at 159.

TABLE 1.—EFPS AS A PERCENT OF

TRADING VOLUME IN SELECTED

CONTRACTS 1986—1996 13

Contract Market 1986 1996

CBT Wheat ....................... 2.32 2.35

KCBT Wheat ..................... 15.61 10.87

MGE Wheat ...................... 24.72 15.31

CBT Corn .......................... 8.14 6.81

CBT Soybeans .................. 5.42 4.57

CBT Soybean Oil .............. 6.52 4.89

CBT Soybean Meal ........... 7.89 7.95

CME Live Cattle ................ 0.06 0.04

CSC Coffee ‘‘C’’ ................ 1.48 4.10

CSC Sugar #11 ................. 3.86 4.69

CSC Cocoa ....................... 6.24 3.17

CBT Treasury Bonds ........ 0.75 5.00

CBT Treasury Notes ......... 1.23 4.59

CME Japanese Yen .......... 7.32 16.11

CME British Pound ........... 7.76 21.53

CME Deutsche Mark ......... 6.12 16.81

CME Swiss Franc ............. 5.96 13.79

COMEX Gold .................... 7.46 9.05

COMEX Silver ................... 3.46 5.04

NYMEX Crude Oil ............. 3.60 2.67

NYMEX Heating Oil #2 ..... 1.90 6.66

13The data shown in Table 1 is for calendar

year 1986 and 1996.

As the table shows, EFP activity as a

share of trading volume has been

relatively stable in traditional

agricultural markets and has declined in

some cases. The trend for financial

futures contracts has been just the

opposite, with EFP activity continuing

to increase, in some cases dramatically.

3. Current Oversight of EFPs

EFP transactions are currently subject

to oversight through a variety of sources,

including: (i) the Commission’s review

of contract market rules governing such

transactions; (ii) the Commission’s

reporting and recordkeeping

requirements; (iii) contract markets’

enforcement of their own rules; (iv) the

Commission’s rule enforcement review

program; and (v) the Commission’s own

enforcement program.

B. Elements of a Bona Fide EFP

The EFP Report described EFP

practices in selected markets, analyzed

the legislative and regulatory framework

surrounding EFPs, and reviewed the

contract market rules and

interpretations that govern them. The

EFP Report suggested possible criteria to

be examined by contract markets in

evaluating whether a particular EFP

transaction is eligible for the Section

4c(a) exception. In particular, the

Division enumerated three essential

elements of a bona fide EFP as follows:

(i) a futures transaction and a cash

transaction which are integrally related;

(ii) an ‘‘exchange’’ of futures contracts

for cash commodity, where the cash

commodity contract provides for the

transfer of ownership of the cash

commodity to the cash buyer upon

performance of the terms of the contract,

with delivery to take place within a

reasonable time thereafter in accordance

with prevailing cash market practice;

and (iii) separate parties to the EFP,

where the accounts involved have

different beneficial ownership or are

under separate control.14

In addition, the Division developed a

non-exclusive list of other indicia to

assist contract markets in determining

whether the essential elements of a bona

fide EFP have been satisfied. These

include: (i) the degree of price

correlation between the futures and cash

legs of the EFP; (ii) the prices of the

futures and cash legs of the EFP and

their relationship to the prevailing

prices in their respective markets; (iii)

whether the cash seller has possession,

the right to possession, or the right to

future possession of the cash

commodity prior to the execution of the

EFP; (iv) the cash seller’s ability to

perform on his delivery obligation in the

absence of prior possession of the cash

commodity, i.e., the cash seller’s access

to the cash market; and (v) whether the

cash buyer acquires title to the cash

commodity.15

These elements can be analyzed in

terms of four categories: (i) the

relationship of the instruments; (ii) the

relationship of the parties; (iii) the

nature of the transaction; and (iv) the

price of the transaction. The following

discussion summarizes the elements

and indicia of a bona fide EFP as set

forth by the Division in the EFP Report.

As noted above, the Commission is

soliciting comments on whether these

standards should be codified in the

Commission’s regulations and/or

refined in any way.

1. Relationship of the Instruments

(a) Qualitative Correlation. In the EFP

Report, the Division determined that the

futures and cash legs of a bona fide EFP

should be correlated with each other,

both qualitatively and quantitatively.16

Qualitative correlation clearly exists

when the cash commodity satisfies the

delivery specifications of the associated

futures contract. However, when the

cash commodity is not deliverable

against the relevant futures contract,

questions arise as to its acceptability as

the cash leg. While some contract

markets focus on whether the cash

commodity is the economic equivalent

of, or is derived from, the particular

commodity specified in the futures

contract, others also consider the price

relationship between the cash and

futures legs of the transaction.

In the EFP Report, the Division

concluded that the cash commodity

should have a reliable and demonstrable

price relationship with the futures

contract involved in the EFP.17 The cash

leg should exhibit price movement that

historically has paralleled the price

movement of the futures contract, with

the cash and futures prices typically

moving in the same direction and at

consistent relative rates of change.

Although perfect price correlation is not

required, a ‘‘strong correlation’’ should

exist. Otherwise, the parties are at risk

that the basis or price differential

between the cash and futures legs will

change significantly prior to the

conclusion of the EFP, thus adversely

affecting the utility of the transaction

itself. The lack of a strong correlation

may indicate that the parties’ motive for

the EFP was to circumvent the

regulatory requirements of the Act or

the Commission’s regulations, such as

the requirement of open and

competitive execution, rather than to

conduct a commercially appropriate

transaction. The Division also

concluded that hedgeable commodities

are appropriate cash legs for EFPs.18

In the EFP Report, the Division noted

that statistical correlation coefficients 19

have been used to justify specific EFPs

involving stock index futures contracts

either before or after the transaction was

consummated.20 The Division also

recommended that contract markets

publicize their determinations regarding

the acceptability of particular

commodities as the cash leg of an EFP

in order to provide more guidance to the

market users of these transactions.21

(b) Quantitative Correlation.

For quantitative correlation to exist,

the Division determined that the cash

commodity position should be

approximately equal in quantity or

dollar value to the futures position and

that appropriate hedge ratios may be
3712 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

22 Id. at 159–160.

For example, if the futures position established

by the EFP transaction represents 50,000 bushels of

corn, then the associated cash leg should also equal

approximately 50,000 bushels of corn. With respect

to the use of appropriate hedge ratios to create

dollar equivalency, traders might cross-hedge a 182-

day T-bill by using more than one 91-day T-bill

futures contract since the risk exposure on the

principal amount of the T-bill increases the higher

the duration of the security. Other instruments with

differing maturities and yields would require

different ratios.

23 Id. at 147, 149–150.

24 Id. at 47, 148 n. 173.

25For example, party A has agreed to sell grain

to and buy futures contracts from party B.

Meanwhile, party B has agreed to sell grain to and

buy futures contracts from party C. When C is ready

to sell futures contracts to B in order to fix the price

of their cash transaction, B directs C to execute the

futures trade with A instead, thus satisfying B’s

obligation to sell futures contracts to A. Thus, A

and C execute an EFP in which C sells futures

contracts to A, but there is no corresponding cash

transaction between A and C. In the absence of this

string trade, parties A and B and parties B and C

must execute separate EFP transactions consistent

with their contractual obligations. Thus, the string

trade serves to match the mutually exclusive futures

obligations so that only one EFP is reported to the

contract market.

26 7 U.S.C. 6b.

27EFP Report at 146.

28 Id. at 149. For example, under this approach,

a third party could assume the seller’s obligation to

deliver the cash commodity, or the cash seller could

contract to purchase the cash commodity from the

third party and direct that delivery be made to the

cash buyer in the EFP.

29 Id. at 179–192, 196.

30 Id. at 181.

used to create such dollar equivalency.22

Again, the absence of such equivalency

may indicate a motive to circumvent

some requirement of the Act or the

Commission’s regulations rather than to

conduct a commercially appropriate

transaction.

(c) Request for Comments. The

Commission is soliciting comments on

the following questions:

(4) How should the ‘‘strong price

correlation’’ standard articulated in the EFP

Report be implemented?

(5) Should the Commission require

contract markets to adopt a minimum

statistical correlation coefficient to be used in

assessing the acceptability of a particular

cash commodity for use as the cash leg of an

EFP?

(6) If a minimum correlation coefficient is

required, should this coefficient apply to all

EFPs, or should it be adjusted to account for

the different commodities involved in EFPs?

(7) What is the appropriate type and scope

of guidance contract markets should be

required to provide to the general public

concerning the acceptability of particular

commodities as the cash leg of an EFP?

2. Relationship of the Parties

(a) Separate Parties. In the EFP

Report, the Division concluded that a

bona fide EFP must be executed

between separate parties.23 Determining

if separate parties are involved in a

particular transaction in turn depends

upon whether the accounts have

different beneficial owners or are under

separate control. This standard permits

separate profit centers of a futures

commission merchant (‘‘FCM’’) to

engage in EFPs with each other in order

to accomplish their trading strategies

and to fulfill their business needs.

(b) String Trades. In the EFP Report,

the Division discussed a method of

effecting an EFP transaction in the grain

markets called a ‘‘pass-through’’ or

‘‘string trade.’’ 24 Under this method, the

two parties to the EFP each have cash

commodity contracts with a different

party or parties which require them to

buy/sell the cash commodity and sell/

buy the corresponding futures contract

in order to set the price for the cash

transaction. All of the parties in the

string have complementary cash

commitments and corresponding

obligations to buy or sell futures

contracts to the next party in the string.

Instead of executing a series of EFP

transactions in which the intermediate

futures positions transferred among the

parties would net out for the common

parties, the first and last parties in the

string execute a single EFP and the other

mutually exclusive futures obligations

are canceled.25

(c) Request for Comments. The

Commission is soliciting comments on

the following questions:

(8) What is the appropriate scope of the

separate parties requirement?

(9) Should the Commission address string

trades as that practice is described in the EFP

Report and, if so, how?

3. Nature of the Transaction

(a) Exchanges of Futures Contracts for

Cash Commodities. As discussed

previously, Section 4c(a) of the Act

excepts EFPs from the prohibition

against various types of

noncompetitively executed transactions.

A bona fide EFP must involve an

‘‘exchange’’ of futures contracts for cash

commodity in which both legs of the

transaction entail actual economic risk.

(b) Futures Leg Requirements. The

futures leg of the EFP must be reported

to and cleared by a contract market

clearing organization. Therefore, it is

subject to the same margin obligations,

both original and variation, as any other

exchange-traded futures transaction. If

the futures leg were netted off-exchange,

this conduct might constitute bucketing

in violation of Section 4b(a) of the Act.26

(c) Cash Leg Requirements. In the EFP

Report, the Division concluded that the

cash commodity contract must impose a

real obligation to transfer ownership of

the cash commodity from the cash seller

to the cash buyer upon performance of

the terms of the contract, with delivery

taking place within a reasonable time

thereafter in accordance with prevailing

cash market practice.27 The Division

further asserted that, although the cash

commodity contract must contemplate

the making and taking of delivery of the

cash commodity, the parties may,

subject to the terms of the contract and

the principles of contract law,

individually transfer their contractual

rights or obligations with respect to the

cash commodity to a third party or may

offset these positions or obligations

prior to delivery.28

In the EFP Report, the Division

discussed several factors to be

considered in analyzing the parties’

intent with respect to the transfer of

cash commodity, including: (i) the

ability of the cash seller to make

delivery and of the cash buyer to take

delivery of the cash commodity; (ii) the

level of creditworthiness required of the

cash seller and buyer; (iii) the form and

terms of the cash commodity contract;

(iv) the documentation underlying the

transfer of cash commodity from the

cash seller to the cash buyer; and (v)

whether the cash buyer acquires an

enforceable claim on the title to the cash

commodity.29

The Division expressed the view that

the cash seller is not required to have

possession, or the right to possession, of

the cash commodity in order to

undertake a contractual obligation to

deliver it in the future by way of an

EFP.30 Nevertheless, the lack of: (i)

possession, (ii) the right to possession,

or (iii) access to the cash market may

indicate that the parties lacked the

requisite intent to execute a cash

transaction in the first place. This

would raise doubts about the legitimacy

of the EFP. Similarly, evidence that the

cash buyer was unable to accept

delivery of the cash commodity may

indicate that the parties never intended

to execute the cash leg of the EFP. An

examination of the documents

underlying the cash transaction,

including the form and the terms of the

cash commodity contract, confirmation

statements, and documents evidencing

title, in light of the state law governing

transfers of ownership is especially

useful in determining the parties’ intent.

In determining whether there has

been, or will be, an actual transfer of

ownership of the cash commodity, the

critical inquiry is whether the buyer of

the cash commodity has acquired or

will acquire, upon completion of

performance under the contract, title to

the cash commodity associated with the
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3713

31 Id. at 185–186.

32 Id. at 186.

33 Id. at 192–193.

34 Id. at 195.

35 Id. Evidence that the cash commodity transfer

is severable from the EFP is necessary, but not

sufficient, to establish the legitimacy of the

integrated transaction. As noted above, the EFP

itself must be bona fide.

36 Id. at 200–201.

37 Id. at 198.

38 Id. at 174–175.

39The Division identified several such examples

in the EFP Report including meeting a margin call,

taking advantage of expected foreign exchange

fluctuations, and complying with internal inventory

policies. Id. at 169–173.

40 Id. at 169.

41 Id. at 175.

EFP.31 In this regard, the Division stated

that the cash commodity contract may

contemplate an immediate transfer of

title or a transfer of title at some

subsequent time.32 Regardless of when

title passes, however, delivery of the

cash commodity should occur within a

reasonable period of time in accordance

with normal industry practice involving

comparable cash market transactions. If

delivery did not occur, the transaction

would need to be scrutinized, the

reasons for failure identified, and a

determination made as to whether the

EFP is bona fide.

(d) Transitory EFPs. In the EFP

Report, the Division expressed concern

about a practice, then occurring

frequently in the gold and foreign

currency markets, involving both an

EFP and an offsetting cash commodity

transfer.33 For example, party A

purchases the cash commodity from

party B and then engages in an EFP

whereby A sells the cash commodity

back to B and receives a long futures

position. As a result of this integrated

transaction, the parties acquire futures

positions but end up with the same cash

market position as they had before the

transaction. These transactions are

sometimes referred to as transitory

EFPs. In such cases, questions arise as

to whether there has been a bona fide

‘‘exchange’’ of the cash commodity as is

required by Section 4c(a) of the Act.

The Division concluded that, in

reviewing transitory EFPs, the EFP and

the cash commodity transfer should be

examined both separately and as an

integrated transaction.34 The parties

must incur actual economic risk in both

legs of the EFP and in the cash

commodity transfer, and the EFP itself

must otherwise be bona fide.

The predominant consideration is

whether the cash commodity transfer

can stand on its own as a commercially

appropriate transaction, with no

obligation on either party to carry out

the EFP.35 One indication is whether the

terms and structure of the cash

commodity transfer are substantially the

same in all material respects as other

cash transactions in that market or more

specifically for those particular

participants. For example, if the price of

the cash commodity is determined

differently or if a lower level of

capitalization is required of the buyer

than would otherwise be the case, then

the cash commodity transfer may not be

genuine. Another indication is whether

the buyer acquires title to the cash

commodity in accordance with

customary cash market practices.

Additional issues to be considered in

evaluating whether the integrated

transaction is bona fide include: (i) The

timing of the cash commodity transfer

and the EFP; (ii) whether the same

parties have executed a number of

integrated transactions in which the

cash commodity transfer never occurs

independently of the EFP; (iii) whether

there have been a series of transactions

in which the same cash commodity is

transferred repeatedly between the same

parties, resulting in the liquidation of a

futures position much larger than the

exchanged cash commodity which

ultimately remains with the original

owner; and (iv) the relationship between

the parties and their patterns of

dealings, including evidence of money

passes between them.36

(e) Contingent EFPs. Contingent EFPs

are an impermissible subset of transitory

EFPs. The existence of conditions tying

the cash commodity transfer and the

EFP together may indicate that the

transactions are not severable but are

contingent upon each other.37 A cash

commodity transfer which cannot stand

on its own may indicate that there was

no actual economic risk in the initial

cash transfer and may raise concerns

about whether the EFP involved an

‘‘exchange’’ of futures contracts for cash

commodity as is required by Section

4c(a) of the Act.

(f) Request for Comments. The

Commission is soliciting comments on

the following questions:

(10) What criteria are appropriate for

judging whether the futures leg of an EFP is

bona fide?

(11) What criteria are appropriate for

judging whether the cash leg of an EFP is

bona fide?

(12) What criteria are appropriate for

determining whether a transitory EFP is bona

fide?

(13) What criteria are appropriate for

determining whether an EFP is contingent?

4. Price of the Transaction

(a) Current Requirements. As

discussed previously, because EFPs are

executed noncompetitively offexchange, the prices of both the futures

and cash legs are determined by mutual

agreement of the parties. In the EFP

Report, the Division concluded that the

price differential between the futures

and cash legs should reflect commercial

realities and that at least one leg of the

transaction should be priced at the

prevailing market.38 Although pricing

one leg of the EFP significantly away

from the market may be justified by

commercial necessity,39 the Division

expressed its concern that such aberrant

pricing can be used to shift substantial

sums of cash from one party to another

or to allocate gains and losses between

the futures and cash sides of the EFP.40

Moreover, when both legs of an EFP are

priced away from the market, the

transaction may not be commercially

appropriate, particularly when one

party could obtain better prices for the

futures and cash legs in another

available market. In the EFP Report, the

Division urged contract markets to

determine whether the pricing of a

particular EFP is supported by a

business purpose.41

(b) Request for Comments. The

Commission is soliciting comments on

the following questions:

(14) Should the Commission require both

the futures and cash legs of an EFP to be

priced within the daily range of their current

respective markets, should it require only

one leg of an EFP to be priced within its daily

range, or should it impose no restrictions on

the price of either leg of an EFP?

(15) Should the Commission require

contract markets to obtain documentation

regarding the business purpose underlying

the pricing of an EFP?

C. Other Regulatory Requirements

Governing EFPs

1. Reporting and Recordkeeping

(a) Current Requirements Under the

Commission’s current regulations EFPs

are subject to broad reporting and

recordkeeping requirements.

Commission Regulation 1.35(a)

generally requires every FCM,

introducing broker (‘‘IB’’), and contract

market member to keep full, complete

and systematic records of all

transactions relating to its business of

dealing in commodity futures,

commodity options, and cash

commodities, to retain such records for

a period of five years, and to produce

them upon request of the Commission

or the Department of Justice.

Commission Regulation 1.38(b) requires

every person handling, executing,

clearing, or carrying EFPs to identify all

related documents by appropriate

symbol or designation. Similarly, under

Commission Regulation 1.35(e), each
3714 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

42The Commission is currently proposing to

amend Regulation 1.55 so that FCMs and IBs would

no longer be required to furnish the specified

written risk disclosure statement to certain

categories of financially accredited customers or to

obtain written acknowledgments of receipt of the

risk disclosure statement before opening a

commodity futures account for these customers. In

addition, the Commission is currently proposing

amendments to relieve FCMs and IBs from

requirements to furnish disclosure statements to

these financially accredited customers pertaining to

foreign futures or foreign options (Regulation

30.6(a)), domestic exchange-traded commodity

options (Regulation 33.7(a)), customers whose

accounts are transferred to another FCM or IB other

than at the customer’s request (Regulation

1.65(a)(3)), and the treatment in bankruptcy of noncash margin held by an FCM (Regulation 190.10(c)).

Distribution of Risk Disclosure Statements by

Futures Commission Merchants and Introducing

Brokers, 62 FR 47612 (Sept. 10, 1997).

43 Id. at 47614.

44Adoption of Customer Protection Rules, 43 FR

31886, 31889 (July 24, 1978).

contract market must maintain a record

showing, by appropriate and uniform

symbols, any transaction which is made

noncompetitively in accordance with

written rules of the contract market.

Commission Regulation 1.35(a–2)

requires FCMs, IBs, and other contract

market members to ask their customers

for documentation of the cash leg of an

EFP upon request of the contract

market, the Commission, or the

Department of Justice and upon receipt

to provide the documentation to the

requesting body; requires customers to

create, retain, and produce such

documentation directly to the

requesting body; and requires that all

contract markets adopt, as necessary,

corresponding rules requiring its

members to provide the documentation

to the contract market.

Under Part 16 of the Commission’s

regulations, each contract market must

report the total quantity of futures

contracts bought or sold in connection

with EFPs to the Commission by

clearing member and must publish the

total quantity of EFPs executed on any

given business day. Part 17 of the

Commission’s regulations requires

FCMs, members of contract markets,

and foreign brokers to report to the

Commission the quantity of EFPs

executed in each special account on the

day it has a reportable futures position

as well as on the first day the account

is no longer reportable. Commission

Regulation 18.05 requires each trader

holding or controlling a reportable

futures position (‘‘large trader’’) to keep

records of all futures and cash

commodity positions and transactions.

Finally, the Commission may issue a

special call under Regulation

21.03(e)(1)(iii) to FCMs, IBs, or

customers that requires information

about EFPs to be submitted for the

particular commodity, contract market,

and delivery months named in the call.

(b) Request for Comments. The

Commission is soliciting comments on

the following question:

(16) Are the current reporting and

recordkeeping requirements relating to EFPs

adequate?

2. Disclosure

(a) Current Requirements.

Commission Regulation 1.55(a)(1)

prohibits an FCM or IB from opening a

commodity futures account for any

customer unless the FCM or IB first

provides the customer with a written

risk disclosure statement prepared by or

approved by the Commission and

receives a signed acknowledgment from

the customer that he or she has received

and understood this statement.42 This

risk disclosure statement, as set forth in

Commission Regulation 1.55(b), does

not specifically address EFPs. However,

Commission Regulation 1.55(f) makes

clear that compliance with the specific

disclosure requirements of Regulation

1.55 does not relieve an FCM or IB from

any other disclosure obligation it may

have under applicable law. These

disclosure obligations arise under

Section 4b of the Act as well as under

state and common law and require an

FCM or IB to provide its customers with

all material information relating to a

transaction, including information

relating to the risks involved in entering

a particular transaction.43

The Commission seeks to ensure full

and fair disclosure of the requirements

of and risks inherent in EFPs. Only

when customers have complete

information regarding EFPs can they

effectively evaluate whether such

transactions are consistent with their

financial goals. The Commission

believes that some guidance as to the

form and content of disclosure

concerning EFPs may be appropriate.

(b) Request for Comments. The

Commission is soliciting comments on

the following questions:

(17) What should be the form and content

of disclosure concerning EFPs?

(18) Should the form and content of

disclosure vary according to the commercial

sophistication of the EFP participant similar

to the Commission’s proposed amendment to

Regulation 1.55?

(19) Should the Commission explicitly

require that customers must be informed that

an EFP is executed noncompetitively, that it

involves a cash transaction, and that their

FCM might take the opposite side of the EFP?

(20) Should the Commission explicitly

require Commission registrants to obtain

customer consent before executing an EFP on

the customer’s behalf?

3. Internal Controls

(a) Current Requirements.

Commission Regulation 166.3 generally

requires all Commission registrants,

except associated persons who have no

supervisory duties, to ‘‘diligently

supervise the handling by its partners,

officers, employees and agents * * * of

all commodity interest accounts carried,

operated, advised or introduced by the

registrant and all other activities * * *

relating to its business as a Commission

registrant.’’ One basic purpose of the

rule is to protect customers by ensuring

that their dealings with employees of

Commission registrants will be

reviewed and overseen by other officials

in the firm.44 Although Commission

Regulation 166.3 currently applies to

EFPs, the Commission believes that

some guidance as to the types of

internal controls that Commission

registrants should be required to

maintain may be appropriate.

(b) Request for Comments. The

Commission is soliciting comments on

the following question:

(21) What internal controls are appropriate

for Commission registrants to ensure

compliance with regulatory requirements

concerning the essential elements of bona

fide EFPs, reporting and recordkeeping, and

disclosure?

4. Transparency

(a) Current Requirements. The current

reporting requirements for EFPs are

outlined above. Exchanges do not

require, and generally do not have a

mechanism for providing, timely

information about EFP bids, offers, and

transactions.

(b) Request for Comments. The

Commission is soliciting comments on

the following questions:

(22) Do existing price reporting standards

provide adequate transparency concerning

EFPs to the marketplace and, if not, are there

alternative methods of achieving improved

price transparency?

(23) Should the Commission require

contract markets to publicize information

about bids and offers, as well as

consummated EFP transactions?

III. Other Noncompetitive Transactions

Executed on or Subject to the Rules of

a Contract Market

A. Types of Eligible Transactions

Although EFPs have raised many

issues and concerns, they have proven

to be useful commercial tools. As noted

above, the Commission seeks to explore

whether there are other types of

noncompetitive transactions that also

could enhance the usefulness of
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3715

45As noted above, pursuant to Section 4c(a) of the

Act, EFPs are explicitly permitted as an exception

to the usual open and competitive execution

requirements established by the Act, but only to the

extent provided for by contract market rules

approved by the Commission. Also as noted,

Commission Regulation 1.38(a) authorizes

noncompetitive transactions if executed in

accordance with contract market rules that have

received Commission approval. All domestic

commodity exchanges permit the execution of EFP

transactions, although there is some variation

among exchange rules.

46 In general, a simplified swap agreement may be

characterized as an agreement between two parties

to exchange a series of cash flows measured by

different interest rates, exchange rates, or prices,

with payments calculated by reference to a

principal base (or notional amount). See Policy

Statement Concerning Swap Transactions, 54 FR

30695 (July 21, 1989). Part 35 of the Commission’s

Regulations defines swap agreements by reference

to the Bankruptcy Code. See 17 CFR 35.1(b)(1).

47EFP Report at 235–240.

48 7 USC 6c(b) and 6c(c).

49CME Rule 538.

50ACC Rule 908.

designated contract markets without

compromising necessary regulatory

safeguards. The Commission has

identified three potential candidates: (i)

EFS transactions; (ii) exchanges of

options for physicals (‘‘EOPs’’); and (iii)

block trades. The Commission

welcomes the identification by

commenters of any other potential types

of transactions.

1. Exchanges of Futures for Swaps

(a) The New York Mercantile

Exchange Proposal. As noted, the

NYMEX has applied to the Commission

for approval of a rule that would permit

the execution of EFS transactions. As

proposed by the NYMEX, EFS

transactions would involve the

noncompetitive exchange of futures

contracts for separately negotiated swap

agreements. In this respect, the proposal

would establish for EFS transactions

provisions that are parallel to, but

separate from, those governing EFP

transactions. 45 Thus, an EFS transaction

would follow the structural form of an

EFP transaction except that a swap

agreement would be substituted for the

physical component of the

transaction. 46

Under the NYMEX proposal, the swap

component of the EFS transaction must

comply with the requirements of Part 35

of the Commission’s regulations or with

the Commission’s 1989 Policy

Statement concerning cash-settled swap

transactions or must otherwise qualify

for or fall within other exemptions or

jurisdictional exclusions under the Act

or Commission regulations. This

initiative represents the first proposal

the Commission has received for

approval of EFS transactions.

The NYMEX states that the rule

proposal in part responds to the

substantial growth that has occurred in

the swaps market during recent years. In

this respect, the NYMEX asserts that

swap transactions, though not

‘‘physical’’ in the traditional sense,

subject market participants to the same

type of price risk. Thus, the NYMEX

claims that the proposal could aid in

linking the on-exchange futures and offexchange swap markets.

The NYMEX believes that allowing

EFS transactions would increase market

efficiency and enhance the use of the

exchange as a risk transfer medium.

Specifically, the NYMEX believes that

both traditional market users and swap

dealers (banks, trading companies, and

energy companies) would benefit from

the availability of EFS transactions. By

a similar line of reasoning, the NYMEX

notes that commodity swap instruments

continue to play an increasingly

important role in providing a risk

management function in crude oil and

other markets, in part because they can

be individually tailored to a user’s

commercial needs and thereby reduce

substantially the presence of basis risk.

Because of this, the NYMEX concludes

that permitting EFS transactions would

reduce basis risk for NYMEX market

participants, enhance competition

among exchange and over-the-counter

markets, and facilitate greater usage of

NYMEX as a centralized market.

The NYMEX affirms that it has not

identified any evidence suggesting that

adoption of the proposal would harm

existing liquidity in NYMEX markets.

Moreover, the NYMEX concludes that

the rule proposal would make the

liquidity present in NYMEX energy

markets accessible to swap market

participants via the EFS process.

Additionally, the NYMEX identifies the

ability of swap participants to close out

futures positions more readily, as the

underlying futures contracts approach

expiration, and thus utilize the

exchange in managing price risk

associated with swap market

transactions as a potential benefit of the

proposal.

The NYMEX also views the financial

safeguards of the on-exchange trading

environment as potentially beneficial,

and attractive to, swap market

participants. The NYMEX concludes

that access to these financial safeguards,

including those associated with the

position limit and margining systems,

either for purposes of creating or

extinguishing swap agreements, would

enable swap market participants to

enhance the credit quality of swap

positions. Thus, in summary, the

NYMEX concludes that several benefits

would accrue to market participants

from adoption of the proposed rule,

including improvements in liquidity

and price transparency, and reductions

in basis and credit risk.

(b) Request for Comments. The

Commission is soliciting comments on

the following questions:

(24) What are the economic reasons firms

might have for engaging in EFS transactions

and what benefits might accrue thereunder,

including the potential benefits to domestic

futures markets, to over-the-counter markets,

and to financial markets generally?

(25) What are the potential costs or risks

of permitting EFS transactions, particularly

with respect to the effect on price discovery,

risk transfer, and the competitive character of

‘‘on-exchange’’ transactions?

(26) Should the Commission approve the

NYMEX rule proposal permitting EFS

transactions?

(27) Should EFS transactions be limited to

particular markets, participants or types of

transactions?

(28) Should special provisions be

established to ameliorate any competitive

costs or otherwise safeguard the competitive

conditions of the on-exchange market?

2. Exchanges of Options for Physicals

(a) Background. The EFP Report

included an examination of EOPs.47 The

Division noted that the statutory

sections governing options trading,

Sections 4c(b) and 4c(c) of the Act,48 do

not provide for the extension of the

Section 4c(a) exception for EFPs to

options. The Division acknowledged

that Regulation 1.38 provides for the

execution of noncompetitive

transactions pursuant to Commissionapproved contract market rules and, on

that basis, concluded that EOP

transactions could potentially fall

within the noncompetitive trade

exception found in that regulation.

The EFP Report’s investigation of

contract market rules found that most

were silent on the question of whether

EOP transactions were acceptable, with

only the Chicago Mercantile Exchange

(‘‘CME’’) rules expressly prohibiting

EOP transactions.49 Although the Amex

Commodities Corporation (‘‘ACC’’)

adopted a rule permitting EOPs,50 it

subsequently withdrew that rule,

apparently prior to the execution of any

EOP transactions.

The Division staff that prepared the

EFP Report were unable to discover any

instances in which an option on a

futures contract was exchanged for a

cash commodity, and the Commission is

not aware that any of these transactions

have occurred since the publication of

the report. The Division observed that

the absence of these transactions could

be due to the fact that market

participants had not yet been able to

design a plan to execute EOPs, perhaps
3716 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

51CME Rule 521 (‘‘All-Or-None Transactions’’);

NYCE Rule 1.10-B (‘‘Block Order Execution’’);

NYFE Rule 312 (‘‘Block Order Execution’’).

The CME all-or-none procedures apply to a

variety of products, including currency futures,

South African Rand options, 28-day Mexican TIIE

futures, 91-day Mexican CETES futures, Brady

Bond futures, IPC futures, Three-month Eurodollar

futures bundle combinations, 13-week U.S.

Treasury Bill futures, British Pound/Deutsche Mark

and Deutsche Mark/Japanese Yen futures, and

Argentine Par Bond futures. The minimum contract

size eligible for execution under these procedures

ranges from 20 contracts to 100 contracts. The

NYCE limits its block order execution procedures

to transactions involving 50 or more FINEX futures

or futures spreads, options spreads or futures/

options combinations in the same contract. The

NYFE limits its block order execution procedures

to transactions involving 15 or more NYSE Large

Composites, 30 or more NYSE Composite Index or

50 or more CRB futures or options, futures spreads,

options spreads or futures/options combinations in

the same contract.

52CME Rule 549.

53The CME recently lowered the minimum

threshold quantity for RFS quotations for currency

futures traded through GLOBEX to 50 contracts.

because of difficulty in establishing an

appropriate basis relationship between

the option and the cash commodity.

The EFP Report indicated that

commentary from contract market

officials and market participants on the

EOP issue was divided. Some

commenters objected on the basis that

an option does not involve a delivery

commitment. However, others indicated

that EOPs could be appropriate in some

circumstances. These commenters

indicated that an EOP might be

appropriate for the grantor of an option,

who has a delivery commitment upon

exercise, or in the case of a deep-in-themoney option, which as a practical

matter appears to be the equivalent of a

futures position. One commenter stated

that EOPs were conceptually viable but

that the instability associated with

option deltas (and therefore option

value) could create great risk for a

person accepting an option in exchange

for a cash commodity. This commenter

also indicated that, assuming this risk

was reflected in the price, EOP

transactions could be very expensive.

(b) Request for Comments. The

Commission is soliciting comments on

the following questions:

(29) Are EOPs viable and do these

transactions offer genuine risk management

benefits?

(30) If so, should EOPs be permitted, and

should there be limitations on EOPs that

reflect the particular risk characteristics of

options?

3. Alternative Execution Procedures

(a) Current Procedures. (1) Contract

Market Large Order Procedures. The

Commission has approved several

contract market rules that establish

alternative execution procedures for

certain transactions. These procedures

generally preserve the competitive

forces available on a centralized market

and thereby comply with the ‘‘open and

competitive’’ requirement of

Commission Regulation 1.38(a).

The CME, the New York Cotton

Exchange (‘‘NYCE’’) and the New York

Futures Exchange (‘‘NYFE’’) have

adopted similar procedures providing

for the execution of large orders.51 These

procedures may be used only upon

customer request or if the large order

bid or offer is the best price available to

satisfy the terms of the order. A member

makes a request for a large order bid

and/or offer in the appropriate trading

area. Responding members may make

bids and/or offers at, above or below the

current prevailing bid or offer in the

underlying market for regular size

orders. Only the best bid and/or offer

shall prevail, and the large order must

be filled on an all-or-none basis. The

large order execution price does not

trigger conditional orders in the

underlying market, such as stop or limit

orders.

The NYCE and NYFE expressly

prohibit an initiating floor broker from

bundling customer orders to meet the

minimum contract size required for

eligibility under the large order

execution procedures, but allow a

responding broker to bundle customer

limit orders and to add orders from his

or her own account to match the

quantity of futures or options in the

large order request. Under the CME allor-none procedures, both the initiating

floor broker and the responding floor

broker may bundle customer orders to

meet the minimum contract size as long

as the customers specifically request

execution under these procedures or the

all-or-none bid or offer is the best price

available to satisfy the terms of the

orders. Although cross trades are not

permitted at the NYCE and NYFE under

these procedures, they are permitted at

the CME. Large order transactions

executed at all three exchanges must be

reported to a designated Exchange

official who records and publishes the

quantity and prices separately from

reports of transactions in the regular

market.

The CME also has adopted separate

large order execution (‘‘LOX’’)

procedures for transactions involving

300 or more futures contracts in the

Standard & Poor’s 500 Stock Price Index

or the Nikkei Stock Average.52 These

procedures, which include the preexecution solicitation of interest and

discussion of price, have only been used

once in the several years they have been

available.

The CME also has adopted request for

size (‘‘RFS’’) quotations for the GLOBEX

system. These procedures supplement

the GLOBEX request for quote (‘‘RFQ’’)

procedures. As originally configured,

RFQ messages were distributed without

any contract quantity indication. Thus,

the adoption of RFS procedures permits

requests for large size transactions for

all contracts traded through GLOBEX,

subject to a minimum threshold

quantity for RFS quotations of 100

contracts.53

(2) Section 4(c) Contract Market

Transactions. As noted previously,

Section 4(c) of the Act vests the

Commission with certain exemptive

authority from the general requirement

that all futures transactions must be

executed on designated contract

markets, subject to specified qualifying

criteria. Part 36 of the Commission’s

regulations adopts certain exemptions

under a pilot program for the

establishment of separate professional

markets which would have less

restrictive requirements governing

trading, reporting, and risk disclosure

for eligible transactions than are

applicable to current contract markets.

Subject to certain recordkeeping and

audit trail requirements, Part 36

procedures provide for the execution of

noncompetitive transactions, regardless

of size. In addition, these transactions

are limited to certain Commission

registrants and sophisticated and/or

institutional traders which meet certain

minimum asset requirements, including

banks, trust companies, savings

associations, credit unions, investment

companies, commodity pools, certain

business associations, employee benefit

plans, government entities, brokerdealers, FCMs, floor brokers, floor

traders, and certain other natural

persons. A contract market may adopt

trading rules permitting the execution of

Part 36 transactions using any

combination of noncompetitive

execution procedures and competitive

on-floor trading procedures.

No contract market has filed a

proposal with the Commission pursuant

to Section 4(c) and Part 36.

Significantly, Part 36 only permits

noncompetitive executions in speciallydesignated, stand-alone, professional

markets. In contrast, the other

noncompetitive trading methods

discussed in this release are adjuncts to

regular trading on or subject to the rules

of a contract market.

(3) Securities Market Block Trading

Procedures. Block trading in securities

markets differs substantially from that

on Commission designated contract
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3717

54 In 1996, block trading on the New York Stock

Exchange comprised 55.9% of the exchange’s

reported volume, or 2,348,457 transactions

accounting for 58.5 billion shares. New York Stock

Exchange Fact Book 1996, at 16 (May 1997).

55NYSE Rule 127; CBOE Rule 6.9.

56NYSE Rule 127(a).

57When positioning a block, the block trader

quotes a tentative price for the stock to the block

customer, and the customer may tentatively accept

this price. Barring an extreme and unexpected

movement in the price of the stock, the customer

may be reasonably assured of execution at the

quoted price.

When a block trader ‘‘shops a block,’’ the trader

contacts one or more potential customers to take the

opposite side of the block at a specified price. The

block trader might be willing to negotiate this price

depending on how interested other investors are in

participating in the block. The block trader

continues to ‘‘shop the block’’ until he or she has

a sufficient quantity of orders for the opposite side

at a single price. At this point, the block trader

returns to the block customer and confirms the

customer’s interest in the block transaction at the

negotiated price, also known as the ‘‘clean-up’’

price.

58NYSE Rule 76.

59NYSE Rule 127(b).

60NYSE Rule 127(c). If the member representing

the block orders decides that the amount of stock

that would be lost is not excessive, then he or she

announces the clean-up price to the crowd and fills

at such price all agency limit orders at the post for

the clean-up price or better. The member then

crosses the remaining block orders at the clean-up

price.

If the member decides that the amount of stock

that would be lost is excessive, then he or she either

may return to the block customers to negotiate a

new clean-up price or may limit participation in the

block by members at the post. The member limits

participation merely by informing the crowd that

they cannot participate freely in the block. After

such an announcement, the member follows the

crossing procedures set forth in NYSE Rule 76 and

makes a bid and offer for the full amount of the

block. A ‘‘reasonable’’ time must elapse before the

cross is completed in order to provide the crowd,

including the Specialist, the opportunity to execute

superior priced bids or offers to provide price

improvement. Thereafter, the member crosses the

orders for the remaining shares at the clean-up

price. The member is not required to fill at the

clean-up price orders limited to the clean-up price

or better. The block is entitled to priority at the

proposed clean-up price.

61NYSE Rule 127(d)(1).

62NYSE Rule 97.

63CBOE Rule 6.9. CBOE Rule 6.9 specifically

allows solicited transactions by ‘‘a member or

member organization representing an order

respecting an option traded on the Exchange * * *

including a spread, combination, or straddle order

as defined in Rule 6.53 and a stock-option order as

defined in Rule 1.1(ii).’’

64CBOE Rule 6.9(d). However, the member is not

required to announce to the trading crowd that

another person has been solicited to participate in

the order. The initiating member simply must

disclose all the terms and conditions of the original

order and any modifications to the trading crowd.

65 CBOE Rule 6.9(a).

Under CBOE Rule 6.45, the highest bid or lowest

offer has priority. Where two or more bids (offers)

for the same option contract represent the highest

(lowest) price, the bid (offer) that is displayed in the

customer limit order book shall have priority over

any other bid at the post. If two or more bids (offers)

represent the highest (lowest) price and the

customer limit order book is not involved, then

priority is determined according to the sequence in

which the bids (offers) were made.

The procedures set forth in CBOE Rule 6.74

govern the crossing of original orders with solicited

orders, except when the solicited party has priority

as is the case under CBOE Rule 6.9(a).

66 CBOE Rule 6.9(b).

markets. Blocks may be traded on

securities exchanges, in over-thecounter securities markets, or through

‘‘principal-to-principal’’ trade execution

venues. In the securities industry, a

block trade is commonly defined as a

transaction involving 10,000 or more

shares or a quantity of stock having a

market value greater than or equal to

$200,000. In recent years, block trading

in securities markets has increased as a

percentage of reported trading volume.54

The New York Stock Exchange

(‘‘NYSE’’) and the Chicago Board

Options Exchange (‘‘CBOE’’) have rules

providing for block trading.55 A

customer desiring to trade a block of

NYSE-listed stocks contacts a block

trader. Depending on the block trader’s

assessment of market demand and

supply, the block trader may notify the

Specialist of the pending block trade.56

If notified, the Specialist may indicate

an interest in participating in the block.

The block trader then must decide

whether to ‘‘position’’ the entire block

by serving as the counterparty or ‘‘shop

the block’’ by seeking customers to take

the other side of the trade. The block

trader may also combine these strategies

by positioning part of the block and

seeking customers for the remaining

shares. Upon agreement of a price for

the block,57 the block order is

transmitted to the NYSE floor for

crossing against the block trader’s house

account or against other customer orders

as arranged in ‘‘shopping the block.’’

Block orders crossed on the NYSE

floor must comply with NYSE rules,

including the following. Block orders

within the current market quotation

must first be offered publicly at a price

higher than the member’s bid by the

minimum variation applicable to that

stock so that the trading crowd may

participate in the block at that publicly

offered price, before the member may

proceed with the cross transaction.58

Block orders crossed outside the current

market quotation must be disclosed to

the Specialist.59 Where the member is

holding agency orders on both sides of

the market, he or she must probe the

market to determine whether more stock

would be lost than is reasonable under

the circumstances to orders in the

crowd.60 Where the member is serving

as the counterparty of the block and

where all or any portion of the block

establishes or increases his or her

position, the member must fill all limit

orders at the post for the clean-up price

or better at the clean-up price, before

any amount may be retained for the

member’s account.61 As an antimanipulation safeguard, when a

member holds any part of a long

position in a stock in its trading account

as a result of a block trade it completed

with a customer, the member is

precluded from effecting certain

transactions in this stock on the same

trading day in which the block trade

was executed.62

At the CBOE, a member or member

organization may solicit another

member, member organization, nonmember customer or broker-dealer

(‘‘solicited person’’) to take the opposite

side of a large-sized order (‘‘original

order’’).63 The member representing the

original order must disclose the terms

and conditions of that order to the

trading crowd before it can be

executed.64

In order to promote disclosure at the

inception of the solicitation period and

to encourage solicited persons to bid or

offer at prices that improve the current

market, the CBOE rule establishes a

series of priority principles for these

solicited transactions. Priority depends

upon whether the original order is

disclosed throughout the solicitation

period, whether the solicited order

improves the best bid or offer in the

crowd and whether the solicited order

matches the original order’s limit.

If the terms and conditions of the

original order are disclosed to the

trading crowd prior to any solicitation

and the order is continuously

represented in the crowd throughout the

solicitation process, then the following

rules apply. If the solicited order

matches the original order’s limit and

improves the best bid or offer in the

trading crowd, then the solicited order

has priority over the crowd and may

trade with the original order at the

improved bid or offered price subject to

the customer limit order book priorities

set forth in CBOE Rule 6.45.65 If the

solicited order does not match the

original order’s limit, but improves the

best bid or offer in the crowd and the

original order is subsequently modified

to match the solicited order’s bid or

offer, then the terms of the original

order, as modified, must be disclosed to

the trading crowd. The crowd has

priority to trade with the modified

original order before this order may be

crossed with the solicited order.66 If the

solicited order does not match the

original order’s limit and meets but does

not improve the best bid or offer in the

trading crowd and the original order is

subsequently modified to match the

solicited order’s bid or offer, then the

trading crowd has priority to trade with
3718 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

67 CBOE Rule 6.9(c).

68 CBOE Rule 6.9(d).

69CBOE Rule 6.9(e). This trading restriction

applies to the solicited party as well as to any other

member or associated person who has knowledge

of all the material terms and conditions of both the

original and solicited orders, including the price. 70 7 U.S.C. 19.

the modified original order at the best

bid or offered price subject to the

customer limit order book priorities.67

Finally, where the terms and conditions

of the original order have not been

disclosed in advance of the solicitation,

the trading crowd has priority to trade

with the original order at the best bid or

offered price subject to the customer

limit order book priorities before the

original order may be crossed with the

solicited order. 68

CBOE members and their associated

persons who have knowledge of all the

material terms and conditions of an

imminent, undisclosed solicited

transaction are prohibited from certain

trading in an option of the same class

that is the subject of the solicited

transaction, the underlying security or

any related instrument. That prohibition

is in effect until the original order and

any modifications are disclosed to the

trading crowd or until the solicited

transaction can no longer reasonably be

considered imminent in view of the

passage of time since the solicitation.69

Block trading also is carried out on

regional securities exchanges and in

over-the-counter securities markets. The

procedures governing block trades in

these markets are generally less complex

than those applicable at the NYSE.

Block trades for stocks listed on regional

exchanges are negotiated off-floor and in

most cases must be crossed on the floor

of the exchange. Moreover, traders

generally do not have to accommodate

limit orders. Over-the-counter block

trades are arranged by a block trader

who then crosses the resulting orders.

Another venue for securities block

trading involves ‘‘principal-toprincipal’’ systems. Generally, block

customers directly enter trade quantities

and bid/ask prices into a computerized

system, which matches the orders

according to the availability of bids and

offers at matching prices. In addition,

block customers may execute block

trades themselves, off-exchange,

without the assistance of a broker or

block trader.

(b) Potential Procedures. Certain

participants in the futures markets have

suggested that the competitive

execution requirements under the

Commission’s regulations be relaxed to

permit block trading procedures similar

to those in the securities exchange and

over-the-counter markets. As noted

previously, the proviso to Commission

Regulation 1.38(a) permits

noncompetitive transactions if executed

pursuant to contract market rules that

have been approved by the Commission.

One of the purposes of this release is

to investigate whether there are

alternative, noncompetitive execution

procedures that would further the

policies and purposes of the Act. If so,

the Commission seeks to determine the

extent to which these procedures could

be structured to serve the purposes of

market participants while not sacrificing

customer protection. The procedures

might be limited according to order size,

class of participant, contract, or some

other category. In addition, the

Commission seeks to determine the

extent to which the procedures would

be, and should be, similar to securities

market procedures.

The following examples, while not

exhaustive, illustrate the range of

possibilities. The least significant

modification of current open and

competitive procedures would expressly

permit market participants to alert

potential counterparties of their interest

in trading in a particular market at a

particular time. Actual execution would

occur pursuant to existing competitive

procedures.

A more significant departure from

current procedures would permit

market participants to divulge not only

a general interest in trading but also

specific information about quantity and

price to potential counterparties. Again,

actual execution would occur

competitively. This might be analogous

to the practice of ‘‘shopping the block’’

in securities markets.

A further variation would permit

negotiation between market

participants. This would permit some

degree of prearrangement although the

execution price would to some extent

remain subject to prices in the

competitive market.

Yet another variation would adjust

execution procedures to confer a degree

of priority on particular orders that they

might not attain in the open and

competitive process. Such priority

could be conferred, for example, on

certain retail orders or on certain

marketmaker orders.

Finally, market participants could be

permitted to execute certain

transactions bilaterally, away from the

centralized marketplace, and simply

report them to the exchange and

clearing house. This would be similar to

the way EFPs are handled currently.

Each of these alternatives potentially

raises concerns, including, among

others:

the impact on price discovery;

the impact on liquidity;

the potential for manipulation; and

the potential for mispricing, frontrunning, or

other customer fraud.

Any proposed procedure would have

to address such concerns. The need for

safeguards is discussed further below.

(c) Request for Comments. The

Commission is soliciting comments on

the following questions:

(31) Should alternative, noncompetitive

execution procedures be permitted on or

subject to the rules of a contract market?

(32) If so, how should these procedures be

structured to address regulatory concerns?

(33) Should these procedures be limited by

order size, participant class, contract, or

some other criteria?

(34) Can adequate safeguards be devised in

connection with these procedures to prevent

manipulation?

(35) Can adequate safeguards be devised in

connection with these procedures to prevent

fraud?

B. Qualifying Standards

1. The Need for Standards

The preceding discussion identifies

particular types of transactions that

might be appropriate for noncompetitive

execution, such as EFS transactions or

block trades. The common thread

connecting these types of transactions

with one another and with EFPs is their

potential ability to fulfill some

particularized need of market

participants that the traditional open

and competitive execution methods

cannot fulfill as well. Congress has

implicitly found with respect to EFPs

that, at least under some circumstances,

they provide certain benefits although

their pricing and execution occurs

outside of the centralized, open and

competitive marketplace. To permit

other types of noncompetitive

transactions, the Commission would

have to make a similar finding. For

example, a contract market seeking

approval of new procedures could

address the effect of the proposal on the

contract market’s usefulness as a vehicle

for price discovery and risk transfer. If

the proposal had the potential to affect

those functions adversely, the contract

market could try to demonstrate

countervailing benefits. The contract

market also could address, pursuant to

Section 15 of the Act,70 whether its

proposal was the least anticompetitive

means of achieving its objective.

Moreover, a contract market might show

that these transactions are structured in

such a way as to complement the

competitive market, not to supplant it.
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3719

71The six are Cantor Fitzgerald, Liberty, RMJ,

Tullet & Tokyo, Garban, and Hilliard & Farber.

2. Request for Comments

The Commission seeks input on the

general qualifying standards that should

govern a proposal’s eligibility for

approval and how compliance with

such standards would be demonstrated.

The Commission is soliciting comments

on the following questions:

(36) What are the appropriate qualifying

standards for noncompetitive transactions

concerning:

(a) the effect on the usefulness of a

designated futures contract as a hedging

mechanism?

(b) the effect on the price discovery function

of a designated futures contract?

(c) the effect on the level of financial integrity

in a designated contract market?

(d) the effect on the level of customer

protection in a designated contract market?

(37) Should access to noncompetitive

transactions be limited to commercials or

sophisticated investors?

(38) Should noncompetitive transactions

be subject to contract market rules?

(39) Are there other appropriate qualifying

standards?

C. Continuing Regulatory Requirements

1. The Need for Requirements

As discussed above, in addition to

determining whether an EFP is bona

fide, there is a need for appropriate

regulatory oversight in areas such as

reporting and recordkeeping, disclosure,

and internal controls. Similar

considerations apply to other types of

noncompetitive transactions.

2. Request for Comments

The Commission seeks input on any

additional requirements that should

apply to a potential noncompetitive

transaction, once it is determined that

the transaction meets basic eligibility

standards. To that end, the Commission

has identified the following areas where

it appears that additional qualifying

requirements would be required in

order to maintain systemic integrity and

to provide guidance to self-regulatory

entities. The Commission seeks input

both as to whether the prospective

requirement is necessary and, if so, how

the requirement could be structured to

provide a meaningful test. The

Commission is soliciting comments on

the following questions:

(40) What are the appropriate standards to

ensure that noncompetitive transactions are

bona fide and meet basic qualifying

requirements on an ongoing basis?

(41) What are the appropriate reporting and

recordkeeping requirements applicable to

these transactions?

(42) What are the appropriate disclosure

requirements applicable to these

transactions?

(43) What are the appropriate internal

controls applicable to these transactions?

(44) What are the appropriate safeguards to

maintain an adequate level of transparency?

(45) What are the appropriate safeguards to

prevent manipulation?

(46) What are the appropriate safeguards to

prevent fraud?

IV. Execution Facilities for

Noncompetitive Transactions Executed

on or Subject to the Rules of a Contract

Market

A. Current, Proposed and Potential

Facilities

As noted in the Introduction, several

organizations have developed execution

facilities for transactions that are

executed off-exchange and reported to

contract markets as EFPs. As with the

procedures discussed in the previous

section, these facilities expand the

opportunity for market participants to

engage in the negotiation of transactions

off the floor of the exchange. It appears,

however, that there are significant

structural differences between these

facilities and traditional methods for the

execution of EFPs. The latter generally

appear to take a bilateral, over-thecounter approach to the negotiation of

trades.

Unlike traditional approaches, these

execution facilities provide a formal

market environment for the negotiation

and arrangement of transactions, are

typically operated by third parties, and

may be beyond the operational and

regulatory purview of contract markets

to some extent. In this respect, however,

the Commission also recognizes that

these facilities perhaps should be

characterized as noncompetitive only in

the sense that the transactions executed

thereon are completed outside of

designated contract markets. Thus,

unlike the execution procedures on a

contract market, the execution

procedures on one of these facilities

have not been formally reviewed and

approved by the Commission for

compliance with the open and

competitive requirements of the Act and

other statutory requirements. The

Commission acknowledges that an

execution facility’s centralized structure

may provide a market environment that

facilitates the competitive execution of

transactions and also may provide

competitive benefits for the underlying

contract markets.

This section includes a discussion of

existing facilities, proposed facilities,

and potential facilities and presumes

that the futures leg of the transaction is

reported to and cleared by an existing

contract market clearing organization.

Generally, the request for comments

relative to this section seeks input as to

whether the regulatory environment

applicable to such transactions

continues to be appropriate in light of

the growth and evolution of activity on

such facilities or whether some form of

additional oversight is needed. As more

fully set out below, the Commission’s

request for comments also seeks input

on the appropriate form of any

prospective regulatory actions

applicable to these facilities.

1. Interdealer Brokers

There are six major interdealer

brokers in the cash U.S. Treasury

securities market.71 All or most offer

basis trading facilities. As noted above,

a basis trade involves the simultaneous

acquisition of positions in actual

Treasury securities and in offsetting

futures contracts. Transactions through

these facilities must meet minimum

trade sizes as well as other qualifying

requirements.

It appears that at least a minimal level

of transparency is maintained for basis

trading on these facilities, although it is

not clear whether that level is

completely adequate. Information on

these basis trades is obtained through

reports published over screen-based

news reporting services, such as Govpx

or Bloomberg. The screens are

anonymous, except that firms may be

identified for basis trade quotations.

It also appears that these firms restrict

their activities to dealing only with

primary dealers and other large

institutional entities. The interdealer

brokers do not reveal counterparty

names, and anonymity is thereby

maintained. Trades generally are cleared

through the Government Securities

Clearing Corporation (‘‘GSCC’’), and

anonymity is maintained even after a

trade is consummated. GSCC nets the

cash market legs of the basis trades.

2. The Chicago Board Brokerage

The CBT is developing a

computerized system for, among other

things, basis trading of U.S. Treasury

securities. The system will be operated

by the Chicago Board Brokerage

(‘‘CBB’’), a subsidiary of the CBT, which

is registered with the Securities and

Exchange Commission (‘‘SEC’’) as a

broker/dealer.

Pricing of basis trades on the CBB

system will be carried out according to

a standardized formula. The futures leg

will be assigned a price equal to the last

sale price for the futures contract. The

cash Treasury leg will be assigned a

price according to the basis spread

relative to the price of the futures leg.

The price of the cash Treasury leg also

will be adjusted to account for
3720 Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices

differences between the coupon rate of

the actual Treasury security and the

standardized 8 percent coupon rate of

the futures contract. The cash leg will be

cleared through the Clearing

Corporation for Options and Securities

(‘‘CCOS’’), a subsidiary of the Board of

Trade Clearing Corporation (‘‘BOTCC’’)

which is registered as a clearing agency

with the SEC. The futures leg will be

cleared through the CBT and BOTCC

pursuant to rules governing EFP

transactions.

3. Potential Facilities for Transactions

Other Than EFPs

The interdealer brokers and the CBB

are facilities for the execution of EFPs.

If the Commission were to permit other

types of noncompetitive trading, such as

block trading, facilities might be

established for the execution of those

types of transactions. For example, a

computerized, bulletin board system

might be established in connection with

the execution of blocks. The

Commission, of course, before

approving relevant contract market

rules, would have the opportunity to

review procedures relating to these

trades. Nonetheless, as discussed below,

the Commission is requesting comments

as to the appropriate form of regulatory

oversight for these facilities.

B. Qualifying Standards

1. Current Requirements

Basis trades executed through these

facilities currently are subject to the

same regulatory requirements as any

other EFP transaction. The

Commission’s oversight of these

facilities does not differ in any way from

its oversight of the EFP markets

generally. The Commission is concerned

that the nature of the transactions

executed on these facilities and the

environment in which they are executed

may differ enough from the nature of

traditional EFPs as to warrant differing

regulatory treatment. Indeed, it could be

argued that some of these facilities have

evolved to the extent that they are

functionally the equivalent of

designated contract markets.

2. Request for Comments

The Commission seeks input on the

regulatory structure appropriate for

these execution facilities. At a threshold

level, this area of inquiry seeks

comments on whether the existing

regulatory structure appears adequate as

currently organized and administered.

To the extent that a commenter believes

the current approach is adequate, a

supporting rationale should be set forth.

To the extent that a commenter believes

the current approach is deficient, the

Commission seeks comments

identifying the nature of the deficiency

and whether new guidelines or

standards are required. Where a

commenter believes that new regulatory

initiatives are required, the Commission

seeks comments on the form and nature

of any such initiatives. Any such

comments should include a supporting

rationale.

Specifically, the Commission is

soliciting comments on the following

questions:

(47) What characteristics distinguish

execution facilities for EFPs from contract

markets?

(48) Is the current regulatory approach

concerning these facilities adequate?

(49) If not, what modifications are

appropriate?

(50) If execution facilities were established

for noncompetitive transactions other than

EFPs, how, if at all, should the regulatory

approach that would apply to those facilities

vary from that currently applicable to

contract markets?

(51) Should execution facilities for EFPs

and other noncompetitive transactions that

are operated by non-contract markets be

subject to oversight by the relevant contract

market?

(52) Should these facilities limit access to

commercials or sophisticated investors?

(53) Should these facilities be subject to

procedures to prevent manipulation?

(54) Should these facilities be subject to

procedures to prevent fraud?

(55) Should these facilities be subject to

procedures to ensure that transactions

executed thereon are bona fide?

(56) Should these facilities be subject to

procedures to provide for market

transparency?

(57) Should these facilities be subject to

procedures related to reporting and

recordkeeping?

V. Summary of Request for Comments

After reviewing the comments, the

Commission will determine whether

rulemaking or other action is

appropriate. Commenters are invited to

discuss the broad range of concepts and

approaches described in this release.

The Commission specifically invites

commenters to compare the advantages

and disadvantages of the possible

changes discussed above with those of

the existing regulatory framework. In

addition to responding to the specific

questions presented, the Commission

encourages commenters to submit any

other relevant information. In sum, the

Commission is soliciting comments on

the following questions:

Overview

(1) Should the standards articulated in the

EFP Report be codified in the Commission’s

regulations and/or refined in any way?

(2) Should other types of noncompetitive

transactions, such as EFS transactions or

block trades, be permitted to be executed on

or subject to the rules of a contract market

and, if so, what standards should apply to

these transactions?

(3) What standards should be applicable to

execution facilities for noncompetitive

transactions executed on or subject to the

rules of a contract market?

Elements of a Bona Fide EFP:

Relationship of the Instruments

(4) How should the ‘‘strong price

correlation’’ standard articulated in the EFP

Report be implemented?

(5) Should the Commission require

contract markets to adopt a minimum

statistical correlation coefficient to be used in

assessing the acceptability of a particular

cash commodity for use as the cash leg of an

EFP?

(6) If a minimum correlation coefficient is

required, should this coefficient apply to all

EFPs, or should it be adjusted to account for

the different commodities involved in EFPs?

(7) What is the appropriate type and scope

of guidance contract markets should be

required to provide to the general public

concerning the acceptability of particular

commodities as the cash leg of an EFP?

Elements of a Bona Fide EFP:

Relationship of the Parties

(8) What is the appropriate scope of the

separate parties requirement?

(9) Should the Commission address string

trades as that practice is described in the EFP

Report and, if so, how?

Elements of a Bona Fide EFP: Nature of

the Transaction

(10) What criteria are appropriate for

judging whether the futures leg of an EFP is

bona fide?

(11) What criteria are appropriate for

judging whether the cash leg of an EFP is

bona fide?

(12) What criteria are appropriate for

determining whether a transitory EFP is bona

fide?

(13) What criteria are appropriate for

determining whether an EFP is contingent?

Elements of a Bona Fide EFP: Price of

the Transaction

(14) Should the Commission require both

the futures and cash legs of an EFP to be

priced within the daily range of their current

respective markets, should it require only

one leg of an EFP to be priced within its daily

range, or should it impose no restrictions on

the price of either leg of an EFP?

(15) Should the Commission require

contract markets to obtain documentation

regarding the business purpose underlying

the pricing of an EFP?

Other Regulatory Requirements

Governing EFPs: Reporting and

Recordkeeping

(16) Are the current reporting and

recordkeeping requirements relating to EFPs

adequate?
Federal Register / Vol. 63, No. 16 / Monday, January 26, 1998 / Notices 3721

Other Regulatory Requirements

Governing EFPs: Disclosure

(17) What should be the form and content

of disclosure concerning EFPs?

(18) Should the form and content of

disclosure vary according to the commercial

sophistication of the EFP participant similar

to the Commission’s proposed amendment to

Regulation 1.55?

(19) Should the Commission explicitly

require that customers must be informed that

an EFP is executed noncompetitively, that it

involves a cash transaction, and that their

FCM might take the opposite side of the EFP?

(20) Should the Commission explicitly

require Commission registrants to obtain

customer consent before executing an EFP on

the customer’s behalf?

Other Regulatory Requirements

Governing EFPs: Internal Controls

(21) What internal controls are appropriate

for Commission registrants to ensure

compliance with regulatory requirements

concerning the essential elements of bona

fide EFPs, reporting and recordkeeping, and

disclosure?

Other Regulatory Requirements

Governing EFPs: Transparency

(22) Do existing price reporting standards

provide adequate transparency concerning

EFPs to the marketplace and, if not, are there

alternative methods of achieving improved

price transparency?

(23) Should the Commission require

contract markets to publicize information

about bids and offers, as well as

consummated EFP transactions?

Types of Eligible Transactions:

Exchanges of Futures for Swaps

(24) What are the economic reasons firms

might have for engaging in EFS transactions

and what benefits might accrue thereunder,

including the potential benefits to domestic

futures markets, to over-the-counter markets,

and to financial markets generally?

(25) What are the potential costs or risks

of permitting EFS transactions, particularly

with respect to the effect on price discovery,

risk transfer, and the competitive character of

‘‘on-exchange’’ transactions?

(26) Should the Commission approve the

NYMEX rule proposal permitting EFS

transactions?

(27) Should EFS transactions be limited to

particular markets, participants or types of

transactions?

(28) Should special provisions be

established to ameliorate any competitive

costs or otherwise safeguard the competitive

conditions of the on-exchange market?

Types of Eligible Transactions:

Exchanges of Options for Physicals

(29) Are EOPs viable and do these

transactions offer genuine risk management

benefits?

(30) If so, should EOPs be permitted, and

should there be limitations on EOPs that

reflect the particular risk characteristics of

options?

Types of Eligible Transactions:

Alternative Execution Procedures

(31) Should alternative, noncompetitive

execution procedures be permitted on or

subject to the rules of a contract market?

(32) If so, how should these procedures be

structured to address regulatory concerns?

(33) Should these procedures be limited by

order size, participant class, contract, or

some other criteria?

(34) Can adequate safeguards be devised in

connection with these procedures to prevent

manipulation?

(35) Can adequate safeguards be devised in

connection with these procedures to prevent

fraud?

Qualifying Standards

(36) What are the appropriate qualifying

standards for noncompetitive transactions

concerning:

(a) the effect on the usefulness of a

designated futures contract as a hedging

mechanism?

(b) the effect on the price discovery function

of a designated futures contract?

(c) the effect on the level of financial integrity

in a designated contract market?

(d) the effect on the level of customer

protection in a designated contract market?

(37) Should access to noncompetitive

transactions be limited to commercials or

sophisticated investors?

(38) Should noncompetitive transactions

be subject to contract market rules?

(39) Are there other appropriate qualifying

standards?

Continuing Regulatory Requirements

(40) What are the appropriate standards to

ensure that noncompetitive transactions are

bona fide and meet basic qualifying

requirements on an ongoing basis?

(41) What are the appropriate reporting and

recordkeeping requirements applicable to

these transactions?

(42) What are the appropriate disclosure

requirements applicable to these

transactions?

(43) What are the appropriate internal

controls applicable to these transactions?

(44) What are the appropriate safeguards to

maintain an adequate level of transparency?

(45) What are the appropriate safeguards to

prevent manipulation?

(46) What are the appropriate safeguards to

prevent fraud?

Execution Facilities for Noncompetitive

Transactions Executed on or Subject to

the Rules of a Contract Market:

Qualifying Standards

(47) What characteristics distinguish

execution facilities for EFPs from contract

markets?

(48) Is the current regulatory approach

concerning these facilities adequate?

(49) If not, what modifications are

appropriate?

(50) If execution facilities were established

for noncompetitive transactions other than

EFPs, how, if at all, should the regulatory

approach that would apply to those facilities

vary from that currently applicable to

contract markets?

(51) Should execution facilities for EFPs

and other noncompetitive transactions that

are operated by non-contract markets be

subject to oversight by the relevant contract

market?

(52) Should these facilities limit access to

commercials or sophisticated investors?

(53) Should these facilities be subject to

procedures to prevent manipulation?

(54) Should these facilities be subject to

procedures to prevent fraud?

(55) Should these facilities be subject to

procedures to ensure that transactions

executed thereon are bona fide?

(56) Should these facilities be subject to

procedures to provide for market

transparency?

(57) Should these facilities be subject to

procedures related to reporting and

recordkeeping?

Issued in Washington, DC, on January 16,

1998.

Jean A. Webb,

Secretary.

[FR Doc. 98–1672 Filed 1–23–98; 8:45 am]

BILLING CODE 6351–01–P

DEPARTMENT OF DEFENSE

Office of the Secretary

Submission for OMB Review;

Comment Request

ACTION: Notice.

The Department of Defense has

submitted to OMB for clearance, the

following proposal for collection of

information under the provisions of the

Paperwork Reduction Act (44 U.S.C.

Chapter 35).

Title, Associated Form, and OMB

Number: Customer Comments; AF Form

3211; OMB Number 0701–(to be

determined).

Type of Request: New Collection.

Number of Respondents: 200.

Responses Per Respondent: 1.

Annual Responses: 200.

Average Burden per Response: 5

minutes.

Annual Burden Hours: 17.

Needs and Uses: Each guest of Air

Force lodging and its contract lodging

operations are provided access to AF

Form 3211. AF Form 3211 gives each

guest the opportunity to comment on

facilities and service received.

Completion of the form is optional. The

information collection requirement is

necessary for Wing leadership to access

the effectiveness of their lodging

program. AF Form 3211 is useful as

background documentation and

supporting material for various

management decisions. The information

is reviewed by higher headquarters

during lodging assistance and Innkeeper

Award competitions.