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[Federal Register Volume 63, Number 16 (Monday, January 26, 1998)]
[Notices]
[Pages 3708-3721]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-1672]

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COMMODITY FUTURES TRADING COMMISSION

Regulation of Noncompetitive Transactions Executed on or Subject 
to the Rules of a Contract Market

AGENCY: Commodity Futures Trading Commission.

ACTION: Concept release.

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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or 
``Commission'') is reevaluating its approach to the regulation of 
noncompetitive transactions executed on or subject to the rules of a 
contract market. Accordingly, the Commission is soliciting comments on 
a broad range of questions concerning the oversight of transactions 
involving (i) the exchange of futures contracts for, or in connection 
with, cash commodities, (ii) other noncompetitive transactions, and 
(iii) the use of execution facilities for noncompetitive transactions. 
Following the receipt of public comments, the Commission will determine 
whether rulemaking is appropriate.

DATES: Comments must be received on or before March 27, 1998.

ADDRESSES: Interested persons should submit their written data, views, 
and opinions to Jean A. Webb, Secretary of the Commission, Commodity 
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street 
N.W., Washington, D.C. 20581. In addition, comments may be sent by 
facsimile transmission to facsimile number (202) 418-5221 or by 
electronic mail to [email protected]. Reference should be made to 
``Regulation of Noncompetitive Transactions Executed on or Subject to 
the Rules of a Contract Market.'' Certain related materials described 
herein are available for inspection at the Office of the Secretariat at 
the above address. Copies of these materials also may be obtained 
through the Office of the Secretariat at the above address or by 
telephoning (202) 418-5100.

FOR FURTHER INFORMATION CONTACT: Rebecca Creed, Attorney, at (202) 418-
5493, Division of Trading and Markets, Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street N.W., Washington, 
D.C. 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Statutory and Regulatory Provisions
    B. Purpose of This Release
    C. Overview
II. Standards Governing EFP Transactions
    A. Background
    1. Historic Uses of EFPs
    2. Current EFP Volume
    3. Current Oversight of EFPs
    B. Elements of a Bona Fide EFP
    1. Relationship of the Instruments
    (a) Qualitative Correlation
    (b) Quantitative Correlation
    (c) Request for Comments
    2. Relationship of the Parties
    (a) Separate Parties
    (b) String Trades

[[Page 3709]]

    (c) Request for Comments
    3. Nature of the Transaction
    (a) Exchanges of Futures Contracts for Cash Commodities
    (b) Futures Leg Requirements
    (c) Cash Leg Requirements
    (d) Transitory EFPs
    (e) Contingent EFPs
    (f) Request for Comments
    4. Price of the Transaction
    (a) Current Requirements
    (b) Request for Comments
    C. Other Regulatory Requirements Governing EFPs
    1. Reporting and Recordkeeping
    (a) Current Requirements
    (b) Request for Comments
    2. Disclosure
    (a) Current Requirements
    (b) Request for Comments
    3. Internal Controls
    (a) Current Requirements
    (b) Request for Comments
    4. Transparency
    (a) Current Requirements
    (b) Request for Comments
III. Other Noncompetitive Transactions Executed on or Subject to the 
Rules of a Contract Market
    A. Types of Eligible Transactions
    1. Exchanges of Futures for Swaps
    (a) The New York Mercantile Exchange Proposal
    (b) Request for Comments
    2. Exchanges of Options for Physicals
    (a) Background
    (b) Request for Comments
    3. Alternative Execution Procedures
    (a) Current Procedures
    (1) Contract Market Large Order Procedures
    (2) Section 4(c) Contract Market Transactions
    (3) Securities Market Block Trading Procedures
    (b) Potential Procedures
    (c) Request for Comments
    B. Qualifying Standards
    1. The Need for Standards
    2. Request for Comments
    C. Continuing Regulatory Requirements
    1. The Need for Requirements
    2. Request for Comments
IV. Execution Facilities for Noncompetitive Transactions Executed on 
or Subject to the Rules of a Contract Market
    A. Current, Proposed and Potential Facilities
    1. Interdealer Brokers
    2. The Chicago Board Brokerage
    3. Potential Facilities for Transactions Other Than EFPs
    B. Qualifying Standards
    1. Current Requirements
    2. Request for Comments
V. Summary of Request for Comments

I. Introduction

A. Statutory and Regulatory Provisions

    Section 4(a) of the Commodity Exchange Act (``Act'') makes it 
unlawful for any person to enter into a contract for the purchase or 
sale of a commodity for future delivery ``unless such transaction is 
conducted on or subject to the rules of a board of trade which has been 
designated by the Commission as a 'contract market' for such 
commodity.'' 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:

    \1\  7 U.S.C. 6(a). As discussed below, Section 4(c) of the Act, 
7 U.S.C. 6(c), vests the Commission with certain exemptive authority 
subject to specified qualifying criteria.
    \2\  7 U.S.C. 6c(a).

    Both the Commodity Exchange Act and the rules and regulations of 
the commodity exchanges require that futures transactions be 
executed openly in a competitive manner.
* * * * *
    Certain carefully prescribed exceptions to competitive trading 
are allowed, but they do not nullify the general requirement of open 
and competitive trading.
    The purpose of this requirement is to ensure that all trades are 
executed at competitive prices and that all trades are focused into 
the centralized marketplace to participate in the competitive 
determination of the price of futures contracts. This system also 
provides ready access to the market for all orders and results in a 
continuous flow of price information. 3
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    \3\ Report of the Senate Committee on Agriculture and Forestry, 
S. Rep. No. 1131, 93rd Cong., 2d Sess. 16 (1974).

    Consistent with this policy, Commission Regulation 1.38(a) requires 
that contract market rules providing for the execution of 
noncompetitive transactions must be submitted to the Commission for 
approval. Commission Regulation 1.38(b) requires all noncompetitive 
transactions as well as all related orders, records, and memoranda to 
be identified and marked. Regulation 1.38 was adopted pursuant to 
Sections 4b and 8a(5) of the Act. 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.''
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    \4\  7 U.S.C. 6b and 12a(5).
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B. Purpose of This Release

    The purpose of this release is to solicit comments on whether the 
regulatory structure governing noncompetitive transactions executed on 
or subject to the rules of a contract market should be modified in 
light of recent developments in the marketplace. The impetus for this 
action comes from several sources, including the following.
    First, ten years have passed since the Division of Trading and 
Markets (``Division'') conducted a comprehensive study of 
EFPs.5 During this time, the use of EFPs has continued to 
grow and evolve.
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    \5\ Report of the Division of Trading and Markets: Exchanges of 
Futures for Physicals (October 1987) (``EFP Report''). This document 
provides a detailed discussion on the history, use and regulation of 
EFPs. Interested parties may obtain a copy of the EFP Report by 
contacting the Commission's Office of the Secretariat at the address 
noted above.
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    Second, several organizations have developed computerized systems 
for basis trading of U.S. Treasury securities. Essentially, a basis 
trade involves the simultaneous acquisition of positions in actual 
Treasury securities and in offsetting futures contracts. Venues for 
basis trading simplify the trading process by enabling traders to 
obtain both cash and futures positions in a single transaction which is 
reported to a contract market as an EFP.
    Third, the New York Mercantile Exchange (``NYMEX'') has sought 
Commission approval for a proposed rule that would permit the exchange 
of futures contracts for, or in connection with, swap agreements (``EFS 
transactions'').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.
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    \6\ Interested parties may obtain a copy of the NYMEX proposal 
permitting EFS transactions by contacting the Commission's Office of 
the Secretariat at the address noted above.
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    Fourth, the Chicago Board of Trade (``CBT''), through counsel, 
requested the Division of Economic Analysis to agree not to recommend 
that the Commission take any enforcement action against the CBT, its 
members or market participants in connection with the CBT's proposed 
implementation of a one-year pilot program facilitating the off-
exchange transfer of futures contracts in agricultural products in 
exchange for related over-the-counter agricultural options.7
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    \7\ The Division of Economic Analysis staff advised counsel 
that, in light of the Commission's ongoing consideration of 
agricultural trade options in connection with its advance notice of 
proposed rulemaking, 62 FR 31375 (June 9, 1997), it was not 
currently appropriate to consider this request. The Commission has 
subsequently proposed removing the prohibition against off-exchange 
trade options on the enumerated agricultural commodities pursuant to 
a three-year pilot program. Trade Options on the Enumerated 
Agricultural Commodities, 62 FR 59624 (Nov. 4, 1997).

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[[Page 3710]]

    Finally, recent legislative proposals contemplate the establishment 
of separate, professional markets.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.
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    \8\ See, e.g., S. 257, 105th Cong., 1st Sess. Sec. 6 (1997).
    Part 36 of the Commission's regulations adopts certain 
exemptions under a pilot program for separate, professional markets. 
Included among the exemptions is a provision exempting certain 
noncompetitive trading subject to the rules of a professional 
market. However, no contract market has filed a proposal with the 
Commission pursuant to Part 36.
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C. Overview

    For the foregoing reasons, the Commission has determined to seek 
comments on whether the existing regulatory structure should be revised 
to provide additional guidance concerning standards governing 
noncompetitive transactions executed on or subject to the rules of a 
contract market. In scope, the Commission's request includes 
transactions that currently are permitted, such as EFPs, as well as 
transactions that are not currently permitted, such as EFS transactions 
or block trades. Of course, if the Commission were to revise its 
regulatory structure relating to noncompetitive transactions, the 
choice of whether to permit these types of transactions on a particular 
contract market would remain, in the first instance, with that contract 
market.
    In general, the Commission is soliciting comments on the following 
questions:

    (1) Should the standards articulated in the EFP Report be 
codified in the Commission's regulations and/or refined in any way?
    (2) Should other types of noncompetitive transactions, such as 
EFS transactions or block trades, be permitted to be executed on or 
subject to the rules of a contract market and, if so, what standards 
should apply to these transactions?
    (3) What standards should be applicable to execution facilities 
for noncompetitive transactions executed on or subject to the rules 
of a contract market?

More specific questions addressing particular aspects of these topics 
are posed in the relevant sections of this release. A consolidated list 
of questions is set forth at the conclusion. The Commission recognizes, 
however, that its identification of the issues may not be exhaustive 
and therefore invites comments on other aspects of these topics even if 
not expressly set out below.
    The Commission is asking these questions for the dual purpose of 
giving notice of its consideration of these issues and of obtaining 
input before proceeding with any specific initiatives. Commenters 
should set forth with particularity the bases for their views. After 
receiving input, the Commission will endeavor to strike an appropriate 
balance among the relevant concerns.

II. Standards Governing EFP Transactions

A. Background

1. Historic Uses of EFPs
    An EFP involves simultaneous transactions in the futures and cash 
commodity markets. The futures market transaction consists of a 
noncompetitive transfer of a futures position between the parties to 
the EFP. Thus, one party buys the physical commodity and simultaneously 
sells (or gives up long) futures contracts while the other party sells 
the physical commodity and simultaneously buys (or receives long) 
futures contracts. Subject to applicable contract market rules, the 
quantity and price of the futures and cash commodity to be exchanged as 
well as other terms are negotiated privately by the parties rather than 
being executed openly and competitively on a contract market. Depending 
on the pre-existing market positions of EFP counterparties, an EFP 
transaction can create, transfer, or extinguish futures positions.
    The EFP exception currently contained in Section 4c(a) of the Act 
first appeared in H.R. 12287, which was introduced in 1932. The report 
of the House Committee on Agriculture accompanying that bill indicates 
that this exception was intended to permit the continuation of what was 
described as an accepted commercial practice:

    Transactions involving the exchange of cash commodities for 
futures in accordance with exchange rules applying to such exchanges 
are exempted, even though they take the form of office trades, it 
being understood that the exchange of cash commodities for futures 
is a common and necessary practice.9

    \9\ Commodity Short Selling, H.R. Rep. No. 1551, 72d Cong., 1st 
Sess. 3 (1932).

    The EFP exception was ultimately adopted with the enactment of the 
Commodity Exchange Act in 1936. None of the amendments to Section 4c(a) 
since that time provides further guidance as to the scope of 
permissible EFP transactions.10
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    \10\ See Commodity Futures Trading Commission Act of 1974, Pub. 
L. No. 93-463, 88 Stat. 1389 (substituted the Commission for the 
Secretary of Agriculture and deleted state law preservation clause); 
Futures Trading Act of 1978, Pub. L. No. 95-405, 92 Stat. 865 
(required contract market rules permitting EFPs to be approved by 
the Commission); Futures Trading Act of 1982, Pub. L. No. 97-444, 96 
Stat. 2294 (exempted transactions in foreign currency options traded 
on a national securities exchange from coverage of the Commodity 
Exchange Act).
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    As discussed in detail in the EFP Report, the use of EFPs has 
evolved to include practices not contemplated at the time Section 4c(a) 
originally was enacted. Indeed, financial futures contracts, which now 
dominate futures trading at some exchanges, did not exist at the time 
the EFP exception was adopted. In the EFP Report, the Division 
concluded that it appeared appropriate to interpret Section 4c(a) to 
accommodate some of these practices, many of which arise out of trading 
practices in various cash markets and which accomplish a variety of 
commercial purposes. 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
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    \11\ EFP Report at 144-145.
    \12\ Id. at 26. For example, the Division has expressed its 
opinion that the EFP ``exemption was not designed to create an 
avenue for traders to use EFP transactions to accomplish what they 
could not otherwise legitimately do, that is, wash trades, 
accommodation trades, fictitious sales, or illegal off-exchange 
transactions.'' Report of the Division of Trading and Markets: 
Volume Investors Corporation 59 n. 54 (July 1985).
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2. Current EFP Volume
    A comparison of statistical data regarding the level of EFP 
activity between the late 1980s (when the EFP Report was published) and 
recent years shows that EFP activity, in many major markets, has 
continued to grow. The following table summarizes such data for 
selected contracts between 1986 and 1996.

[[Page 3711]]

   Table 1.--EFPs as a Percent of Trading Volume in Selected Contracts  
                             1986--1996 \13\                            
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                    Contract Market                       1986     1996 
------------------------------------------------------------------------
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 
------------------------------------------------------------------------
\13\ The data shown in Table 1 is for calendar year 1986 and 1996.      

    As the table shows, EFP activity as a share of trading volume has 
been relatively stable in traditional agricultural markets and has 
declined in some cases. The trend for financial futures contracts has 
been just the opposite, with EFP activity continuing to increase, in 
some cases dramatically.
3. Current Oversight of EFPs
    EFP transactions are currently subject to oversight through a 
variety of sources, including: (i) the Commission's review of contract 
market rules governing such transactions; (ii) the Commission's 
reporting and recordkeeping requirements; (iii) contract markets' 
enforcement of their own rules; (iv) the Commission's rule enforcement 
review program; and (v) the Commission's own enforcement program.

B. Elements of a Bona Fide EFP

    The EFP Report described EFP practices in selected markets, 
analyzed the legislative and regulatory framework surrounding EFPs, and 
reviewed the contract market rules and interpretations that govern 
them. The EFP Report suggested possible criteria to be examined by 
contract markets in evaluating whether a particular EFP transaction is 
eligible for the Section 4c(a) exception. In particular, the Division 
enumerated three essential elements of a bona fide EFP as follows: (i) 
a futures transaction and a cash transaction which are integrally 
related; (ii) an ``exchange'' of futures contracts for cash commodity, 
where the cash commodity contract provides for the transfer of 
ownership of the cash commodity to the cash buyer upon performance of 
the terms of the contract, with delivery to take place within a 
reasonable time thereafter in accordance with prevailing cash market 
practice; and (iii) separate parties to the EFP, where the accounts 
involved have different beneficial ownership or are under separate 
control.14
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    \14\  EFP Report at 146-150.
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    In addition, the Division developed a non-exclusive list of other 
indicia to assist contract markets in determining whether the essential 
elements of a bona fide EFP have been satisfied. These include: (i) the 
degree of price correlation between the futures and cash legs of the 
EFP; (ii) the prices of the futures and cash legs of the EFP and their 
relationship to the prevailing prices in their respective markets; 
(iii) whether the cash seller has possession, the right to possession, 
or the right to future possession of the cash commodity prior to the 
execution of the EFP; (iv) the cash seller's ability to perform on his 
delivery obligation in the absence of prior possession of the cash 
commodity, i.e., the cash seller's access to the cash market; and (v) 
whether the cash buyer acquires title to the cash 
commodity.15
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    \15\ Id. at 150-151.
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    These elements can be analyzed in terms of four categories: (i) the 
relationship of the instruments; (ii) the relationship of the parties; 
(iii) the nature of the transaction; and (iv) the price of the 
transaction. The following discussion summarizes the elements and 
indicia of a bona fide EFP as set forth by the Division in the EFP 
Report. As noted above, the Commission is soliciting comments on 
whether these standards should be codified in the Commission's 
regulations and/or refined in any way.
1. Relationship of the Instruments
    (a) Qualitative Correlation. In the EFP Report, the Division 
determined that the futures and cash legs of a bona fide EFP should be 
correlated with each other, both qualitatively and 
quantitatively.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.
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    \16\ Id. at 152-160.
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    In the EFP Report, the Division concluded that the cash commodity 
should have a reliable and demonstrable price relationship with the 
futures contract involved in the EFP.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
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    \17\ Id. at 155.
    \18\ Id. at 157.
    The Division referred to Administrative Determination 239, 
issued by the Commodity Exchange Authority on December 16, 1974, 
which advised that, ``[i]f a commodity, product or by-product is 
hedgeable under the Act, it may be exchanged for futures. If it is 
not hedgeable, it may not be exchanged.'' See generally 17 CFR 
1.3(z) (defines bona fide hedging transactions and positions); 
Clarification of Certain Aspects of the Hedging Definition, 52 FR 
27195 (July 20, 1987).
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    In the EFP Report, the Division noted that statistical correlation 
coefficients 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
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    \19\ A correlation coefficient measures the degree to which the 
movements of two variables are related. Here the variables consist 
of the price of the futures contracts and the price of the cash 
commodity.
    \20\ EFP Report at 158.
    \21\ Id. at 159.
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    (b) Quantitative Correlation.
    For quantitative correlation to exist, the Division determined that 
the cash commodity position should be approximately equal in quantity 
or dollar value to the futures position and that appropriate hedge 
ratios may be

[[Page 3712]]

used to create such dollar equivalency.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.
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    \22\ Id. at 159-160.
    For example, if the futures position established by the EFP 
transaction represents 50,000 bushels of corn, then the associated 
cash leg should also equal approximately 50,000 bushels of corn. 
With respect to the use of appropriate hedge ratios to create dollar 
equivalency, traders might cross-hedge a 182-day T-bill by using 
more than one 91-day T-bill futures contract since the risk exposure 
on the principal amount of the T-bill increases the higher the 
duration of the security. Other instruments with differing 
maturities and yields would require different ratios.
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    (c) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (4) How should the ``strong price correlation'' standard 
articulated in the EFP Report be implemented?
    (5) Should the Commission require contract markets to adopt a 
minimum statistical correlation coefficient to be used in assessing 
the acceptability of a particular cash commodity for use as the cash 
leg of an EFP?
    (6) If a minimum correlation coefficient is required, should 
this coefficient apply to all EFPs, or should it be adjusted to 
account for the different commodities involved in EFPs?
    (7) What is the appropriate type and scope of guidance contract 
markets should be required to provide to the general public 
concerning the acceptability of particular commodities as the cash 
leg of an EFP?
2. Relationship of the Parties
    (a) Separate Parties. In the EFP Report, the Division concluded 
that a bona fide EFP must be executed between separate 
parties.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.
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    \23\ Id. at 147, 149-150.
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    (b) String Trades. In the EFP Report, the Division discussed a 
method of effecting an EFP transaction in the grain markets called a 
``pass-through'' or ``string trade.'' 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
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    \24\ Id. at 47, 148 n. 173.
    \25\ For example, party A has agreed to sell grain to and buy 
futures contracts from party B. Meanwhile, party B has agreed to 
sell grain to and buy futures contracts from party C. When C is 
ready to sell futures contracts to B in order to fix the price of 
their cash transaction, B directs C to execute the futures trade 
with A instead, thus satisfying B's obligation to sell futures 
contracts to A. Thus, A and C execute an EFP in which C sells 
futures contracts to A, but there is no corresponding cash 
transaction between A and C. In the absence of this string trade, 
parties A and B and parties B and C must execute separate EFP 
transactions consistent with their contractual obligations. Thus, 
the string trade serves to match the mutually exclusive futures 
obligations so that only one EFP is reported to the contract market.
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    (c) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (8) What is the appropriate scope of the separate parties 
requirement?
    (9) Should the Commission address string trades as that practice 
is described in the EFP Report and, if so, how?
3. Nature of the Transaction
    (a) Exchanges of Futures Contracts for Cash Commodities. As 
discussed previously, Section 4c(a) of the Act excepts EFPs from the 
prohibition against various types of noncompetitively executed 
transactions. A bona fide EFP must involve an ``exchange'' of futures 
contracts for cash commodity in which both legs of the transaction 
entail actual economic risk.
    (b) Futures Leg Requirements. The futures leg of the EFP must be 
reported to and cleared by a contract market clearing organization. 
Therefore, it is subject to the same margin obligations, both original 
and variation, as any other exchange-traded futures transaction. If the 
futures leg were netted off-exchange, this conduct might constitute 
bucketing in violation of Section 4b(a) of the Act.26
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    \26\ 7 U.S.C. 6b.
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    (c) Cash Leg Requirements. In the EFP Report, the Division 
concluded that the cash commodity contract must impose a real 
obligation to transfer ownership of the cash commodity from the cash 
seller to the cash buyer upon performance of the terms of the contract, 
with delivery taking place within a reasonable time thereafter in 
accordance with prevailing cash market practice.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
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    \27\ EFP Report at 146.
    \28\ Id. at 149. For example, under this approach, a third party 
could assume the seller's obligation to deliver the cash commodity, 
or the cash seller could contract to purchase the cash commodity 
from the third party and direct that delivery be made to the cash 
buyer in the EFP.
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    In the EFP Report, the Division discussed several factors to be 
considered in analyzing the parties' intent with respect to the 
transfer of cash commodity, including: (i) the ability of the cash 
seller to make delivery and of the cash buyer to take delivery of the 
cash commodity; (ii) the level of creditworthiness required of the cash 
seller and buyer; (iii) the form and terms of the cash commodity 
contract; (iv) the documentation underlying the transfer of cash 
commodity from the cash seller to the cash buyer; and (v) whether the 
cash buyer acquires an enforceable claim on the title to the cash 
commodity.29
---------------------------------------------------------------------------

    \29\ Id. at 179-192, 196.
---------------------------------------------------------------------------

    The Division expressed the view that the cash seller is not 
required to have possession, or the right to possession, of the cash 
commodity in order to undertake a contractual obligation to deliver it 
in the future by way of an EFP.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.
---------------------------------------------------------------------------

    \30\ Id. at 181.
---------------------------------------------------------------------------

    In determining whether there has been, or will be, an actual 
transfer of ownership of the cash commodity, the critical inquiry is 
whether the buyer of the cash commodity has acquired or will acquire, 
upon completion of performance under the contract, title to the cash 
commodity associated with the

[[Page 3713]]

EFP.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.
---------------------------------------------------------------------------

    \31\ Id. at 185-186.
    \32\ Id. at 186.
---------------------------------------------------------------------------

    (d) Transitory EFPs. In the EFP Report, the Division expressed 
concern about a practice, then occurring frequently in the gold and 
foreign currency markets, involving both an EFP and an offsetting cash 
commodity transfer.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.
---------------------------------------------------------------------------

    \33\ Id. at 192-193.
---------------------------------------------------------------------------

    The Division concluded that, in reviewing transitory EFPs, the EFP 
and the cash commodity transfer should be examined both separately and 
as an integrated transaction.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.
---------------------------------------------------------------------------

    \34\ Id. at 195.
---------------------------------------------------------------------------

    The predominant consideration is whether the cash commodity 
transfer can stand on its own as a commercially appropriate 
transaction, with no obligation on either party to carry out the 
EFP.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.
---------------------------------------------------------------------------

    \35\ Id. Evidence that the cash commodity transfer is severable 
from the EFP is necessary, but not sufficient, to establish the 
legitimacy of the integrated transaction. As noted above, the EFP 
itself must be bona fide.
---------------------------------------------------------------------------

    Additional issues to be considered in evaluating whether the 
integrated transaction is bona fide include: (i) The timing of the cash 
commodity transfer and the EFP; (ii) whether the same parties have 
executed a number of integrated transactions in which the cash 
commodity transfer never occurs independently of the EFP; (iii) whether 
there have been a series of transactions in which the same cash 
commodity is transferred repeatedly between the same parties, resulting 
in the liquidation of a futures position much larger than the exchanged 
cash commodity which ultimately remains with the original owner; and 
(iv) the relationship between the parties and their patterns of 
dealings, including evidence of money passes between them.36
---------------------------------------------------------------------------

    \36\ Id. at 200-201.
---------------------------------------------------------------------------

    (e) Contingent EFPs. Contingent EFPs are an impermissible subset of 
transitory EFPs. The existence of conditions tying the cash commodity 
transfer and the EFP together may indicate that the transactions are 
not severable but are contingent upon each other.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.
---------------------------------------------------------------------------

    \37\ Id. at 198.
---------------------------------------------------------------------------

    (f) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (10) What criteria are appropriate for judging whether the 
futures leg of an EFP is bona fide?
    (11) What criteria are appropriate for judging whether the cash 
leg of an EFP is bona fide?
    (12) What criteria are appropriate for determining whether a 
transitory EFP is bona fide?
    (13) What criteria are appropriate for determining whether an 
EFP is contingent?
4. Price of the Transaction
    (a) Current Requirements. As discussed previously, because EFPs are 
executed noncompetitively off-exchange, the prices of both the futures 
and cash legs are determined by mutual agreement of the parties. In the 
EFP Report, the Division concluded that the price differential between 
the futures and cash legs should reflect commercial realities and that 
at least one leg of the transaction should be priced at the prevailing 
market.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
---------------------------------------------------------------------------

    \38\ Id. at 174-175.
    \39\ The Division identified several such examples in the EFP 
Report including meeting a margin call, taking advantage of expected 
foreign exchange fluctuations, and complying with internal inventory 
policies. Id. at 169-173.
    \40\ Id. at 169.
    \41\ Id. at 175.
---------------------------------------------------------------------------

    (b) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (14) Should the Commission require both the futures and cash 
legs of an EFP to be priced within the daily range of their current 
respective markets, should it require only one leg of an EFP to be 
priced within its daily range, or should it impose no restrictions 
on the price of either leg of an EFP?
    (15) Should the Commission require contract markets to obtain 
documentation regarding the business purpose underlying the pricing 
of an EFP?

C. Other Regulatory Requirements Governing EFPs

1. Reporting and Recordkeeping
    (a) Current Requirements Under the Commission's current regulations 
EFPs are subject to broad reporting and recordkeeping requirements. 
Commission Regulation 1.35(a) generally requires every FCM, introducing 
broker (``IB''), and contract market member to keep full, complete and 
systematic records of all transactions relating to its business of 
dealing in commodity futures, commodity options, and cash commodities, 
to retain such records for a period of five years, and to produce them 
upon request of the Commission or the Department of Justice. Commission 
Regulation 1.38(b) requires every person handling, executing, clearing, 
or carrying EFPs to identify all related documents by appropriate 
symbol or designation. Similarly, under Commission Regulation 1.35(e), 
each

[[Page 3714]]

contract market must maintain a record showing, by appropriate and 
uniform symbols, any transaction which is made noncompetitively in 
accordance with written rules of the contract market. Commission 
Regulation 1.35(a-2) requires FCMs, IBs, and other contract market 
members to ask their customers for documentation of the cash leg of an 
EFP upon request of the contract market, the Commission, or the 
Department of Justice and upon receipt to provide the documentation to 
the requesting body; requires customers to create, retain, and produce 
such documentation directly to the requesting body; and requires that 
all contract markets adopt, as necessary, corresponding rules requiring 
its members to provide the documentation to the contract market.
    Under Part 16 of the Commission's regulations, each contract market 
must report the total quantity of futures contracts bought or sold in 
connection with EFPs to the Commission by clearing member and must 
publish the total quantity of EFPs executed on any given business day. 
Part 17 of the Commission's regulations requires FCMs, members of 
contract markets, and foreign brokers to report to the Commission the 
quantity of EFPs executed in each special account on the day it has a 
reportable futures position as well as on the first day the account is 
no longer reportable. Commission Regulation 18.05 requires each trader 
holding or controlling a reportable futures position (``large trader'') 
to keep records of all futures and cash commodity positions and 
transactions. Finally, the Commission may issue a special call under 
Regulation 21.03(e)(1)(iii) to FCMs, IBs, or customers that requires 
information about EFPs to be submitted for the particular commodity, 
contract market, and delivery months named in the call.
    (b) Request for Comments. The Commission is soliciting comments on 
the following question:

    (16) Are the current reporting and recordkeeping requirements 
relating to EFPs adequate?
2. Disclosure
    (a) Current Requirements. Commission Regulation 1.55(a)(1) 
prohibits an FCM or IB from opening a commodity futures account for any 
customer unless the FCM or IB first provides the customer with a 
written risk disclosure statement prepared by or approved by the 
Commission and receives a signed acknowledgment from the customer that 
he or she has received and understood this statement.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
---------------------------------------------------------------------------

    \42\ The Commission is currently proposing to amend Regulation 
1.55 so that FCMs and IBs would no longer be required to furnish the 
specified written risk disclosure statement to certain categories of 
financially accredited customers or to obtain written 
acknowledgments of receipt of the risk disclosure statement before 
opening a commodity futures account for these customers. In 
addition, the Commission is currently proposing amendments to 
relieve FCMs and IBs from requirements to furnish disclosure 
statements to these financially accredited customers pertaining to 
foreign futures or foreign options (Regulation 30.6(a)), domestic 
exchange-traded commodity options (Regulation 33.7(a)), customers 
whose accounts are transferred to another FCM or IB other than at 
the customer's request (Regulation 1.65(a)(3)), and the treatment in 
bankruptcy of non-cash margin held by an FCM (Regulation 190.10(c)). 
Distribution of Risk Disclosure Statements by Futures Commission 
Merchants and Introducing Brokers, 62 FR 47612 (Sept. 10, 1997).
    \43\ Id. at 47614.
---------------------------------------------------------------------------

    The Commission seeks to ensure full and fair disclosure of the 
requirements of and risks inherent in EFPs. Only when customers have 
complete information regarding EFPs can they effectively evaluate 
whether such transactions are consistent with their financial goals. 
The Commission believes that some guidance as to the form and content 
of disclosure concerning EFPs may be appropriate.
    (b) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (17) What should be the form and content of disclosure 
concerning EFPs?
    (18) Should the form and content of disclosure vary according to 
the commercial sophistication of the EFP participant similar to the 
Commission's proposed amendment to Regulation 1.55?
    (19) Should the Commission explicitly require that customers 
must be informed that an EFP is executed noncompetitively, that it 
involves a cash transaction, and that their FCM might take the 
opposite side of the EFP?
    (20) Should the Commission explicitly require Commission 
registrants to obtain customer consent before executing an EFP on 
the customer's behalf?
3. Internal Controls
    (a) Current Requirements. Commission Regulation 166.3 generally 
requires all Commission registrants, except associated persons who have 
no supervisory duties, to ``diligently supervise the handling by its 
partners, officers, employees and agents * * * of all commodity 
interest accounts carried, operated, advised or introduced by the 
registrant and all other activities * * * relating to its business as a 
Commission registrant.'' One basic purpose of the rule is to protect 
customers by ensuring that their dealings with employees of Commission 
registrants will be reviewed and overseen by other officials in the 
firm.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.
---------------------------------------------------------------------------

    \44\ Adoption of Customer Protection Rules, 43 FR 31886, 31889 
(July 24, 1978).
---------------------------------------------------------------------------

    (b) Request for Comments. The Commission is soliciting comments on 
the following question:

    (21) What internal controls are appropriate for Commission 
registrants to ensure compliance with regulatory requirements 
concerning the essential elements of bona fide EFPs, reporting and 
recordkeeping, and disclosure?
4. Transparency
    (a) Current Requirements. The current reporting requirements for 
EFPs are outlined above. Exchanges do not require, and generally do not 
have a mechanism for providing, timely information about EFP bids, 
offers, and transactions.
    (b) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (22) Do existing price reporting standards provide adequate 
transparency concerning EFPs to the marketplace and, if not, are 
there alternative methods of achieving improved price transparency?
    (23) Should the Commission require contract markets to publicize 
information about bids and offers, as well as consummated EFP 
transactions?

III. Other Noncompetitive Transactions Executed on or Subject to 
the Rules of a Contract Market

A. Types of Eligible Transactions

    Although EFPs have raised many issues and concerns, they have 
proven to be useful commercial tools. As noted above, the Commission 
seeks to explore whether there are other types of noncompetitive 
transactions that also could enhance the usefulness of

[[Page 3715]]

designated contract markets without compromising necessary regulatory 
safeguards. The Commission has identified three potential candidates: 
(i) EFS transactions; (ii) exchanges of options for physicals 
(``EOPs''); and (iii) block trades. The Commission welcomes the 
identification by commenters of any other potential types of 
transactions.
1. Exchanges of Futures for Swaps
    (a) The New York Mercantile Exchange Proposal. As noted, the NYMEX 
has applied to the Commission for approval of a rule that would permit 
the execution of EFS transactions. As proposed by the NYMEX, EFS 
transactions would involve the noncompetitive exchange of futures 
contracts for separately negotiated swap agreements. In this respect, 
the proposal would establish for EFS transactions provisions that are 
parallel to, but separate from, those governing EFP transactions. 
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
---------------------------------------------------------------------------

    \45\ As noted above, pursuant to Section 4c(a) of the Act, EFPs 
are explicitly permitted as an exception to the usual open and 
competitive execution requirements established by the Act, but only 
to the extent provided for by contract market rules approved by the 
Commission. Also as noted, Commission Regulation 1.38(a) authorizes 
noncompetitive transactions if executed in accordance with contract 
market rules that have received Commission approval. All domestic 
commodity exchanges permit the execution of EFP transactions, 
although there is some variation among exchange rules.
    \46\ In general, a simplified swap agreement may be 
characterized as an agreement between two parties to exchange a 
series of cash flows measured by different interest rates, exchange 
rates, or prices, with payments calculated by reference to a 
principal base (or notional amount). See Policy Statement Concerning 
Swap Transactions, 54 FR 30695 (July 21, 1989). Part 35 of the 
Commission's Regulations defines swap agreements by reference to the 
Bankruptcy Code. See 17 CFR 35.1(b)(1).
---------------------------------------------------------------------------

    Under the NYMEX proposal, the swap component of the EFS transaction 
must comply with the requirements of Part 35 of the Commission's 
regulations or with the Commission's 1989 Policy Statement concerning 
cash-settled swap transactions or must otherwise qualify for or fall 
within other exemptions or jurisdictional exclusions under the Act or 
Commission regulations. This initiative represents the first proposal 
the Commission has received for approval of EFS transactions.
    The NYMEX states that the rule proposal in part responds to the 
substantial growth that has occurred in the swaps market during recent 
years. In this respect, the NYMEX asserts that swap transactions, 
though not ``physical'' in the traditional sense, subject market 
participants to the same type of price risk. Thus, the NYMEX claims 
that the proposal could aid in linking the on-exchange futures and off-
exchange swap markets.
    The NYMEX believes that allowing EFS transactions would increase 
market efficiency and enhance the use of the exchange as a risk 
transfer medium. Specifically, the NYMEX believes that both traditional 
market users and swap dealers (banks, trading companies, and energy 
companies) would benefit from the availability of EFS transactions. By 
a similar line of reasoning, the NYMEX notes that commodity swap 
instruments continue to play an increasingly important role in 
providing a risk management function in crude oil and other markets, in 
part because they can be individually tailored to a user's commercial 
needs and thereby reduce substantially the presence of basis risk. 
Because of this, the NYMEX concludes that permitting EFS transactions 
would reduce basis risk for NYMEX market participants, enhance 
competition among exchange and over-the-counter markets, and facilitate 
greater usage of NYMEX as a centralized market.
    The NYMEX affirms that it has not identified any evidence 
suggesting that adoption of the proposal would harm existing liquidity 
in NYMEX markets. Moreover, the NYMEX concludes that the rule proposal 
would make the liquidity present in NYMEX energy markets accessible to 
swap market participants via the EFS process. Additionally, the NYMEX 
identifies the ability of swap participants to close out futures 
positions more readily, as the underlying futures contracts approach 
expiration, and thus utilize the exchange in managing price risk 
associated with swap market transactions as a potential benefit of the 
proposal.
    The NYMEX also views the financial safeguards of the on-exchange 
trading environment as potentially beneficial, and attractive to, swap 
market participants. The NYMEX concludes that access to these financial 
safeguards, including those associated with the position limit and 
margining systems, either for purposes of creating or extinguishing 
swap agreements, would enable swap market participants to enhance the 
credit quality of swap positions. Thus, in summary, the NYMEX concludes 
that several benefits would accrue to market participants from adoption 
of the proposed rule, including improvements in liquidity and price 
transparency, and reductions in basis and credit risk.
    (b) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (24) What are the economic reasons firms might have for engaging 
in EFS transactions and what benefits might accrue thereunder, 
including the potential benefits to domestic futures markets, to 
over-the-counter markets, and to financial markets generally?
    (25) What are the potential costs or risks of permitting EFS 
transactions, particularly with respect to the effect on price 
discovery, risk transfer, and the competitive character of ``on-
exchange'' transactions?
    (26) Should the Commission approve the NYMEX rule proposal 
permitting EFS transactions?
    (27) Should EFS transactions be limited to particular markets, 
participants or types of transactions?
    (28) Should special provisions be established to ameliorate any 
competitive costs or otherwise safeguard the competitive conditions 
of the on-exchange market?
2. Exchanges of Options for Physicals
    (a) Background. The EFP Report included an examination of 
EOPs.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 Commission-approved contract market rules and, 
on that basis, concluded that EOP transactions could potentially fall 
within the noncompetitive trade exception found in that regulation.
---------------------------------------------------------------------------

    \47\ EFP Report at 235-240.
    \48\ 7 USC 6c(b) and 6c(c).
---------------------------------------------------------------------------

    The EFP Report's investigation of contract market rules found that 
most were silent on the question of whether EOP transactions were 
acceptable, with only the Chicago Mercantile Exchange (``CME'') rules 
expressly prohibiting EOP transactions.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.
---------------------------------------------------------------------------

    \49\ CME Rule 538.
    \50\ ACC Rule 908.
---------------------------------------------------------------------------

    The Division staff that prepared the EFP Report were unable to 
discover any instances in which an option on a futures contract was 
exchanged for a cash commodity, and the Commission is not aware that 
any of these transactions have occurred since the publication of the 
report. The Division observed that the absence of these transactions 
could be due to the fact that market participants had not yet been able 
to design a plan to execute EOPs, perhaps

[[Page 3716]]

because of difficulty in establishing an appropriate basis relationship 
between the option and the cash commodity.
    The EFP Report indicated that commentary from contract market 
officials and market participants on the EOP issue was divided. Some 
commenters objected on the basis that an option does not involve a 
delivery commitment. However, others indicated that EOPs could be 
appropriate in some circumstances. These commenters indicated that an 
EOP might be appropriate for the grantor of an option, who has a 
delivery commitment upon exercise, or in the case of a deep-in-the-
money option, which as a practical matter appears to be the equivalent 
of a futures position. One commenter stated that EOPs were conceptually 
viable but that the instability associated with option deltas (and 
therefore option value) could create great risk for a person accepting 
an option in exchange for a cash commodity. This commenter also 
indicated that, assuming this risk was reflected in the price, EOP 
transactions could be very expensive.
    (b) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (29) Are EOPs viable and do these transactions offer genuine 
risk management benefits?
    (30) If so, should EOPs be permitted, and should there be 
limitations on EOPs that reflect the particular risk characteristics 
of options?
3. Alternative Execution Procedures
    (a) Current Procedures. (1) Contract Market Large Order Procedures. 
The Commission has approved several contract market rules that 
establish alternative execution procedures for certain transactions. 
These procedures generally preserve the competitive forces available on 
a centralized market and thereby comply with the ``open and 
competitive'' requirement of Commission Regulation 1.38(a).
    The CME, the New York Cotton Exchange (``NYCE'') and the New York 
Futures Exchange (``NYFE'') have adopted similar procedures providing 
for the execution of large orders.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.
---------------------------------------------------------------------------

    \51\ CME Rule 521 (``All-Or-None Transactions''); NYCE Rule 
1.10-B (``Block Order Execution''); NYFE Rule 312 (``Block Order 
Execution'').
    The CME all-or-none procedures apply to a variety of products, 
including currency futures, South African Rand options, 28-day 
Mexican TIIE futures, 91-day Mexican CETES futures, Brady Bond 
futures, IPC futures, Three-month Eurodollar futures bundle 
combinations, 13-week U.S. Treasury Bill futures, British Pound/
Deutsche Mark and Deutsche Mark/Japanese Yen futures, and Argentine 
Par Bond futures. The minimum contract size eligible for execution 
under these procedures ranges from 20 contracts to 100 contracts. 
The NYCE limits its block order execution procedures to transactions 
involving 50 or more FINEX futures or futures spreads, options 
spreads or futures/options combinations in the same contract. The 
NYFE limits its block order execution procedures to transactions 
involving 15 or more NYSE Large Composites, 30 or more NYSE 
Composite Index or 50 or more CRB futures or options, futures 
spreads, options spreads or futures/options combinations in the same 
contract.
---------------------------------------------------------------------------

    The NYCE and NYFE expressly prohibit an initiating floor broker 
from bundling customer orders to meet the minimum contract size 
required for eligibility under the large order execution procedures, 
but allow a responding broker to bundle customer limit orders and to 
add orders from his or her own account to match the quantity of futures 
or options in the large order request. Under the CME all-or-none 
procedures, both the initiating floor broker and the responding floor 
broker may bundle customer orders to meet the minimum contract size as 
long as the customers specifically request execution under these 
procedures or the all-or-none bid or offer is the best price available 
to satisfy the terms of the orders. Although cross trades are not 
permitted at the NYCE and NYFE under these procedures, they are 
permitted at the CME. Large order transactions executed at all three 
exchanges must be reported to a designated Exchange official who 
records and publishes the quantity and prices separately from reports 
of transactions in the regular market.
    The CME also has adopted separate large order execution (``LOX'') 
procedures for transactions involving 300 or more futures contracts in 
the Standard & Poor's 500 Stock Price Index or the Nikkei Stock 
Average.52 These procedures, which include the pre-execution 
solicitation of interest and discussion of price, have only been used 
once in the several years they have been available.
---------------------------------------------------------------------------

    \52\ CME Rule 549.
---------------------------------------------------------------------------

    The CME also has adopted request for size (``RFS'') quotations for 
the GLOBEX system. These procedures supplement the GLOBEX request for 
quote (``RFQ'') procedures. As originally configured, RFQ messages were 
distributed without any contract quantity indication. Thus, the 
adoption of RFS procedures permits requests for large size transactions 
for all contracts traded through GLOBEX, subject to a minimum threshold 
quantity for RFS quotations of 100 contracts.53
---------------------------------------------------------------------------

    \53\ The CME recently lowered the minimum threshold quantity for 
RFS quotations for currency futures traded through GLOBEX to 50 
contracts.
---------------------------------------------------------------------------

    (2) Section 4(c) Contract Market Transactions. As noted previously, 
Section 4(c) of the Act vests the Commission with certain exemptive 
authority from the general requirement that all futures transactions 
must be executed on designated contract markets, subject to specified 
qualifying criteria. Part 36 of the Commission's regulations adopts 
certain exemptions under a pilot program for the establishment of 
separate professional markets which would have less restrictive 
requirements governing trading, reporting, and risk disclosure for 
eligible transactions than are applicable to current contract markets. 
Subject to certain recordkeeping and audit trail requirements, Part 36 
procedures provide for the execution of noncompetitive transactions, 
regardless of size. In addition, these transactions are limited to 
certain Commission registrants and sophisticated and/or institutional 
traders which meet certain minimum asset requirements, including banks, 
trust companies, savings associations, credit unions, investment 
companies, commodity pools, certain business associations, employee 
benefit plans, government entities, broker-dealers, FCMs, floor 
brokers, floor traders, and certain other natural persons. A contract 
market may adopt trading rules permitting the execution of Part 36 
transactions using any combination of noncompetitive execution 
procedures and competitive on-floor trading procedures.
    No contract market has filed a proposal with the Commission 
pursuant to Section 4(c) and Part 36. Significantly, Part 36 only 
permits noncompetitive executions in specially-designated, stand-alone, 
professional markets. In contrast, the other noncompetitive trading 
methods discussed in this release are adjuncts to regular trading on or 
subject to the rules of a contract market.
    (3) Securities Market Block Trading Procedures. Block trading in 
securities markets differs substantially from that on Commission 
designated contract

[[Page 3717]]

markets. Blocks may be traded on securities exchanges, in over-the-
counter securities markets, or through ``principal-to-principal'' trade 
execution venues. In the securities industry, a block trade is commonly 
defined as a transaction involving 10,000 or more shares or a quantity 
of stock having a market value greater than or equal to $200,000. In 
recent years, block trading in securities markets has increased as a 
percentage of reported trading volume.54
---------------------------------------------------------------------------

    \54\ In 1996, block trading on the New York Stock Exchange 
comprised 55.9% of the exchange's reported volume, or 2,348,457 
transactions accounting for 58.5 billion shares. New York Stock 
Exchange Fact Book 1996, at 16 (May 1997).
---------------------------------------------------------------------------

    The New York Stock Exchange (``NYSE'') and the Chicago Board 
Options Exchange (``CBOE'') have rules providing for block 
trading.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.''
---------------------------------------------------------------------------

    \55\ NYSE Rule 127; CBOE Rule 6.9.
    \56\ NYSE Rule 127(a).
    \57\ When positioning a block, the block trader quotes a 
tentative price for the stock to the block customer, and the 
customer may tentatively accept this price. Barring an extreme and 
unexpected movement in the price of the stock, the customer may be 
reasonably assured of execution at the quoted price.
    When a block trader ``shops a block,'' the trader contacts one 
or more potential customers to take the opposite side of the block 
at a specified price. The block trader might be willing to negotiate 
this price depending on how interested other investors are in 
participating in the block. The block trader continues to ``shop the 
block'' until he or she has a sufficient quantity of orders for the 
opposite side at a single price. At this point, the block trader 
returns to the block customer and confirms the customer's interest 
in the block transaction at the negotiated price, also known as the 
``clean-up'' price.
---------------------------------------------------------------------------

    Block orders crossed on the NYSE floor must comply with NYSE rules, 
including the following. Block orders within the current market 
quotation must first be offered publicly at a price higher than the 
member's bid by the minimum variation applicable to that stock so that 
the trading crowd may participate in the block at that publicly offered 
price, before the member may proceed with the cross 
transaction.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 
anti-manipulation safeguard, when a member holds any part of a long 
position in a stock in its trading account as a result of a block trade 
it completed with a customer, the member is precluded from effecting 
certain transactions in this stock on the same trading day in which the 
block trade was executed.62
---------------------------------------------------------------------------

    \58\ NYSE Rule 76.
    \59\ NYSE Rule 127(b).
    \60\ NYSE Rule 127(c). If the member representing the block 
orders decides that the amount of stock that would be lost is not 
excessive, then he or she announces the clean-up price to the crowd 
and fills at such price all agency limit orders at the post for the 
clean-up price or better. The member then crosses the remaining 
block orders at the clean-up price.
    If the member decides that the amount of stock that would be 
lost is excessive, then he or she either may return to the block 
customers to negotiate a new clean-up price or may limit 
participation in the block by members at the post. The member limits 
participation merely by informing the crowd that they cannot 
participate freely in the block. After such an announcement, the 
member follows the crossing procedures set forth in NYSE Rule 76 and 
makes a bid and offer for the full amount of the block. A 
``reasonable'' time must elapse before the cross is completed in 
order to provide the crowd, including the Specialist, the 
opportunity to execute superior priced bids or offers to provide 
price improvement. Thereafter, the member crosses the orders for the 
remaining shares at the clean-up price. The member is not required 
to fill at the clean-up price orders limited to the clean-up price 
or better. The block is entitled to priority at the proposed clean-
up price.
    \61\ NYSE Rule 127(d)(1).
    \62\ NYSE Rule 97.
---------------------------------------------------------------------------

    At the CBOE, a member or member organization may solicit another 
member, member organization, non-member customer or broker-dealer 
(``solicited person'') to take the opposite side of a large-sized order 
(``original order'').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
---------------------------------------------------------------------------

    \63\ CBOE Rule 6.9. CBOE Rule 6.9 specifically allows solicited 
transactions by ``a member or member organization representing an 
order respecting an option traded on the Exchange * * * including a 
spread, combination, or straddle order as defined in Rule 6.53 and a 
stock-option order as defined in Rule 1.1(ii).''
    \64\ CBOE Rule 6.9(d). However, the member is not required to 
announce to the trading crowd that another person has been solicited 
to participate in the order. The initiating member simply must 
disclose all the terms and conditions of the original order and any 
modifications to the trading crowd.
---------------------------------------------------------------------------

    In order to promote disclosure at the inception of the solicitation 
period and to encourage solicited persons to bid or offer at prices 
that improve the current market, the CBOE rule establishes a series of 
priority principles for these solicited transactions. Priority depends 
upon whether the original order is disclosed throughout the 
solicitation period, whether the solicited order improves the best bid 
or offer in the crowd and whether the solicited order matches the 
original order's limit.
    If the terms and conditions of the original order are disclosed to 
the trading crowd prior to any solicitation and the order is 
continuously represented in the crowd throughout the solicitation 
process, then the following rules apply. If the solicited order matches 
the original order's limit and improves the best bid or offer in the 
trading crowd, then the solicited order has priority over the crowd and 
may trade with the original order at the improved bid or offered price 
subject to the customer limit order book priorities set forth in CBOE 
Rule 6.45.65 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

[[Page 3718]]

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
---------------------------------------------------------------------------

    \65\  CBOE Rule 6.9(a).
    Under CBOE Rule 6.45, the highest bid or lowest offer has 
priority. Where two or more bids (offers) for the same option 
contract represent the highest (lowest) price, the bid (offer) that 
is displayed in the customer limit order book shall have priority 
over any other bid at the post. If two or more bids (offers) 
represent the highest (lowest) price and the customer limit order 
book is not involved, then priority is determined according to the 
sequence in which the bids (offers) were made.
    The procedures set forth in CBOE Rule 6.74 govern the crossing 
of original orders with solicited orders, except when the solicited 
party has priority as is the case under CBOE Rule 6.9(a).
    \66\  CBOE Rule 6.9(b).
    \67\  CBOE Rule 6.9(c).
    \68\  CBOE Rule 6.9(d).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \69\ CBOE Rule 6.9(e). This trading restriction applies to the 
solicited party as well as to any other member or associated person 
who has knowledge of all the material terms and conditions of both 
the original and solicited orders, including the price.
---------------------------------------------------------------------------

    Block trading also is carried out on regional securities exchanges 
and in over-the-counter securities markets. The procedures governing 
block trades in these markets are generally less complex than those 
applicable at the NYSE. Block trades for stocks listed on regional 
exchanges are negotiated off-floor and in most cases must be crossed on 
the floor of the exchange. Moreover, traders generally do not have to 
accommodate limit orders. Over-the-counter block trades are arranged by 
a block trader who then crosses the resulting orders.
    Another venue for securities block trading involves ``principal-to-
principal'' systems. Generally, block customers directly enter trade 
quantities and bid/ask prices into a computerized system, which matches 
the orders according to the availability of bids and offers at matching 
prices. In addition, block customers may execute block trades 
themselves, off-exchange, without the assistance of a broker or block 
trader.
    (b) Potential Procedures. Certain participants in the futures 
markets have suggested that the competitive execution requirements 
under the Commission's regulations be relaxed to permit block trading 
procedures similar to those in the securities exchange and over-the-
counter markets. As noted previously, the proviso to Commission 
Regulation 1.38(a) permits noncompetitive transactions if executed 
pursuant to contract market rules that have been approved by the 
Commission.
    One of the purposes of this release is to investigate whether there 
are alternative, noncompetitive execution procedures that would further 
the policies and purposes of the Act. If so, the Commission seeks to 
determine the extent to which these procedures could be structured to 
serve the purposes of market participants while not sacrificing 
customer protection. The procedures might be limited according to order 
size, class of participant, contract, or some other category. In 
addition, the Commission seeks to determine the extent to which the 
procedures would be, and should be, similar to securities market 
procedures.
    The following examples, while not exhaustive, illustrate the range 
of possibilities. The least significant modification of current open 
and competitive procedures would expressly permit market participants 
to alert potential counterparties of their interest in trading in a 
particular market at a particular time. Actual execution would occur 
pursuant to existing competitive procedures.
    A more significant departure from current procedures would permit 
market participants to divulge not only a general interest in trading 
but also specific information about quantity and price to potential 
counterparties. Again, actual execution would occur competitively. This 
might be analogous to the practice of ``shopping the block'' in 
securities markets.
    A further variation would permit negotiation between market 
participants. This would permit some degree of prearrangement although 
the execution price would to some extent remain subject to prices in 
the competitive market.
    Yet another variation would adjust execution procedures to confer a 
degree of priority on particular orders that they might not attain in 
the open and competitive process. Such priority could be conferred, for 
example, on certain retail orders or on certain marketmaker orders.
    Finally, market participants could be permitted to execute certain 
transactions bilaterally, away from the centralized marketplace, and 
simply report them to the exchange and clearing house. This would be 
similar to the way EFPs are handled currently.
    Each of these alternatives potentially raises concerns, including, 
among others:

the impact on price discovery;
the impact on liquidity;
the potential for manipulation; and
the potential for mispricing, frontrunning, or other customer fraud.

    Any proposed procedure would have to address such concerns. The 
need for safeguards is discussed further below.
    (c) Request for Comments. The Commission is soliciting comments on 
the following questions:

    (31) Should alternative, noncompetitive execution procedures be 
permitted on or subject to the rules of a contract market?
    (32) If so, how should these procedures be structured to address 
regulatory concerns?
    (33) Should these procedures be limited by order size, 
participant class, contract, or some other criteria?
    (34) Can adequate safeguards be devised in connection with these 
procedures to prevent manipulation?
    (35) Can adequate safeguards be devised in connection with these 
procedures to prevent fraud?

B. Qualifying Standards

1. The Need for Standards
    The preceding discussion identifies particular types of 
transactions that might be appropriate for noncompetitive execution, 
such as EFS transactions or block trades. The common thread connecting 
these types of transactions with one another and with EFPs is their 
potential ability to fulfill some particularized need of market 
participants that the traditional open and competitive execution 
methods cannot fulfill as well. Congress has implicitly found with 
respect to EFPs that, at least under some circumstances, they provide 
certain benefits although their pricing and execution occurs outside of 
the centralized, open and competitive marketplace. To permit other 
types of noncompetitive transactions, the Commission would have to make 
a similar finding. For example, a contract market seeking approval of 
new procedures could address the effect of the proposal on the contract 
market's usefulness as a vehicle for price discovery and risk transfer. 
If the proposal had the potential to affect those functions adversely, 
the contract market could try to demonstrate countervailing benefits. 
The contract market also could address, pursuant to Section 15 of the 
Act,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.
---------------------------------------------------------------------------

    \70\ 7 U.S.C. 19.

---------------------------------------------------------------------------

[[Page 3719]]

2. Request for Comments
    The Commission seeks input on the general qualifying standards that 
should govern a proposal's eligibility for approval and how compliance 
with such standards would be demonstrated. The Commission is soliciting 
comments on the following questions:

    (36) What are the appropriate qualifying standards for 
noncompetitive transactions concerning:

(a) the effect on the usefulness of a designated futures contract as 
a hedging mechanism?
(b) the effect on the price discovery function of a designated 
futures contract?
(c) the effect on the level of financial integrity in a designated 
contract market?
(d) the effect on the level of customer protection in a designated 
contract market?

    (37) Should access to noncompetitive transactions be limited to 
commercials or sophisticated investors?
    (38) Should noncompetitive transactions be subject to contract 
market rules?
    (39) Are there other appropriate qualifying standards?

C. Continuing Regulatory Requirements

1. The Need for Requirements
    As discussed above, in addition to determining whether an EFP is 
bona fide, there is a need for appropriate regulatory oversight in 
areas such as reporting and recordkeeping, disclosure, and internal 
controls. Similar considerations apply to other types of noncompetitive 
transactions.
2. Request for Comments
    The Commission seeks input on any additional requirements that 
should apply to a potential noncompetitive transaction, once it is 
determined that the transaction meets basic eligibility standards. To 
that end, the Commission has identified the following areas where it 
appears that additional qualifying requirements would be required in 
order to maintain systemic integrity and to provide guidance to self-
regulatory entities. The Commission seeks input both as to whether the 
prospective requirement is necessary and, if so, how the requirement 
could be structured to provide a meaningful test. The Commission is 
soliciting comments on the following questions:

    (40) What are the appropriate standards to ensure that 
noncompetitive transactions are bona fide and meet basic qualifying 
requirements on an ongoing basis?
    (41) What are the appropriate reporting and recordkeeping 
requirements applicable to these transactions?
    (42) What are the appropriate disclosure requirements applicable 
to these transactions?
    (43) What are the appropriate internal controls applicable to 
these transactions?
    (44) What are the appropriate safeguards to maintain an adequate 
level of transparency?
    (45) What are the appropriate safeguards to prevent 
manipulation?
    (46) What are the appropriate safeguards to prevent fraud?

IV. Execution Facilities for Noncompetitive Transactions Executed 
on or Subject to the Rules of a Contract Market

A. Current, Proposed and Potential Facilities

    As noted in the Introduction, several organizations have developed 
execution facilities for transactions that are executed off-exchange 
and reported to contract markets as EFPs. As with the procedures 
discussed in the previous section, these facilities expand the 
opportunity for market participants to engage in the negotiation of 
transactions off the floor of the exchange. It appears, however, that 
there are significant structural differences between these facilities 
and traditional methods for the execution of EFPs. The latter generally 
appear to take a bilateral, over-the-counter approach to the 
negotiation of trades.
    Unlike traditional approaches, these execution facilities provide a 
formal market environment for the negotiation and arrangement of 
transactions, are typically operated by third parties, and may be 
beyond the operational and regulatory purview of contract markets to 
some extent. In this respect, however, the Commission also recognizes 
that these facilities perhaps should be characterized as noncompetitive 
only in the sense that the transactions executed thereon are completed 
outside of designated contract markets. Thus, unlike the execution 
procedures on a contract market, the execution procedures on one of 
these facilities have not been formally reviewed and approved by the 
Commission for compliance with the open and competitive requirements of 
the Act and other statutory requirements. The Commission acknowledges 
that an execution facility's centralized structure may provide a market 
environment that facilitates the competitive execution of transactions 
and also may provide competitive benefits for the underlying contract 
markets.
    This section includes a discussion of existing facilities, proposed 
facilities, and potential facilities and presumes that the futures leg 
of the transaction is reported to and cleared by an existing contract 
market clearing organization. Generally, the request for comments 
relative to this section seeks input as to whether the regulatory 
environment applicable to such transactions continues to be appropriate 
in light of the growth and evolution of activity on such facilities or 
whether some form of additional oversight is needed. As more fully set 
out below, the Commission's request for comments also seeks input on 
the appropriate form of any prospective regulatory actions applicable 
to these facilities.
1. Interdealer Brokers
    There are six major interdealer brokers in the cash U.S. Treasury 
securities market.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.
---------------------------------------------------------------------------

    \71\ The six are Cantor Fitzgerald, Liberty, RMJ, Tullet & 
Tokyo, Garban, and Hilliard & Farber.
---------------------------------------------------------------------------

    It appears that at least a minimal level of transparency is 
maintained for basis trading on these facilities, although it is not 
clear whether that level is completely adequate. Information on these 
basis trades is obtained through reports published over screen-based 
news reporting services, such as Govpx or Bloomberg. The screens are 
anonymous, except that firms may be identified for basis trade 
quotations.
    It also appears that these firms restrict their activities to 
dealing only with primary dealers and other large institutional 
entities. The interdealer brokers do not reveal counterparty names, and 
anonymity is thereby maintained. Trades generally are cleared through 
the Government Securities Clearing Corporation (``GSCC''), and 
anonymity is maintained even after a trade is consummated. GSCC nets 
the cash market legs of the basis trades.
2. The Chicago Board Brokerage
    The CBT is developing a computerized system for, among other 
things, basis trading of U.S. Treasury securities. The system will be 
operated by the Chicago Board Brokerage (``CBB''), a subsidiary of the 
CBT, which is registered with the Securities and Exchange Commission 
(``SEC'') as a broker/dealer.
    Pricing of basis trades on the CBB system will be carried out 
according to a standardized formula. The futures leg will be assigned a 
price equal to the last sale price for the futures contract. The cash 
Treasury leg will be assigned a price according to the basis spread 
relative to the price of the futures leg. The price of the cash 
Treasury leg also will be adjusted to account for

[[Page 3720]]

differences between the coupon rate of the actual Treasury security and 
the standardized 8 percent coupon rate of the futures contract. The 
cash leg will be cleared through the Clearing Corporation for Options 
and Securities (``CCOS''), a subsidiary of the Board of Trade Clearing 
Corporation (``BOTCC'') which is registered as a clearing agency with 
the SEC. The futures leg will be cleared through the CBT and BOTCC 
pursuant to rules governing EFP transactions.
3. Potential Facilities for Transactions Other Than EFPs
    The interdealer brokers and the CBB are facilities for the 
execution of EFPs. If the Commission were to permit other types of 
noncompetitive trading, such as block trading, facilities might be 
established for the execution of those types of transactions. For 
example, a computerized, bulletin board system might be established in 
connection with the execution of blocks. The Commission, of course, 
before approving relevant contract market rules, would have the 
opportunity to review procedures relating to these trades. Nonetheless, 
as discussed below, the Commission is requesting comments as to the 
appropriate form of regulatory oversight for these facilities.

B. Qualifying Standards

1. Current Requirements
    Basis trades executed through these facilities currently are 
subject to the same regulatory requirements as any other EFP 
transaction. The Commission's oversight of these facilities does not 
differ in any way from its oversight of the EFP markets generally. The 
Commission is concerned that the nature of the transactions executed on 
these facilities and the environment in which they are executed may 
differ enough from the nature of traditional EFPs as to warrant 
differing regulatory treatment. Indeed, it could be argued that some of 
these facilities have evolved to the extent that they are functionally 
the equivalent of designated contract markets.
2. Request for Comments
    The Commission seeks input on the regulatory structure appropriate 
for these execution facilities. At a threshold level, this area of 
inquiry seeks comments on whether the existing regulatory structure 
appears adequate as currently organized and administered. To the extent 
that a commenter believes the current approach is adequate, a 
supporting rationale should be set forth. To the extent that a 
commenter believes the current approach is deficient, the Commission 
seeks comments identifying the nature of the deficiency and whether new 
guidelines or standards are required. Where a commenter believes that 
new regulatory initiatives are required, the Commission seeks comments 
on the form and nature of any such initiatives. Any such comments 
should include a supporting rationale.
    Specifically, the Commission is soliciting comments on the 
following questions:

    (47) What characteristics distinguish execution facilities for 
EFPs from contract markets?
    (48) Is the current regulatory approach concerning these 
facilities adequate?
    (49) If not, what modifications are appropriate?
    (50) If execution facilities were established for noncompetitive 
transactions other than EFPs, how, if at all, should the regulatory 
approach that would apply to those facilities vary from that 
currently applicable to contract markets?
    (51) Should execution facilities for EFPs and other 
noncompetitive transactions that are operated by non-contract 
markets be subject to oversight by the relevant contract market?
    (52) Should these facilities limit access to commercials or 
sophisticated investors?
    (53) Should these facilities be subject to procedures to prevent 
manipulation?
    (54) Should these facilities be subject to procedures to prevent 
fraud?
    (55) Should these facilities be subject to procedures to ensure 
that transactions executed thereon are bona fide?
    (56) Should these facilities be subject to procedures to provide 
for market transparency?
    (57) Should these facilities be subject to procedures related to 
reporting and recordkeeping?

V. Summary of Request for Comments

    After reviewing the comments, the Commission will determine whether 
rulemaking or other action is appropriate. Commenters are invited to 
discuss the broad range of concepts and approaches described in this 
release. The Commission specifically invites commenters to compare the 
advantages and disadvantages of the possible changes discussed above 
with those of the existing regulatory framework. In addition to 
responding to the specific questions presented, the Commission 
encourages commenters to submit any other relevant information. In sum, 
the Commission is soliciting comments on the following questions:

Overview

    (1) Should the standards articulated in the EFP Report be 
codified in the Commission's regulations and/or refined in any way?
    (2) Should other types of noncompetitive transactions, such as 
EFS transactions or block trades, be permitted to be executed on or 
subject to the rules of a contract market and, if so, what standards 
should apply to these transactions?
    (3) What standards should be applicable to execution facilities 
for noncompetitive transactions executed on or subject to the rules 
of a contract market?

Elements of a Bona Fide EFP: Relationship of the Instruments

    (4) How should the ``strong price correlation'' standard 
articulated in the EFP Report be implemented?
    (5) Should the Commission require contract markets to adopt a 
minimum statistical correlation coefficient to be used in assessing 
the acceptability of a particular cash commodity for use as the cash 
leg of an EFP?
    (6) If a minimum correlation coefficient is required, should 
this coefficient apply to all EFPs, or should it be adjusted to 
account for the different commodities involved in EFPs?
    (7) What is the appropriate type and scope of guidance contract 
markets should be required to provide to the general public 
concerning the acceptability of particular commodities as the cash 
leg of an EFP?

Elements of a Bona Fide EFP: Relationship of the Parties

    (8) What is the appropriate scope of the separate parties 
requirement?
    (9) Should the Commission address string trades as that practice 
is described in the EFP Report and, if so, how?

Elements of a Bona Fide EFP: Nature of the Transaction

    (10) What criteria are appropriate for judging whether the 
futures leg of an EFP is bona fide?
    (11) What criteria are appropriate for judging whether the cash 
leg of an EFP is bona fide?
    (12) What criteria are appropriate for determining whether a 
transitory EFP is bona fide?
    (13) What criteria are appropriate for determining whether an 
EFP is contingent?

Elements of a Bona Fide EFP: Price of the Transaction

    (14) Should the Commission require both the futures and cash 
legs of an EFP to be priced within the daily range of their current 
respective markets, should it require only one leg of an EFP to be 
priced within its daily range, or should it impose no restrictions 
on the price of either leg of an EFP?
    (15) Should the Commission require contract markets to obtain 
documentation regarding the business purpose underlying the pricing 
of an EFP?

Other Regulatory Requirements Governing EFPs: Reporting and 
Recordkeeping

    (16) Are the current reporting and recordkeeping requirements 
relating to EFPs adequate?

[[Page 3721]]

Other Regulatory Requirements Governing EFPs: Disclosure

    (17) What should be the form and content of disclosure 
concerning EFPs?
    (18) Should the form and content of disclosure vary according to 
the commercial sophistication of the EFP participant similar to the 
Commission's proposed amendment to Regulation 1.55?
    (19) Should the Commission explicitly require that customers 
must be informed that an EFP is executed noncompetitively, that it 
involves a cash transaction, and that their FCM might take the 
opposite side of the EFP?
    (20) Should the Commission explicitly require Commission 
registrants to obtain customer consent before executing an EFP on 
the customer's behalf?

Other Regulatory Requirements Governing EFPs: Internal Controls

    (21) What internal controls are appropriate for Commission 
registrants to ensure compliance with regulatory requirements 
concerning the essential elements of bona fide EFPs, reporting and 
recordkeeping, and disclosure?

Other Regulatory Requirements Governing EFPs: Transparency

    (22) Do existing price reporting standards provide adequate 
transparency concerning EFPs to the marketplace and, if not, are 
there alternative methods of achieving improved price transparency?
    (23) Should the Commission require contract markets to publicize 
information about bids and offers, as well as consummated EFP 
transactions?

Types of Eligible Transactions: Exchanges of Futures for Swaps

    (24) What are the economic reasons firms might have for engaging 
in EFS transactions and what benefits might accrue thereunder, 
including the potential benefits to domestic futures markets, to 
over-the-counter markets, and to financial markets generally?
    (25) What are the potential costs or risks of permitting EFS 
transactions, particularly with respect to the effect on price 
discovery, risk transfer, and the competitive character of ``on-
exchange'' transactions?
    (26) Should the Commission approve the NYMEX rule proposal 
permitting EFS transactions?
    (27) Should EFS transactions be limited to particular markets, 
participants or types of transactions?
    (28) Should special provisions be established to ameliorate any 
competitive costs or otherwise safeguard the competitive conditions 
of the on-exchange market?

Types of Eligible Transactions: Exchanges of Options for Physicals

    (29) Are EOPs viable and do these transactions offer genuine 
risk management benefits?
    (30) If so, should EOPs be permitted, and should there be 
limitations on EOPs that reflect the particular risk characteristics 
of options?

Types of Eligible Transactions: Alternative Execution Procedures

    (31) Should alternative, noncompetitive execution procedures be 
permitted on or subject to the rules of a contract market?
    (32) If so, how should these procedures be structured to address 
regulatory concerns?
    (33) Should these procedures be limited by order size, 
participant class, contract, or some other criteria?
    (34) Can adequate safeguards be devised in connection with these 
procedures to prevent manipulation?
    (35) Can adequate safeguards be devised in connection with these 
procedures to prevent fraud?

Qualifying Standards

    (36) What are the appropriate qualifying standards for 
noncompetitive transactions concerning:

(a) the effect on the usefulness of a designated futures contract as 
a hedging mechanism?
(b) the effect on the price discovery function of a designated 
futures contract?
(c) the effect on the level of financial integrity in a designated 
contract market?
(d) the effect on the level of customer protection in a designated 
contract market?

    (37) Should access to noncompetitive transactions be limited to 
commercials or sophisticated investors?
    (38) Should noncompetitive transactions be subject to contract 
market rules?
    (39) Are there other appropriate qualifying standards?

Continuing Regulatory Requirements

    (40) What are the appropriate standards to ensure that 
noncompetitive transactions are bona fide and meet basic qualifying 
requirements on an ongoing basis?
    (41) What are the appropriate reporting and recordkeeping 
requirements applicable to these transactions?
    (42) What are the appropriate disclosure requirements applicable 
to these transactions?
    (43) What are the appropriate internal controls applicable to 
these transactions?
    (44) What are the appropriate safeguards to maintain an adequate 
level of transparency?
    (45) What are the appropriate safeguards to prevent 
manipulation?
    (46) What are the appropriate safeguards to prevent fraud?

Execution Facilities for Noncompetitive Transactions Executed on or 
Subject to the Rules of a Contract Market: Qualifying Standards

    (47) What characteristics distinguish execution facilities for 
EFPs from contract markets?
    (48) Is the current regulatory approach concerning these 
facilities adequate?
    (49) If not, what modifications are appropriate?
    (50) If execution facilities were established for noncompetitive 
transactions other than EFPs, how, if at all, should the regulatory 
approach that would apply to those facilities vary from that 
currently applicable to contract markets?
    (51) Should execution facilities for EFPs and other 
noncompetitive transactions that are operated by non-contract 
markets be subject to oversight by the relevant contract market?
    (52) Should these facilities limit access to commercials or 
sophisticated investors?
    (53) Should these facilities be subject to procedures to prevent 
manipulation?
    (54) Should these facilities be subject to procedures to prevent 
fraud?
    (55) Should these facilities be subject to procedures to ensure 
that transactions executed thereon are bona fide?
    (56) Should these facilities be subject to procedures to provide 
for market transparency?
    (57) Should these facilities be subject to procedures related to 
reporting and recordkeeping?

    Issued in Washington, DC, on January 16, 1998.
Jean A. Webb,
Secretary.
[FR Doc. 98-1672 Filed 1-23-98; 8:45 am]
BILLING CODE 6351-01-P
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