dominant and potentially destabilizing position into the last ten trading days of an
expiring contract. You assert that structural changes should not be made in the absence
of any empirical evidence of market manipulations that distorted prices. The CBOT
simply chose, in light of the market conditions noted above, to take the present action to
prevent those conditions from adversely affecting our contracts.

Position limits versus position accountability: You rightly point out that Exchange
regulations provide for position accountability in these contracts. If the CBOT had
believed these standards were sufficient to fulfill its self-regulatory mandate given the
aforementioned conditions, without disruption, it would not have established position
limits. It is not uncommon for large market participants to establish positions many times
the new limits prior to liquidating or rolling those positions. It would be unacceptably
disruptive if the Exchange, under the banner of enforcement of position accountability,
were to prevent the establishment of positions that in nearly all cases are rolled or
liquidated prior to the contracts’ last ten trading days.

In any event, the Business Conduct Committee does not have the authority to order a
position reduction as you suggest in your letter. This power is reserved for the Board of
Directors and requires emergency action, the most disruptive action an Exchange or the
Commission can take, Thus, establishing position limits in the context of the present
environment is the most effective short-term alternative for simultaneously fulfilling the
Exchange’s self-regulatory mandate, minimizing the impact on the risk management
options of our customers, and reducing the likelihood of regulatory interference in the
price discovery process.

Position limits and hedges: The position limits as established do not preclude a
participant’s ability to hedge its interest rate exposure with Treasury futures contracts.
Rather the amendments merely limit the extent to which such exposure can be hedged in
the expiring contract during the contract’s last ten trading days. As noted above, the
great majority of hedgers either liquidate or roll their hedge positions well in advance of a
contract’s last ten trading days.

Any suggestion that it would be impossible for a dealer to respond to a customer’s
request to sell large blocks of Treasury securities during the last ten trading days ofa
delivery month because the dealer would be unable to hedge with futures overlooks the
fact that, by that time, volume and liquidity have moved to the next quarterly expiration,
and that is where such a position is most likely to be hedged. As a practical matter,
significant new positions are rarely established in an expiring contract during its last ten
trading days.

Moreover, the position limits should mitigate decorrelation between futures contract price
dynamics and price dynamics in the underlying Treasury securities market, at least to the
extent that the limits insulate futures contract pricing from misevaluation associated with
pricing distortions in the repo market. This, in turn, should directly support the
effectiveness of futures hedge positions.


peak contract open interest; in three of the four Treasury contracts the total December
2005 open interest was below the position limit established for any single entity.

We hope that this response has been helpful in clarifying the CBOT’s decision.

Sincerely,
Bernard W. Dan Q Charles P. Carey
President Chairman

cc: Honorable Reuben Jeffery II
Honorable Sharon Brown-Hruska
Honorable Walter L. Lukken
Honorable Fred Hatfield
Honorable Michael V, Dunn
Richard A. Shilts
James L. Carley
Patrick J. McCarty



extreme levels of richness experienced during the last two months are less likely to reoccur going
forward, The dislocations in the repo market and protracted shortages of ctd issues should be
lessened by the position limits... Volatility of the calendar spreads should decline and the wild
“whipsawing” that occurred in TYMS/TYUS calendar spread is less likely to occur, We believe
that the open interest at expiry for futures should decline toward more historic levels.”

The CBOT will, of course, continue to evaluate its Treasury contracts and carefully
monitor the conditions that have given rise to its decision to establish position limits.
Clearly, the Exchange intends to maintain position limits in these contracts only for as
long as the CBOT judges that they are necessary to fulfill the contract function and
market integrity objectives outlined in this letter.

Aggregation Issues

The FIA, in its letter, maintains that the aggregation requirements established by the
CBOT are unworkable and will inevitably result in violation of the limits. Aggregation is
necessary if any position limit is to achieve its intended purpose. The CBOT’s
requirements in the context of Treasury futures are consistent with those that have long
been established in the futures industry whereby multiple positions that are subject to
common ownership or control are aggregated for position limit purposes (see CFTC
Regulations 150.4(a) and (b)), Indeed, these are the same standards applied in the
context of current position accountability regulations for these products.

As the FIA ultimately acknowledges in footnote 9 of its letter, the exemption standards
referenced in both Commission Rule 150.3 and CBOT Regulation 425.05 explicitly do
not apply to spot-month positions. The adopting Federal Register Release 64 F.R. 24038
States, in part, that:

“The exemption permits the total positions of the trading entity or vehicle to
exceed speculative limits during nonspot months, but requires that each
independent account controller trading on the entity’s behalf to comply with the
applicable limits. During the spot month, all positions of the entity are required
to be aggregated and are subject to the spot-month speculative position limit
level.” (emphasis added)

Although Commission regulations 150.3 and 150.4 explicitly apply to position limits
imposed directly by the Commission, Part 38 guidance for compliance with Core
Principle 5 similarly states, in part: .

“Contract markets should have aggregation rules that apply to those accounts
under common control, those with common ownership, i.e. where there is a ten
percent or greater financial interest, and those traded according to an express or
implied agreement. Contract markets will be permitted to set more stringent
aggregation policies.”

In short, it is simply incorrect to say that under existing policy in al] other contracts,
aggregation is required only where there is common control.


Finally, given the stated objectives of the position limits, hedge exemptions would render
the limits largely meaningless as very few large-scale positions in these contracts would
fail to qualify for such an exemption.

Position limits and the roll: The FIA argues that the position limits will create a second
roll that “itself is likely to cause an artificial price.” (emphasis in original). First, it is not
clear how the long or short will know, as the FIA asserts, that “there is going to be a
forced liquidation.” Open interest can comprise any number of participants, and the
Commission’s Commitment of Traders Report you reference certainly does not break out
the number or size of positions in an expiring Treasury futures contract. Clearly this
report would not provide participants with the information you suggest, and it is not clear
how such confidential position information could be otherwise secured. The fact that
both longs and shorts have to comply with the limits levels the playing field between the
longs and shorts holding positions greater than the limits. With respect to liquidity
during the last ten trading days of an expiring contract, there are few circumstances that
compromise liquidity more than a dominant position holder, who by virtue of market
congestion or whatever other circumstance, may find itself able to exert market power.
Position limits effectively inhibit such a scenario and provide all market participants with
the confidence of knowing that it is so.

By taking the action it did, the CBOT sought, and succeeded in, providing greater clarity
and confidence to market participants regarding the contracts. A sampling of published
research from FIA member firms indicates their concurrence:

“During the past month, we have heard several questions regarding whether or not the CBOT will
try to prevent market participants from squeezing futures contracts and have discussed possible
options for deterring squeezes available to the CBOT. On Wednesday, June 29, the CROT
answered these questions....While these new limits at the end of the trading period will not
eliminate the possibility of inefficient deliveries, they make it more difficult for any one speculator
to engineer a squeeze of the contract, because it will probably require multiple accounts taking
maximum delivery to engineer a squeeze successfully ... we would not be surprised to see open
interest on the December 10-year contract eventually outstrip that of the September contract.”

“With respect to [the CBOT’s] motivation, one may suspect it has been the emergence of negative
net bases, potential squeeze games and a general disorderly market — all topics which we have
discussed at length in recent months. While these have certainly played a significant role, we
believe it may be more directly related to the resulting fall in open interest duc to some investors
avoiding the market... The more important question is whether or not these position limits will
eliminate the futures market's problems. Judging from the market's response today, the answer
would seem to be yes. Our opinion, however, is that the limits will alleviate, but not eliminate,
many of the recent issues in the market, To start with, the 50,000 contract limit on the 10 year
contract is not a paltry amount...Perhaps it was the fear of a squeeze by one or two large investors
which pushed the net basis so negative in the first place....If this was the case, the comfort of
knowing that no one investor will be able to hold such large positions into delivery going forward
may remove some of the psychological premium that has recently been priced into the market.”

“The new position limits on Treasury Bond and note futures, along with likely closer scrutiny by
the CBOT and regulators, should help improve liquidity and lower volatility somewhat in both the
futures and in the respective cash and repo markets for the cheapest-to-deliver (CTD) Treasury
securities... The ctd cash issues should trade much closer to fair valuc on the Treasury curve and
futures should trade substantially less rich and much closer to their theoretical fair value..the


In summary, the Exchange does not believe the enforcement of these limits puts it or its
customers in an untenable position, and it certainly does not expect the rash of violations
the FIA appears to inexplicably anticipate.

Jurisdiction, Process and Dissemination

In its letter, the FIA expresses “deep reservations” concerning the process which
accompanied the amendments to Regulation 425.01 and you voice concern that it lacked
the transparency essential to permit the CFTC to fulfill its responsibilities under the
Commodity Exchange Act. As an initial point, the CBOT’s adoption of amendments to
Regulation 425.01 was self-certified in a manner fully consistent with applicable
Commission regulations and core principles'. Secondly, as stated earlier, the CFTC was
very involved with the CBOT in its monitoring of recent Treasury futures expirations and
was certainly privy to the CBOT’s motives for instituting position limits. Moreover,
relevant government authorities were aware of the CBOT’s deliberation over whether to
impose position limits, and were duly advised as required once the Exchange made its
decision to proceed.

The CBOT obviously has every incentive to consider unsolicited as well as solicited
input from its market participants to ensure that the contracts we list and the rules we
develop meet their needs and furnish the integrity, efficiency and reliability that they
have come to expect from our contract markets, Our decision to establish position limits
thus incorporated feedback from a diverse group of market participants, some of which
was developed in a carefully controlled and confidential process that reflected the
sensitive nature of the topics under discussion.

The decision and the announcement were made in a manner consistent with how other
rule amendments are established. The CBOT took care to ensure the integrity and
confidentiality of the ultimate decision by the Board of Directors to impose position
limits, The announcement itself was made following the close of the e-cbot market on
June 29". As you know, the FIA received a separate e-mail at the time of the
announcement, alerting the FIA to the amendment.

The Exchange has noted the FIA’s recommendation that a more inclusive process for
soliciting feedback and a more extensive plan for notification would have been
beneficial. These ideas merit consideration, and the Exchange will certainly examine its
process in the context of future actions to ascertain whether the process might be
improved while maintaining its integrity.

The FIA also questions whether procedures provided for in the Commodity Exchange
Act and Commission regulations for self-certification of rules adopted for contracts that
have open interest are “appropriate.” The Exchange complied with these procedures.
Nevertheless, mindful of the concerns about open interest, the CBOT determined to defer
implementation for five months, to the December 2005 contract. At the time of the
announcement, open interest in the December contract was a small fraction of typical

' A copy of these amendments was also filed with the Secretary of the Treasury.


teh iteret

© ChicagoBoardof Trade

WE TS PY St
Bernard W. Dan : > Fu 5 02
President and

Chief Executive Officer OFC. 0. bh. CoeRETARIAT

August 15, 2005

Ms. Jean Webb

Secretariat

Commodity Futures Trading Commission
1155 21® Street, N.W.

Washington, D.C. 20581

Dear Ms. Webb:

Enclosed please find the Chicago Board of Trade’s August 10 response to
correspondence received from the Futures Industry Association regarding position limits
in Treasury futures contracts.

Sincerely,

Premarel

Bernard W. Dan

141 W. Jackson Bivd.
Chicago, Illinois 60604-2994
312 435-3606

Fax: 312 347-4259


The Exchange’s aggregation program utilizes the ownership and control information
provided by the clearing firm, or in some cases the customer, on the CFTC Form 102 to
identify accounts that potentially merit aggregation. The Exchange has made clear in its
broadly-attended conversations with FIA representatives and staff, including you, that
independently controlled accounts owned by separate legal entities (irrespective of
whether they share a parent) will be disaggregated. This, in fact, is a more liberal
approach than exists under CFTC or CBOT rules in the context of other products that
have position limits in the spot month. Other than that point, the Exchange is not
aggregating accounts any differently than it does in any other context, and the Exchange
has explicitly stated that, assuming a firm is presently reporting its large trader positions
correctly, there is no need for any modification to its reporting procedures.

Clearly many FIA firms are involved in markets that currently employ position limits and
have had little difficulty complying with the relevant regulations. Recognizing, however,
that market participants have not recently had to comply with position limits in these
contracts, the Exchange has offered to assist any position holder or clearing firm in
understanding how the Exchange presently aggregates accounts through its aggregation
program and to provide its current and recent aggregated position data if desired.
Exchange Market Surveillance staff have had a number of such meetings with FIA
members, and firms have generally indicated a high degree of comfort with how their
accounts are being aggregated, irrespective of whether they support the decision on the
position limits.

Although as a historical and empirical matter, very few positions would have been
impacted by these limits in the last ten trading days, all accounts that have held positions
of this size are likely to have had discussions with Exchange Market Surveillance
representatives in past expirations in the context of its regular monitoring of positions as
contracts approach expiration. In keeping with the Exchange’s regular market
surveillance activities, these representatives will routinely be in contact with large
position holders welt before the date that such limits take effect, or promptly in the very
uncommon circumstance that a position suddenly becomes large well into the expiry
month.

Finally, your concerns regarding the capacity of FIA member firms to adequately monitor
for potential intraday violations are probably overstated given a proper understanding of
aggregation standards and given the small number of accounts that are apt to be ina
position to breach the limits. Despite this, as a practical matter, the Exchange receives
position information on an end of day basis, While position limits, as a rule, apply on an
intraday basis, the Exchange would need a compelling reason to examine an account’s
intraday activity. More broadly, the FIA should rest assured that the position limits have
been implemented for the specific purposes outlined in this letter, and that any
inadvertent breaches of the limits will be handled in that context, as with other products
that have position limits.


active and sophisticated market participants were disturbed by conditions such as those
discussed above prior to the Exchange’s establishing position limits. In light of the
manifest concem of a broad group of participants, and following our careful consultation
with relevant regulatory agencies and a diverse group of market participants, the CBOT
Board of Directors determined to take this action. :

Position Limits: Structure, Function and Operation

The CBOT has a statutory self-regulatory responsibility to ensure the integrity of its
markets. The Commodity Exchange Act requires the CBOT to comply with certain core
principles, one of which unequivocally states that it is the obligation of a board of trade to
prevent manipulation, price distortion and disruptions of the delivery or cash settlement
process. With this stricture in mind, we established position limits precisely for the
purpose of reducing the potential threat of market manipulation, congestion or price
distortions.

In light of the CBOT’s history of public comment filings advocating various forms of
relief with respect to position limits, it is evident that the Exchange adopted this course
only because it strongly believed that it was necessary to do so to preserve the integrity of
these contracts given present conditions. And it is not a mere coincidence that the
Treasury has also proposed a backstop lending facility at this particular time.

Structure: The structural elements of the new position limits are intended to enhance
confidence in the integrity of the markets within the scope of the CBOT’s capabilities
while exerting the least possible impact upon participants’ abilities to use the contracts
for their intended risk management function.

First, the limits take effect ten days before last trading day (rather than
throughout the spot month), by which time the substantial majority of the
calendar roll is typically completed.

Second, the quantity levels are high enough that, based on historical data
(including recent periods of record open interest), relatively few entities would
exceed the prescribed thresholds during the contracts’ fast ten trading days.

Third, the Jimits apply to both long and short position holders, rather than just the
long position holders as in certain other markets.

Fourth, the levels are such that the basis optionality embedded in the contracts
Temains intact.

With regard to the last of these, you note in your letter that the CBOT has made
“abundantly clear” that the terms of its Treasury futures contracts explicitly provide for
delivery of any security in the basket of qualified issues. The amended position limit
regulation adopted by the Exchange does not preclude multi-asset deliveries, nor was it
intended to do so. Rather, it ensures that a single participant (or multiple participants
acting pursuant to an express or implied understanding) cannot establish and hold a


futures market are all closely and elaborately linked. A confluence of factors across these
markets furnished the context for the decision to establish position limits.

First, the recent and present combination of low yields and a flat yield curve
strongly favors delivery of Treasury issues with relatively short durations and
short remaining times to maturity; in the case of 10-Year Treasury Note futures,
these issues tend to be those that the Treasury sold three or more years ago.

Second, the issue sizes of Treasury securities that are now attractive for delivery
into Treasury futures happen to be unusually small, partly as an artifact of the
Treasury’s reduced borrowing needs during the years of fiscal surplus (1999-
2001), and partly due to changes in the Treasury’s funding practices.

Third, the notional value represented by open interest in Treasury futures has
grown rapidly and dramatically relative to the underlying cash market. It now
Tepresents nearly double the proportion of the cash Treasury market as it did two
years ago.

Fourth, the increased incidence of fail epidemics since 9/11 in the cash Treasury
market, and especially in the Treasury repo market, has eroded trade certainty in
the cash Treasury market in ways that impair the ability of market participants to
perform cash-futures arbitrage.

Regarding the last of these considerations, in the U.S. Treasury Department’s recent
background briefing to the Bond Market Association’s Treasury Borrowing Advisory
Committee on a proposed backstop securities lending facility, Treasury staff identified
the following risks of the more frequent and severe fails in the cash and repo markets:

Impaired liquidity in the cash market

Loss of price convergence in the futures market
Operational cost of resolving fails

Ultimately higher borrowing costs for Treasury

Against this backdrop, and in consideration of the Exchange’s assessment of past and
upcoming contract expirations, the CBOT’s decision to implement position limits was a
prudent and proactive initiative intended to preserve the integrity of price convergence
between cash and futures, to insulate Treasury futures from potential manipulative
conduct and the perception of “squeeze” conditions, and more generally, to make fair
valuation of these contracts less susceptible to distortion arising from an increasing lack
of discipline and trade certainty in the Treasury financing market.

The CBOT and other financial regulators have received communications from a broad
array of market participants — many of them representatives of FLA member firms and
prominent clients of FIA member firms - regarding the CBOT’s Treasury futures and
activities in the cash markets. A sampling of analysts’ reports written by major
investment banks and prominent FIA member firms confirms that some of the most


© ChicagoBoardof Trade

August 10, 2005

John M. Damgard

President

Futures Industry Association
2001 Pennsylvania Ave. NW
Suite 600

Washington DC 20006-1823

Re: Position Limits in Treasury Futures During Last Ten Trading Days

Dear Mr. Damgard,

Thank you for your letter regarding the Chicago Board of Trade’s recent amendments to
Regulation 425.01, which established position limits during the last ten days of trading in
expiring Treasury futures, beginning with the December 2005 expiration. As stated in
our previous public notice, the amendments were implemented to help ensure that these
contracts perform their price discovery and risk management functions in the best
interests of the broad spectrum of market users and in keeping with our responsibilities as
a self-regulatory organization.

The CBOT’s most critical responsibilities are to protect the integrity of its contracts and
to provide for fair, efficient and orderly markets on behalf of all market participants. In
addition to the interests of certain large participants, whom the Exchange obviously
values as customers, the importance of Treasury futures to the U.S, economy and world
financial markets demands that we take all necessary measures to protect and enhance the
integrity of these contracts.

The Rationale for Position Limits: Measured Response To Market Concern

Large open interest near a contract’s expiry and/or large deliveries are not necessarily
indicative of a problem, though such conditions are monitored closely by Exchange staff.
Treasury futures, like other physically-delivered futures contracts, are not primarily
intended as a market for the physical transfer of the underlying securities; however, as
you observe in your letter, the possibility of delivery is the fundamental link between the
futures contract price and the price of the underlying. It is precisely this convergence of
the two prices that makes a futures contract relevant and useful for market participants.

Convergence does not occur in isolation, The liquidity of the underlying cash market and
the ease of arbitrage between the futures and cash markets can either facilitate or impair
the process, In this case, the cash market for Treasury securities, the repo market and the

141 W, Jackson Blvd.
Chicago, lilinois 60604-2994
912 435-3500