RULE ENFORCEMENT REVIEW 

OF THE 

KANSAS CITY BOARD OF TRADE 

Division of Market Oversight 

June 16, 2006 
Table of Contents 

I. INTRODUCTION .............................................................................................................. 1 

II. SUMMARY OF FINDINGS AND RECOMMENDATIONS........................................... 3 

 A. Compliance Staff ......................................................................................................... 3

 B. Market Surveillance ..................................................................................................... 3

 C. Audit Trail.................................................................................................................... 4

 D. Trade Practice Surveillance ......................................................................................... 5

 E. Disciplinary Matters..................................................................................................... 5

 F. Dispute Resolution ....................................................................................................... 6

III. COMPLIANCE STAFF...................................................................................................... 7 

IV. MARKET SURVEILLANCE .......................................................................................... 10 

 A. Overview of Routine Surveillance............................................................................. 10

 B. Surveillance of Expiring Contracts............................................................................ 12

 1. Expiring Futures................................................................................................... 12

 2. Expiring Options.................................................................................................. 13

 3. Expiration Files.................................................................................................... 14

 C. Large Trader Reporting and Enforcement of Speculative Position 

 Limits, Hedge Exemptions, and Position Accountability........................................... 14

 D. Exchange of Futures for Physicals and Exchange of Futures for Risk 

 Transactions ................................................................................................................ 15

 E. Conclusions and Recommendations........................................................................... 17

V. AUDIT TRAIL ................................................................................................................. 18 

 A. Trade Recordation Requirements............................................................................... 19

 1. Floor Order Tickets............................................................................................. 19

 2. Trading Cards...................................................................................................... 19

 3. Trading Card Collection ..................................................................................... 20

 B. Audit Trail Reviews................................................................................................... 21

 1. Full and Limited-Scope Reviews......................................................................... 21

 2. Member Compliance Rates.................................................................................. 22

 C. Trade Timing.............................................................................................................. 23

 D. Safe Storage Capability.............................................................................................. 25

 E. Conclusions and Recommendations........................................................................... 26

2
VI. TRADE PRACTICE SURVEILLANCE.......................................................................... 28 

 A. Automated Surveillance System................................................................................ 29

 B. Routine TPIs and Special Investigations.................................................................... 30

 C. Floor Surveillance ...................................................................................................... 31

 D. Adequacy and Timeliness of Investigations.............................................................. 32

 E. Conclusions and Recommendations........................................................................... 33

VII. DISCIPLINARY MATTERS ........................................................................................... 34 

 A. Disciplinary Committees and Procedures.................................................................. 34

 B. Sanctions Imposed ..................................................................................................... 36

 C. Timeliness of Disciplinary Procedures ...................................................................... 37

 D. Conclusions and Recommendation............................................................................ 38

VIII. DISPUTE RESOLUTION................................................................................................ 39 

 A. Customer Arbitration ................................................................................................. 39

 B. Member-to-Member Arbitration ................................................................................ 41

 C. Conclusions and Recommendations........................................................................... 42

3
RULE ENFORCMENT REVIEW 

OF THE 

KANSAS CITY BOARD OF TRADE 

 

I. INTRODUCTION 

 The Division of Market Oversight (“Division”) has completed a rule enforcement review 

of the self-regulatory programs at the Kansas City Board of Trade (“KCBT” or “Exchange”) for 

compliance with applicable core principles under Section 5(d) of the Commodity Exchange Act 

(“Act”) and Part 38 of the Commission’s regulations.1

 The Division’s review covered core 

principles that relate to the Exchange’s market surveillance, audit trail, trade practice 

surveillance, disciplinary and dispute resolution programs. The review focused on the period of 

August 1, 2004 through August 1, 2005 (“target period”).2

 The Division evaluated KCBT compliance with the following core principles: 

• Core Principle 2 – Compliance with Rules and Core Principle 12 – Protection of 

Market Participants: relate to surveillance, enforcement, and disciplinary 

procedures used by a contract market to protect market participants from abusive 

trading practices; 

• Core Principle 4 – Monitoring of Trading and Core Principle 5 – Position 

Limitations or Accountability: relate to an exchange’s program to prevent 

manipulation, price distortion, and disruptions of the delivery or cash settlement 

process, and for enforcing its speculative position limits and position accountability 

rules; 

 

1

 Rule enforcement reviews prepared by the Division are intended to present an analysis of an exchange’s overall 

compliance capabilities for the period under review. Such reviews deal only with programs directly addressed in the 

review and do not assess all programs. The Division’s analyses, conclusions, and recommendations are based, in 

large part, upon the Division’s evaluation of a sample of investigation and disciplinary case files, and other 

exchange documents. This evaluation process, in some instances, identifies specific deficiencies in particular 

exchange investigations or methods but is not designed to uncover all instances in which an exchange does not 

address effectively all exchange rule violations or other deficiencies. Neither is such a review intended to go beyond 

the quality of the exchange’s self-regulatory systems to include direct surveillance of the market, although some 

direct testing is performed as a measure of quality control. 

2

 The Division’s prior rule enforcement review of the KCBT was presented to the Commission on February 23, 

2003. 
• Core Principle 10 – Trade Information and Core Principle 17 – Recordkeeping: 

relate to the maintenance of an audit trail that can be used to assist a contract market 

in the identification and prosecution of customer and market abuses, and the 

maintenance and safe storage of trade-related records; and 

• Core Principle 13 – Dispute Resolution: relates to fair and equitable dispute 

resolution procedures for customers and member-to-member disputes.3

 To assess KCBT compliance with these core principles, Division staff examined 

Exchange compliance procedures and numerous documents used by the Exchange’s Department 

of Audits & Investigations (“A&I”) in performing its compliance and surveillance 

responsibilities. These documents included, among other things: 

• computer reports and other documentation used routinely for trade practice 

surveillance, market surveillance and audit trail rule enforcement; 

• trade practice investigation, audit trail and disciplinary case files; 

• trade practice investigation, floor surveillance, and disciplinary logs; 

• contract expiration files; 

• minutes of arbitration, disciplinary committee, and Board of Directors (“Board”) 

meetings held during the target period; and 

• compliance manuals and guidelines. 

The Division also interviewed A&I officials with respect to the operation of the Exchange’s 

self-regulatory programs.4

 

3

 Appendix B to Part 38 of the Commission’s regulations provides guidance concerning the core principles with 

which a designated contract market must comply to maintain its designation. In addition, Appendix B provides 

acceptable practices for several of the core principles. Although the acceptable practices establish non-exclusive 

safe harbors, they do not establish a mandatory means of compliance with the core principles. Appendix B provides 

acceptable practices for Core Principles 2, 10, 13, and 17; however, acceptable practices are not set forth for Core 

Principle 12. In promulgating Part 38, the Commission reserved the authority to adopt acceptable practices for Core 

Principle 12 at a later date. 

4

 A copy of the October 26-27, 2005 transcript of the interview can be found in Appendix 1. 

2
 The Division provided the Exchange an opportunity to review and comment on a draft of 

this report on May 17, 2006. On May 23, 2006, Division staff conducted an exit conference with 

KCBT officials to discuss the report’s findings and recommendations. 

II. SUMMARY OF FINDINGS AND RECOMMENDATIONS 

 A. Compliance Staff 

Findings

• The Exchange’s compliance department, the Department of Audits and 

Investigations, consists of two staff members, the Vice President-Compliance and the 

Assistant Vice President –Compliance. These staff members are responsible for 

carrying out all of the Exchange’s self-regulatory obligations, including market 

surveillance, trade practice surveillance, audit trail rule enforcement and disciplinary 

programs, as well as financial surveillance. 

• Although the Vice President and Assistant Vice President have extensive compliance 

experience, the multiple daily surveillance activities that must be performed by A&I 

staff to meet its self-regulatory responsibilities are placing a strain on staff in keeping 

pace with the Exchange’s record volume. This is evidenced by the need for regular 

increased assistance by the Exchange’s accountant to conduct routine trade practice 

surveillance. 

 

Recommendation

• The Exchange should increase its A&I staffing to a level that would keep pace 

with growth in trading activity to enable the Exchange to efficiently and 

effectively perform routine surveillance activities. 

 B. Market Surveillance 

Findings

• The Exchange monitors prices, volume, open interest, spread relationships, 

deliverable supplies and market news on a daily basis. In addition, A&I keeps 

informed of cash market developments and delivery intentions. 

 

• The Exchange heightens surveillance during the expiring contract month, beginning 

prior to first notice day. Surveillance of expiring contracts typically focuses on 

potential position concentrations, deliverable supplies, and the relationship between 

open interest and deliverable supplies. 

3
• The Exchange also has adequate procedures for monitoring reportable trader 

positions, enforcing speculative position limits, and identifying exchanges of futures 

for physicals and exchanges of futures for risk transactions that warrant further 

investigation. 

 The Division has no recommendations in this area. 

 C. Audit Trail 

Findings

• The Exchange uses transaction and Time and Sales data in its automated surveillance 

system to monitor for potential trading violations, and to provide evidence of any rule 

violations. The Exchange’s audit trail program includes quarterly audit trail reviews 

of clearing firms and floor members to assess compliance with order ticket and 

trading card recordation requirements. The Exchange also routinely monitors 

compliance with its one-minute trade timing requirement. 

• Floor members and clearing firms demonstrated a high level of compliance with 

Exchange audit trail rules during the target period. In addition, audit trail reviews 

were thorough, well documented and completed in a timely manner. 

• Back-up tapes containing confidential trade register data are stored each night, 

unencrypted, in an unsecured off-site location. In addition, restore procedures and 

tapes containing historical trade register and Time and Sales data are not periodically 

tested for possible degradation or data loss. 

Recommendations

• The Exchange should encrypt the trade data back-up tapes taken off-site each 

night, or alternatively, deposit them in a secure off-site location; and 

• The Exchange should periodically test historical trade data and Time and Sales 

back-up tapes for degradation or data loss, and its restore procedures for 

expeditious and complete system recovery.

4
D. Trade Practice Surveillance 

Findings

• The Exchange reviews its trade register, the Time Audit Report, on a daily basis and 

examines all exceptions identified on the report for possible violations. The TAR 

shows possible trade practice violations by performing edit functions based on 

predetermined parameters designed to identify specific types of trading abuses, such 

as trading ahead, accommodation trading and wash trading. 

• The Exchange targets its more active members for routine trade practice 

investigations, examining three to five days of trading activity for those members 

annually. In addition, Exchange staff conducts floor surveillance periodically each 

day to monitor for trading violations. 

 

• The Exchange’s investigations were completed in a timely manner, well documented, 

and, in large part, thorough. The Exchange also improved the quality of its 

investigations by expanding the scope of investigations to examine for possible 

patterns of violations, particularly when the subject member has a prior disciplinary 

history. 

 The Division has no recommendations in this area. 

 E. Disciplinary Matters 

Findings

• The Exchange’s Complaint Committee considered three cases during the target 

period. Two cases involved audit trail recordkeeping violations by two floor 

members, and one involved inaccurate reporting of open interest by a member firm. 

The two members were fined $100 and $200, respectively, and the firm was fined 

$500. The Exchange also issued 23 reminder letters and 12 warning letters, primarily 

for trading card recordkeeping and trade timing violations. 

• The member who received a $200 fine had been issued one previous warning letter 

regarding audit trail violations, while the member who received a $100 fine was 

issued consecutive warning letters in the two months prior to the sanction. In 

addition, the latter member received reminder and warning letters in the two previous 

years. In view of this member’s history of audit trail violations, a larger sanction was 

warranted. 

5
Recommendation

• Impose sanctions that serve as an effective deterrent against members who 

repeatedly violate the Exchange’s audit trail rules. 

 F. Dispute Resolution 

Findings

• Exchange rules provide customers with voluntary procedures for arbitration that are 

fundamentally fair and equitable. Each party has the right to counsel and each party 

receives adequate notice of claims presented against them and an opportunity to be 

heard on all claims, defenses, and counterclaims. KCBT’s arbitration procedures 

require a prompt hearing and authorize prompt, written, final settlement awards that 

are not subject to appeal within the Exchange. KCBT also provides arbitration 

procedures for member-to-member disputes. 

• The one customer arbitration case heard during the target period was handled in 

conformance with Exchange rules and procedures, and was adequately documented. 

There were no member-to-member arbitrations during the target period. 

 The Division has no recommendations in this area. 

6
III. COMPLIANCE STAFF 

Core Principle 2 – Compliance with Rules: 

The board of trade shall monitor and enforce compliance with rules of the contract 

market, including the terms and conditions of any contracts to be traded and any 

limitations on access to the contract market. 

 Pursuant to Appendix B to Part 38 of the Commission’s regulations, a contract market’s 

trade practice surveillance program should have the arrangements, resources, and authority 

necessary to perform effective rule enforcement. The arrangements and resources attendant to 

the program should facilitate the direct supervision of the contract market, including analysis of 

relevant data. 

 Currently, A&I consists of two staff members, the Vice President-Compliance, who 

reports to the President and CEO of the Exchange, and the Assistant Vice President –

Compliance. These staff members are responsible for administering the Exchange’s market 

surveillance, trade practice surveillance, and audit trail and disciplinary programs, as well as the 

Exchange’s financial surveillance program. The Exchange’s accountant assists A&I staff on a 

part-time basis. The Vice President and Assistant Vice President have extensive compliance 

experience. The Vice President has 18 years of Exchange experience, and the Assistant Vice 

President has been at the Exchange for 15 years. Each has served in his current position for the 

past eight years. 

 With respect to market surveillance activities, the Vice President is primarily responsible 

for surveillance of expiring wheat futures and options, and monitoring of reportable positions. 

The Assistant Vice President is primarily responsible for daily market surveillance activities, 

such as the monitoring of price changes, volume, open interest and spread relationships. 

7
 With respect to trade practice surveillance and audit trail rule enforcement, the Vice 

President is responsible for monitoring the wheat options contract (for both open outcry and 

electronic trading), the electronic wheat futures contract, and the Value Line futures and options 

contracts.5

 The Assistant Vice President is responsible for monitoring the wheat futures 

contract. The Exchange’s accountant regularly assists A&I staff by conducting audit trail 

reviews and trade practice investigations of a routine nature. However, more recently, beginning 

in March 2006, due to the demands of increased trading volume, the accountant has started 

reviewing trading activity in wheat options and the Exchange’s “Outtrade Report” to assist A&I 

staff with their daily surveillance. 

 The Division believes that the multiple daily surveillance activities that must be 

performed by A&I staff to meet its self-regulatory responsibilities, including market, trade 

practice and financial surveillance, are placing a significant strain on A&I staff with respect to 

keeping pace with the Exchange’s steadily increasing trading volume.6 The recent need for 

increased assistance by the Exchange’s accountant to satisfy routine trade practice surveillance 

obligations, such as monitoring of wheat options trading, demonstrates the necessity for 

 

5

 KCBT lists contracts in hard red winter wheat and Value Line futures and options for both open outcry and 

electronic trading. Since December 12, 2004, Value Line futures and options have been traded exclusively on the ecbot electronic platform. During the target period, wheat futures and options were pit traded and listed on e-cbot 

during after hours trading. On August 1, 2006, wheat futures trading will be expanded to include side-by-side 

(electronic and pit) trading. 

6

 In 2005, KCBT set an all-time record for trading volume (3,953,536 contracts), exceeding the previous record set 

in 2002 by 19 percent. Further, for the tenth time in 12 years, the KCBT set a new annual volume record in the 

wheat futures by breaking the previous annual record in 2004 by 30 percent. That trend has continued in 2006, with 

April volume exceeding April 2005 volume by 56 percent. Overall, year-to-date volume through April 2006 was up 

nearly 58 percent. 

8
additional A&I staff. Additional staff would enhance the overall effectiveness and efficiency of 

the Exchange’s compliance department, and allow it to meet the demands of increasing volume. 

 Based on the foregoing, the Division recommends that the Exchange: 

• Increase its A&I staffing to a level that would keep pace with growth in trading 

activity to enable the Exchange to efficiently and effectively perform routine 

surveillance activities. 

9
IV. MARKET SURVEILLANCE 

Core Principle 4 – Monitoring Trading: 

The board of trade shall monitor trading to prevent manipulation, price distortion, 

and disruptions of the delivery or cash-settlement process. 

Core Principle 5 – Position Limitations or Accountability: 

To reduce the potential threat of market manipulation or congestion, especially 

during trading in the delivery month, the board of trade shall adopt position 

limitation or position accountability for speculators, where necessary and 

appropriate. 

 Pursuant to the acceptable practices set forth in Appendix B to Part 38 of the 

Commission’s regulations, an acceptable market surveillance program should regularly collect 

and evaluate market data to determine whether markets are responding to the forces of supply 

and demand. An exchange also should have routine access to the positions and trading of its 

market participants. To diminish potential expiration problems that may arise from excessively 

large speculative positions, an exchange may need to establish spot-month speculative limits for 

some commodities. Such position limits are not necessary for markets where the threat of 

excessive speculation or manipulation is very low. For some contracts, such as financial 

instruments, an exchange may provide for position accountability in lieu of position limits. 

A. Overview of Routine Surveillance 

 A&I’s routine market surveillance activities include daily monitoring of prices, volume, 

open interest, and deliverable supplies where applicable. A&I examines the “Volume and Open 

Interest by FCM Report” (“Volume and Open Interest Report”) for each contract on a daily 

basis. The report lists pit trades and trades off the centralized market, such as exchange of 

futures for physicals (‘EFP”) transactions and transfer trades, option exercises, and ending gross 

10
long and short positions for all clearing members in all months. The report, which also includes 

codes that highlight for review any open position changes greater than the clearing member’s 

daily volume, is reviewed for any significant change in open interest.7 A&I analyzes significant 

changes to determine possible reasons for the change and any market impact. Staff also contacts 

the respective clearing member if any questions remain as to whether the problem was resolved 

satisfactorily or if further action is necessary. A&I notes the amounts of increases or decreases 

in the clearing member’s open positions on the Volume and Open Interest Report, and provides a 

brief explanation from the clearing member.8

 Price changes are reviewed daily. A&I reviews daily price changes for KCBT contracts, 

as well as cumulative price changes dating back to expiration of the preceding contract, and the 

spread differential between the nearby and each deferred month. In addition, in connection with 

surveillance of its wheat contract, staff tracks daily price movements of wheat futures at the 

Chicago Board of Trade and Minneapolis Grain Exchange, and the spreads between those 

markets and the KCBT contract. Staff also monitors price movements and spreads in Value Line 

futures against the Value Line Spot Index, S&P 500 future and spot indexes, New York Stock 

Exchange Composite Index future and spot indexes, and the Dow Jones future and spot indices. 

 Finally, KCBT reviews daily and weekly stock reports to monitor deliverable supplies of 

wheat. A&I receives a “Daily Stock Report” from its 15 “regular elevators,” which shows the 

 

7

 A significant change includes an abrupt increase or decrease in the total open interest in any clearing member’s 

positions or an abrupt switch from a long to a short position, or vice versa. 

8 During the target period, A&I opened one investigation, #SP0503, that resulted from a review of the Volume and 

Open Interest Report. The investigation revealed that a clearing member had a large reduction in its July 2005 

wheat futures position, in excess of its daily volume for July 11, 2005. A&I found that the clearing member 

accepted give-up transfer trades totaling 70 contracts from another clearing member and failed to properly offset 

these contracts on a timely basis. As a result, open interest in the July 2005 contract was overstated by 70 contracts, 

or 18%, on July 11, two days before the last trading day. A&I referred the reporting violation to the Complaint 

Committee and the firm was fined $500. See pp. 39-42 for a discussion of the Exchange’s disciplinary program. 

11
gross amount of wheat and other commodities either held in storage or for which warehouse 

receipts are held as of the previous day’s close of business.9

 The gross amount is posted on the 

trading floor each morning, along with the increase or decrease from the previous business day. 

The regular elevators also provide a “Weekly Deliverable Stocks Report.” A&I uses to this 

report to determine if any discrepancies exist between the daily and weekly statistics. If 

discrepancies are identified, A&I reports them for follow-up to the KCBT’s President and CEO. 

 A&I also reviews the Weekly Deliverable Stocks Reports, Daily Stock Reports, daily 

railroad receipts and shipments, and registered warehouse receipts to verify the deliverable 

supply of wheat. A&I contacts the parties or members with outstanding warehouse receipts in 

order to confirm their status. In addition, A&I compiles wheat stocks information, and issues a 

report every Tuesday indicating the total deliverable grades, total non-deliverable grades, and 

total Commodity Credit Corporation (“CCC”) stocks for the Hutchinson and Kansas City 

elevators.10 

B. Surveillance of Expiring Contracts 

 1. Expiring Futures 

 To ensure orderly liquidations, A&I heightens surveillance of open positions in expiring 

contracts, beginning a few days before the first notice day of a wheat future, i.e., the last business 

day of the month preceding the delivery month. A&I reviews the house and customer positions 

held by each clearing member and prepares a spreadsheet for the three largest long and short 

position holders (and any other clearing members with positions of 100 contracts or more), and 

 

9

 Regular elevators are those elevators that have satisfied the Exchange’s requirements for facilities, capacity, 

location, and financing, and have been approved for delivery of hard red winter wheat against the futures contract. 

10 The CCC, a government-owned entity affiliated with the United States Department of Agriculture, assists farmers 

and offers price support programs, foreign sales programs, and export credit programs for agricultural commodities. 

12
their respective percentage of open interest. A&I monitors these clearing members throughout 

the expiration period until their positions are liquidated. 

 On first notice day of the wheat futures contract, A&I sends liquidation notice letters to 

clearing members reminding them of the delivery date and the last trading day of the expiring 

month.11 Throughout the expiring month, A&I routinely contacts clearing members and other 

position holders about their intentions to make or take delivery, and reminds them that an orderly 

liquidation is expected. In addition, A&I routinely performs an “economic justification” test, 

calculating the difference between the cost to procure wheat through the delivery process and the 

cash market. Staff reviews current market prices and spread trading activity to determine which 

would be more economical given the current market conditions. 

 2. Expiring Options 

 For wheat and Value Line option contracts, A&I reviews an “In-the-Money Report 

Summary” that it receives from the KCBT Clearing Corporation (“Clearing Corporation”) a 

week prior to expiration. The report shows the clearing members, number of long and short 

option positions, house or customer designation, and the settlement price of the expiring contract. 

A&I sends liquidation letters to the clearing members with long in-the-money positions one 

week before the last trading day of the expiring option month. A&I requires clearing members 

to sign and date all liquidation letters, acknowledging that they have received the notification. 

The purpose of the letter is to remind clearing members that, pursuant to KCBT Rules 2515.04 

and 2615.04, in-the-money option positions are exercised automatically unless instructions to the 

contrary are delivered to the Clearing Corporation by 4:00 p.m. the day the letter is received. 

 

11 The Value Line futures contract is cash-settled; therefore, liquidation letters are not sent, and delivery-related 

issues associated with its expiration do not occur. 

13
 A&I also reviews an “Exercise – Delivery Trade Register Report” that lists options that 

were exercised on the previous business day. The report identifies the clearing member, 

premium, settlement price, quantity bought and/or sold, and the dollar amount exercised. A&I 

reviews the report to ensure that the options were properly exercised, particularly those exercised 

on the last trading day. During the target period, all in-the-money options were exercised 

properly or were automatically exercised pursuant to Exchange rules. 

 3. Expiration Files 

 A&I documents its surveillance of expiring months in contract expiration files. The 

expiration files contain price change and open interest liquidation spreadsheets, spreadsheets 

listing the largest long and short position holders, copies of liquidation letters sent to clearing 

members, delivery notices, in-the-money summaries, reports of exercises and memos detailing 

phone conversations with relevant parties. 

 The Division reviewed the five expiration files for wheat futures during the target period, 

and found that the files were well-documented and reflective of the surveillance activities 

conducted. 

C. Large Trader Reporting and Enforcement of Speculative Position 

 Limits, Hedge Exemptions, and Position Accountability 

 KCBT rules concerning speculative limits prescribe the maximum number of net futuresequivalent contracts (futures and options) which any one person or entity may own or control on 

the same side of the market without an approved exemption. The Exchange has adopted the 

federal speculative limits set forth in Commission Regulation 150.2 for wheat futures and 

14
options.12 KCBT Rule 2415.02 and Resolution 26-2621.00-02 prescribe the position limits for 

Value Line futures and options, respectively. 

 A&I monitors speculative position limits and reportable positions by obtaining weekly 

large trader position reports from Division surveillance staff in Chicago via encrypted email. 

The reports list, by owner, each account that has a reportable position, as well as the filing firm, 

account type indicator, future month and year, position long and short, and for options, put or 

call indicator, strike price, delta, and delta-adjusted long and short position. Additional reports 

can be produced more frequently, upon request. A&I reviews reportable positions to ensure that 

traders do not exceed speculative position limits, to identify possible concentrations of positions 

that may disrupt the market, and to monitor the activity of the largest traders in the markets. In 

addition, A&I obtains copies of the CFTC Form 102 for new reportable accounts, and CFTC 

Form 40 (Statement of Reporting Trader) from Division surveillance staff, as needed. 

 There were no speculative limit violations during the target period.13 

D. Exchange of Futures for Physicals and Exchange of Futures for Risk 

 Transactions 

 KCBT rules allow for two types of trades to be executed off the centralized market -- 

transactions in futures made either in connection with EFPs or for the purpose of establishing the 

price of cash commodities, and, since 2002, Exchange of Futures for Risk (“EFR”) transactions, 

which involve the exchange of futures contracts for or in connection with over-the-counter 

(“OTC”) derivative transactions.14 To ensure that EFPs and EFRs are transacted in accordance 

 

12 Under federal speculative limits, the Commission is responsible for approving hedge exemptions for the wheat 

contract; however, the Exchange obtains copies of the approval letters, when needed. 

13 The KCBT does not have position accountability rules since speculative position limits apply to each contract. 

14 See KCBT Rule 1128.00 (allowing EFP transactions), Rule 1128.01 (specifying EFP clearing requirements), and 

Rule 1128.02 (requiring the production of EFP documentation upon request). See also, KCBT Rule 1129.00 

15
with Exchange rules, A&I examines its trade register, the Time Audit Report (“TAR”), on a 

daily basis. A&I reviews the report for EFPs or EFRs that may warrant further investigation, 

such as those that have the same clearing firm and account number on both sides of the 

transaction, are unusually large, or are priced outside the daily trading range. If any of these 

elements are identified, A&I contacts the clearing member and/or account owner to determine 

whether the transaction was bona fide, and obtains supporting documentation to verify the 

transference of the commodity. 

 During the target period, A&I’s review of the TAR revealed no EFPs that warranted 

further investigation. In this connection, Division staff conducted an independent review of 

EFPs using cleared trade data on 12 randomly selected days during the target period and, 

similarly, did not find any EFPs that appeared suspicious or otherwise warranted further 

investigation. 

 For the first two years of EFR trading, A&I requested documentation for all EFR 

transactions to confirm the OTC components, the validity of the documents (confirmation or 

master swap agreement), and the parties involved. In the past few years and during the target 

period, A&I has incorporated EFR surveillance into its daily review of the TAR. A&I obtained 

documentation on 12 EFR transactions during the target period. The Division’s review of the 

files indicated that appropriate documentation was obtained, including swap transaction 

confirmations, equity runs, order tickets, and correspondence between the parties, including email communications. 

 (allowing EFR transactions), Rule 1129.01 (specifying EFR clearing requirements), and Rule 1129.02 (requiring the 

production of EFR documentation upon request). 

16
E. Conclusions and Recommendations 

 The Division found that the Exchange maintains an adequate market surveillance 

program. The Exchange monitors prices, volume, open interest, spread relationships, deliverable 

supplies and market news on a daily basis. In addition, A&I keeps informed of cash market 

developments and delivery intentions. Surveillance of expiring contracts typically focuses on 

position concentrations, deliverable supplies, and the relationship between open interest and 

deliverable supplies. A&I works closely with Division surveillance staff, particularly during 

expiring months, to ensure an orderly liquidation. The Exchange also has adequate procedures 

for monitoring reportable traders, enforcing speculative position limit rules and identifying 

suspicious EFPs and EFRs for follow-up. 

 Based on the foregoing, the Division has no recommendations in this area. 

17
V. AUDIT TRAIL 

Core Principle 10 – Trade Information: 

The board of trade shall maintain rules and procedures to provide for the recording 

and safe storage of all identifying trade information in a manner that enables the 

contract market to use the information for purposes of assisting in the prevention of 

customer and market abuses and providing evidence of any violations of the rules of 

the contract market. 

Core Principle 17 – Recordkeeping: 

The board of trade shall maintain records of all activities related to the business of 

the contract market in a form and manner acceptable to the Commission for a 

period of five years. 

 Pursuant to the acceptable practices set forth in Appendix B to Part 38 of the 

Commission’s regulations, an effective contract market audit trail should capture and retain 

sufficient trade-related information to permit contract market staff to detect trading abuses and 

reconstruct transactions within a reasonable period of time. In addition, the contract market must 

create and maintain an electronic transaction history database that contains information with 

respect to transactions executed on the contract market. An acceptable audit trail also must be 

able to track a customer order from time of receipt through fill allocation or other disposition. 

Further, an acceptable audit trail should include original source documents, transaction history, 

electronic analysis capability and safe storage capability. 

 Commission Regulation 1.31 governs the manner in which an exchange is required to 

maintain trade-related records. The regulation mandates that all records required to be kept 

under the Act or Commission regulations be maintained for five years and be readily accessible 

during the first two years. Most categories of required records may be stored on either 

micrographic or electronic storage media for the full five-year maintenance period. However, 

18
trading cards, documents on which trade information is originally recorded in writing, and order 

tickets must be retained in hard copy for five years. 

A. Trade Recordation Requirements 

 1. Floor Order Tickets 

 At KCBT, orders are either written on floor order tickets by clearing firm staff or 

electronically received at firm trading floor desks, via the Trade Order Processing System 

(“TOPS”), an industry-wide order routing system.15 Order tickets are then handed to floor 

brokers or order instructions are flashed, i.e., hand-signaled, into the pit. Upon execution, a floor 

broker either records fill information on the order ticket or flashes fill information back to the 

firm’s desk. The Exchange requires an order ticket to include an account identifier, order 

number, entry timestamp indicating when the order was received on the floor, and exit timestamp 

indicating when the filled order was returned or reported back to a firm’s desk.16

 2. Trading Cards 

KCBT also requires each member to record all trade executions for customer and 

personal accounts on trading cards promptly upon the purchase or sale of any contract.17 Floor 

members record trades on double-sided cards, with buys on one side and sells on the other. The 

card must contain the member’s trading initials, clearing firm code, date, time of trade execution 

to the nearest minute, quantity, commodity, month, price, opposite member and clearing firm 

initials, and for option contracts, premium, strike price, and put or call indicator. Members must 

 

15 Eight of the Exchange’s 20 clearing firms receive orders via TOPS. Each firm has a TOPS machine at its trading 

floor desk that prints orders received from various office locations in the form of an order ticket. Another clearing 

firm has a TOPS machine to only send orders to Chicago; it does not receive orders for KCBT contracts. 

16 KCBT Resolution 11-1130.00-1. 

17 KCBT Rule 1115.00. 

19
record their trades in non-erasable ink, in sequential order, and without skipping lines between 

trades. In addition, a line must be drawn to separate trades executed during the opening and 

closing periods from other trades. 

 Three different types of trading cards are used at the Exchange: (1) personal trading 

cards; (2) brokerage cards; and (3) master cards. Personal trading cards, which are used by 

Exchange members to record personal trades, are pre-printed with the respective member’s 

trading initials and card sequence numbers. Members must mark through any remaining unused 

lines on a personal trading card before starting a new card. Brokerage cards, which do not 

contain pre-printed sequence numbers, are used to record executions for house and customer 

accounts. A broker uses a separate brokerage card for each clearing firm for which he or she fills 

house or customer orders. Finally, a broker also may record all house and customer fills together 

on a master card and then have the required trade information transcribed onto separate broker 

cards, one per clearing firm. Master cards are used by brokers who fill orders for numerous 

clearing firms and prefer not to carry or hold separate cards for each firm. Only two brokers 

used master cards during the target period. 

 3. Trading Card Collection 

Personal trading cards and brokerage cards must be submitted to clearing firms no later 

than 15 minutes after each 30-minute trading interval and promptly timestamped upon 

collection.18 Clearing firms must submit trades to the Clearing Corporation within 60 minutes 

after each 30-minute interval. The clearing system matches trades that agree on quantity, 

 

18 KCBT Rule 1115.02. Master cards are not subject to Exchange collection requirements because only data 

recorded on personal trading cards and brokerage cards are entered into the clearing system. However, pursuant to 

Commission Regulation 1.31, members who use master cards must save the cards for five years and produce the 

cards upon request. 

20
brokers, month, price, and clearing firms as soon as both sides are entered. Clearing firms can 

enter trades and correct errors until the first reconciliation report listing all matched trades is 

distributed, approximately 45 minutes after the close of each contract. In addition to the 

reconciliation report, clearing firms are given a list of trades that cannot be matched due to a data 

inconsistency (“cutout trades”). The Clearing Corporation busts all cutout trades that are not 

resolved by 4:00 p.m., the end of the final reconciliation process. However, cutout trades that 

are busted may be resolved prior to the opening on the following business day “as of” the 

original trade date. 

 The Clearing Corporation provides A&I with a “Daily Out-Trade Audit Report” 

(“Outtrade Report”) that contains a record of all cutout trades, corrections, and busted trades 

from the previous business day. A&I reviews this report daily to ensure that trade corrections 

were not made to facilitate non-competitive or fictitious trades. A&I also reviews all as-of trades 

by comparing the trade price to the previous day’s Time and Sales Report (“Time and Sales”). 

B. Audit Trail Reviews 

 1. Full and Limited-Scope Reviews 

 KCBT conducts quarterly reviews of order tickets and trading cards (“audit trail 

reviews”) to monitor compliance with its trade recordation requirements. Audit trail reviews 

alternate between full-scope and limited-scope reviews. Full-scope reviews encompass all 

Exchange clearing firms and floor members.19 A&I endeavors to perform a full-scope review on 

each member annually. Limited-scope reviews primarily focus on clearing firms and floor 

 

19 When KCBT initiates an audit trail review, one review is opened to examine clearing firms and a separate review 

is opened to examine floor members. 

21
members who received a previous reminder or warning letter, or were referred to the Complaint 

Committee in the previous full-scope audit trail review. 

 For both full-scope and limited-scope reviews, A&I randomly selects a three-day period 

and examines all trading cards and order tickets prepared by the firms and floor members under 

review. If A&I finds that a clearing firm’s or floor member’s error rate exceeds five percent of 

the cards or transactions examined, A&I issues a reminder or warning letter, or refers the matter 

to the Complaint Committee for possible disciplinary action.20

 2. Member Compliance Rates 

 During the target period, A&I conducted two full-scope and one limited-scope audit trail 

reviews in which it examined a total of 4,296 order tickets prepared by 20 clearing firms and 

3,769 trading cards (2,124 brokerage cards and 1,645 personal trading cards) prepared by 40 

floor members. The Division examined the three review’s files, and found a high level of 

member compliance with KCBT’s trade recordation requirements. Specifically, all of the order 

tickets examined contained order numbers and account identifiers; 4,241 of the order tickets (99 

percent) included both entry and exit timestamps; and 98 percent of the trading cards were 

promptly timestamped upon collection. 

 With respect to floor members’ brokerage and personal trading cards, the reviews 

indicated that all of the trading cards were written in the required non-erasable ink. In addition, 

99 percent of the cards had no skipped lines, and properly identified the opening and closing 

periods with a drawn line. Executing clearing firms were recorded on 98 percent of the cards, 97 

 

20 A&I generally issues a reminder letter for a first offense if a member’s deficiency level is between five and ten 

percent, or a warning letter if the member’s deficiency level exceeds ten percent. A second offense for the same 

violation within one year generally results in a warning letter. If a member continues to violate audit trail rules 

following receipt of a warning letter, A&I refers that member to the Complaint Committee. 

22
percent of the cards were collected by the clearing member within 15 minutes of each 30-minute 

trading interval and 96 percent of the cards included the date, commodity, price, quantity, time, 

opposite clearing firm, and put or call indicator for option trades. In addition, 99 percent of the 

personal trading cards reviewed were preprinted with members’ trading initials, and trading card 

sequence numbers and 98 percent had unused lines properly marked through. Finally, 99 percent 

of the personal trading cards were properly started after each 30-minute trading interval. 

 The Division’s examination of KCBT’s audit trail reviews found that the files were 

thorough, well documented, and completed in a timely manner. The files included copies of all 

original floor orders, brokerage cards, and personal trading cards examined during the reviews, 

worksheets, and copies of all reminder and warning letters. Each file also included a form that 

showed the start date, completion date, final report date, and the dates of any resulting 

disciplinary actions. 

C. Trade Timing 

 As noted above, KCBT requires that the buying and selling members manually record the 

time of each pit trade to the nearest minute on his or her trading card. KCBT enforces this 

requirement by reviewing its daily trade register, the TAR, which contains various codes 

indicating possible trade timing errors.21 

 The TAR identifies seven types of timing errors that may be indicative of a trade timing 

violation. The first error is “Bought Side-No Trade” (“B-NT”). The TAR compares the time 

recorded by the buyer to the Time and Sales listing. If no trade is indicated on Time and Sales at 

the time recorded by the buyer, or within one minute preceding or one minute following that 

time, the trade is coded B-NT. The second error is “Sold Side-No Trade” (“S-NT”). The 

 

21 A sample copy of the TAR can be found in Appendix 2. 

23
computer program follows the same procedures as for a B-NT, but compares the seller’s 

recorded time to the prices recorded on Time and Sales. The third error, “No Quote at This 

Price” (“No Quote”), is a combination of a B-NT and S-NT. Thus, a trade is coded as a No 

Quote if the trade does not appear on Time and Sales within a minute of the time recorded by 

either the buyer or the seller. 

 The fourth type of timing error identified on the TAR is “Time Out of Limits” (“TOL”). 

A trade is coded TOL if the times recorded by both the buyer and the seller are marked as 

accurate by the system but there is more than two minutes between the two times. The fifth error 

noted on the TAR is “Bought Side-Untimed Trade” (“B-UT”). A trade is coded B-UT if the 

buyer fails to record a time for the trade on his or her trading card. Similarly, a trade is coded as 

“Sold Side-Untimed Trade” (“S-UT”) if the seller fails to record a time for a trade on his or her 

trading card. The final timing error, “Invalid Spread,” refers to a spread differential that does not 

appear on Time and Sales within the minute or minute preceding or following the trade time 

recorded by either the buyer or seller. 

 A&I reviews the TAR daily and compiles monthly statistics of each member’s timing 

errors. Members with a high error rate, generally between five and ten percent, are scheduled for 

a routine trade practice investigation (“TPI”).22 As part of the routine TPI, A&I collects the 

member’s trading records for the time period under review, and examines all trade timing errors 

to determine whether the errors were broker recordation errors or firm keypunch errors. After 

verifying the errors, if A&I finds that the member’s trade timing deficiency level exceeded five 

percent of his or her transactions, A&I issues either a reminder or warning letter, or refers the 

 

22 A routine TPI is a review of a member’s trading activity for potential trade violations over a three- to five-day 

time period. See pp. 30-31 for a discussion of the Exchange’s routine TPI program. 

24
member to the Complaint Committee for possible disciplinary action. Two reminder letters and 

one warning letter were issued during the target period for trade timing violations.23

 D. Safe Storage Capability 

 The Clearing Corporation captures, saves, stores and backs-up all trade data entered into 

the clearing system, including those trades executed electronically on the e-cbot platform. The 

Clearing Corporation produces and maintains five back-up tapes throughout the day on an AS 

400 computer system. These five tapes, plus a PC hard drive, are taken to a Clearing 

Corporation employee’s home each night and returned early the next business day. The Clearing 

Corporation also backs-up the trade information to an AS 400 server located at a disaster 

recovery site in Chicago with total on-line system replication 24 hours a day. A yearly historical 

file of the trade register data is backed-up to tape from the AS 400 computer at the beginning of 

the following year, and is stored in a bank safety deposit box. 

 Time and Sales data are stored electronically at the Exchange.24 The data are initially 

stored on an HP Nonstop Server (Tandem) with disks in a mirrored-configuration, which 

provides 100% duplication of data and offers the highest reliability. Twice daily and once 

monthly, the Time and Sales data are backed-up to tape.25 The daily tapes are kept in a fireproof safe on-site at the Exchange. The monthly tapes are stored off-site at the Vice PresidentOperations’ home. In addition, Time and Sales files are saved to tape at the end of each calendar 

 

23 Investigations W0415, W0511 and W0504 can be found in Appendix 3. 

24 Time and Sales data include all publicly disseminated information sent to quotes vendors (e.g., Reuters, DTN, and 

Bloomberg). For KCBT open outcry markets, the information contains text messages, bid, ask and trade prices, 

previous day’s volume, open interest (as of previous day’s close, as reported to the clearinghouse), high/low/last 

message, settlements and range quotations. The information for KCBT electronic contracts includes bid price with 

volume, ask price with volume, trade price with volume, high/low/last message, settlement message and range 

quotations. 

 

25 Time and Sales is also backed-up at the Clearing Corporation. 

25
year with two copies made; one copy is stored on-site in the fire-proof safe, and the other is 

stored off-site in the Vice President-Operations’ home.26

 Time and Sales data are also backed-up to tape nightly from the Exchange’s primary 

administrative server. In addition, these data are backed-up once a month to tape. Similar to the 

tapes backed-up from the Tandem server, the daily tapes are stored on-site in the Exchange’s 

fire-proof safe, and the monthly tapes are stored at the Vice President-Operations’ home. KCBT 

is also developing plans for backing-up Time and Sales data to its Chicago disaster recovery 

server. 

 E. Conclusions and Recommendations 

 

 The Division found that the Exchange maintains an adequate audit trail program. A&I 

uses trade register and Time and Sales data in its automated surveillance system to monitor for 

potential trading violations and to provide evidence of any rule violations. The Exchange’s audit 

trail program includes quarterly audit trail reviews of clearing firms and floor members to assess 

compliance with order ticket and trading card recordation requirements. The Exchange also 

routinely monitors compliance with its one-minute trade timing requirement. The Division’s 

review of the Exchange’s full- and limited-scope reviews found that clearing firms and floor 

members demonstrated a high level of compliance with Exchange audit trail rules. In addition, 

the audit trail reviews were thorough, well documented and completed in a timely manner. 

 However, the Division believes that the Exchange should enhance its safe storage 

practices to ensure that its proprietary audit trail information is properly safeguarded, and that 

data recovery can be performed quickly in an emergency situation. In order to protect against 

theft or tampering, the daily trade data tapes taken off-site each night to an employee’s home 

 

26 KCBT currently stores year-to-date Time and Sales information back to 1993. 

26
should be encrypted or, alternatively, deposited in a secure off-site location. In addition, trade 

register data and Time and Sales tapes that are backed-up yearly should periodically be tested for 

possible degradation or loss of data. Restore procedures also should be tested periodically to 

ensure an expeditious and complete recovery should the tapes be needed on an emergency basis. 

 Based on the foregoing, the Division recommends that the Exchange: 

• Encrypt the trade data back-up tapes taken off-site each night, or alternatively, 

deposit them in a secure off-site location; and 

• Periodically test the historical trade data and Time and Sales back-up tapes 

stored off-site for degradation or data loss, and its restore procedures for 

expeditious and complete system recovery. 

27
VI. TRADE PRACTICE SURVEILLANCE 

Core Principle 2 – Compliance with Rules: 

The board of trade shall monitor and enforce compliance with rules of the contract 

market, including the terms and conditions of any contracts to be traded and any 

limitations on access to the contract market. 

Core Principle 12 – Protection of Market Participants: 

The board of trade shall establish and enforce rules to protect market participants 

from abusive practices committed by any party acting as an agent for the 

participants. 

 Pursuant to Appendix B to Part 38 of the Commission’s regulations, a contract market’s 

trade practice surveillance program should have the arrangements, resources, and authority 

necessary to perform effective rule enforcement. The arrangements and resources attendant to 

the program should facilitate the direct supervision of the contract market, including analysis of 

relevant data. An acceptable program should have systems that maintain all data reflecting the 

details of each transaction executed on the contract market. In this regard, the program should 

include routine electronic analysis of these data to detect potential trading violations. The 

program also should provide for appropriate and thorough investigation of all potential trading 

violations brought to the contract market’s attention, including member and Commission 

referrals and customer complaints. In addition, the program should have the authority to 

discipline, suspend, or terminate the activities of members or market participants pursuant to 

clear and fair standards.27

 

27 That aspect of Core Principle 2 which relates to the disciplining of members who violate Exchange rules is 

discussed below in Section VII, Disciplinary Program. This section of the report addresses the Exchange’s program 

for monitoring its markets for possible trading abuses and the investigation of any abuses identified. 

28
A. Automated Surveillance System 

 The TAR serves as the Exchange’s automated surveillance system. The TAR identifies 

possible trade practice violations in pit and electronic trading by performing edit functions based 

on predetermined parameters designed for specific types of trading abuses. 28 All trades meeting 

the criteria for one or more parameters are flagged as exceptions on the TAR with a violation 

code. The codes relate to violations such as trading ahead of customer orders, accommodation 

trading and wash trading. The system also identifies all cross trades, which are referred to as 

“ring trades” at KCBT. 

 A&I staff reviews the TAR daily and conducts an initial inquiry into each trade coded as 

a possible violation. A formal investigation is opened if further information and more detailed 

analyses are needed to determine whether a rule violation occurred, or if a particular member has 

an unusually high number of exceptions on a given day or during a given month. For example, 

with respect to possible wash trades and accommodation trades, A&I’s initial inquiry considers 

factors such as the price difference between the trades, the amount of time between the trades, 

the price movement during that time, and the number of contracts traded. When necessary, A&I 

also requests trading cards and order tickets and/or discusses the questionable trade(s) with the 

member(s) involved. 

 The Division randomly selected 12 days over the course of the target period to examine 

A&I’s daily TAR reviews. The Division found that A&I adequately reviewed all coded trades, 

and pertinent information reflecting staff’s initial analysis regarding such trades was recorded on 

the respective TAR. 

 

28 As discussed earlier on pp. 23-24, the TAR also identifies possible trade timing errors. 

29
 A&I also uses an “Observer” software application provided by e-CBOT to aid in 

monitoring KCBT electronic trading on its platform. The Observer system allows A&I to 

readily access all orders entered on e-cbot for KCBT contracts. A&I can drill down to obtain 

detailed information on each matched trade and related orders, or to review a trader’s activity 

during the current session or the past seven business days. Historical order and trade data can be 

accessed up to 45 days through the system. A&I can also monitor the market depth. 

 B. Routine TPIs and Special Investigations 

 A&I complements its daily TAR review of all members’ trading activity with routine 

TPIs that examine the activity of its more active members. The Exchange strives to perform one 

routine TPI on each active member during the calendar year. An active member is defined as 

one who trades at least 300 contracts over a three- to five-day period. A routine TPI is a 

comprehensive examination of a member’s trading activity for possible rule violations, typically 

over a three-to five-day period. A&I examines at least 300 trades during a routine TPI. A&I 

examined 22 of the 24 active traders at the Exchange during the target period.29

 A&I reviews all trades of the subject member during the designated review period of a 

routine TPI. Staff first obtains a report from the TAR to isolate the member’s possible timing 

errors and trade practice violations, and requests relevant trading cards and order tickets. A&I 

then analyzes all of the possible timing errors and trading violations, and reviews the order 

tickets and trading cards for recordkeeping compliance. A&I also interviews the member under 

review to discuss any possible violations. If, upon completion of its TPI, A&I concludes that a 

reasonable basis exists for finding that a rule violation has occurred, it will issue a reminder or 

warning letter, or refer the matter to the Complaint Committee for consideration of charges. 

 

29 Active traders, as defined by the Exchange, represented approximately one-quarter of the floor population. 

30
 A&I also conducts what it refers to as “Special Investigations” whenever evidence 

indicates that a possible violation of Exchange rules may have occurred. Special Investigations 

generally are initiated from observations of unusual trading activity arising from floor 

surveillance, daily TAR reviews, Commission or National Futures Association referrals, or 

member, customer, or anonymous complaints. The Exchange’s quarterly audit trail reviews are 

also classified as Special Investigations.30

 C. Floor Surveillance 

 A&I conducts daily floor surveillance on the open and close of wheat, and randomly 

during the day for a 15- to 20-minute time period.31 If a market is exceptionally active or 

volatile, A&I staff will stay on the floor longer, typically until the activity abates. Observations 

made during daily floor surveillance may result in a more targeted analysis of a member’s 

trading activity during A&I’s TAR review and can result in the opening of an investigation. 

Similarly, if A&I has reason to believe that a member is engaging in prohibited trading activity, 

it will closely monitor the member’s trading activity while on the floor to enhance an ongoing 

investigation. 

 A&I maintains a daily floor surveillance log for each contract.32 The log reflects the 

observer’s initials, date and time of surveillance, and any material observations. If a possible 

trading violation is observed, the staff member prepares a “Floor Surveillance Report” and notes 

 

30 A&I records information relating to each routine TPI or Special Investigation on the Exchange’s investigation log. 

The information recorded includes the investigation number, name(s) of the member(s) under investigation, the date 

the investigation was opened and closed, the name of the staff member conducting the investigation, the source of 

the investigation, and findings. If an investigation is referred for disciplinary action, the log will reflect the actions 

taken and the dates of such actions. A copy of the investigation log can be found in Appendix 4. 

31 Both A&I staff members observe the opening and closing periods for the wheat futures contract, due to the higher 

trading volume. 

 

32 A copy of the floor surveillance log can be found in Appendix 5. 

31
this on the floor surveillance log. Floor Surveillance Reports list the following information: (1) 

the date and time of the observation; (2) the staff member who observed the incident; (3) the 

member or firm observed; (4) the possible violation; (5) any prior instances of similar conduct; 

(6) the action taken, including summaries of any conversations between A&I staff and members 

related to the incident; and (7) an investigation number if the matter is examined further. 

 There were no instances of suspicious trading activity observed by Exchange staff during 

the target period, nor did Division staff observe any suspicious activity during its routine floor 

surveillance. 

 D. Adequacy and Timeliness of Investigations 

 

 During the target period, the Exchange closed 32 investigations, which included 25 

routine TPIs and seven Special Investigations. Seven of the investigations, five routine TPIs and 

two Special Investigations, were opened prior to the target period. The Division reviewed all 32 

investigations, and conducted an in-depth review of 16 investigations for adequacy and 

thoroughness, including nine routine TPIs and seven Special Investigations. 

Each investigation was well documented. Files included a summary of the investigative 

steps taken (with the date each step was completed), copies of TARs and Time and Sales, 

profit/loss reports for the subject member’s personal trades during the time period under review, 

spreadsheets, work papers, summaries of interviews, letters notifying the subject member of the 

investigation and its results, and a copy of the investigation report. In addition, investigations 

were completed in a timely manner. Of the 32 closed investigations, 30 were completed within 

four months and two were completed within six months. Three investigations that remained 

open at the end of the target period have since been closed. All were completed within four 

months of their respective opening date. Lastly, the Exchange’s investigations were generally 

32
thorough, and investigations were expanded in scope, when appropriate, to look for possible 

patterns of violations.33

E. Conclusions and Recommendations 

 The Division found that the Exchange maintains an adequate trade practice surveillance 

program. The Exchange reviews its TAR report on a daily basis and examines all exceptions 

identified on the report for possible violations. The Exchange also conducts routine trade 

practice investigations of its more active members, examining three to five days of trading 

activity for those members annually. In addition, Exchange staff conducts floor surveillance 

periodically each day to monitor for trading violations. 

 The Exchange’s investigations were completed in a timely manner, well documented, 

and, in large part, thorough. The Exchange also improved the quality of its investigations by 

expanding the scope of investigations to look for possible patterns of violations, particularly 

when the subject member has a prior disciplinary history. 

 The Division has no recommendations in this area. 

 

33 The Division, however, notes two investigations, which involved possible trading ahead of customers, that it 

believes should have been more thoroughly investigated. In the first investigation, #W0424, the Exchange did not 

investigate a possible audit trail violation involving an order that appeared to be flashed to the pit incrementally, but 

which did not contain requisite timestamps reflecting the time each portion was flashed for execution. Based on the 

one timestamp present on the customer order ticket, it appears that the broker may have traded for his own account 

while holding the customer order. In the second investigation, #W0511, it appears that a broker may have executed 

two personal trades during the closing range while holding a customer “market on close,” or MOC, order. Although 

A&I obtained the trading card from one of the opposite brokers, it did not obtain the trading card from the broker 

opposite his second trade in order to confirm that the broker’s personal trades were done before the closing range 

began. A&I should have requested the additional documentation to support its conclusion that no violation 

occurred. 

33
VII. DISCIPLINARY MATTERS 

Core Principle 2 – Compliance with Rules: 

The board of trade shall monitor and enforce compliance with rules of the contract 

market, including the terms and conditions of any contracts to be traded and any 

limitations on access to the contract market. 

 As noted earlier, Core Principle 2 requires, among other things, that an exchange have the 

authority to discipline, suspend, or terminate the activities of members or market participants 

pursuant to clear and fair standards. Consequently, an acceptable compliance program should 

provide for prompt and effective disciplinary action for any violation that is found to have been 

committed. 

A. Disciplinary Committees and Procedures 

 The Complaint Committee and the Business Conduct Committee (“BCC”) serve as the 

Exchange’s two primary disciplinary committees. The Complaint Committee consists of ten 

members representing various Exchange interests who are appointed each year by the Chairman 

of the Exchange and approved by the Board of Directors.34 The BCC consists of five members, 

three of whom are elected, the First Vice Chairman of the Exchange and the President of the 

Clearing Corporation.35 The elected members serve staggered three-year terms so that each year 

one new member is elected to replace a departing elected member. 

 The Complaint Committee is a grand jury-type committee that reviews investigation 

reports referred by A&I to determine whether a Notice of Charges should be issued.36 In this 

 

34 KCBT Rule 247.00. 

35 KCBT Rule 244.00. 

36 KCBT Rules 1410.00 and 1414.00. 

34
regard, the Complaint Committee must meet within ten business days of receipt of an 

investigation report to consider the matter.37 Exchange policy requires that the Complaint 

Committee determine one of the following: (1) additional investigation or evidence is necessary; 

(2) no reasonable basis exists for finding a violation; (3) a reasonable basis exists for finding a 

violation, but prosecution is not warranted;38 or (4) a reasonable basis exists for finding a 

violation and the matter should proceed for adjudication to the BCC for hearing. 

 If the Complaint Committee determines that formal charges should be issued, A&I staff 

prepares a Notice of Charges.39 A Notice of Charges must include a summary of the possible 

violations, the rules alleged to have been violated, and the options available to the charged party. 

Those options include filing a written answer within ten business days either admitting or 

denying the charges, or filing a “nolo contendere” plea. A failure by the charged party to file a 

written answer within the prescribed time period will be deemed to be a not guilty plea and a 

hearing will be scheduled.40 Upon being served with a Notice of Charges, the charged party has 

the right to be represented by counsel in all succeeding stages of the disciplinary proceedings.41

 The Complaint Committee receives and considers all settlement offers. If the Complaint 

Committee accepts a settlement offer, the offer is then forwarded to the BCC for final acceptance 

and approval.42 The BCC must consider a settlement offer within ten business days of receipt 

 

37 KCBT Rule 1412.00. 

38 If the Complaint Committee finds that there was a violation but prosecution is not warranted, it generally will 

issue a warning letter. The Complaint Committee did not issue any warning letters during the target period. All 

such letters sent during the target period were issued by A&I staff. 

39 KCBT Rule 1414.00. 

40 KCBT Rule 1414.02. A nolo contendere plea is neither an admission nor denial of guilt but has the effect of a 

member waiving all proceedings except a hearing, if necessary, to set appropriate penalties. KCBT Rule 1414.02(f). 

41 KCBT Rule 1425.00(a). 

42 KCBT Rule 1416.00. 

35
from the Complaint Committee.43 If the BCC rejects a settlement offer, a full hearing on the 

matter is scheduled either before the entire BCC or a panel of the BCC.44 The BCC is required, 

under most circumstances, to issue a written decision within 15 business days.45 A decision of 

the BCC may be appealed to the Board within ten business days. The Board or a panel of the 

Board is required to hear the appeal within 20 business days and to issue a written decision 

within 30 calendar days of the hearing.46

B. Sanctions Imposed

 Three cases, involving two floor members and one clearing firm, were referred by A&I to 

the Complaint Committee for disciplinary action during the target period.47 Each of the cases 

was subsequently settled. Two of the cases involved audit trail recordkeeping violations, and the 

third case involved a firm’s accurate reporting of open positions two days before last trading day 

in July 2005 wheat. The Exchange levied fines of $100, $200, and $500, respectively, against 

the three members.48 Although $800 is a small amount of fines for a 12-month period, except 

for the two investigations described earlier where additional inquiry should have been conducted, 

 

43 KCBT Rule 1417.00. 

44 KCBT Rules 1417.01 and 1421.00. No hearings were held during the target period. 

45 KCBT Rule 1432.01. 

46 KCBT Rules 1437.00 and 1442.00. 

47 During the target period, A&I also issued 23 reminder letters and 12 warning letters, predominately for trade 

timing and recordkeeping violations. 

48 In all three cases, the Complaint Committee rejected the initial settlement offers. The two floor members 

originally offered warning letters and the clearing firm offered $300. 

36
the Division did not find anything to suggest that additional cases should have been brought 

before a disciplinary panel.49

 Both recordkeeping cases resulted from a limited scope audit trail review in November 

2004 of members who had recently received either a reminder letter or warning letter for audit 

trail violations. The member who received a $200 fine had received a previous warning letter in 

September 2004. The member who was fined $100 had received warning letters in the two 

previous months, September and October 2004, and reminder letters and warning letters in 2002 

and 2003. Given the member’s history of recordkeeping violations, the Division believes that 

the Exchange should have imposed a larger sanction. 

C. Timeliness of Disciplinary Procedures

 The Division found that the Complaint Committee reviewed investigation reports 

promptly after receiving them. Exchange rules require that the Complaint Committee meet 

within ten business days of receiving an investigation report to consider the report and determine 

whether to issue a Notice of Charges within ten business days of the respective meeting.50

 The Complaint Committee met two times during the target period to review the 

investigation reports for the three above-noted cases. In each instance, the Complaint Committee 

met within ten business days of receiving an investigation report to consider the report, reached 

its decision on the day of the meeting, decided to issue a Notice of Charges, and issued such 

notice within ten business days following the meeting. All of the respondents submitted 

settlement offers within 14 days, and those offers were reviewed and accepted by both the 

Complaint Committee and the BCC within 20 days of their submission. 

 

49 See n. 33 at p. 33 for a discussion of the two investigations. 

50 KCBT Rules 1412.00 and 1413.00. 

37
D. Conclusions and Recommendation

 The Exchange’s Complaint Committee considered three cases during the target period. 

Two cases involved audit trail recordkeeping violations by two floor members, and one involved 

inaccurate reporting of open interest by a member firm. The two members were fined $100 and 

$200, respectively, and the firm was fined $500. The Exchange also issued 23 reminder letters 

and 12 warning letters, primarily for trading card recordkeeping and trade timing violations. 

 The member who received a $200 fine had been issued one previous warning letter 

regarding audit trail violations, while the member who received a $100 fine was issued 

consecutive warning letters in the two months prior to the sanction, in addition to a reminder and 

warning letter in the two previous years. In view of the latter member’s history of audit trail 

violations, a larger sanction was warranted. 

 Based on the foregoing, the Division recommends that the Exchange: 

• Impose sanctions that serve as an effective deterrent against members who 

repeatedly violate the Exchange’s audit trail rules. 

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VIII. DISPUTE RESOLUTION 

Core Principle 13 – Dispute Resolution: 

The board of trade shall establish and enforce rules regarding and provide facilities 

for alternative dispute resolution as appropriate for market participants and any 

market intermediaries. 

 Pursuant to the acceptable practices set forth in Appendix B to Part 38, an exchange is 

required to provide a customer dispute resolution mechanism that is fundamentally fair and 

equitable, and available on a voluntary basis. In this regard, customers should have the 

opportunity to have their claims heard and decided by an objective and impartial decision maker. 

Each party should have the right to counsel and be provided with adequate notice of claims 

presented against him or her and an opportunity to be heard on all claims, defenses, and 

counterclaims. In addition, the process should provide for the opportunity of a prompt hearing, 

and parties should be notified of the fees and costs that may be assessed. An exchange’s dispute 

resolution mechanism also should authorize prompt, written, final settlement awards that are not 

subject to appeal within the exchange. Finally, if an exchange provides procedures for the 

resolution of member-to-member disputes (not involving customers), the procedures for 

resolving such disputes must be independent of and not interfere with the resolution of 

customers’ claims or grievances. 

A. Customer Arbitration 

 KCBT customers are afforded voluntary dispute resolution through the Exchange’s 

customer arbitration rules and procedures. A customer may elect to have his or her claim or 

grievance against a member or its employees heard by either a panel of the Exchange’s 

Arbitration Committee or by a specially constituted panel which has at least a majority of panel 

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members who are not Exchange members or associated with any member of any designated 

contract market or employee thereof.51

 Any customer desiring to submit a matter in dispute for arbitration must file a written 

sworn complaint alleging the nature of the dispute, the basic facts, the damages sought, and the 

name of the member within one year after the date of the transaction from which the dispute 

arose. If the member fails to answer the complaint in writing within ten days, or fails to sign an 

agreement to arbitrate, the member will be deemed as refusing to arbitrate and incurs the 

possibility of disciplinary action by the BCC, including an award for the customer.52 A member 

also has the right to file counterclaims that arise out of the transaction or occurrence that is the 

subject of the customer’s claim or grievance. The customer must reply to the counterclaim 

within ten days.53

 Arbitration proceedings are held at the KCBT, unless otherwise agreed to by the parties, 

and are required to take place in a timely manner. Each party has the right to be represented by 

counsel at its own expense. Each party also is entitled to appear in person or by telephone 

conference at the arbitration hearing unless the claim submitted is less than $2,500, in which case 

the claim may be resolved without a hearing on the basis of submitted written documents.54

 The hearing body must meet to discuss the case within two business days after the 

hearing and make its decision within ten business days after receipt of the transcript. The 

hearing body must render its award(s) or finding(s) within five business days after its decision. 

 

51 KCBT Rules 1500.00, 1503.00, 1503.01 and 1503.02. A customer also may elect to have his or her claim or 

grievance heard by a single arbitrator who meets the requirements of former Commission Regulation 180.2(a). 

KCBT Rule 1503.03. 

52 KCBT Rules 1510.00, 1510.01, 1514.00, and 1517.00. 

53 KCBT Rules 1524.00 and 1524.01. 

54 KCBT Rules 1528.00, 1528.01, 1528.02, 1528.03, 1529.00 and 1531.00. 

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There is no right to appeal to any entity within the KCBT to overturn the arbitration decision. 

The only right of appeal is under applicable law. A member’s refusal to comply with an award 

within 30 calendar days of its issuance is a violation of KCBT Rules.55

 Arbitration fees are initially paid by the party bringing the case. Those fees, and any 

additional incurred costs, are ultimately assessed against either of the parties in the case, as may 

be decided by the hearing body and included in its award or finding.56 

 KCBT considered one customer arbitration case during the target period, which the 

Division found was handled in accordance with Exchange rules and procedures. 

B. Member-to-Member Arbitration 

 KCBT’s member-to-member arbitration rules and procedures are generally similar to the 

customer arbitration rules. However, any member who commences legal action against another 

member for any dispute must first attempt to arbitrate under Exchange rules or be subject to 

Exchange disciplinary action. If arbitration has been attempted and rejected, then a legal action 

may be commenced and the member failing or refusing to arbitrate also may be subject to 

Exchange disciplinary action. Exchange rules also provide that member-to-member disputes 

involving futures contract transactions are independent of and separate from any customer claims 

or grievances submitted for dispute resolution.57 There were no member-to-member arbitrations 

during the target period. 

 

55 KCBT Rules 1541.00 through 1541.06. 

56 KCBT Rules 1548.00 and 1551.00. 

57 KCBT Rules 1600.00, 1603.00 and 1604.00. 

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C. Conclusions and Recommendations 

 KCBT rules provide customers with voluntary procedures for arbitration that are 

fundamentally fair and equitable. Each party has the right to counsel and each party receives 

adequate notice of the claims presented against them and an opportunity to be heard on all 

claims, defenses, and counterclaims. KCBT’s arbitration procedures require a prompt hearing 

and authorize prompt, written, final settlement awards that are not subject to appeal within the 

Exchange. KCBT also provides adequate arbitration procedures for member-to-member 

disputes. Any member who commences legal action against another member for any dispute 

must first attempt to arbitrate under Exchange rules or be subject to Exchange disciplinary 

action. In addition, member-to-member arbitration procedures are separate from and 

independent of customer claims or grievances. 

 The one customer arbitration case heard during the target period was handled in 

accordance with Exchange rules and procedures. There were no member-to-member arbitrations 

during the target period. 

 Based on the foregoing, the Division has no recommendations in this area. 

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