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[Federal Register: January 26, 1998 (Volume 63, Number 16)]

[Notices]

[Page 3708-3721]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr26ja98-32]



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COMMODITY FUTURES TRADING COMMISSION





Regulation of Noncompetitive Transactions Executed on or Subject

to the Rules of a Contract Market



AGENCY: Commodity Futures Trading Commission.



ACTION: Concept release.



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SUMMARY: The Commodity Futures Trading Commission ("CFTC" or

"Commission") is reevaluating its approach to the regulation of

noncompetitive transactions executed on or subject to the rules of a

contract market. Accordingly, the Commission is soliciting comments on

a broad range of questions concerning the oversight of transactions

involving (i) the exchange of futures contracts for, or in connection

with, cash commodities, (ii) other noncompetitive transactions, and

(iii) the use of execution facilities for noncompetitive transactions.

Following the receipt of public comments, the Commission will determine

whether rulemaking is appropriate.



DATES: Comments must be received on or before March 27, 1998.



ADDRESSES: Interested persons should submit their written data, views,

and opinions to Jean A. Webb, Secretary of the Commission, Commodity

Futures Trading Commission, Three Lafayette Centre, 1155 21st Street

N.W., Washington, D.C. 20581. In addition, comments may be sent by

facsimile transmission to facsimile number (202) 418-5221 or by

electronic mail to [email protected]. Reference should be made to

"Regulation of Noncompetitive Transactions Executed on or Subject to

the Rules of a Contract Market." Certain related materials described

herein are available for inspection at the Office of the Secretariat at

the above address. Copies of these materials also may be obtained

through the Office of the Secretariat at the above address or by

telephoning (202) 418-5100.



FOR FURTHER INFORMATION CONTACT: Rebecca Creed, Attorney, at (202) 418-

5493, Division of Trading and Markets, Commodity Futures Trading

Commission, Three Lafayette Centre, 1155 21st Street N.W., Washington,

D.C. 20581.



SUPPLEMENTARY INFORMATION:



Table of Contents



I. Introduction

    A. Statutory and Regulatory Provisions

    B. Purpose of This Release

    C. Overview

II. Standards Governing EFP Transactions

    A. Background

    1. Historic Uses of EFPs

    2. Current EFP Volume

    3. Current Oversight of EFPs

    B. Elements of a Bona Fide EFP

    1. Relationship of the Instruments

    (a) Qualitative Correlation

    (b) Quantitative Correlation

    (c) Request for Comments

    2. Relationship of the Parties

    (a) Separate Parties

    (b) String Trades



[[Page 3709]]



    (c) Request for Comments

    3. Nature of the Transaction

    (a) Exchanges of Futures Contracts for Cash Commodities

    (b) Futures Leg Requirements

    (c) Cash Leg Requirements

    (d) Transitory EFPs

    (e) Contingent EFPs

    (f) Request for Comments

    4. Price of the Transaction

    (a) Current Requirements

    (b) Request for Comments

    C. Other Regulatory Requirements Governing EFPs

    1. Reporting and Recordkeeping

    (a) Current Requirements

    (b) Request for Comments

    2. Disclosure

    (a) Current Requirements

    (b) Request for Comments

    3. Internal Controls

    (a) Current Requirements

    (b) Request for Comments

    4. Transparency

    (a) Current Requirements

    (b) Request for Comments

III. Other Noncompetitive Transactions Executed on or Subject to the

Rules of a Contract Market

    A. Types of Eligible Transactions

    1. Exchanges of Futures for Swaps

    (a) The New York Mercantile Exchange Proposal

    (b) Request for Comments

    2. Exchanges of Options for Physicals

    (a) Background

    (b) Request for Comments

    3. Alternative Execution Procedures

    (a) Current Procedures

    (1) Contract Market Large Order Procedures

    (2) Section 4(c) Contract Market Transactions

    (3) Securities Market Block Trading Procedures

    (b) Potential Procedures

    (c) Request for Comments

    B. Qualifying Standards

    1. The Need for Standards

    2. Request for Comments

    C. Continuing Regulatory Requirements

    1. The Need for Requirements

    2. Request for Comments

IV. Execution Facilities for Noncompetitive Transactions Executed on

or Subject to the Rules of a Contract Market

    A. Current, Proposed and Potential Facilities

    1. Interdealer Brokers

    2. The Chicago Board Brokerage

    3. Potential Facilities for Transactions Other Than EFPs

    B. Qualifying Standards

    1. Current Requirements

    2. Request for Comments

V. Summary of Request for Comments



I. Introduction



A. Statutory and Regulatory Provisions



    Section 4(a) of the Commodity Exchange Act ("Act") makes it

unlawful for any person to enter into a contract for the purchase or

sale of a commodity for future delivery "unless such transaction is

conducted on or subject to the rules of a board of trade which has been

designated by the Commission as a 'contract market' for such

commodity." <SUP>1</SUP> Although Congress has indicated that trading

on contract markets be conducted generally in an open and competitive

manner, it also has recognized the need for certain, limited exceptions

to that requirement. Section 4c(a) of the Act prohibits various types

of noncompetitively executed transactions but provides an exception for

transfer trades, office trades, and exchanges of futures for physicals

("EFPs") that are executed in accordance with contract market rules

that have been approved by the Commission. <SUP>2</SUP> With reference

to these statutory provisions, the Senate Committee on Agriculture and

Forestry stated:



    \1\  7 U.S.C. 6(a). As discussed below, Section 4(c) of the Act,

7 U.S.C. 6(c), vests the Commission with certain exemptive authority

subject to specified qualifying criteria.

    \2\  7 U.S.C. 6c(a).



    Both the Commodity Exchange Act and the rules and regulations of

the commodity exchanges require that futures transactions be

executed openly in a competitive manner.

* * * * *

    Certain carefully prescribed exceptions to competitive trading

are allowed, but they do not nullify the general requirement of open

and competitive trading.

    The purpose of this requirement is to ensure that all trades are

executed at competitive prices and that all trades are focused into

the centralized marketplace to participate in the competitive

determination of the price of futures contracts. This system also

provides ready access to the market for all orders and results in a

continuous flow of price information. <SUP>3</SUP>

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    \3\ Report of the Senate Committee on Agriculture and Forestry,

S. Rep. No. 1131, 93rd Cong., 2d Sess. 16 (1974).



    Consistent with this policy, Commission Regulation 1.38(a) requires

that contract market rules providing for the execution of

noncompetitive transactions must be submitted to the Commission for

approval. Commission Regulation 1.38(b) requires all noncompetitive

transactions as well as all related orders, records, and memoranda to

be identified and marked. Regulation 1.38 was adopted pursuant to

Sections 4b and 8a(5) of the Act. <SUP>4</SUP> Section 8a(5) authorizes

the Commission to "make and promulgate such rules and regulations as,

in the judgment of the Commission, are reasonably necessary to

effectuate any of the provisions or to accomplish any of the purposes

of this Act."

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    \4\  7 U.S.C. 6b and 12a(5).

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B. Purpose of This Release



    The purpose of this release is to solicit comments on whether the

regulatory structure governing noncompetitive transactions executed on

or subject to the rules of a contract market should be modified in

light of recent developments in the marketplace. The impetus for this

action comes from several sources, including the following.

    First, ten years have passed since the Division of Trading and

Markets ("Division") conducted a comprehensive study of

EFPs.<SUP>5</SUP> During this time, the use of EFPs has continued to

grow and evolve.

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    \5\ Report of the Division of Trading and Markets: Exchanges of

Futures for Physicals (October 1987) ("EFP Report"). This document

provides a detailed discussion on the history, use and regulation of

EFPs. Interested parties may obtain a copy of the EFP Report by

contacting the Commission's Office of the Secretariat at the address

noted above.

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    Second, several organizations have developed computerized systems

for basis trading of U.S. Treasury securities. Essentially, a basis

trade involves the simultaneous acquisition of positions in actual

Treasury securities and in offsetting futures contracts. Venues for

basis trading simplify the trading process by enabling traders to

obtain both cash and futures positions in a single transaction which is

reported to a contract market as an EFP.

    Third, the New York Mercantile Exchange ("NYMEX") has sought

Commission approval for a proposed rule that would permit the exchange

of futures contracts for, or in connection with, swap agreements ("EFS

transactions").<SUP>6</SUP> This proposal would establish provisions

for EFS transactions that are parallel to, but separate from, those

governing EFP transactions. Thus, an EFS transaction would follow the

form of an EFP except that a swap agreement would be substituted for

the physical component.

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    \6\ Interested parties may obtain a copy of the NYMEX proposal

permitting EFS transactions by contacting the Commission's Office of

the Secretariat at the address noted above.

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    Fourth, the Chicago Board of Trade ("CBT"), through counsel,

requested the Division of Economic Analysis to agree not to recommend

that the Commission take any enforcement action against the CBT, its

members or market participants in connection with the CBT's proposed

implementation of a one-year pilot program facilitating the off-

exchange transfer of futures contracts in agricultural products in

exchange for related over-the-counter agricultural options.<SUP>7</SUP>

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    \7\ The Division of Economic Analysis staff advised counsel

that, in light of the Commission's ongoing consideration of

agricultural trade options in connection with its advance notice of

proposed rulemaking, 62 FR 31375 (June 9, 1997), it was not

currently appropriate to consider this request. The Commission has

subsequently proposed removing the prohibition against off-exchange

trade options on the enumerated agricultural commodities pursuant to

a three-year pilot program. Trade Options on the Enumerated

Agricultural Commodities, 62 FR 59624 (Nov. 4, 1997).



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[[Page 3710]]



    Finally, recent legislative proposals contemplate the establishment

of separate, professional markets.<SUP>8</SUP> The Commission wishes to

explore whether it is possible to achieve some of the objectives of

these proposals by expanding the boundaries of permissible

noncompetitive trading on existing contract markets. In contrast to the

legislative proposals, a revised structure governing noncompetitive

transactions could act as an adjunct rather than as an alternative to

existing regulated markets. Such an approach might improve the

usefulness and efficiency of existing markets for institutional or

professional users but with a reduced risk of market fragmentation.

Thus, carefully designed revisions to the regulatory structure

governing noncompetitive transactions could have a procompetitive

effect.

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    \8\ See, e.g., S. 257, 105th Cong., 1st Sess. Sec. 6 (1997).

    Part 36 of the Commission's regulations adopts certain

exemptions under a pilot program for separate, professional markets.

Included among the exemptions is a provision exempting certain

noncompetitive trading subject to the rules of a professional

market. However, no contract market has filed a proposal with the

Commission pursuant to Part 36.

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C. Overview



    For the foregoing reasons, the Commission has determined to seek

comments on whether the existing regulatory structure should be revised

to provide additional guidance concerning standards governing

noncompetitive transactions executed on or subject to the rules of a

contract market. In scope, the Commission's request includes

transactions that currently are permitted, such as EFPs, as well as

transactions that are not currently permitted, such as EFS transactions

or block trades. Of course, if the Commission were to revise its

regulatory structure relating to noncompetitive transactions, the

choice of whether to permit these types of transactions on a particular

contract market would remain, in the first instance, with that contract

market.

    In general, the Commission is soliciting comments on the following

questions:



    (1) Should the standards articulated in the EFP Report be

codified in the Commission's regulations and/or refined in any way?

    (2) Should other types of noncompetitive transactions, such as

EFS transactions or block trades, be permitted to be executed on or

subject to the rules of a contract market and, if so, what standards

should apply to these transactions?

    (3) What standards should be applicable to execution facilities

for noncompetitive transactions executed on or subject to the rules

of a contract market?



More specific questions addressing particular aspects of these topics

are posed in the relevant sections of this release. A consolidated list

of questions is set forth at the conclusion. The Commission recognizes,

however, that its identification of the issues may not be exhaustive

and therefore invites comments on other aspects of these topics even if

not expressly set out below.

    The Commission is asking these questions for the dual purpose of

giving notice of its consideration of these issues and of obtaining

input before proceeding with any specific initiatives. Commenters

should set forth with particularity the bases for their views. After

receiving input, the Commission will endeavor to strike an appropriate

balance among the relevant concerns.



II. Standards Governing EFP Transactions



A. Background



1. Historic Uses of EFPs

    An EFP involves simultaneous transactions in the futures and cash

commodity markets. The futures market transaction consists of a

noncompetitive transfer of a futures position between the parties to

the EFP. Thus, one party buys the physical commodity and simultaneously

sells (or gives up long) futures contracts while the other party sells

the physical commodity and simultaneously buys (or receives long)

futures contracts. Subject to applicable contract market rules, the

quantity and price of the futures and cash commodity to be exchanged as

well as other terms are negotiated privately by the parties rather than

being executed openly and competitively on a contract market. Depending

on the pre-existing market positions of EFP counterparties, an EFP

transaction can create, transfer, or extinguish futures positions.

    The EFP exception currently contained in Section 4c(a) of the Act

first appeared in H.R. 12287, which was introduced in 1932. The report

of the House Committee on Agriculture accompanying that bill indicates

that this exception was intended to permit the continuation of what was

described as an accepted commercial practice:



    Transactions involving the exchange of cash commodities for

futures in accordance with exchange rules applying to such exchanges

are exempted, even though they take the form of office trades, it

being understood that the exchange of cash commodities for futures

is a common and necessary practice.<SUP>9</SUP>



    \9\ Commodity Short Selling, H.R. Rep. No. 1551, 72d Cong., 1st

Sess. 3 (1932).



    The EFP exception was ultimately adopted with the enactment of the

Commodity Exchange Act in 1936. None of the amendments to Section 4c(a)

since that time provides further guidance as to the scope of

permissible EFP transactions.<SUP>10</SUP>

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    \10\ See Commodity Futures Trading Commission Act of 1974, Pub.

L. No. 93-463, 88 Stat. 1389 (substituted the Commission for the

Secretary of Agriculture and deleted state law preservation clause);

Futures Trading Act of 1978, Pub. L. No. 95-405, 92 Stat. 865

(required contract market rules permitting EFPs to be approved by

the Commission); Futures Trading Act of 1982, Pub. L. No. 97-444, 96

Stat. 2294 (exempted transactions in foreign currency options traded

on a national securities exchange from coverage of the Commodity

Exchange Act).

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    As discussed in detail in the EFP Report, the use of EFPs has

evolved to include practices not contemplated at the time Section 4c(a)

originally was enacted. Indeed, financial futures contracts, which now

dominate futures trading at some exchanges, did not exist at the time

the EFP exception was adopted. In the EFP Report, the Division

concluded that it appeared appropriate to interpret Section 4c(a) to

accommodate some of these practices, many of which arise out of trading

practices in various cash markets and which accomplish a variety of

commercial purposes. <SUP>11</SUP> However, the Division also stated

that the historical context in which the EFP exception first was

enacted and the statutory language of Section 4c(a) itself necessarily

imply certain limits on the permissible scope of EFP transactions as an

exception to the general requirement of competitive execution.

<SUP>12</SUP>

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    \11\ EFP Report at 144-145.

    \12\ Id. at 26. For example, the Division has expressed its

opinion that the EFP "exemption was not designed to create an

avenue for traders to use EFP transactions to accomplish what they

could not otherwise legitimately do, that is, wash trades,

accommodation trades, fictitious sales, or illegal off-exchange

transactions." Report of the Division of Trading and Markets:

Volume Investors Corporation 59 n. 54 (July 1985).

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2. Current EFP Volume

    A comparison of statistical data regarding the level of EFP

activity between the late 1980s (when the EFP Report was published) and

recent years shows that EFP activity, in many major markets, has

continued to grow. The following table summarizes such data for

selected contracts between 1986 and 1996.



[[Page 3711]]







   Table 1.--EFPs as a Percent of Trading Volume in Selected Contracts

                             1986--1996 \13\

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                    Contract Market                       1986     1996

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CBT Wheat.............................................     2.32     2.35

KCBT Wheat............................................    15.61    10.87

MGE Wheat.............................................    24.72    15.31

CBT Corn..............................................     8.14     6.81

CBT Soybeans..........................................     5.42     4.57

CBT Soybean Oil.......................................     6.52     4.89

CBT Soybean Meal......................................     7.89     7.95

CME Live Cattle.......................................     0.06     0.04

CSC Coffee "C"......................................     1.48     4.10

CSC Sugar #11.........................................     3.86     4.69

CSC Cocoa.............................................     6.24     3.17

CBT Treasury Bonds....................................     0.75     5.00

CBT Treasury Notes....................................     1.23     4.59

CME Japanese Yen......................................     7.32    16.11

CME British Pound.....................................     7.76    21.53

CME Deutsche Mark.....................................     6.12    16.81

CME Swiss Franc.......................................     5.96    13.79

COMEX Gold............................................     7.46     9.05

COMEX Silver..........................................     3.46     5.04

NYMEX Crude Oil.......................................     3.60     2.67

NYMEX Heating Oil #2..................................     1.90    6.66

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\13\ The data shown in Table 1 is for calendar year 1986 and 1996.



    As the table shows, EFP activity as a share of trading volume has

been relatively stable in traditional agricultural markets and has

declined in some cases. The trend for financial futures contracts has

been just the opposite, with EFP activity continuing to increase, in

some cases dramatically.

3. Current Oversight of EFPs

    EFP transactions are currently subject to oversight through a

variety of sources, including: (i) the Commission's review of contract

market rules governing such transactions; (ii) the Commission's

reporting and recordkeeping requirements; (iii) contract markets'

enforcement of their own rules; (iv) the Commission's rule enforcement

review program; and (v) the Commission's own enforcement program.



B. Elements of a Bona Fide EFP



    The EFP Report described EFP practices in selected markets,

analyzed the legislative and regulatory framework surrounding EFPs, and

reviewed the contract market rules and interpretations that govern

them. The EFP Report suggested possible criteria to be examined by

contract markets in evaluating whether a particular EFP transaction is

eligible for the Section 4c(a) exception. In particular, the Division

enumerated three essential elements of a bona fide EFP as follows: (i)

a futures transaction and a cash transaction which are integrally

related; (ii) an "exchange" of futures contracts for cash commodity,

where the cash commodity contract provides for the transfer of

ownership of the cash commodity to the cash buyer upon performance of

the terms of the contract, with delivery to take place within a

reasonable time thereafter in accordance with prevailing cash market

practice; and (iii) separate parties to the EFP, where the accounts

involved have different beneficial ownership or are under separate

control.<SUP>14</SUP>

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    \14\  EFP Report at 146-150.

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    In addition, the Division developed a non-exclusive list of other

indicia to assist contract markets in determining whether the essential

elements of a bona fide EFP have been satisfied. These include: (i) the

degree of price correlation between the futures and cash legs of the

EFP; (ii) the prices of the futures and cash legs of the EFP and their

relationship to the prevailing prices in their respective markets;

(iii) whether the cash seller has possession, the right to possession,

or the right to future possession of the cash commodity prior to the

execution of the EFP; (iv) the cash seller's ability to perform on his

delivery obligation in the absence of prior possession of the cash

commodity, i.e., the cash seller's access to the cash market; and (v)

whether the cash buyer acquires title to the cash

commodity.<SUP>15</SUP>

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    \15\ Id. at 150-151.

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    These elements can be analyzed in terms of four categories: (i) the

relationship of the instruments; (ii) the relationship of the parties;

(iii) the nature of the transaction; and (iv) the price of the

transaction. The following discussion summarizes the elements and

indicia of a bona fide EFP as set forth by the Division in the EFP

Report. As noted above, the Commission is soliciting comments on

whether these standards should be codified in the Commission's

regulations and/or refined in any way.

1. Relationship of the Instruments

    (a) Qualitative Correlation. In the EFP Report, the Division

determined that the futures and cash legs of a bona fide EFP should be

correlated with each other, both qualitatively and

quantitatively.<SUP>16</SUP> Qualitative correlation clearly exists

when the cash commodity satisfies the delivery specifications of the

associated futures contract. However, when the cash commodity is not

deliverable against the relevant futures contract, questions arise as

to its acceptability as the cash leg. While some contract markets focus

on whether the cash commodity is the economic equivalent of, or is

derived from, the particular commodity specified in the futures

contract, others also consider the price relationship between the cash

and futures legs of the transaction.

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    \16\ Id. at 152-160.

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    In the EFP Report, the Division concluded that the cash commodity

should have a reliable and demonstrable price relationship with the

futures contract involved in the EFP.<SUP>17</SUP> The cash leg should

exhibit price movement that historically has paralleled the price

movement of the futures contract, with the cash and futures prices

typically moving in the same direction and at consistent relative rates

of change. Although perfect price correlation is not required, a

"strong correlation" should exist. Otherwise, the parties are at risk

that the basis or price differential between the cash and futures legs

will change significantly prior to the conclusion of the EFP, thus

adversely affecting the utility of the transaction itself. The lack of

a strong correlation may indicate that the parties' motive for the EFP

was to circumvent the regulatory requirements of the Act or the

Commission's regulations, such as the requirement of open and

competitive execution, rather than to conduct a commercially

appropriate transaction. The Division also concluded that hedgeable

commodities are appropriate cash legs for EFPs.<SUP>18</SUP>

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    \17\ Id. at 155.

    \18\ Id. at 157.

    The Division referred to Administrative Determination 239,

issued by the Commodity Exchange Authority on December 16, 1974,

which advised that, "[i]f a commodity, product or by-product is

hedgeable under the Act, it may be exchanged for futures. If it is

not hedgeable, it may not be exchanged." See generally 17 CFR

1.3(z) (defines bona fide hedging transactions and positions);

Clarification of Certain Aspects of the Hedging Definition, 52 FR

27195 (July 20, 1987).

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    In the EFP Report, the Division noted that statistical correlation

coefficients <SUP>19</SUP> have been used to justify specific EFPs

involving stock index futures contracts either before or after the

transaction was consummated.<SUP>20</SUP> The Division also recommended

that contract markets publicize their determinations regarding the

acceptability of particular commodities as the cash leg of an EFP in

order to provide more guidance to the market users of these

transactions.<SUP>21</SUP>

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    \19\ A correlation coefficient measures the degree to which the

movements of two variables are related. Here the variables consist

of the price of the futures contracts and the price of the cash

commodity.

    \20\ EFP Report at 158.

    \21\ Id. at 159.

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    (b) Quantitative Correlation.

    For quantitative correlation to exist, the Division determined that

the cash commodity position should be approximately equal in quantity

or dollar value to the futures position and that appropriate hedge

ratios may be



[[Page 3712]]



used to create such dollar equivalency.<SUP>22</SUP> Again, the absence

of such equivalency may indicate a motive to circumvent some

requirement of the Act or the Commission's regulations rather than to

conduct a commercially appropriate transaction.

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    \22\ Id. at 159-160.

    For example, if the futures position established by the EFP

transaction represents 50,000 bushels of corn, then the associated

cash leg should also equal approximately 50,000 bushels of corn.

With respect to the use of appropriate hedge ratios to create dollar

equivalency, traders might cross-hedge a 182-day T-bill by using

more than one 91-day T-bill futures contract since the risk exposure

on the principal amount of the T-bill increases the higher the

duration of the security. Other instruments with differing

maturities and yields would require different ratios.

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    (c) Request for Comments. The Commission is soliciting comments on

the following questions:



    (4) How should the "strong price correlation" standard

articulated in the EFP Report be implemented?

    (5) Should the Commission require contract markets to adopt a

minimum statistical correlation coefficient to be used in assessing

the acceptability of a particular cash commodity for use as the cash

leg of an EFP?

    (6) If a minimum correlation coefficient is required, should

this coefficient apply to all EFPs, or should it be adjusted to

account for the different commodities involved in EFPs?

    (7) What is the appropriate type and scope of guidance contract

markets should be required to provide to the general public

concerning the acceptability of particular commodities as the cash

leg of an EFP?

2. Relationship of the Parties

    (a) Separate Parties. In the EFP Report, the Division concluded

that a bona fide EFP must be executed between separate

parties.<SUP>23</SUP> Determining if separate parties are involved in a

particular transaction in turn depends upon whether the accounts have

different beneficial owners or are under separate control. This

standard permits separate profit centers of a futures commission

merchant ("FCM") to engage in EFPs with each other in order to

accomplish their trading strategies and to fulfill their business

needs.

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    \23\ Id. at 147, 149-150.

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    (b) String Trades. In the EFP Report, the Division discussed a

method of effecting an EFP transaction in the grain markets called a

"pass-through" or "string trade." <SUP>24</SUP> Under this method,

the two parties to the EFP each have cash commodity contracts with a

different party or parties which require them to buy/sell the cash

commodity and sell/buy the corresponding futures contract in order to

set the price for the cash transaction. All of the parties in the

string have complementary cash commitments and corresponding

obligations to buy or sell futures contracts to the next party in the

string. Instead of executing a series of EFP transactions in which the

intermediate futures positions transferred among the parties would net

out for the common parties, the first and last parties in the string

execute a single EFP and the other mutually exclusive futures

obligations are canceled.<SUP>25</SUP>

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    \24\ Id. at 47, 148 n. 173.

    \25\ For example, party A has agreed to sell grain to and buy

futures contracts from party B. Meanwhile, party B has agreed to

sell grain to and buy futures contracts from party C. When C is

ready to sell futures contracts to B in order to fix the price of

their cash transaction, B directs C to execute the futures trade

with A instead, thus satisfying B's obligation to sell futures

contracts to A. Thus, A and C execute an EFP in which C sells

futures contracts to A, but there is no corresponding cash

transaction between A and C. In the absence of this string trade,

parties A and B and parties B and C must execute separate EFP

transactions consistent with their contractual obligations. Thus,

the string trade serves to match the mutually exclusive futures

obligations so that only one EFP is reported to the contract market.

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    (c) Request for Comments. The Commission is soliciting comments on

the following questions:



    (8) What is the appropriate scope of the separate parties

requirement?

    (9) Should the Commission address string trades as that practice

is described in the EFP Report and, if so, how?

3. Nature of the Transaction

    (a) Exchanges of Futures Contracts for Cash Commodities. As

discussed previously, Section 4c(a) of the Act excepts EFPs from the

prohibition against various types of noncompetitively executed

transactions. A bona fide EFP must involve an "exchange" of futures

contracts for cash commodity in which both legs of the transaction

entail actual economic risk.

    (b) Futures Leg Requirements. The futures leg of the EFP must be

reported to and cleared by a contract market clearing organization.

Therefore, it is subject to the same margin obligations, both original

and variation, as any other exchange-traded futures transaction. If the

futures leg were netted off-exchange, this conduct might constitute

bucketing in violation of Section 4b(a) of the Act.<SUP>26</SUP>

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    \26\ 7 U.S.C. 6b.

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    (c) Cash Leg Requirements. In the EFP Report, the Division

concluded that the cash commodity contract must impose a real

obligation to transfer ownership of the cash commodity from the cash

seller to the cash buyer upon performance of the terms of the contract,

with delivery taking place within a reasonable time thereafter in

accordance with prevailing cash market practice.<SUP>27</SUP> The

Division further asserted that, although the cash commodity contract

must contemplate the making and taking of delivery of the cash

commodity, the parties may, subject to the terms of the contract and

the principles of contract law, individually transfer their contractual

rights or obligations with respect to the cash commodity to a third

party or may offset these positions or obligations prior to

delivery.<SUP>28</SUP>

---------------------------------------------------------------------------



    \27\ EFP Report at 146.

    \28\ Id. at 149. For example, under this approach, a third party

could assume the seller's obligation to deliver the cash commodity,

or the cash seller could contract to purchase the cash commodity

from the third party and direct that delivery be made to the cash

buyer in the EFP.

---------------------------------------------------------------------------



    In the EFP Report, the Division discussed several factors to be

considered in analyzing the parties' intent with respect to the

transfer of cash commodity, including: (i) the ability of the cash

seller to make delivery and of the cash buyer to take delivery of the

cash commodity; (ii) the level of creditworthiness required of the cash

seller and buyer; (iii) the form and terms of the cash commodity

contract; (iv) the documentation underlying the transfer of cash

commodity from the cash seller to the cash buyer; and (v) whether the

cash buyer acquires an enforceable claim on the title to the cash

commodity.<SUP>29</SUP>

---------------------------------------------------------------------------



    \29\ Id. at 179-192, 196.

---------------------------------------------------------------------------



    The Division expressed the view that the cash seller is not

required to have possession, or the right to possession, of the cash

commodity in order to undertake a contractual obligation to deliver it

in the future by way of an EFP.<SUP>30</SUP> Nevertheless, the lack of:

(i) possession, (ii) the right to possession, or (iii) access to the

cash market may indicate that the parties lacked the requisite intent

to execute a cash transaction in the first place. This would raise

doubts about the legitimacy of the EFP. Similarly, evidence that the

cash buyer was unable to accept delivery of the cash commodity may

indicate that the parties never intended to execute the cash leg of the

EFP. An examination of the documents underlying the cash transaction,

including the form and the terms of the cash commodity contract,

confirmation statements, and documents evidencing title, in light of

the state law governing transfers of ownership is especially useful in

determining the parties' intent.

---------------------------------------------------------------------------



    \30\ Id. at 181.

---------------------------------------------------------------------------



    In determining whether there has been, or will be, an actual

transfer of ownership of the cash commodity, the critical inquiry is

whether the buyer of the cash commodity has acquired or will acquire,

upon completion of performance under the contract, title to the cash

commodity associated with the



[[Page 3713]]



EFP.<SUP>31</SUP> In this regard, the Division stated that the cash

commodity contract may contemplate an immediate transfer of title or a

transfer of title at some subsequent time.<SUP>32</SUP> Regardless of

when title passes, however, delivery of the cash commodity should occur

within a reasonable period of time in accordance with normal industry

practice involving comparable cash market transactions. If delivery did

not occur, the transaction would need to be scrutinized, the reasons

for failure identified, and a determination made as to whether the EFP

is bona fide.

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    \31\ Id. at 185-186.

    \32\ Id. at 186.

---------------------------------------------------------------------------



    (d) Transitory EFPs. In the EFP Report, the Division expressed

concern about a practice, then occurring frequently in the gold and

foreign currency markets, involving both an EFP and an offsetting cash

commodity transfer.<SUP>33</SUP> For example, party A purchases the

cash commodity from party B and then engages in an EFP whereby A sells

the cash commodity back to B and receives a long futures position. As a

result of this integrated transaction, the parties acquire futures

positions but end up with the same cash market position as they had

before the transaction. These transactions are sometimes referred to as

transitory EFPs. In such cases, questions arise as to whether there has

been a bona fide "exchange" of the cash commodity as is required by

Section 4c(a) of the Act.

---------------------------------------------------------------------------



    \33\ Id. at 192-193.

---------------------------------------------------------------------------



    The Division concluded that, in reviewing transitory EFPs, the EFP

and the cash commodity transfer should be examined both separately and

as an integrated transaction.<SUP>34</SUP> The parties must incur

actual economic risk in both legs of the EFP and in the cash commodity

transfer, and the EFP itself must otherwise be bona fide.

---------------------------------------------------------------------------



    \34\ Id. at 195.

---------------------------------------------------------------------------



    The predominant consideration is whether the cash commodity

transfer can stand on its own as a commercially appropriate

transaction, with no obligation on either party to carry out the

EFP.<SUP>35</SUP> One indication is whether the terms and structure of

the cash commodity transfer are substantially the same in all material

respects as other cash transactions in that market or more specifically

for those particular participants. For example, if the price of the

cash commodity is determined differently or if a lower level of

capitalization is required of the buyer than would otherwise be the

case, then the cash commodity transfer may not be genuine. Another

indication is whether the buyer acquires title to the cash commodity in

accordance with customary cash market practices.

---------------------------------------------------------------------------



    \35\ Id. Evidence that the cash commodity transfer is severable

from the EFP is necessary, but not sufficient, to establish the

legitimacy of the integrated transaction. As noted above, the EFP

itself must be bona fide.

---------------------------------------------------------------------------



    Additional issues to be considered in evaluating whether the

integrated transaction is bona fide include: (i) The timing of the cash

commodity transfer and the EFP; (ii) whether the same parties have

executed a number of integrated transactions in which the cash

commodity transfer never occurs independently of the EFP; (iii) whether

there have been a series of transactions in which the same cash

commodity is transferred repeatedly between the same parties, resulting

in the liquidation of a futures position much larger than the exchanged

cash commodity which ultimately remains with the original owner; and

(iv) the relationship between the parties and their patterns of

dealings, including evidence of money passes between them.<SUP>36</SUP>

---------------------------------------------------------------------------



    \36\ Id. at 200-201.

---------------------------------------------------------------------------



    (e) Contingent EFPs. Contingent EFPs are an impermissible subset of

transitory EFPs. The existence of conditions tying the cash commodity

transfer and the EFP together may indicate that the transactions are

not severable but are contingent upon each other.<SUP>37</SUP> A cash

commodity transfer which cannot stand on its own may indicate that

there was no actual economic risk in the initial cash transfer and may

raise concerns about whether the EFP involved an "exchange" of

futures contracts for cash commodity as is required by Section 4c(a) of

the Act.

---------------------------------------------------------------------------



    \37\ Id. at 198.

---------------------------------------------------------------------------



    (f) Request for Comments. The Commission is soliciting comments on

the following questions:



    (10) What criteria are appropriate for judging whether the

futures leg of an EFP is bona fide?

    (11) What criteria are appropriate for judging whether the cash

leg of an EFP is bona fide?

    (12) What criteria are appropriate for determining whether a

transitory EFP is bona fide?

    (13) What criteria are appropriate for determining whether an

EFP is contingent?

4. Price of the Transaction

    (a) Current Requirements. As discussed previously, because EFPs are

executed noncompetitively off-exchange, the prices of both the futures

and cash legs are determined by mutual agreement of the parties. In the

EFP Report, the Division concluded that the price differential between

the futures and cash legs should reflect commercial realities and that

at least one leg of the transaction should be priced at the prevailing

market.<SUP>38</SUP> Although pricing one leg of the EFP significantly

away from the market may be justified by commercial

necessity,<SUP>39</SUP> the Division expressed its concern that such

aberrant pricing can be used to shift substantial sums of cash from one

party to another or to allocate gains and losses between the futures

and cash sides of the EFP.<SUP>40</SUP> Moreover, when both legs of an

EFP are priced away from the market, the transaction may not be

commercially appropriate, particularly when one party could obtain

better prices for the futures and cash legs in another available

market. In the EFP Report, the Division urged contract markets to

determine whether the pricing of a particular EFP is supported by a

business purpose.<SUP>41</SUP>

---------------------------------------------------------------------------



    \38\ Id. at 174-175.

    \39\ The Division identified several such examples in the EFP

Report including meeting a margin call, taking advantage of expected

foreign exchange fluctuations, and complying with internal inventory

policies. Id. at 169-173.

    \40\ Id. at 169.

    \41\ Id. at 175.

---------------------------------------------------------------------------



    (b) Request for Comments. The Commission is soliciting comments on

the following questions:



    (14) Should the Commission require both the futures and cash

legs of an EFP to be priced within the daily range of their current

respective markets, should it require only one leg of an EFP to be

priced within its daily range, or should it impose no restrictions

on the price of either leg of an EFP?

    (15) Should the Commission require contract markets to obtain

documentation regarding the business purpose underlying the pricing

of an EFP?



C. Other Regulatory Requirements Governing EFPs



1. Reporting and Recordkeeping

    (a) Current Requirements Under the Commission's current regulations

EFPs are subject to broad reporting and recordkeeping requirements.

Commission Regulation 1.35(a) generally requires every FCM, introducing

broker ("IB"), and contract market member to keep full, complete and

systematic records of all transactions relating to its business of

dealing in commodity futures, commodity options, and cash commodities,

to retain such records for a period of five years, and to produce them

upon request of the Commission or the Department of Justice. Commission

Regulation 1.38(b) requires every person handling, executing, clearing,

or carrying EFPs to identify all related documents by appropriate

symbol or designation. Similarly, under Commission Regulation 1.35(e),

each



[[Page 3714]]



contract market must maintain a record showing, by appropriate and

uniform symbols, any transaction which is made noncompetitively in

accordance with written rules of the contract market. Commission

Regulation 1.35(a-2) requires FCMs, IBs, and other contract market

members to ask their customers for documentation of the cash leg of an

EFP upon request of the contract market, the Commission, or the

Department of Justice and upon receipt to provide the documentation to

the requesting body; requires customers to create, retain, and produce

such documentation directly to the requesting body; and requires that

all contract markets adopt, as necessary, corresponding rules requiring

its members to provide the documentation to the contract market.

    Under Part 16 of the Commission's regulations, each contract market

must report the total quantity of futures contracts bought or sold in

connection with EFPs to the Commission by clearing member and must

publish the total quantity of EFPs executed on any given business day.

Part 17 of the Commission's regulations requires FCMs, members of

contract markets, and foreign brokers to report to the Commission the

quantity of EFPs executed in each special account on the day it has a

reportable futures position as well as on the first day the account is

no longer reportable. Commission Regulation 18.05 requires each trader

holding or controlling a reportable futures position ("large trader")

to keep records of all futures and cash commodity positions and

transactions. Finally, the Commission may issue a special call under

Regulation 21.03(e)(1)(iii) to FCMs, IBs, or customers that requires

information about EFPs to be submitted for the particular commodity,

contract market, and delivery months named in the call.

    (b) Request for Comments. The Commission is soliciting comments on

the following question:



    (16) Are the current reporting and recordkeeping requirements

relating to EFPs adequate?

2. Disclosure

    (a) Current Requirements. Commission Regulation 1.55(a)(1)

prohibits an FCM or IB from opening a commodity futures account for any

customer unless the FCM or IB first provides the customer with a

written risk disclosure statement prepared by or approved by the

Commission and receives a signed acknowledgment from the customer that

he or she has received and understood this statement.<SUP>42</SUP> This

risk disclosure statement, as set forth in Commission Regulation

1.55(b), does not specifically address EFPs. However, Commission

Regulation 1.55(f) makes clear that compliance with the specific

disclosure requirements of Regulation 1.55 does not relieve an FCM or

IB from any other disclosure obligation it may have under applicable

law. These disclosure obligations arise under Section 4b of the Act as

well as under state and common law and require an FCM or IB to provide

its customers with all material information relating to a transaction,

including information relating to the risks involved in entering a

particular transaction.<SUP>43</SUP>

---------------------------------------------------------------------------



    \42\ The Commission is currently proposing to amend Regulation

1.55 so that FCMs and IBs would no longer be required to furnish the

specified written risk disclosure statement to certain categories of

financially accredited customers or to obtain written

acknowledgments of receipt of the risk disclosure statement before

opening a commodity futures account for these customers. In

addition, the Commission is currently proposing amendments to

relieve FCMs and IBs from requirements to furnish disclosure

statements to these financially accredited customers pertaining to

foreign futures or foreign options (Regulation 30.6(a)), domestic

exchange-traded commodity options (Regulation 33.7(a)), customers

whose accounts are transferred to another FCM or IB other than at

the customer's request (Regulation 1.65(a)(3)), and the treatment in

bankruptcy of non-cash margin held by an FCM (Regulation 190.10(c)).

Distribution of Risk Disclosure Statements by Futures Commission

Merchants and Introducing Brokers, 62 FR 47612 (Sept. 10, 1997).

    \43\ Id. at 47614.

---------------------------------------------------------------------------



    The Commission seeks to ensure full and fair disclosure of the

requirements of and risks inherent in EFPs. Only when customers have

complete information regarding EFPs can they effectively evaluate

whether such transactions are consistent with their financial goals.

The Commission believes that some guidance as to the form and content

of disclosure concerning EFPs may be appropriate.

    (b) Request for Comments. The Commission is soliciting comments on

the following questions:



    (17) What should be the form and content of disclosure

concerning EFPs?

    (18) Should the form and content of disclosure vary according to

the commercial sophistication of the EFP participant similar to the

Commission's proposed amendment to Regulation 1.55?

    (19) Should the Commission explicitly require that customers

must be informed that an EFP is executed noncompetitively, that it

involves a cash transaction, and that their FCM might take the

opposite side of the EFP?

    (20) Should the Commission explicitly require Commission

registrants to obtain customer consent before executing an EFP on

the customer's behalf?

3. Internal Controls

    (a) Current Requirements. Commission Regulation 166.3 generally

requires all Commission registrants, except associated persons who have

no supervisory duties, to "diligently supervise the handling by its

partners, officers, employees and agents * * * of all commodity

interest accounts carried, operated, advised or introduced by the

registrant and all other activities * * * relating to its business as a

Commission registrant." One basic purpose of the rule is to protect

customers by ensuring that their dealings with employees of Commission

registrants will be reviewed and overseen by other officials in the

firm.<SUP>44</SUP> Although Commission Regulation 166.3 currently

applies to EFPs, the Commission believes that some guidance as to the

types of internal controls that Commission registrants should be

required to maintain may be appropriate.

---------------------------------------------------------------------------



    \44\ Adoption of Customer Protection Rules, 43 FR 31886, 31889

(July 24, 1978).

---------------------------------------------------------------------------



    (b) Request for Comments. The Commission is soliciting comments on

the following question:



    (21) What internal controls are appropriate for Commission

registrants to ensure compliance with regulatory requirements

concerning the essential elements of bona fide EFPs, reporting and

recordkeeping, and disclosure?

4. Transparency

    (a) Current Requirements. The current reporting requirements for

EFPs are outlined above. Exchanges do not require, and generally do not

have a mechanism for providing, timely information about EFP bids,

offers, and transactions.

    (b) Request for Comments. The Commission is soliciting comments on

the following questions:



    (22) Do existing price reporting standards provide adequate

transparency concerning EFPs to the marketplace and, if not, are

there alternative methods of achieving improved price transparency?

    (23) Should the Commission require contract markets to publicize

information about bids and offers, as well as consummated EFP

transactions?



III. Other Noncompetitive Transactions Executed on or Subject to

the Rules of a Contract Market



A. Types of Eligible Transactions



    Although EFPs have raised many issues and concerns, they have

proven to be useful commercial tools. As noted above, the Commission

seeks to explore whether there are other types of noncompetitive

transactions that also could enhance the usefulness of



[[Page 3715]]



designated contract markets without compromising necessary regulatory

safeguards. The Commission has identified three potential candidates:

(i) EFS transactions; (ii) exchanges of options for physicals

("EOPs"); and (iii) block trades. The Commission welcomes the

identification by commenters of any other potential types of

transactions.

1. Exchanges of Futures for Swaps

    (a) The New York Mercantile Exchange Proposal. As noted, the NYMEX

has applied to the Commission for approval of a rule that would permit

the execution of EFS transactions. As proposed by the NYMEX, EFS

transactions would involve the noncompetitive exchange of futures

contracts for separately negotiated swap agreements. In this respect,

the proposal would establish for EFS transactions provisions that are

parallel to, but separate from, those governing EFP transactions.

<SUP>45</SUP> Thus, an EFS transaction would follow the structural form

of an EFP transaction except that a swap agreement would be substituted

for the physical component of the transaction. <SUP>46</SUP>

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    \45\ As noted above, pursuant to Section 4c(a) of the Act, EFPs

are explicitly permitted as an exception to the usual open and

competitive execution requirements established by the Act, but only

to the extent provided for by contract market rules approved by the

Commission. Also as noted, Commission Regulation 1.38(a) authorizes

noncompetitive transactions if executed in accordance with contract

market rules that have received Commission approval. All domestic

commodity exchanges permit the execution of EFP transactions,

although there is some variation among exchange rules.

    \46\ In general, a simplified swap agreement may be

characterized as an agreement between two parties to exchange a

series of cash flows measured by different interest rates, exchange

rates, or prices, with payments calculated by reference to a

principal base (or notional amount). See Policy Statement Concerning

Swap Transactions, 54 FR 30695 (July 21, 1989). Part 35 of the

Commission's Regulations defines swap agreements by reference to the

Bankruptcy Code. See 17 CFR 35.1(b)(1).

---------------------------------------------------------------------------



    Under the NYMEX proposal, the swap component of the EFS transaction

must comply with the requirements of Part 35 of the Commission's

regulations or with the Commission's 1989 Policy Statement concerning

cash-settled swap transactions or must otherwise qualify for or fall

within other exemptions or jurisdictional exclusions under the Act or

Commission regulations. This initiative represents the first proposal

the Commission has received for approval of EFS transactions.

    The NYMEX states that the rule proposal in part responds to the

substantial growth that has occurred in the swaps market during recent

years. In this respect, the NYMEX asserts that swap transactions,

though not "physical" in the traditional sense, subject market

participants to the same type of price risk. Thus, the NYMEX claims

that the proposal could aid in linking the on-exchange futures and off-

exchange swap markets.

    The NYMEX believes that allowing EFS transactions would increase

market efficiency and enhance the use of the exchange as a risk

transfer medium. Specifically, the NYMEX believes that both traditional

market users and swap dealers (banks, trading companies, and energy

companies) would benefit from the availability of EFS transactions. By

a similar line of reasoning, the NYMEX notes that commodity swap

instruments continue to play an increasingly important role in

providing a risk management function in crude oil and other markets, in

part because they can be individually tailored to a user's commercial

needs and thereby reduce substantially the presence of basis risk.

Because of this, the NYMEX concludes that permitting EFS transactions

would reduce basis risk for NYMEX market participants, enhance

competition among exchange and over-the-counter markets, and facilitate

greater usage of NYMEX as a centralized market.

    The NYMEX affirms that it has not identified any evidence

suggesting that adoption of the proposal would harm existing liquidity

in NYMEX markets. Moreover, the NYMEX concludes that the rule proposal

would make the liquidity present in NYMEX energy markets accessible to

swap market participants via the EFS process. Additionally, the NYMEX

identifies the ability of swap participants to close out futures

positions more readily, as the underlying futures contracts approach

expiration, and thus utilize the exchange in managing price risk

associated with swap market transactions as a potential benefit of the

proposal.

    The NYMEX also views the financial safeguards of the on-exchange

trading environment as potentially beneficial, and attractive to, swap

market participants. The NYMEX concludes that access to these financial

safeguards, including those associated with the position limit and

margining systems, either for purposes of creating or extinguishing

swap agreements, would enable swap market participants to enhance the

credit quality of swap positions. Thus, in summary, the NYMEX concludes

that several benefits would accrue to market participants from adoption

of the proposed rule, including improvements in liquidity and price

transparency, and reductions in basis and credit risk.

    (b) Request for Comments. The Commission is soliciting comments on

the following questions:



    (24) What are the economic reasons firms might have for engaging

in EFS transactions and what benefits might accrue thereunder,

including the potential benefits to domestic futures markets, to

over-the-counter markets, and to financial markets generally?

    (25) What are the potential costs or risks of permitting EFS

transactions, particularly with respect to the effect on price

discovery, risk transfer, and the competitive character of "on-

exchange" transactions?

    (26) Should the Commission approve the NYMEX rule proposal

permitting EFS transactions?

    (27) Should EFS transactions be limited to particular markets,

participants or types of transactions?

    (28) Should special provisions be established to ameliorate any

competitive costs or otherwise safeguard the competitive conditions

of the on-exchange market?

2. Exchanges of Options for Physicals

    (a) Background. The EFP Report included an examination of

EOPs.<SUP>47</SUP> The Division noted that the statutory sections

governing options trading, Sections 4c(b) and 4c(c) of the

Act,<SUP>48</SUP> do not provide for the extension of the Section 4c(a)

exception for EFPs to options. The Division acknowledged that

Regulation 1.38 provides for the execution of noncompetitive

transactions pursuant to Commission-approved contract market rules and,

on that basis, concluded that EOP transactions could potentially fall

within the noncompetitive trade exception found in that regulation.

---------------------------------------------------------------------------



    \47\ EFP Report at 235-240.

    \48\ 7 USC 6c(b) and 6c(c).

---------------------------------------------------------------------------



    The EFP Report's investigation of contract market rules found that

most were silent on the question of whether EOP transactions were

acceptable, with only the Chicago Mercantile Exchange ("CME") rules

expressly prohibiting EOP transactions.<SUP>49</SUP> Although the Amex

Commodities Corporation ("ACC") adopted a rule permitting

EOPs,<SUP>50</SUP> it subsequently withdrew that rule, apparently prior

to the execution of any EOP transactions.

---------------------------------------------------------------------------



    \49\ CME Rule 538.

    \50\ ACC Rule 908.

---------------------------------------------------------------------------



    The Division staff that prepared the EFP Report were unable to

discover any instances in which an option on a futures contract was

exchanged for a cash commodity, and the Commission is not aware that

any of these transactions have occurred since the publication of the

report. The Division observed that the absence of these transactions

could be due to the fact that market participants had not yet been able

to design a plan to execute EOPs, perhaps



[[Page 3716]]



because of difficulty in establishing an appropriate basis relationship

between the option and the cash commodity.

    The EFP Report indicated that commentary from contract market

officials and market participants on the EOP issue was divided. Some

commenters objected on the basis that an option does not involve a

delivery commitment. However, others indicated that EOPs could be

appropriate in some circumstances. These commenters indicated that an

EOP might be appropriate for the grantor of an option, who has a

delivery commitment upon exercise, or in the case of a deep-in-the-

money option, which as a practical matter appears to be the equivalent

of a futures position. One commenter stated that EOPs were conceptually

viable but that the instability associated with option deltas (and

therefore option value) could create great risk for a person accepting

an option in exchange for a cash commodity. This commenter also

indicated that, assuming this risk was reflected in the price, EOP

transactions could be very expensive.

    (b) Request for Comments. The Commission is soliciting comments on

the following questions:



    (29) Are EOPs viable and do these transactions offer genuine

risk management benefits?

    (30) If so, should EOPs be permitted, and should there be

limitations on EOPs that reflect the particular risk characteristics

of options?

3. Alternative Execution Procedures

    (a) Current Procedures. (1) Contract Market Large Order Procedures.

The Commission has approved several contract market rules that

establish alternative execution procedures for certain transactions.

These procedures generally preserve the competitive forces available on

a centralized market and thereby comply with the "open and

competitive" requirement of Commission Regulation 1.38(a).

    The CME, the New York Cotton Exchange ("NYCE") and the New York

Futures Exchange ("NYFE") have adopted similar procedures providing

for the execution of large orders.<SUP>51</SUP> These procedures may be

used only upon customer request or if the large order bid or offer is

the best price available to satisfy the terms of the order. A member

makes a request for a large order bid and/or offer in the appropriate

trading area. Responding members may make bids and/or offers at, above

or below the current prevailing bid or offer in the underlying market

for regular size orders. Only the best bid and/or offer shall prevail,

and the large order must be filled on an all-or-none basis. The large

order execution price does not trigger conditional orders in the

underlying market, such as stop or limit orders.

---------------------------------------------------------------------------



    \51\ CME Rule 521 ("All-Or-None Transactions"); NYCE Rule

1.10-B ("Block Order Execution"); NYFE Rule 312 ("Block Order

Execution").

    The CME all-or-none procedures apply to a variety of products,

including currency futures, South African Rand options, 28-day

Mexican TIIE futures, 91-day Mexican CETES futures, Brady Bond

futures, IPC futures, Three-month Eurodollar futures bundle

combinations, 13-week U.S. Treasury Bill futures, British Pound/

Deutsche Mark and Deutsche Mark/Japanese Yen futures, and Argentine

Par Bond futures. The minimum contract size eligible for execution

under these procedures ranges from 20 contracts to 100 contracts.

The NYCE limits its block order execution procedures to transactions

involving 50 or more FINEX futures or futures spreads, options

spreads or futures/options combinations in the same contract. The

NYFE limits its block order execution procedures to transactions

involving 15 or more NYSE Large Composites, 30 or more NYSE

Composite Index or 50 or more CRB futures or options, futures

spreads, options spreads or futures/options combinations in the same

contract.

---------------------------------------------------------------------------



    The NYCE and NYFE expressly prohibit an initiating floor broker

from bundling customer orders to meet the minimum contract size

required for eligibility under the large order execution procedures,

but allow a responding broker to bundle customer limit orders and to

add orders from his or her own account to match the quantity of futures

or options in the large order request. Under the CME all-or-none

procedures, both the initiating floor broker and the responding floor

broker may bundle customer orders to meet the minimum contract size as

long as the customers specifically request execution under these

procedures or the all-or-none bid or offer is the best price available

to satisfy the terms of the orders. Although cross trades are not

permitted at the NYCE and NYFE under these procedures, they are

permitted at the CME. Large order transactions executed at all three

exchanges must be reported to a designated Exchange official who

records and publishes the quantity and prices separately from reports

of transactions in the regular market.

    The CME also has adopted separate large order execution ("LOX")

procedures for transactions involving 300 or more futures contracts in

the Standard & Poor's 500 Stock Price Index or the Nikkei Stock

Average.<SUP>52</SUP> These procedures, which include the pre-execution

solicitation of interest and discussion of price, have only been used

once in the several years they have been available.

---------------------------------------------------------------------------



    \52\ CME Rule 549.

---------------------------------------------------------------------------



    The CME also has adopted request for size ("RFS") quotations for

the GLOBEX system. These procedures supplement the GLOBEX request for

quote ("RFQ") procedures. As originally configured, RFQ messages were

distributed without any contract quantity indication. Thus, the

adoption of RFS procedures permits requests for large size transactions

for all contracts traded through GLOBEX, subject to a minimum threshold

quantity for RFS quotations of 100 contracts.<SUP>53</SUP>

---------------------------------------------------------------------------



    \53\ The CME recently lowered the minimum threshold quantity for

RFS quotations for currency futures traded through GLOBEX to 50

contracts.

---------------------------------------------------------------------------



    (2) Section 4(c) Contract Market Transactions. As noted previously,

Section 4(c) of the Act vests the Commission with certain exemptive

authority from the general requirement that all futures transactions

must be executed on designated contract markets, subject to specified

qualifying criteria. Part 36 of the Commission's regulations adopts

certain exemptions under a pilot program for the establishment of

separate professional markets which would have less restrictive

requirements governing trading, reporting, and risk disclosure for

eligible transactions than are applicable to current contract markets.

Subject to certain recordkeeping and audit trail requirements, Part 36

procedures provide for the execution of noncompetitive transactions,

regardless of size. In addition, these transactions are limited to

certain Commission registrants and sophisticated and/or institutional

traders which meet certain minimum asset requirements, including banks,

trust companies, savings associations, credit unions, investment

companies, commodity pools, certain business associations, employee

benefit plans, government entities, broker-dealers, FCMs, floor

brokers, floor traders, and certain other natural persons. A contract

market may adopt trading rules permitting the execution of Part 36

transactions using any combination of noncompetitive execution

procedures and competitive on-floor trading procedures.

    No contract market has filed a proposal with the Commission

pursuant to Section 4(c) and Part 36. Significantly, Part 36 only

permits noncompetitive executions in specially-designated, stand-alone,

professional markets. In contrast, the other noncompetitive trading

methods discussed in this release are adjuncts to regular trading on or

subject to the rules of a contract market.

    (3) Securities Market Block Trading Procedures. Block trading in

securities markets differs substantially from that on Commission

designated contract



[[Page 3717]]



markets. Blocks may be traded on securities exchanges, in over-the-

counter securities markets, or through "principal-to-principal" trade

execution venues. In the securities industry, a block trade is commonly

defined as a transaction involving 10,000 or more shares or a quantity

of stock having a market value greater than or equal to $200,000. In

recent years, block trading in securities markets has increased as a

percentage of reported trading volume.<SUP>54</SUP>

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    \54\ In 1996, block trading on the New York Stock Exchange

comprised 55.9% of the exchange's reported volume, or 2,348,457

transactions accounting for 58.5 billion shares. New York Stock

Exchange Fact Book 1996, at 16 (May 1997).

---------------------------------------------------------------------------



    The New York Stock Exchange ("NYSE") and the Chicago Board

Options Exchange ("CBOE") have rules providing for block

trading.<SUP>55</SUP> A customer desiring to trade a block of NYSE-

listed stocks contacts a block trader. Depending on the block trader's



assessment of market demand and supply, the block trader may notify the

Specialist of the pending block trade.<SUP>56</SUP> If notified, the

Specialist may indicate an interest in participating in the block. The

block trader then must decide whether to "position" the entire block

by serving as the counterparty or "shop the block" by seeking

customers to take the other side of the trade. The block trader may

also combine these strategies by positioning part of the block and

seeking customers for the remaining shares. Upon agreement of a price

for the block,<SUP>57</SUP> the block order is transmitted to the NYSE

floor for crossing against the block trader's house account or against

other customer orders as arranged in "shopping the block."

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    \55\ NYSE Rule 127; CBOE Rule 6.9.

    \56\ NYSE Rule 127(a).

    \57\ When positioning a block, the block trader quotes a

tentative price for the stock to the block customer, and the

customer may tentatively accept this price. Barring an extreme and

unexpected movement in the price of the stock, the customer may be

reasonably assured of execution at the quoted price.

    When a block trader "shops a block," the trader contacts one

or more potential customers to take the opposite side of the block

at a specified price. The block trader might be willing to negotiate

this price depending on how interested other investors are in

participating in the block. The block trader continues to "shop the

block" until he or she has a sufficient quantity of orders for the

opposite side at a single price. At this point, the block trader

returns to the block customer and confirms the customer's interest

in the block transaction at the negotiated price, also known as the

"clean-up" price.

---------------------------------------------------------------------------



    Block orders crossed on the NYSE floor must comply with NYSE rules,

including the following. Block orders within the current market

quotation must first be offered publicly at a price higher than the

member's bid by the minimum variation applicable to that stock so that

the trading crowd may participate in the block at that publicly offered

price, before the member may proceed with the cross

transaction.<SUP>58</SUP> Block orders crossed outside the current

market quotation must be disclosed to the Specialist.<SUP>59</SUP>

Where the member is holding agency orders on both sides of the market,

he or she must probe the market to determine whether more stock would

be lost than is reasonable under the circumstances to orders in the

crowd.<SUP>60</SUP> Where the member is serving as the counterparty of

the block and where all or any portion of the block establishes or

increases his or her position, the member must fill all limit orders at

the post for the clean-up price or better at the clean-up price, before

any amount may be retained for the member's account.<SUP>61</SUP> As an

anti-manipulation safeguard, when a member holds any part of a long

position in a stock in its trading account as a result of a block trade

it completed with a customer, the member is precluded from effecting

certain transactions in this stock on the same trading day in which the

block trade was executed.<SUP>62</SUP>

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    \58\ NYSE Rule 76.

    \59\ NYSE Rule 127(b).

    \60\ NYSE Rule 127(c). If the member representing the block

orders decides that the amount of stock that would be lost is not

excessive, then he or she announces the clean-up price to the crowd

and fills at such price all agency limit orders at the post for the

clean-up price or better. The member then crosses the remaining

block orders at the clean-up price.

    If the member decides that the amount of stock that would be

lost is excessive, then he or she either may return to the block

customers to negotiate a new clean-up price or may limit

participation in the block by members at the post. The member limits

participation merely by informing the crowd that they cannot

participate freely in the block. After such an announcement, the

member follows the crossing procedures set forth in NYSE Rule 76 and

makes a bid and offer for the full amount of the block. A

"reasonable" time must elapse before the cross is completed in

order to provide the crowd, including the Specialist, the

opportunity to execute superior priced bids or offers to provide

price improvement. Thereafter, the member crosses the orders for the

remaining shares at the clean-up price. The member is not required

to fill at the clean-up price orders limited to the clean-up price

or better. The block is entitled to priority at the proposed clean-

up price.

    \61\ NYSE Rule 127(d)(1).

    \62\ NYSE Rule 97.

---------------------------------------------------------------------------



    At the CBOE, a member or member organization may solicit another

member, member organization, non-member customer or broker-dealer

("solicited person") to take the opposite side of a large-sized order

("original order").<SUP>63</SUP> The member representing the original

order must disclose the terms and conditions of that order to the

trading crowd before it can be executed.<SUP>64</SUP>

---------------------------------------------------------------------------



    \63\ CBOE Rule 6.9. CBOE Rule 6.9 specifically allows solicited

transactions by "a member or member organization representing an

order respecting an option traded on the Exchange * * * including a

spread, combination, or straddle order as defined in Rule 6.53 and a

stock-option order as defined in Rule 1.1(ii)."

    \64\ CBOE Rule 6.9(d). However, the member is not required to

announce to the trading crowd that another person has been solicited

to participate in the order. The initiating member simply must

disclose all the terms and conditions of the original order and any

modifications to the trading crowd.

---------------------------------------------------------------------------



    In order to promote disclosure at the inception of the solicitation

period and to encourage solicited persons to bid or offer at prices

that improve the current market, the CBOE rule establishes a series of

priority principles for these solicited transactions. Priority depends

upon whether the original order is disclosed throughout the

solicitation period, whether the solicited order improves the best bid

or offer in the crowd and whether the solicited order matches the

original order's limit.

    If the terms and conditions of the original order are disclosed to

the trading crowd prior to any solicitation and the order is

continuously represented in the crowd throughout the solicitation

process, then the following rules apply. If the solicited order matches

the original order's limit and improves the best bid or offer in the

trading crowd, then the solicited order has priority over the crowd and

may trade with the original order at the improved bid or offered price

subject to the customer limit order book priorities set forth in CBOE

Rule 6.45.<SUP>65</SUP> If the solicited order does not match the

original order's limit, but improves the best bid or offer in the crowd

and the original order is subsequently modified to match the solicited

order's bid or offer, then the terms of the original order, as

modified, must be disclosed to the trading crowd. The crowd has

priority to trade with the modified original order before this order

may be crossed with the solicited order.<SUP>66</SUP> If the solicited

order does not match the original order's limit and meets but does not

improve the best bid or offer in the trading crowd and the original

order is subsequently modified to match the solicited order's bid or

offer, then the trading crowd has priority to trade with



[[Page 3718]]



the modified original order at the best bid or offered price subject to

the customer limit order book priorities.<SUP>67</SUP> Finally, where

the terms and conditions of the original order have not been disclosed

in advance of the solicitation, the trading crowd has priority to trade

with the original order at the best bid or offered price subject to the

customer limit order book priorities before the original order may be

crossed with the solicited order. <SUP>68</SUP>

---------------------------------------------------------------------------



    \65\  CBOE Rule 6.9(a).

    Under CBOE Rule 6.45, the highest bid or lowest offer has

priority. Where two or more bids (offers) for the same option

contract represent the highest (lowest) price, the bid (offer) that

is displayed in the customer limit order book shall have priority

over any other bid at the post. If two or more bids (offers)

represent the highest (lowest) price and the customer limit order

book is not involved, then priority is determined according to the

sequence in which the bids (offers) were made.

    The procedures set forth in CBOE Rule 6.74 govern the crossing

of original orders with solicited orders, except when the solicited

party has priority as is the case under CBOE Rule 6.9(a).

    \66\  CBOE Rule 6.9(b).

    \67\  CBOE Rule 6.9(c).

    \68\  CBOE Rule 6.9(d).

---------------------------------------------------------------------------



    CBOE members and their associated persons who have knowledge of all

the material terms and conditions of an imminent, undisclosed solicited

transaction are prohibited from certain trading in an option of the

same class that is the subject of the solicited transaction, the

underlying security or any related instrument. That prohibition is in

effect until the original order and any modifications are disclosed to

the trading crowd or until the solicited transaction can no longer

reasonably be considered imminent in view of the passage of time since

the solicitation.<SUP>69</SUP>

---------------------------------------------------------------------------



    \69\ CBOE Rule 6.9(e). This trading restriction applies to the

solicited party as well as to any other member or associated person

who has knowledge of all the material terms and conditions of both

the original and solicited orders, including the price.

---------------------------------------------------------------------------



    Block trading also is carried out on regional securities exchanges

and in over-the-counter securities markets. The procedures governing

block trades in these markets are generally less complex than those

applicable at the NYSE. Block trades for stocks listed on regional

exchanges are negotiated off-floor and in most cases must be crossed on

the floor of the exchange. Moreover, traders generally do not have to

accommodate limit orders. Over-the-counter block trades are arranged by

a block trader who then crosses the resulting orders.

    Another venue for securities block trading involves "principal-to-

principal" systems. Generally, block customers directly enter trade

quantities and bid/ask prices into a computerized system, which matches

the orders according to the availability of bids and offers at matching

prices. In addition, block customers may execute block trades

themselves, off-exchange, without the assistance of a broker or block

trader.

    (b) Potential Procedures. Certain participants in the futures

markets have suggested that the competitive execution requirements

under the Commission's regulations be relaxed to permit block trading

procedures similar to those in the securities exchange and over-the-

counter markets. As noted previously, the proviso to Commission

Regulation 1.38(a) permits noncompetitive transactions if executed

pursuant to contract market rules that have been approved by the

Commission.

    One of the purposes of this release is to investigate whether there

are alternative, noncompetitive execution procedures that would further

the policies and purposes of the Act. If so, the Commission seeks to

determine the extent to which these procedures could be structured to

serve the purposes of market participants while not sacrificing

customer protection. The procedures might be limited according to order

size, class of participant, contract, or some other category. In

addition, the Commission seeks to determine the extent to which the

procedures would be, and should be, similar to securities market

procedures.

    The following examples, while not exhaustive, illustrate the range

of possibilities. The least significant modification of current open

and competitive procedures would expressly permit market participants

to alert potential counterparties of their interest in trading in a

particular market at a particular time. Actual execution would occur

pursuant to existing competitive procedures.

    A more significant departure from current procedures would permit

market participants to divulge not only a general interest in trading

but also specific information about quantity and price to potential

counterparties. Again, actual execution would occur competitively. This

might be analogous to the practice of "shopping the block" in

securities markets.

    A further variation would permit negotiation between market

participants. This would permit some degree of prearrangement although

the execution price would to some extent remain subject to prices in

the competitive market.

    Yet another variation would adjust execution procedures to confer a

degree of priority on particular orders that they might not attain in

the open and competitive process. Such priority could be conferred, for

example, on certain retail orders or on certain marketmaker orders.

    Finally, market participants could be permitted to execute certain

transactions bilaterally, away from the centralized marketplace, and

simply report them to the exchange and clearing house. This would be

similar to the way EFPs are handled currently.

    Each of these alternatives potentially raises concerns, including,

among others:



the impact on price discovery;

the impact on liquidity;

the potential for manipulation; and

the potential for mispricing, frontrunning, or other customer fraud.



    Any proposed procedure would have to address such concerns. The

need for safeguards is discussed further below.

    (c) Request for Comments. The Commission is soliciting comments on

the following questions:



    (31) Should alternative, noncompetitive execution procedures be

permitted on or subject to the rules of a contract market?

    (32) If so, how should these procedures be structured to address

regulatory concerns?

    (33) Should these procedures be limited by order size,

participant class, contract, or some other criteria?

    (34) Can adequate safeguards be devised in connection with these

procedures to prevent manipulation?

    (35) Can adequate safeguards be devised in connection with these

procedures to prevent fraud?



B. Qualifying Standards



1. The Need for Standards

    The preceding discussion identifies particular types of

transactions that might be appropriate for noncompetitive execution,

such as EFS transactions or block trades. The common thread connecting

these types of transactions with one another and with EFPs is their

potential ability to fulfill some particularized need of market

participants that the traditional open and competitive execution

methods cannot fulfill as well. Congress has implicitly found with

respect to EFPs that, at least under some circumstances, they provide

certain benefits although their pricing and execution occurs outside of

the centralized, open and competitive marketplace. To permit other

types of noncompetitive transactions, the Commission would have to make

a similar finding. For example, a contract market seeking approval of

new procedures could address the effect of the proposal on the contract

market's usefulness as a vehicle for price discovery and risk transfer.

If the proposal had the potential to affect those functions adversely,

the contract market could try to demonstrate countervailing benefits.

The contract market also could address, pursuant to Section 15 of the

Act,<SUP>70</SUP> whether its proposal was the least anticompetitive

means of achieving its objective. Moreover, a contract market might

show that these transactions are structured in such a way as to

complement the competitive market, not to supplant it.

---------------------------------------------------------------------------



    \70\ 7 U.S.C. 19.



---------------------------------------------------------------------------



[[Page 3719]]



2. Request for Comments

    The Commission seeks input on the general qualifying standards that

should govern a proposal's eligibility for approval and how compliance

with such standards would be demonstrated. The Commission is soliciting

comments on the following questions:



    (36) What are the appropriate qualifying standards for

noncompetitive transactions concerning:



(a) the effect on the usefulness of a designated futures contract as

a hedging mechanism?

(b) the effect on the price discovery function of a designated

futures contract?

(c) the effect on the level of financial integrity in a designated

contract market?

(d) the effect on the level of customer protection in a designated

contract market?



    (37) Should access to noncompetitive transactions be limited to

commercials or sophisticated investors?

    (38) Should noncompetitive transactions be subject to contract

market rules?

    (39) Are there other appropriate qualifying standards?



C. Continuing Regulatory Requirements



1. The Need for Requirements

    As discussed above, in addition to determining whether an EFP is

bona fide, there is a need for appropriate regulatory oversight in

areas such as reporting and recordkeeping, disclosure, and internal

controls. Similar considerations apply to other types of noncompetitive

transactions.

2. Request for Comments

    The Commission seeks input on any additional requirements that

should apply to a potential noncompetitive transaction, once it is

determined that the transaction meets basic eligibility standards. To

that end, the Commission has identified the following areas where it

appears that additional qualifying requirements would be required in

order to maintain systemic integrity and to provide guidance to self-

regulatory entities. The Commission seeks input both as to whether the

prospective requirement is necessary and, if so, how the requirement

could be structured to provide a meaningful test. The Commission is

soliciting comments on the following questions:



    (40) What are the appropriate standards to ensure that

noncompetitive transactions are bona fide and meet basic qualifying

requirements on an ongoing basis?

    (41) What are the appropriate reporting and recordkeeping

requirements applicable to these transactions?

    (42) What are the appropriate disclosure requirements applicable

to these transactions?

    (43) What are the appropriate internal controls applicable to

these transactions?

    (44) What are the appropriate safeguards to maintain an adequate

level of transparency?

    (45) What are the appropriate safeguards to prevent

manipulation?

    (46) What are the appropriate safeguards to prevent fraud?



IV. Execution Facilities for Noncompetitive Transactions Executed

on or Subject to the Rules of a Contract Market



A. Current, Proposed and Potential Facilities



    As noted in the Introduction, several organizations have developed

execution facilities for transactions that are executed off-exchange

and reported to contract markets as EFPs. As with the procedures

discussed in the previous section, these facilities expand the

opportunity for market participants to engage in the negotiation of

transactions off the floor of the exchange. It appears, however, that

there are significant structural differences between these facilities

and traditional methods for the execution of EFPs. The latter generally

appear to take a bilateral, over-the-counter approach to the

negotiation of trades.

    Unlike traditional approaches, these execution facilities provide a

formal market environment for the negotiation and arrangement of

transactions, are typically operated by third parties, and may be

beyond the operational and regulatory purview of contract markets to

some extent. In this respect, however, the Commission also recognizes

that these facilities perhaps should be characterized as noncompetitive

only in the sense that the transactions executed thereon are completed

outside of designated contract markets. Thus, unlike the execution

procedures on a contract market, the execution procedures on one of

these facilities have not been formally reviewed and approved by the

Commission for compliance with the open and competitive requirements of

the Act and other statutory requirements. The Commission acknowledges

that an execution facility's centralized structure may provide a market

environment that facilitates the competitive execution of transactions

and also may provide competitive benefits for the underlying contract

markets.

    This section includes a discussion of existing facilities, proposed

facilities, and potential facilities and presumes that the futures leg

of the transaction is reported to and cleared by an existing contract

market clearing organization. Generally, the request for comments

relative to this section seeks input as to whether the regulatory

environment applicable to such transactions continues to be appropriate

in light of the growth and evolution of activity on such facilities or

whether some form of additional oversight is needed. As more fully set

out below, the Commission's request for comments also seeks input on

the appropriate form of any prospective regulatory actions applicable

to these facilities.

1. Interdealer Brokers

    There are six major interdealer brokers in the cash U.S. Treasury

securities market.<SUP>71</SUP> All or most offer basis trading

facilities. As noted above, a basis trade involves the simultaneous

acquisition of positions in actual Treasury securities and in

offsetting futures contracts. Transactions through these facilities

must meet minimum trade sizes as well as other qualifying requirements.

---------------------------------------------------------------------------



    \71\ The six are Cantor Fitzgerald, Liberty, RMJ, Tullet &

Tokyo, Garban, and Hilliard & Farber.

---------------------------------------------------------------------------



    It appears that at least a minimal level of transparency is

maintained for basis trading on these facilities, although it is not

clear whether that level is completely adequate. Information on these

basis trades is obtained through reports published over screen-based

news reporting services, such as Govpx or Bloomberg. The screens are

anonymous, except that firms may be identified for basis trade

quotations.

    It also appears that these firms restrict their activities to

dealing only with primary dealers and other large institutional

entities. The interdealer brokers do not reveal counterparty names, and

anonymity is thereby maintained. Trades generally are cleared through

the Government Securities Clearing Corporation ("GSCC"), and

anonymity is maintained even after a trade is consummated. GSCC nets

the cash market legs of the basis trades.

2. The Chicago Board Brokerage

    The CBT is developing a computerized system for, among other

things, basis trading of U.S. Treasury securities. The system will be

operated by the Chicago Board Brokerage ("CBB"), a subsidiary of the

CBT, which is registered with the Securities and Exchange Commission

("SEC") as a broker/dealer.

    Pricing of basis trades on the CBB system will be carried out

according to a standardized formula. The futures leg will be assigned a

price equal to the last sale price for the futures contract. The cash

Treasury leg will be assigned a price according to the basis spread

relative to the price of the futures leg. The price of the cash

Treasury leg also will be adjusted to account for



[[Page 3720]]



differences between the coupon rate of the actual Treasury security and

the standardized 8 percent coupon rate of the futures contract. The

cash leg will be cleared through the Clearing Corporation for Options

and Securities ("CCOS"), a subsidiary of the Board of Trade Clearing

Corporation ("BOTCC") which is registered as a clearing agency with

the SEC. The futures leg will be cleared through the CBT and BOTCC

pursuant to rules governing EFP transactions.

3. Potential Facilities for Transactions Other Than EFPs

    The interdealer brokers and the CBB are facilities for the

execution of EFPs. If the Commission were to permit other types of

noncompetitive trading, such as block trading, facilities might be

established for the execution of those types of transactions. For

example, a computerized, bulletin board system might be established in

connection with the execution of blocks. The Commission, of course,

before approving relevant contract market rules, would have the

opportunity to review procedures relating to these trades. Nonetheless,

as discussed below, the Commission is requesting comments as to the

appropriate form of regulatory oversight for these facilities.



B. Qualifying Standards



1. Current Requirements

    Basis trades executed through these facilities currently are

subject to the same regulatory requirements as any other EFP

transaction. The Commission's oversight of these facilities does not

differ in any way from its oversight of the EFP markets generally. The

Commission is concerned that the nature of the transactions executed on

these facilities and the environment in which they are executed may

differ enough from the nature of traditional EFPs as to warrant

differing regulatory treatment. Indeed, it could be argued that some of

these facilities have evolved to the extent that they are functionally

the equivalent of designated contract markets.

2. Request for Comments

    The Commission seeks input on the regulatory structure appropriate

for these execution facilities. At a threshold level, this area of

inquiry seeks comments on whether the existing regulatory structure

appears adequate as currently organized and administered. To the extent

that a commenter believes the current approach is adequate, a

supporting rationale should be set forth. To the extent that a

commenter believes the current approach is deficient, the Commission

seeks comments identifying the nature of the deficiency and whether new

guidelines or standards are required. Where a commenter believes that

new regulatory initiatives are required, the Commission seeks comments

on the form and nature of any such initiatives. Any such comments

should include a supporting rationale.

    Specifically, the Commission is soliciting comments on the

following questions:



    (47) What characteristics distinguish execution facilities for

EFPs from contract markets?

    (48) Is the current regulatory approach concerning these

facilities adequate?

    (49) If not, what modifications are appropriate?

    (50) If execution facilities were established for noncompetitive

transactions other than EFPs, how, if at all, should the regulatory

approach that would apply to those facilities vary from that

currently applicable to contract markets?

    (51) Should execution facilities for EFPs and other

noncompetitive transactions that are operated by non-contract

markets be subject to oversight by the relevant contract market?

    (52) Should these facilities limit access to commercials or

sophisticated investors?

    (53) Should these facilities be subject to procedures to prevent

manipulation?

    (54) Should these facilities be subject to procedures to prevent

fraud?

    (55) Should these facilities be subject to procedures to ensure

that transactions executed thereon are bona fide?

    (56) Should these facilities be subject to procedures to provide

for market transparency?

    (57) Should these facilities be subject to procedures related to

reporting and recordkeeping?



V. Summary of Request for Comments



    After reviewing the comments, the Commission will determine whether

rulemaking or other action is appropriate. Commenters are invited to

discuss the broad range of concepts and approaches described in this

release. The Commission specifically invites commenters to compare the

advantages and disadvantages of the possible changes discussed above

with those of the existing regulatory framework. In addition to

responding to the specific questions presented, the Commission

encourages commenters to submit any other relevant information. In sum,

the Commission is soliciting comments on the following questions:



Overview



    (1) Should the standards articulated in the EFP Report be

codified in the Commission's regulations and/or refined in any way?

    (2) Should other types of noncompetitive transactions, such as

EFS transactions or block trades, be permitted to be executed on or

subject to the rules of a contract market and, if so, what standards

should apply to these transactions?

    (3) What standards should be applicable to execution facilities

for noncompetitive transactions executed on or subject to the rules

of a contract market?



Elements of a Bona Fide EFP: Relationship of the Instruments



    (4) How should the "strong price correlation" standard

articulated in the EFP Report be implemented?

    (5) Should the Commission require contract markets to adopt a

minimum statistical correlation coefficient to be used in assessing

the acceptability of a particular cash commodity for use as the cash

leg of an EFP?

    (6) If a minimum correlation coefficient is required, should

this coefficient apply to all EFPs, or should it be adjusted to

account for the different commodities involved in EFPs?

    (7) What is the appropriate type and scope of guidance contract

markets should be required to provide to the general public

concerning the acceptability of particular commodities as the cash

leg of an EFP?



Elements of a Bona Fide EFP: Relationship of the Parties



    (8) What is the appropriate scope of the separate parties

requirement?

    (9) Should the Commission address string trades as that practice

is described in the EFP Report and, if so, how?



Elements of a Bona Fide EFP: Nature of the Transaction



    (10) What criteria are appropriate for judging whether the

futures leg of an EFP is bona fide?

    (11) What criteria are appropriate for judging whether the cash

leg of an EFP is bona fide?

    (12) What criteria are appropriate for determining whether a

transitory EFP is bona fide?

    (13) What criteria are appropriate for determining whether an

EFP is contingent?



Elements of a Bona Fide EFP: Price of the Transaction



    (14) Should the Commission require both the futures and cash

legs of an EFP to be priced within the daily range of their current

respective markets, should it require only one leg of an EFP to be

priced within its daily range, or should it impose no restrictions

on the price of either leg of an EFP?

    (15) Should the Commission require contract markets to obtain

documentation regarding the business purpose underlying the pricing

of an EFP?



Other Regulatory Requirements Governing EFPs: Reporting and

Recordkeeping



    (16) Are the current reporting and recordkeeping requirements

relating to EFPs adequate?



[[Page 3721]]



Other Regulatory Requirements Governing EFPs: Disclosure



    (17) What should be the form and content of disclosure

concerning EFPs?

    (18) Should the form and content of disclosure vary according to

the commercial sophistication of the EFP participant similar to the

Commission's proposed amendment to Regulation 1.55?

    (19) Should the Commission explicitly require that customers

must be informed that an EFP is executed noncompetitively, that it

involves a cash transaction, and that their FCM might take the

opposite side of the EFP?

    (20) Should the Commission explicitly require Commission

registrants to obtain customer consent before executing an EFP on

the customer's behalf?



Other Regulatory Requirements Governing EFPs: Internal Controls



    (21) What internal controls are appropriate for Commission

registrants to ensure compliance with regulatory requirements

concerning the essential elements of bona fide EFPs, reporting and

recordkeeping, and disclosure?



Other Regulatory Requirements Governing EFPs: Transparency



    (22) Do existing price reporting standards provide adequate

transparency concerning EFPs to the marketplace and, if not, are

there alternative methods of achieving improved price transparency?

    (23) Should the Commission require contract markets to publicize

information about bids and offers, as well as consummated EFP

transactions?



Types of Eligible Transactions: Exchanges of Futures for Swaps



    (24) What are the economic reasons firms might have for engaging

in EFS transactions and what benefits might accrue thereunder,

including the potential benefits to domestic futures markets, to

over-the-counter markets, and to financial markets generally?

    (25) What are the potential costs or risks of permitting EFS

transactions, particularly with respect to the effect on price

discovery, risk transfer, and the competitive character of "on-

exchange" transactions?

    (26) Should the Commission approve the NYMEX rule proposal

permitting EFS transactions?

    (27) Should EFS transactions be limited to particular markets,

participants or types of transactions?

    (28) Should special provisions be established to ameliorate any

competitive costs or otherwise safeguard the competitive conditions

of the on-exchange market?



Types of Eligible Transactions: Exchanges of Options for Physicals



    (29) Are EOPs viable and do these transactions offer genuine

risk management benefits?

    (30) If so, should EOPs be permitted, and should there be

limitations on EOPs that reflect the particular risk characteristics

of options?



Types of Eligible Transactions: Alternative Execution Procedures



    (31) Should alternative, noncompetitive execution procedures be

permitted on or subject to the rules of a contract market?

    (32) If so, how should these procedures be structured to address

regulatory concerns?

    (33) Should these procedures be limited by order size,

participant class, contract, or some other criteria?

    (34) Can adequate safeguards be devised in connection with these

procedures to prevent manipulation?

    (35) Can adequate safeguards be devised in connection with these

procedures to prevent fraud?



Qualifying Standards



    (36) What are the appropriate qualifying standards for

noncompetitive transactions concerning:



(a) the effect on the usefulness of a designated futures contract as

a hedging mechanism?

(b) the effect on the price discovery function of a designated

futures contract?

(c) the effect on the level of financial integrity in a designated

contract market?

(d) the effect on the level of customer protection in a designated

contract market?



    (37) Should access to noncompetitive transactions be limited to

commercials or sophisticated investors?

    (38) Should noncompetitive transactions be subject to contract

market rules?

    (39) Are there other appropriate qualifying standards?



Continuing Regulatory Requirements



    (40) What are the appropriate standards to ensure that

noncompetitive transactions are bona fide and meet basic qualifying

requirements on an ongoing basis?

    (41) What are the appropriate reporting and recordkeeping

requirements applicable to these transactions?

    (42) What are the appropriate disclosure requirements applicable

to these transactions?

    (43) What are the appropriate internal controls applicable to

these transactions?

    (44) What are the appropriate safeguards to maintain an adequate

level of transparency?

    (45) What are the appropriate safeguards to prevent

manipulation?

    (46) What are the appropriate safeguards to prevent fraud?



Execution Facilities for Noncompetitive Transactions Executed on or

Subject to the Rules of a Contract Market: Qualifying Standards



    (47) What characteristics distinguish execution facilities for

EFPs from contract markets?

    (48) Is the current regulatory approach concerning these

facilities adequate?

    (49) If not, what modifications are appropriate?

    (50) If execution facilities were established for noncompetitive

transactions other than EFPs, how, if at all, should the regulatory

approach that would apply to those facilities vary from that

currently applicable to contract markets?

    (51) Should execution facilities for EFPs and other

noncompetitive transactions that are operated by non-contract

markets be subject to oversight by the relevant contract market?

    (52) Should these facilities limit access to commercials or

sophisticated investors?

    (53) Should these facilities be subject to procedures to prevent

manipulation?

    (54) Should these facilities be subject to procedures to prevent

fraud?

    (55) Should these facilities be subject to procedures to ensure

that transactions executed thereon are bona fide?

    (56) Should these facilities be subject to procedures to provide

for market transparency?

    (57) Should these facilities be subject to procedures related to

reporting and recordkeeping?



    Issued in Washington, DC, on January 16, 1998.

Jean A. Webb,

Secretary.

[FR Doc. 98-1672 Filed 1-23-98; 8:45 am]

BILLING CODE 6351-01-P
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