Best Practices

for

Organized Electronic Markets

Commodity Futures Trading Commission

Technology Advisory Committee

Market Access Subcommittee

24 April 2002
2

Table of Contents

Mission Statement & Scope 3

Background 4

Best Practice Recommendations 7

Bandwidth, Order Eligibility and Flickering Quotes 8

Block Trading and Internalization of Order Flow 15

Transparency 24

Error Resolution 26

Market makers 33

Competitiveness 40

Further Analysis 40

Conclusion 41

Attachment I Technology Advisory Committee Members 42

Attachment II Market Access Subcommittee Members

and Industry Advisors 45
3

1.0 Mission Statement and Scope

1.1 Mission of the Market Access Subcommittee

The mission of the Market Access Subcommittee1 includes (1) addressing the public

policy aspects of the nexus between applications of technology to organized markets and

how those applications of technology might be used to facilitate or to frustrate fair and

equitable access to organized markets by all relevant market participants and (2) assisting

the Commission through the Technology Advisory Committee,2 in fulfilling its mission

statement, in particular, “...analyzing the application of new technologies in financial

services and commodity markets, as well as by market professionals and market users,

particularly in the areas of system capacities and readiness, order flow practices, and

clearing and payment activities...”

1.2 Scope

Organized markets may operate in physical, automated or electronic venues. The Market

Access Subcommittee has completed its review of market access issues germane to

organized markets operating electronic venues. The subcommittee’s recommendations

and best practices for electronic venues, "Best Practices for Organized Electronic

Markets" was submitted to the full Technology Advisory Committee for its review and

consideration on November 27, 2001 as an Interim Report.3 Relevant comments

provided at and subsequent to that meeting have been addressed. At the meeting of the

Technology Advisory Committee, the subcommittee was asked to increase the scope of

its final report to also include recommend best practices for resolution of clearly

erroneous trades occurring on electronic markets. The subcommittee has completed its

work and submits its Final Report to the Technology Advisory Committee for its

consideration and acceptance. Throughout the report, there are a number of

recommended best practices, only some of which are highlighted in italics; many are not.

A full understanding of the report will almost certainly require a full reading of the

report, including its footnotes.

 

1

 The members and industry advisors of the Market Access Subcommittee are listed in Attachment II.

2

 The members of the CFTC's Technology Advisory Committee are listed in Attachment I.

3

 The subcommittee's Interim Report continues to be available on the CFTC's website.
4

2.0 Background

The costs of regulation and market access preferences, over time, should produce real

economic benefit to public market participants in a proportion that is roughly equivalent

to those associated public costs.

"...regulation under which [domestic exchanges] operate should have

clear benefits which outweigh the cost of that regulation."4

That is, the real economic costs of (1) public sector regulation; (2) private sector

regulation (e.g., rules adopted by organized markets and self regulatory organizations);

and (3) applications of technology, privileged market access and trade processing

conventions adopted by organized markets should be balanced against a reasonable

expectation of proportionate and concomitant public benefits (presumptive responsibility).

In particular, the Market Access Subcommittee has been guided by (2) and (3) above.

"To ascertain the net effect of a proposed policy change on social well -

being, we must first have a way of measuring the gains to the gainers and

the losses to the losers. Implicit in this statement is a central tenet of

Benefit-Cost Analysis (BCA) : the effects of a policy change on society

are no more or no less than the aggregate of the effects on the individuals

who comprise society. Thus, if no individual would be made better off by

a policy change, there are no benefits associated with it; nor are there costs

if no one is made worse off. In other words, BCA counts no values other

than those held by the individual members of society."5

2.1 Market Access Efficiencies

Dramatic changes and efficiencies in computing and communications technology can

now make decision critical information available, real-time, in a format that can easily be

exchanged with other parties, anywhere in the world. These advances make it both

technically feasible and cost-effective for market participants to enter into transactions on

electronic market venues that heretofore would otherwise have been too costly to

undertake. Even the pure economics of inaugurating and maintaining newly organized

markets have changed. In contrast to the more customary expenses of physical market

venues, the new economics of modern organized markets are measured in kilobytes,

nanoseconds and bandwidth.

 

4

 House of Representatives, 106th Congress, First Session (August 5, 1999) (Remarks of James E.

Newsome, Commissioner, CFTC, Subcommittee on Risk Management, Research, and Specialty Crops of

the Committee on Agriculture).

5

 Portney, Paul R. "Benefit-Cost Analysis." The Fortune Encyclopedia of Economics. Compiled by David

R. Henderson, Ph.D., New York: Warners Books, 1993
5

2.2 Privileged Market Access

Market participants with either superior market information or superior market access,

over time, will have a considerable market advantage over those whose market

information or market access is subordinate. In cases where subordinate market access is

due entirely to client choice, e.g., telecommunications media or informational content, the

subcommittee takes no issue. Fair does not, in every case, necessarily mean equal in

every regard. Market participants and classes of market participants should be able to

freely choose which unbundled market access services they wish to buy and those which

they do not.

In physical market venues, clients must open accounts with futures commission

merchants (FCMs); their orders must be filled by registered floor brokers, and the trade

processing conventions of the physical environment ostensibly mandate trade

intermediation at execution (floor members have the opportunity to execute their trades

opposite the orders of customers). All (completely) electronic environments are very

different. Mandated trade intermediation at execution has been largely replaced by the

time/price paradigm.6

 There are no registered floor brokers in an all electronic market.

Some new electronic markets have no FCMs or trade intermediaries at all.

Privileged market access refers to any rule, policy or processing convention of organized

markets that discriminates among classes of market participants when providing any of

their services, access to their services or access to market critical information. There are

other market privileges more specific to market maker structures that are addressed in

that section (Section 3.5) of this Final Report.

2.3 Market Structure

Virtually all theories that form the foundation of presumptive responsibility, public sector

regulation and private sector rules and processing conventions have been originally based

upon the model of organized markets operating in a physical venue. Worldwide, many

organized markets are gravitating to all electronic, screen-based venues. Many organized

markets, historically operating exclusively as physical venues are currently operating in a

hybrid cusp of highly automated physical venues (defined as automated venues by the

subcommittee). Some organized markets have implemented side-by-side combinations

of electronic and automated venues. Others operate in an automated venue during regular

trading hours and an electronic venue during non-traditional trading hours. Many newer

organized markets, particularly those outside the U.S., are electronic and have never been

otherwise. This migration from physical, to automated, to electronic venues is often

 

6

 An order from any class of market participant with the oldest time stamp, within a limit price, should be

executed first. There are many other trade match algorithms. Some match proportionately against all

opposite orders at the same limit price. Others give priority to a market participant that “turns” the market.

Most importantly, these are all quantifiable economic criteria that can be automated without subjectivity

and which do not, in and of themselves, provide a market advantage or other market preference to any

market participant or class of market participant.
6

accompanied by a somewhat diminished presence7

 of trade processing intermediaries.8

In those instances where this has been the case, there is also often a diminished level of

presumptive responsibility for trade processing intermediaries to continue to assume.

It is not the intention of the subcommittee that the Final Report be meant to suggest that

exchanges should adopt a particular market structure. It recognizes that, within the

boundaries established by their regulatory obligations, exchanges are free to adopt the

market structure which best meets the needs of their customers, reflects the commercial

environment in which they operate and takes account of the characteristics of the

products that they trade and the relevant underlying market.

2.4 Supervisory Oversight

" ... the first imperative when evaluating market regulation is to enunciate

clearly the public policy objectives that government regulation would be

intended to promote. What market characteristics do policymakers seek to

encourage? Efficiency? Fair and open access? What phenomena do we

wish to discourage or eliminate? Fraud, manipulation, or other unfair

practices? Systemic instability? Without explicit answers to these

questions, government regulation is unlikely to be effective. More likely,

it will prove unnecessary, burdensome, and perhaps even contrary to what

more careful consideration would reveal to be the underlying objectives."9

Regulations, rules, processing conventions and the application of technology (as they

affect market access) should be fundamentally as different for physical, automated and

electronic venues as the processes of those respective venues differ from each other.10

While the means of accessing markets and the costs of such access have been

dramatically reduced, the continued presence of privileged market access structures

continues to involve a public cost. This public cost comes with a presumption that these

privileged market access structures and mandated trade processing intermediaries are

accompanied by a concomitant public benefit, most likely a high standard of

performance.

Many of the provisions of the Commodity Exchange Act (as it applies to Designated

Contract Markets) and the rules of organized markets were originally based on the

presumption that exchanges would continue as physical trading venues and that order

 

7

 Trade intermediaries may continue to have a significant presence in many organized markets operating

electronic venues. This will be driven largely by client choice.

8

 Most notably the diminished presence of floor brokers and other individuals that handle orders.

9

 Remarks of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System at the

Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, February 21,

1997.

10 It is not the intention of the subcommittee to imply that organized markets operating electronic markets

should necessarily be subject to a regulatory cost structure that is less than that for automated markets or

for physical markets. That determination can only be made by the authority providing supervisory

oversight.
7

transmission, execution and confirmation media would continue to be dominated by

telephone and paper. The Commodity Futures Trading Commission Act (the “CFTC

Act”) enacted in 1974, substantially updated the Commodity Exchange Act (the “Act”).

However, the context for that effort was an environment of “brick and mortar”

marketplaces and high costs of accessing markets other than through “tiers” of market

intermediaries. Trade intermediaries, segregation of client funds and other initiatives

were present by virtue of regulations and/or organized markets’ rules and processing

conventions.

2.5 Structured Approach

The presumptive responsibilities of processing intermediaries that have been granted

market access privileges, in any venue, should remain proportionate to the public costs of

those market access privileges, particularly now, with the observable migration of

markets from physical, to automated, to electronic venues. The continued application of

private sector rules, structures and processing conventions that were developed and

presumably justified in an environment where market access was not global in scope and

often achievable at declining costs, may serve to inappropriately perpetuate privileged

market access by market participants or classes of market participants as these organized

markets continue to migrate from physical, to automated, to electronic venues.

Structure should be developed that would address and review the continued

appropriateness of applying regulations, private sector rules, processing conventions and

the application of technology (as it may affect market access) that were developed for

physical venues to automated venues and electronic venues to ensure that (1) privileges

of classes of market participants are not perpetuated solely by the phenomenon of

migration of organized markets from one venue to the next; and (2) the privileges of

classes of market participants in all venues should be re-justified by an analysis that

weighs the public benefits against the public costs of such privileges. This analysis

should include a discussion of the relevant public policy issues raised and must involve

input both by organized markets whose venues provide such privileged access and by

market participants whose market access would be deemed as subordinate.

3.0 Best Practice Recommendations

Some might believe that "best practices" should encompass all business methodologies

that would meet or exceed some minimally acceptable threshold of appropriateness.

Those responsible for providing supervisory oversight may or may not agree with that

approach. Those organized markets to which best practices are meant to apply, might

argue that they should have the broadest possible latitude to manage their own affairs,

provided that their respective methodologies meet or exceed some minimally acceptable

threshold of appropriateness. Still others argue that organized markets should be allowed

to operate electronic markets below any minimally acceptable threshold of
8

appropriateness if they fully disclose all material facts regarding any potential

remedialities.

The Market Access Subcommittee's approach to recommending best practices has been

mostly guided by plain and simple English. Webster11 defines best as "exceeding all

others in excellence". The best practices recommended in this Final Report reflect the

majority consensus of the subcommittee as being those practices that are the most

excellent business practices among any number of possible practices that others might

deem to meet or exceed some minimally acceptable threshold of appropriateness.

3.1 Bandwidth, Order Eligibility and Flickering Quotes

Order entry bandwidth is defined12 as an organized market's end-to-end electronic

processing capacity; from the receipt of orders from the client to the delivery of those

orders to the venue of the order book. Bandwidth is not exclusively transmission

(communications line) time. It is the amount of data that can be transmitted in a fixed

amount of time.

3.1.1 Client Initiated Choice of Telecommunications Media

There are many relevant bandwidth factors with which the subcommittee takes no issue.

The subcommittee recognizes that for many valid reasons all market participants' orders

(sent at the same time) may not necessarily arrive at the venue of the order book at

exactly the same time. The objective of this section is not to suggest what technology

applications might be best but rather what business practices seem most fair.

End user market participants have widely different needs for both informational content

and speed of transmission. Many organized markets operating electronic venues or the

trade intermediaries involved in those markets appropriately provide market participants

with a selection of telecommunications media from which they may choose. The public

good is generally best served when market participants are offered a wide selection of

unbundled services from which they can decide what they want to buy and what they do

not.

Recommendation: An organized market operating an electronic venue should not

intentionally limit market access by withholding its order entry bandwidth to a market

participant or class of market participant.

 

11 Webster's II New College Dictionary, p. 105.

12 The most relevant technical definition of bandwidth is the amount of data that can be transmitted in a

fixed amount of time. For digital devices, bandwidth is usually expressed in bits per second or bytes per

second.
9

Market participants that value content highly and speed of transmission less so, may

select an internet based communications solution. Market participants that value both

speed and content may select a T1 line. Two points are relevant. All market participants

that have selected the same category of connectivity should be treated equally13 within

that category. All market participants should have an equal opportunity to procure any

category of connectivity generally available14 to all other market participants. Other

organized markets may provide a single method of connectivity to all market participants

on grounds of security, efficiency or cost.

The subcommittee recognizes that data originating from more distant geographic points

(across the same communications medium) will arrive a fraction of a second later than

data originating at the exact same time from a less distant point. At some extreme point

of automated trading, this phenomenon might begin to become problematic with some

consistency, but instances of such are hard to find. In an ideal environment, organized

markets operating electronic venues should periodically test their systems in an attempt to

quantify this spatial phenomenon and at least make the results of its test(s) available to

those market participants (as a group) that would most likely be adversely affected, so

that they would at least know the time differential to which their orders are likely to be

subject.

3.1.2 Order Entry Bandwidth

Organized markets provide a public benefit when both inbound and outbound

information (data) can predictably be processed, unfettered by any data queues or any

other interruptions. When unfettered access is available, market transparency can be

optimized as the elapsed time between the moment that market participants express their

opinions by entering their orders and the time that other market participants can observe

and react to the expression of those opinions (whether as an unfilled bids or offers or as

matched trades) the more valuable the information is to all involved, including those

simply observing the process. This market transparency is also important (and provides a

public benefit) to all market participants that are involved in either the underlying cash

market or in any derivative products based on the underlying cash product.

Order entry bandwidth is also an issue of particular importance to the many market

participants that have developed automated trading models that create computer

generated orders in a small fraction of a second, based on near instantaneous market

information received. Intuitively, the utility (and arguably the potential profitability) of

such market participants' orders is a function of (1) the quality of their respective trading

 

13 This includes cost. While the subcommittee recognizes that organized markets may implement complex

quotation fee structures (on outbound data), it is the subcommittee's expectation that for inbound data, and

for all market participants electing the same order entry telecommunications medium, there would be no

price differentiation other than for throughput (especially large users of bandwidth) or in some cases,

distance from the host.

14 The reference is only to factors under the control of the organized market. An organized market

operating an electronic venue cannot, for example, be held responsible for the paucity of T1 lines between

Barrow, Alaska and Chicago.
10

models; and (2) the inbound and outbound bandwidth capacity15 of the relevant organized

market. Even for market participants that may not be deploying this degree of

automation, robust bandwidth capacity, particularly for an organized market operating an

electronic venue, is critical.

Recommendation: An organized market operating an electronic venue should not ration

the processing capabilities (bandwidth) of its automated order processing systems in any

way that would intentionally create or maintain a market access preference16 for any

market participant or class of market participant.

The subcommittee recognizes that incoming orders, subject to credit controls, will likely

arrive at the venue of the order book later than comparable orders not subject to credit

controls. Implementation of automated credit controls in electronic venues reflects good

business practices by those that assume client risk and does not create a market access

preference by discrimination. The subcommittee recognizes (for electronic markets that

have trade intermediaries) that, currently, client level credit controls can only be

practically implemented at the broker level. Nonetheless, the scope of this report must

address organized markets with and without intermediaries. However, all orders that are

subject to credit controls or similar types of filters should be processed in a uniform way

that would not create or maintain a market access preference for any market participant or

class of market participants.17

From a market participant's perspective, an organized market's order entry bandwidth

likely includes everything between themselves and the market as it is reflected on the

trading screen. This would include public networks. From the organized market's

perspective, its entry bandwidth likely includes all proprietary systems and

communications capacity and likely excludes all processing over which it has no control.

Client choice is important and many market participants will elect to communicate with

organized markets using public networks. Widespread usage of public networks in

general, is accompanied by significant public benefits.

Recommendation: Organized markets operating electronic venues should maintain the

operating capacity to operate their electronic markets (including order entry systems),

even on particularly active market days, without noticeable and significant system

processing degradation.

 

15 For emphasis, it is interesting to note that the quality of the trading model is entirely within their control

and bandwidth capacity is entirely outside their control.

16 This means providing any time, place, execution priority or informational advantages.

17 Organized markets should not, in an attempt to circumvent this best practice, mandate that an entire class

of market participants’ orders be subjected to credit control processing (while all orders of a more

privileged class of market participant would not), where there are no distinguishing differences (in credit

quality) between the relevant classes of market participants. Doing so could only be deemed a tactic to

intentionally provide preferential market access to one class of market participant by intentionally delaying

the receipt of all others' orders (into the order book) and thereby creating a market access preference for

that class whose orders were not subject to credit controls.
11

This is a high and costly standard and should be accompanied by some test of

reasonableness. Intuitively, it would seem to be in the vested interest of the organized

markets themselves to advertise their respective order entry bandwidth capacity in easily

understandable terms.18 Doing so would minimize any potential disconnect between the

perceptions of market participants and the processing realities of the organized markets

on which they are active.

The subcommittee recognizes, especially when trading options products in an electronic

market venue, that computer (or other automated) generated bids and offers will need to

be near continuously refreshed as the price of the underlying product (or volatility)

change. This will necessarily consume large portions of the end-to-end processing

bandwidth of the affected organized markets. The subcommittee also recognizes that

temporary order queuing is most likely to occur when economic data or unexpected news

affecting organized markets is announced. This is also when many market participants

would argue that they are at most financial risk if undue queuing persists. As organized

markets provide a public benefit by providing price transparency into their respective

markets, bids and offers that are frequently refreshed provide a significant public benefit.

The adequacy of organized markets' processing bandwidth should be periodically

examined and reviewed for adequacy by organized markets' respective outside audit

firms and by national authorities.

Recommendation: In an effort to ensure that organized markets operating electronic

markets can maintain sufficient order entry bandwidth, they should consider recapturing

their respective “bandwidth capacity” expenses by charging bandwidth usage fees to

those market participants (without regard to class) that consume their processing

bandwidth, proportionate to their respective usage19,20 of such processing bandwidth.

 

18 For example, "volume equivalent to four times the average will result in performance degradation of less

than half a second". While "best" practices would likely be interpreted by many to mean that significant

system degradation should not normally occur in market situations within four or five standard deviations,

the best practice standard cannot be completely open ended. It is important to note that the perception of

system degradation by market participants will also likely include degradation of communications media

outside of the control of the relevant organized market. It is thus all the more important that organized

markets make clear what their respective order entry bandwidth is, what it includes and what it does not.

19 A sliding scale is specifically suggested. Market participants having the highest incidence of quotes to

trades should expect to pay a disproportionately higher portion of bandwidth usage fees. Reference is made

to the market maker section of this report in which it is suggested that organized markets should be

encouraged to provide financial incentives to market makers rather than providing time, place, execution

priority or informational advantages. Waiving all or a portion of bandwidth usage fees to market makers

would constitute an appropriate financial incentive that might be offered, rather than providing privileged

market access, including bandwidth priority.

20 Intuitively, some minimum threshold should apply, otherwise every order ever received would be subject

to the bandwidth tariff. The essence of the recommendation is that the disproportionate users are currently

getting a free ride at the expense of all, and should either pay for their disproportionate usage or change

their quotation injection methodology.
12

The subcommittee recognizes that maintaining and upgrading an organized market’s

(electronic venue) end-to-end processing bandwidth necessarily involves a significant

and concomitant expense. An organized electronic market which experiences no

discernible order entry system degradation on remarkable market days but which

recaptures the expense of maintaining a robust bandwidth capacity to avoid such

degradation by charging bandwidth usage fees to those market participants (without

regard to class) that disproportionately consume its processing bandwidth, is preferable

to an organized electronic market that routinely experiences order queuing delays21 but

charges no such fees.

3.1.3 Order Queuing Structures

The subcommittee recognizes that all organized electronic markets must have some

capability to automatically22 queue incoming orders to otherwise prevent the trade

matching engine from becoming overwhelmed and from crashing. In all such cases,

organized markets should (1) ensure that all market participants have easy access to the

"rules of engagement" under which all such queuing algorithms operate; (2) attempt to

implement the queuing structure as close as possible to the point of entry of the order (the

furthest from the order book and the closest to the client); (3) use time23 exclusively

(FIFO) as the basis for releasing queued orders into the order book; and (4) design and

test to ensure that no queuing algorithm could create a market access privilege for any

market participant or class of market participant. Implementing the queuing process as

close as possible to the client and making its current status transparent to all market

participants puts more control into the hands of the client, ensuring that they are promptly

informed of the approximate queuing time to which their orders are subject. The client

could then better manage24 its own order output stream, knowing the status of an

organized market's order queuing structure.

 

21 Some would argue that an organized market should be permitted to provide (presumably) low cost

services, including routine system performance degradation if it discloses its performance capabilities to all

market participants. While this may be appropriate, it is not at all persuasive that doing so would constitute

a best practice "equal to" or "better than" the subcommittee's recommended best practice. 22 Organized markets utilizing queuing structures should display the current status of its queuing structure

to all market participants (not just those with orders queued).

23 It had been suggested that straight cancellation orders might have priority over all others. There was no

meaningful support among the members of the subcommittee for this concept. An automated process of

checking every single order in the queue to identify the cancellation orders would also slow down the

release of all orders in the queue, all of the time. 24 Allowing market participants to know (view) the prevailing order queuing delay time, might provide a

significant public benefit. Knowing the degree to which a market's order entry system is experiencing

performance degradation might cause highly automated market participants to throttle back their respective

quotation refreshment frequencies. As virtually all such market participants are highly automated, it is not

unlikely that, acting as a group, but for individualistic reasons, they might collectively throttle back their

respective quotation refreshment frequencies, benefiting all market participants. These same active trading

concerns might also appreciate the opportunity to enter certain straight cancel orders into the order book

before the order entry system performance degraded further.
13

3.1.4 Order Eligibility

Recommendation: An organized market operating an electronic venue should not operate

any order processing system, pass any rule or allow any order processing conventions

that impose any restrictions (other than the presence of credit filters or automated

incoming order queuing algorithms) that discriminate between the equal priority of (1)

computer generated orders versus non-computer generated orders, (2) among types of

orders or (3) among market participants or class of market participants.

This prohibition is universal. Applications of technology should not be used to create or

to maintain privileged market access.

Recommendation: An organized market operating an electronic venue should not

operate any order processing system, pass any rule or allow any order processing

conventions that would otherwise preclude any market participant or class of market

participant from entering simultaneous 2-way quotes.

Rules precluding market participants from entering 2-way quotes in electronic markets

could be specifically designed to shield market makers from legitimate competitors. The

legitimate quotes (including 2-way quotes) of highly automated market participants might

provide all interested market participants with prices more competitive than the quoted

prices of the designated market maker. One could argue that permitting all market

participants to enter all types of orders freely, improves transparency and potentially

improves the probability that market participants' orders might be matched opposite other

market participant's orders.

3.1.5 Flickering Quotes

The subcommittee addressed several issues associated with the increased presence of

flickering quotes within the context of the challenges of providing robust bandwidth in

electronic market venues. Increased usage of Automated Price Injection Models

(“APIMs”) by market participants (ostensibly to improve one's queue position in the

order book) has become problematic and exacerbates organized markets' efforts to

provide reasonable bandwidth, both inbound and outbound. The consensus of the

subcommittee is that flickering quotes are not necessarily bad; they are real quotes that

are subject to immediate acceptance. However, bandwidth congestion as a side effect

associated with flickering quotes is detrimental.

Bandwidth is not a free or inexpensive good. Electronic trading, including the increased

usage of APIMs, consumes very large amounts of bandwidth, particularly in products

with high volatility (where bids and offers are typically refreshed with high frequency).

More generally, unless properly managed or incented, APIMs can generate an enormous

amount of message traffic at prices often significantly outside the best bid and offer and
14

often lasting only for moments (hence flickering quotes), which contribute little to

improve real market transparency or liquidity.

Organized markets periodically review the amount of bandwidth that they need to operate

and the amount of host processing capacity that they require in order to run an efficient

market that meets the needs of market participants. In doing so, they must balance the

risk of purchasing excessive bandwidth and host capacity which would drive up their

operating costs and presumably the costs passed on to market participants, against the

risk of having inadequate bandwidth and processing capacity which would be manifested

in poor levels of service and, unless addressed, loss of market participants to other

exchanges, the Over-the Counter market or to ECNs.

Electronic markets often have complex trade matching algorithms designed to execute

orders representing a combination25 of trades or trades involving implied pricing.

Flickering quotes not only consume order entry bandwidth capacity but, to the degree that

a flickering quote might also be eligible as a component (leg) of a potential combination

trade, they also consume the processing power of the trade match engine. In the long run,

increase usage of APIMs may neither lead to narrower bid/offer spreads nor a meaningful

increase in "at-the-money" liquidity.

There are significant public benefits associated with valid and robust price discovery.

Flickering quotes may consume more bandwidth than they contribute to bona fide price

transparency. Said another way, while not being illegal, flickering quotes often involve

more public costs (by both congesting bandwidth and by actually being present in the

order book for a seemingly infinitesimal instant) than they seem to provide public benefit.

Suboptimal order entry bandwidth has a detrimental effect on market transparency. If

markets had free and open bandwidth, even with the machine gun quotes of APIMs, the

market would be alert and able to deal with potential abuse. Best practice would be for

organized markets operating electronic venues to provide sufficient order entry

bandwidth so that, even during active markets, there would not be significant observable

system performance degradation. In order to pay for such robust bandwidth, organized

markets should charge fees for bandwidth usage.26 However, all organized markets

operating electronic venues, even those with the most robust order entry bandwidth, still

need to have the capacity to queue orders at or prior to the order book gateway but to do

so without discriminating among market participants or classes of market participants.

 

25 For example, a calendar month spread differential would be a basic combination trade. Options trading

based on implied volatility provides an excellent example of implied price processing that consumes CPU

capacity whether quotes flicker or not.

26 It makes no sense to charge every market participant that ever enters an order. Organized markets

already have fee structures that apply to executed trades. Significant users of order entry bandwidth should

pay reasonable fees to cover their respective significant bandwidth usage.
15

3.2 Block Trading, and Internalization of Order Flow27

3.2.1 Background

Financial futures gained significant acceptance as legitimate financial tools in the late

1970's. Increased acceptance from institutional clients brought to the forefront,

disparities in the large order execution customs and practices of the underlying cash

markets and futures markets. Institutional traders with singularly large orders to execute

sought certainty of execution (getting the entire trade successfully executed), preferably

all at one price. Futures markets then were not entirely accommodative to these kinds of

orders; futures traders insisted that their bids and offers were subject only to immediate

acceptance. Liquidity (size) that was thought to be present (and at what levels) in the

trading pits often retreated to safer levels once it became obvious that a floor broker was

handling a particularly large order. FCMs, as agents, insisted (for fairness) that a large

order should be executed against all relevant resting orders.

The execution of such large institutional orders, of necessity, requires the immediate

presence of counterparties with commensurate risk capital. When trading pits could not

effectively assimilate such large orders, price gaps occurred, often resulting in

unnecessary and unhealthy volatility. More than occasionally frustrated, institutional

traders sought alternative methods and alternative markets. Working together, interested

parties tried countless alternatives.28 The emergence of exchanges in other countries, the

trading of economically equivalent products subject to different regulatory regimes and

the growth of the Over-the-Counter derivatives market provided accommodative

techniques for negotiating large orders. Compromise and consensus were brought to

bear, allowing domestic organized markets to develop plausible execution techniques for

large orders. In general, "block trading" techniques involve execution accommodations

generally permitting very large orders to be executed at a single price. The most liberal

accommodations (not necessarily in the U.S.) also permit the entire trade to be executed

opposite a single counterparty, and have the trade registered with the relevant clearing

organization, and assimilated into the open interest.

From a public policy perspective, block trading is, on net, beneficial. It can be argued

that it is somewhat imprudent to permit trading in a product that has particularly wide

swings in trading volume if some accommodation for block trades is not made.

Providing an appropriate structure (that assimilates the subcommittee's best practice) to

accommodate block trading on organized markets operating electronic venues should

 

27 The best practices recommended in this section are intended to apply only to reasonably mature products

(or individual contract months or options series) listed for trading on organized electronic markets. More

specifically, the best recommended practices assume that, for a given product, there is (1) a single

successful organized market, (there may be more than one market, but one market clearly dominates); (2)

that market is perceived to be the primary source of price discovery for the majority of relevant commercial

market participants; (3) the liquidity in that product would, at a minimum, be described as reasonably

sufficient, i.e. it would not be described as a nascent product by most commercial market participants; and

(4) the market venue is electronic.

28 Today's block trading conventions were preceded by Exchange of Physicals for Futures, Large Order

Executions, Sunshine Trading, All or Nothing trades and countless other initiatives.
16

create the potential to attract some not insignificant portion of privately negotiated

contracts, agreements and transactions that would otherwise be executed away from

organized markets, back onto organized markets. By doing so, these large transactions

would improve price transparency, add to liquidity,29 provide revenues, become

assimilated into the audit trail, become subject to private sector rules and public sector

regulations and quite likely benefit from all of the advantages routinely associated with

the clearing process. Therefore, block trading of large orders on organized markets

operating electronic venues is to be encouraged.

3.2.2 Approach

The subcommittee's recommended best practice is, of necessity, complex. It suggests a

bifurcated procedure that that provides appropriately different techniques for (1)

unusually large and potentially disruptive orders; and (2) an optional30 technique for

orders that are unmistakably remarkable in quantity. The former is referred to as the

subcommittee's core recommendation; the latter as the optional recommendation. The

optional recommendation is only available for extremely large block trades and provides

that they may optionally be internalized off the trading screen, but still must be reported

in no less than 90 seconds. The optional recommendation is only meant to be available to

an organized electronic market that has implemented the core block trading

recommendation.

3.2.3 Core Best Practice

The entire remainder of this section constitutes the subcommittee's recommend core best

practice for block trading and internalization of order flow.

3.2.3.1 Minimum Eligible Quantity

Orders eligible to be block traded must be of an appropriate minimum quantity. The

minimum permissible quantity for executing block trades on electronic market venues

will change as liquidity in that product/market changes from time to time. In general, the

minimum quantity should be large enough that it represents a marked departure from the

size of otherwise large orders that can be readily observed as being executed in that

electronic product/market. For an order to be eligible to be block traded, it need not be

remarkable in size, but its size should be substantial enough that it would otherwise move

the market substantially and that by directing that order to the market (otherwise without

a facility for block trading), a commercial market participant would have every

 

29 Enhanced liquidity, better price transparency and being meaningfully assimilated into the audit trail

would only actually occur if the organized market adopted the subcommittee's core recommendation.

30 The optional best practice for orders that are unmistakably remarkable in quantity is meant only to be

available to organized electronic markets that have adopted the recommended core best practice for block

trades.
17

expectation that the order would (1) be temporarily and unnecessarily disruptive to the

market; and (2) likely be executed at an average price that would reasonably be deemed

to be uncommercial, relative to the underlying cash market for that derivative product or

with respect to the market prices of correlative products at that time. Periodically,

organized electronic markets should back test their respective minimum eligible block

trade quantities for reasonableness by checking the actual percentages (by product) of

total trades that were executed as block trades. Trends should be analyzed to ensure that

their respective market is not simply turning into a block trading market, where block

trades are not exceptional at all.

When determining whether a block trade satisfies the relevant minimum permissible

block trade quantity and when following the subcommittee's core best practice, the

determination is made before the recommended process starts. In the alternative, market

participants can always attempt to benefit, themselves, from any price improvement that

the market might provide. There are risks and rewards associated with this alternate

strategy. If attempting to benefit, themselves, from any potential price improvement,

market participants would enter a limit order expecting to take out all disclosed and

undisclosed resting orders, not knowing the quantities of the resting undisclosed orders.

In doing so, the unfilled residual quantity (to be internalized) might then be less than the

minimum permissible block trade quantity, and would not be eligible as a block trade.

Said another way, simply entering a limit order intentionally, through several bid (or

offer) levels would not, in and of itself, start the block trading process (if the market

participant is attempting to benefit from any potential price improvement) and hence does

not become the point at which one determines if the block trade quantity would satisfy

the minimum amount.

3.2.3.2 Preference for Disclosed Orders in the Order Book

An FCM taking the opposite side of a block trade should be obligated to take out all

disclosed resting bids and take the remainder of the orders at the block price as principal.

Under virtually all (block trade) circumstances, the potential practice of allowing block

orders to take out resting displayed orders at their respective limit prices would always

serve to the detriment of those affected market participants (when compared to the

subcommittee’s recommended core best practice), rendering their resting orders as

veritable "market road kill" by block trades which were never even displayed in the order

book. Market participants should receive incentives for leaving resting orders in the

order book and not be penalized.

The subcommittee’s approach distinguishes between displayed and undisplayed resting

orders and rewards the former for their valuable contribution to enhance the price

transparency of the relevant market venue. The subcommittee's recommended core best

practice (resting displayed bids get filled at the lower "block" price) provides a financial

incentive to all market participants to enter orders into the order book. In return, not only

would they not potentially be "run over" by a block trade, but they would also have some

significant possibility of receiving price improvement at trade execution.
18

It was noted that (in the example developed by the subcommittee) the block seller would

have access to the same information in the order book that every other market participant

would have. It is reasonable to assume that any experienced block trader (in our

example) knows that his/her order is going to take the market down to significantly lower

levels. The certainty of getting the entire order filled at a not unreasonable average price

is of paramount importance; otherwise the block seller’s request of an FCM for a block

trade quote would not have received serious consideration in the first place.

A potential block seller always has two options:

1. Block seller attempts to benefit from any potential price improvement.

Give the FCM a limit sell order to take out (as agent) the resting bids (disclosed and

undisclosed) at their respective prices31 (any potential price improvement would be for

the account and risk of the block seller) and expect to request that the FCM internalize

the unfilled residual quantity at the limit price (and run the risk that the unfilled quantity

might not then meet the minimum block trade quantity). The disclosed resting bids would

be executed at their limit price and thus, the FCM would, consistent with its agency

obligations, obtain price improvement for its customer’s trade. As the quantities of any

resting undisclosed orders are unknown, the unfilled residual quantity may be less than

the minimum permissible block trade amount. Should this be the case, the (would be)

block seller could only utilize any on-screen execution strategies otherwise customarily

available (on that venue and for that product), but the unfilled residual quantity could not

be internalized at any price, and no block trade would be reported. If the unfilled residual

amount satisfies the minimum block trade amount, that residual amount would be

internalized by the FCM at the limit price and would be promptly reported (the quantity

reported would be the unfilled residual quantity).

2. (Recommended) Gives any potential price improvement to the displayed orders.

The block seller would approach the FCM and request a limit price for the entire block

trade for a quantity certain.32 The FCM would enter an appropriate combination of

orders to take out the resting disclosed orders at the limit (block) price, providing any

potential price improvement to the resting disclosed orders in the order book. No

undisclosed orders would be involved. The amount of the quantity otherwise unfilled at

the limit price would be internalized33 by the FCM as a block trade regardless of the

(residual) amount, as the determination of whether the block trade quantity satisfied the

 

31 It is entirely conceivable that some electronic venues’ policies could include the stipulation that market

orders also take out undisclosed reserves. The subcommittee provides no recommendations regarding the

public policy implications of permitting undisclosed reserves.

32 The block trade quantity either would or would not satisfy the minimum block trade quantity for that

product. The determination of whether the contemplated block trade quantity satisfies the minimum

permissible block trade quantity is not be subject to any subsequent event.

33 Under most market conditions, the FCM would be able to accurately estimate this residual quantity

before agreeing to internalize it.
19

block trade minimum was made when the market participant first approached the FCM.

The block trade would be promptly reported as the entire block trade quantity.

3.2.3.3 Undisplayed Resting Orders (reserves) in the Order Book

Undisplayed reserves should not be granted equivalent priority to displayed orders when

participating in an execution of a block trade. Orders eligible for preferred priority

should be those orders that, as a group, were visible (price and actual quantity) in the

order book. A market venue that provides market participants visibility into a robust

order book provides significant public benefit. While undisplayed reserves may

contribute to the liquidity of an organized market venue, by definition, they contribute

virtually nothing to enhance transparency of the order book. The time priority of

undisclosed reserves being refreshed after the block trade has been completed is

addressed in the detailed example.

Detailed Example

The subcommittee agreed that the best way to summarize its recommended best practice

for block trading was to do so with an example that would address all of the issues that

the subcommittee deemed relevant to recommending a best practice. The reference

example that was used by the subcommittee focuses attention on the relevant issues and

is included immediately below.

The venue for the subcommittee's example is a monopoly market; that is, there are really

no other electronic (venue) markets that operate during substantially the same time zones

for a fungible product and that are considered by a significant proportion of commercial

market participants to constitute a bona fide source of price transparency. The prevailing

market is xx.24 bid and xx.25 offered. The market is typical; there are bids in the order

book below the xx.24 bid and offers above the xx.25 offer. Aggregate resting size in the

book expands the further the bids and offers rest below and above the prevailing market

price. All market participants that have trading terminals can see the order book five

prices up and down.

A market participant having this information34 indicated to its FCM that it wanted to

execute a block sell order having notional value of $5 million.35 Further assume that this

market venue permits market participants to enter undisclosed reserves36 into the order

book. Prior to executing the block order, the order book looks like the following:

 

34 It is not relevant whether the market participant could see the order book on its own trading terminal or

whether its carrying broker provided this price/quantity information.

35 Assume that a $5 million single order otherwise exceeds any minimum order size for a block order for

that product/venue.

36 The subcommittee provides no opinion with respect to the potential public costs and benefits of

permitting market participants to enter undisclosed reserves into the order book of an organized market

operating an electric venue. The members of the subcommittee believed that the example needed the

robustness of undisclosed reserve balances in order to communicate the subcommittee's premise that trade

matching algorithms should give the highest time/price priority to orders that provide price discovery and
20

Order Book

xx.29 {not relevant to this example}

xx.28 {not relevant to this example}

xx.27 {not relevant to this example}

xx.26 aggregate offers (4) of $34,000 [undisclosed aggregate reserves (3) of $66,000]

xx.25 aggregate offers (3) of $23,000 [undisclosed aggregate reserves (2) of $50,000]

xx.24 aggregate bids (2) of $43,000 [undisclosed aggregate reserves (1) of $50,000]

xx.23 aggregate bids (3) of $65,000 [undisclosed aggregate reserves (2) of $150,000]

xx.22 aggregate bids (5) of $111,000 [undisclosed aggregate reserves (3) of $250,000]

xx.21 aggregate bids (7) of $167,000 [undisclosed aggregate reserves (4) of $400,000]

xx.20 aggregate bids (9) of $222,000 [undisclosed aggregate reserves (6) of $550,000]

xx.19 aggregate bids (4) of $300,000 [undisclosed aggregate reserves (2) of $500,000]37

The FCM indicates that it would be prepared to execute a block trade for all38 $5 million

at xx.20.

The subcommittee's recommended best practice would require the following steps:

1. The $43,000 bids (2) at xx.24 get filled at xx.20.39

2. The $65,000 bids (3) at xx.23 get filled at xx.20.

3. The $111,000 bids (5) at xx.22 get filled at xx.20.

4. The $167,000 bids (7) at xx.21 get filled at xx.20.

5. The $222,000 bids (9) at xx.20 get filled at xx.20.

6. The $4,392,000 gets block traded (internalized) with the FCM at xx.20.

7. Trades 1 through 5 would occur on the screen and would be instantly

transparent to all market participants that have trading terminals.40 It would

not, at that time, be apparent whether someone simply "turned” the market

with a large order or whether a block trade was involved.41

8. As soon as practicable, but in any event, not less than 90 seconds later, the

FCM must submit the block trade to the market venue for retransmission

(without any delay) through its trade reporting system. At a minimum, the

transmission should contain at least four elements; the product description,

 transparency. Undisclosed reserve balances provide none, and therefore should be subordinate to disclosed

bids and offers when block trades are being executed.

37 Technically, the xx.19 bids would not have been displayed when the market was xx.24 bid / xx.25

offered as our mythical venue displays bids and offers 5 prices up and down.

38 In our example, however, the actual quantity of the FCM's block trade (the residual) is $4,392,000.

39 The concept of having limit orders benefit from price improvement is not new. Many electronic markets

already have single price opening algorithms that do exactly that.

40 Even for market participants that might otherwise only have rudimentary quotation devices (rather than

trading terminals) the executions opposite the resting bids at xx.24, xx.23, xx.22, xx.21 and xx.20 would be

displayed in rapid succession, providing reasonable transparency that some form of large sell order was just

executed.

41 If the venue had a policy of allowing market and limit orders to take out undisclosed reserve balances, (in

this example) those market participants that had undisclosed reserve balances to buy (at relevant prices)

would likely have the first opportunity to realize that the market went through the limit price of their hidden

reserve balances. That being so, those market participants could logically deduce that the order that took

out the resting displayed bids but not the undisclosed reserve balances must have been a block trade.
21

(month/series, strike, etc.), the quantity of $4,392,000, the price of xx.20 and

the approximate time that the trade was executed.42,43 The market venue

should promptly disseminate the block trade information over its quotation

system.

3.2.3.4 Time Priority for Undisclosed Reserves

Assume that after this phenomenon is observed on the screen, the market begins to

regroup at xx.19 bid and xx.20 offered. The following procedures constitute the

subcommittee's best practice for handling the undisclosed reserve balances that were

associated with the various bids at xx.24 through xx.20.

1. If the bidder at xx.24 that had an undisclosed reserve of $50,000 wishes to

enter a fully disclosed bid for that quantity ($50,000) or any lesser amount at

xx.19, its time/price priority should be subordinate only to the (4) prior resting

disclosed bids for an aggregate amount of $300,000.

2. If the bidder at xx.24 that had an undisclosed reserve of $50,000 wishes to

transport its undisclosed bid for that quantity or any lesser amount at xx.19,

the time/price priority for its undisclosed reserve balance should be

subordinate only to the (4) prior resting disclosed bids for an aggregate

amount of $300,000 and the (2) resting undisclosed reserve balances that

aggregate $500,000.

3. All other undisclosed reserve balances at xx.23, xx.22, and xx.21 should, as

groups have new time/price priority in descending limit price order44 and

within limit price, should maintain whatever time/price priority (relative to

each other) they had prior to the execution of the block trade.

3.2.4 Optional Best Practice for Orders of Unmistakably Remarkable Quantity

3.2.4.1 Minimum Eligible Quantity

Orders eligible to be block traded under the subcommittee's recommended optional best

practice must be of an appropriate minimum quantity. The minimum permissible

 

42 From the subcommittee’s perspective, the time at which the (9) resting bids at xx.20 were taken out

would arguably be the proper start time to report the residual of the block trade. The residual trade should

be reported to the exchange as soon as practicable and in no event later than 90 seconds later.

43 If the market venue typically reports opposite clearing firm information on matched trades then the FCM

executing the block buy trade would receive matched trade confirmation from the order book that it was

both the buying and selling FCM. If FCM identity information is not otherwise distributed to uninvolved

third parties (anyone else with a trading terminal) on all other matched trades, it should not be disclosed for

block trades. That is, the provision (or not) of opposite FCM information should be no different for block

trades than for any other matched trades.

44 Conversely, a block buy order would give priority to the lowest offers firstly.
22

quantity for executing jumbo45 block trades on electronic market venues using the

optional best practice will change as liquidity in that product/market changes from time

to time. In general, the minimum quantity should be unmistakably remarkable in

quantity to the degree that it represents a marked departure from the minimum quantity

eligible for block trades under the subcommittee's core best practice and should be

several multiples thereof.

Periodically, organized electronic markets should back test their respective jumbo block

trade minimum eligible quantities for reasonableness, by checking the actual percentages

(by product) of total trades that were executed as jumbo block trades. Trends should be

analyzed to ensure that their respective market is not simply turning into jumbo block

trading market, where such trades are not exceptional at all. Given the subcommittee's

particularly defining criteria for an appropriate minimum eligible quantity for the core

best practice, it would be expected that jumbo block trades under the subcommittee's

recommended optional best practice should comprise a modest fraction of trades block

traded under the subcommittee's recommended core best practice.46

3.2.4.2 Procedure

The procedure for internalizing a jumbo block trade is without complication. The trade is

completely internalized between the client and FCM. The organized market still must be

notified of the trade as soon as practicable and in any event, no less than 90 seconds after

all of the terms of the trade have been finalized. Neither party to the jumbo block trade

may enter any trades directly related to the jumbo block trade (in the relevant product)

until the organized market disseminates the particulars of the jumbo block trade across its

quotation system. Such dissemination of a jumbo block trade across its quotation system

serves as notification to the market place that the terms of the trade are final and the trade

has been accepted into the open interest.

The parties may, at all times, act as agent in the product in the interim and may execute a

directly related trade in a correlated product, but not the product (any month [if a futures]

or option series [if an option]) in which the jumbo block trade took place. The parties

internalizing the trade may begin to shift risk (by entering an order into the relevant

product days in advance), but run a risk in doing so that the other party will not finalize

all terms and complete the trade. Such anticipatory trades would have been appropriately

executed on the screen, providing all market participants the opportunity to trade against

them and with full transparency.

 

45 Alternatively, whatever term of art the industry elects to use to describe block trades internalized as

provided by the subcommittee's optional best practice.

46 However, it is at least theoretically possible that for a given derivative product that likely has a unique

underlying cash market, the number of contracts and transactions in these "jumbo" block trades might

exceed or even be a multiple of the number of contracts and transactions in non-jumbo block trades (as

provided in the core best practice) even if the recommended criteria for determining the minimum eligible

quantity for the core best practice were followed.
23

The FCM internalizing the trade must provide the organized market with the specifics of

price, quantity, and time. The organized market should promptly report the trade

(product description [month/series, strike, etc.], price, quantity and time) with obvious

notations that it was a jumbo block trade. Organized markets wishing to implement this

optional best practice must take reasonable actions to make market participants aware

that their resting orders will not participate opposite jumbo block trades.

At issue are fundamental issues of fairness. Resting orders in the order book are very

likely the primary price discovery source for block traders and FCMs prepared to

internalize block trades. The (displayed) resting orders of market participants are

continuously at risk of immediate acceptance and provide virtually all of the fuel for the

price discovery process. While they provide this significant public benefit, most market

participants will have no opportunity to participate opposite a jumbo block trade and may

potentially be adversely affected after the terms of a jumbo block trade are disseminated.

Market participants look to, and organized markets tout levels of open interest as the

second best indicator of market liquidity. For the vast majority of market participants

that will never participate in block trades, the presence of block trades in the open interest

is thus considerably misleading. These market participants may or may not potentially

benefit from having jumbo block trades present in the open interest. Jumbo block trades

as liquidating trades could cause the open interest to decline in gaps. On any given day,

the decline in open interest could exceed the volume of trading that actually took place on

the screen.

Some would argue that absent a jumbo block trade best practice, this business would not

be executed on organized electronic markets at all. If this were indeed so, the

recommended best practice for jumbo block trades would not necessarily cause market

participants to be losing something that they have now. By requiring that (1) jumbo

block trades must be promptly reported; and (2) trades directly related to the block trade

not be entered into the primary market until they are reported, market participants'

displayed orders should likely receive some consideration proportionate to their

considerable liquidity and transparency value. The issue is not at all about providing

some protection to displayed orders; it is about providing guidelines for fair and

reasonable access to organized electronic markets while accommodating business needs

of large market participants that have easy access to Over-the-Counter markets.

3.2.5 Prompt Trade Reporting

The FCM internalizing a block trade or a jumbo block trade has the affirmative

responsibility to report the trade (product description [month/series, strike, etc.], price,

quantity and time) but no information respecting the identity of the client as soon as

practicable, and in no event, later than 90 seconds after all of the terms of the trade are

finalized.47 The subcommittee is unanimous on this point. The subcommittee makes no

 

47 The subcommittee is aware that the current practices of firms that routinely internalize order flow are

reasonably disparate. Therefore, some standardization for the reporting of block trades will likely be

required for all affected firms to comply with the 90 second requirement. A survey of current procedures
24

recommendation respecting acceptable media over which the FCM should report the

block trade; that would be specified by the relevant organized market. All organized

markets should achieve and maintain the highest level of price transparency to its market

participants, upon whose order flow the market venue is completely dependent.

3.2.6 Multiple Market Venues for Economically Equivalent Products

Healthy competition among organized markets48 serves the public good. Where multiple

market venues concurrently serve as bona fide price discovery centers, FCMs may have

some affirmative responsibility to use their best efforts to direct a customer’s orders49 to

the market venue that provides the most favorable terms for the execution of that

customer’s order (i.e., cost, liquidity, price, speed of execution, etc.). Any responsibility

in this area would lie with the FCM, not the organized market operating an electronic

marketplace. In the U.S. futures industry, the absence of both a unified quotation system

and a central limit order book make it all but impossible for all FCMs to pragmatically

adhere to a meaningful best execution practice for fungible products offered on multiple

venues. Some FCMs may elect to develop proprietary systems to monitor and route

orders to the venue deemed to be in the best interest of the client. It is the consensus of

the subcommittee that an automated block trading best practice for fungible products

operating across multiple electronic trading venues would be extraordinarily difficult to

achieve, absent either mandatory or privately negotiated linkages of market centers.

3.3 Transparency

3.3.1 Pre-trade Execution

Electronic markets function efficiently when market participants have the opportunity to

use transparent market information to make trading and investment decisions, enter

orders to do so, and achieve predictable results.

Recommendation: Organized markets operating electronic venues should uniformly

display their respective order books for all products to all market participants without

any preference to any market participant or class of market participant.

 among affected firms would seem appropriate. Approval of counterparty credit exposure should not be an

issue as the trade, by definition, will be cleared.

48 The subcommittee notes that widely disparate comments have been made respecting the issue of the

probable economic barrier(s) to inaugurate an organized electronic market. The subcommittee provides no

opinion on whether the current economic barriers to inaugurate an organized electronic market seem high

or low, other than to note that organized markets, as a group, tend to describe these economic barriers to

entry as being low, and end-user market participants describe these economic barriers to entry as being high

enough that viable alternatives to entrenched electronic markets are not realistic. Intuitively, both positions

cannot concurrently be correct.

49 Specifically, orders not otherwise directed by the client for venue specific execution.
25

For a given product, an organized market should not disseminate its entire order book to

one class of market participant but disseminate only a fraction of its order book to other

market participants. If only a portion50 of the order book is displayed, that portion should

be disseminated uniformly, and be made available to all classes of market participants

without discrimination. Informational content and timeliness of transmission should not

be discriminatory among classes of market participants.

Client choice of informational content is paramount. Organized markets do not have to

disseminate the entire order book to market participants that have elected, by their

selection of informational content, not to receive it. If an organized market has different

offerings of (order book) informational content, it simply must make all offerings

available to all classes of market participants.

3.3.2 Post-trade Execution

One of the great public benefits of all organized markets, including organized markets

operating electronic venues, is the dissemination of market prices. Organized markets

focus attention centrally. All market participants that have an economic interest in a

particular product/venue can express their market view and the composite of all of those

views determines a product’s instantaneous fair market value. All interested market

participants should have equal access to this valuable information.

Recommendation: Organized markets operating electronic venues should not disseminate

price or price and quantity information with any preference to any market participant or

class of market participant. Neither the timeliness of dissemination nor informational

content may differ among market participants or classes of market participants willing to

pay the same fees to receive the same information at the same time.

The subcommittee does not take issue with the practice of some organized markets that

sell their real-time quotation data for a premium price and a delayed quotation feed at a

lesser price, nor the practice of charging different fees to provide quotation services to

different classes of market participants. The subcommittee would, however, take issue if

an organized market51 were to decline to provide appropriate quotation data, content and

transmission speed, at all, to a market participant or class of market participant (that were

otherwise willing to pay appropriate fees to subscribe to such quotation service). This

 

50 For example, five strikes or futures ticks up and down.

51 It is not the intention of the subcommittee to imply that outbound market quotations are in all cases the

exclusive property of the relevant organized market, although there is some case law in the U.S. that

suggests that this may be the case for futures exchanges. On other select market venues, a cogent argument

might be made that certain market data (most notably, transparency into the order book) are the property of

a select subgroup of specialized market participants. The subcommittee intentionally provides no opinion

on this issue other than to note that disagreement on this issue may be present for some market venues. The

applicability of the subcommittee's recommendations does not turn on the ownership of the relevant data

and should apply to whomsoever is the rightful owner of the data.
26

would be particularly problematic (and would raise significant public policy issues) if the

organized market in question were also perceived to be the primary source of price

discovery for the majority of relevant commercial market participants.

3.4 Error Resolution

Similar to the Block Trading section (3.2) the format and detailed contents of this section

do not readily provide a meaningful opportunity to highlight (in italics) certain best

practice recommendations. Other than the Background section (below) the entire

remainder of this major section comprises the subcommittee's recommended best

practices for resolution of clearly erroneous trades.

3.4.1 Background

Order entry media for electronic markets are very different than those for most physical

market venues. Automated trading models interact with near real time quotation streams

and generate orders in fractions of a second without any human intervention. Once an

order is transmitted towards the order book, it is rarely, if ever, subject to human review.

Orders involving human intervention have as their point of origin either (1) a computer

keyboard; (2) a computer mouse; or (3) computer-based voice recognition technology.

Many orders are computer generated and involve no human intervention or interaction.

Speed of execution varies with the trading venue, with electronic venues typically seen as

being the most expedient. This expediency though, is achieved largely from the absence

of human intervention. Veritably every person that touches an order in a physical trading

hall, whether unwittingly or not, makes a value judgement about the reasonableness of

that order at that moment in time. So while physical and automated venues provide many

opportunities to test for reasonableness, these venues also provide environments where

human imperfections can cause errors. Human error will always be present to some

degree in any organized market, whether electronically operated or otherwise.

Errors in electronic markets often not only have direct repercussions but also can have

extraordinarily significant indirect repercussions. Efficient market transparency media

may display errant quotes and errant trades in fractions of seconds. To the degree that

market participants active in electronic markets have automated trading systems, those

systems may have already reacted to an errant trade (as an outbound trade quote) before

the party making the error even realizes that they have made such an error. Because

errors often have a ripple effect that may spill over into other products and other markets,

determining the span of influence over which error resolution policies should

appropriately be applied, becomes the most difficult of challenges.
27

3.4.2 Purpose statement

A best practice for resolution of clearly erroneous trades should strike a balance between

the speed, efficiency, and certainty of execution demanded by market professionals and

the responsibility of organized markets operating electronic venues to maintain market

integrity and, to the degree possible, preclude erroneous quotes from being disseminated.

It is unlikely that any organized market operating an electronic venue could effectively

preclude the possibility of all incidences of clearly erroneous trades without unacceptably

restricting the trading practices of its market participants. While organized markets

should be provided appropriate flexibility to determine their respective policies for the

resolution of clearly erroneous trades, those policies should produce results that are

expedient, equitable, predictable and not based on the class of market participants

involved.

3.4.3 Prevention (before the trade)

National authorities must ensure that organized markets operating electronic venues,

(likely having national or international implications) have the immediate capacity to

operate an electronic market place prudentially. Expertise of staff, financial health and

systems redundancy are of paramount importance when granting approval to inaugurate

emerging electronic markets.

Primary responsibility for performance on trades and resolution of clearly erroneous

trades lies with the member or clearing member that is held directly responsible for the

trade by the organized market or its clearing organization. Standards for such

membership should include a formal determination that the firm has the immediate

capacity to conduct its business in an all electronic environment, its systems have been

adequately tested, its staff properly trained and its financial health appropriate when

compared to its peers. Error resolution policies should not relieve market participants

from their financial responsibilities or potential liability for making trades that are

ultimately deemed to be "mistrades" if their actions caused financial loss to other parties.

Where organized electronic markets have trade intermediaries, it is important that those

intermediaries structure their respective trading environments in a responsible and

appropriate way, including the affirmative obligation to hire and train suitable and

competent staff and to make appropriate risk management provisions. It is expected that

trade intermediaries would have the capacity to establish and maintain quantity limits on

clients having indirect52 electronic access to markets.

Trade intermediaries and organized markets should, when and where appropriate,

implement "are you sure?" alerts based upon the difference between the last trade price

and the price entered in the order. Permissible price bands as error prevention tools are

 

52 Indirect access is meant to mean that clients would have trading terminals, but their orders would be

subject to credit control limitations managed by their trade intermediaries.
28

far more absolute, but similar in function, preventing trades with clearly erroneous prices

to enter the order book at all. These alerts often catch transcription errors at the source,

requiring no further action. Similarly (maximum) quantity limits provide a useful error

detection mechanism, especially effective at precluding the juxtaposition of entering a

price in the quantity field. Many organized markets have implemented both "are you

sure?" alerts and permissible price bands at the product level. Where trade intermediaries

have allowed clients to have indirect electronic access, implementation of client specific

permissible price bands and maximum quantities should be encouraged.

The testing of automated trading models into live market environments should always be

avoided. Market participants that would test systems against a live trading environment

clearly have no intention of submitting any bona fide orders and provide neither liquidity

nor market transparency. Yet market participants that have developed automated trading

models, including APIMs, legitimately need the opportunity to thoroughly test their

systems in a realistic electronic environment. The only plausible alternative is for

organized markets to provide a test platform for market participants to utilize. This could

be either a separate test platform operating during normal (electronic) trading hours or the

primary operating platform, running scripted trades with both realistic prices and trade

frequency that would be made available when the market is not open. National

authorities providing supervisory oversight should ensure that organized markets

operating electronic venues have made appropriate provisions to allow market

participants to thoroughly test their trading systems.53 This requirement grows

increasingly important as utilization of automated trading models becomes more

commonplace and trading models are near constantly modified and upgraded to

incorporate improvements.

3.4.4 Transaction Resolution (after the trade)

It would appear that there are transaction resolution actions that need to be taken

expediently and error remuneration actions that need not. The subcommittee suggests

that organized markets bifurcate their error resolution procedures to reflect this, so that

relevant issues are consistently addressed and resolved in the optimum order. Organized

markets operating electronic venues should completely separate the processes of

transaction resolution from the processes associated with fees, penalties and forfeiture.

Market participants require that the former occur swiftly, predictably and likely not be

market participant specific; the latter may likely involve deliberation, discretion and be

market participant specific. Market participants must have complete confidence that the

application of error resolution policies will not result in a capricious outcome.

Predictability and expediency are critical in determining whether or not to "bust" a trade.

So called, "No Bust" collars are effective tools that provide both expediency and

predictability to this process. Organized markets should make their no bust collars

readily available either as pages on their electronic trading systems, their respective web

 

53 There is some precedent in the larger financial services industry for providers to charge for access to

testbed platforms, typically above some (free) level that would provide a positive incentive to test.
29

sites or both. Any changes to no bust collars should be appropriately publicized. Even

when the determination has been made to bust a trade that may have involved a series of

prices, only trades with prices outside of the no bust collar should be busted. Market

participants with orders at or near the market (within the "no bust" collar) should have

every expectation of good execution and should not become involved with a busted trade.

Completely automated markets will almost certainly have disseminated the specifics of a

clearly erroneous trade over its quotation system even before the error is detected.

Organized markets should promptly inform market participants (either by way of its

quotation system or its trading system, the former being preferable) when the

determination has been made to bust the trade. Notice of such action to bust the trade

should contain the product description, (month/series, strike, etc.) quantity, price and

approximate time that the trade was executed. The identity of the parties should not be

revealed at this juncture. Organized markets should have the option but not the

obligation to notify the market when there is the potential for a clearly erroneous trade to

be busted, but before final determination to do so has been made.54 During the

determination period, organized markets should provide no information to interested

parties that are not direct parties to a trade that may potentially be busted other than

regulators. Market participants having an interest in the potential outcome (but are not

direct parties to the trade) should not detract from the process by calling organized

markets for information to which they are not entitled.

In order for transaction resolution to occur expediently, organized markets should

establish clear maximum time limits within they must be notified of a request to bust a

clearly erroneous trade. These time limits should be simple, well publicized and not

product specific. Organized markets should have the option but not the obligation to

consider a request to bust a clearly erroneous trade if the request is received after the

maximum time limit has expired.55 Under such circumstances, some consideration

should be given to the circumstances of the counterparty.56 It is noted that while several

organized markets have well publicized time limits within which they must be notified by

others of a clearly erroneous trade, they have made no similar representations respecting

the time within which they, themselves, will predictably make an appropriate

determination. It may be good business practice to do so, at least for trades promptly

reported, and would likely bring a much needed sense of predictability to the process.

 

54 Markets that might elect to notify market participants of the potential for breaking a trade (rather than

after the actual determination to bust the trade has been made) should do so consistently, and their policy in

this area should be clearly stated and readily available.

55 Markets' policies in this area must be stated clearly, be readily available to market participants, and

exercised in a manner fosters consistency and predictability.

56 For example, one organized market gives the fee to the counterparty(s) for their inconvenience (and

expense) if the trade is busted. This would appear to be a reasonable approach, particularly if the request to

bust a trade was not received during the specified time limit.
30

When making transaction resolution decisions, organized markets should take actions

that only affect their own immediate market place. Organized markets should have the

option, but not the obligation of busting trades in their own, highly inter-related products

(including options on those products) provided:

(1) the decision tree within which the organized market will determine whether or not it

will bust clearly erroneous trades is well defined in advance and has been made easily

available to market participants and;

(2) the inter-related product(s) that may be affected are well defined and that information

has been made easily available to market participants well in advance and;

(3) over time, organized markets electing to exercise (or not to exercise this authority)

should do so in a consistent manner that fosters a sense of predictability and;

(4) any trades busted would be outside of the "no bust" range(s) for those respective

product(s) [all trades inside the no bust collars would stand] and;

(5) organized markets electing to retain this optional authority should vest such authority

only with exceptionally experienced staff that understand markets well.

Knowing in advance, the likely breadth of remedial action that might be taken by

organized markets would also bring an increased sense of predictability to the process.

Conversely, if organized markets were to routinely permit busting trades in other

products or in other related markets, trade intermediaries would likely begin to charge

premiums to cover their potential increased liability to process orders in the relevant

products.

When making a determination to bust a clearly erroneous trade, an organized market

should never take into consideration the identity of the market participant or the trade

intermediary unless one or the other (or both) habitually abuses the error resolution

process. Anonymity should be preserved during the transaction resolution process. Loss

of anonymity may become a component of the subsequent penalties and forfeiture

process for habitual offenders, as a tool to provide an appropriate incentive for

improvement, but counterparty identity should not be a consideration when determining

whether or not to bust a trade.

Notwithstanding the aforementioned concerns for having organized markets establish a

keen sense of predictability when determining whether or not to bust a trade, there still

may be unique circumstances when such markets should exercise the discretion not to

bust a trade that on its face, would appear to be a clearly erroneous trade. The classic

example is an unsuccessful attempt to "turn" the market by entering a large offer through

multiple levels of resting bids. If the market subsequently regroups at that lower level,

the market participant realizes instantaneous open trade equity on all of the sales at higher

prices. If the strategy fails and the market regroups to where it was before the attempt,

the market participant cries "clearly erroneous error" and requests that the trades outside

of the no bust collar be busted. There are undoubtedly other examples where some

discretion should remain with the organized market. Such discretion can and should be

used by organized markets in a manner that would only enhance, rather than undermine a

much needed sense of predictability to the process.
31

3.4.5 Fees, Penalties and Forfeiture

After the organized market has made an expeditious and impartial decision to bust a

trade, it must make a determination of what consideration (if any) should be awarded to

the counterparty(s) to the busted trade and what further punitive measures would fit the

circumstances. There is some evidence to suggest that establishing a flat fee or a fee

based on quantity for simply requesting that a trade be busted, can be an effective tool to

deter claims involving trades that would otherwise have little or no market impact. At

least one organized market passes this fee through to the counterparty(s) to the trade for

the inconvenience (and expense) of their involvement.

Errors of every kind and motivation tarnish the image of the organized markets on which

they occur. At some extreme point, concern that legitimate trades might not stand, could

actually precipitate an outright loss of business. Those that might attempt to improperly

profit from the nuances of the system need to be otherwise deterred from doing so.

Those that simply make an innocent mistake should still participate in the adverse

economic consequences of their actions. Organized markets should establish, maintain

and widely publish their respective guidelines for penalties and forfeiture related to

clearly erroneous trades on their electronic markets and web sites.

Organized markets' penalties and forfeiture should be proportionate to the market

mayhem caused, tempered by a determination (if at all possible) of intent. The recent

(error) performance of market participants should be taken into consideration when

assessing penalties and/or forfeiture. A sliding scale of increasing penalties and

forfeiture for repeat offenders has been shown to provide an effective economic incentive

to improve procedures and/or to hire more or more experienced personnel. There is some

evidence to suggest that the threat of losing one's anonymity (should the relevant market

participant again be involved in (cause) another clearly erroneous trade in the

immediately foreseeable future) can cause remarkably recuperative performance.

In general, any basis for assessing fees, penalties and forfeiture should be well known in

advance, be predictably applied, be proportionate to the market mayhem caused (or

proportionate to the gravity of intentional acts that prove to be detrimental to the

exchange), provide an economic disincentive for future poor performance and should not

be based upon the class of market participant(s) involved. Organized markets should also

retain the discretion to penalize market participants in situations where clearly erroneous

trades are not necessarily broken.57

 

57 Specific reference is made to the last paragraph of the Transaction Resolution section.
32

3.4.6 Training and Standardization

Individual staff of both market participants and organized markets should be identified as

error resolution specialists. They must be adequately trained, particularly so for market

participants that must deal with the currently disparate error resolution policies of a

number of organized markets. Critical (error resolution specialist) contact information

should be distributed widely to potentially interested parties by organized markets, trade

intermediaries and market participants.58

Intuitively, as organized markets operating electronic venues continue to mature,

particularly in the U.S., common business sense would suggest that some uniform best

practice for the resolution of clearly erroneous trades would emerge as a standard. In a

truly innovative industry, some trial and error may still likely provide the best way to

arrive at an optimal standard. The further passage of time might also cause refinement to

a standard after one has been established.

Forces of consolidation and globalization have the potential to positively affect the

potential emergence of common best practices among organized markets operating

electronic markets. With increasing frequency, many of the same major firms (or their

affiliates) account for a significant proportion of the transactionalized volume of the

world's organized markets. It behooves these large firms, trade associations, selfregulatory organizations and exchanges to proactively work towards homogenizing these

error resolution practices into a best practices template. Simply said, this will otherwise

occur naturally and later; with some coordinated effort, it could and should occur sooner.

Markets may independently establish disparate policies for resolution of clearly

erroneous trades occurring on electronic venues. Confidence in US futures markets

would likely decline if public customers were (respecting trades that were or were not

busted on multiple venues) treated unequally or unfairly, particularly on undirected

trades. The absence of both a unified quotation system and a central limit order book

increases the probability that this might occur. If unable to reach a reasonably uniform

approach among domestic organized electronic markets trading economically equivalent

products, the CFTC should have the authority to interceded in an effort to, at a minimum,

homogenize otherwise disparate error resolution policies. It is not clear that the CEA or

the CFMA currently conveys this authority.

 

58 If possible, phone numbers for error resolution personnel (critical contacts) should be generously

distributed and easy to remember.
33

3.5 Market Makers59

3.5.1 Background

The subcommittee defines "market makers" as incented liquidity providers that are

specifically contracted to operate under structures administered by organized markets

operating electronic venues. Market makers are given financial consideration and/or

granted market access privileges in return for maintaining some minimum market

presence in a particular product.60 Market makers provide significant public benefits by

generating liquidity for nascent products. The market access preferences (often

exclusive) granted to market makers most typically translate into a revenue stream that is

roughly approximated by the quotient of the magnitude of the market access preferences

granted multiplied by the magnitude of the order flow of market participants over which

these advantages might be applied.

Market makers take an economic chance61 that their early support (by their committed

presence) of one nascent product (which, despite their effort might prove to be entirely

unsuccessful) would preclude them from otherwise getting in on the ground floor on

another product or simply trading a mature product in other than a market maker

capacity. Other than any pure financial incentives that might be provided by the

organized market, the real expense of maintaining a market maker structure falls entirely

on the order flow of market participants active in that product.

It is generally agreed that in the very early stages of developing a product, market makers

are often undervalued, i.e., they may provide greater public benefit than the profits that

they can generate (at a public cost). As a product begins to mature, sustainable liquidity

begins to develop naturally, and a single market venue begins to emerge as the victor, the

 

59 The best practices recommended in this section are intended to apply only to reasonably mature products

(or individual contract months or options series) listed for trading on organized electronic markets. More

specifically, the best recommended practices assume that, for a given product, there is (1) a single

successful organized market, (there may be more than one market, but one market clearly dominates); (2)

that market is perceived to be the primary source of price discovery for the majority of relevant commercial

market participants; (3) the liquidity in that product would, at a minimum, be described as reasonably

sufficient, i.e. it would not be described as a nascent product by most commercial market participants; and

(4) the market venue is electronic.

60 The subcommittee recognizes that even in mature contracts, there may very well be specific contract

months or options series (within a product) where the presence of a market maker would be beneficial. In

many cases, the subcommittee's recommendations should be applied at the contract month or options series

level, rather than the contract or product level. Some organized markets have rules that include criteria

specifically meant to capture the essence of reasonable market liquidity for the purpose of determining

when dual trading of certain contract months or option series should be permitted or not. It is not at all

clear why similar criteria have not been developed and applied to market maker structures. The

subcommittee specifically suggests this idea as a good starting point from which the concept might more

easily be implemented.

61 The opportunity cost of taking such a chance is diminished if the incentives granted to market makers are

largely financial, as the subcommittee recommends.
34

public benefits and public costs of maintaining a market maker structure become roughly

proportionate. It is only after sustainable market liquidity establishes itself more

naturally through competitive forces that the subcommittee takes issue with the

proportionality of the public benefits versus the public costs. For it is at precisely this

starting point of measurement that the cumulative public benefits and cumulative public

costs may disconnect in radical disproportion. In a truly mature product, the order flow

may be many orders of magnitude greater than when the product was developing. The

public costs (ostensibly a tariff on the order flow of market participants) of continuing to

maintain a market maker structure in a mature product can be considerable. Conversely,

as liquidity becomes more self-sustaining than not, the tangible public benefits often

become questionable at best.

In many cases, market access privileges granted to market makers have been granted in

perpetuity, allowing the current holder to actually sell the future rights to this public cost

to another as a private asset. Selling such a franchise (a capitalized stream of anticipated

future revenues [public costs]) rewards the holder of the private right for a future period

of committed market maker service that they then never perform. Worse, it provides

every economic incentive to the new holder of this private right to exploit their respective

market access privileges to the fullest, extracting the maximum possible revenue stream

off the order flow of market participants just to recapture his or her investment.

3.5.2 Business Models

Those that would attempt to economically justify granting market maker (market access)

privileges in perpetuity attempt to ground their arguments on the venture capitalist model.

Simply stated, in order to incent market makers to provide this function and commit their

capital, they are entitled to a potential profit proportionate to the magnitude of the future

order flow of the product. This argument collapses in several aspects. The first issue is

one of potentially unwarranted or disproportionate enrichment. The true success of the

relevant product may have little or nothing to do with the performance of the market

maker at all (or the risks undertaken). Venture capital markets are swift to reward or

penalize venture capitalists' real performance. Said another way, the product might just

have been the better mousetrap that was launched at exactly the right time. Additionally,

organized markets, having national implications, are not at all comparable to widget

shops that can just spring up if venture capital is available. They are heavily regulated

institutions only undertaken with some sense of gravity. If derivatives exchanges were

actually funded with venture capital, it is far more likely that they would internalize all

possible revenue streams. The last thing they would do would be to allow market access

privileges to be privatized, to be bought and sold as the private assets of others. The most

convincing argument against the appropriateness of the venture capitalist model turns on

the issue of monopoly powers and the inherent ability to extract monopoly rents. Venture

capitalists are never granted instant monopolies and are seldom if ever in a position to

pass rules that shield them from competitors.
35

A far more appropriate (but still generously imperfect) business model that might better

be applied to nascent products traded on organized markets would be that of granting

patents.62 In an effort to promote the general well being, patents are granted for unique

products and services from pharmaceuticals to jet engines. By intentionally granting

patents for finite periods, it is recognized that not only do risk takers need to be

concomitantly rewarded for their ideas and performance, but that the associated public

costs should not be open-ended. It is truly difficult to identify any other commercial

market sector (other than a few privately held power utilities) where national authorities

have approved (either by review or failure to review) the practice of permitting private

sector monopoly powers to be granted in perpetuity. This practice, in those instances that

are of real concern to the subcommittee, has the potential to provide a disconnect

between the public benefits and public costs associated with public sector regulation

and/or private sector rules. This disconnect runs completely contrary to the

subcommittee's basic tenet of presumptive responsibility.

3.5.3 Tying

A potential practice that could also have adverse public policy implications relates to the

manner in which organized markets might issue or assign specific market maker

privileges and responsibilities. Just as certain forms of "tying" have been determined to

be improper in banking,63 this practice should be reviewed were it to be considered by

organized markets inaugurating market maker structures. If a market maker or

association of market makers were assigned to make markets in, for example, 15

products, two of which were reasonably mature (and arguably didn't require the

continued presence of a market maker at all) and the remaining 13 were truly nascent

products, then it would be reasonably likely that most of the public costs of sustaining the

market maker structure would fall on the order flow of market participants involved in

the two mature products, and most of the public benefits would be received by market

participants involved in the 13 nascent products. The potential for this phenomenon

would reflect a disconnect between the distribution of those incurring the public costs and

those receiving the public benefits.

3.5.4 Approach

The determination of when organized markets should begin to consider dismantling

market maker structures is indeed a difficult one. The factors involved in that

determination would arguably be fewer and less complex for an organized market that

has demutualized and where pure economic considerations and competitive factors would

 

62 Patents are a public policy tool specifically designed to ensure that public costs of innovation do not

become open-ended. This is a discussion of patents within the context of business models. It is not a

discussion of patents within the context of organized electronic markets. The subcommittee makes no

opinion about the appropriateness of applying business process patents to organized electronic markets.

63 Christian A. Johnson, "Holding Credit Hostage for Underwriting Ransom": Rethinking Bank Antitying

Rules, 64 University of Pittsburgh Law Review (Issue No. 1 2002).
36

almost certainly carry the day over entrenched private interests. There have been

instances where the presence of a committed market maker was voluntarily or

involuntarily terminated and order flow was lost. An organized market may wish to

reintroduce a committed market maker for a particular product to defend it against a new

competitive product introduced by another exchange.

The real difficulty of recommending best practices for market maker structures is that

there is an "appropriateness continuum" of examples that can be observed only

retrospectively, and that this report, by its very nature, must be written and presented at a

single moment in time; while its recommended best practices must past the test of time.

This appropriateness continuum runs from white to gray to black of examples that

represent degrees of the balance or imbalance between (1) ensuring that talented market

makers are rewarded for making markets and developing liquidity in nascent products

when no one else seems willing to do so and before sustainable liquidity has otherwise

developed, and (2) ensuring that there is never an egregious disconnect between the

public benefits and the (seemingly open-ended) public costs associated with perpetuating

market access preferences.

The subcommittee's issue at hand is persuading interested parties, that (1) whether

currently or at some point in the future, there is the potential that the proportion of the

cumulative public benefits and cumulative public costs associated with a market maker

structure is unacceptably inappropriate (the black zone); and (2) that there may currently

be observable instances of abuse within that zone. Precisely where gray stops and where

black begins will change somewhat over time. It is the subcommittee's intent that by

sharing the tenets and basic criteria that were used when developing best practices for

market maker structures, future analyses of the equitability of market access might

effectively be continued by others.

3.5.5 Competition and Client Choice

The subcommittee is unanimously of the opinion that bona fide competition among

electronic venues (for products that are economic equivalents) will always ameliorate

most concerns over market maker structures. Competition among organized markets

usually comes with significant public benefits. However, when all organized markets

trading economically equivalent mature products are similarly laden with the overhead of

market maker structures, competition comes with significantly fewer public benefits than

when at least one organized market provides market participants with a real selection of

unbundled services from which they can determine which services they may wish to buy

and which they may not.

The comment has been made that continued presence of market maker structures is an

effective strategy for organized markets and entrenched market makers to keep

competitive initiatives at bay. Bearing in mind the significant public costs of maintaining

market maker structures in mature products, and the benefits of competition between
37

markets, it is not at all clear what proportionate public benefit would be provided by

doing so.

Competition among all market participants creates public benefits. To the degree that a

market maker begins to be exposed to legitimate competition from other non-market

maker market participants, its continued presence and associated public costs should

automatically cause the relevant organized market(s) to reassess the appropriateness of

continuing the market maker program for that product.

3.5.6 Market Maker Incentives

Some organized markets currently provide incentives to market makers by providing

financial incentives and/or time, place, informational or priority advantages, including

superior speed of order trade transmission, reduced fees and guaranteeing the market

maker some minimum portion of the order flow of market participants. In nascent

products, where market maker structures continue to be appropriate, and/or where

organized markets compete with each other with economically equivalent products,

organized markets should have the flexibility to offer a broad range of incentives to

market makers. The majority of subcommittee members, however, felt that financial

incentives alone, should be sufficient under most circumstances.

Recommendation: An organized market operating an electronic venue should not, other

than under unusually illiquid circumstances, provide privileged market access to market

makers by violating the time/price paradigm within the order book. Under no

circumstances should any class of market participant’s orders be allowed to violate the

time/price paradigm, other than orders of market makers.

It is suggested that fee or other monetary incentives64 alone, should provide adequate

incentive to attract sufficient liquidity provider(s) with far less public costs than violating

the time/price paradigm. Said another way, all financial incentive alternatives should be

exhausted before pursuing non-financial alternatives.

Recommendation: In all cases, organized markets should ensure that all market

participants have ready access to a full description of the time, place, informational, or

priority advantages that market makers have been granted, (by product or product type,

should market maker advantages differ by product type).

 

64 Reference is made to the recommendation on page 11 and Section 3.3, Transparency. Organized

markets could offer reduced quotation fees to market makers, including a reduced fee structure for

bandwidth usage. It is reasonable to assume that a market maker in an all-electronic venue would likely

incur significant bandwidth usage fees. An organized market's ability to significantly reduce such

bandwidth usage fees would appear to be a perfect opportunity to provide significant financial incentives.
38

Organized markets should be able (and encouraged) to privately negotiate the financial

incentives and arrangements that it makes with its market makers. While the financial

incentives are largely private contracts and are likely best kept that way, market maker

responsibilities should be made available to the public.

To the degree that an organized market decides to grant market makers market access

privileges beyond or in lieu of financial incentives, all market participants have a right to

know the terms of those non-financial incentives. Market makers' market access

preferences can directly affect the manner in which a non-market maker order might be

executed. Some market participants may not care. Those that do, must have access to

sufficient and relevant information on the time, place, informational or priority

preferences granted to market makers so that they might draw their own conclusions

about the potential impact that those market access preferences might have on the

execution of their respective orders.

3.5.7 Public Policy Issues

Market maker structures provide a significant public benefit by maintaining some defined

minimum level of market liquidity in nascent products (presumably when no one else is

willing to do so) and often contribute to maintaining “orderly” markets. The public is

not, however, well served when market maker structures are not dismantled well after

sustainable market liquidity establishes itself naturally. There may be products or

circumstances where market liquidity is particularly slow65 to develop; therefore, some

appropriate criterion of minimum market liquidity rather than the passage of time should

determine an appropriate frequency with which the continued presence of market maker

structures should be reviewed.

Recommendation: The continued presence and rationale of market maker structures (by

product) should be reviewed with a frequency that automatically increases as sustainable

market liquidity in the relevant product increases. The onus should be on the organized

market to again justify the continued presence of privileged market maker structures

based on economic and illiquidity factors.

Any appropriate analysis of market maker structures should reflect the same public policy

issues that were addressed when the government established the regulatory structures that

place limiting parameters on patents and copyrights. National authorities, pursuant to the

oversight responsibilities delegated to them, should not permit marketmaking structures

to degenerate into perpetuities, ostensibly levying a permanent parasitic tariff on the

 

65 Scott Johnston's soon to be famous pickle derivatives example makes this point well. There may be

products, e.g. pickles that have a concentration of commercial interest (either as buyers or producers). End

user participation may be intermittent, cyclical or just slow to develop. In such cases, any reasonable

analysis of the liquidity in pickle derivatives would conclude that the public good would likely be best

served by continuing a market maker structure. This is consistent with the subcommittee's approach to

market maker structures.
39

order flow of market participants. As liquidity develops with predictable consistency,

market maker programs should be reevaluated to ensure that the public costs (market

maker benefits) directly or indirectly through fee incentives incurred are appropriately

proportionate to the public benefits received by investors when the market maker

program was inaugurated.

Recommendation: Market makers should be allowed to earn a not unreasonable, risk

adjusted return for their services. A structure that requires market makers be “held” for

no more than a “one lot” or some other veritably meaningless quantity should be

allowed to earn a concomitantly de minimus risk adjusted return on capital.

In attempting to address the public policy issues that are germane to market maker

structures, the subcommittee looks to an appropriate balance between the relevant

tradeoffs involved. Just as a market maker's return can become excessive when its

market access privileges continue to be applied to the order flow of a mature product, a

market maker's return can appear equally excessive if he or she is required only to

assume some infinitesimal minimum market presence. The magnitude of private benefits

is not in dispute. The net present value of the potential profits associated with the ability

to maintain a time, place, informational or order priority advantage, non-competitively

and in perpetuity, over the order flow of market participants is a very valuable (and

arguably disproportionate) private benefit which comes entirely at the expense of the

international investing public.

Recommendation: If market maker structures are not dismantled after sufficient liquidity

develops, then the quantity for which a market maker is held should be consistently

proportionate to an appropriate liquidity criterion66 for as long as the market maker

structure is then perpetuated.

First and foremost, the subcommittee is strongly of the opinion that market maker

structures should be dismantled once sufficient liquidity develops within a series/product.

Organized markets should have policies and procedures in place to recognize when

market maker structures are no longer required. One way to provide an automated

"liquidity reality check" on a market maker structure would be to increase the quantity for

which the market maker is held in a manner such that it increases linearly as the liquidity

in the product increases. It would eventually become obvious even to the market maker,

that its services are likely no longer required. At some point (arguably a point well

beyond the [market liquidity] point at which the majority of subcommittee members

would have the relevant market maker structure dismantled), vintage market makers

would likely abandon their market preferences anyway, rather than be held to a quantity

three or four orders of magnitude greater than the quantities for which they were

originally held when the market maker structure was inaugurated.

 

66 Indicative criteria might be volume, average trade size, frequency of quotations (other than by the market

maker) open interest, incidents of block trades, etc.
40

4.0 Competitiveness

Intuitively, the best practices among internationally relevant organized electronic markets

should, over time, begin to reflect striking similarities. Arguably, best practices are

simply detailed articulations of common business sense, tempered with an appropriate

dose of equitability and fairness.

It has always been the expectation of the subcommittee that its recommended best

practices would find their way to other international regulatory fora to be reviewed,

debated and implemented. It is for this very reason that great care has been taken in

drafting this Final Report, to make domestic references sparingly, and only when

necessary for clarity.

In drafting the Final Report, the members and industry advisors of the subcommittee

drew upon their approximately 170 years of collective experience in derivatives and

global capital markets. Benefiting from such hindsight, the subcommittee recognizes that

asymmetric and/or isolated implementation of any best practices may, under certain

circumstances, have the unintended consequence of penalizing those organized markets

that have implemented best practices in an effort to excel. Over time, organized markets

that truly address the needs of all classes of market participants and strive to have the

very best business practices should be rewarded with the order flow of market

participants. It is equally incumbent on market participants to recognize that the

implementation of best practices that may be designed to serve them well, may be

accompanied by some added expense or inconvenience. Excellence does not just happen.

When addressing the subcommittee's recommended best practices, national authorities

should continue to be cognizant of competitive issues and, to the degree possible, coordinate their actions in an effort to minimize any significant potential dislocations of

business. It would be most unfortunate if organized markets striving to achieve

excellence were rewarded for their efforts by losing their respective order flow to markets

with lesser standards.

5.0 Further Analysis

While it is far from unanimous, there would appear to be an emerging consensus that

organized markets operating physical venues and automated venues will likely migrate to

electronic venues. Several things should be clarified: (1) many of those that have

expressed such an opinion are not necessarily in a position to exert any influence over the

process; (2) even among those that share this opinion, there are disparate opinions on

how long such a migration might actually take; and (3) the subcommittee is simply noting

the opinions of others and not itself, expressing any opinion on this issue. This issue is,

however, quite relevant as the subcommittee's Interim Report, expressed the collective

opinion of the subcommittee that its work should "...be allowed to continue, providing

the time and resources to examine similar market access issues germane to automated

market venues".
41

Undertaking this Final Report involved considerable resources. A professional review of

technology related issues in automated venues would be an even greater undertaking. If

organized markets operating automated venues are, indeed, likely to migrate to electronic

venues, the subcommittee's best practices will be awaiting them. Should this migration

be as inevitable as some would have us believe, not only would the subcommittee's

recommendations (for automated venues) have a particularly short shelf life, but again

attracting the caliber of talent to undertake such a review might prove difficult.

Accordingly, the subcommittee retracts its interim recommendation to continue its work

to study automated markets in favor of waiting for an appropriate period of time to

monitor the potential rate of migration from automated to electronic venues to determine

if undertaking a similar study of automated market venues would be appropriate.

6.0 Conclusion

The Market Access Subcommittee has completed its analysis of the public policy issues

relating to applications of technology to electronic organized markets as such

applications affect equitable market access, and submits its Final Report to the full

Technology Advisory Committee for its review and acceptance. The Final Report

addresses technology applications prior to trade execution, at trade match, information

dissemination after trade match and error resolution. The subcommittee’s guiding

principals were equity of market access, the considerable value of market transparency,

reasonable parity among all classes of market participants and balancing the public costs

of privileged market access against the expected public benefits.

The end product is a compilation of recommendations and best practices for organized

markets operating electronic venues and support for those recommendations, grounded in

public policy tenets. While it is understood that the instant relevance of the

subcommittee’s Final Report is to the CFTC, specific references to the Commission have

been intentionally minimized in this Final Report to maximize the potential

transportability of these best practices to organized markets subject to the supervisory

oversight of other national authorities.

The members of the subcommittee wish to join the chair in acknowledging the

considerable contribution of our industry advisors, Blair Hull and Bill Miller, and thank

them for sharing their insights and perspectives on these important issues.
42

Attachment I

TECHNOLOGY ADVISORY COMMITTEE MEMBERS

Matthew Andresen

President

The Island ECN, Inc.

David Battan

Vice President and General Counsel

Interactive Brokers LLC

Peter F. Borish

Senior Managing Director of Business Development

OneChicago

George Crapple

Co-Chairman and Co-Chief Executive Officer

The Millburn Corporation

Daniel Cunningham

Partner

Allen & Overy

John P. Davidson III

Managing Director

Morgan Stanley Dean Witter & Co., Inc.

Yvonne J. Downs

Senior Vice President of Compliance

National Futures Association

Bryan T. Durkin

Senior Vice President and Administrator

Office of Investigations and Audits and Order Routing

Chicago Board of Trade

Robert Fitzsimmons

President and Chief Operating Officer

Nasdaq Liffe Markets

Richard Friesen

Managing Partner

Friesen Consulting
43

Jim Heinz

Managing Partner

Marquette Partners LP

Audrey Hirschfeld

Senior Vice President and General Counsel

New York Board of Trade

Kent Horsager

President and Chief Executive Officer

Minneapolis Grain Exchange

Philip McBride Johnson

Head of Exchange-Traded Derivatives

Skadden, Arps, Slate, Meagher & Flom LLP

Scott Johnston

Managing Director and Chief Information Officer

Chicago Mercantile Exchange

Anthony Leitner

Managing Director and General Counsel for Equities

Goldman Sachs

John W. McPartland

Financial Markets Advisor to the

 Federal Reserve Bank of Chicago and

Capital Markets Advisor to the

 Center for Law and Financial Markets (IIT)

Hank Mlynarski

President

BrokerTec Futures Exchange LLC

BrokerTec Clearing Company LLC

Laurence Mollner

Managing Member

Mariah Trading Company LLC

Brett Paulson

Senior Vice President and Chief Information Officer

Board of Trade Clearing Corporation
44

Robert R. Petersen

President and Chief Executive Officer

Kansas City Board of Trade

Kenneth M. Raisler

Partner

Sullivan & Cromwell

Edward J. Rosen

Partner

Cleary Gottlieb, Steen & Hamilton

Neal Wolkoff

Executive Vice President

New York Mercantile Exchange
45

Attachment II

MARKET ACCESS SUBCOMMITTEE MEMBERS, AND INDUSTRY

ADVISORS

MEMBERS

David Battan

Vice President and General Counsel

Interactive Brokers LLC

Chris Concannon

Vice President of Business Development

The Island ECN, Inc.

Jim Heinz

Managing Partner

Marquette Partners LP

Scott Johnston

Managing Director and Chief Information Officer

Chicago Mercantile Exchange

Anthony Leitner

Managing Director and General Counsel for Equities

Goldman Sachs

John W. McPartland (Chair)

Financial Markets Advisor to the Federal Reserve Bank of Chicago and

Capital Markets Advisor to the Center for Law and Financial Markets (IIT)

Neal Wolkoff

Executive Vice President

New York Mercantile Exchange

INDUSTRY ADVISORS

Blair Hull

Matlock Capital LLC, and

Founder of Hull Trading Company

William Miller

Independent Risk Oversight Officer, Commonfund Group, and

Chairman, End Users of Derivatives Council