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[Federal Register: November 25, 2003 (Volume 68, Number 227)]
[Proposed Rules]
[Page 66032-66040]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr25no03-14]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 36


Exempt Commercial Markets

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rule.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'') is
proposing two actions relating to electronic trading facilities that
operate in reliance on the exemption in section 2(h)(3) of the
Commodity Exchange Act (``the Act''). First, the Commission is
proposing to amend Rule 36.3(b), which governs Commission access to
information regarding transactions on such trading facilities, to
provide for access to more relevant and useful information from all
such markets. Second, the Commission is proposing rules that would
require those electronic trading facilities that operate in reliance on
the exemption in section 2(h)(3) and that perform a significant price
discovery function for transactions in the underlying cash market to
publicly disseminate certain specified trading data. These price
discovery rules are being proposed pursuant to section 2(h)(4) of the
Act, which authorizes the Commission to prescribe rules and regulations
to ensure timely dissemination by such trading facilities of price,
trading volume, and other trading data to the extent appropriate.

DATES: Comments must be received by January 26, 2004.

ADDRESSES: Comments should be sent to the Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington,
DC 20581, attention: Office of the Secretariat. Comments may be sent by
facsimile transmission to 202-418-5521 or, by e-mail to [email protected]. Reference should be made to ``Proposed Rules for
Exempt Commercial Markets.''

FOR FURTHER INFORMATION CONTACT: Nancy E. Yanofsky, Chief Counsel (telephone 202-418-5292, e-mail [email protected]), or Don Heitman,
Senior Special Counsel (telephone 202-418-5041, e-mail [email protected]), Division of Market Oversight, Commodity Futures
Trading Commission, Three Lafayette Center, 1155 21st Street, NW.,
Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

    The Commodity Futures Modernization Act of 2000 (``CFMA''), Pub. L.
106-554, created an exemption from the Commission's jurisdiction for
transactions conducted on certain electronic commercial markets
(``exempt commercial markets,'' ``ECMs'' or ``Sec.  2(h)(3) markets'').
Specifically, Sec.  2(h)(3) of the Act provides that, except to the
extent provided in Sec.  2(h)(4), nothing in the Act shall apply to a
transaction in an exempt commodity \1\ that is: (a) Entered into on a
principal-to-principal basis solely between persons that are eligible
commercial entities at the time the persons enter into the agreement,
contract, or transaction; and (b) executed or traded on an electronic
trading facility. Section 2(h)(4) provides that a transaction described
in Sec.  2(h)(3) shall be subject to certain specified provisions of
the Act, such as the Act's antimanipulation and antifraud provisions,
and furthermore, that such transactions shall be subject to price
dissemination rules if the electronic trading facility serves a
significant price discovery function for the underlying cash market.
Section 2(h)(5) requires an electronic trading facility relying on the
exemption in Sec.  2(h)(3) to provide the Commission with certain
information and to comply with information access provisions set out in
Sec.  2(h)(5)(B)(i).
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    \1\ Under the Act, exempt commodities generally are tangible,
non-agricultural commodities and include energy and metals products.
See Sec.  1a(14) of the Act, 7 U.S.C. 1a(14).
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II. Information Access Provisions

    Section 2(h)(5)(B)(i) of the Act requires an electronic trading
facility relying on the exemption provided in Sec.  2(h)(3) to provide
the Commission with information regarding trading activity on the
facility. The statute establishes two alternatives for providing that
information:

    (I) provide the Commission with access to the facility's trading
protocols and electronic access to the facility with respect to
transactions conducted in reliance on the exemption set forth in
paragraph (3); or
    (II) provide such reports to the Commission regarding
transactions executed on the facility in reliance on the exemption
set forth

[[Page 66033]]

in paragraph (3) as the Commission may from time to time request to
enable the Commission to satisfy its obligations under this Act.

These two statutory alternatives are referred to hereafter as,
respectively, the ``electronic access option'' and the ``reporting
option.''
    Regulation 36.3(b)(1), published on August 10, 2001, was intended
to implement the foregoing statutory provisions. It provides as
follows:

    (b) Required information. (1) A facility operating in reliance
on the exemption in section 2(h)(3) of the Act, initially and on an
ongoing basis, must:
    (i) Provide the Commission with access to the facility's trading
protocols and electronic access to transactions conducted on the
facility in reliance on such exemption; or
    (ii) Attach its initial trading protocols and any amendments
thereto in hard copy form to the notification required in paragraph
(a) of this section and provide in a form and manner acceptable to
the Commission, as determined by the Commission in response to a
petition by the exempt market relying on the exemption in section
2(h)(3) of the Act, information regarding transactions by large
traders on the facility.

    To date, those trading facilities that have sought to comply with
this regulation have generally chosen the former, the electronic access
option. In applying the electronic access option, the Commission has
generally accepted from ECMs electronic access to their trading
protocols (i.e., the trading agreements and/or other terms and
conditions applicable to trades on the facility, generally available on
their Web sites) in addition to view-only electronic access to the data
stream of trades taking place on the system. The Commission suggested,
when it adopted Part 36, that such electronic access would provide
information similar to that provided by large trader reports filed with
the Commission with respect to trading on designated contract markets:

    The [electronic] access requirement provides the Commission with
information on a routine, ongoing basis, thereby serving many of the
functions that large trader reports serve on the regulated markets.
Using this access, the Commission is able to surveil transactions on
the market in order to enforce its anti-manipulation authority.\2\

    \2\ 66 FR 42264, Aug. 10, 2001.
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    In practice, however, the Commission's Division of Market Oversight
(``Division'') has found that the view-only information provided under
the electronic access option, by those trading facilities that have
filed notifications under section 2(h)(3) over the last 24 months, is
neither as relevant,\3\ nor as useful,\4\ as anticipated.
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    \3\ The electronic access option, as currently applied, gives
the Commission information regarding all contracts traded on an
ECM's trading facility. This may include a large amount of
irrelevant, extraneous data regarding contracts that are not
contracts for future delivery of a commodity, or options, and are,
therefore, not within the Commission's exclusive jurisdiction.
    \4\ The Division's surveillance staff have determined that the
information available through the current view-only electronic
access to ECM trading facilities is not, in fact, equivalent to the
large trader information received with respect to designated
contract markets.
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    Therefore, the Commission is proposing to amend its regulations to
focus Rule 36.3(b)(1) more precisely so as to provide the Commission
with access to more relevant and useful information regarding trading
activity on exempt commercial markets. Under the amended rules, an
electronic trading facility filing a notification with the Commission
under Rule 36.3 would be required, initially and on an ongoing basis,
to: (1) Provide the Commission with access to the facility's trading
protocols, either electronically or in hard copy form; (2) identify
those transactions conducted on the facility with respect to which it
intends to rely on the exemption in section 2(h)(3); and (3) inform the
Commission whether it intends to satisfy the information access
requirement of section 2(h)(5)(B)(i) of the Act with respect to such
transactions through the electronic access option provided in paragraph
36.3(b)(1)(ii)(B), or the reporting option provided in paragraph
36.3(b)(1)(ii)(A), as described below.
    The trading facility would not be required to include among the
agreements, contracts or transactions for which it is seeking an
exemption those agreements, contracts or transactions that are not
contracts for future delivery of a commodity, or options, and are,
therefore, not subject to the Commission's exclusive jurisdiction.
Thus, for example, the trading facility would not be required to
identify, or provide information with respect to, agreements, contracts
or transactions involving ``any sale of any cash commodity for deferred
shipment or delivery.'' Such transactions are excluded from the
Commission's exclusive jurisdiction under section 1a(19) of the Act
(commonly referred to as ``the forward contract exclusion''). Neither
would a trading facility be required to identify, or provide
information with respect to, agreements, contracts or transactions that
constitute cash or spot transactions, which are contracts for present,
rather than future, delivery and likewise are not subject to the
Commission's exclusive jurisdiction.
    In complying with amended Rule 36.3, trading facilities shall make
their best effort to identify to the Commission only those agreements,
contracts or transactions that are subject to the Commission's
exclusive jurisdiction and with respect to which they intend to rely on
the exemption provided in section 2(h)(3). Should a new agreement,
contract or transaction be added, or an existing one amended, that
would be traded in reliance on the exemption, the trading facility
should amend its notice accordingly.
    A trading facility that does not offer trading in any futures or
option contracts subject to the Commission's exclusive jurisdiction--
for example, a facility where only cash or forward contracts are
traded--is not required to file a notification under Rule 36.3. Such a
facility is not subject to the Commodity Exchange Act.
    Consistent with section 2(i) of the Act,\5\ the mere fact that it
was identified as being traded in reliance on the section 2(h)(3)
exemption would not be construed as creating a presumption that any
agreement, contract or transaction is or otherwise would be subject to
the Act. Thus, for example, in any enforcement action involving any
such agreement, contract or transaction, the Commission would be
required to prove its jurisdiction independently of an ECM's
identification of that agreement, contract or transaction for purposes
of information access under Rule 36.3. Also, should a trading facility
seeking in good faith to comply with Rule 36.3 fail to identify for
information access purposes a particular agreement, contract or
transaction, which is later determined to be a futures or option
contract subject to the Commission's exclusive jurisdiction, such
failure would not be construed by the Commission as a violation of
section

[[Page 66034]]

4(a) of the Act.\6\ However, such transaction would still remain
subject to the Commission's antifraud and antimanipulation authority.
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    \5\ Section 2(i) of the Commodity Exchange Act provides that:
    (1) No provision of this Act shall be viewed as implying or
creating any presumption that --
    (A) any agreement, contract or transaction that is excluded from
this Act under section 2(c), 2(d), 2(e), 2(f), or 2(g) of this Act
or Title IV of the Commodity Futures Modernization Act of 2000, or
exempted under section 2(h) or 4(c) of this Act; or
    (B) any agreement, contract or transaction, not otherwise
subject to this Act, that is not so excluded or exempted is or would
otherwise be subject to this Act.
    (2) No provision of, or amendment made by, the Commodity Futures
Modernization Act of 2000 shall be construed as conferring
jurisdiction on the Commission with respect to any such agreement,
contract or transaction, except as expressly provided in section 5a
of this Act (to the extent provided in section 5a(g) of this Act),
5b of this Act, or 5d of this Act.
    \6\ Section 4(a) of the Act makes it unlawful to trade a
contract for future delivery of a commodity in the U.S. unless on a
contract market designated by, or a derivatives transaction
execution facility registered with, the Commission.
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    Trading facilities electing to provide information under the
reporting option would be required to file weekly reports containing
information that could be useful to the Commission in enforcing its
antifraud and antimanipulation authority with respect to those trading
facilities. Such reports would include, in a form and manner approved
by the Commission, a report for each business day, showing for each
transaction executed on the facility in reliance on the exemption set
forth in section 2(h)(3) the following information: the commodity, the
location,\7\ the maturity date, whether it is a financially settled or
physically delivered instrument, the date of execution, the time of
execution, the price, the quantity, and such other information as the
Commission may determine, and for an option instrument, the type of
option (call or put) and the strike price. Each such report would be
required to be electronically transmitted weekly, within such time
period as is acceptable to the Commission following the end of the week
to which the data applies.
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    \7\ In this context, ``location'' means the delivery or the
price-basing location specified in the agreement, contract or
transaction.
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    Those trading facilities wishing to provide information pursuant to
the electronic access option (Rule 36.3(b)(1)(ii)(B)) would be
required, initially and on an ongoing basis, to provide the Commission
with electronic access to those transactions conducted on the facility
in reliance on the exemption in section 2(h)(3). Such access must be
structured so as to permit the Commission to capture in permanent form
a continuing record of trades on the facility such that the Commission
would be able to reconstruct and compile the same information regarding
transactions on the trading facility that would otherwise be provided
by the trading facility under the reporting option (Rule
36.3(b)(1)(ii)(A)) described above.
    The Commission expects that the information that will be provided
by ECMs in reports required under Rule 36.3(b)(1)(ii)(A), or compiled
by the Commission through electronic access provided under Rule
36.3(b)(1)(ii)(B), will be useful in identifying aberrant price
behavior, including intraday price spikes. Such price anomalies may
serve as indicators of the need for further Commission investigation.
In such instances, the Commission may, among other things, use the
special call authority provided by section 2(h)(5)(B)(iii) to determine
whether a manipulation may have occurred warranting appropriate
enforcement action.
    This reactive oversight differs from that applicable to Designated
Contract Markets (``DCMs'') and registered Derivatives Transaction
Execution Facilities (``DTFs''). Those markets are subject to a greater
degree of regulatory oversight than ECMs and, accordingly, are required
to provide more frequent and detailed transaction data, which enables
the Commission not only to investigate and punish manipulation after-
the-fact, but to detect and prevent it as well.
    Proposed Rule 36.3(b)(1)(iii) would require a trading facility to
maintain a record of allegations or complaints concerning instances of
suspected fraud or manipulation. The record would be required to
include the name of the complainant, if provided, the date of the
complaint, the market instrument, the substance of the allegations, and
the name of the person at the trading facility who received the
complaint. The intent of this provision is to make clear that the
language of section 2(h)(5)(B)(ii) of the Act, which requires a trading
facility to maintain ``records of activities related to its business as
an electronic trading facility exempt under paragraph (3),'' extends to
maintaining records relating to allegations or complaints of fraud or
manipulation in trading activity on the facility.
    Proposed Rule 36.3(b)(1)(iv) would require a trading facility to
provide to the Commission a copy of the record of each substantive
complaint no later than three days after the complaint is received. The
basis for this requirement is the language appearing at the end of
section 2(h)(5)(B)(i)(II) (the reporting option), which states that
reports regarding transactions executed on the facility are provided
``to enable the Commission to satisfy its obligations under this Act.''
The purpose expressed in this language seems to apply not only to the
reporting subparagraph in which it appears, but also to the electronic
access subparagraph that precedes it. Clearly, the two subparagraphs
are intended to provide alternative methods of reaching the same
objective, which is to impart information to the Commission that will
enable it to perform its duties under the Act.
    Given the Commission's duty to enforce the antifraud and
antimanipulation provisions of the Act with respect to transactions
conducted in reliance on the section 2(h)(3) exemption, the Commission
believes it is crucial that ECMs report complaints of such activities.
Reports to the Commission are consistent with an ECM's ongoing
obligations under section 2(h)(5)(D) both to comply with paragraph
2(h)(5) itself and to require participants trading on the facility in
reliance on the section 2(h)(3) exemption to ``agree to comply with all
applicable law.'' Such reports are especially important given the
after-the-fact nature of the Commission's oversight of such trading
activity. It is also significant that the ECMs receiving these
complaints (unlike more highly-regulated DCMs or DTFs) have no self-
regulatory responsibility or authority, and thus no ability to respond
to such complaints themselves beyond denying the violator future access
to the trading facility. This creates an even greater need for the
Commission to receive information that will enable it to take action in
response to such suspected manipulation or fraud.
    It should be noted that the reporting requirement is limited to
``substantive'' claims of manipulation or fraud. The Commission's
intent in including this limitation is to allow an ECM to exercise its
judgment to weed out clearly frivolous claims.\8\
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    \8\ An ECM could, as an alternative to exercising such judgment,
choose to forward all complaints to the Commission.
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III. Price Discovery Provisions

    With respect to price dissemination rules, section 2(h)(4)(D)
specifically provides that a transaction described in section 2(h)(3)
shall be subject to:

    such rules and regulations as the Commission may prescribe if
necessary to ensure timely dissemination by the electronic trading
facility of price, trading volume, and other trading data to the
extent appropriate, if the Commission determines that the electronic
trading facility performs a significant price discovery function for
transactions in the cash market for the commodity underlying any
agreement, contract, or transaction executed or traded on the
electronic trading facility.

    On August 10, 2001, the Commission published Rule 36.3, which
implements the notification, information and other provisions of the
CFMA related to section 2(h)(3) exempt commercial markets. See 66 FR
42255. Subsection (c)(2) of Rule 36.3 provides that the Commission may
make a determination that such a trading facility performs a
significant price discovery function under section 2(h)(4)(D) by order,
and that such finding shall be made after notice and an opportunity for
a hearing

[[Page 66035]]

through submission of written data, views and arguments.
    To date, ten electronic commercial markets have notified the
Commission of their intent to operate as ECMs in reliance on the
section 2(h)(3) exemption. The Commission has issued acknowledgment
letters to seven ECMs, and is considering the issuance of
acknowledgment letters to the other three markets. In view of the
Commission's receipt of these section 2(h)(3) notifications, the
Commission now is proposing to add specificity to its price discovery
rules in several ways. First, the Commission is proposing to adopt two
criteria that the Commission will use to determine whether a section
2(h)(3) market performs a significant price discovery function for the
underlying cash market. Second, the Commission is proposing to specify
the information that must be disseminated by section 2(h)(3) markets
that serve such a significant price discovery function. Third, the
Commission is proposing certain amendments to its procedures for making
a price discovery determination.\9\
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    \9\ The types of instruments traded on exempt commercial markets
vary widely. Some of these instruments, but not all of them, are
subject to the Commission's exclusive jurisdiction. The Commission's
proposed rules are directed only to those instruments that are
traded in reliance on the section 2(h)(3) exemption and are
otherwise subject to the Commission's exclusive jurisdiction.
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A. The Elements of Price Discovery

    Price discovery commonly is defined as the process of determining
prices through the interaction of buyers and sellers. Prices may be
discovered by a single buyer and seller in a privately negotiated
bilateral cash market transaction, or through the simultaneous
interaction of multiple buyers and sellers in organized markets.
    Organized markets, which include futures markets and certain cash
markets where trading takes place in accordance with established rules,
often perform an important role in facilitating price discovery in the
broader cash markets. In particular, these markets facilitate price
discovery in cash markets by efficiently incorporating supply and
demand information for the underlying commodity into the transaction
prices or bids and offers through the operation of a centralized market
for the commodity. Thus, the price discovery process on organized
markets may significantly enhance the efficiency of the overall cash
market.
    The extent to which price information is used in establishing
prices for cash market transactions that occur outside of the organized
markets provides a relevant factor for determining the contribution of
that market to price discovery and for determining whether there is a
federal interest in the dissemination of such price information.\10\
Such price information may be used in varying degrees to facilitate the
establishment of prices and may also serve as one of a number of
sources of price information that are consulted by cash market
participants in developing bids, offers, or transaction prices. In
certain circumstances, such price information may be sufficiently well
regarded by the industry that it serves as an important benchmark for
cash market participants to consider in setting bids or offers or in
negotiating cash market transaction prices.\11\ In other circumstances,
prices discovered on a market may be such an integral and indispensable
part of the price determination process in the underlying cash market
that bids, offers or cash market transaction prices have a relatively
high correlation to the prices discovered on the market. This latter
practice is known as price basing.
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    \10\ It is this effect that section 2(h)(4) addresses when it
provides that information shall be disseminated by an exempt
commerciald market when ``the electronic trading facility performs a
significant price discovery function for transactions in the cash
market for the commodity underlying any agreement, contract or
transaction executed.''
    \11\ If the price information discovered on a market is widely
respected in an industry, such recognition by the industry in
question may lead to the publication of such information in
established industry publications.
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    Price basing is a frequently observed practice in many futures
markets and some cash markets. As indicated above, under price basing,
commercial entities establish transaction prices for the underlying
commodity, or a related commodity, based directly on the prices
discovered on an organized market. These entities may or may not trade
in the organized market. The cash market transaction prices established
through price basing may be either spot or forward prices.
    Prices discovered on futures or organized cash markets vary widely
with regard to their influence on transaction prices established in
broader cash markets. For instance, many long-established organized
markets for agricultural, metal, and energy commodities appear to
perform a crucial price discovery role for the broader cash markets, as
reflected by the widespread practice of price basing in many of these
markets. For example, for certain dairy products, the price discovery
function of established organized cash markets is so significant that
prices established on such markets are extensively used for price
basing even though the organized market's prices may be based on a
relatively small number of transactions. Similarly, prices established
on actively traded futures markets for commodities like grains,
oilseeds, natural gas and petroleum products are extensively used for
price basing. In contrast, newly established organized markets may be
less likely to perform a significant price discovery function for their
associated cash markets in their early stages of development.
    As indicated above, the relative significance of prices discovered
on an organized market for its underlying cash market is directly
related to the extent to which such prices are used in the
establishment of transaction prices between commercial entities. As a
result of this relationship, the use of a market's prices for price
basing, either directly or indirectly, provides observable indicia that
the market performs a significant price discovery function that would
serve as a basis for such a determination under section 2(h)(4).

B. Proposed Criteria for Making Price Discovery Determination

    While the Act authorizes the Commission to make a determination
that a section 2(h)(3) market performs a significant price discovery
function, it does not define that term or contain criteria to guide
that determination. Accordingly, the Commission is proposing to
establish the following two alternative criteria for determining that a
section 2(h)(3) market performs a significant price discovery function:

    (a) Cash market bids, offers or transactions are directly based
on or quoted at a differential to the prices generated on the market
on a more than occasional basis; or
    (b) The market's prices are routinely disseminated in a widely
distributed industry publication and are consulted by the industry
on a more than occasional basis for pricing cash market
transactions.

    Under the proposed criteria, a section 2(h)(3) market would be
deemed to be performing a significant price discovery function under
section 2(h)(4)(D) when a market's prices are used for price basing on
a more than occasional basis or are published in a widely distributed
industry publication and consulted by the industry on a more than
occasional basis for pricing purposes.\12\ As

[[Page 66036]]

discussed above, price basing as described under criterion (a) directly
confirms that the prices being generated on the market have significant
utility with regard to discovering prices in connection with cash
market transactions. Furthermore, publication of a section 2(h)(3)
market's prices in a widely distributed industry publication, and
industry consulting those prices on a more than occasional basis,
confirms that the prices are thought to be sufficiently reliable and
acceptable to be considered to be a significant source of price
discovery.
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    \12\ The Commission is aware of econometric techniques used by
academics to measure the relative contribution to the price
discovery process by various financial markets trading similar
assets (See, e.g., Hasbrouck, J., One Security, Many Markets:
Determining the Contribution to Price Discovery, Journal of Finance,
50 P 1175-1199, 1995.). However, the Commission understands that
these techniques would require price data for both the exempt
commercial market and for the individual transactions in the
associated cash market. These transaction prices may not be
published or otherwise available (indeed, cash market transaction
prices may be proprietary), which would preclude application of
these statistical techniques. Moreover, these techniques likely
would not be familiar to industry participants and may be costly to
perform. For these reasons, the Commission is not proposing to base
its criteria on the econometric techniques used in the academic
literature.
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    In evaluating a section 2(h)(3) market's price discovery role,
assessments under criterion (a) would include an analysis of whether
cash market participants are quoting bid or offer prices or entering
into transactions at prices that are set, either explicitly or
implicitly, at a differential to prices established on a section
2(h)(3) market. Cash market prices are set explicitly at a differential
to the section 2(h)(3) market when, for instance, they are quoted in
dollars and cents above or below the reference market's prices. Cash
prices are set implicitly at a differential to a section 2(h)(3)
market's prices when, for instance, they are arrived at after adding
to, or subtracting from, the section 2(h)(3) market's price, but then
quoted or reported as a flat price.\13\ The Commission will also
consider whether cash market entities are quoting cash prices based on
a section 2(h)(3) market's prices on a more than occasional basis. \14\
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    \13\ For example, if crude oil prices were generated on a
section 2(h)(3) market, price basing practices that would satisfy
criterion (a) would include cases where cash market bids or offers
would be explicitly quoted at a differential to the prices generated
on that market (e.g., ten cents per barrel above the exempt market's
price for crude oil delivered in July). In addition, criterion (a)
would encompass cases where cash market bids, offers or transaction
prices are quoted as a whole price (e.g., $30/barrel) and such price
is calculated implicitly by adding to, or subtracting from, the
section 2(h)(3) market's prices a specified price differential
(e.g., a $30/barrel quoted price is derived as the sum of a ten-cent
per barrel differential plus the exempt market's price of $29.90/
barrel).
    \14\ As in cash markets underlying many established futures
markets, the differential for a particular cash market bid, offer or
transaction may vary from time to time in response to changes in
various factors that affect the relationship between cash market
prices and prices discovered on a section 2(h)(3) market.
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    With regard to criterion (b), consideration would be given to
whether prices established on a section 2(h)(3) market are reported in
a widely distributed industry publication, such as Platts Oil Gram,
Inside FERC or the Lundberg Survey. In making this determination, the
Commission would consider the reputation of the publication within the
industry, how frequently it is published and whether the information
contained in the publication is consulted by industry participants for
pricing cash market transactions on a more than occasional basis.
    Under the proposal, an exempt commercial market would be required
to notify the Commission when it has reason to believe that one or more
of the markets that it is operating in reliance on section 2(h)(3) meet
either of the specified criteria.\15\ The Commission specifically asks
commenters to discuss potential financial costs and legal risks created
by the proposed notification requirement. Do the aforementioned
factors, specifically, that prices be used on ``more than an occasional
basis,'' and that they be ``widely distributed,'' provide enough
specificity to enable trading facilities to make a determination
regarding notification obligations. If not, what further guidance could
be provided that would enable a determination?
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    \15\ In addition, the Commission may, at any time, sua sponte,
conduct an assessment as to whether an exempt market is serving a
significant price discovery function for the associated cash market.
In this regard, the Commission would consider a number of factors in
deciding whether to initiate a review of a market's price discovery
function, including whether the market holds itself out as
performing a price discovery function for the underlying cash
market. To facilitate its review of a market's price discovery
function in such cases, the Commission is proposing to require that
an electronic trading facility operating in reliance on section
2(h)(3) notify the Commission when the facility commences holding
its markets out as serving a price discovery function.
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    Upon receipt of such a filing, the Commission's staff would conduct
an assessment of the facility's markets operated in reliance on section
2(h)(3) to identify those markets that perform a significant price
discovery function for the associated cash market. The scope of the
inquiry conducted by the Commission would vary. In the course of its
assessment, Commission staff might contact cash market participants to
verify the extent to which they refer to the market for price basing.
The assessment might also examine whether the section 2(h)(3) market,
although occasionally performing a price discovery function, failed to
do so on a more than occasional basis and thus does not perform a
significant price discovery function.
    If the available information indicates that a market is serving a
significant price discovery function for the underlying cash market,
the Commission would notify the section 2(h)(3) market that it appears
to be performing a significant price discovery function and provide the
market with an opportunity for a hearing through the submission of
written data, views and arguments. The Commission, after consideration
of all relevant information, would issue an order determining whether
or not the section 2(h)(3) market serves a significant price discovery
function.\16\
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    \16\ The proposed rules would also provide the market with an
opportunity to request at any time that the Commission review the
continuing appropriateness of its determination in light of changed
facts or circumstances.
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C. Information To Be Disseminated by a Price Discovery Market

    The Commission has not previously addressed the nature and scope of
the information that should be disclosed by a price discovery market
subject to section 2(h)(4)(D), other than by incorporating in its rules
the Act's requirement that the exempt commercial market disseminate
publicly ``price, trading volume and other trading data to the extent
appropriate with respect to transactions executed in reliance on the
exemption as specified in the order.'' See Commission Rule 36.3(c)(2).
In determining the nature and scope of the information that should be
disclosed under the proposed rules, the Commission has looked to other
provisions of the Act that impose public dissemination requirements on
other categories of regulated and unregulated markets.
    With respect to other markets, sections 5(d)(7) and (8) of the Act
require designated contract markets to make available to the public:
(i) Information concerning the terms and conditions of the contracts
and the mechanisms for executing transactions; and (ii) daily
information on settlement prices, volume, open interest, and opening
and closing ranges for actively traded contracts. Sections 5a(d)(4) and
(5) require registered derivatives transaction execution facilities to
disclose publicly: (i) Information concerning contract terms and
conditions, trading conventions, mechanisms and practices, financial
integrity protections, and other information relevant to participation
in trading on the facility; and (ii) if the Commission determines that
the

[[Page 66037]]

contracts perform a significant price discovery function for
transactions in the cash market for the commodity underlying the
contracts, daily information on settlement prices, volume, open
interest, and opening and closing price ranges for contracts traded on
the facility. Section 5d(d) requires exempt boards of trade (``EBOTs'')
to disseminate publicly on a daily basis information on trading volume,
opening and closing ranges, open interest, and other trading data
appropriate to the market if the Commission determines that the EBOT is
a significant source of price discovery for transactions in the cash
market for the commodity underlying the contracts.
    As noted, the Act only stipulates that an ECM should make available
``price, trading volume and other trading data to the extent
appropriate.'' However, as also noted above, this requirement is
unclear as to what precisely is intended to be made available to the
public by ECMs, especially with regard to the term ``price.'' Based on
the information that is required to be made available by a comparably
regulated market, the EBOT, the Commission requests comment on the
reasonableness of requiring similar information, including trading
activity measures, price information, and certain contextual
information. The Commission also requests comment on what contextual
information should be made available in order to assure that the public
can accurately interpret the meaning of the trading activity and price
information.
    Specifically, the Commission is requesting comment on a requirement
that the ECMs serving a price discovery function publicly disseminate
the following information on a daily basis:
    Contextual information:
    [sbull] Contract terms and conditions or product descriptions; and
    [sbull] Trading conventions, mechanisms, and practices.
Trading activity information:
    [sbull] Trading volume; and
    [sbull] Open interest, if available.
    Price information:
    [sbull] Opening and closing prices or price ranges;
    [sbull] High and low prices;
    [sbull] A volume-weighted average price; or
    [sbull] Any other price information approved by the Commission.\17\
---------------------------------------------------------------------------

    \17\ The section 2(h)(3) market may satisfy the dissemination
requirements by placing the information on its website, providing
the information to a financial information service, or using a
combination of these media. Furthermore, the section 2(h)(3) market
may disseminate such additional information as it believes is
appropriate for price discovery purposes. A section 2(h)(3) market
may also publish all of the information specified in proposed rule
36.3(c)(2)(iv) whether or not the Commission has made a price
discovery determination applicable to that market under rule
36.3(c)(2)(iii). Such voluntary dissemination by a section 2(h)(3)
market may, in appropriate circumstances, obviate the need for the
market to notify the Commission and for the Commission to make a
price discovery determination.
---------------------------------------------------------------------------

    The types of contextual, trading activity and price information
that the Commission proposes to require to be published potentially
would be useful to the price basing process; i.e., this information
potentially would be useful for commercial entities that do not
participate directly in a market, but use the market's prices as a
basis for setting prices for cash market transactions. The reasoning
regarding the individual elements of the proposed market information
reporting requirements is discussed below.
    Contextual information: Information regarding the terms and
conditions of the contracts traded on a Sec.  2(h)(3) market and the
market's trading rules is necessary to facilitate the public's accurate
interpretation of the meaning of data on prices and trading activity
reported by markets. This information collectively defines the items
being traded on a market as well as a contract's pricing basis and
therefore is critical to those who would gather information for
purposes of risk management, price basing, or speculation in the
market. Ill-defined products and trading conventions will not result in
prices with sufficient specificity to be useful for such purposes.
    Trading activity: It appears appropriate to require that exempt
commercial markets that serve a significant price discovery function
disseminate information related to activity in the market, such as
daily trading volume data and open interest (if such information is
available). In this regard, in futures and option markets, trading
activity most often is measured by volume of trading or open interest.
Volume of trading, which is required by statute to be provided by
exempt commercial markets, is the number of contracts transacted in a
commodity in a market over a specified period of time, generally
defined as a day. Daily trading volume data provide an indication of
the level of past interest in trading in a particular market. Markets
with consistently high trading volumes are generally considered to be
more liquid \18\ than those with lower levels of volume. Thus, the
availability of such information, which can serve as a measure of the
liquidity of the market on which prices are determined, is important
for the interpretation of the reliability of the prices on the market
and the general availability of this market statistic is important for
an exempt commercial market's continued functioning as a price
discovery mechanism.
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    \18\ Liquidity is a measure of a market's ability to absorb
large orders within a short period of time without requiring a
substantial change in price. Liquid markets are often described as
``broad'' and/or ``deep,'' whereas illiquid markets re often
described as ``thin.'' The liquidity of a market is an indication of
the quality or the reliability of the prices determined thereon.
---------------------------------------------------------------------------

    Open interest is defined as the number of open contracts observed
at the close of trading each day. Like trading volume, open interest
also is often regarded as an indicator of market liquidity, as higher
levels of open interest indicate, in part, traders' confidence that
their positions can be readily liquidated without materially affecting
the price they receive for such a transaction. Moreover, as noted,
imposing a requirement that exempt commercial markets publish open
interest data if available,\19\ as well as data on trading volume, is
consistent with the Act's requirements for EBOTs that are determined by
the Commission to be serving a significant price discovery function.
---------------------------------------------------------------------------

    \19\ Open interest data generally would be available for markets
such as Designated Contract Markets (``DCMs''), which provide an
exclusive forum for offset of positions thereon. However, the
Commission understands that, unlike positions on a DCM--where
contracts entered into on the exchange can only be offset on that
exchange--positions established on an ECM can be offset away from
the ECM, without the ECM's knowledge. Therefore, it might be
impossible for an ECM to maintain accurate open interest data.
---------------------------------------------------------------------------

    Price information: With regard to price information, both the Act
and the logic of price basing require access to price data. Reliable
price information is also critical for speculative trading. In
considering price-reporting requirements, the Commission has focused on
the reporting of delayed price information, rather than real-time price
data. In this regard, the Commission notes that the Act does not appear
to require publication of real-time price data. The Commission also
notes that many exchanges charge fees for real-time market data
(usually bids, offers and transaction prices), and that such fees can
be an important source of exchange revenues. The exchanges also make
certain market summary data freely available to the public on a delayed
basis (where the delay can be as little as 10 minutes). This delayed
market information generally includes opening and closing prices or
price ranges, daily high and low prices, settlement prices, daily
trading volume

[[Page 66038]]

and open interest. The Commission interprets the Act as allowing exempt
commercial markets to reap gains from the sale of real-time market
data, but also to require these markets to publish the required market
summary information noted above without charge to the marketplace on a
delayed basis.
    In view of the different types of exempt markets, the Commission
proposes to provide flexibility in regard to the specific price
information to be published by section 2(h)(3) markets. Specifically,
the Commission proposes to require that markets publish opening and
closing prices or price ranges, daily high and low prices, or volume
weighted average prices over a period of time that is representative of
trading on the market. In addition, on a case-by-case basis, the
Commission proposes to permit markets to publish other price
information, in lieu of the price measures enumerated above, subject to
the Commission's approval.
    As noted above, the Act requires that opening and closing price
ranges be provided by the Act's other category of exempt market--EBOTs.
However, because not all exempt markets will have such information
available, as a consequence of the way trading is conducted, the
Commission recommends that two alternative price measures, the day's
high and low, or the day's volume weighted average price, be provided.
Established exchanges commonly publish high and low prices for each
trading session. In addition, high and low prices provide useful
information regarding the range of daily trading activity. Volume
weighted average prices provide a good estimate of the price applicable
to most transactions executed on a market during daily trading sessions
and, accordingly, may provide a better indication of the representative
prices observed in a market on a given day than the other measures
noted above. Finally, as noted, the Commission is proposing to give
markets the flexibility of publishing alternative price measures,
subject to Commission approval, if such measures would provide the
public with an adequate indication of the market's daily price levels.

IV. Cost Benefit Analysis

    Section 15 of the Act, as amended by section 119 of the CFMA,
requires the Commission to consider the costs and benefits of its
action before issuing a new regulation or order under the Act. By its
terms, section 15(a) does not require the Commission to quantify the
costs and benefits of its action or to determine whether the benefits
of the action outweigh its costs. Rather, section 15(a) simply requires
the Commission to ``consider the costs and benefits'' of the subject
rule or order.
    Section 15(a) further specifies that the costs and benefits of the
proposed rule or order shall be evaluated in light of five broad areas
of market and public concern: (1) Protection of market participants and
the public; (2) efficiency, competitiveness, and financial integrity of
futures markets; (3) price discovery; (4) sound risk management
practices; and (5) other public interest considerations. The Commission
may, in its discretion, give greater weight to any one of the five
enumerated areas of concern and may, in its discretion, determine that,
notwithstanding its costs, a particular rule or order is necessary or
appropriate to protect the public interest or to effectuate any of the
provisions or to accomplish any of the purposes of the Act.
    The proposed price dissemination rules are intended to facilitate
the continued performance of an exempt market's price discovery
function. As discussed above, this function involves social benefits
that extend beyond the market and its users. Moreover, the information
that the proposed rules require exempt markets to disseminate is
virtually certain to either exist already or be a byproduct of the
operation of the market, especially one performing a significant price
discovery function. Finally, the Commission is proposing to accept
website posting of the required information in satisfaction of the
rule, as it currently does for designated contract markets and
registered derivatives transaction execution facilities. Because the
exempt markets subject to the proposed rule are by definition
electronic markets, all of which maintain internet websites,
dissemination costs should not be significant.
    In formulating the proposed price dissemination rules, the
Commission also has taken into consideration that organized markets
must produce prices before they can disseminate them. The Commission
acknowledges that price discovery, i.e., the production of prices, is a
costly activity requiring considerable investment by an organized
market. Restrictions on the dissemination of prices discovered on an
organized exchange can be viewed as a legitimate means of protecting
the exchange's investment in the production of accurate prices. The
Commission acknowledges the concerns raised in certain academic studies
showing that some forms of mandated price dissemination rules can
produce unintended consequences such as: (1) Less accurate prices; (2)
higher trading costs; (3) wealth transfers from those who produce
prices to those who consume the information contained in prices
discovered elsewhere; and (4) wealth transfers from some classes of
market participants to others.\20\ These studies apply to rules
concerning the dissemination of highly valuable real-time prices. Since
the proposed rule applies only to the dissemination of less valuable
delayed prices, the possibilities of this rule producing significant
unintended consequences appear to be low.
---------------------------------------------------------------------------

    \20\ See J. Harold Mulherin, Jeffry Netter, and James A.
Overdahl, Prices are Property: the Organization of Financial
Exchanges from a Transaction Cost Perspective, Journal of Law and
Economics 34 (October 1991) 591-644; and J. Harold Mulherin, Market
Transparency: Pros. Cons. and Property Rights, Journal of Applied
Corporate Finance Volume 5 Number 4 (Winter 1993) 94-97.
---------------------------------------------------------------------------

    The Commission also has considered the costs and benefits of the
proposed amendments to regulation 36.3(b)(1), regarding information
access, in light of the above-noted specific areas of concern
identified in section 15. The Commission intends that the amended rules
would impose the minimum requirements necessary to enable it to perform
its oversight functions and to carry out its mandate to protect the
public interest in markets that are free of fraud, abuse and
manipulation.
    After considering these factors, the Commission has determined to
propose the rules and rule amendments set forth below.
    The Commission specifically invites public comment on its
application of the criteria contained in the Act for consideration.
Commenters are also invited to submit any quantifiable data that they
may have concerning the costs and benefits of the proposed rules with
their comment letter.

V. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA), 5 U.S.C. 601 et seq.,
requires federal agencies, in promulgating rules, to consider the
impact of those rules on small entities. The rules proposed herein
would affect exempt commercial markets. The Commission has previously
determined that exempt commercial markets are not small entities for
purposes of the RFA.\21\ Accordingly, the Chairman, on behalf of the
Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that the
proposed rules will not have a

[[Page 66039]]

significant economic impact on a substantial number of small entities.
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    \21\ 66 FR 42256, 42268 (Aug. 10, 2001).
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B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)), which
imposes certain requirements on federal agencies (including the
Commission) in connection with their conducting or sponsoring any
collection of information as defined by the PRA, does not apply to this
rule. The proposed rules do not appear to contain information
collection requirements that require the approval of the Office of
Management and Budget.

List of Subjects in 17 CFR Part 36

    Commodity futures, Commodity Futures Trading Commission.

    In consideration of the foregoing, and pursuant to the authority in
the Commodity Exchange Act and, in particular, sections 2(h)(3)-(5) of
the Act, the Commission hereby proposes to amend Chapter I of Title 17
of the Code of Federal Regulations as follows:

PART 36--EXEMPT MARKETS

    1. The authority citation for part 36 continues to read as follows:

    Authority: 7 U.S.C. 2, 6, 6c, and 8a.

    2. Section 36.3 is proposed to be amended by revising paragraphs
(b)(1)(i) and (ii), by adding new paragraphs (b)(1)(iii) and (iv), by
redesignating paragraphs (b)(2) and (b)(3) as paragraphs (b)(3) and
(b)(4), by adding a new paragraph (b)(2), by adding a heading to
paragraph (c)(1), by revising paragraph (c)(2), and by adding a heading
to paragraph (c)(3) to read as follows:


Sec.  36.3  Exempt commercial markets.

* * * * *
    (b) * * *
    (1) * * *
    (i) Provide the Commission with access to the facility's trading
protocols, either electronically or in hard copy form;
    (ii) Identify to the Commission those transactions conducted on the
facility with respect to which it intends to rely on the exemption in
section 2(h)(3) of the Act and, with respect to such transactions,
either:
    (A) Submit to the Commission, in a form and manner acceptable to
the Commission, a report for each business day, showing for each
transaction executed on the facility in reliance on the exemption set
forth in section 2(h)(3) of the Act the following information: The
commodity, the location, the maturity date, whether it is a financially
settled or physically delivered instrument, the date of execution, the
time of execution, the price, the quantity, and such other information
as the Commission may determine, and for an option instrument the type
of option (call or put) and the strike price. Each such report shall be
electronically transmitted weekly, within such time period as is
acceptable to the Commission after the end of the week to which the
data applies; or
    (B) Provide the Commission, in a form and manner acceptable to the
Commission, with electronic access to those transactions conducted on
the facility in reliance on the exemption in section 2(h)(3) of the
Act, which access would allow the Commission to compile the information
described in paragraph (b)(1)(ii)(A) of this section and create a
permanent record thereof;
    (iii) Maintain a record of allegations or complaints received by
the trading facility concerning instances of suspected fraud or
manipulation in trading activity conducted in reliance on the exemption
set forth in section 2(h)(3) of the Act. The record shall contain the
name of the complainant, if provided, the date of the complaint, the
market instrument, the substance of the allegations, and the name of
the person at the trading facility who received the complaint; and
    (iv) Provide to the Commission, either electronically or in hard
copy form, a copy of the record of each substantive complaint received
pursuant to paragraph (b)(1)(iii) of this section no later than three
business days after the complaint is received.
    (2) The Commission hereby delegates, until the Commission orders
otherwise, the authority to determine the form and manner of submitting
reports, the time within which such reports shall be filed, and the
form and manner of providing electronic access, under paragraph (b)(1)
of this section, to the Director of the Division of Market Oversight
and such members of the Commission's staff as the Director may
designate. The Director may submit to the Commission for its
consideration any matter that has been delegated by this paragraph.
Nothing in this paragraph prohibits the Commission, at its election,
from exercising the authority delegated in this paragraph.
* * * * *
    (c) * * *
    (1) Prohibited representation. * * *
    (2) Market data dissemination. (i) Criteria for price discovery
determination. An electronic trading facility operating in reliance on
the exemption in section 2(h)(3) of the Act performs a significant
price discovery function for transactions in the cash market for a
commodity underlying any agreement, contract, or transaction executed
or traded on the electronic trading facility when:
    (A) Cash market bids, offers or transactions are directly based on,
or quoted at a differential to, the prices generated on the market on a
more than occasional basis; or
    (B) The market's prices are routinely disseminated in a widely
distributed industry publication and are consulted by the industry on a
more than occasional basis for pricing cash market transactions.
    (ii) Notification. An electronic trading facility operating in
reliance on section 2(h)(3) of the Act shall notify the Commission when
it has reason to believe that:
    (A) Cash market bids, offers or transactions are directly based on,
or quoted at a differential to, the prices generated on the market on a
more than occasional basis;
    (B) The market's prices are routinely disseminated in a widely
distributed industry publication; or
    (C) The market holds itself out to the public as performing a price
discovery function for the cash market for the commodity.
    (iii) Price discovery determination. Following receipt of a notice
under paragraph (c)(2)(ii) of this section, or on its own initiative,
the Commission may notify an electronic trading facility operating in
reliance on section 2(h)(3) of the Act that the trading facility
appears to meet the criteria for performing a significant price
discovery function under paragraph (c)(2)(i)(A) or (B) of this section.
Before making a final price discovery determination under this
paragraph, the Commission shall provide the electronic trading facility
with an opportunity for a hearing through the submission of written
data, views and arguments. Any such written data, views and arguments
shall be filed with the Secretary of the Commission in the form and
manner and within the time specified by the Commission. After
consideration of all relevant matters, the Commission shall issue an
order containing its determination whether the electronic trading
facility performs a significant price discovery function under the
criteria of paragraph (c)(2)(i)(A) or (B) of this section.
    (iv) Price dissemination. An electronic trading facility that the
Commission has determined performs a significant price discovery
function under paragraph (c)(2)(iii) of this paragraph shall
disseminate publicly and on a daily basis all of the following

[[Page 66040]]

information with respect to transactions executed in reliance on the
exemption:
    (A) Contract terms and conditions, or a product description, and
trading conventions, mechanisms and practices;
    (B) Trading volume by commodity and, if available, open interest;
and
    (C) The opening and closing prices or price ranges, the daily high
and low prices, a volume-weighted average price that is representative
of trading on the market, or such other daily price information as
proposed by the facility and approved by the Commission.
    (v) Modification of price discovery determination. A trading
facility that the Commission has determined performs a significant
price discovery function under paragraph (c)(2)(iii) of this section
may petition the Commission at any time to modify or vacate that
determination. The petition shall contain an appropriate justification
for the request. The Commission, after notice and opportunity for a
hearing through the submission of written data, views and arguments,
shall grant, grant subject to conditions, or deny such request.
    (3) Required representation. * * *

    Issued in Washington, DC, on November 20, 2003, by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 03-29437 Filed 11-24-03; 8:45 am]
BILLING CODE 6351-01-P
```