[Federal Register Volume 73, Number 182 (Thursday, September 18, 2008)]
[Proposed Rules]
[Pages 54097-54106]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-21865]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1 and 38


Execution of Transactions: Regulation 1.38 and Guidance on Core 
Principle 9

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or 
``CFTC'') is re-proposing a number of amendments to its rules, guidance 
and acceptable practices, initially proposed on July 1, 2004,\1\ 
concerning trading off the centralized market, including the addition 
of guidance on contract market block trading rules and exchanges of 
futures for commodities or derivatives positions. The Commission is re-
proposing these amendments and requesting comment as part of its 
continuing efforts to update its regulations in light of the Commodity 
Futures Modernization Act of 2000 (``CFMA'').
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    \1\ 69 FR 39880.

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DATES: Comments must be received by November 17, 2008.

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 
<a href="/cdn-cgi/l/email-protection#e695838594839287949fa685809285c8818990"><span class="__cf_email__" data-cfemail="1063757362756471626950737664733e777f66">[email protected]</span></a>. Reference should be made to ``Proposed Rules for 
Trading Off the Centralized Market.'' Comments may also be submitted by 
connecting to the Federal eRulemaking Portal at http://www.regulations.gov and following comment submission instructions.

FOR FURTHER INFORMATION CONTACT: Gabrielle A. Sudik, Special Counsel, 
Division of Market Oversight; Telephone 202-418-5171; e-mail 
<a href="/cdn-cgi/l/email-protection#47203432232e2c072421332469202831"><span class="__cf_email__" data-cfemail="f196828495989ab192978592df969e87">[email protected]</span></a>; Commodity Futures Trading Commission, Three Lafayette 
Center, 1155 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

    Commission Regulation 1.38 (17 CFR 1.38) sets forth a requirement 
that all purchases and sales of a commodity for future delivery or a 
commodity option on or subject to the rules of a designated contract 
market (``DCM'') should be executed by open and competitive methods. 
This ``open and competitive'' requirement is modified by a proviso that 
allows transactions to be executed in a ``non-competitive'' manner if 
the transaction is in compliance with DCM rules specifically providing 
for the non-competitive execution of such transactions, and such rules 
have been submitted to, and approved by, the Commission.
    The Commodity Futures Modernization Act of 2000 (``CFMA''),\2\ 
which was enacted after Regulation 1.38 was promulgated,\3\ 
significantly changed the Federal regulation of commodity futures and 
option markets by replacing ``one-size-fits-all'' regulation with 
broad, flexible core principles.\4\ At the same time, the CFMA modified 
section 3 of the Commodity Exchange Act (``Act'') (7 U.S.C. 1 et seq.), 
making a finding that transactions subject to the Act provide ``a means 
for managing and assuming price risks, discovering prices, or 
disseminating pricing information through trading in liquid, fair and 
financially secure trading facilities,'' and providing that the purpose 
of the Act is now, among other things, ``to deter and prevent price 
manipulation or any other disruptions to market integrity; to ensure 
the financial integrity of all transactions subject to this Act and the 
avoidance of systemic risk; to protect all market participants from 
fraudulent or other abusive sales practices and misuses of customer 
assets. * * * '' \5\ The CFMA also expanded the types of transactions 
that could lawfully be executed off the centralized market. 
Specifically, the CFMA permits DCMs to establish trading rules that: 
(1) Authorize the exchange of futures for swaps; or (2) allow a futures 
commission merchant, acting as principal or agent, to enter into or 
confirm the execution of a contract for the purchase or sale of a 
commodity for future delivery if the contract is reported, recorded, or 
cleared in accordance with the rules of a contract market or 
derivatives clearing organization.\6\ At the same time, exchanges must 
balance such rules with Core Principle 9 (7 U.S.C. 5(d)(9)) (Execution 
of transactions), which states ``The board of trade shall provide a 
competitive, open, and efficient market and mechanism for executing 
transactions.''
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    \2\ Public Law 106-554, 114 Stat. 2763 (2000). Under the CFMA, 
such DCM rules may be effected by the certification procedures set 
forth in section 5c(c) of the Commodity Exchange Act and 40.6 of the 
Commission's regulations.
    \3\ Regulation 1.38 was originally adopted in 1953 by the 
Commodity Exchange Authority, the predecessor of the Commission. See 
18 FR 176 (Jan. 19, 1953). For subsequent amendments, see 31 FR 5054 
(Mar. 29, 1966), 41 FR 3191 (Jan. 21, 1976, eff. Feb. 20, 1976), and 
46 FR 54500 (Nov. 3, 1981, eff. Dec. 3, 1981).
    \4\ The CFMA was intended, in part, ``to promote innovation for 
futures and derivatives.'' Sec.  2 of the CFMA. It was also intended 
``to reduce systemic risk,'' and ``to transform the role of the 
[Commission] to oversight of the futures markets.'' Id.
    \5\ 7 U.S.C. Sec.  5 (2000).
    \6\ See Section 7(b)(3) of the Act.
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    In 2001, the Commission promulgated regulations implementing 
provisions of the CFMA that established procedures relating to trading 
facilities, interpreted certain of the CFMA's provisions, and provided 
guidance on compliance with various of its requirements.\7\ Later, in 
2002, the Commission promulgated amendments to those regulations in 
response to issues that had arisen in administering the rules, noting 
that the Commission would consider ``additional amendments to the rules 
implementing the CFMA based upon further administrative experience.'' 
\8\ Consistent with that rationale, the Commission now proposes to 
amend Commission Regulation 1.38 and Commission guidance and acceptable 
practices concerning Core Principle 9 as it relates to Commission 
Regulation 1.38 to include changes that the Commission has developed 
based upon its experience administering those provisions.
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    \7\ See 66 FR 14262 (Mar. 9, 2001) and 66 FR 42256 (Aug. 10, 
2001).
    \8\ See 67 FR 20702 (Apr. 26, 2002) and 67 FR 62873 (Oct. 9, 
2002).

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[[Page 54098]]

II. Discussion of the Proposed Rule Amendments, Guidance and Acceptable 
Practices

A. The Commission's July 1, 2004 Notice of Proposed Rulemaking

    On July 1, 2004, the Commission published proposed amendments to 
Regulation 1.38 and Commission guidance concerning Core Principle 9, 
found in Appendix B to Part 38 of the Commission's Regulations (17 CFR 
Part 38) (the ``July 1, 2004 NPRM'').\9\ The Commission proposed to 
update the language of Regulation 1.38 to more accurately identify the 
types of transactions that may lawfully be executed off a contract 
market's centralized market and to simplify the language of the 
Regulation. The Commission also wished to provide more detail regarding 
acceptable practices for how contract markets can satisfy the 
requirements of Core Principle 9, particularly on four general topics: 
Electronic trading systems, general provisions for transactions off the 
centralized market, block transactions, and the exchange of futures for 
a commodity or a derivatives position.
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    \9\ 69 FR 39880 (July 1, 2004).
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    The Commission received seven comment letters in response to the 
July 1, 2004 NPRM: From the Chicago Mercantile Exchange (``CME''), the 
Futures Industry Association (``FIA''), the Chicago Board of Trade 
(``CBOT''), the U.S. Futures Exchange (``USFE'') (two letters), the DRW 
Trading Group (``DRW''), and Man Financial. The comments addressed 
eight general areas of concern: The proposed amendments to Regulation 
1.38, the Commission's proposed guidance for compliance with Core 
Principle 9 in general, block trading in general, the minimum size of 
block transactions, block trade prices, the time within which parties 
must report block trades to the exchange, block trades between 
affiliated parties, and the exchange of futures for a commodity or a 
derivatives position. Some comments offered specific recommendations 
regarding the proposed amendments, while other comments were of a more 
general nature.
    Between the publication of the July 1, 2004 NPRM and this current 
proposal, the Commission has continued to gain experience in 
administering Regulation 1.38 and Core Principle 9. Staff has also 
learned more about the common practices involved in transactions done 
off of the centralized market from the comment letters received, from 
informal interviews with various entities in the futures industry, from 
DCM rule submissions, and from informal studies of trading data related 
to off-centralized-market transactions. In light of this, as well as 
the length of time that has passed since the July 1, 2004 NPRM, the 
Commission has determined to re-propose amendments to Regulation 1.38 
and the guidance to Core Principle 9. Commenters are invited to submit 
feedback on all areas of this proposal, including those areas already 
addressed in earlier comment letters.

B. Core Principle 9 Guidance and Acceptable Practices

    This proposal contains regulations, guidance and acceptable 
practices. Commission regulations, such as Regulation 1.38, are 
requirements that all contract markets must follow. Such regulations go 
beyond mere illustrations of how a contract market may comply with a 
section of the Act; they are requirements that stand alone and that the 
Commission believes are necessary in order to comply with the Act. In 
issuing guidance, the Commission strives to offer advice about how 
contract markets can ensure compliance with sections of the Act. The 
Commission recognizes that in certain areas there is more than one 
possible approach that would allow a contract market to comply with a 
related Section of the Act. For example, as will be discussed below, 
there can be more than one way to determine an appropriate minimum size 
for block trades. The Commission offers guidance on such subjects in an 
effort to inform the exchanges of what it believes are some reasonable 
approaches to take when tackling such issues and concerns to be 
addressed in complying with Core Principles. The acceptable practices 
provide examples of how exchanges may satisfy particular requirements 
of the Core Principles; they do not establish mandatory means of 
compliance.\10\ Acceptable practices are more specific than guidance. 
An exchange rule modeled after an acceptable practice will be presumed 
to comply with the related Core Principle, since the Commission has 
already found such practice complies with that Core Principle. The 
Commission wishes to emphasize that acceptable practices are intended 
to assist DCMs by establishing non-exclusive safe harbors.\11\ The 
introduction to Appendix B to Part 38 makes it clear that the 
acceptable practices in Appendix B are not the sole means of achieving 
compliance with the Act:
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    \10\ See Section 5c(a) of the Act 7 U.S.C. 7a-2(a).
    \11\ The Commission notes that safe harbor treatment applies 
only to compliance with the specific aspect of the Core Principle in 
question. In this regard, an exchange rule that meets a safe harbor 
will not necessarily protect the exchange or market participants 
from charges of violations of other sections of the Act or other 
aspects of the Core Principle.

    Acceptable practices meeting the requirements of the core 
principles are set forth in paragraph (b) following each core 
principle. Boards of trade that follow the specific practices 
outlined under paragraph (b) for any core principle in this appendix 
will meet the applicable core principle. Paragraph (b) is for 
illustrative purposes only, and does not state the exclusive means 
for satisfying a core principle.\12\
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    \12\ See also A New Regulatory Framework for Trading Facilities, 
Intermediaries and Clearing Organizations Proposed Rules, 66 FR 
14262, 14263 (March 9, 2001).

    The Commission also notes that it drafted the acceptable practices 
based on its experience in reviewing exchange rules and in considering 
related matters currently facing the Commission. The acceptable 
practices provided in the proposal are, in large measure, modeled on 
exchange rules that have previously been found to satisfy the 
requirements of Core Principle 9. The Commission does not mean to imply 
that it will find other rules unacceptable. Indeed, some of the 
acceptable practices explicitly note that a DCM could adopt rules that 
differ from the acceptable practice, although any such deviation would 
still require the DCM and parties to trades to comply with Core 
Principle 9, as required by section 5(d)(1) of the Act.
    The Commission believes that its proposed issuance of guidance and 
acceptable practices will generally ease the burden on exchanges in 
complying with Core Principle 9. Without the adoption of these 
amendments, DCMs are without any meaningful guidance as to whether 
their requirements for trading off the centralized market comply with 
Core Principle 9. These amendments provide certainty for those rules 
that fall under an acceptable practice, while the burden for those that 
fall outside of the acceptable practices is no greater than before. The 
Commission believes that it would not be appropriate to lessen the 
specificity of the acceptable practices because doing so would render 
the guidance meaningless.

C. General Changes to the Re-Proposed Amendments

    The amendments proposed in this rulemaking are in large measure 
substantively similar to what was proposed in the July 1, 2004 NPRM. 
This proposal, like its predecessor, strives to update the language of 
Regulation 1.38 to more accurately

[[Page 54099]]

identify the types of transactions that may lawfully be executed off of 
a contract market's centralized market and to simplify the language of 
the Regulation. The proposed language also updates Regulation 1.38 to 
make it clear that DCMs may self-certify (not just seek approval for) 
rules or rule amendments related to transactions off the centralized 
marketplace. This proposed amendment is consistent with section 5c(c) 
of the Act, which allows for the certification of any DCM rule or rule 
amendment.
    In addition, Regulation 1.38 requires, subject to certain 
exceptions, that all purchases and sales of a commodity for future 
delivery or a commodity option on or subject to the rules of a DCM 
should be executed by open and competitive methods. The implicit 
assumption in Regulation 1.38 is that trading should take place on the 
centralized market unless there is a compelling reason to allow certain 
transactions to take place off the centralized market. Similarly, 
exchange rules and policies that allow such transactions should ensure 
that the impact on the centralized market is kept to a minimum. For 
example, certain types of off-centralized market transactions, such as 
block trades and exchanges of futures for related positions, can create 
new positions or reduce prior positions. If these transactions become 
the exclusive or predominant method of establishing or offsetting 
positions in a particular market, it might jeopardize the centralized 
market's role in price discovery and would not comply with Core 
Principle 9, which provides that trading be competitive, open and 
efficient.\13\ Other types of off-centralized market transactions are 
bookkeeping in nature, such as transfer trades or office trades, which 
move existing positions between accounts. These transactions do not 
affect the price discovery mechanism of the centralized market because 
they do not establish or offset positions.
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    \13\ See also, section 3(a) of the Act, which finds that 
transactions subject to the Act provide ``a means for managing and 
assuming price risks, discovering prices, or disseminating pricing 
information through trading in liquid, fair and financially secure 
trading facilities.'' Using the example above, markets on which 
transactions are exclusively or predominantly carried out by blocks 
are not liquid markets. Furthermore, it has been questioned whether 
markets are fair if they do not offer viable centralized trading. 
This also calls into question such a market's compliance with 
designation criterion 3, 7 U.S.C. 7(b)(3), which requires the 
exchange to establish and enforce trading rules to ensure fair and 
equitable trading through the facilities of the contract market.
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    This proposed rulemaking also addresses the same four general 
topics under Core Principle 9 that were addressed in the July 1, 2004 
NPRM: Electronic trading systems, general provisions for transactions 
off the centralized market, block transactions, and the exchange of 
futures for a commodity or a derivatives position.
    The majority of changes made since the July 1, 2004 NPRM strive to 
do one of two things. First, the Commission has attempted to clarify 
any language that was ambiguous, particularly in response to questions 
raised in the comment letters. Second, the proposed acceptable 
practices under Core Principle 9 have been redrafted to more closely 
resemble the language of the acceptable practices for the other Core 
Principles. The Commission believes that in addition to harmonizing the 
language of the acceptable practices, these changes make the language 
of the acceptable practices easier to read.
    The Commission has made more significant changes to the proposed 
amendments in three areas, based on the comment letters received, as 
well as the Commission's own experience in administering Regulation 
1.38 and Core Principle 9. These three areas, discussed in more detail 
below, concern the appropriate minimum size of block trades; when block 
trades may be permitted between affiliated parties; and exchanges of 
futures for a commodity or derivatives position, including the 
permissibility of transitory exchanges of futures for a commodity or 
derivatives position (``transitory EFPs'').

D. The Minimum Size of Block Trades

    In the July 1, 2004 NPRM the Commission proposed that an acceptable 
minimum size for block trades would be at a level larger than 90% of 
the transactions in a relevant market (``90% threshold'') or, for new 
contracts with no relevant market, 100 contracts. CME, CBOT, DRW, FIA 
and USFE all offered comments regarding those proposed acceptable 
practices. CME and CBOT disagreed with the Commission's proposed 
minimum sizes of the 90% threshold and 100 contracts: CME thought the 
numbers were arbitrary, unresponsive to market needs and inconsistent 
with the Commission's oversight role. Similarly, CBOT believed there 
may be instances where 90% or 100 contracts could be too high or not 
high enough. CBOT suggested that an acceptable minimum block trade size 
be at the point where the block would move the market or where the 
customer would not be able to obtain a fair price or fill the order on 
the centralized market.
    DRW suggested that the Commission clarify its intent that the 
minimum block trade size should be derived from the size of trades in 
the entire relevant market, which should include the central market, 
related derivatives markets and the cash market. DRW also suggested 
that using the 90% threshold would result in artificially low minimums 
because many transactions in the central market are often broken down 
into smaller trades at the same price. DRW suggested tying the minimum 
block trade size to the size of orders instead of trades or by 
developing a risk-based system that would consider both outright and 
spread transactions.
    USFE seemed to imply that the 90% threshold should be lower for 
options than for futures. USFE noted that options transactions, 
particularly combination trades, are more complex than futures trades 
and require more human intervention than other trades. The options 
market is therefore more conducive to trading off the centralized 
market. While USFE did not suggest a different minimum threshold for 
options, it indicated that more off-centralized-market trading of 
options was necessary until technology could accommodate complex 
options positions on the electronic trading screen.
    In response to these comments, as well as the Commission's own 
increased knowledge about block trades, the Commission is changing the 
proposed guidance and acceptable practices on this topic. In this 
regard, the Commission's guidance for determining appropriate minimum 
sizes relies on the purpose for allowing block trades. Block trades are 
allowed to be transacted off the centralized market for two reasons. 
First, prices attendant to the execution of large transactions on the 
centralized market may diverge from prevailing market prices that 
reflect supply and demand of the commodity. This is because the 
centralized market may not provide sufficient liquidity to execute 
large transactions without a significant risk premium, so that the 
prices of such trades tend to reflect, to a significant degree, the 
cost of executing the trade. Accordingly, reporting these prices as 
conventional market trades would be misleading to the public. Second, 
block trading facilitates hedging by providing a means for commercial 
firms to transact large orders without the need for significant price 
concessions and resulting price uncertainty for parties to the 
transaction that would occur if transacted on the centralized market. 
Using these reasons as guidance, block trades should be limited to 
large orders, where ``large'' is the number at which there is a 
reasonable expectation that

[[Page 54100]]

the order could not be filled in its entirety at a single price, but 
would need to be broken up and executed at different prices if 
transacted in the centralized marketplace. As such, the proposed 
guidance notes that minimum block trade sizes should be larger than the 
size at which a single buy or sell order is customarily able to be 
filled in its entirety at a single price (though not necessarily with a 
single counterparty) in that contract's centralized market, and 
exchanges should determine a fixed minimum number of contracts needed 
to meet this threshold.
    The Commission now believes that its previous means of determining 
an appropriate minimum size--the 90% threshold--may not be appropriate 
for all markets because this figure does not necessarily correspond 
with the size of the order that would move the market price. Because 
the determination of what constitutes a large trade will vary between 
DCMs, contracts and even over time, the acceptable practices will not 
set forth an explicit threshold, but will instead leave it to the DCMs 
to determine appropriate minimum sizes, based on the above purpose.\14\ 
This new approach should also address DRW's concern that using trade 
size alone to determine a threshold might result in lower-than-
appropriate minimum sizes, because breaking an order into several small 
trades ideally should not affect the overall volume or liquidity of the 
centralized market. Similarly, the presence of many small trades 
submitted by multiple traders will also not artificially lower the 
appropriate minimum block trade size. The Commission also understands 
that, as exchange volume migrates from floor trading to electronic 
trading, the average size of transactions tends to decrease, resulting 
in artificially low 90% thresholds and minimum block trade sizes that 
are too low given the criteria discussed above.
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    \14\ In this regard, the guidance could result in different DCMs 
arriving at different minimum size requirements for the same or 
similar futures contracts, if the liquidity and volume on each DCM 
is different.
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    One method by which DCMs could determine what number of contracts 
is an appropriate minimum size would be to assess the market liquidity 
(the number of contracts the centralized market is able to absorb at 
the best execution price) and market depth (which measures the 
potential price slippage if a large order were to be executed in the 
centralized market). For example, a DCM could examine a contract's 
market liquidity over time and determine that a certain size order in 
that contract could rarely, if ever, be filled in its entirety at the 
best price, and set a minimum block trade size based on this data. Such 
calculations should be re-examined periodically, as volume, liquidity 
and market depth change over time to ensure that a contract's minimum 
block trade size remains appropriate. Such an analysis would most 
easily be done for an electronically-traded contract, since trade data 
about the contract is easy to gather and analyze.
    Calculating a minimum size based on market liquidity and depth is 
not the only possible way to determine what size order should be 
considered ``large.'' DCMs could employ other methods to reasonably 
determine what size order would move the price in the centralized 
market. For instance, along with a review of trade sizes and/or order 
sizes, DCMs could interview experienced floor brokers and floor traders 
to determine what size order is generally too large to fill at a single 
price. This method might be most appropriate for open-outcry markets 
because DCMs will not have the same type of trade data generated by 
electronic trading platforms, and will not as easily be able to 
determine, based on electronic data, what size order is ``large.''
    For new contracts that have no trading history, a DCM should strive 
to set its initial minimum block trade size based on what the DCM 
reasonably believes will be a ``large'' order (i.e., the order size 
that would likely move the market price). So, for example, the DCM 
might base its initial minimum block trade size on sources of data 
other than transaction data in that particular contract such as 
transaction patterns in related futures or cash markets, the DCM's 
experience regarding other newly-launched contracts, and/or a survey of 
potential market users to determine how many contracts might be 
executed in a typical transaction. Where a DCM is unable to determine 
an appropriate minimum size (due, for instance, to the lack of data in 
other markets or other methods for estimating an appropriate minimum 
size), the Commission believes it would be an acceptable practice for a 
DCM to set the minimum block trade size at 100 contracts. In the past, 
the Commission has considered 100 contracts to be a reasonable figure 
to use as the minimum size until enough market data exist to allow that 
figure to be adjusted, if need be. Once there is adequate trade data to 
re-evaluate the minimum size, the DCM should ensure that it be adjusted 
to a level where a trade would move the centralized market, if traded 
there.
    In this regard, the Commission proposes as an acceptable practice 
that DCMs review the minimum size thresholds for block trades no less 
frequently than on a quarterly basis to ensure that the minimum sizes 
remain appropriate for each contract. As noted in the proposed 
guidance, such review should take into account the sizes of trades in 
the centralized market and the market's volume and liquidity. This 
review and any necessary adjustments should be made to both new and 
existing contracts. In addition, quarterly reviews of minimum block 
trade sizes should take into account whether the minimum sizes ensure 
that block trades remain the exception, rather than the rule. As noted 
above, transactions off the centralized market should remain an 
exception as the expectation is that most trading will occur on the 
centralized market. Exchanges that established their minimum sizes for 
block trades long ago may find they need to adjust their minimum sizes 
as a result of changes in volume, liquidity, or the typical sizes of 
transactions in the respective market.
    Finally, the Commission notes that DCMs are free to require a 
minimum size that is larger than what the guidance suggests a ``large'' 
trade would be. They are not obligated to set the minimum size at the 
smallest acceptable minimum size.

E. Block Trades Between Affiliated Parties

    Based on comment letters and the Commission's growing experience 
with implementing Core Principle 9, the Commission has determined to 
revise Regulation 1.38 and the related acceptable practices regarding 
block trades between affiliated parties. An affiliated party is a party 
that directly or indirectly through one or more persons, controls, is 
controlled by, or is under common control with another party. These 
proposed changes differ from the July 1, 2004 NPRM's treatment of block 
trades between affiliated parties.
    Block trades between affiliated parties may be permitted by DCMs, 
so long as appropriate safeguards are in place to guard against the 
heightened possibility that transactions between two closely related 
parties are more susceptible to abuse, such as setting unreasonable 
prices, artificially boosting volume, money passing, or wash trading. 
It is not always clear that two related parties are motivated solely by 
their own separable best interests, since they often both report to or 
are accountable to a single person or entity, and as such they may be 
encouraged by those in control of both sides of the transaction to 
engage in trading strategies that benefit from abusive trading 
practices. It is for this reason that the Commission believes it

[[Page 54101]]

is appropriate that DCMs that allow block trades between affiliates 
also include additional safeguards to guard against the heightened 
possibility of abuse, and that DCMs must have rules to ensure that 
these safeguards are satisfied.
    The Commission proposes to amend Regulation 1.38 by requiring that 
when block trades take place between affiliated parties: (i) The block 
trade price must be based on a competitive market price, either by 
falling within the contemporaneous bid/ask spread on the centralized 
market or calculated based on a contemporaneous market price in a 
related cash market; (ii) each party must have a separate and 
independent legal bona fide business purpose for engaging in the 
trades; and (iii) each party's decision to enter into the block trade 
must be made by a separate and independent decision-maker. Under the 
acceptable practices for Core Principle 9, a DCM could permit block 
trades between affiliated parties that meet these requirements and are 
otherwise appropriate parties to engage in block trading.\15\
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    \15\ Similarly, the proposed acceptable practices regarding the 
prices of block trades also include reference to Regulation 1.38 as 
it relates to block trades between affiliated parties.
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    The Commission believes these proposed requirements for block 
trades between affiliated parties strike an appropriate balance between 
making clear that such trades are allowable and ensuring that each 
party is acting independently when it agrees to enter into such a 
transaction. The requirement that affiliated parties who engage in a 
block trade meet objective criteria regarding that block trade will 
help guard against the possibility that such closely related parties 
might collude in some type of abuse.

F. Exchange of Futures for a Commodity or for a Derivatives Position

    In the July 1, 2004 NPRM, the Commission proposed to include 
acceptable practices regarding the exchange of futures for a commodity 
or derivatives position (often referred to as an exchange-for-physical 
or EFP, although it also includes, but is not limited to, similar 
transactions such as exchanges-for-swaps or exchanges-for-risk). 
Specifically, the Commission proposed a definition of what constituted 
a bona fide EFP in the Core Principle 9 acceptable practices. The 
Commission received comments from FIA, CBOT and CME regarding these 
acceptable practices. Among other things, the commenters requested the 
Commission clarify that trades commonly known as ``transitory EFPs'' 
are still permitted and that third parties may effect the cash portion 
of an EFP transaction.
    In response to these comments and other concerns that have arisen 
since the July 1, 2004 NPRM, the Commission is proposing to make two 
substantive amendments to its acceptable practices regarding exchanges 
of futures for a commodity or derivatives position. First, the 
Commission is proposing to expand the acceptable practices regarding 
EFPs' bona fides, pricing, reporting, and DCMs' publication of EFP 
transactions. Second, the Commission is proposing to make clear that 
transitory EFPs are permissible when each part of the transaction--the 
EFP itself and the related cash transaction--is a stand-alone, bona 
fide transaction.
    The Commission is proposing to offer general acceptable practices 
for exchange of futures for a commodity or derivatives position, 
including a definition of what constitutes a bona fide EFP, the pricing 
of the legs, the reporting of the transaction to the exchange, and the 
exchange's obligation, consistent with Regulation 16.01, to publicize 
daily the total quantity of exchanges of futures for a commodity or 
derivatives position. In response to the comment letters, the 
Commission is proposing to clarify in the text of the acceptable 
practices that a DCM may permit a third party to facilitate the 
transfer of the cash leg of an EFP, so long as the commodity or 
derivatives position is passed through to the party receiving the 
futures position. These provisions are meant to be consistent with 
previous publications by the Commission, including the 1987 EFP Report 
prepared by the Commission's then Division of Trading and Markets and 
the 1998 EFP Concept Release.\16\
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    \16\ DIVISION OF TRADING AND MARKETS, REPORT ON EXCHANGES OF 
FUTURES FOR PHYSICALS (1987) (the 1987 EFP Report); 63 FR 3708 (Jan. 
26, 1998) (the 1998 EFP Concept Release).
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    The essential elements of bona fide EFPs have been provided in the 
guidance to Core Principle 9 below. The proposed elements are found in 
current contract market ``exchange of futures'' rules and are based on 
the essential elements for bona fide EFPs detailed in the 1987 EFP 
Report.\17\ The elements include separate but integrally related 
transactions, an actual transfer of ownership of the commodity or 
derivatives position, and both legs transacted between the same two 
parties. The Commission notes that the determination whether an actual 
transfer of ownership has occurred will depend upon the facts and 
circumstances of each transaction. In each instance where an exchange 
of futures for a commodity or for a derivatives position is linked to 
another offsetting transaction, the particular facts and circumstances 
may warrant a determination that there was not an actual ownership 
transfer of each leg of the commodity or derivatives position.
---------------------------------------------------------------------------

    \17\ See generally, the 1987 EFP Report. See also, CBOT Rules 
331.08; CFE Rule 414; CME Rule 538; KCBT Rules 1128.00, 1128.02, 
1129.00, and 1129.02; MGE Rule 719; NYBOT Rules 4.12 and 4.13; NYMEX 
Rules 6.21, 6.21A and 6.21E; and OCX Rule 416.
---------------------------------------------------------------------------

    Further, the Commission is proposing that the acceptable practices 
relating to the bona fides of an EFP should apply to transitory EFPs as 
well. A transitory EFP involves both an EFP and an offsetting cash 
commodity transfer. For example, party A purchases the cash commodity 
from party B and then engages in an EFP whereby A sells the cash 
commodity back to B and receives a long futures position. As a result 
of these two transactions, the parties acquire futures positions but 
end up with the same cash market positions they had before the 
transaction.
    To be a legitimate transitory EFP, the cash transaction must be 
bona fide and the EFP itself must be bona fide. As with an EFP, a 
primary indicator of a bona fide cash transaction is the actual 
transfer of ownership of the cash commodity or position. In this 
regard, the cash leg of the transaction must be able to stand on its 
own as a commercially appropriate transaction, and may not be 
intrinsically linked to the EFP transaction. A cash commodity transfer 
that cannot stand on its own may indicate that there was no actual 
economic risk in the cash leg of the related EFP and may raise concerns 
about whether the EFP involved an ``exchange'' of futures contracts for 
cash commodity as required by Section 4c(a) of the Act. There must be 
no obligation on either party that the cash transaction will require 
the execution of a related EFP, or vice versa.

G. Other Proposed Acceptable Practices

    The rest of the proposed acceptable practices are for the most part 
similar to what was proposed in the July 1, 2004 NPRM. As with the 
acceptable practices discussed more fully above, the Commission 
considered the comment letters when re-drafting these acceptable 
practices, and strove to clarify any ambiguities and make them easier 
to read. And, as in the July 1, 2004 NPRM, the Commission notes that 
these proposed acceptable practices are based in large measure on 
existing DCM rules.

[[Page 54102]]

1. Block Trade Prices
    In the July 1, 2004 NPRM, the Commission proposed acceptable 
practices regarding the prices of block trades. The most basic element 
of this acceptable practice is that prices be ``fair and reasonable.'' 
In its comment letter, CBOT noted an inconsistency between the text of 
the July 1, 2004 NPRM proposed guidance and the preamble and also 
questioned whether ``circumstances'' of the party or market could or 
should be relevant in determining whether a block trade price is fair 
and reasonable. In this proposal, the Commission intends to eliminate 
the ambiguity and to make clear its belief that a DCM could permit 
``circumstances'' to be a factor in determining whether a block trade 
price was fair and reasonable. Such an approach could include, for 
example, the participants' legitimate trading objectives or the 
condition of the market. The Commission does not believe that 
permitting such flexibility will harm the centralized market because, 
regardless of how a block trade price is determined, it must still be 
fair and reasonable. The ability to price the trade away from the 
centralized market is not a carte blanche to set unfair or unreasonable 
prices.
2. Block Trade Reporting Times
    In the July 1, 2004 NPRM, the Commission proposed in its acceptable 
practices that block trades should be reported to the contract market 
within a reasonable period of time. In response, DRW made two 
suggestions: First, that reasonable reporting times for block trades 
should be as close to immediately after the completion of the trade as 
possible, with a maximum of no more than 5 minutes; and second, that 
parties to a block trade should not be allowed to trade in the 
centralized market until information about the block trade has been 
made public.
    The Commission will re-propose that block trades should be reported 
to the contract market within a reasonable period of time. The 
Commission declines to establish a specific length of time in order to 
allow exchanges to determine what an appropriate length of time should 
be on a contract-by-contract basis. But the Commission notes that most 
current DCM rules require reporting of block trades within 5 
minutes.\18\ A small number of DCM rules allow as many as 15 minutes, 
but the Commission understands these are limited to contracts that have 
very high block trade minimum size thresholds or where the contracts 
are typically traded as part of large and complex spreads, requiring 
more time to double check details and convey the information to the 
exchange.\19\ When determining length of time for parties to report 
block trades, DCMs should consider the importance of providing 
information about block trades to the market as well as the potential 
for abuses, such as front running, and whether longer reporting periods 
may heighten the potential for abuse. Additionally, staff has 
previously noted that allowing a few minutes' delay between the time a 
block trade is executed and reported will allow the market price to 
continue to respond to prevailing supply and demand factors, and not be 
unduly influenced by the block itself. In other words, a reporting 
delay will help the centralized market avoid the momentary price and 
volume distortion that would occur if large trades were made on the 
centralized market in the first place. In regards to whether parties to 
a block trade may trade in the centralized market before the block 
trade information is published, the Commission believes that the 
reporting window offers parties to the block trade an opportunity to 
hedge or offset the trade, which in turn supplies information to the 
centralized market. As such, the Commission believes that compliance 
with the Core Principles does not require that DCMs restrict the 
ability of parties to a block trade from making transactions on the 
central marketplace before the block trade is reported. DCMs, however, 
are permitted to forbid such trading.
---------------------------------------------------------------------------

    \18\ See, e.g., CBOT Rule 331.05(d); CME Rule 526(F); NYMEX Rule 
6.21C.
    \19\ See, e.g., CME Rule 526(F).
---------------------------------------------------------------------------

3. Publication of Transaction Details
    The Commission is re-proposing that DCMs would publicize details 
about transactions off the centralized market immediately upon the 
receipt of the transaction report. The Commission wishes to clarify 
that it does not intend to impose new publication requirements on DCMs 
in regards to trades made off the centralized market beyond what is 
required by the Commission's regulations. So, for example, DCMs would 
need to publish the total number of exchanges of futures for a 
commodity or for a derivatives position, as required by Commission 
Regulation 16.01. But there would be no similar requirement to publish 
office trades or transfer trades.
    Similarly, the proposed guidance also identifies publication of 
block trade details by DCMs immediately upon receipt of block trade 
reports as an acceptable practice.\20\ The proposed acceptable 
practices also would require the DCM to identify block trades on its 
trade register.
---------------------------------------------------------------------------

    \20\ This also is an element of compliance with Designation 
Criterion 3 (Fair and Equitable Trading) and Core Principle 8 (Daily 
Publication of Trading Information).
---------------------------------------------------------------------------

4. Recordkeeping
    Current Commission Regulation 1.38(b) provides that every person 
handling, executing, clearing, or carrying trades, transactions or 
positions that are not competitively executed, must identify and mark 
by appropriate symbol or designation all such transactions or contracts 
and all associated orders, records, and memoranda. In addition to 
updating the language of Regulation 1.38(b), the proposed amendments 
add this requirement to the guidance under Core Principle 9, in order 
to provide consolidated guidance regarding recordkeeping practices 
pertaining to transactions off the centralized market.
    Similarly, acceptable block trade rules would require parties to, 
and members facilitating, a block trade to keep appropriate records. 
Appropriate block trade records would comply with the requirements of 
Core Principle 10 and Core Principle 17. Records kept in accordance 
with the requirements of Statement No. 133 (``Accounting for Derivative 
Instruments and Hedging Activities''), issued by the Financial 
Accounting Standards Board (``FASB''), would be satisfactory.\21\ 
Acceptable block trade rules would require that block orders be 
recorded by the member and time-stamped with both the time the order 
was received by the member and the time the order was executed. When 
requested by the exchange, the Commission or the Department of Justice, 
parties to, and members facilitating, a block trade shall provide 
records to document that the block trade is executed in accordance with 
contract market rules.
---------------------------------------------------------------------------

    \21\ FASB Statement No. 133 provides guidance on the use of 
accounting for corporate hedge activity involving derivative 
transactions. The statement includes guidance on documenting the 
hedging relationship.
---------------------------------------------------------------------------

5. Testing of Automated Trading Systems
    The guidance for Core Principle 9 also addresses the testing and 
review of automated trading systems. Currently, the guidance states 
that acceptable testing of automated systems should be ``objective,'' 
and calls for the provision of ``objective'' test results to the 
Commission. The proposed guidance would also call for the provision to 
the

[[Page 54103]]

Commission of test results of any ``non-objective'' testing carried out 
by or for a DCM (such as informal in-house reviews) regarding the 
system functioning capacity or security of any automated trading 
systems. Although the results of ``non-objective'' testing would be of 
more limited use, the Commission believes that test results of any 
``non-objective'' testing carried out by or for the DCM should also be 
provided to the Commission.
6. Parties to a Block Trade
    The Commission is proposing that block trade parties are required 
to be eligible contract participants (``ECPs'') as that term is defined 
in Section 1a(12) of the Act, although commodity trading advisors 
(``CTAs'') and investment advisors having over $25 million in assets 
under management, including foreign persons performing equivalent 
roles, are allowed to carry out block trades for non-ECP customers.
    A majority of exchanges that permit block trading prohibit persons 
from effecting block trades on behalf of customers unless the person 
receives a customer's explicit instruction or prior consent to do 
so.\22\ The proposed rulemaking incorporates this prohibition as an 
acceptable practice.
---------------------------------------------------------------------------

    \22\ See CME Rule 526(C), CFE Rule 415(a)(i), CBOT Rule 
331.05(a), NYBOT Rule 4.31(a)(ii)(A), OCX Rule 417(a)(i), and USFE 
Rule 415(c).
---------------------------------------------------------------------------

III. Request for Comment

    The Commission requests comment on all aspects of this proposal.

IV. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act \23\ requires federal agencies, in 
proposing rules, to consider the impact of those rules on small 
businesses. The rule amendments proposed herein will affect DCMs, FCMs, 
CTAs and large traders. The Commission has previously established 
certain definitions of ``small entities'' to be used by the Commission 
in evaluating the impact of its rules on small entities in accordance 
with the RFA.\24\ The Commission has previously determined that 
DCMs,\25\ registered FCMs,\26\ and large traders \27\ are not small 
entities for purposes of the RFA. With respect to CTAs, the Commission 
has determined to evaluate within the context of a particular rule 
proposal whether CTAs would be considered ``small entities'' for 
purposes of the Regulatory Flexibility Act and, if so, to analyze the 
economic impact on the affected entities of any such rule at that 
time.\28\ The Commission believes that the instant proposed rules will 
not place any new burdens on entities that would be affected hereunder, 
and the Commission does not expect the proposed amendments in most 
cases to cause persons to change their current methods of doing 
business. This is because requirements under this proposal, if adopted, 
would be similar to most existing DCM requirements.
---------------------------------------------------------------------------

    \23\ 5 U.S.C. 601 et seq.
    \24\ 47 FR 18618-21 (Apr. 30, 1982).
    \25\ Id. at 18618-19.
    \26\ Id. at 18619-20.
    \27\ Id. at 18620.
    \28\ Id. at 18620.
---------------------------------------------------------------------------

    Accordingly, the Commission does not expect the rules, as proposed 
herein, to have a significant economic impact on a substantial number 
of small entities. Therefore, the Chairman, on behalf of the 
Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the 
proposed amendments will not have a significant economic impact on a 
substantial number of small entities. The Commission invites the public 
to comment on this finding and on its proposed determination that the 
entities covered by these rules would not be small entities for 
purposes of the Regulatory Flexibility Act.

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 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. The proposed rule amendments do not require a new collection 
of information on the part of any entities subject to these rules. 
Accordingly, for purposes of the Paperwork Reduction Act of 1995, the 
Commission certifies that these rule amendments do not impose any new 
reporting or recordkeeping requirements.

C. 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. The Commission understands 
that, by its terms, Section 15 does not require the Commission to 
quantify the costs and benefits of a new regulation or to determine 
whether the benefits of the proposed regulation outweigh its costs. Nor 
does it require that each proposed regulation be analyzed in isolation 
when that regulation is a component of a larger package of regulations 
or of rule revisions. Rather, Section 15 simply requires the Commission 
to ``consider the costs and benefits'' of its action.
    Section 15(a) further specifies that costs and benefits shall be 
evaluated in light of five broad areas of market and public concern: 
Protection of market participants and the public; efficiency, 
competitiveness, and financial integrity of futures markets; price 
discovery; sound risk management practices; and other public interest 
considerations. Accordingly, the Commission could, in its discretion, 
give greater weight to any one of the five enumerated areas of concern 
and could, in its discretion, determine that, notwithstanding its 
costs, a particular regulation was necessary or appropriate to protect 
the public interest, to effectuate any of the provisions, or to 
accomplish any of the purposes of the Act.
    The proposed amendments constitute a package of amendments to 
Regulation 1.38 and to guidance that the Commission originally 
promulgated to implement the CFMA. The amendments are proposed in light 
of past experience with the implementation of the CFMA and are intended 
to facilitate increased flexibility and consistency. Some sections of 
the proposed amendments merely clarify or make explicit past Commission 
decisions concerning transactions off the centralized market.
    As most provisions incorporate DCM rules previously approved by the 
Commission or submitted to the Commission under its self-certification 
procedures, the proposed amendments would not, in most cases, impose 
new costs on DCMs or market participants. The great majority of current 
DCM rules already meet the acceptable practices proposed. Furthermore, 
these amendments incorporate standards that the Commission has 
previously determined protect market participants and the public, the 
financial integrity or price discovery function of the markets, and 
sound risk management practices. Moreover, the additional clarification 
of acceptable practices provides a benefit to markets and market 
participants. In addition, the amendments are expected to benefit 
efficiency and competition by providing more detailed guidance as to 
acceptable means of meeting the applicable designation criteria and 
core principles, thus allowing a greater degree of legal certainty to 
the markets and market participants.
    After considering the five factors enumerated in the Act, the 
Commission has determined to propose the rules and rule amendments set 
forth below. The Commission invites public comment on its application 
of the cost-benefit provision. Commenters also are invited to submit 
any data that they may have quantifying the costs and benefits of the

[[Page 54104]]

proposed rules with their comment letters.

List of Subjects

17 CFR Part 1

    Block transactions, Commodity futures, Contract markets, 
Transactions off the centralized market, Reporting and recordkeeping 
requirements.

17 CFR Part 38

    Block transactions, Commodity futures, Contract markets, 
Transactions off the centralized market, Reporting and recordkeeping 
requirements.

    In consideration of the foregoing, the Commission hereby proposes 
to amend Chapter I of Title 17 of the Code of Federal Regulations as 
follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    1. The authority citation for part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h, 
6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a, 
13a-1, 16, 16a, 19, 21, 24, and 24, as amended by the Commodity 
Futures Modernization Act of 2000, Appendix E of Pub L. 106-554, 114 
Stat. 2763 (2000).
    2. Section 1.38 is revised to read as follows:


Sec.  1.38  Execution of transactions.

    (a) Transactions on the centralized market. All purchases and sales 
of any commodity for future delivery, and of any commodity option, on 
or subject to the rules of a designated contract market, shall be 
executed openly and competitively by open outcry, or posting of bids 
and offers, or by other equally open and competitive methods, in a 
place or through an electronic system provided by the contract market, 
during the hours prescribed by the contract market for trading in such 
commodity or commodity option.
    (b) Transactions off the centralized market; requirements.
    (1) Notwithstanding paragraph (a) of this section, transactions may 
be executed off the centralized market, including by transfer trades, 
office trades, block trades, inter-exchange spread transactions, or 
trades involving the exchange of futures for commodities or for 
derivatives positions, if transacted in accordance with written rules 
of a contract market that provide for execution away from the 
centralized market and that have been certified to or approved by the 
Commission. Every person handling, executing, clearing, or carrying the 
trades, transactions or positions described in this paragraph shall 
comply with the rules of the appropriate contract market and 
derivatives clearing organization, including to identify and mark by 
appropriate symbol or designation all such transactions or contracts 
and all orders, records, and memoranda pertaining thereto.
    (2) Block trades between affiliated parties; requirements. An 
affiliated party is a party that directly or indirectly through one or 
more persons, controls, is controlled by, or is under common control 
with another party. In addition to the other requirements of this 
section, block trades between affiliated parties are permitted only in 
accordance with written rules of a contract market that provide that:
    (i) The block trade price must be based on a competitive market 
price, either by falling within the contemporaneous bid/ask spread on 
the centralized market or calculated based on a contemporaneous market 
price in a related cash market,
    (ii) Each party must have a separate and independent legal bona 
fide business purpose for engaging in the trades, and
    (iii) Each party's decision to enter into the block trade must be 
made by a separate and independent decision-maker.

PART 38--DESIGNATED CONTRACT MARKETS

    3. The authority citation for part 38 is revised to read as 
follows:

    Authority: 7 U.S.C. 2, 5, 6, 6c, 7 and 12a, as amended by the 
Commodity Futures Modernization Act of 2000, Appendix E of Pub. L. 
106-554, 114 Stat. 2763 (2000).

    4. Appendix B to Part 38 is revised to read as follows:

Appendix B to Part 38--Guidance on, and Acceptable Practices in, 
Compliance With Core Principles

    Core Principle 9 of section 5(d) of the Act: EXECUTION OF 
TRANSACTIONS--The board of trade shall provide a competitive, open, 
and efficient market and mechanism for executing transactions.
    (a) Guidance.
    (1) Transactions on the centralized market.
    (i) Purchases and sales of any commodity for future delivery, 
and of any commodity option, on or subject to the rules of a 
contract market shall be executed openly and competitively by open 
outcry, by posting of bids and offers, or by other equally open and 
competitive methods, in a place or through an electronic system 
provided by the contract market, during the hours prescribed by the 
contract market for trading in such commodity or commodity option.
    (ii) A competitive and open market's mechanism for executing 
transactions includes a contract market's methodology for entering 
orders and executing transactions.
    (iii) Appropriate objective testing and review of a contract 
market's automated systems should occur initially and periodically 
to ensure proper system functioning, adequate capacity and security. 
A designated contract market's analysis of its automated system 
shall address compliance with appropriate principles for the 
oversight of automated systems, ensuring proper system 
functionality, adequate capacity and security.
    (2) Transactions off the centralized market.
    (i) In order to facilitate the execution of transactions, 
transactions may be executed off the centralized market, including 
by transfer trades, office trades, block trades, inter-exchange 
spread transactions, or trades involving the exchange of futures for 
a commodity or for a derivatives position, if transacted in 
accordance with written rules of a contract market that specifically 
provide for execution of such transactions away from the centralized 
market and that have been certified to or approved by the 
Commission.
    (ii) Every person handling, executing, clearing, or carrying 
trades off the centralized market shall comply with the rules of the 
applicable designated contract market and derivatives clearing 
organization, including to identify and mark by appropriate symbol 
or designation all such transactions or contracts and all orders, 
records, and memoranda pertaining thereto.
    (iii) A designated contract market that determines to allow 
trades off the centralized market shall ensure that such trading 
does not operate in a manner that compromises the integrity of price 
discovery on the centralized market or facilitate illegal or non-
bona fide transactions.
    (3) Block trades-minimum size.
    (i) When determining the number of contracts that constitutes 
the appropriate minimum size for block trades, a contract market 
should ensure that block trades are limited to large transactions 
and that the minimum size is appropriate for that specific contract, 
by applying the principles set forth in this section. For any 
contract that has been trading for one calendar quarter or longer, 
the acceptable minimum block trade size should be a number larger 
than the size at which a single buy or sell order is customarily 
able to be filled in its entirety at a single price in that 
contract's centralized market. Factors to consider in determining 
what constitutes a large transaction could include an analysis of 
the market's volume, liquidity and depth; a review of typical trade 
sizes and/or order sizes; and input from floor brokers, floor 
traders and/or market users. For any contract that has been listed 
for trading for less than one calendar quarter, an acceptable 
minimum block trade size in such contract should be the size of 
trade the exchange reasonably anticipates will not be able to be 
filled in its entirety at a single price in that contract's 
centralized market. An appropriate minimum size could be estimated 
based on centralized market data in a related futures contract, the 
same contract traded on another exchange, or trading activity in the 
underlying cash market. The exchange could also consider the 
anticipated volume,

[[Page 54105]]

liquidity and depth of the contract; input from potential market 
users; or consider that exchange's experience with offering similar 
new contracts. The minimum size thresholds for block trades should 
be reviewed periodically to ensure that the minimum size remains 
appropriate for each contract. Such review should take into account 
the sizes of trades in the centralized market and the market's 
volume and liquidity.
    (b) Acceptable practices.
    (1) General matters relating to trade execution facilities.
    (i) General provisions. [Reserved]
    (ii) Electronic trading systems.
    (A) The guidelines issued by the International Organization of 
Securities Commissions (IOSCO) in 1990 (which have been referred to 
as the ``Principles for Screen-Based Trading Systems''), and adopted 
by the Commission on November 21, 1990 (55 FR 48670), as 
supplemented in October 2000, are appropriate guidelines for a 
designated contract market to apply to electronic trading systems.
    (B) Any objective testing and review of the system should be 
performed by a qualified independent professional. A professional 
that is a certified member of the Information Systems Audit and 
Control Association experienced in the industry is an example of an 
acceptable party to carry out testing and review of an electronic 
trading system.
    (C) Information gathered by analysis, oversight, or any program 
of testing and review of any automated systems regarding system 
functioning, capacity and security must be made available to the 
Commission upon request.
    (iii) Pit trading. [Reserved]
    (2) Transactions off the centralized market.
    (i) General provisions.
    (A) Allowable trades. Acceptable transactions off the 
centralized market include: transfer trades, office trades, block 
trades, inter-exchange spread transactions or trades involving the 
exchange of futures for commodities or for derivatives positions, if 
transacted in accordance with written rules of a contract market 
that specifically provide for execution away from the centralized 
market and that have been certified to or approved by the 
Commission.
    (B) Reporting. Transactions executed off the centralized market 
should be reported to the contract market within a reasonable period 
of time.
    (C) Publication. The contract market should publicize details 
about block trade transactions immediately upon the receipt of the 
transaction report and publicize daily the total quantity of the 
exchange of futures for commodities or for derivatives positions and 
the total quantity of the block trades that are included in the 
total volume of trading, as required by Sec.  16.01 of this chapter.
    (D) Recordkeeping. Parties to, and members facilitating, 
transactions off the centralized market should keep appropriate 
records. Appropriate recordkeeping for transactions off the 
centralized market would comply with Core Principle 10 and Core 
Principle 17.
    (E) Identification of trades. Section 1.38(b) of this chapter 
establishes the requirements regarding the identification of trades 
off the centralized market. It requires contract market rules to 
require every person handling, executing, clearing, or carrying 
trades, transactions or positions that are executed off the 
centralized market, including transfer trades, office trades, block 
trades or trades involving the exchange of futures for a commodity 
or for a derivatives position, to identify and mark by appropriate 
symbol or designation all such transactions or contracts and all 
orders, records, and memoranda pertaining thereto.
    (F) Identification in the trade register. The contract market 
should identify transactions executed off the centralized market in 
its trade register, using separate indicators for each such type of 
transaction.
    (ii) Block trades.
    (A) Acceptable minimum block trade size.
    (a) New contracts or contracts that have been listed for trading 
for less than one calendar quarter. If an exchange has no reasonable 
basis upon which to estimate an initial minimum size, a minimum 
block trade size of 100 contracts would be appropriate.
    (b) Periodic review. The minimum size thresholds for block 
trades should be reviewed no less frequently than on a quarterly 
basis to ensure that the minimum size remains appropriate for each 
contract.
    (B) Appropriate parties.
    (a) Acceptable block trade parties should be limited to eligible 
contract participants. However, contract market rules could also 
allow a commodity trading advisor registered pursuant to Section 4m 
of the Act, or a principal thereof, including any investment advisor 
who satisfies the criteria of Sec.  4.7(a)(2)(v) of this chapter, or 
a foreign person performing a similar role or function and subject 
as such to foreign regulation, to transact block trades for 
customers who are not eligible contract participants, if such 
commodity trading advisor, investment advisor or foreign person has 
more than $25,000,000 in total assets under management.
    (b) Affiliated parties. An affiliated party is a party that 
directly or indirectly through one or more persons, controls, is 
controlled by, or is under common control with another party. 
Section 1.38(b) of this chapter establishes the requirements 
regarding block trades between affiliated parties. Contract market 
rules could permit block trades between affiliated parties that meet 
the requirements of Regulation 1.38 and are otherwise appropriate 
parties.
    (C) Aggregation of orders. The aggregation of orders for 
different accounts in order to satisfy the minimum size requirement 
should be prohibited except in appropriate circumstances. 
Aggregation would be acceptable if done by a commodity trading 
advisor registered pursuant to Section 4m of the Act, or a principal 
thereof, including any investment advisor who satisfies the criteria 
of Sec.  4.7(a)(2)(v) of this chapter, or a foreign person 
performing a similar role or function and subject as such to foreign 
regulation, if such commodity trading advisor, investment advisor or 
foreign person has more than $25,000,000 in total assets under 
management.
    (D) Acting for a customer. A person should transact a block 
trade on behalf of a customer only when the person has received an 
instruction or prior consent to do so from the customer.
    (E) Recordkeeping. Parties to, and members facilitating, a block 
trade should keep appropriate records. Appropriate block trade 
records would comply with Core Principle 10 and Core Principle 17. 
Records kept in accordance with the requirements of FASB Statement 
No. 133 (``Accounting for Derivative Instruments and Hedging 
Activities'') would be acceptable records. Block trade orders must 
be recorded by the member and time-stamped with both the time the 
order was received and the time the order was reported, and must 
indicate when block trades are between affiliated parties. When 
requested by the exchange, the Commission or the Department of 
Justice, parties to, and members facilitating, a block trade shall 
provide records to document that the block trade is executed in 
conformance with contract market rules.
    (F) Reporting. Block trades should be reported to the contract 
market within a reasonable period of time.
    (G) Publication. The contract market should publicize details 
about the block trade immediately upon the receipt of the 
transaction report and publicize daily the total quantity of the 
block trades that are included in the total volume of trading, as 
required by Sec.  16.01 of this chapter.
    (H) Identification in the trade register. The contract market 
should identify block trades as such on its trade register, and 
should identify when block trades are between affiliated parties.
    (I) Pricing. (a) Block trades between non-affiliated parties 
should be at a price that is fair and reasonable. Consideration of 
whether a block trade price is fair and reasonable could take into 
account the size of the block plus the price and size of other 
trades in any relevant markets at the applicable time, or the 
circumstances of the market or the parties to the block trade. 
Relevant markets could include the contract market itself, the 
underlying cash markets and/or other related futures or options 
markets. If a contract market rule requiring a fair and reasonable 
price includes the circumstances of the parties or of the market, a 
block trade participant could execute a block transaction at a price 
that was away from the market provided that the participant retains 
documentation to demonstrate that the price was indeed fair and 
reasonable under the participant's or market's particular 
circumstances.
    (b) Block trades between affiliated parties are subject to the 
pricing requirements of Sec.  1.38(b) of this chapter.
    (iii) Exchange of futures for commodities or for derivatives 
positions.
    (A) Bona fide exchange of futures for commodities or for 
derivatives positions. The exchange of futures for commodities or 
for derivatives positions would include separate but integrally 
related transactions involving the same or a related commodity, with 
price correlation and quantitative equivalence of the futures and 
cash legs. An exchange of futures for commodities or for derivatives 
positions would be between a buyer of futures who is the seller of 
the corresponding commodity or derivatives position and a

[[Page 54106]]

seller of futures who is the buyer of the corresponding commodity or 
derivatives position. A third party could be permitted to facilitate 
the purchase and sale of the commodity or derivatives position as 
long as the commodity or derivatives position is passed through to 
the party that receives the futures position. The transaction would 
have to result in an actual transfer of ownership of the commodity 
or derivatives position. It also would have to be between parties 
with different beneficial owners or under separate control, who had 
possession, right of possession, or right to future possession of 
the commodity or derivatives position prior to the trade, the 
ability to perform the transaction, and resulting in a transfer of 
title.
    (B) Pricing. The price differential between the futures leg and 
the commodities leg or derivatives position should reflect 
commercial realities, and at least one leg of the transaction should 
be priced at the prevailing market price.
    (C) Transitory exchange of futures for commodities or for 
derivatives positions. Parties to an exchange of futures for 
commodities or for derivatives positions could be permitted to 
engage in a separate but related cash transaction that offsets the 
cash leg of the exchange of futures for commodities or for 
derivatives positions. The related cash transaction would have to 
result in an actual transfer of ownership of the commodity or 
derivatives position and demonstrate other indicia of being a bona 
fide transaction as described in paragraph (a). The cash transaction 
must be able to stand on its own as a commercially appropriate 
transaction, with no obligation on either party that the cash 
transaction be dependent upon the execution of the related exchange 
of futures for commodities or for derivatives positions, or vice 
versa.
    (D) Reporting. Exchanges of futures for commodities or for 
derivatives positions should be reported to the contract market 
within a reasonable period of time.
    (E) Publication. The contract market would publicize daily the 
total quantity of exchanges of futures for commodities or for 
derivatives positions that are included in the total volume of 
trading, as required by Sec.  16.01 of this chapter.
    (iv) Office trades. [Reserved]
    (v) Transfer trades. [Reserved]

    Issued in Washington, DC on September 12, 2008 by the 
Commission.
David Stawick,
Secretary of the Commission.

[FR Doc. E8-21865 Filed 9-17-08; 8:45 am]
BILLING CODE 6351-01-P


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