Source: https://www.cftc.gov/sites/default/files/tm/tmnymexrer092998.htm
Timestamp: 2018-06-25 02:04:55
Document Index: 453781005

Matched Legal Cases: ['§30', '§30', '§30', '§30', 'art 33', '§30']

Review of the Financial and Sales Practice Compliance Program of the New York Mercantile Exchange
This is a report on the review of the Division of Trading and Markets' ("Division") of the design and execution of the audit, financial and sales practice compliance program ("program") of the New York Mercantile Exchange ("NYMEX"). The target review period is from the date of the previous review, September 30, 1995, through September 30, 1998.
In conducting its review, the Division employs techniques which rely heavily on the sampling of audit workpapers, files, records, other documents prepared and retained by the SRO being reviewed, as well as interviews of SRO staff. The success of a review depends in large measure on the willing cooperation of SRO management and staff, and the completeness and accuracy of the documentation and representations provided by SRO management in support of its Program. Therefore, a review will not necessarily uncover every program failure or identify every needed improvement.
The Division conducted this full-scope review, in part, through a series of interim reviews performed over the course of the target review period. Interim reviews of a SRO’s program are made by the Division in order to maintain ongoing contact and familiarity with the status of the relevant SRO’s financial rule and sales practice enforcement programs. Any significant findings discovered by the Division during an interim review are brought to each SRO's attention at the time they are found to initiate prompt corrective action. In preparing the formal written report of its oversight activities, the Division draws upon the results of all of the interim reviews conducted since the last formal written report.
The Division found that NYMEX's Program is well designed, that its compliance staff generally execute their reviews thoroughly and that the Program complies with applicable regulatory requirements. The Division has no current recommendations for the correction or enhancement of NYMEX’s Program.
The prior report on NYMEX's Program, as of September 30, 1995 and issued on October 31, 1995, contained a recommendation for enhancement of the Program. This recommendation and NYMEX's response are summarized below:
Recommendation - Update Audit Guides: NYMEX and the other futures SROs use the uniform audit program developed and maintained by the Joint Audit Committee ("JAC") and reviewed by the Division. The Division recommended that the in-field audit program be revised to explicitly test for compliance with Division of Trading and Markets' Financial and Segregation Interpretation No. 13 ("Interpretation No. 13"). Interpretation No. 13 does not permit inter-affiliate transfers of funds to be counted for net capital and segregation purposes, unless they are "good" funds for banking purposes, i.e., the proceeds from the deposit of any check received from an affiliate must have cleared the bank before the funds can be counted for regulatory compliance purposes.
Status of recommendation: In 1996, JAC amended its uniform audit guide to include audit procedures for testing cash transactions to ascertain that checks drawn on non-segregated accounts and deposited into segregated accounts are not considered segregated assets until the bank has posted the funds to the segregated accounts. Also, audit procedures were added requiring the auditor to review a sample of deposits drawn on the bank accounts of affiliates and to inquire of the firm that the deposits are not considered good for capital purposes by both entities. We found that NYMEX uses these amended procedures and, accordingly, that the recommendation was adopted.
IV. SCOPE OF THE REVIEW
This is a full-scope review of NYMEX's audit, financial and sales practice compliance program. The report is, in part, the result of fieldwork conducted during a series of periodic interim in-field visits to the SRO over the course of the target review period. The Division believes that conducting fieldwork on a periodic interim basis is advantageous, because it facilitates ongoing coverage of the execution of SRO programs and, accordingly, findings and recommendations are brought to each SRO's attention at the time they are identified by the Division without waiting for a formal report. Maintaining updated in-field audit programs is a responsibility of each SRO.
During the target review period, the Division conducted three interim reviews as of April 1996, June 1997 and January 1998. The April 1996 review focused on day-to-day financial surveillance activities, financial and sales practice compliance audits, disciplinary actions and providing required notices to the Commission. The June 1997 review focused on the review of financial reports, the review of subordinated loan agreements, the monitoring of withdrawing and discontinuing members and providing required notices to the Commission. The January 1998 review focused on day-to-day financial surveillance activities, financial and sales practice compliance audits, the review of financial reports, disciplinary actions, the review of subordinated loan agreements, the monitoring of withdrawing and discontinuing members and providing required notices to the Commission. Additional work on the full scope review was conducted in 1998.
In conducting this review, the Division's staff interviewed officials of NYMEX and reviewed a variety of data, including:
written programs and supporting guides, manuals, and procedures;
audit workpapers and written reports for full and limited scope reviews;
documentation of the processing and review of financial reports filed by FCM members;
documentation of the processing of subordinated loan agreements and related control data;
early warning reports;
documentation of the execution of the daily financial surveillance program;
disciplinary actions, including related reports and records; and
The Division’s staff employed a combination of random sampling and judgment in selecting items for review. The table below sets forth the number of financial and sales practice audits, limited scope reviews, financial reports and disciplinary actions, respectively, performed or reviewed by NYMEX and reviewed by the Division. The results of the Division’s review for each program area are discussed in the sections that follow.
Carried out by NYMEX
Reviewed by Division
Financial and Sales Practice Audits
A. Regulatory Basis for the Program
NYMEX’s Program is operated pursuant to the requirements of the Commodity Exchange Act ("Act"), applicable Commission regulations, and interpretive guidance. Commission Rule 1.51 requires each contract market to use due diligence in maintaining a continuing affirmative action program to secure compliance with various provisions of the Act, and with the contract market's bylaws, rules and regulations, which the contract market is required by the Act to enforce. Commission Rule 1.52 requires a SRO to adopt and conduct surveillance of minimum financial requirements, no less stringent than those contained in the Commission's regulations. The Division of Trading and Markets' Financial and Segregation Interpretation No. 4-1 ("Interpretation No. 4-1")1 provides guidance as to how a SRO should conduct its Program. Addendum A2 to the Division's Interpretation No. 4-1 provides guidance regarding the sales practice portion of a SRO's Program. Addendum B3 to the interpretation provides guidance regarding coordinating financial rule enforcement programs conducted by SROs (futures and securities) over dually registered firms.
By formal agreement, all futures SROs, including NYMEX, are members of the JAC and, hence, participate in a joint audit plan that has been approved by the Commission pursuant to Rule 1.52(g). The purpose of the joint audit plan is to coordinate futures industry sales practice and financial surveillance programs, to assure efficient program coverage, and to avoid duplicative audits of futures commission merchants ("FCMs"). The arrangements under the joint audit plan ensure that those FCMs which are members of more than one SRO are subject to routine periodic audits by only one SRO. Each FCM has an SRO designated by the JAC, referred to as the "DSRO ", that is responsible for routine in-field audit and financial surveillance activities over that firm.4 As of September 30, 1998, NYMEX was the DSRO for 18 FCMs. (See Exhibit I.) In the event a DSRO discovers an apparent violation of a Commission rule or the rule of another SRO, the matter will be referred to the relevant SRO or to the Commission for appropriate follow-up and possible action. Any recommendation the Division makes regarding the written programs applicable to an individual SRO's in-field audit program is considered for adoption by the JAC as part of its annual written program review and update.
B. The New York Mercantile Exchange
NYMEX was founded in 1872 and originally was named the Butter and Cheese Exchange of New York. On April 25, 1994, the members of NYMEX and the Commodity Exchange Inc. ("COMEX") voted to consolidate their operations and, as of August 3, 1994, COMEX officially merged with and operated as a division of NYMEX. NYMEX is located at One North End Avenue in New York City’s World Financial Center. As of September 30, 1998, NYMEX had 54 clearing members and approximately 600 employees. NYMEX is the world's leading marketplace for trading futures and options on energy and metals products. In 1997, NYMEX's trading volume made it the largest contract market in New York and the third-ranked U.S. contract market overall in terms of contract volume. The trading volume for NYMEX’s futures and options contracts (including COMEX’s contracts) is presented in Exhibit II.
C. Staffing and Organization of the Compliance Function
NYMEX’s compliance department is responsible for the enforcement of NYMEX's rules and the execution of NYMEX’s Program. A vice president heads the Compliance Department; he reports to the Senior Vice President, Regulatory Affairs and Operations. In addition, the department has a compliance counsel and two associate counsels.
The compliance department is organized into three sections: 1) Financial Surveillance Section ("FSS"), 2) Trade Practice Section ("TPS") and 3) Market Surveillance Section ("MSS"). As of September 30, 1998, the three sections of NYMEX’s compliance department are organized as follows:
1. Financial Surveillance Section
FSS is responsible for conducting routine and special audits of FCM members' books and records for which NYMEX is the DSRO to ensure compliance with NYMEX and Commission rules. In addition, FSS is responsible for the receipt and review of FCM members’ financial reports and subordinated loan agreements and the ongoing daily surveillance of FCM members to identify those firms with potential financial difficulties.
FSS is staffed by a director, an associate director, three managers, one supervisor, one risk management specialist and 11 auditors. All of the professional staff have either accounting or finance degrees. The director and associate director are certified public accountants. As of September 30, 1998, the experience levels of the FSS staff were as follows:
10, 14 & 24
2. Trade Practice Section
TPS conducts surveillance of the trading practices on the floor of the exchange to detect trading patterns that appear to be in violation of NYMEX and Commission rules. The section staff consists of a director, three managers, two supervisors, 11 trade practice analysts, one floor observer and two clerks. As of September 30, 1998, the experience levels of the TPS staff were as follows:
Trade Practice Analyst
Floor Observer
3. Market Surveillance Section
MSS collects and reviews market activity data of members and their customers for indications of possible congestion and/or market situations conducive to possible price distortion and to identify related violations of NYMEX rules. The staff consists of a director, three managers, six market surveillance analysts and four computer operators. In addition, the staff had a considerable amount of experience prior to joining NYMEX. As of September 30, 1998, the experience levels of the MSS staff were as follows:
A. Day-to-Day Financial Surveillance
NYMEX operates its day-to-day financial surveillance program for the purpose of identifying actual and potential financial difficulties of member firms. It includes: 1) the daily monitoring of pay and collect data and the review of related financial data; 2) an intensified level of financial surveillance during volatile markets, focusing on firms with large or concentrated exposures; and 3) the monitoring of high-risk firms. (See "Monitoring High-Risk Firms", infra.) These procedures are supplemented by periodic review of customer segregation, firm net capital computations and margin and debit/deficits calculations. These activities and the results of the Division's review of each are described more fully below.
1. Monitoring of Daily Activity
NYMEX has a computerized "early warning system" to monitor clearing members on a daily basis. This system calculates potential early warning levels by taking a clearing member's most recent adjusted net capital5 and subtracting the member's total accumulated net settlement to date on NYMEX contracts to determine the member's projected adjusted net capital. If such projected adjusted net capital is below the NYMEX's minimum capital requirement, the NYMEX's staff will investigate the member's financial situation and may request current financial data.
In addition, on a daily basis, the NYMEX determines the daily maximum amount a clearing member could lose if the NYMEX contracts make limit moves against the member's net open position. If the adjusted net capital is less than the amount of the daily limit move per net contract position of the firm, further investigation of the firm's financial status will be conducted to determine the amount of futures and/or options positions which the firm is capable of holding in relation to its adjusted net capital.
NYMEX has an agreement with the Board of Trade Clearing Corporation ("BOTCC") allowing NYMEX to use the BOTCC's risk analysis system. This system, known as Simulated Analysis of Financial Exposure ("SAFE"), is an account risk analysis system which measures the current and future risk exposure of all clearing member firms whose open positions in NYMEX contracts are transmitted to BOTCC. Risk exposure is projected assuming a one-day unfavorable limit move in each contract. When the SAFE system is used, the NYMEX’s staff follows the following procedures:
NYMEX will review the net variation margin incurred by each clearing member, first for activity on NYMEX and then for all other domestic clearing associations, to determine the clearing member's aggregate activity and the gains or losses thereon.
Changes in original margin requirements for member firms are compared to firm net capital.
Changes in the proportional relationship between last-reported net capital and aggregate margin requirements are reviewed.
Daily "exposure amounts", i.e., the potential loss based on an unfavorable one-day limit move on a firm's open positions, as calculated by NYMEX, are compared to the "Risk Based" margin requirement (customer and proprietary positions) per the BOTCC system.
Clearing members whose net pays to NYMEX may be more than 20 percent of their adjusted net capital are identified and contacted to determine material undermargined/deficit accounts.
Clearing members whose net pays to other commodity exchanges may be more than 50 percent of their adjusted net capital are identified and may be contacted to determine if any settlement problems exist.
NYMEX requires certain FCMs to report information daily, via facsimile, regarding the margin status of customer accounts. The information reported for each such account includes the customer's name, the equity in the customer's account, initial margin requirement, securities on deposit, the amount of the margin call, the number of days the call has been outstanding and the expected disposition of the call. NYMEX staff reviews this information for potential rule violations, charges against net capital and concentrations. NYMEX requires this information from, for example, FCMs which have a significant number of customers who are floor members. NYMEX does not require daily information from other FCMs which are well capitalized, have no history of margin problems, and have a large percentage of commercial or institutional customers.
In addition to the above, intra-day margin calls issued by NYMEX's clearing house to the clearing member firms are reviewed promptly after they are issued to determine whether the applicable clearing members have sufficient capital or other funds to cover the calls and whether additional liquidity arrangements may be necessary.
In conducting its review, the Division’s staff inspected the NYMEX "Net Capital Early Warning Report," which shows each clearing member’s net capital as adjusted for the firm’s accumulated net settlement, as well as internal memoranda prepared by NYMEX staff documenting its daily review activities. The Division’s review of documentation related to the daily monitoring activities conducted by NYMEX disclosed no significant exceptions.
2. Review of Price Movements and Market Volatility
Each morning, NYMEX reviews the net change in the settlement price of each of its futures contracts. If a price moves near or to the limit, the margin information required to be filed by select FCMs for which NYMEX is the DSRO may be extended to include all FCM clearing members. In addition, FCMs may be required to report daily segregation information. On a daily basis, the price moves on all other markets are also monitored. If any such contracts move limit up or down for two consecutive days, FCM member firms carrying such contracts on behalf of customers are contacted to obtain current positions in the contracts and the margin status of accounts holding those contracts.
During a period of high volatility, NYMEX may request additional information from a member, such as the daily segregation records, which would show the amount of funds required to be in segregated accounts for customers and the amount of funds on deposit in segregated accounts. NYMEX will also contact other futures exchanges that are the DSRO for clearing members of NYMEX if it has any concern about the exposure of a clearing member resulting from a large net pay.
NYMEX deems a volatile market to have occurred when the price for a contract has moved limit up or down for two consecutive days. Using this definition as a parameter, the Division's review disclosed that there were at least nine instances of a volatile market in the palladium contract between May 1, 1996 and January 1998. NYMEX's surveillance of its clearing members during these volatile markets included reviews of: (a) pay and collect information to assess firms with large variation payments and the size of such payments relative to their adjusted net capital; (b) percentage changes in original margin on deposit; (c) Intra-day margin calls and super margin calls; (d) information received daily from members regarding margin calls and disposition of such calls; and (e) other financial data.
As a result of these volatile markets, the margin requirements for the palladium contract were increased to contract value. In addition, during this period palladium had very little open interest and the participants in the market were usually hedgers.
NYMEX did not contact any of its clearing members during these periods because its analysis of large trader information and familiarity with the financial capabilities of palladium market participants did not indicate potential payment problems. Indeed, all clearing house margin calls were timely met.
During these volatile markets, NYMEX did not report any material violations of its financial rules by FCMs for which it is the DSRO. Also, there were no firms considered high-risk firms because of these price limit moves, and there were no instances noted when NYMEX should have followed up with a firm but did not. The Division also noted various other occasions when NYMEX performed follow-up work on clearing members having large positions even though the settlement prices had not fluctuated sufficiently for NYMEX to deem it to be a volatile market.
The Division reviewed changes in the settlement prices of NYMEX futures contracts and NYMEX’s documentation of its work during a volatile market. These procedures included review of NYMEX "price Sheet Logs," on which settlement prices are tracked, to determine instances where limit moves on particular contracts occurred on consecutive days. The Division’s staff also inspected the NYMEX "Intra-Day Margin Pro Rated Report" for those days for which there was a volatile market. This report identifies clearing member firms with intra-day margin calls. The intra-day margin calls were compared to each clearing member firm’s most recent adjusted net capital to ascertain whether the firm may have been adversely affected. Based on the results of the procedures applied during our review, the Division concluded that the policies in the Program covering the review of price movements and market volatility were carried out in a satisfactory manner. This conclusion was supported by NYMEX’s record of promptly and appropriately responding to inquiries from Division staff during periods of market volatility.
3. Segregation/Secured Amount Surveillance
At the beginning of each week, NYMEX requires each FCM for which it is the DSRO to submit, via facsimile, segregation and secured amount data as of the previous Friday which will show: (a) the amount of funds required to be on deposit in segregated accounts and/or set aside in §30.7 separate accounts; (b) the amount of funds on deposit in segregated accounts and/or §30.7 separate accounts; and (c) the amount of deficits in customer accounts (regulated and non-regulated), if any. Upon receipt of the segregation and/or secured amount data, the coordinator for each firm will:
Test the clerical accuracy of the segregation/secured amount data and input the figures to the Financial Surveillance Segregation computer program;
Review changes in amount of deficits in customer accounts (regulated and non-regulated);
Review the high-risk ratio calculation; and
Notify the Director of Financial Surveillance immediately of any FCM who may be undersegregated or high-risk.
For each member carrying customer accounts, the Division obtained schedules taken from NYMEX’s computer system that showed the segregation information, the amount of customer and non-customer deficits, the most recent adjusted net capital and the firm’s high-risk ratio. These schedules were reviewed to ascertain that none of the firms were undersegregated, that the amount of the customer and non-customer deficits did not have a material adverse effect on the firm’ adjusted net capital and that the firm’s ratio of customers’ funds to adjusted net capital did not result in the firm being identified as a high-risk firm. Based on these procedures applied during our review, the Division concluded that this section of NYMEX’s Program was executed in a satisfactory manner.
4. Margin and Debit/Deficit Reviews
NYMEX has, in the past, required each FCM for which it is DSRO to submit, within seven days after the end of each month, a copy of its customer "equity tabulation" which reflects account information including: (a) the customer's name and account number; (b) the customer's open positions in all futures contracts; (c) the customer's ledger balance; and (d) the unrealized gains and losses on open positions in the customer's account. The equity tabulation was used to perform periodic in-house margin and/or debit/deficit reviews.
Due to a lack of problems discovered during these reviews and NYMEX’s day-to-day experience with margin calls from FCMs for which it is DSRO, NYMEX elected to discontinue monthly margin reviews after September 30, 1994, except as part of the annual audit, and to perform in-house debit/deficit reviews on a semi-annual basis. In January 1996, NYMEX elected to resume its in-house margin and debit/deficit reviews on a quarterly or semi-annual basis depending on the amount of risk exposure of the firm to NYMEX based on the number of floor trader accounts and/or the trading volume of the firm. NYMEX continues to receive equity tabulations on a monthly basis which are reviewed for any notable changes in the firm's customer base. NYMEX allows two of its FCMs to submit summary margin information in the form of a "money line" report instead of their equity tabulation due to the size of the equity tabulation.6
A sample of customers trading NYMEX contracts is reviewed to verify that the FCM is charging the proper margin rates, and that margin calls are being timely met. Accounts belonging to NYMEX floor members are reviewed to verify that the members are meeting their individual financial requirements. A margin call/deficit listing is prepared based on information from the equity tabulation, and the disposition of the margin calls and/or deficits are obtained from the FCM.
In conjunction with the margin reviews, NYMEX's staff may conduct a deficit review. This review will determine whether accounts in deficit are being handled properly in the computation of adjusted net capital and whether the deficits may pose a potential threat to the financial viability of the firm.
The Division’s staff reviewed the workpapers for eight margin and debit/deficit reviews completed by NYMEX. The review included procedures to confirm that NYMEX followed the procedures in its program for conducting margin and debit/deficit reviews. The Division's staff reviewed a sample of the equity tabulations to verify that NYMEX identified customer deficit and undermargined accounts in its review. The Division's staff followed up with NYMEX to ascertain that the disposition of any exceptions noted in its review were appropriate. In addition, the Division's staff determined if any undermargined and/or deficit accounts would have had a significant impact on the capital of the firm. The Division's staff also compared the NYMEX margin rates to the margin rates the firm used on its equity tabulation. The Division's review did not disclose any significant findings or exceptions and the Division concluded that NYMEX carried out this section of its Program in a satisfactory manner.
5. Monitoring High-Risk Firms
Division guidance requires intensified monitoring of firms that pose the greatest risks to the financial integrity of the contract markets, clearing houses, other member firms or to customer funds. An FCM is considered high-risk by NYMEX if any of the following conditions exist: (a) failure to meet minimum capital requirements; (b) adjusted net capital below the early warning level; (c) failure to meet Commission segregation requirements; (d) failure to maintain current books and records; (e) ratio of segregation and secured amount requirements to adjusted net capital equal to or greater than 13 to 1; and (f) other conditions that are considered by NYMEX to indicate potential problems.
NYMEX closely monitors those FCMs for which it is DSRO that it has identified as high-risk firms. NYMEX will obtain, via facsimile on a daily basis, the following information from such firms in order to facilitate more intense surveillance: (a) the total amount of funds required to be in segregated accounts and §30.7 separate accounts; (b) the total amount of funds in segregated accounts and §30.7 separate accounts; (c) the total amount of unsecured debit balances and deficits in customer and non-customer accounts; and (d) aggregate proprietary futures and options trading losses since the previous financial report.
During the review period, NYMEX identified three FCMs for which it was DSRO as high-risk firms. During an audit, NYMEX discovered that one of these firms was carrying, as a proprietary account, an omnibus account for its parent company. In the account, the parent company was clearing trades for its customers; therefore, the account on the books of the FCM should have been classified as a customer omnibus account. When the account was reclassified the firm became undersegregated by approximately $4.3 million on November 30, 1994. The misclassification of this account existed through March 24, 1995 when the problem was finally rectified. During an audit of another FCM, NYMEX found that the firm was undersegregated from May 19, 1995 to June 29, 1995 due to the firm overstating the balance for cash in bank on its daily segregation records. The overstatement was the result of a cash posting error. After an adjustment was made to correct the cash balance, the revised records reflected insufficiencies of customer funds in segregated accounts. Also, NYMEX detected through its weekly financial surveillance that a third firm had a ratio of segregation/secured amount required to adjusted net capital greater than 13 to 1 on at least 40 days between the period November 6, 1997 and January 6, 1998. As part of its monitoring of this FCM, NYMEX received and reviewed financial information on a daily basis. To resolve the high-risk situation, the firm was required by NYMEX to institute better internal control procedures to manage its segregated funds.
The Division reviewed memoranda prepared by the NYMEX staff, audit reports, workpapers and investigative reports to ascertain whether NYMEX’s actions pertaining to firms subject to the high-risk surveillance were appropriate. The Division’s staff reviewed NYMEX’s "High Risk FCM Analysis" forms that high-risk FCMs are required to file for one month to determine that the forms were being filed and that they contained the required information, including the firm’s segregation requirements, secured amount requirements and current adjusted net capital. Based upon NYMEX’s handling of the above-referenced cases and a review of the information received on FCMs which had been identified as high-risk, the Division concluded that this segment of NYMEX’s Program concerning day-to-day financial surveillance was generally in accord with the applicable regulatory requirements and was executed in a satisfactory manner.
B. Financial and Sales Practice Compliance Audits
1. Financial Audit Procedures
NYMEX's Program provides that a biennial full scope audit shall be conducted, on a surprise basis, of each FCM for which it is the DSRO. In conducting its full scope audits, NYMEX uses the uniform audit program prepared by JAC. Procedures may be limited depending on the type of business actually conducted by the FCM. A limited scope audit is conducted, on a surprise basis, each year a full scope audit is not performed. In conducting its limited scope audits, NYMEX uses the limited scope examination program prepared by JAC. In conjunction with the annual audit at each FCM, a margin review is performed.
The Program also provides that newly registered FCMs, for which NYMEX becomes DSRO, should be visited within three months after the FCM has begun handling customers' accounts. The Program provides that the Commission's Eastern Regional Office will be notified in the event an audit is not completed within five months of the inception of fieldwork.
2. Compliance and Sales Practice Procedures
Part 33 of the Commission's regulations requires contract markets, designated as option contract markets, to adopt option customer protection rules and maintain a comprehensive program of compliance, including sales practice audits of FCM members that solicit options customers. Section 17(p)(3) of the Act requires each futures association registered under the Act to establish minimum standards governing the sales practices of its members and persons associated therewith for transactions subject to the provisions of the Act. As the only futures association registered under the Act, National Futures Association ("NFA") is responsible for futures sales practices, and has sales practice rules with respect to futures contracts for which there is no corresponding NYMEX rule. During the review period, the NFA was the SRO ultimately responsible for the surveillance of futures sales practices over the FCMs for which NYMEX is the DSRO. The NFA performed futures sales practice audits of FCMs identified as conducting on-going retail futures business. In a letter dated June 25, 1998, NYMEX notified the NFA that effective July 1, 1998 it will assume the futures related sales practice responsibilities from the NFA and will perform such function as part of its overall affirmative action program.
In conducting its full scope audit at an FCM for which it is the DSRO, NYMEX reviews the FCM's compliance with NYMEX rules pertaining to the handling of customer accounts and the required option sales practice audit procedures. In conducting its audit, including option sales practice phases, NYMEX uses the compliance section of the uniform audit program. During the target review period, the full uniform audit program was executed with the exception of a limited number of "futures only" sales practice audit steps which are performed by NFA. The uniform audit program includes sales practice audit procedures covering the following areas:
Review promotional and advertising materials for fraudulent or misleading information which may have been provided to customers;
Review customer files to confirm that the FCM has a record that customers have received required risk disclosures;
Review records of customers' orders to confirm that customer identification, commodity futures or option designation, and price instructions are contained on office order tickets;
Review files to verify that confirmations and account statements issued to customers meet requirements;
Review files to verify that, where applicable, customers have authorized discretionary trading, and review related account activity for unusual patterns of trading; and
Review records of complaints received from customers as a means to identify areas of potential solicitation and account handling abuse.
The options sales practice section of the uniform audit program is not executed during limited scope audits. However, the workpapers for both full and limited scope audits contain specific information on each FCM which is used by NYMEX to develop a profile of the firm which is a part of the audit priority system required by the Addendum to Interpretation No. 4-1.
The files for complaints received from customers are maintained by the Trade Practice Section of the Compliance Department of NYMEX. Prior to commencing an audit, the financial surveillance staff will review these files. If there are any complaints, FSS will investigate them if applicable or related to the audit.
3. Execution of In-field Examinations
a. NYMEX Audit Policy: The Division read the audit reports for the 28 full scope and 27 limited scope financial audits of FCMs completed by NYMEX during the target review period. The Division also reviewed the workpapers in detail for eight of the full scope audits and eight of the limited scope audits. This review disclosed that NYMEX's audit program and its execution thereof met the requirements of Interpretation No. 4-1 and the addenda thereto as follows:
Audits were conducted with sufficient frequency to meet the audit coverage requirements;
NYMEX generally took appropriate action with respect to its audit findings;
NYMEX's workpapers contained documentation that NYMEX's scope setting process was adequate for NYMEX to determine that its FCM members were complying with the Commission's and NYMEX's net capital, recordkeeping and reporting requirements and the Commission's segregation and secured requirements;
The scope of NYMEX's biennial full scope audit took into consideration all information available on the firm, including its compliance history, information obtained through on-site evaluation, testing of the firm's internal controls and contained information explaining the reasons for extending audit testing of the activities pertaining to specific branch offices and Guaranteed Introducing Brokers.
NYMEX carried out sufficient testing to conclude whether the FCM member's records were current with regard to daily segregation calculations, monthly net capital computations, daily reconciliation’s of open commodity trades and the settlement account, monthly reconciliation’s of other control accounts, and posting of transactions and adjustments to current balances;
Requirements to conduct audits on a surprise basis were met;
NYMEX commenced all fieldwork for each audit reviewed within two months of the "as of" date (with an exception due to a scheduling problem with a securities SRO) and each audit was completed within five months of the inception of fieldwork;
NYMEX carried out at least one-half of all audits at dates other than a required quarterly financial reporting date;
NYMEX made no examinations as of the FCM's fiscal year-end;
NYMEX conducted its examinations using JAC's written audit programs, which had been reviewed by the Division. The programs were sufficiently comprehensive to provide reasonable assurance that FCMs audited under JAC are in compliance with applicable Commission regulations, Division interpretations, and with SRO rules related, directly or indirectly, to Commission requirements for SRO Programs or Commission regulations. The programs contained steps addressing sales practice and compliance areas;
NYMEX has an audit priority system which meets the requirements of Interpretation No. 4-1 and Addendum A thereto and is designed for determining when extended procedures are necessary for scheduling firms for non-routine audits and to set the scope for routine audits. The audit priority system considers customer complaints, sanctions in effect relating to the firm, results of past audits and any relevant information received from other SROs, such as NFA's tracking system for associated persons. In addition, the audit priority system, using both the full and limited scope JAC audit programs, collects and documents annually the FCM's profile of accounts carried, how the firm obtains orders and/or solicits its accounts, and the type and number of sales outlets, including branches and Guaranteed Introducing Brokers; and
During the target review period, NYMEX kept the Commission informed of any important issues as they arose.
b. Results of overlapping audits: The Division's audit staff conducted, as of June 30, 1997, a direct oversight financial and segregation audit at one of the FCMs for which NYMEX is the DSRO. The primary purpose of the Division’s audit was to verify the quality of the SRO's field audit program. The Division traces exceptions it finds to the SRO's workpapers to ascertain whether these, or similar exceptions, were present during the SRO's review period and whether they were handled appropriately by the SRO. The Division found that, in apparent violation of Commission Rule 1.32, the FCM failed to prepare segregation records for five days during the period April 2, 1997 through April 7, 1997. Also, the Division’s audit revealed that the FCM failed to notify the Commission, as required by Commission Rule 1.12(c), that it did not prepare the daily segregation record for five days. In addition, due to an inaccuracy in methodology, the firm prepared an inaccurate segregation record for twenty-two business days during the period February 24, 1997 through August 4, 1997. As corrected, the records reflected a small deficiency of customer funds in segregated accounts.
Prior to the Division’s audit, NYMEX had conducted, as of April 30, 1996, a limited scope audit at the same FCM. NYMEX’s audit did not disclose any material violations of the Commission’s rules. However, the audit disclosed that the firm had entered into a segregated reverse repurchase agreement with a registered securities broker/dealer. NYMEX’s review of documentation disclosed that the broker/dealer was the custodian of the securities underlying the agreement. The Division of Trading and Markets’ Financial and Segregation Interpretation No. 2-1 provides that a securities broker/dealer may not be the custodian of the underlying securities. The audit also disclosed that the firm did not have a valid acknowledgment letter for a segregated account with a bank. The letter had been executed by the bank’s affiliated securities broker/dealer. The bank should have executed the letter. The audit also disclosed deficiencies that NYMEX considered as being weaknesses in the firm’s internal accounting controls. Specifically, NYMEX found a lack of coordination and communication between the FCM and its overseas parent company whose employees were performing several of the FCM’s routine accounting functions. This lack of coordination and communication resulted in the firm’s preparing inaccurate financial statements.
NYMEX conducted a full scope audit of the same firm after the Division’s audit. A review of this audit by the Division disclosed that the audit did not disclose any material violations of the Commission’s rules. However, NYMEX found that the while coordination and communication between the FCM and its parent company had improved, additional improvement was warranted. There were errors and omissions in the reconciliation of the bank accounts, the carrying broker accounts had not been reconciled to the firm’s general ledger, and balances were incorrectly classified on the financial report for November 30, 1997. The audit also disclosed that the firm prepared an inaccurate segregation record as of November 28, 1997, in that it understated its residual interest in customer funds by at least $960,000.
Upon tracing these compliance exceptions to the relevant sections of NYMEX's audit workpapers, the Division concluded that NYMEX had effectively followed its programs. The differences in findings noted by NYMEX as compared to those made during the Division’s audit were consistent with the different audit dates.
c. Sales Practices: During the target review period, NYMEX was the DSRO for one FCM with a significant amount of "retail" business. This FCM had 142 retail customers that represented approximately 75 percent of its total number of customers. Fifty percent of the retail business was conducted through the firm’s branch offices. NYMEX did not audit the firm’s branch offices because the firm’s retail futures and options business is done as an accommodation for the firm’s securities customers and the firm does not specifically solicit retail futures business. NYMEX did review the internal audit reports and workpapers that the firm prepares in maintaining surveillance over its branch offices.
In addition, two other FCMs for which NYMEX is the DSRO had branch offices and one FCM for which NYMEX is the DSRO had guaranteed an introducing broker. One of the FCMs with branch offices did not solicit retail customers and the retail customers of the other such FCM (which was soliciting) did not make up a significant percentage of its total customer funds. When NYMEX audits the FCM with a guaranteed introducing broker, it also reviews the records of the introducing broker. NYMEX maintained a sales practice profile on each FCM for which it was the DSRO and updated the information when there was a significant change. This update may occur after an audit of an FCM or upon review of the monthly customer "equity tabulation" received from the FCM. NYMEX can produce a profile from its computer at any time on each FCM for which it is the DSRO. The review disclosed that the sales practice profiles were sufficiently detailed and provided an accurate illustration of the extent of the retail business conducted by the FCMs for which NYMEX is the DSRO.
NYMEX, as required under the provisions of the Addendum to Interpretation No. 4-1, provided NFA with firm profiles for the FCMs for which NYMEX was the DSRO. The NFA reviewed the profiles and conducted the required limited scope audits for those FCMs identified as conducting a significant amount of retail business. During the target review period, the NFA conducted 14 sales practice audits at FCMs for which NYMEX is the DSRO. NFA did not notify NYMEX of any material violations or findings.
During the target review period, NYMEX did not receive any complaints from customers of FCMs for which NYMEX is the DSRO. The only complaints received by NYMEX were related to trading floor activities (bad fills, settlement prices, unfilled orders, etc.). In addition, NYMEX did not receive any option promotional material during the review period.
The Division concluded that the financial and sales practice compliance audits conducted by NYMEX were in accordance with applicable regulatory standards. The Division also noted that the audit findings were adequately documented in the NYMEX’s audit reports and workpapers. The overall quality of the audit workpapers in documenting the execution of the program was generally good.
C. Review of Financial Reports
Prior to June 30, 1997, NYMEX required semiannual financial reports from clearing member FCMs for which it was the DSRO and quarterly financial reports from non-clearing member FCMs for which it was the DSRO.7 Financial reports from FCMs for which NYMEX is the DSRO are reviewed to determine that the FCMs are complying with NYMEX's minimum financial requirement. Each report is reviewed for timeliness, accuracy, completeness and consistency with prior periods. To facilitate the review, a 1-FR Analysis Sheet and a 1-FR Analysis Checklist, which are designed to guide the reviewer, are completed.
When reviewing financial reports, NYMEX's Program requires that:
1. A preliminary review of the financial report should be conducted within two days after receipt of the financial report to identify any failure to meet the minimum financial requirements and/or failure to have sufficient funds in segregation to pay commodity and options customers;
2. A detailed review should be commenced within two weeks of receipt and completed within four weeks of receipt; and
3. A final resolution of any discrepancies found in the detailed review normally should be completed within six weeks of original receipt of the report absent unusual items.
If the review discloses any apparent violations of NYMEX rules, the matter will be referred to the appropriate committee for further action. At the conclusion of the review of a financial report, a joint audit plan cover sheet with key financial information is provided to the other SROs in which the FCM holds membership. Key financial information include any deficiencies found, the amount required to be segregated, the amount required to be set aside in §30.7 separate accounts and the minimum capital requirements.
During the target review period, NYMEX received and reviewed 169 financial reports. The Division selected 39 of the 169 financial reports for review. The Division's review indicated that NYMEX promptly reviewed financial reports in an average "turn-around time" of twelve days or less, and did not have a backlog of financial reports to process at the conclusion of the review. The Division's review also showed that the financial reports were received on time, that they were examined within the required time parameters, and that all communications with FCMs with respect to the correction of errors found during the review process were made promptly. The Division concluded that NYMEX received and processed financial reports during the review period in a satisfactory manner.
When NYMEX's Compliance Department decides that there is a reasonable basis for determining that a rule violation has occurred, an investigative report is forwarded to the Business Conduct Committee which reviews the report and decides on the appropriate action to be taken. If some action is warranted, it may be in the form of a warning letter or an instruction to the enforcement staff to file a complaint against the member. If a settlement with the member cannot be reached, the complaint is filed with the Adjudication Committee.
During the review period, NYMEX instituted six disciplinary actions against six FCM members. The violations included failure to collect margin from a customer, failure to maintain sufficient records, the omission of time stamps on order tickets, and delays in reporting trade breaks. Monetary fines ranging from $2,000 to $35,000 were levied against five FCM members and a warning letter was sent to the sixth FCM member. The Division selected five of the six disciplinary actions for detailed review. Based on this review, the Division has concluded that NYMEX has demonstrated its willingness to take disciplinary action against FCM members who violate its rules.
E. Notices to the Commission
When material violations of the Commission's regulations and/or other SRO's rules are found during any of NYMEX’s financial surveillance activities, its staff is required promptly to notify the Commission. The Program provides that immediate notification must be given when an FCM: 1) is not in compliance with the minimum capital requirements; 2) has adjusted net capital below the early warning levels; 3) has failed to segregate/secure or has misused customers' funds; 4) has denied NYMEX staff access to its records; or 5) has failed to maintain current books and records.
When NYMEX's staff discovers an apparent violation of the Commission's regulations which requires a notification to the Commission by an FCM, NYMEX's Program requires the staff promptly to advise the FCM of its filing responsibility and ascertain that the FCM has made the filing.
NYMEX's Program provides further that the Commission's Eastern Regional Office will be notified in the event an audit is not completed within five (5) months of the inception of fieldwork and of all actions with regard to subordinated loan agreements. In addition, NYMEX's Program provides that the Commission will be notified whenever a member FCM ceases to be a member in good standing.
During the target review period, the Division found that NYMEX notified the Commission in almost all instances where notification was required. These notifications principally included instances of FCMs who were undersegregated, financial audits in progress for more than five months and approval of subordinated loan agreements. However, NYMEX failed to notify the Commission, as required by Commission Rule 1.52(j), that four FCMs withdrew from membership with NYMEX.
NYMEX did not agree with the Division’s interpretation of Rule 1.52(j), which requires the Commission to be notified when an FCM ceases to be a member in good standing. NYMEX’s understanding of the requirement of this rule was that notification was only required for a member which withdrew its membership due to disciplinary or financial problems. In the case of these four instances, there were no disciplinary or financial problems. Nonetheless, in a letter dated April 21, 1998, NYMEX informed the Division that it has implemented procedures whereby it will be responsible for the timely disclosure of all member FCM withdrawals to both the Commission’s Washington and New York offices.
Commission Rule 1.59 requires that contract markets, clearing organizations and futures associations adopt rules which prohibit employees and contractors from disclosing confidential information and from trading the employing organizations commodity contracts and related commodity interests.
NYMEX requires its employees to complete a conflict of interest statement each year, which contains the following prohibitions:
1. Disclosing any information of a confidential nature that is not available to the public.
2. Owning any stock or any financial interest of any kind in a member firm of NYMEX unless specific written approval is received from the president of NYMEX or a person designated by the president.
3. Trading commodity futures or option contracts personally or through another.
4. Owning a membership or interest in a membership on NYMEX or any other commodity exchange.
During the review, the Division inspected the files maintained by NYMEX which contain the signed conflict of interest statements for its audit staff. The inspection disclosed that in 1996, NYMEX had 19 employees on its audit staff and all had signed the necessary statement. In 1997, seven auditors were hired to replace seven auditors who left NYMEX and all 19 employees had signed the statement. In 1998, one staff member left NYMEX and all remaining eighteen staff members had signed the necessary statement.
VII. YEAR 2000 COMPLIANCE
The Division has been monitoring NYMEX’s year 2000 preparedness activities with respect to the FCMs for which NYMEX is the DSRO. In this connection, the NYMEX Audit Department is participating in the JAC year 2000 project, which is a coordinated effort to assess and monitor all FCMs and other major registrants for year 2000 preparedness. As part of this project, NYMEX mailed JAC’s "Year 2000 Compliance Questionnaire" to all of the FCMs for which it is the DSRO early in 1998. Since the mailing, NYMEX has received responses and conducted review and followup actions on all of the firms for which NYMEX is the DSRO. In NYMEX’s opinion, "[n]one of the responses have raised a ‘red flag.’" In addition, NYMEX plans to review and update the questionnaire responses with each member FCM during each FCM's next annual audit. Because FCMs are audited annually, on-site review of each questionnaire responses will be accomplished for all FCMs well before the arrival of the year 2000.
On June 1, 1998, an Update was distributed to the FCM community informing them of reporting and disclosure requirements for Year 2000 problems. Included with this letter was the CFTC Advisory Letter dated April 29,1998 detailing these reporting and disclosure requirements for FCMs, SROs and other commodity entities.
The Division concluded that NYMEX's design and execution of its financial and sales practice compliance program complies with applicable regulatory standards. The Division has no major recommendations for enhancement of NYMEX's Program.
1 Comm. Fut. L. Rep. (CCH) ¶7114A (July 1985).
2 Comm. Fut. L. Rep. (CCH) ¶7114C (October 1993).
3 Comm. Fut. L. Rep. (CCH) ¶7114D (October 1995).
4 However, each exchange clearing organization conducts day-to-day financial surveillance with respect to the positions carried by member firms relative to trading in its respective exchange's contracts.
5 NYMEX requires each FCM for which it is DSRO to submit a monthly net capital computation in accordance with Commission Rule 1.17 within 17 days after the applicable month-end.
6 A money-line report shows the customer’s account balance, the initial and maintenance margin, securities on deposit, the total equity and margin excess or margin call. An equity tabulation additionally shows the open positions in the customer’s account as well as the customer’s equity or deficit, the open trade equity, the market value of any options, the market value or margin value for the securities on deposit.
7 Commission Rule 1.10(b)(1) requires FCMs to file quarterly financial reports. Effective June 30, 1997, the Commission revised Rule 1.52(a) to delete from the rule the section that permitted DSROs to allow their FCMs to file financial reports semiannually.
SCHEDULE OF NYMEX's DSRO FIRMS
AND THEIR FINANCIAL REQUIREMENTS
Segregation Required
Secured Amt. Required
CIBC OPPENHEIMER CORP.*
317,384,330
284,219,426
9,206,188
CREDIT LYONNAIS ROUSE (USA), LTD.
9,837,770
7,983,391
48,576,006
CRESVALE INTL. (US), LLC*
11,877,532
11,627,532
1,307,259
570,203
FIRST CHICAGO STONE
16,928,586
15,761,835
30,711,314
GELDERMANN, INC.
16,673,100
15,419,800
76,934,400
208,251,516
139,169,559
1,755,001,587
557,548,779
KLEIN & COMPANY FUTURES, INC.
2,795,923
2,264,645
13,717,330
4,314,365
2,824,389
40,043,138
MG LONDON, INC.
19,909,729
19,659,729
PARIBAS FUTURES INC.
48,251,671
41,554,261
196,582,263
12,297,898
PIONEER FUTURES INC.
5,453,704
3,571,653
51,271,531
REPUBLIC NEW YORK SEC. CORP.*
58,614,129
47,876,925
264,726,889
3,745,696
ROTHSCHILD, INC.*
5,017,306
4,767,306
RUDOLF WOLFF & COMPANY, INC.
3,906,170
3,656,170
5,525,213
SHB COMMODITIES INC.
2,079,973
SPEAR LEEDS & KELLOGG*
328,608,173
309,602,927
207,439,120
28,321,690
STERLING COMMODITIES CORP.
4,139,622
3,085,310
26,626,741
TRILAND USA, INC.
20,091,975
8,561,103
*Are also registered broker/dealers.
NYMEX FUTURES AND OPTIONS CONTRACTS TRADED
AND TRADING VOLUME
NYMEX DIVISION
Gas-Crude Oil Spread
Heating-Crude Oil Spread
Palo Verde Electricity
Calif. Oregon Border Electricity
Source: Futures Industry Association, Inc., Monthly Volume Report and Monthly Options Report, December 1995-1997.