Futures Markets: Heightened Audit Trail Standards Not Met But Progress Continues
Published: 1996-09-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO provided information on the Commodity Futures Trading Commission's (CFTC) actions to enforce Futures Trading Practices Act (FTPA) audit trail provisions.
section_title: What GAO Found
paragraphs: GAO found that: (1) 7 U.S. futures exchanges are in compliance with FTPA 1-minute trade timing and sequencing standards; (2) CFTC is unable to determine the status of four other exchanges until it reviews the results of the audit trail tests; (3) audit trail test results for the Chicago Board of Trade (CBT) and the Chicago Mercantile Exchange (CME) are not precise enough to verify their compliance with existing audit trail standards; (4) none of the exchanges fully complied with the heightened audit trail standards as of October 28, 1995; (5) CFTC has delayed requiring some audit trail enhancements to existing systems due to assurances that electronic trading terminals would be in place by the statutory deadline; (6) CFTC has granted the Coffee, Sugar & Cocoa Exchange and the New York Mercantile Exchange temporary relief from the FTPA statutory deadline; (7) CBT and CME were not in compliance with the heightened FTPA guidelines after additional retests; (8) CFTC has not determined the practicability of certain FTPA provisions, including the requirement to capture broker receipt time for customer orders; (9) CFTC plans to act on exchange petitions for exemption from the dual trading ban; and (10) CFTC needs to keep Congress informed of its actions to facilitate additional FTPA audit standards.

section_title: Letter
paragraphs: The Honorable Pat Roberts Chairman The Honorable E (Kika) de la Garza Ranking Minority Member Committee on Agriculture House of Representatives In August 1989, the Department of Justice, in cooperation with the Commodity Futures Trading Commission (CFTC), conducted an undercover investigation at the Chicago Board of Trade (CBT) and the Chicago Mercantile Exchange (CME). The investigation disclosed illegal trading practices designed to enrich participants. In a September 1989 report to Congress, we concluded that most of the types of illegal practices disclosed could have been detected with improved audit trails—the physical records of the price and time of each trade. We recommended that CFTC heighten audit trail standards by requiring a more accurate and comprehensive record of trades. Congress incorporated the then existing audit trail standards, as well as heightened standards, in the Futures Trading Practices Act (FTPA) of 1992 (P.L. 102-546). The FTPA required that, not later than 2 years after its enactment, CFTC report to Congress on the progress of U.S. futures exchanges in meeting the audit trail standards and include recommendations on the appropriateness of extending the October 28, 1995, deadline for meeting the standards or for modifying them. CFTC addressed two issues in its November 1994 report to Congress: (1) exchange compliance with the existing trade timing standards and (2) exchange progress toward complying with the heightened standards.CFTC did not recommend any extension of time or modification to the standards. The FTPA further required that we report our views on the issues CFTC addressed in its report. As agreed with your committees, our objectives were to report on the status of exchange compliance with the existing and heightened standards as well as CFTC actions to enforce the FTPA audit trail provisions.
subsections: section_title: Background
paragraphs: Futures contracts obligate the holder to buy or sell a specific amount or value of an underlying asset, reference rate, or index (called the underlying) at a specified price on a specified future date. This obligation can be met through delivery of the underlying or by cash settlement. Futures contracts are designed to manage the risk of changes in the value of underlying assets, rates, and indexes by allowing market users to economically replicate investments in them. By buying and selling futures, users can either assume or transfer the risk of price fluctuations. The futures markets also serve a price discovery function by establishing a price at which a buyer and seller will complete a transaction. These prices are often used in setting the terms of other contracts.
Futures contracts are bought and sold at centralized auction markets called exchanges. In the United States, futures contracts are usually traded through a competitive system, called “open-outcry,” in which floor participants verbally make bids and offers to each other at centralized exchange locations, called “trading pits or rings.” Two types of floor participants execute trades in these pits—floor brokers and floor traders. Floor brokers execute trades for customers and may also execute trades for their personal or employer accounts. In contrast, floor traders execute trades only for their personal accounts.
According to industry officials, U.S. futures markets are largely used by institutions rather than individual “retail” investors. These institutions include banks, insurance companies, mutual funds, corporate pension plans, large corporations, and various federal, state, and local governmental entities. Institutional users expect near instantaneous execution of their orders to secure targeted prices, especially when price movements in the futures markets become rapid. Delays in order execution can increase the risk of a user not obtaining a targeted price (“price slippage”) and can thereby affect the success of the user’s market strategy.
The U.S. futures markets are self-regulated by the 11 active futures exchanges, with CFTC providing federal oversight. Weaknesses in controls over futures trading can provide dishonest floor participants with the opportunity to cheat customers and to conceal this cheating by manipulating the recorded price and time of trades. The FTPA requires that each exchange maintain and use controls to monitor trading in order to deter and detect such illegal activities. These controls must include audit trail systems that capture essential data on trade participants, terms, times, and sequencing.
CFTC audit trail standards in effect prior to the enactment of the FTPA required that exchange audit trail systems (1) assign trade times accurate to within 1 minute of trade execution—referred to as the 1-minute trade timing standard and (2) sequence trades for each floor broker and floor trader. All U.S. futures exchanges were required to comply with these standards. They were subsequently written into the FTPA along with the heightened standards, which required that audit trail data be continually provided to the exchange in an unalterable manner and that it be precise, complete, and independent. The FTPA made compliance with most of the heightened requirements subject to a CFTC determination on the practicability of implementation. Also, exchanges having a minimum average daily trading volume of less than 8,000 contracts in each of its contract markets could qualify for an exemption from the heightened standards if they could demonstrate substantial compliance with the act’s audit trail standards and trade monitoring requirements.
In November 1994, five exchanges were covered by the heightened standards because of their trading volume: (1) CBT; (2) CME; (3) the Coffee, Sugar & Cocoa Exchange (CSCE); (4) the Commodity Exchange, Inc. (COMEX); and (5) the New York Mercantile Exchange (NYMEX). As of the quarter ended on September 30, 1995, a sixth exchange—the New York Cotton Exchange (NYCE)—exceeded the minimum volume criteria and became subject to these standards. Because it had just recently become subject to the standards, in October 1995, CFTC gave the exchange additional time to demonstrate good faith progress towards compliance with them. CFTC plans to test NYCE’s audit trail system beginning in October 1996. As a result, this report does not discuss NYCE compliance with the heightened standards.
Futures exchanges use one of four types of systems to meet audit trail standards—manual, imputed timing, pit card timestamping, and computer trade matching. Five of the 11 active U.S. futures exchanges use manual systems to record trade times—COMEX, the Kansas City Board of Trade, the Minneapolis Grain Exchange, NYCE, and the New York Futures Exchange. Under these systems, floor traders and brokers manually record the time of all trades in sequence on trading cards. Four active exchanges—CBT, CME, CSCE, and the MidAmerica Commodity Exchange—use imputed timing systems. These systems use computer-based algorithms to assign times to trades after they have occurred. They use information from audit trail documentation, including data recorded by floor traders and brokers and data generated independently of them. NYMEX is the only exchange using the pit card system. Under this system, the exchange assigns a time to each trade by timestamping a card that the seller is required to submit within 1 minute of trade execution. Finally, one active U.S. exchange, the Philadelphia Board of Trade, uses computers to match and execute trades.
Electronic systems for meeting audit trail requirements are currently under development—including an electronic hand-held trading terminal and electronic order routing systems. Although the FTPA does not mandate the use of any particular system to meet the heightened standards, Congress knew that three exchanges—CBT, CME, and COMEX—had voluntarily committed to developing electronic hand-held trading terminals when it considered the legislation. The exchanges expected that these electronic terminals would help meet the FTPA audit trail standards and also reduce costs by, among other things, reducing trading errors and administrative expenses. The FTPA legislative history indicates that Congress encouraged CFTC not to require fundamental changes to existing audit trail systems if doing so would cause disproportionate expense or might delay implementation of electronic systems. Under the FTPA, an exchange ultimately must demonstrate compliance with the act’s audit trail standards to continue acting as a market in futures contracts. The act provides CFTC with the authority to issue a deficiency order should an exchange fail to comply with its audit trail standards. The act also sets forth conditions under which dual trading will be banned in high-volume markets. However, it allows CFTC to grant an exemption from the ban to an exchange that can show, among meeting other requirements, that it complies with the act’s audit trail standards. All exchanges covered by the ban have filed petitions for an exemption, and these petitions are still pending. Because the ban on dual trading takes effect when CFTC acts to deny an exchange exemption petition, the ban has yet to take effect on any covered exchange.
section_title: Objectives, Scope, and Methodology
paragraphs: To report on the status of exchange compliance with the existing and heightened standards and CFTC actions to enforce the FTPA audit trail provisions, we reviewed CFTC’s (1) November 1994 report to Congress on audit trails; (2) June 1995 report on the results of exchange audit trail testing; (3) November 3, 1995, letters to four exchanges with agency conclusions related to their good faith efforts to comply with the FTPA; (4) August 1996 report on the status of exchange audit trail compliance and the results of further exchange audit trail testing; (5) other relevant CFTC studies and reports; and (6) the legislative history of the FTPA. We interviewed officials at CFTC headquarters in Washington, D.C., and at CFTC’s Central Regional Office to discuss the FTPA audit trail standards and CFTC efforts to evaluate exchange compliance with them. We also interviewed CBT, CME, CSCE, and NYMEX officials to discuss their views on the standards and their efforts to comply with FTPA and CFTC requirements. We chose these four exchanges because CFTC selected them for initial audit trail testing. We also reviewed documents from these exchanges that described their audit trail systems and the results of exchange audit trail testing.
We conducted our audit work between March 1995 and August 1996, primarily in Washington, D.C., and Chicago, in accordance with generally accepted government auditing standards. We obtained written comments on a draft of this report from CFTC, CBT, CME, and CSCE. These comments are discussed at the end of this letter and are reprinted in appendixes II through V. CFTC, CBT, CME, CSCE, and NYMEX provided additional technical comments on the draft report, which were incorporated as appropriate.
section_title: CFTC Could Not Determine CBT or CME Compliance With the 1-Minute Trade Timing Standard
paragraphs: CFTC could not determine whether CBT or CME—the two largest futures exchanges—complied with the 1-minute trade timing standard before issuing its November 1994 report to Congress or after subsequent testing of their audit trail systems. Before issuing its November 1994 report, CFTC required the exchanges to submit documentation of their audit trail systems’ compliance with the FTPA audit trail standards. On the basis of this and other evidence, CFTC found that 7 of 11 exchanges were in compliance with the 1-minute trade timing and sequencing standards. CFTC concluded that the remaining four exchanges—CBT, CME, CSCE, and NYMEX—had not yet proven their audit trail systems met the standards. CFTC also required these exchanges to conduct two tests in 1994 to measure the capabilities of their audit trail systems. The first test addressed compliance with the 1-minute trade timing and sequencing standards and required that at least 90 percent of sampled trade execution times be consistent with the timing information and sequence recorded on supporting trade documents. CFTC conducted another round of comparable tests at CBT and CME in March 1996.
CFTC reported in June 1995 that CBT and CME test one results were too imprecise to verify compliance with the 1-minute trade timing standard. These two exchanges use computer-based algorithms to impute or estimate trade execution times after the fact. The computer, based on timing information recorded on trade documentation, calculates a span of time, or timing window, during which a trade probably took place and then selects a likely execution time within that window. For exchanges with imputed timing systems, CFTC required, as part of the test, that the average length of the timing windows be 2 minutes or less to approximate the 1-minute trade timing standard. Although 90 percent of imputed trade times of sampled trades at CBT and CME were found to be accurate (i.e., consistent with the supporting documentation), the length of many timing windows was in excess of 2 minutes. At CBT, 41 percent of the accurate trade times had timing windows of 2 minutes or less. At CME, 72 percent of the accurate trade times had timing windows of 2 minutes or less. CFTC concluded that these results were too imprecise to verify compliance with the 1-minute trade timing standard and later, as discussed on page 12, recommended that CBT and CME implement numerous audit trail improvements. The March 1996 retests at CBT and CME showed that these numbers had improved to 69 percent and 80 percent, respectively, but were still short of the 90-percent precision level CFTC sought.
Test one results at both CSCE and NYMEX exceeded the 90-percent accuracy requirement. Further, at CSCE, which also uses an imputed trade timing system, 91 percent of these accurately timed trades had timing windows of less than 2 minutes, thus meeting the accuracy requirement. At NYMEX, however, the sequence of trades determined by times stamped on pit cards by exchange employees was often different from the sequence recorded by traders and brokers on trading cards. NYMEX is addressing this problem with a new integrated trading/pit card. (See app. I for details.)
section_title: CFTC Has Not Found Any Exchange in Full Compliance With the Heightened Standards, but Found That Progress Continued to Be Made
paragraphs: The heightened standards required additional improvements to exchange audit trails. As of October 28, 1995, when the standards took effect, the electronic trading terminals that exchanges had begun to develop that might bring some exchanges into compliance with them were not fully operational, and significant delays were envisioned. In the absence of the terminals, CFTC did not find any of the exchanges covered by the heightened standards to be in full compliance with them. Given this situation, the statute required that CFTC consider any circumstances that prevented compliance despite an exchange’s good faith effort—thus qualifying an exchange for a statutory safe harbor. COMEX received a de facto determination that it had made a good faith effort in November 1994, when CFTC determined its manual audit trail system did not require testing. In November 1995, based on exchange audit trail test results and implementation of recommended audit trail improvements, CFTC notified CSCE and NYMEX that they had qualified for a safe harbor but deferred a decision on CBT and CME until further testing. CFTC reported in August 1996 that, although the results of further testing showed considerable improvements, CBT and CME did not demonstrate compliance with the heightened standards. CFTC gave the exchanges until January 1, 1997, to make further improvements. In addition, CFTC has yet to address the practicability of certain of the audit trail provisions of the act, including the broker receipt timing requirement, but agency officials told us that CFTC plans to do so. It also plans to act on exchange petitions for exemption from the dual trading ban beginning in September 1996.
subsections: section_title: The Heightened Standards Require Improved Audit Trails
paragraphs: In addition to meeting the requirements of the existing 1-minute trade timing and sequencing standards, including capturing the essential data on the participants, terms, times, and sequencing of all trades, the heightened standards require that this information be continually provided to the exchange in an unalterable manner and that it be precise, complete, and independent. Continually providing data to an exchange could reduce the opportunity for floor brokers and traders to illegally alter the trading record. The requirement that the data be unalterable is to prevent floor brokers or traders from changing a trading record without detection.
Also, while existing CFTC regulations required exchanges to sequence trades, the act requires exchange audit trail systems to be sufficiently precise to determine, to the extent practicable, the sequence of all trades by each floor trader and floor broker. Exact trade sequencing would help detect trading abuses, such as trading ahead of customer orders. In addition, the FTPA now requires the exchanges to obtain, to the extent practicable, more complete timing information for customer orders, including the time an order is received on the exchange floor, received by the floor broker for execution, and reported from the floor as executed. More complete times could also improve an exchange’s ability to accurately sequence trades.
Finally, the act requires that the execution time for each trade be recorded independently of the person making the trade or derived through automatic or other similarly reliable means. Independent or automatic trade recording could increase the reliability of the data collected by preventing the broker or trader from falsifying the record. The FTPA made compliance with this and most of its other audit trail requirements subject to a CFTC determination on the practicability of implementation. The FTPA authorized CFTC to defer the deadline for compliance with the heightened standards if it determined that circumstances beyond the control of an exchange prevented compliance, despite affirmative good faith efforts to comply. Also, the act required CFTC to exempt an exchange from the heightened standards if the average daily trading volume in each of its contract markets was less than 8,000 contracts and if it could demonstrate substantial compliance with the act’s audit trail standards and trade monitoring requirements.
section_title: Electronic Trading Terminals Were Not Fully Operational and Have Been Significantly Delayed
paragraphs: Three of the exchanges covered by the heightened standards have worked on electronic trading terminals for recording and processing trades, but none of these terminals is fully operational. The terminals were intended to provide the exchanges with continual and unalterable audit trail data that would be more precise, complete, and independent. However, they are limited in their ability to create a “perfect” audit trail. For example, CFTC officials told us that data could be altered before being entered into the terminals. CME officials also indicated that, while the terminals can record the precise time that a floor trader or broker begins to record a trade, the floor trader or broker may be forced to delay entering trade information in order to execute other customer or personal trades. CFTC officials told us that, consistent with the FTPA, the agency has never taken the position that electronic trading terminals are the only way to meet the heightened standards. These officials also said that the agency will determine the extent to which the terminals satisfy the statutory standards based on the particulars of their individual design and operation.
COMEX began developing a hand-held terminal in 1986 for recording and timing trades. NYMEX acquired the rights to this project when it merged with COMEX in 1994, making COMEX an operating division. NYMEX subsequently decided not to pursue the project because of developmental problems and because it believed that its manual audit trail system met the requirements of the FTPA. After the initial results of the CFTC/Department of Justice undercover investigation were announced, CBT and CME began a joint venture to automate trade recording and timing by developing a hand-held automated data input terminal, called AUDIT. According to CBT and CME, as of June 30, 1996, they had incurred expenditures of $14.2 million and $9.1 million, respectively, in external and internal costs to develop AUDIT. The exchanges initially told CFTC that AUDIT would be operational by the October 28, 1995, statutory deadline for implementing the FTPA heightened audit trail standards. However, CBT and CME informed CFTC before the issuance of its 1994 report that AUDIT would not be operational by October 1995. The exchanges have since indicated that further delays in implementation would occur and that the planned capability of AUDIT to handle customer trades would be delayed, perhaps significantly. CBT officials told us that they expect delays in implementing the customer trade processing capability of AUDIT because of the need to develop an order routing system for a new trading floor that is under construction. CME officials also told us that, although the exchange is continuing with its efforts to implement AUDIT, it is now considering the use of off-the-shelf technology for customer trade processing because of AUDIT software development problems.
In addition to AUDIT, CBT and CME are developing other electronic systems that could enhance audit trails and contribute to compliance with the act’s provisions. CBT and CME have jointly developed an automated trade order processing system, called TOPS Route. Both exchanges have also developed and continue to enhance universal broker work stations, called Electronic Clerk at CBT and CUBS at CME. CBT is also developing a booth work station called Computer Order Management, Entry, and Timing, or COMET. TOPS Route rapidly transmits orders from a firm’s office to its booth on the trading floor and records the time that an order is received at the booth and the time it is filled. CUBS and Electronic Clerk organize orders received on the floor and provide the time that the broker receives an order, the time the order is filled, and the time the broker confirms the order fill to the firm’s booth on the trading floor. COMET provides a mechanism for delivering and receiving order information and other messages into and out of the trading pit. According to CME, TOPS Route is expected to be implemented for most clearing firms, while the extent of CUBS implementation will depend on space constraints and the differing needs of brokers. In June 1996, CME began a 6-month pilot program in one of its markets under which TOPS Route and CUBS are integrated to form a continuous order routing system. CBT expects TOPS Route and COMET/Electronic Clerk to be substantially implemented when its new trading floor opens in February 1997.
These automated order routing systems could enhance audit trails by meeting the FTPA requirements for recording the time an order reaches the exchange floor, the time the broker receives an order, and the time the order fill is recorded. According to CFTC officials, these systems should result in better timing data for orders by augmenting existing sequencing information.
section_title: CFTC Gave CBT and CME Additional Time to Improve Their Audit Trails
paragraphs: CFTC determined that CSCE and NYMEX had made good faith efforts to comply with the heightened standards, thus qualifying them for a statutory safe harbor. COMEX was in effect granted a safe harbor in November 1994 when it was not required to test its audit trail system. CFTC reported that COMEX had produced evidence that its manual system met the 1-minute trade timing standard. CFTC initially deferred a decision on whether CBT and CME had made a good faith effort to comply with the heightened standards until after a retest of their audit trail systems. After its March 1996 retests, CFTC gave the exchanges additional time to improve their audit trails without determining whether they had qualified for a safe harbor.
To assess progress towards compliance with the heightened standards in the absence of electronic systems, in 1994, CFTC required four exchanges—CBT, CME, CSCE, and NYMEX—to perform a second test of trade sequencing capabilities, using more exacting criteria than were used for the first test. According to CFTC officials, these criteria were designed to approximate the precision or enhanced sequencing requirements of the heightened standards. As with the first test, CFTC required that 90 percent of sampled trades be accurately sequenced. The test results showed that only CSCE met the 90-percent accuracy requirement for all samples tested. CFTC recommended that NYMEX implement 9, CBT implement 17, and CME implement 18 additional improvements to their audit trail systems to increase timing precision and show progress towards compliance with the heightened standards. Although CSCE passed the test, CFTC recommended that CSCE implement six improvements to its audit trail system. At the same time it made these recommendations, CFTC urged the exchanges to continue efforts to implement electronic systems. (See app. I for a list of CFTC’s recommendations.)
According to CFTC, prompt implementation of the recommended audit trail improvements would demonstrate a good faith effort toward meeting the heightened standards. A finding of good faith would mean that an exchange had satisfied the statutory requirement for progress and, therefore, was entitled to a safe harbor. CFTC found that both CSCE and NYMEX had made good faith efforts to comply with the standards by the statutory deadline. CSCE agreed to implement all but one recommendation. However, CFTC concluded that this recommendation did not relate to trade timing accuracy and, therefore, was not material to a good faith finding. NYMEX agreed to implement all but one audit trail recommendation but offered CFTC an acceptable alternative. Both CBT and CME agreed to implement almost all of CFTC’s audit trail recommendations or offered alternatives. CBT declined to implement two of CFTC’s recommendations based on tests it conducted. CBT said these tests indicated that the recommendations disrupted trading, would increase trade processing costs, or would not improve audit trail accuracy. CBT also offered CFTC an acceptable alternative for one recommendation. CME declined to implement one recommendation but informed CFTC that it would continue to evaluate the recommendation. The exchange said it based its decision on tests it conducted that indicated the recommendation disrupted trading and would increase trade processing costs. CME also offered CFTC an acceptable alternative for one recommendation. (See app. I for details on the exchanges’ responses to CFTC’s recommendations.)
The CFTC recommendation that both CBT and CME declined to implement, based on their tests, was the requirement that floor traders manually record the execution time for the first and either sixth or last trade on every trading card. As discussed on page 4, these two exchanges use computer-based algorithms to impute trade times after the fact, rather than requiring floor traders or brokers to record the times that personal or customer trades are executed. CBT reported that its own separate tests showed that adding manual times to trading cards disrupted trading, increased clearing firms’ trade processing costs, and resulted in less accurate computer-imputed times because traders were unable to record accurate times during hectic trading. CME reported that traders involved in its separate test had indicated that recording these times disrupted trading. However, CME’s tests did not show a reduction in audit trail accuracy. Nonetheless, the exchange expressed concern that this requirement would increase trade processing costs for clearing firms and could result in delays in execution of customer orders or degrade overall market efficiency.
In November 3, 1995, correspondence, CFTC notified CSCE and NYMEX that they had qualified for the statutory safe harbor. Although CFTC did not indicate when the safe harbor would end, CFTC told the exchanges that it would retest them to evaluate whether the changes they made brought them into compliance with the FTPA audit trail standards. CFTC reported in August 1996 that it plans to assess CSCE and NYMEX audit trail improvements during rule enforcement reviews in 1997.
CFTC also notified CBT and CME on November 3, 1995, that a decision on whether they qualified for the statutory safe harbor would be deferred until the results of another round of tests were obtained. CFTC tested these exchanges in March 1996 to evaluate the effect of the agreed-to improvements on their audit trails. The agency reported in August 1996 that the test results showed improvements in the precision of the exchanges’ audit trails but that neither exchange met the heightened standards. CFTC did not determine that CBT and CME had demonstrated the good faith effort required to be granted a safe harbor under the act. Instead, CFTC gave each exchange until October 28, 1996, to report on how they intended to improve their audit trails and until January 1997 to implement the improvements.
Implementation of all CFTC recommendations will not necessarily result in full compliance with the heightened standards. CFTC reported in June 1995 that the exchanges may need to implement additional improvements to their systems to achieve compliance. According to CFTC officials, full compliance with the heightened standards is an objective against which the exchanges must continually be tested as the quality of audit trail data also depends on other factors, such as the accuracy of data entry, the integrity of pricing data, and the handling of trade errors. Ultimately, all of the exchanges covered by the FTPA heightened standards must comply with them or be subject to CFTC disciplinary action unless, as discussed next, CFTC finds compliance with a standard impracticable.
section_title: CFTC Has Not Fully Addressed the Practicability of All of the Act’s Provisions
paragraphs: Several exchanges have raised concerns about CFTC’s obligations under the FTPA for determining the practicability of the heightened audit trail requirements, including the need to assess the cost of compliance as well as to address differences between the exchanges. As previously discussed, the act requires CFTC to address the practicability of most of the heightened standards and authorizes the agency to promulgate standards, in some cases by either rule or order. To date, CFTC has issued guidance on how orders “flashed” into a trading pit can satisfy the broker receipt timing requirement of the act, but has not addressed the practicability of capturing broker receipt times for nonflashed orders. According to CFTC, its June 1995 recommendations to the four exchanges represent guidance on how to demonstrate the good faith effort required by the FTPA in the absence of full compliance.
In June 1996, the exchanges testified that the FTPA requirement to capture broker receipt time was not currently practicable. Separately, CBT and CSCE also expressed concern that due to differences in trading volume and in the way customer orders are routed, trades recorded, and execution times derived, audit trail features that are practicable at one exchange may be impracticable at another exchange without significantly disrupting trading. CBT told us that the act contemplates that CFTC’s practicability determination would result from testing its proposed enhancements to audit trails and conducting cost-benefit analyses of them. Both CBT and CME said the act contemplates that CFTC would consider the cost of enhancements and the effectiveness of reasonable alternatives to proposed enhancements. CSCE was concerned that CFTC make its practicability determination on an exchange-by-exchange basis and that those determinations consider the financial capability of the exchange.
CFTC officials told us that the agency intends to provide further guidance on the practicability of the broker receipt time requirement. They said that determining the practicability of this requirement is a dynamic process that will be affected by ongoing exchange initiatives to develop automated order routing systems. They also said that further dialogue with the exchanges and the floor broker community needs to occur before the agency can reach a conclusion on the practicability of capturing broker receipt times for nonflashed orders and that CFTC has scheduled an industry roundtable discussion for October 1996 where this topic will be addressed. CFTC also reported that it plans to address the practicability of further integrating customer and personal trades at CBT and CME.
According to CFTC, the FTPA does not require it to conduct a cost-benefit analysis of audit trail enhancements. CFTC reported, however, that the cost of achieving a perfect audit trail may be prohibitive and that the costs of complying with the heightened standards must be taken into account. Further, the agency reported that the act does not specify the method of achieving compliance but rather sets forth a performance standard that can be satisfied by any means. CFTC has used testing to determine if exchange enhancements bring them into compliance with the act’s audit trail standards. As part of this process, CFTC has let the exchanges decide whether to implement electronic systems or lower-cost manual measures to meet the standards. CFTC has also accepted certain lower-cost exchange alternatives for demonstrating a good faith effort to comply with the heightened audit trail standards. CFTC reported that the agency accounted for exchange differences during audit trail testing at the four exchanges. Our review of CFTC recommendations indicated that CFTC generally tailored its recommended improvements to each exchange.
section_title: Dual Trading Ban Exemption Petitions Are Still Pending
paragraphs: The FTPA set forth conditions under which dual trading in contract markets in which the average daily trading volume equals or exceeds 8,000 contracts would be banned. The statute also requires that dual trading at an exchange be exempted from the ban if the exchange can show that it has an effective trade monitoring system that includes compliance with the act’s audit trail standards. The FTPA included the ban to limit the opportunity for trading abuses to occur. It linked an exemption from the ban to compliance with the act’s audit trail standards because an effective audit trail facilitates the detection of trading abuses and, therefore, acts as a deterrent to them.
The dual trading ban was to take effect 30 days after the effective date of the dual trading regulations or whenever CFTC acted to deny an exchange’s exemption petition. On July 28, 1993, CFTC issued the dual trading regulations, which required that a petition for exemption from the dual trading ban be supported by evidence that, among other things, at least 90 percent of the trade times assigned by an exchange audit trail meet the 1-minute trade timing standard. The regulations, as required by the FTPA, also suspended enforcement of the ban for all exchanges that filed timely exemption petitions. According to the act and regulations, the suspension would remain in effect until the agency ruled on the petitions. The FTPA required CFTC to act on an exemption petition within 75 days of receipt, or as soon as practicable. The exchanges covered by the ban all filed petitions, but these petitions are still awaiting CFTC action. As a result, the exchanges are authorized to continue dual trading. CFTC officials told us the agency determined that given the relationship between the dual trading ban and compliance with the audit trail standards, it was essential to address the status of the exchanges’ audit trails first. According to CFTC, it plans to act on the exemption petitions, which may be updated to reflect audit trail enhancements, beginning with COMEX in September 1996, CBT and CME in January 1997, and the remaining exchanges to follow.
section_title: Conclusions
paragraphs: CFTC has taken actions to enforce exchange compliance with the FTPA audit trail standards. Also, the exchanges we reviewed have continued to make progress toward compliance with them. Nonetheless, we are concerned that the momentum toward achieving compliance could be lost now that the legislatively mandated deadline has passed without any covered exchange being found in full compliance. The audit trails of CBT and CME—the two largest futures exchanges—do not yet meet the heightened standards. CFTC also concluded that they were insufficiently precise to verify compliance with the 1-minute trade timing standard that predates the FTPA. In addition, implementation of electronic trading terminals that have the potential to bring these exchanges into compliance with the standards is uncertain. Also, it is not clear when the exchanges currently qualifying for the statutory safe harbor will achieve compliance with the heightened standards through continued good faith efforts. Further, CFTC has not yet fully addressed the practicability of all the act’s requirements as part of its ongoing effort to enforce the heightened standards. Finally, the dual trading provisions of FTPA have not yet been fully implemented. Thus, it is particularly important that Congress be informed of exchange progress toward meeting the heightened audit trail standards and other requirements of the act as well as steps CFTC is taking to facilitate such progress. The FTPA reporting requirement achieved this result, but CFTC issued its report in 1994 and no further reporting requirements exist.
section_title: Recommendation
paragraphs: We recommend that the Chairperson, CFTC, inform Congress periodically on exchange progress towards compliance with the FTPA heightened audit trail standards and on implementation of the dual trading ban—including any mitigating factors delaying compliance or implementation and the steps CFTC is taking to encourage continued progress. Such information could be provided annually in a report on or about October 28, the anniversary of the statutory deadline for compliance with the heightened standards, or through periodic testimonies before congressional committees.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from CFTC, CBT, CME, CSCE, and NYMEX. CFTC supported our recommendation; the exchanges did not address it in their written comments. Written comments from CFTC, CBT, CME, and CSCE and our additional responses are contained in appendixes II through V; NYMEX provided oral technical comments. These technical comments as well as those provided by CFTC and the other exchanges were incorporated into the report as appropriate.
We reported that the exchanges included in our review have continued to make progress towards compliance with the heightened FTPA audit trail standards, but no exchange has been found in full compliance with them. CME indicated that, contrary to our report conclusions, the exchange is in substantial compliance with the FTPA audit trail requirements, either through direct compliance or because some requirements of the act are impracticable. First, CME infers that we made an assessment of its compliance with the act, reflecting a misunderstanding of our review objectives and resulting conclusions. Congress delegated responsibility for ensuring compliance with the act’s audit trail provisions to CFTC. We were responsible for reporting on the status of compliance with the act, including CFTC actions to enforce exchange compliance with it. Second, as stated in our report, CFTC plans to work with the exchanges to address the practicability of the act’s provisions related to broker receipt time and with CBT and CME to address the practicability of further integrating customer and personal trades.
In addition to CME, the other three exchanges indicated varying degrees of disagreement with CFTC’s conclusions that their audit trail systems were not yet in compliance with the act’s requirements. CFTC reached its initial conclusions about compliance with the act based on testing of exchange audit trails and exchange implementation of its subsequent recommendations. CFTC has done additional testing and evaluation of CBT and CME audit trails and has reported that, although improvements were made, the test results did not show compliance with the heightened standards.
CME commented that we and CFTC have focused exclusively on statistical measurement without reference to the underlying purpose of an audit trail—deterring trade practice violations. We agree that the ultimate measure of the effectiveness of an audit trail is its ability to deter as well as detect such violations. However, the effectiveness of an audit trail in these areas can be difficult to verify. The use of statistical measures along with other relevant information, provides a baseline against which progress toward compliance with the audit trail standards can be measured. It also provides a basis, given the differing exchange audit trail systems, of comparing the progress of the exchanges to each other. The latter provides some assurance that the standards are consistently and, therefore, fairly applied.
We are sending copies of this report to the Chairperson, CFTC, and other interested parties. We will also make copies available to others upon request.
Please contact me at (202) 512-8678 or Cecile O. Trop, Assistant Director, at (312) 220-7705 if you or your staff have any questions. Major contributors to this report are listed in appendix VI.
section_title: CFTC Recommendations to Futures Exchanges for Improving Their Audit Trails and Exchange Responses
paragraphs: The following are the audit trail improvements that CFTC recommended in June 1995 to the Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), Coffee, Sugar & Cocoa Exchange (CSCE), and New York Mercantile Exchange (NYMEX) and the exchanges’ individual responses. The exchanges indicated that they had either implemented or planned to implement and/or test some of the improvements prior to CFTC’s issuance of the audit trail test results and its June 1995 recommendations.
subsections: section_title: Recommendations to CBT and CME
paragraphs: CFTC recommended that CBT and CME implement 17 and 18 improvements, respectively, to their audit trail systems. The following 11 recommendations were common to both exchanges: (1) Limit the number of trades recorded on each trading card to six. (2) Record and use manual execution times for at least the first and sixth trades on each trading card, and use more manual times in the lower volume markets. (3) Use one-sided trading cards to record personal buys and sells in sequence. (4) Use a new trading card with the change of each bracket period. (5) Use a special indicator to designate customer orders “flashed” into the trading pit. (6) Use seconds in the imputed timing system where available, including seconds from customer order ticket timestamps. (7) Add the time a customer trade is stamped as executed to the imputed timing system. (8) Promptly supply members with information on audit trail data inconsistencies and require corrections that reflect actual events. (9) Aggressively enforce audit trail data recordation and submission requirements, especially for spread trades, and ensure that timing data are entered correctly. (10) Aggressively enforce order ticket timestamping procedures for orders flashed into the trading pit. (11) Reprogram the imputed timing system to use all additional data obtained as a result of CFTC’s recommendations when assigning execution times to trades.
CFTC recommended that CBT implement the following additional improvements: (12) Complete efforts to capture real-time quotes in the time and sales register for trades executed during the opening of the trading  session. (13) Include the identity of trade participants in the time and sales register  for spread trades. (14) Aggressively enforce requirements to record the correct  customer-type indicator codes. (15) Upgrade timestamp clocks to record times to the second.
CBT was also required to implement two refinements to the computer-based algorithm used by its imputed timing system to assign times to trades.
CFTC recommended that CME implement the following additional improvements: (12) Use order-type information to derive times for trades. (13) Use clearing receipt time in the imputed timing system. (14) Synchronize timestamp clocks across the floor and upgrade timestamp  clocks to record times to the second.
CME was also required to implement four refinements to the computer-based algorithm used by its imputed timing system to assign times to trades.
subsections: section_title: Exchange Responses
paragraphs: CBT agreed to implement 14 of the 17 recommendations and offered an acceptable alternative for one recommendation. CME agreed to implement 16 of the 18 recommendations and offered an acceptable alternative for one recommendation. Both exchanges had planned to test the recordation of manual execution times for certain trades on each trading card (recommendation 2) and one-sided trading cards (recommendation 3) prior to June 1995. CBT had also planned to test recommendations 1, 4, 7, and 8 prior to this time.
Both CBT and CME declined to implement CFTC’s recommendation to record and use manual execution times for certain trades on each trading card and use more manual times in the lower-volume markets (recommendation 2) based on tests conducted separately at both exchanges. CBT said that its own separate test results indicated that requiring manual execution times decreased the accuracy level of its imputed timing system because traders were unable to record accurate execution times during hectic trading. According to CBT, some traders commented that this requirement disrupted their trade recordation efficiency, and that due to being focused on executing trades, they frequently were unable to record execution times until several minutes after the actual time of execution. CBT clearing firms also indicated that this requirement would increase trade processing costs.
CME declined to implement this recommendation but informed CFTC that it would continue to evaluate the recommendation. The exchange’s separate tests indicated that the requirement impaired trading. According to CME, some higher-volume floor traders complained that they could not continue to trade at their accustomed pace while having to manually record execution times during busy periods in the market. The exchange was also concerned that this requirement would increase trade processing costs for clearing firms and could result in delays in execution of customer orders or degrade overall market efficiency.
CBT also declined to include the identity of trade participants in the time and sales register for spread trades (CBT recommendation 13) based on tests conducted in two of its markets. These tests indicated that this recommendation did not substantially improve audit trail accuracy. According to CBT, reporting this information to exchange price reporters also significantly reduced price reporting efficiency and disrupted trading. The exchange is integrating synchronized timestamp clocks that record times to the nearest second (CBT recommendation 15) as clocks are replaced. CBT indicated that it plans to use the upgraded devices on its new trading floor, which is currently under construction. CBT also offered an alternative to one of the recommended refinements to its computer-based algorithm, which CFTC accepted.
CME offered an alternative to synchronizing timestamp clocks across the exchange floor and upgrading timestamp clocks to record times to the second (CME recommendation 14), which CFTC accepted. CME’s alternative was to conduct more frequent audits of timeclock accuracy, apply more pressure on firms to ensure that timeclocks are accurately set, and require firms to upgrade timeclocks as they are replaced. The exchange believed that this approach satisfied CFTC’s recommendation without incurring excessive costs.
section_title: Recommendations to CSCE
paragraphs: CFTC recommended that CSCE implement the following six improvements to its audit trail system: (1) Complete upgrades to its price reporting system to include entry of the selling floor trader’s or floor broker’s identity in the time and sales register. (2) Manually record execution times for every fifth trade on each trading card. (3) Aggressively enforce order ticket recordkeeping requirements. (4) Place customer account numbers on the trade register.(5) Use timestamp clocks that record times to the second at such time as the exchange moves to a new facility. (6) Ensure that the imputed timing system derives only one possible execution time for each trade.
subsections: section_title: Exchange Response
paragraphs: CSCE agreed to implement five of the six recommendations. CSCE announced its plans to upgrade its price reporting system to include the selling party’s identity in the time and sales register (recommendation 1) and began testing of recording manual times for every fifth trade on a card (recommendation 2) prior to June 1995. CSCE declined to implement the recommendation to place customer account numbers on the trade register (recommendation 4) because it would interfere with the exchange’s ability to quickly process and match trades. CFTC said that including account numbers on the trade register provides a useful surveillance tool; however, it indicated that because customer account numbers are not related to trade timing accuracy, CSCE could come within the safe harbor without implementing the recommendation.
According to CSCE, the recommendations related to enforcing order ticket recordkeeping requirements (recommendation 3) and upgrading timestamp clocks to record times to the second (recommendation 5) will not impact trade timing and sequencing at the exchange because its imputed timing system does not use order ticket timestamps to derive trade execution times.
section_title: Recommendations to NYMEX
paragraphs: CFTC recommended that NYMEX implement the following nine improvements to its audit trail system: (1) Integrate pit card system times with trade sequence data on trading cards through manual or electronic means. (2) Manually record execution times for the first and every fifth trade  thereafter on each trading card.(3) Limit the number of trades recorded on each trading card. (4) Collect trading cards within 15 minutes after the end of each 30-minute bracket period. (5) Develop a time and sales register for spread trades. (6) Enhance the timeliness of data entry for the pit card system. (7) Aggressively enforce timeliness of pit card submissions and trading card sequencing requirements. (8) Place customer account numbers on the trade register. (9) Use timestamp clocks that record times to the second at such time as the exchange moves to a new facility.
subsections: section_title: Exchange Response
paragraphs: NYMEX agreed to implement eight of the nine recommendations. The exchange offered an alternative to collecting trading cards within 15 minutes after the end of each bracket period (recommendation 4), which CFTC accepted. Specifically, NYMEX agreed to introduce a new integrated trading card that provides for concurrently recording trade information on both a trading card and a pit card. The exchange began developing the new card prior to June 1995. In addition to recording trade information on trading cards, the selling participant to each trade must record trade information on a separate card called a pit card. The pit card is required to be thrown into a net in the center of the trading pit within 1 minute of trade execution where it is collected by an exchange employee. The employee then timestamps the card, which establishes the official trade execution time. Tests required by CFTC disclosed that the sequence of trades as determined by this time stamp was frequently different than the sequence as recorded on trading cards by brokers and traders. According to CFTC, the new integrated card should also address the sequencing inconsistencies between pit cards and trading cards disclosed by testing.
section_title: Comments From the Commodity Futures Trading Commission
section_title: Comments From the Chicago Board of Trade
paragraphs: The following are GAO’s comments on the Chicago Board of Trade’s letter dated July 17, 1996.
subsections: section_title: GAO Comments
paragraphs: 1. CBT commented that in wielding its exemptive powers under the FTPA, CFTC broadly exempted the over-the-counter markets from virtually all Commodity Exchange Act requirements, including those related to audit trails. We are preparing a separate report on the differences in regulatory oversight of the over-the-counter derivatives and futures markets and possible challenges to regulatory policy raised by these differences. 2. CBT commented that the FTPA requires CFTC to conduct cost-benefit analyses to determine the practicability of the heightened audit trail standards. CFTC has reported that the costs of complying with the heightened standards must be taken into account, but the agency has concluded, as reported on page 16 of our report, that the FTPA does not require a formal cost-benefit analysis. 3. CBT noted that, in contrast to our draft report, the exchange has adopted using seconds in its imputed timing system where available, and it is integrating synchronized timeclocks to record times to the nearest second. We corrected the report.
section_title: Comments From the Chicago Mercantile Exchange
section_title: Comments From the Coffee, Sugar & Cocoa Exchange
section_title: Major Contributors to This Report
paragraphs: Thomas J. McCool, Associate Director Cecile O. Trop, Assistant Director Roger E. Kolar, Evaluator-in-Charge Cristine M. Marik, Evaluator Daniel K. Lee, Evaluator The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent.
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