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. 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. 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.