[Federal Register Volume 64, Number 111 (Thursday, June 10, 1999)]
[Notices]
[Pages 31195-31198]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-14713]
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COMMODITY FUTURES TRADING COMMISSION
Alternative Executive, or Block Trading, Procedures for the
Futures Industry
AGENCY: Commodity Futures Trading Commission.
ACTION: Advisory.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'') will
consider contract market proposals to adopt alternative executive
execution, or block trading, procedures for large size or other types
of orders on a case-by-case basis under a flexible approach to the
requirements of the Commodity Exchange Act (``Act'') and the
Commission's regulations. The Commission continues to be open to
further comments on the various issues surrounding potential
alternative execution procedures from industry participants.
EFFECTIVE DATE: This Advisory is effective upon issuance.
FOR FURTHER INFORMATION CONTACT:
Rebecca L. Creed, Attorney, Division of Trading and Markets, Commodity
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,
NW, Washington, DC 20581. Telephone: (202) 418-5430.
SUPPLEMENTARY INFORMATION:
I. Introduction
After careful consideration of public comments and interviews with
interested securities and futures industry participants, the Commission
has decided to evaluate contract market proposals to adopt alternative
execution, or block trading, procedures for large size or other types
of orders on a case-by-case basis. As discussed below, the Commission
believes that the appropriate terms and conditions governing such
execution procedures are best addressed in the context of specific
proposals. The Commission stands ready to consider any rule proposal
submitted by a contract market that expressly allows such transactions
to be executed using any combination of competitive and noncompetitive
execution procedures. The Commission plans to take a flexible approach
in considering such proposals.
[[Page 31196]]
II. The Commission Solicited Comments on Alternative Execution, or
Block Trading Procedures in its Concept Release Concerning the
Regulation of Noncompetitive Transactions Executed on or Subject to
the Rules of a Contract Market
On January 26, 1998, the Commission published a Concept Release in
the Federal Register for public comment concerning the regulation of
noncompetitive transactions executed on or subject to the rules of a
contract market.\1\ Among other things, the Concept release discussed a
wide range of issues concerning alternative execution procedures.\2\
Specifically, the Commission wished to explore whether certain
alternative execution procedures for large size or other types of
orders could be developed to satisfy the needs of market participants
while furthering the policies and purposes of the Act and the
Commission's regulations. Through the questions posed in the Concept
Release, commenters were asked whether the Commission should permit
alternative execution procedures pursuant to the rules of a contract
market; what general qualifying standards should govern a proposal's
eligibility for approval by the Commission; and whether additional
regulatory requirements should be imposed on these procedures to
maintain integrity and to provide guidance to self-regulatory
entities.\3\ Of the sixty-four comment letters the Commission received
in response to the Concept Release, fifty-seven specifically addressed
such execution procedures.\4\
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\1\ 63 FR 3708 (January 26, 1998).
Throughout the Concept Release and in this Advisory, the
Commission uses the term ``noncompetitive transaction'' to refer to
those transactions that are negotiated and executed by
counterparties other than through open outcry or other competitive
means, but in accordance with the written rules of a contract market
that have been submitted to and approved by the Commission. The
noncompetitive transactions discussed in the Concept Release are
distinguishable from those abusive trading practices prohibited by
section 4c(a) of the Act, such as wash sales, cross trades,
accommodation trades, and fictitious sales. Moreover, as noted by
many of the commenters responding to the Concept Release, these
noncompetitive transactions might be structured in such a manner
that promotes competitive pricing, transparency, or other beneficial
goals.
The Commission recognizes, however, that new execution
procedures for large size or other types of orders might utilize a
combination of competitive and noncompetitive trading practices. The
term ``alternative execution procedures'' is intended to embrace the
entire range of potential execution procedures that might be
proposed by a contract market including those referred to in the
Concept Release and comments thereon as block trading procedures.
This includes those procedures that provide some degree of exposure
of large size orders to the competitive pressures of the centralized
futures marketplace as well as those that are purely noncompetitive.
\2\ The Release also included questions concerning the oversight
of: (1) Exchanges of futures contracts for physicals (``EFPs''),
which are authorized under the Act and the Commission's regulations;
(2) other potential noncompetitive transactions, including exchanges
of futures contracts for qualifying swap agreements (``EFS
transaction'') and exchanges of option contracts for physicals
(``EOPs''); and (3) the use of execution facilities for
noncompetitive transactions. The overall purpose of the Concept
Release was to solicit comments on the current regulatory structure
governing noncompetitive transactions and whether this approach
should be modified in light of recent developments in the
marketplace.
On January 7, 1999, the Commission approved the New York
Mercantile Exchange's (``NYMEX'') proposal to adopt new Rule 6.21A,
which authorize EFS transactions pursuant to the terms and
conditions of a three-year pilot program. See Commission Press
Release No. 4228-99. Any contract market which is interested in
allowing EFS transactions in their designated markets may submit a
proposal to the Commission for its consideration, pursuant to
Section 5a(a)(12)(A) of the Act and Commission Regulation 1.41.
\3\ The comment period on the Concept Release originally was
scheduled to run from January 26, 1998, through March 27, 1998, but
was extended by the Commission until April 27, 1998. 63 FR 13640
(March 20, 1998). At the request of the Futures Industry
Association, the Commission further extended the comment period on
those parts of the Release that related to alternative execution
procedures until September 1, 1998. 63 FR 24164 (May 1, 1998).
\4\ Several comments submitted multiple and/or joint comment
letters.
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These comment letters revealed two divergent viewpoints concerning
the adoption of alternative execution procedures by contract markets.
Eleven commenters generally supported such procedures, while forty-nine
commenters generally opposed them. The supporting comment letters
indicated that alternative execution procedures should be implemented
in order to alleviate the current difficulties faced by institutional
market participants in executing large futures and option orders. These
commenters stated that execution procedures could be structured in such
a way as to minimize any negative impact on market volume, liquidity,
price discovery, transparency, or customer protection. Conversely, the
opposing comment letters generally stated that alternative execution
procedures would divert order flow away from the centralized,
competitive marketplace, thereby reducing liquidity and jeopardizing
the price discovery and hedging functions of the futures markets. These
commenters stated that such execution procedures would prevent floor
traders and certain other entities from participating in large
transactions between institutions and that customers ultimately would
be harmed by the lack of transparency associated with these procedures.
A. Current Contract Market Large Order Execution Procedures
Under the Act and the Commission's regulations, all futures and
option transactions generally must be executed openly and competitively
by open outcry, by posting of bids and offers, or by equally open and
competitive methods in the trading pit or ring or similar place
provided by a designated contract market.\5\ As noted in the Concept
Release, the Commission has approved or allowed into effect various
contract market rules which establish procedures for the execution of
large orders.\6\ These procedures generally preserve the competitive
forces available on a centralized market and thereby comply with the
open and competitive execution requirement. The Commission also has
taken steps to streamline its own regulations to facilitate the
adoption of large order execution (``LOX'') procedures by contract
markets.\7\
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\5\ See sections 4(a) and 4b of the Act; Commission Regulation
1.38(a). There are, however, certain limited exceptions to this
requirement. Section 4c(a) of the Act prohibits certain types of
noncompetitive or otherwise abusive trading practices, such as wash
sales, cross trades, accommodations trades, and fictitious sales,
but provides an exception for EFPs that are executed in accordance
with contract market rules that have been approved by the
Commission. An EFP involves simultaneous transactions in the futures
and cash commodity markets. One party buys the physical commodity
and simultaneously sells (or gives up long) futures contracts while
the other party sells the physical commodity and simultaneously buys
(or receives long) futures contracts. Subject to applicable contract
market rules, the futures transaction is negotiated privately by the
parties rather than being executed openly and competitively on a
centralized market. All domestic contract markets permit EFPs,
although there is some variation among the specific contract market
rule which govern these transactions.
\6\ See, e.g., Chicago Mercantile Exchange (``CME'') Rule 521
(``All-Or-None Transactions''); New York Cotton Exchange (``NYCE'')
Rule 1.10-B (``Block Order Execution''); New York Futures Exchange
(``NYFE'') Rule 312 (``Block Order Execution'').
CME also has developed request for quote (``RFQ'') procedures
which allow market participants to solicit transactions of a
particular size for any of the contracts traded through Globex2, its
electronic trading system. In addition, CMD allows firms to engage
in pre-execution discussions regarding Globex2 trades as long as the
solicited counterparty waits a reasonable period of the time before
entering an order opposite that of the initiating party.
\7\ Commission Regulation 1.39 generally sets forth the
conditions and requirements governing the crossing of simultaneous
buying and selling orders of different principals. Under Regulation
1.39(a), when trading is conducted in a pit or ring, a contract
market member may execute buying and selling orders from different
principals for the same commodity directly between such principals
at the market price, pursuant to the written rules of such contract
market which have been approved by the Commission, provided that the
member first offers both orders to the pit. In 1991, the Commission
amended Regulation 1.39 to allow a contract market member to follow
alternative procedures for the crossing of orders if these
procedures comply with contract market LOX rules that have been
approved by the Commission. 56 FR 12336 (March 25, 1991).
CME adopted, and the Commission approved, Rule 549 which
established LOX procedures for transactions involving 300 or more
futures contracts in the Standard & Poor's 500 Stock Price Index or
the Nikkei Stock Average. Despite allowing the pre-execution
solicitation of interest and discussion of price, these LOX
procedures were used by market participants on only one occasion in
the several years they were available. Ultimately, CME terminated
these procedures in April 1998.
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[[Page 31197]]
There is some debate, however, as to whether the existing
procedures meet the needs of futures market participants. Several
commenters responding to the Concept Release stated that the
availability of alternative execution procedures is crucial to
attracting and retaining institutional participation in the futures
markets: These participants increasingly need to trade large quantities
of futures contracts in connection with their securities activities.
According to commenters, such transactions would severely tax the
available liquidity of the centralized futures marketplace. These
commenters stated that alternative execution procedures would allow
large futures transactions, which require size and price certainty, to
be implemented in an efficient and cost effective manner.
B. Potential Alternative Execution Procedures Discussed in the Concept
Release
Pursuant to section 4(a) of the Act and Commission Regulation
1.38(a), the Commission has broad authority to approve contract market
rules which allow futures and option transactions to be executed in the
noncompetitive manner.\8\ The text of these provision does not limit
the types of noncompetitive transactions that may be approved by the
Commission. In light of this authority, the Concept Release sought to
identify new execution procedures that go beyond those that already
exist in the futures industry and to encourage debate on such
procedures. The Release described several scenarios which departed from
the usual open and competitive execution requirement in various
degrees. Certain examples envisioned market participants being allowed
to alert potential counterparties of their general interest in trading
a particular contract at a particular time, to divulge specific
information about quantity and price to potential counterparties, or to
negotiate the specific terms of futures and option transactions.
Another variation would adjust execution procedures to confer a degree
of priority on particular orders, such as market maker orders, that
they might not attain in the open and competitive trading
environment.\9\ Finally, the Release noted that market participants
might be permitted to execute certain transactions bilaterally, away
from the centralized marketplace, and to report them to the relevant
contract market and clearing organization in a manner similar to the
way EFPs are handled currently. These examples, while not exhaustive,
were intended to illustrate a range of possible execution procedures
that could be adopted by contract markets.
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\8\ Section 4(a) makes it unlawful for any person to enter into
a contract for the purchase or sale of a commodity for future
delivery ``unless such transaction is conducted on or subject to the
rules of board of trade which has been designated by the Commission
as a contract market for such commodity.'' Commission Regulation
1.38(a) provides that the open and competitive execution requirement
``shall not apply to transaction which are executed noncompetitively
in accordance with written rules of the contract market which have
been submitted to and approved by the Commission, specifically
providing for the noncompetitive execution of such transactions.''
As noted previously, the Commission exercised this authority in
approving NYMEX's proposal of EFS transactions.
\9\ The Commission already has approved several contract market
proposals establishing market maker programs. These programs, which
aim to encourage market participation in specified new or low volume
contracts, often provide market makers with certain trading
priorities that they would not otherwise obtain under traditional
open and competitive execution methods. See, e.g., Coffee, Sugar &
Cocoa Exchange (``CSCE'') Registered Market Maker Program (approved
by the Commission on April 30, 1991); Chicago Board of Trade
(``CBOT'') Modified Market Maker Program for the Wilshire Small Cap
Index Future Contract (allowed into effect without prior Commission
approval on June 18, 1993); CME Principal Market Maker Program
(approved by the Commission on April 10, 1995); NYMEX Specialist
Market Maker Program (approved by the Commission on July 8, 1998).
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The Concept Release also discussed how block trading procedures
operate in the securities markets.\10\ Generally speaking, with respect
to securities exchanges, the specific terms of a block transaction are
negotiated ``upstairs'' away from the exchange floor. Exchange rules
govern the manner in which such transactions ultimately are brought to
the floor for execution. Typically, a brokerage firm will arrange the
block transaction for its customer. After receiving a customer's order
to purchase or sell a block of securities, the firm must decide whether
to contact the exchange specialist.\11\ By contacting the specialist,
the firm can determine the prevailing price of the stock and as well as
the needs of the specialist. If the specialist is interested in taking
the opposite side of the entire block at a mutually agreeable price,
there is no need to utilize the block trading procedures.
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\10\ In the securities industry, a block trade is commonly
defined as a transaction involving 10,000 or more shares. Blocks may
be traded on securities exchanges, in over-the-counter markets, or
through ``principal-to-principal'' trade execution venues. 63 FR
3708, 3717-3718 (January 26, 1998).
\11\ Under New York Stock Exchange (``NYSE'') Rule 127(a), a
member organization that receives an order for the purchase or sale
of a block of stock is obligated to explore the market to determine
whether ti can absorb the order without a significant impact on
price. Unless professional judgment dictates otherwise, this
research should include contacting the specialist to ascertain the
extent of the specialist's interest in participating in the block at
a specific price or prices.
Each stock listed on the NYSE is allocated to a specialist. The
specialist, through his or her many roles, is responsible for
maintaining the market's fairness, competitiveness and efficiency.
At the beginning of each trading day, the specialist establishes a
fair market price for each of his or her assigned stocks. The
specialist also provides current market quotations to other brokers
throughout the day. The specialist executes limit and stop orders
for other brokers on a commission basis and maintains the limit
order book. Moreover, the specialist is obligated to maintain
``orderly markets'' in his or her assigned stocks by making sure
that trading occurs throughout the day with minimal price
fluctuations. Finally, the specialist acts as a dealer by buying
stocks from the trading crowd when other bids are available or
selling stocks to the trading crowd when other offers are not made.
The specialist's goal is to minimize the temporary imbalance between
public supply and demand.
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If block trading procedures are necessary, the brokerage firm must
then decide whether to ``position'' the block for its house account, to
``shop the block'' by contacting potential customers to take the
opposite side of the transaction, or to combine these strategies. Upon
agreement to a price for the block,\12\ the customer's order is
transmitted to the floor where it is crossed against the firm's house
account and/or against other customer orders, subject to applicable
exchange rules.\13\
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\12\ When positioning a block, the brokerage firm quotes a
tentative price for the stock. Barring an extreme and unexpected
movement in the price of the stock, the customer may be reasonably
assured of execution at the quoted price. In ``shopping the block,''
the firm contacts potential customers to take the opposite side at a
specified price. The firm might be willing to negotiate this price
depending on how interested other investors are in participating in
the transaction. The firm continues to contact potential customers
until there is a sufficient quantity of orders for the opposite side
at a single price. At this point, the firm returns to its original
customer to confirm his or her interest in the block transaction at
the negotiated price, also known as the ``clean-up price.
\13\ A block transaction that is proposed to be priced within
the current market bid-ask spread is subject to NYSE Rule 76, which
governs cross trades. Under this rule, when the floor broker has an
order to buy and an order to sell in the same security, the broker
must ``publicly offer such security at a price which is higher than
his bid by the minimum variation permitted in such security before
making a transaction with himself.'' All such bids and offers must
be clearly announced to the trading crowd before the floor broker
can proceed with the cross transaction.
A block transaction that is proposed to be priced outside of the
current market quotation is subject to NYSE Rule 127. Under this
rule, the floor broker must: (1) Inform the specialist of his or her
intention to cross the block orders at a specific price; (2) probe
the market to determine whether more stock would be lost to orders
in the trading crowd than is reasonable under the circumstances; (3)
fill at least a portion of the limit orders previously entered at
the trading post from the block orders; and (4) cross the remaining
block orders at the negotiated clean-up price. NYSE Rule 127 sets
forth the broker's obligation to fill the limit orders of the
specialist and the trading crowd. Such obligations depend, in part,
on whether the broker is handling agency orders for both sides of
the block transaction or whether all or a part of one side of the
block is for the brokerage firm's house account.
The Chicago Board Options Exchange (``CBOE'') also has
procedures which allow potential counterparties to negotiate the
terms and conditions of certain complex and large size option orders
prior to the time such orders are brought down to the trading floor.
Under CBOE Rule 6.9, a member or member organization representing an
order for an option traded on CBOE (``original order''), including
spread, combination, straddle, or stock-option orders, may solicit a
member, member organization, customer, or broker-dealer to transact
in person or by order (``solicited order'') with the original order.
The priority of the solicited order is dependent upon the degree of
disclosure of the original order to the trading crowd and upon
whether the solicited order improves the market price.
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[[Page 31198]]
The success of the block trading procedures described above is
dependent upon the particular market structure of the securities
industry. As noted above, the specialist plays an extremely important
role in managing the entire process. Moreover, the trading crowd for a
particular stock may be substantially smaller than the floor population
surrounding a designated contract market. Over the years, as well as in
response to the Commission's Concept Release, certain market
participants have suggested that the open and competitive execution
requirement be relaxed to permit block trading procedures similar to
those found in the securities industry. These commenters assert that
such procedures can be adopted by contract markets with minimal adverse
effects on market volume, liquidity, transparency, or customer
protection. However, given the significant differences in market
structure that exist between the securities and futures markets, it is
questionable whether securities block trading procedures could be
easily transferred to contract markets. Although the supporting comment
letters generally urged the Commission to allow block trading
procedures, they did not specify how these procedures should be
implemented, whether the specialist's role should be replicated on the
futures side, or the extent to which the trading crowd should be
allowed to participate in a block transaction.
III. The Commission's Approach to Alternative Execution Procedures
Given the lack of consensus among the commenters responding to the
Concept Release and among industry participants regarding the
appropriate terms and conditions which should govern alternative
execution procedures for large size or other types of orders, the
Commission has decided to evaluate such procedures on a case-by-case
basis. Under this approach, each contract market would, of course,
retain the discretion whether to permit alternative execution
procedures. Additionally, each contract market would have the ability
to develop procedures that reflect the particular characteristics and
needs of its individual markets and market participants. For example, a
contract market might decide to employ different execution procedures
for each of the individual contracts for which it is designated.
The Commission will consider proposals from contract markets to
permit alternative execution procedures. The Commission encourages
contract markets to solicit the input of, and coordinate with, various
interested parties in the development of such execution procedures for
large orders, including its membership, futures commission merchants,
end-users, and industry associations. The Commission also notes that
the ideas discussed in and the specific questions asked by the Concept
Release provide general guidance as to the various issues that should
be addressed by a contract market seeking Commission approval of
particular alternative execution procedures. For example, a contract
market should discuss the impact of its proposal on the usefulness of
the contract market as a vehicle for price discovery and risk transfer,
whether its proposal represents the least anticompetitive means of
achieving its objective,\14\ whether the proposed transactions fulfill
some need of market participants that traditional open outcry cannot
fulfill as well, and whether the transaction are structured in such a
way as to complement the competitive market.
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\14\ See section 15 of the Act.
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Based on its experience in reviewing contract market proposals for
alternative execution procedures, the Commission will determine whether
any further Commission action is appropriate. As stated above, the
Commission remains open to further written comments on the various
topics surrounding potential alternative execution procedures.
Moreover, Commission staff stands ready to discuss these issues with
industry representatives.
Issued in Washington, DC on June 4, 1999.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 99-14713 Filed 6-9-99; 8:45 am]
BILLING CODE 6351-01-M