SECOND INTERNATIONAL ROUNDTABLE ON SECURITIES MARKETS IN CHINA

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1 A. Introduction SECOND INTERNATIONAL ROUNDTABLE ON SECURITIES MARKETS IN CHINA Issues Related to Regulatory Oversight of Financial Futures Markets Prepared by Richard A. Shilts 1 The primary purpose of regulatory oversight of financial futures markets is the protection of the markets and customers who trade on those markets. This is accomplished by establishing (1) measures that ensure market integrity by detecting and preventing manipulation and distorted prices, (2) measures that ensure the financial integrity of the marketplace, and (3) measures that protect customers against abusive trade practices and fraud. In this paper, issues related to regulatory oversight in connection with the preservation of market integrity of financial futures markets are discussed in some detail. Issues related to preserving financial integrity and customer protection are addressed in summary form. Effective oversight of financial futures markets is essential to ensure that the markets operate in a manner that is conducive to performing their economic functions. The key economic functions of futures markets are providing a means of offsetting price risk (hedging) and a mechanism for price discovery or price basing. Hedging involves the transfer of price risks incidental to operating a business to other futures traders (speculators) who willingly assume such risk in hopes of making a profit. Price discovery is the process of arriving at a price at which one person will buy and another will sell a futures contract for a specific expiration date. For some commodities, futures prices also serve as key reference prices for firms active in the cash market for the underlying instrument. Futures markets also may provide other benefits, such as making it possible for commercial firms to operate on narrower profit margins, potentially resulting in lower financing costs and higher profit margins for the hedger. On the other hand, futures markets are susceptible to various types of abuses necessitating effective regulatory oversight. In that regard, futures contracts are highly leveraged instruments, final settlement involves delivery or cash payments based on finite, potentially manipulable aspects of the market, and participants in these markets may include commercial and speculative traders, some of which are relatively unsophisticated and vulnerable to trading abuses. B. The Unites States Model There are several models of regulatory oversight of exchange-traded derivatives markets throughout the world, including self regulation by the exchanges, industry-wide self-regulatory organizations, and governmental authorities. In the U.S., the futures industry is subject to oversight at each of these three levels: Federal regulation by the CFTC; industry regulation by the National Futures Association (NFA); and self-regulation by the U.S. futures exchanges themselves. The CFTC regulatory framework is directed toward oversight of exchange trading of futures and option contracts and of intermediaries engaging in such transactions on behalf of customers. Congress created the CFTC in 1974 as an independent agency with mandates to assure that futures markets operate fairly and that prices determined on these markets are free of distortion. The CFTC conducts market 1 Richard Shilts is the Acting Director of the Division of Economic Analysis (Division) of the U.S. Commodity Futures Trading Commission (CFTC or Commission). The Division operates the CFTC s programs for ensuring the market integrity of U.S. futures markets, including review of the terms and conditions of listed futures and option contracts and daily market surveillance. The views expressed herein do not necessarily represent those of the CFTC.

2 surveillance of all products traded on U.S. futures exchanges and reviews the design of contracts to ensure they are not susceptible to manipulation. The Commission is responsible for oversight of the exchanges market and financial surveillance, their rule enforcement programs, and for directly auditing FCMs and introducing brokers that are not members of any self regulatory organization. The exchanges are responsible for regulating activity on their markets. Exchanges establish rules covering clearance of trades, trade orders and records, position limits, price limits, disciplinary actions, floor trading practices and standards of business conduct. Exchanges conduct market and financial surveillance and they seek to ensure that trading is open and competitive, that prices are publicly disseminated, and that participants are protected against counterparty risk. They ensure financial integrity in various ways, including; operating a system of daily payment and collection of margin on a mark-tomarket basis; setting minimum capital, segregation and reporting requirements applicable to entities dealing with customers; and ultimately by requiring the clearing organization to guarantee the integrity of each transaction entered into on that exchange. The NFA has primary regulatory responsibility for persons and entities involved in brokerage activities that are not members or member firms of a futures exchange, since the exchanges themselves have primary regulatory responsibility for their members and member firms. The NFA registers persons and firms dealing with customers on futures exchanges. Before registering a new person or firm, the NFA conducts a background check of the applicant to determine whether they should be precluded from conducting business. In addition, companies and individuals who handle customer funds or give trading advice must apply for registration through the NFA. C. Ensuring Market Integrity; Preventing Manipulation and Distorted Prices The primary means by which government authorities, self-regulatory organizations and exchanges can address market integrity issues for exchange-traded futures contracts are by ensuring appropriate contract design and active market surveillance. These measures will help prevent a number of manipulative or abusive practices including: intentionally causing, or attempting to cause, artificial prices; intentionally disseminating false or misleading information; corners or squeezes, in which a controlling position is accumulated in the underlying cash and/or futures markets; collusive trades that improperly seek to avoid exposure to the pricing mechanism of the market; and violations of any applicable limits on position sizes. Appropriate contract design is essential for mitigating the potential for price manipulation as well as other trading abuses. Among other things, when faulty terms are present, damage to hedgers or industry pricing may result before corrections can be made, leading to circumstances in which the only way to deal with such problems may be by extraordinary measures such as emergency action. Market manipulation, defaults, and other disruptions or emergency actions may result in diminished credibility in the marketplace, reduced trading activity in futures markets in general, or reduced trading in the affected futures market, which would undermine the economic benefits offered by futures trading. Moreover, since futures trading represents an integral component of key sectors of a nation s economy and the world economy, any disruptive effects could have a widespread impact. Nevertheless, no matter how well designed, effective oversight requires an active market surveillance program to address abusive practices by traders, to deal with unforeseen events in the cash market that may affect deliverable supplies or the cash-settlement process, and to address concentrations in positions. Some abusive practices can be identified in their formative stages by such a program, in which case, the authorities can initiate appropriate actions to prevent the abuse from occurring. Other market abuses are best prevented by effective deterrence or by structural limits on trading, such as position limits, margin differentials or other measures. If market participants believe abusive practices will promptly be detected, 2

3 investigated and, as appropriate, penalized by market authorities, they are less likely to risk engaging in the abusive activity. o Contract Design Various governmental bodies and international organizations have adopted contract design standards or best practices that provide guidance to exchanges in developing contract terms and conditions. In this regard, IOSCO (the International Organization of Securities Commissions) has set forth best practices that represent internationally accepted benchmarks for contract design for physical-delivery and cash settled contracts. Similarly, the CFTC has adopted its Guideline No. 1 which sets forth contract design guidance for U.S. exchanges. In general, contract design standards are adopted to ensure that the terms and conditions of contracts meet design benchmarks. The objective of establishing these standards is to ensure that contracts are not readily susceptible to manipulation, that the delivery and/or settlement mechanism is reliable and fair, and that the prices of the underlying financial instrument and the futures contract converge at expiration and, as a consequence, can serve a valid risk-management function. The initial responsibility for contract design generally rests with the exchange listing the futures contract. Market authorities need to emphasize specific issues related to the nature of the underlying reference commodity and consider differences in the cash markets. Market authorities oversight of contract design should consider IOSCO s international benchmarks; however, they may also need to adopt additional criteria geared to the unique characteristics of the cash market underlying the futures contract or the economic situation in that country. Specific issues that should be addressed include the delivery characteristics and procedures for physical delivery contracts or settlement terms for cash-settled contracts. Market authorities also need to have in place measures to ensure that listed contracts meet the established criteria. Such oversight may include prior approval or review of new contracts before listing, requiring exchanges to certify that a new contract meets the contract design standards (in lieu of prior approval), or ongoing review of trading activity and the terms and conditions of contracts after they are listed. Physical Delivery Contracts: For futures contracts providing for physical delivery of the underlying instrument, the key issues relate to the specific contract terms and conditions chosen by the board of trade and the deliverable supply of the financial instrument implied by the exchange-specified terms and conditions. Terms and conditions refers to the specific characteristics or nature of the financial instrument that is deliverable, delivery procedures, contract size, price limits, speculative limits, etc. that govern trading and the delivery process for the futures contract. In general, the terms and conditions of a futures contract should, to the greatest extent possible, reflect the usual operation of the cash market for the product underlying the futures contract. The terms and conditions should be designed to avoid any impediments to the delivery of the financial instrument to ensure that the price of the futures contract converges to the cash market value of the financial instrument at the expiration of a trading month. In designing a contract, the views and opinions of participants in the underlying cash market and prospective users of the contracts should be given considerable weight. It should be noted that it may not be feasible or appropriate in all cases to specify contract terms and conditions that conform to cash market practices in all respects. Deviations for particular contract terms may be necessary in cases where commercial practices vary widely among different segments of the industry, where a special provision is necessary to avoid impediments to the delivery process, or to encourage commercial or speculative participation in the contract. However, exchanges should specify 3

4 terms that deviate from cash market practices only if such deviations are necessary for the success of the contract, and they would neither cause the contract to become susceptible to price manipulation or distortion nor undermine the commercial utility of the contract. Specification of contract terms and conditions should be based on historical patterns of supply, such as changes in issuance patterns for contracts based on debt instruments, and market concentration in the production (issuance patterns), ownership, and consumption of the underlying instrument. Careful consideration also should be given to the specified quality, grade or rating of the deliverable financial instrument and whether there exist external factors or regulatory controls that could affect the price or supply of the instrument. Consideration should also be given to whether the underlying financial instrument is traded on a domestic or international basis. The specified terms and conditions, considered as a whole, should result in a deliverable supply that is sufficient to ensure that the contract would not be conducive to price manipulation or distortion. In general, the term deliverable supply means the quantity of the financial instrument meeting contract specifications that reasonably can be expected to be readily available to short traders and salable by long traders at its market value in normal cash marketing channels during the specified delivery period. Deliverable supply reflects the quantity of the financial instrument that potentially could be made available for sale on a spot basis. Deliverable supply consists of available supplies of the instrument meeting the contract's delivery standards that are available, at prevailing cash market values, to traders wishing to make future delivery. For example, in the U.S. Treasury markets, significant quantities of notes and bonds typically are held by the central bank (the U.S. Federal Reserve) and in the long-term investment portfolios of institutional firms (e.g., insurance companies or pension funds) and would not be readily available for delivery on a futures contracts on government debt instruments, except at distorted prices. An adequate deliverable supply would be a quantity of the financial instrument that would meet the normal or expected range of delivery demand without causing futures prices to become distorted relative to cash market prices. If deliverable supplies are inadequate, supplies needed to meet delivery demand would likely come from atypical sources that may represent an uneconomic transaction in commerce. Exchanges should estimate the deliverable supplies that likely would be available for the delivery months specified in the contract. An estimate of deliverable supplies should take into consideration the terms and conditions specified for the financial product deliverable under the terms of the futures contract and the economic realities of the cash market underlying the futures contract. The opinions of knowledgeable trade sources can be invaluable in developing such estimates. For physical-delivery, financial instrument futures contracts exhibiting low levels of deliverable supply or where the cash market is dominated by few participants, a spot month speculative position limit may need to be specified to limit the total quantity of the financial instrument that a trader can demand on delivery. Specifying a spot month limit is an effective way to constrain traders ability to manipulate the futures contract at a time when physical delivery may be required and when the contract is most vulnerable to price fluctuation caused by abnormally large positions or disorderly trading practices. The CFTC has required that exchanges adopt spot-month speculative limits for physical-delivery contracts, and that the specified levels be based upon an analysis of deliverable supplies and the history of spot-month liquidations. In this regard, the CFTC has required that the spot-month limit for physical-delivery contracts must be no more than 25 percent of the estimated deliverable supply. Finally, it should be noted that effective contract design oversight is a continuing obligation. Market authorities and exchanges must periodically reassess listed contracts to ensure that the terms and conditions remain consistent with cash market practices. This is important because cash markets continually evolve, which may result in a need to modify contract terms to reflect current cash market practices. In addition, exchanges should retain powers and procedures to address and, where necessary, 4

5 vary the terms of contracts that produce manipulative or disorderly conditions and to suspend or terminate trading in contracts in which changes in cash market conditions are such that the underlying instrument may no longer be an acceptable product for an exchange-traded futures contract. Cash-Settled Contracts: Cash settlement is a method of settling certain futures or option contracts whereby, at contract expiration, the seller (or short) in effect pays the buyer (or long) the cash value of the financial instrument being traded based upon a procedure specified in the contract. This cash payment is made in lieu of physical delivery of the financial instrument underlying the futures or option contract. Because there is no delivery, cash-settled contracts do not raise issues such as squeezes or corners. Cash settled contracts, however, raise other concerns about manipulation and price distortion. In particular, a cash-settled contract may create an incentive to manipulate or artificially influence the underlying market upon which the cash-settlement price is derived or to exert undue influence on the cash-settlement computation in order to profit on a futures position in that financial instrument. For example, if the cash market is relatively illiquid, a person with a large futures position may be able to distort the cashsettlement price by buying or selling a relatively small amount of the underlying financial for the purpose of benefiting the person s futures position. The trader would expect the gain realized through cash settlement of the futures position at the distorted price to exceed any loss incurred by buying or selling a smaller amount of the underlying financial instrument at possibly unfavorable prices. Accordingly, careful consideration should be given to the nature of the cash market for the underlying financial instrument and the specific procedures used to derive the cash-settlement price. Situations conducive to manipulation include those in which the volume of cash market transactions or the number of potential participants that may be contacted in determining the cash-settlement price are very low; indeed, if the market is very illiquid with few traders, the instrument may not be a viable candidate for cash settlement. Thus, a significant consideration is the size and liquidity of the cash market and the number of commercial participants in the instrument that underlies the futures contract. In addition, consideration should be given to the commercial acceptability, public availability, and timeliness of the individual prices or the price series that is to be used to calculate the cash-settlement price. The actual procedures to be used in deriving the cash-settlement price are of critical concern. Where an independent third party calculates the price, consideration should be given to any comments or objections raised by the third party. This includes an evaluation of the extent to which the third party has, or will adopt, safeguards to guard against unauthorized or premature release of the price itself or any key data used in deriving the price. Such safeguards may include special security procedures to protect against premature release of the cash-settlement price prior to its scheduled public release time, prohibitions against derivatives trading by employees, or public dissemination of the names of sources and the price quotes they provide. Where an exchange itself generates the cash-settlement price series, it is essential that the calculation procedure contain safeguards against potential attempts to artificially influence the price. For example, if the cash-settlement price is derived by the exchange based on a survey of cash market sources, the exchange should maintain a list of such entities which all should be reputable sources with knowledge of the cash market. In addition, the sample of sources polled should be representative of the cash market, and the poll should be conducted at a time when trading in the cash market is active. Based on the CFTC s experience, such a cash-settlement survey should include a minimum of four independent entities if such sources do not take positions in the financial instrument (e.g., if the survey list is comprised exclusively of brokers) or eight independent entities if such sources trade for their own accounts (e.g., if the survey list is comprised of dealers or merchants). In general, the cash-settlement price calculation should involve computational procedures that eliminate or reduce the impact of any potentially unrepresentative data. This typically involves a requirement that 5

6 certain of the highest and lowest quotes be eliminated in making the calculation. However, where the cashsettlement calculation involves a very large number of price quotes, or is based on prices obtained from a liquid, transparent cash marketplace, such procedures may not be necessary. Finally, for financial instruments exhibiting low levels of cash market trading activity or where the market is dominated by few participants with little transparency, consideration should be given toward specifying a speculative position limit applicable to trading at the expiration of the contract as a deterrent to attempts to manipulate the cash-settlement price. The speculative limit should be set at a level that would minimize any incentives for futures traders to profit on a large futures position by artificially influencing the underlying cash market or the cash-settlement computation. o Market Surveillance Background: The primary goal of a market surveillance program is to monitor trading activity to detect and prevent manipulation or abusive practices. Market surveillance may be conducted by staff at the exchange, by industry-wide self regulatory organizations, or by a governmental market authority. Market surveillance programs rely heavily upon monitoring the positions of large traders and upon continual assessments of cash/futures price relationships considering market fundamentals. Market surveillance staff should monitor the daily activities of large traders, key price relationships, and relevant supply and demand factors in an ongoing, daily review of potential market problems. Surveillance staff should have expert knowledge of the unique aspects of underlying markets, including relevant supply and demand factors, so that they can readily identify situations that could pose a threat of manipulation and take appropriate preventive actions. Procedures should be in place so that the surveillance staff has ready access to key information about the underling cash markets as well as data on the activities and positions of traders in the markets. Using this information, surveillance staff must be able to distinguish the normal futures market response of a commercial trader or a speculator to prevailing supply and demand conditions from the futures market activity of a trader intent upon manipulating prices. Market surveillance issues can be summarized according to the two types of settlement provisions physical delivery and cash settlement. Surveillance procedures for physical-delivery financial contracts: Financial futures contracts that require delivery of the underlying financial instrument are most susceptible to manipulation when the deliverable supply is small relative to the size of positions held by traders, individually or in related groups, as the contract approaches expiration. The more difficult and costly it is to augment deliverable supplies within the time constraints of the expiring futures contract's delivery terms, the more susceptible to manipulation the contract becomes. Key surveillance questions for physical-delivery contracts include: Who owns the deliverable supplies of the underlying financial instrument? Are the positions held by the largest long trader(s) greater in size than deliverable supplies not already owned by such trader(s)? Are the long traders likely to demand delivery? Is taking delivery the least costly means of acquiring the financial instrument? 6

7 To what extent are the largest short traders capable of making delivery? Is making futures delivery a better alternative than selling the financial instrument in the cash market? Is the futures price, as the contract approaches expiration, reflecting the cash market value of the deliverable financial instrument? Is the price spread between the expiring future and the next delivery month reflective of underlying supply and demand conditions in the cash market? An excellent barometer for potential futures contract liquidation problems is the basis relationship (i.e., the difference between the financial instrument s cash and futures prices). When the price of the liquidating future is abnormally higher than underlying cash prices or both the futures and underlying cash price are abnormally higher than cash prices for comparable financial instruments, there is reason to examine the causes and to assess the motives of traders holding long futures positions. In this regard, price aberrations in the cash market for the underlying financial instrument may provide an indication of (or an opportunity for) an attempted manipulation. Surveillance staff need to monitor cash prices for the financial instrument specified for delivery on the futures contract in relation to cash prices for nondeliverable instruments that would be close, or identical, substitutes in the cash market. Relatively high prices for deliverable, as compared to non-deliverable, financial instruments may be an indication of an attempt to remove deliverable supplies from the futures market as part of an attempted manipulation. Also, the presence of market participants taking positions vastly beyond their financial means or their capacity to take delivery or make settlement may be another sign of manipulative activity. Finally, financial futures contracts frequently involve delivery of government debt (e.g., bonds or, notes) or currencies. The exchange or market authorities surveillance staff, therefore, should maintain open lines of communication with affected government authorities having jurisdiction over the instrument such as the central bank and the treasury department to share information to address any problems. Cash-settled financial contracts. The size of a trader's position at the expiration of a cash-settled futures contract cannot affect the price of that contract because the trader cannot demand or make delivery of the underlying financial. The surveillance emphasis in cash-settled contracts should focus on the integrity of the cash price series used to settle the futures contract. Since manipulation of the cash market can yield a profit in the futures contract, staff must monitor futures positions of significant size and be alert for unusual cash market activities on the part of large futures traders, especially in the period of time that the final cash price for futures settlement is determined. Pertinent surveillance questions for those markets are: As the futures contract expiration approaches, is the cash price moving in a manner consistent with supply and demand factors and/or with other comparable cash prices that are not used in the cash-settlement process? Do traders with large positions in the expiring future have the capacity to affect the cash price series used to settle the futures contract? What information can be obtained from the organization that compiles the cash price series regarding how the price is determined for the period in question? Is anyone reporting prices that appear to be out of line with prices reported by others, and can it be determined if the party reporting those prices holds a futures position that would be affected favorably by those prices? 7

8 As with physical-delivery contracts, price aberrations in the cash market for the underlying financial instrument may provide an indication of (or an opportunity for) an attempted manipulation. Surveillance staff should monitor cash prices for the underlying financial instrument in relation to cash prices for related instruments that would be close, or identical, substitutes in the cash market, since unusual price relationships may be an indication of an attempt to remove supplies from the cash market as part of an attempted manipulation. Also, to the extent participants in the markets take positions beyond their normal trading patterns or clear financial means or capacity to take delivery or make settlement, this may be a sign of manipulative activity. Regulatory Response to Market Disruptions: When problems are identified, the exchange or other market authorities should have the authority to take appropriate action to prevent, or minimize the impact of, manipulative or price distorting behavior. The regulatory response to the potential for a market disruption must be tailored to the specific market circumstances, the nature of the trader(s) involved, the response of the exchange officials, and the time available. Possible actions include both private actions and public actions. Surveillance staff at the market authority should communicate privately with their counterparts at the exchange and with the traders on both sides of a market situation. Contacting a trader, usually by telephone, and asking probing questions about the market and their position in the futures and the underlying market is the first level of regulatory response -- it tells traders that their positions and actions are being closely monitored. Hopefully, this fact alone will cause traders to act responsibly/legally. If concerned about a trader s actions, surveillance staff may verbally caution the trader about a course of conduct and request documentation that, for example, they own cash bonds that are being hedged with futures contracts. If the problem persists, the market authority may send the trader a formal letter of warning, usually hand delivered or by fax, that cities specific elements of the law and notes that if their action, or inaction, results in an apparent violation, they will be investigated. Similar kinds of these jawboning actions should also be taken by the exchange. If the futures market involves governmental debt, the central bank and other affected regulatory bodies should be briefed on the situation. These regulatory responses should be kept private among the regulators and with the individual traders. The marketplace should not be aware of any specific, heightened surveillance concern, so that market participants do not make trading decisions on the basis of the potential for regulatory action. As noted above, the goal is to ensure that the market responds to the natural forces of supply and demand by preventing artificial prices that might be due to the influence of a specific trader or group of traders. If the likelihood of regulatory action becomes a market factor, the regulators have simply substituted one artificial force for another. Thus, the market authority and the exchange should proceed with a public action only when all other measures have been exhausted. Where a public action becomes necessary, the market authority should generally look to the exchange to exercise its self-regulatory powers to resolve a potential or actual market problem. Every exchange should have the power to take an emergency action to address a serious market situation. In general, the market authority should defer to the exchange so long as it is likely to resolve the emergency. If an exchange fails to take actions, the market authority should have broad emergency powers under which it can order the exchange to take appropriate action. Governmental authorities should not take an emergency action indiscriminately and should do so only to restore or maintain orderly trading using a remedy that is likely to be less severe than the malady to be cured. Such actions could include limiting trading to liquidating transactions, imposing or reducing limits on positions, requiring the liquidation of positions, extending the delivery period for physical delivery contracts, or closing the market. The CFTC has found that most issues are resolved without the need to use its own emergency powers. In this regard, the CFTC has had to take emergency actions only four times in its 27-year history, demonstrating its commitment to not intervene in markets unless all other efforts have been unsuccessful. 8

9 Information Sharing: Cooperative information sharing among the exchange trading the futures contract, affected regulatory bodies within that country and exchanges and market authorities in other countries is now seen as an important element of an effective market surveillance program, especially in recognition of the increasingly linked global marketplace for derivatives products. Moreover, for financial products that are traded on an international basis, effective information sharing arrangements help maintain market integrity by facilitating the detection of potential market problems and situations, by helping to deter such problems, and by providing a recognized means of sanctioning abusive or manipulative conduct. Effective information sharing also can help reduce systemic risk for exchange-traded markets involving all types of financial products. It should be noted that the Technical Committee of IOSCO has issued several reports on cooperative information sharing issues. IOSCO published its Guidance on Information Sharing, which identifies information relevant to market authorities in addressing specific types of market events. Many of the information sharing elements contained in that document are also applicable to surveillance of suspected market abuses and manipulation. Market problems necessitating cooperative information sharing may result from unanticipated adjustments in fundamental supply and demand factors for the financial instrument, major hostilities or political actions, as well as dangerous concentrations of positions in the futures market and related cash and over-the-counter markets. To adequately address these potential problems, market authorities should have access to sufficient information about activity on the futures exchange and in related cash and overthe-counter markets to evaluate the overall composition of the market and to assess whether the futures market is functioning properly. Having information that details a trader s whole position, including positions on the futures exchange as well as in cash and over-the-counter markets, generally is critical to appropriately assess the risk of the trader s position and the nature of that trader s market strategies. IOSCO has provided practical guidance to market authorities for sharing information during periods of market and /or firm crises and it has identified the types of information needed to assist in assessing and managing the impact of a market problem. First, before or as soon as futures trading is started, surveillance staff should ensure that they have procedures in place for prompt access to critical information and that they can share such information with other market authorities. Market authorities should continually assess whether they or the exchanges have access to critical information. Market authorities should clarify whether there are any legal or other impediments to sharing such information, and they should be aware of any conditions under which such information may be shared, including any confidentiality concerns. In addition, where legal impediments or other obstacles to information sharing exist, market authorities should undertake affirmative steps, within the scope of their powers, to encourage the removal of such obstacles. According to the IOSCO guidance, in addressing a major market problem, surveillance staff should have, or have the means to obtain, information on: firms with the largest exposures on the market; details of margin calls, including margin calls that have been satisfied, as well as those that have not been made; legal, regulatory, and other actions being taken to address the crisis; and trading data such as trading volume, short selling and program trading transactions. 9

10 Finally, it should be noted that a crisis can adversely affect the ability to generate or to produce accurate and timely information. If the crisis is the result of fraud or operational failure, the quality of information may be compromised. Special concerns related to futures on equities. Generally, equities and derivatives markets likely will be closely linked through inter-market arbitrage. Therefore, effective surveillance of equity futures markets requires coordination among the exchanges trading the underlying equities and equity options to address inter-market trading abuses, such as manipulation, frontrunning of customer orders and insider trading. If the stock index underlying the futures and/or option contract is broad based, in terms of both the number and capitalization of the equities included in the index, intermarket price manipulation and insider trading (regarding information on individual stocks) concerns will be greatly reduced. Narrow-based indices and single-stock derivatives may require more aggressive surveillance and added protections with respect to misuse of information, especially to the extent that the market is, or acts like, a market in a single security. An exchange listing an equity-based futures contract should cooperate with any other regulatory bodies having jurisdiction over the component securities. It should also have in place information-sharing agreements to facilitate cooperation on surveillance issues and to ensure that adequate surveillance can be accomplished. This is the most effective means to detect a manipulation attempt that involves trading on both the futures exchange and the securities exchange. The surveillance sharing agreement preferably should be between the exchanges, or if not possible, bilateral or multilateral agreements between the two counties regulators. It should be noted that, if a manipulation attempt were underway, time may be critical and thus reliance on regulator-to-regulator agreements may not be as effective as an exchange-toexchange agreements. D. Ensuring Financial Integrity Firms that handle the money of customers who trade futures or options are required to keep customers equity accounts separate from the firm s accounts, mark customer accounts to the present market value at the close of each day, and place any funds due a customer in an account separate from the firm s own fund or account. This segregation of funds protects clients funds in case of a firm s separate financial difficulty. In the U.S., a variety of procedures have been adopted to protect customers and safeguard funds deposited in futures accounts. For example, the CFTC seeks to protect customers by requiring firms dealing with customers to disclose market risks and past performance information, by requiring that customer funds be kept in accounts separate from those maintained by the firm for its own use, and by requiring customer accounts to be adjusted to reflect the current market value at the close of trading each day. In addition, the CFTC monitors registrant supervision systems, internal controls and sales practice compliance programs. Further, all registrants are required to complete ethics training. Several key components that have been adopted to ensure the financial integrity of futures markets include the establishment of clearing facilities, a system of margining, and capital requirements. Clearing. An effective clearing organization generally has been viewed as an essential part of a futures market. Exchange clearing houses accept contracts for clearance only for the accounts of their members, and they guarantee the payment of variation margin to clearing members with net gains on positions in their accounts at the clearing house. The clearing process for futures contracts effects multilateral netting by novation. Following the execution of a futures contract on the exchange, the contract is presented for clearance on the clearing organization by a clearing organization member. In the clearing process, the 10

11 clearing organization is substituted for the original parties to the contract, becoming the universal counterparty to every cleared contract, the clearing organization guarantees performance of each cleared contract. The variation margin representing losses required to be paid to the clearing organization by clearing firms carrying losing positions is paid by the clearing organization as variation gains to clearing firms carrying opposite positions. The clearing organization guarantee comes into operation if a clearing member is unable to pay the variation margin due on its losing positions. Thus, if a clearing firm carrying a losing position defaults, the clearing organization assures payment to firms carrying profitable positions. The clearing organization guarantee function is secured by original margin deposits required for each cleared contract, as well as guarantee funds or other sources. Margin. As indicated above, clearing organizations collect original and variation margin from their members. The collection of variation margin is intended to eliminate credit risk from the market on a daily or more frequent basis and to facilitate transactions among anonymous counterparties. The most commonly used methodology for calculation of margin is the Standard Portfolio Analysis of Risk (SPAN) system. SPAN is a computer program that calculates margin using a portfolio evaluation model. The model projects the risks of various moves in price and volatility levels on option and futures positions. It develops a combined maintenance margin level based upon the aggregate risk of the combined positions. Clearing Member Capital. Most clearing houses require their members to maintain a minimum level of capital in order to ensure that clearing members will be able to meet their obligations to the clearing house and to their customers. Most clearing houses also require their members to make substantial deposits to a clearinghouse guarantee fund to cover any default by a clearing member. Capital Requirements. Exchanges or market authorities may prescribe minimum financial requirements for entities engaging in futures business as well as standards for calculating how those requirements are met. Capital usually includes liquid assets. There should be in place an early warning system under which firms are required to notify the market authority of certain adverse changes in their financial condition in order to allow for sufficient time to address a financial situation before it results in a market disruption or customer loss. Customer Funds Protection Segregation of Accounts. In the U.S., both FCMs and clearing organizations must separately account for both customer funds deposited to margin, guarantee or secure futures positions and the accruals (gains or losses) on such positions, on their books and records. All such customer funds must be segregated from the carrying firm s own funds and must be treated as belonging to the customer. An FCM must always maintain in the segregated account, free from claims, sufficient funds to meet all the obligations it would owe to customers if their accounts were closed out at current market prices. The funds segregation requirement is intended to protect not only the security of customer funds but the security of the market as well. Because all amounts owed to customers must be secured, segregation helps to prevent a run on firm in most market conditions. Segregation also facilitates the transfer of accounts from a failing firm to a solvent one, thus allowing customers to maintain their positions without any disruption to the customer or clearinghouse. Thus, segregation serves to protect the customer and to prevent any ripple effect. Financial Compliance Programs. Futures exchange may adopt and enforce minimum financial requirements and reporting rules for its members. In many cases, capital rules apply only to firms carrying customer funds, as members trading solely for their own account are subject only to exchange and/or clearing organization rules. The futures exchange has the primary direct responsibility to ensure the financial integrity of its member firms. Recordkeeping. Entities involved in intermediating futures transactions should maintain records of all securities and property received from customers and margins used to establish, guarantee, or secure a 11

12 futures or exchange option transaction. For each account carried, this information should include a record of the name and address of the customer and the customer s principal occupation or business. Records should also be kept concerning details of the investment of customer funds, computing periodically the amount of customer funds required to be on deposit and actually on deposit in segregated accounts and the residual interest in those funds. E. Protection Of Customers Exchanges and market authorities should have in place procedures and rules to protect customers by assuring fairness to traders on the futures market. Common customer protection features include procedures to ensure open and competitive order execution, audit trail requirements, procedures for settling customer disputes, record keeping and oversight of exchange governance. Order Execution. For reasons noted above, futures and option contracts serve their essential economic functions when prices are freely determined. This is best accomplished when trades are executed openly and competitively. This requires the adoption of trading procedures that are open and competitive. Exceptions to an open and competitive standard may be permissible to accomplish bona fide commercial risk management needs. Common noncompetitive execution procedures adopted by futures exchanges include exchanges of futures for physicals (EFPs) and block trading provisions. Audit Trail. The purpose of an audit trail is to prevent abuse of customer orders and other improper trade practices by allowing compliance personnel to reconstruct trading on the exchange and thereby detect suspicious trading patterns. An exchange should have an adequate system for making and filing reports showing the details and terms of all transactions executed on the exchange. In the U.S., clearinghouses and contract markets are required to maintain daily trading records. Customer Dispute Resolution. Exchanges should have in place procedures, such as arbitration, for settling customer claims for grievances against exchange members and their employees. The predispute agreement should be endorsed by the customer but not be a precondition to the customer obtaining the firm s services. Exchange Governance. Exchanges should consider adopting rules establishing composition requirements for their governing boards and major disciplinary committees, prohibiting persons with certain disciplinary histories from serving on any oversight panel. These requirements may enhance the credibility of the exchange by taking account of the fact that exchanges are public marketplaces. These requirements are intended to assure representational diversity on governing boards, to foster integrity and impartiality in decision-making, and to prevent preferential treatment in disciplinary proceedings. 12

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