The Commodity Futures Trading Commission (CFTC or “Commission”) is proposing new rules to implement the CFTC Reauthorization Act of 2008 (“Reauthorization Act”). The Reauthorization Act expanded the Commission’s authority over electronic trading facilities, known as exempt commercial markets (ECMs). This advisory provides background information to understand the context of these changes and a summary of the proposed requirements.
What Is the Background of the Proposed Rules?
The Commodity Futures Modernization Act of 2000 established an exemption for transactions in exempt commodities traded on ECMs. Such commodities include, among others, energy products, precious and industrial metals and air emission allowances. Under this exemption, ECMs are neither licensed by, nor registered with, the CFTC, but are subject to certain record keeping and reporting requirements.
Initially, ECMs were trading platforms where sophisticated commercial parties could find counterparties through an anonymous electronic matching system. Over the past several years, however, ECMs have evolved to include a wider participant base and, in some cases, centralized clearing. Additionally, the settlement prices of certain ECM contracts are now linked to the settlement prices of designated contract markets and some ECMs have become price discovery markets for certain commodities, including natural gas.
These developments raised concerns with respect to an increased possibility of price manipulation. The Reauthorization Act and the Commission’s proposed implementing rules address these concerns by establishing a new regulatory category—ECMs on which significant price discovery contracts (SPDCs) are traded; by increasing reporting requirements and market transparency in these markets; and by making them subject to a number of self-regulatory responsibilities.
How Does the Commission Identify an SPDC?
The Commission is proposing to use four criteria when identifying whether a contract is an SPDC: price linkage, arbitrage, material price reference and material liquidity. No one factor would control, however, and the Commission would have wide discretion in determining whether a contract is an SPDC. Generally, the Commission is proposing to look at whether the trading volume of an ECM contract is high enough to affect regulated markets, whether the contract serves as an independent price reference used by the public, whether the contract’s settlement terms are linked to the settlement price of a contract traded on a Designated Contract Market or whether the contract can be used to effectively arbitrage between markets.
The Commission would make this determination by issuing an Order after publication in the Federal Register of an invitation to the ECM and other interested persons to provide written data and views relevant to the Commission’s determination. The Commission would learn of potential new SPDCs through its own information and surveillance activities in addition to the proposed requirement that ECMs notify the Commission that a contract potentially may serve as an SPDC.
What Requirements Would Apply to ECMs with SPDCs?
If the Commission determines a contract to be an SPDC, the proposed rules would impose a number of new regulatory obligations on the ECM:
Under the rules as proposed, ECMs would be required to adopt position limits or position accountability levels for cleared SPDCs. Once a trade exceeds an established limit, the ECM would initiate an investigation to determine whether the individual’s position is bona fide and, if not, order the trader to reduce the position. The Commission anticipates that SPDCs would be subject to spot month speculative position limits. Uncleared SPDCs would be subject to a new measure of trading activity, the “volume accountability level,” which would operate in a manner similar to position accountability rules.
Large Trader Position Reporting
The CFTC is also proposing to impose large trader position reporting requirements with respect to cleared contracts that have been found to be an SPDC. Under the proposal, ECMs would be required to provide clearing member reports for SPDCs to the Commission. The reported information would be required to include settlement prices, price range, volume, open interest and other pertinent market information. In addition, the Commission is proposing to require ECMs to provide trade data on a daily basis, including data that would identify the trader for each transaction executed on the market. The Commission will use this data in its trade practice, market and financial surveillance programs.
ECMs-trading SPDCs would be required to monitor and enforce compliance with the rules of their market in order to prevent manipulation, price distortion and disruption of the delivery or cash-settlement process. ECMs could accomplish this by establishing regulatory departments, or by delegating this role to an appropriate third party. Similarly, ECMs with SPDCs would be required to be able to collect information, maintain audit trails and carry out appropriate information-sharing agreements.
Additionally, ECMs would be required to establish and enforce rules to minimize conflicts of interest in their decision-making processes between their self-regulatory duties and their commercial interests. This could include establishing regulatory oversight committees and disciplinary panels. ECMs would also be required to certify that the terms and conditions of the contracts comply with applicable requirements.
Lastly, ECMs would be required to adopt rules to provide for the exercise of emergency authority to alter or supplement contract rules, liquidate positions and suspend or curtail trading in any contract that serves as a significant price discovery function.
What Requirements Apply to ECMs that do not Trade SPDCs?
Although most of the proposed enhanced requirements would apply only to ECMs on which SPDCs are traded, the proposed rules also would require all ECMs to file quarterly reports about the terms and conditions for all contracts traded on the facility, whether or not the contract has been found to be an SPDC. Additionally, all ECMs must submit weekly reports for contracts that average five trades per day or more. The Commission believes that this information will assist it in determining whether the contracts are SPDCs.
What is the Likely Effect of the Proposed Rules for Market Participants?
Market participants will be most affected by the proposed requirement that ECMs impose speculative position limits, position accountability or volume accountability levels with respect to SPDCs. Once in place, such levels will potentially limit the size of positions that traders may carry or require traders to justify carrying positions in excess of the limits. The Commission recognizes that, when such limits are initially imposed, traders may already have positions exceeding the limits, and will provide a grace period to come into compliance with new limits. In addition, market participants will be subject to special calls for information with respect to their trading activities.
In general, the proposed rules can be expected to provide greater market transparency, and to provide greater confidence to all market participants in the integrity of pricing in these markets and in the likelihood that market abuses will be detected and remedied.
How to Participate in the Rulemaking Process
The Commission will receive comments on any aspect of the proposed rules. Comments may be submitted electronically to [email protected]. All comments will be posted on the CFTC’s website, http://www.cftc.gov.
Comments must be received on or before February 10, 2009.