FCStone Merchant Services LLC and INTL FCStone Financial Inc., affiliated companies, agreed to pay a collective fine of US $280,000 to resolve an enforcement action brought by the Commodity Futures Trading Commission related to exchange for related position transactions executed by FCStone Merchant for its own account between December 2013 and March 2014. FCStone Financial, a registered futures commission merchant and clearing member of the Chicago Mercantile Exchange, reported the relevant EFRPs to the CME for processing and was also charged as a principal violator as well as with failure to supervise. According to the CFTC, FCStone Merchant executed EFRP transactions with a counterparty on “numerous occasions” involving CME-traded Canadian Dollar futures and physical canola seed. These transactions, said the Commission, were entered into by FCStone Merchant to help a client manage its financial inventory storage costs associated with canola production and currency risk. However, explained the CFTC, because the two components of the purported EFRPs did not have “a reasonable degree of price correlation,” they did not constitute appropriate EFRPs under the applicable CME rule (click here to access CME Group Rule 538.C). As a result, the futures transactions were non-bona fide under applicable law and the relevant CFTC regulation, alleged the Commission. (Click here to access 7 USC §6c(a)(1) and (2) and here to access CFTC Rule 1.38.) The CFTC also said that FCStone Financial’s reporting of these transactions based “solely” on its affiliate’s designation of these transactions as EFRPs made it liable as a principal for the non-bona fide futures transactions and, independently, constituted a failure to supervise. According to the CFTC, FCStone Financial “failed to verify that the EFRPs at issue had the necessary corresponding and related cash or OTC derivatives positions required for EFRPs before they were reported to the CME.”
FCStone Merchant and FCStone Financial settled the CFTC’s charges without admitting or denying any of the Commission’s findings or conclusions.
In July 2015, wholly owned subsidiaries of INTL FCStone Inc., including INTL FCStone Markets LLC and INTL Commodities, Inc., were charged by CME Group exchanges with violating EFRP rules, typically by having insufficient or no documentation for the related position component of the EFRP. The firms paid a collective fine of US $160,000 to resolve the CME Group exchanges’ charges. (Click here for details in the article “FCStone Companies and Goldman Sachs Receive Largest Fines in CME Group’s 27 Disciplinary Actions Cascade” in the July 26, 2017 edition of Bridging the Week.)
Compliance Weeds and My View: EFRPs are privately negotiated transactions between two parties. They involve, by each party, the simultaneous purchase or sale of an exchange futures or options contract and the opposite-side-of-the-market sale or purchase of an equivalent quantity of a cash product, by-product, or over-the-counter derivative instrument that has a “reasonable degree” of price correlation to the commodity referenced in the exchange contract. (Click here for background in CME Market Regulation Advisory Notice RA1716-5 (October 18, 2017).) If one party buys the exchange contract and sells the risk position, the other party sells the exchange contract and buys the risk position.
EFRPs are an approved exception to the CFTC’s requirement that all futures and related option transactions must be executed “openly and competitively by open outcry or posting of bids and offers or by other equally competitive methods, in the trading pit or ring or similar place provided by [a] contract market.” However, for EFRPs to be authorized, they must be executed “in accordance with written rules of the contract market that have been submitted to and approved by the Commission” that provide for noncompetitive transactions. (Click here to access CFTC Rule 1.38(a).)
The CFTC alleged that the futures and related positions of FCStone Merchant’s EFRPs were not sufficiently correlated consistent with CME requirements. As a result, the transactions violated the applicable CME rule. The CFTC explained that, because the futures component of the EFRPs were privately negotiated, not competitively executed, and were in violation of CME rule, they did not fit within the Commission's safe harbor. Accordingly, FCStone Merchant was charged by the CFTC with executing noncompetitive transactions in violation of applicable law and the relevant CFTC rule.
FCStone Financial, the clearing member affiliate of FCStone Merchant, was also charged with engaging in non-bona fide futures transactions and failure to supervise as a result of its reporting of its affiliate’s transactions to CME. (Click here to access CFTC Rule 166.3.) Based on the facts set forth in the relevant settlement order, it appears the CFTC’s beef against FCStone Financial was that, by reporting its affiliate’s transactions to the CME as EFRPs in the first place, the firm effectively represented they were bona fide. FCStone Financial made this implicit representation, without independently verifying the legitimacy of FCStone Merchant’s transactions, implied the Commission.
However, neither this view of FCStone Financial’s obligations, nor the consequences of its activities, appears supported by law, let alone ordinary business practice.
The obligations of a CME clearing member in connection with EFRP transactions are limited and clear. A clearing member FCM may have a contractual obligation to report trades for its customer, which if it does, it must perform timely and accurately. A clearing member FCM also has certain confirmation reporting obligations to its customers as well as, potentially, large trader reporting requirements. (Click here for background in CME Market Regulation Advisory Notice RA1716-5 (October 18, 2017), Q/As 20 and 22-24.)
When a CME clearing member accepts an EFRP for processing, it does so solely as an agent for its customer – even if the customer is an affiliate. Indeed, under applicable CFTC rule, there is no obligation for a clearing member to even view the documentation underlying the EFRP of a customer unless expressly requested by an exchange, the CFTC or other authorized requesting body. The clearing member solely serves a bookkeeper role. According to the relevant CFTC rule:
Upon request of the designated contract market [or] the Commission, … each futures commission merchant, … and member of a designated contract market … shall request from its customers and, upon receipt thereof, provide to the requesting body documentation of cash transactions underlying exchanges of futures...
(Emphasis added; click here to access CFTC Rule 1.35(c)(1).)
Under this rule, if in response to a regulatory request a clearing member asks a customer for underlying EFRP documentation and the customer fails to comply, the clearing member is not liable for the failure of the customer. It is only required to provide to an authorized requesting body documentation it actually receives from a customer.
A prior CME Group guidance governing EFRPs was potentially ambiguous in one part regarding a clearing member’s role in the processing of EFRPs. It said that clearing members should exercise “due diligence” to identify circumstances when a customer’s EFRP transactions might be non-bona fide. However, the MRAN made clear that, despite this ambiguous language, a clearing member would only be liable for an exchange rule violation if the “clearing member ha[d] notice or knowledge of the execution of non-bona fide EFRPs by its customer and [failed] to take appropriate action.” (Click here for details in CME Group MRAN RA-1612-5 (September 20, 2016).)
In any case, a few weeks ago, CME Group amended this MRAN to expressly eliminate the ambiguous language. Now, solely if “a clearing member has actual or constructive notice or knowledge of the execution of non-bona fide EFRPs by its customer and the clearing member fails to take appropriate action” will a clearing member be deemed to have violated the applicable CME EFRP rule. (Click here for background in the article “CME Group Proposes to Eliminate Requirement for Clearing Members to Detect Non-Bona Fide EFRPs; Cautions Traders on Orders During the Globex Pre-Open” in the October 22, 2017 edition of Bridging the Week.)
Only persons actually executing EFRPs appear potentially liable under the law and CFTC rule governing non-competitive transactions; the legal provisions referenced by the CFTC to prosecute FCStone Financial do not address the reporting of such transactions to exchanges. (Click here to access 7 USC §6c(a)(1) and (2) and here to access CFTC Rule 1.38.)
Moreover, it is not clear what the CFTC’s basis was to charge FCStone Financial with failure to supervise. An FCM has no apparent obligation to supervise its customer’s EFRP activities – including activity of affiliates – absent affirmative notice of wrongdoing or constructive notice that something untoward is going on. An FCM is not a guarantor of its customers compliance with law.
In September, the CFTC similarly charged Merrill Lynch, Pierce, Fenner & Smith Incorporated, another FCM, with failure to supervise for not diligently overseeing responses to a CME Group Market Regulation investigation related to block trades executed by its affiliate, Bank of America, N.A. According to allegations by the Commission, Merrill’s regulatory breach derived from it not independently assessing information regarding the block trades provided to it by its affiliate that subsequently turned out to be false. (Click here for background in the article “FCM Agrees to Pay US $2.5 Million CFTC Fine for Relying on Affiliate’s Purportedly Misleading Analysis of Block Trades for a CME Group Investigation ” in the September 24, 2017 edition of Bridging the Week.) There was nothing in the CFTC’s settlement order that suggested that Merrill Lynch was on notice of something untoward in connection with its CME production on behalf of its client.
Both this enforcement action involving FCStone Financial and the CFTC’s prior action against Merrill Lynch suggest that the Commission may be expanding its view of the supervisory obligation of FCMs regarding the compliance by their customers of laws and rules governing the conduct of customers – even without an FCM's actual or constructive knowledge of any violation. This, however, would be an impractical obligation and does not appear supported by language in any existing law or rule.
At a minimum, if this is an evolving Commission view, the CFTC should at least issue formal guidance so that brokers can better understand their new responsibilities going forward. More appropriately, however, if the CFTC seeks to expand the reach of an existing rule, it should do so through a formal rulemaking process with an opportunity for public comment, rather than through enforcement actions.