[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