[Federal Register Volume 69, Number 126 (Thursday, July 1, 2004)]
[Proposed Rules]
[Pages 39880-39886]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14815]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1 and 38


Execution of Transactions: Regulation 1.38 and Guidance on Core 
Principle 9

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or 
``CFTC'') is proposing a number of amendments to its rules concerning 
trading off the centralized market, including the addition of guidance 
on contract market block trading rules. The Commission is proposing 
these rule amendments and requesting comment as part of its continuing 
efforts to update its regulations in light of the Commodity Futures 
Modernization Act of 2000 (``CFMA'').

DATES: Comments must be received by August 30, 2004.

ADDRESSES: Comments should be sent to the Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, 
DC 20581, attention: Office of the Secretariat. Comments may be sent by 
facsimile transmission to 202-418-5521 or, by e-mail to 
[email protected]. Reference should be made to ``Proposed Rules for 
Trading Off the Centralized Market.'' Comments may also be submitted by 
connecting to the Federal eRulemaking Portal at http://www.regulations.gov and following comment submission instructions.

FOR FURTHER INFORMATION CONTACT: Riva Spear Adriance, Associate Deputy 
Director for Market Review, Division of Market Oversight, Commodity 
Futures Trading Commission, Three Lafayette Center, 1155 21st Street, 
NW., Washington, DC 20581. Telephone 202-418-5494; e-mail 
[email protected].

SUPPLEMENTARY INFORMATION:

I. Background

    Commission Regulation Section 1.38 (17 CFR 1.38) sets forth a 
requirement that all purchases and sales of a commodity for future 
delivery or a commodity option on or subject to the rules of a 
designated contract market (``DCM'') should be executed by open and 
competitive methods. This ``open and competitive'' requirement is 
modified by a proviso that allows transactions to be executed in a 
``non-competitive'' manner if the transaction is in compliance with DCM 
rules specifically providing for the non-competitive execution of such 
transactions, and such rules have been submitted to, and approved by, 
the Commission.
    Since Regulation 1.38 was promulgated,\1\ the CFMA was enacted.\2\ 
Federal regulation of commodity futures and option markets was 
significantly changed by the CFMA, which replaced ``one-size-fits-all'' 
regulation with broad, flexible core principles.\3\ At the same time, 
the CFMA modified Section 3 of the Act, such that the purpose of the 
Act is now, among other things, ``to deter and prevent price 
manipulation or any other disruptions to market integrity; to ensure 
the financial integrity of all transactions subject to this Act and the 
avoidance of systemic risk; to protect all market participants from 
fraudulent or other abusive sales practices and misuses of customer 
assets * * *'' \4\ The CFMA also specifically expanded the types of 
transactions that could lawfully be executed off the centralized 
market. Specifically, the CFMA permits DCMs to establish trading rules 
that: (1) Authorize the exchange of futures for swaps; or (2) allow a 
futures commission merchant, acting as principal or agent, to enter 
into or confirm the execution of a contract for the purchase or sale of 
a commodity for future delivery if the contract is reported, recorded, 
or cleared in accordance with the rules of a contract market or 
derivatives clearing organization.\5\
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    \1\ Regulation 1.38 was originally adopted in 1953 by the 
Commodity Exchange Authority, the predecessor of the Commission. See 
18 FR 176 (Jan. 19, 1953). For subsequent amendments, see 31 FR 5054 
(Mar. 29, 1966), 41 FR 3191 (Jan. 21, 1976, eff. Feb. 20, 1976), and 
46 FR 54500 (Nov. 3, 1981, eff. Dec. 3, 1981).
    \2\ Pub. L. 106-554, 114 Stat. 2763 (2000). Under the CFMA, such 
rules may be effected by the certification procedures set forth in 
section 5c(c) of the Act and 40.6 of the Commission's regulations.
    \3\ The CFMA was intended, in part, ``to promote innovation for 
futures and derivatives.'' See Sec.  2 of the CFMA. It was also 
intended ``to reduce systemic risk,'' and ``to transform the role of 
the [Commission] to oversight of the futures markets.'' Id.
    \4\ 7 U.S.C. 5 (2000).
    \5\ See section 7(b)(3) of the Act.

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[[Page 39881]]

    The Commission promulgated regulations implementing provisions of 
the CFMA relating to trading facilities in 2001, which established 
procedures relating to trading facilities, interpreted certain of the 
CFMA's provisions and provided guidance on compliance with various of 
its requirements.\6\ Later, the Commission promulgated amendments to 
those regulations in response to issues that had arisen in 
administering the rules, noting that the Commission would consider 
``additional amendments to the rules implementing the CFMA based upon 
further administrative experience.'' \7\ Consistent with that 
rationale, the Commission now proposes to amend: (i) Commission 
Regulation 1.38; and (ii) Commission guidance concerning Core Principle 
9 as it relates to Commission Regulation 1.38, to include changes that 
the Commission believes necessary based upon its experience 
administering those provisions.\8\
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    \6\ See 66 FR 14262 (Mar. 9, 2001) and 66 FR 42256 (Aug. 10, 
2001).
    \7\ See 67 FR 20702 (Apr. 26, 2002) and 67 FR 62873 (Oct. 9, 
2002).
    \8\ Core Principle 9 (7 U.S.C. 5(d)(9) (Execution of 
transactions) states that ``The board of trade shall provide a 
competitive, open, and efficient market and mechanism for executing 
transactions.''
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II. Discussion of the Proposed Rule Amendment and Guidance

A. Proposed Amendments to Regulation 1.38

    At the time that the Commission promulgated its first rules 
implementing the CFMA, it retained Regulation 1.38 as applicable to 
DCMs. The Commission now proposes to rearrange and amend Regulation 
1.38 in light of further consideration of the implications of the CFMA 
and administrative experience. The proposed amendments simplify the 
text and update the requirements of Regulation 1.38, including language 
specifically expanding types of transactions that may lawfully be 
executed off of a DCM's centralized market in accordance with the CFMA.
    For instance, the Act, as amended by the CFMA, specifically allows 
the exchange of futures for swaps,\9\ and since the CFMA was enacted, 
several DCMs have adopted rules that allow the exchange of futures for 
swaps,\10\ or for another derivatives position.\11\ The Commission is 
proposing, therefore, to update the language of Regulation 1.38 by 
substituting the phrase ``the exchange of futures for a commodity or 
for a derivatives position'' for the phrase ``the exchange of futures 
for cash commodities or the exchange of futures in connection with cash 
commodity transactions.'' \12\ Furthermore, as the CFMA implemented the 
rule certification procedures of Section 5c(c)(1) of the Act,\13\ the 
proposed changes to Regulation 1.38 would add transactions carried out 
pursuant to certified rules to the transactions that are allowed to be 
executed away from the centralized market.\14\
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    \9\ See section 5(b)(3) of the Act (7 U.S.C. 7(b)(3)).
    \10\ See, e.g. (Chicago Board of Trade (``CBOT'') Rule 444.04, 
INET Futures Exchange, LLC (``INET'') Rule 606, Merchants Exchange 
(``ME'') Rule 418(b), New York Board of Trade (``NYBOT'') Rule 4.13, 
New York Mercantile Exchange, Inc. (``NYMEX'') Rule 6.21A and U.S. 
Futures Exchange, LLC (``USFE'') Rule 417.
    \11\ See, e.g., (i) rules allowing the exchange of futures for 
options NQLX LLC Futures Exchange (``NQLX'') Rule 420 (Exchange for 
Physical Trades) and USFE Rule 418 (Volatility (``VOLA'') Trading 
Facility--Exchange of Futures for Options)); (ii) rules allowing for 
the exchange of futures over-the-counter (``OTC'') derivatives 
(Kansas City Board of Trade (``KCBT'') Rule 1129 (Exchange For Risk 
(``EFR'') Transactions) and CBOT Rule 444.06 (Exchange of Futures 
for, or in Connection with, OTC Agricultural Option Transactions)); 
and (iii) rules allowing the exchange of futures for any derivative, 
by-product or related product (NYMEX Rule 6.21 (Exchange of Futures 
for, or in Connection with, Product).
    \12\ The Commission observes that although this language retains 
the phrase ``futures for [a] commodity,'' it does not retain the 
phrase ``in connection with [a] commodity.'' The Commission also 
notes that the phrase ``exchange of futures for a commodity or for a 
derivatives position'' does not include elements of these exchanges. 
Instead, essential elements of bona fide exchange of futures trades 
have been provided in the guidance to Core Principle 9 below. See 
infra section III.B.4. See also proposed Appendix B(9)(b)(2)(iii) to 
Part 38.
    \13\ Under section 5c(c)(1) of the Act as amended by the CFMA, 
DCMs are allowed to implement any new rule or rule amendment, except 
for material changes to enumerated agricultural products, by 
providing a written certification to the Commission that the new 
rule, or rule amendment complies with this Act and the Commission's 
regulations.
    \14\ See proposed Regulation 1.38(b). Current Regulation 1.38 
limits transactions that can be executed away from the centralized 
market to those transactions carried out pursuant to rules approved 
by the Commission.
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B. Amendments to Guidance on Core Principle 9

    The Commission proposes to rearrange and amend its guidance for 
compliance with Core Principle 9 in light of consideration of the 
implications of the CFMA and further administrative experience. The 
proposed guidance separates guidance provided for DCM transactions on 
the centralized market from guidance provided for DCM transactions off 
the centralized market. The current proposal also provides more 
detailed information concerning acceptable practices regarding the 
execution of transactions off the centralized market. Specifically, 
given the Commission's growing experience with markets in which block 
trades are permitted, this release proposes amending the guidance to 
provide more detail regarding acceptable block trading rules. 
Additionally, the proposed guidance describes under what circumstances 
the exchange rules can permit arm's length block trades between 
affiliated parties.
1. General Guidance
    Current Commission Regulation 1.38(b) provides that every person 
handling, executing, clearing, or carrying trades, transactions or 
positions that are not competitively executed, must identify and mark 
by appropriate symbol or designation all such transactions or contracts 
and all associated orders, records, and memoranda. As well as updating 
the language of Regulation 1.38(b), the proposed amendments add this 
requirement to the guidance under Core Principle 9, to provide 
consolidated guidance regarding recordkeeping practices pertaining to 
transactions off the centralized market.
    The guidance for Core Principle 9 also addresses the testing and 
review of automated trading systems. Currently, the guidance states 
that acceptable testing of automated systems should be ``objective,'' 
and calls for the provision of ``objective'' test results.\15\ The 
proposed guidance would also call for the provision to the Commission 
of test results of any ``non-objective'' testing carried out by or for 
a DCM (i.e., in-house reviews) regarding the system functioning 
capacity or security of any automated trading systems. Although the 
results of ``non-objective'' testing would be of more limited use, the 
Commission believes that test results of any ``non-objective'' testing 
carried out by or for the DCM should also be provided to the 
Commission.
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    \15\ Appendix B (a)(1)(iii) and (b)(1)(ii)(B), both to Part 38.
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2. Block Trade Rules
    The Commission is proposing to provide guidance to DCMs with 
respect to their rules for block transactions. The guidance provides 
block trade standards that would be acceptable to the Commission. These 
acceptable block trade standards adopt elements of block trade rules 
previously approved by the Commission. For example, under proposed 
Appendix B(9)(b)(2)(ii)(B) to Part 38, block trade parties generally 
are required to be eligible contract participants (``ECPs''), although 
commodity trading advisors (``CTA'') and investment advisors having 
over $25 million in assets under management \16\ are allowed to carry 
out

[[Page 39882]]

block trades for non-ECP customers. The Commission originally approved 
a comparable requirement in CX and Chicago Mercantile Exchange 
(``CME'') block-trading rules.\17\
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    \16\ Including foreign persons performing equivalent roles.
    \17\ See CX Rule 305-A and CME Rule 523. CX's and CME's original 
block trade rules both called for the CTA or investment advisor to 
have $50 million in assets under management. Subsequently, CME 
submitted a rule change that lowered the amount of assets required 
to be under management to $25 million for CTAs and investment 
advisors. This requirement is currently found in CME, CBOE Futures 
Exchange (``CFE''), CBOT, NYBOT, OneChicago Futures Exchange 
(``OCX'') and USFE block trading rules (Rules: 523(I), 415(a)(ii), 
331.05(c), 4.31, 417(ii) and 415(b); all respectively). Although 
BTEX trading operations have been suspended, its block trading rules 
also included this requirement. This requirement is not included in 
NQLX and INET block trading rules (Rules 419(a) and 704(a), 
respectively), as those rules limit block trades to members and 
wholesale customers.
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    Under proposed Appendix B(9)(b)(2)(ii)(A) to Part 38, a DCM must 
determine a minimum size for block transactions. An acceptable minimum 
size would be no smaller than the customary size of large transactions 
in any relevant markets.\18\ Aggregation of orders for different 
accounts in order to satisfy the minimum size requirement would be 
prohibited except in appropriate circumstances.\19\ Under the proposal, 
the aggregation of orders would be acceptable only if done by certain 
registered persons having discretion to trade customer accounts.\20\
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    \18\ See proposed Appendix B(9)(b)(2)(ii)(A) to Part 38.
    \19\ See proposed Appendix B(9)(b)(2)(ii)(C) to Part 38.
    \20\ Appropriate registered persons include a CTA registered 
pursuant to section 4m of the Act, or a principal thereof, including 
any investment advisor who satisfies the criteria of Sec.  
4.7(a)(2)(v) of this chapter, or a foreign person performing a 
similar role or function and subject as such to foreign regulation, 
where such CTA, investment advisor or foreign person has more than 
$25,000,000 in total assets under management. This requirement is 
currently found in CME, CBOT, CFE, NYBOT, OCX and USFE block trading 
rules ((Rules: 523(I), 331.05(c), 415(a)(ii), 4.31(a)(i), 417(ii) 
and 415(f); all respectively)). BTEX and CX block trading rules also 
included this requirement. INET Rule 704(c) and NQLX Rule 419(c)(2) 
each include a similar rule that allows aggregation only for 
advisers with discretion over multiple discretionary accounts of 
appropriate customers (``wholesale customers'' or ``block trader'' 
respectively).
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    A majority of exchanges that permit block trading prohibit persons 
from effecting block trades on behalf of customers unless the person 
receives a customer's explicit instruction or prior consent to do 
so.\21\ The proposed guidance incorporates this prohibition as an 
acceptable practice.
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    \21\ See CME Rule 526(C), CFE Rule 415(a)(i), CBOT Rule 
331.05(a), NYBOT Rule 4.31(a)(ii)(A), OCX Rule 417(a)(i), and USFE 
Rule 415(c). BTEX's block trading rules also tracked this 
requirement.
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    Under the proposed guidance, acceptable block trade rules would 
require parties to, and members facilitating, a block trade to keep 
appropriate records.\22\ Appropriate block trade records would comply 
with the requirements of Core Principle 10 and Core Principle 17. 
Records kept in accordance with the requirements of Statement No. 133 
(``Accounting for Derivative Instruments and Hedging Activities''), 
issued by the Financial Accounting Standards Board (``FASB''), would be 
satisfactory.\23\ Acceptable block trade rules would require that block 
orders be recorded by the member and time-stamped with both the time 
the order was received by the member and the time the order was 
executed. This guidance is based on CME and USFE block trading rules 
that have been approved by the Commission.\24\ When requested during an 
investigation, parties to, and members facilitating, a block trade 
should provide records to document that the block trade is executed in 
accordance with contract market rules.
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    \22\ Proposed Appendix B(9)(b)(2)(ii)(E) to Part 38.
    \23\ FASB Statement No. 133 provides guidance on the use of 
accounting for corporate hedge activity involving derivative 
transactions. The statement includes guidance on documenting the 
hedging relationship.
    \24\ Rules 536.A and 415(c), respectively. BTEX block trading 
rules also tracked this requirement.
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    Proposed Appendix B(9)(b)(2)(ii)(F) to Part 38 requires reporting 
of the block trade to the DCM within a reasonable period of time once 
the transaction is executed. Reporting periods previously approved by 
the Commission, when executed under comparable circumstances, would be 
considered reasonable time periods for reporting a block transaction to 
the DCM.\25\
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    \25\ Currently, NYBOT block trading rule requires reporting of 
block trades within two minutes. See Rule 4.31(a)(v). CBOT, CME 
(generally), and INET rules require reporting of a block trade 
within five minutes, although CME allows 15 minutes for reporting 
block trades in Eurodollars. See Rules 331.05(d), 526.F., and 
704(e)(iv), respectively. NQLX rules require reporting of a block 
trade to the DCM within eight minutes. See Rule 419(g)(2). The OCX 
rule, in comparison, requires that parties report the block trade 
``without delay'' and also prohibits carrying out offsetting trades 
until after the block trade has been reported to and disseminated by 
the exchange. See Rules 417(e) and (f). Finally, the USFE rule 
requires that the block trade buyer enter the details of the block 
trade into the USFE trading system immediately upon agreement to 
enter into the trade, to which the seller must respond within 15 
minutes confirming the block transaction on the electronic trading 
system. See Rule 415(h). By the seller's confirmation of the block 
transaction on the trading system, USFE is immediately, and 
automatically, notified of the block trade.
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    The proposed guidance also identifies publication of block trade 
details by DCMs immediately upon receipt of block trade reports as an 
acceptable practice.\26\ This proposed acceptable practice would also 
require the DCM to identify block trades on its trade register.\27\
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    \26\ Proposed Appendix B(9)(b)(2)(ii)(G) to Part 38. See also, 
CME, CFE, CBOT, INET, NYBOT, OCX and USFE block trading rules. This 
is also an element of compliance with Designation Criterion 3 (Fair 
and Equitable Trading) and Core Principle 8 (Daily Publication of 
Trading Information).
    \27\ Proposed Appendix B(9)(b)(2)(ii)(H) to Part 38.
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    Under the proposed guidance, acceptable block trade rules would 
require that the block trades be at a price that is fair and 
reasonable.\28\ Consideration of whether a block transaction price is 
fair and reasonable could take into account: (i) The size of the block; 
and (ii) the price and size of other trades in any relevant markets at 
the applicable time, or the circumstances of the market or the parties 
to the block trade.\29\ Relevant markets could include, without 
limitation, the DCM itself, the underlying cash markets and/or other 
related futures markets.
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    \28\ Proposed Appendix B(9)(b)(2)(ii)(I) to Part 38.
    \29\ A similar ``fair and reasonable'' price parameter is found 
in Commission memoranda on block trading, in versions of Part 38 
regulations adopted prior to the passage of the CFMA (see 65 FR 
77962, see also 65 FR 82272 (withdrawing regulations due to 
enactment of the CFMA)) as well as current CBOT, CFE, CME, and NYBOT 
block trading rules, Rules 331.05(b), 415(c), 526.D., 4.31(a)(iii), 
respectively.
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    If a DCM rule requiring a fair and reasonable price included the 
``circumstances'' of the parties or of the market within its 
parameters, a block trade participant could execute a block transaction 
at a price that was away from the market provided that the participant 
retained documentation to demonstrate that the price was indeed fair 
and reasonable under the participant's legitimate trading objectives or 
the market's particular circumstances. Analysis of whether a block 
trade price outside the bid/ask spread or prices of contemporaneous 
transactions in the futures market is fair and reasonable, however, 
should consider how the block trade price reflects commercial 
realities. A price that is away from any market may raise suspicion 
concerning the legitimacy of the trade.
    As a result, inclusion of the ``circumstances'' of the parties or 
of the market within the parameters of the fair and reasonable price 
guidance provides flexibility to market participants while allowing the 
DCM to later review the price of the block trade, as the exchange would 
have the ability to obtain trade participant documentation if 
necessary.
3. Block Trades Between Affiliated Parties
    Under the proposed guidance, acceptable block trade rules would

[[Page 39883]]

require that block trades be arm's length transactions.\30\ For 
exchanges that desire to allow block trading between affiliated 
parties, however, the proposed Appendix B(9)(b)(2)(ii)(J) to Part 38, 
would also provide guidance on acceptable rules for affiliate block 
trades, which when carried out consistent with the guidance would be 
presumed to be arm's length transactions. Specifically, the proposed 
guidance provides that block transactions between parties that have an 
arm's length organizational structure will be presumed to be at arm's 
length. Under the guidance, an ``arm's length organizational 
structure'' is one in which the counterparties (whether affiliated or 
not), each have a separate account controller, with its own 
responsibility to review and evaluate the terms and conditions and the 
potential risks and benefits of prospective transactions. 
Alternatively, block transactions between affiliated parties will be 
presumed to be at arm's length if they are executed during trading 
hours and are carried out at an arm's length price, as provided by the 
guidance.\31\
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    \30\ Proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
    \31\ See proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
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    In addition to the requirements previously discussed, acceptable 
DCM rules for affiliate block trades would require: (i) Execution 
during the contract's trading hours; (ii) transaction prices that fall 
within the bid/ask spread on electronic trading systems or prices of 
contemporaneous related trading floor transactions, although if the 
contract does not have a bid/ask spread or any floor transactions at 
the time of the block transaction, then the contemporaneous bid/ask 
spread or price of transactions on related futures or cash markets 
could be used; and (iii) identification of the trade on the order 
ticket and to the DCM as a trade that was between affiliated parties.
    The proposed price parameters for affiliate block trades (a 
prevailing bid-ask spread or price of contemporaneous related floor 
transactions) would be a narrower subset of the fair and reasonable 
price parameter proposed for block trades between parties that are not 
affiliated.\32\ Block transactions between affiliated parties raise 
concerns that such block trades may be susceptible to abuse. Under the 
Commission's proposal, only block trade prices between affiliated 
parties that fall within a price parameter using concrete prices 
(contemporaneous bid-ask spread or prices in contemporaneous market(s)) 
would be assumed to be at arm's length. Such a pricing parameter 
provides an objective method for determining whether the price of an 
affiliated party block trade was fairly negotiated and absent any 
pricing abuse, and, consequently, warranting a presumption that the 
block trade was carried out at arm's length.
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    \32\ See proposed Appendices B(9)(b)(2)(ii)(J)(2) and 
B(9)(b)(2)(ii)(I) to Part 38.
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    The Commission expects that the proposed guidance will benefit DCMs 
that are interested in allowing affiliate block transactions, as well 
as participants that desire to take advantage of such rules as the 
guidance provides participants with alternative means to comply with 
the requirement that block transactions be carried out at arm's 
length.\33\ Affiliate block trades that are not carried out according 
to this guidance could be subject to greater scrutiny. Such scrutiny 
would not be based on a presumption of illegitimacy, but on lack of 
information about the trade. Firms that execute affiliate block 
transactions outside of the guidance, therefore, should preserve 
records (in addition to those they are required to keep in any event) 
in order to answer any questions regarding the trade.
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    \33\ See proposed Appendix B(9)(b)(2)(ii)(J) to Part 38.
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4. Exchange of Futures for a Commodity or for a Derivatives Position
    The essential elements of bona fide exchange of futures trades have 
been provided in the guidance to Core Principle 9 below.\34\ The 
elements proposed are found in current contract market EFP, EFS, EFR 
and EFO rules and are based on the essential elements for bona fide 
EFPs detailed in the 1987 EFP Report prepared by the Commission's then 
Division of Trading and Markets.\35\ The elements include separate but 
integrally related transactions, an actual transfer of ownership of the 
commodity or derivatives position, and both legs transacted between the 
same two parties. The Commission notes that the determination whether 
an actual transfer of ownership has occurred will depend upon the facts 
and circumstances of each transaction. In each instance where an 
exchange of futures for a commodity or for a derivatives position is 
linked to another offsetting transaction, the particular facts and 
circumstances may warrant a determination that there was not an actual 
ownership transfer of each leg of the commodity or derivatives 
position.
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    \34\ See proposed Appendix B(9)(b)(2)(iii) to Part 38.
    \35\ See generally, Division of Trading and Markets, Report on 
Exchanges of Futures for Physicals (1987). See also, CBOT Rules 
444.01, 444.01B, 444.04 and 444.06; CBOE Rule 414; CME Rule 538; 
INET Rules 705 and 706; KCBT Rules 1128.00, 1128.02, 1129.00, and 
1129.02; ME Rule 418; MGE Rule 719; NQLX Rule 420; NYBOT Rules 4.12 
and 4.13, NYMEX Rules 6.21, 6.21A and 6.21E, and OCX Rule 416.
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IV. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act \36\ requires federal agencies, in 
proposing rules, to consider the impact of those rules on small 
businesses. The rule amendments adopted herein will affect DCMs, FCMs, 
CTAs and large traders. The Commission has previously established 
certain definitions of ``small entities'' to be used by the Commission 
in evaluating the impact of its rules on small entities in accordance 
with the RFA.\37\ The Commission has previously determined that 
DCMs,\38\ registered FCMs,\39\ and large traders \40\ are not small 
entities for the purpose of the RFA. With respect to CTAs, the 
Commission has determined to evaluate within the context of a 
particular rule proposal whether CTAs would be considered ``small 
entities'' for purposes of the Regulatory Flexibility Act and, if so, 
to analyze the economic impact on the affected entities of any such 
rule at that time.\41\ The Commission believes that the instant 
proposed rules will not place any new burdens on entities that would be 
affected hereunder, and the Commission does not expect the proposed 
amendments to cause persons to change their current methods of doing 
business in most cases. This is because requirements under the instant 
proposal, if adopted, would be similar to most existing DCM 
requirements.
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    \36\ 5 U.S.C. 601 et seq.
    \37\ 47 FR 18618-21 (Apr. 30, 1982).
    \38\ Id. at 18618-19.
    \39\ Id. at 18619-20.
    \40\ Id. at 18620.
    \41\ 47 FR at 18618, 18620.
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    Accordingly, the Commission does not expect the rules, as proposed 
herein, to have a significant economic impact on a substantial number 
of small entities. Therefore, the Chairman, on behalf of the 
Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the 
proposed amendments will not have a significant economic impact on a 
substantial number of small entities. The Commission invites the public 
to comment on this finding and on its proposed determination that the 
trading facilities covered by these rules would not be small entities 
for purposes of the Regulatory Flexibility Act.

[[Page 39884]]

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 imposes certain requirements on 
federal agencies (including the Commission) in connection with their 
conducting or sponsoring any collection of information as defined by 
the PRA. The proposed rule amendments do not require a new collection 
of information on the part of any entities subject to these rules. 
Accordingly, for purposes of the Paperwork Reduction Act of 1995, the 
Commission certifies that these rule amendments do not impose any new 
reporting or recordkeeping requirements.

C. Cost-Benefit Analysis

    Section 15 of the Act, as amended by section 119 of the CFMA, 
requires the Commission to consider the costs and benefits of its 
action before issuing a new regulation. The Commission understands 
that, by its terms, Section 15 does not require the Commission to 
quantify the costs and benefits of a new regulation or to determine 
whether the benefits of the proposed regulation outweigh its costs. Nor 
does it require that each proposed regulation be analyzed in isolation 
when that regulation is a component of a larger package of regulations 
or of rule revisions. Rather, section 15 simply requires the Commission 
to ``consider the costs and benefits'' of its action.
    Section 15(a) further specifies that costs and benefits shall be 
evaluated in light of five broad areas of market and public concern: 
protection of market participants and the public; efficiency, 
competitiveness, and financial integrity of futures markets; price 
discovery; sound risk management practices; and other public interest 
considerations. Accordingly, the Commission could, in its discretion, 
give greater weight to any one of the five enumerated areas of concern 
and could, in its discretion, determine that, notwithstanding its 
costs, a particular regulation was necessary or appropriate to protect 
the public interest, to effectuate any of the provisions, or to 
accomplish any of the purposes of the Act.
    The proposed amendments constitute a package of amendments to 
Regulation 1.38 and to guidance that the Commission originally 
promulgated to implement the CFMA. The amendments are proposed in light 
of past experience with the implementation of the CFMA, and are 
intended to facilitate increased flexibility and consistency. Some 
sections of the proposed amendments merely clarify or make explicit 
past Commission decisions concerning transactions off the centralized 
market.
    As most provisions incorporate rules previously approved by the 
Commission, the proposed amendments would not, in most cases, impose 
new costs on DCMs or market participants. Most current DCM rules 
already meet the acceptable practices proposed, furthermore, these 
amendments incorporate standards that the Commission has previously 
determined protect market participants and the public,\42\ the 
financial integrity or price discovery function of the markets, and 
sound risk management practices. Moreover, the additional clarification 
of acceptable practices provides a benefit to markets and market 
participants. In addition, the amendments are expected to benefit 
efficiency and competition by providing more detailed guidance as to 
acceptable means of meeting the applicable designation criteria and 
core principles, allowing a greater degree of legal certainty to the 
markets and market participants.
---------------------------------------------------------------------------

    \42\ See, e.g. proposed Appendix B(9)(b)(2)(ii)(B) to Part 38. 
See also, supra notes 14-15 and accompanying text.
---------------------------------------------------------------------------

    After considering the five factors enumerated in the Act, the 
Commission has determined to propose the rules and rule amendments set 
forth below. The Commission invites public comment on its application 
of the cost-benefit provision. Commenters also are invited to submit 
any data that they may have quantifying the costs and benefits of the 
proposed rules with their comment letters.

List of Subjects in 17 CFR Parts 1 and 38

    Block transactions, Commodity futures, Contract markets, 
Transactions off the centralized market, Reporting and recordkeeping 
requirements.

    In consideration of the foregoing, the Commission hereby proposes 
to amend Chapter I of Title 17 of the Code of Federal Regulations as 
follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C.

    2. Section 1.38 is proposed to be revised to read as follows:


Sec.  1.38  Execution of transactions.

    (a) Transactions on the centralized market. All purchases and sales 
of any commodity for future delivery, and of any commodity option, on 
or subject to the rules of a contract market, shall be executed openly 
and competitively by open outcry, or posting of bids and offers, or by 
other equally open and competitive methods, in a place provided by the 
contract market, during the regular hours prescribed by the contract 
market for trading in such commodity or commodity option.
    (b) Trades off the centralized market; requirements. 
Notwithstanding paragraph (a) of this section, transactions may be 
executed away from a centralized market, including by transfer trades, 
office trades, block trades, or trades involving the exchange of 
futures for a commodity or for a derivatives position, if transacted in 
accordance with written rules of a contract market that provide for 
execution away from the centralized market and that have been certified 
to or approved by the Commission. Every person handling, executing, 
clearing, or carrying the trades, transactions or positions described 
in this paragraph shall comply with the rules of the appropriate 
contract market and derivatives clearing organization, including to 
identify and mark by appropriate symbol or designation all such 
transactions or contracts and all orders, records, and memoranda 
pertaining thereto.

PART 38--DESIGNATED CONTRACT MARKETS

    3. The authority section for Part 38 continues to read as follows:

    Authority: 7 U.S.C. 2, 5, 6, 6c, 7 and 12a, as amended by the 
Commodity Futures Modernization Act of 2000, Appendix E of Pub. L. 
106-554, 114 Stat. 2763 (2000).

    4. In Appendix B to Part 38 Core Principle 9 is proposed to be 
revised to read as follows:

Appendix B to Part 38--Guidance on, and Acceptable Practices in, 
Compliance With Core Principles

* * * * *
    Core Principle 9 of section 5(d) of the Act: EXECUTION OF 
TRANSACTIONS--The board of trade shall provide a competitive, open, 
and efficient market and mechanism for executing transactions.
    (a) Application guidance--(1) Transactions on the centralized 
market. (i) All purchases and sales of any commodity for future 
delivery, and of any commodity option, on or subject to the rules of 
a contract market shall be executed openly and competitively by open 
outcry, or posting of bids and offers, or by other equally open and 
competitive methods, in a place provided by the contract market, 
during the regular hours prescribed by the contract market for 
trading in such commodity or commodity option.
    (ii) A competitive and open market and mechanism for executing 
transactions includes a board of trade's methodology for entering 
orders and executing transactions.

[[Page 39885]]

    (iii) Appropriate objective testing and review of a contract 
market's automated systems should occur initially and periodically 
to ensure proper system functioning, adequate capacity and security. 
A designated contract market's analysis of its automated system 
shall address compliance with appropriate principles for the 
oversight of automated systems, ensuring proper system 
functionality, adequate capacity and security.
    (2) Transactions off the centralized market. (i) Transactions 
may be executed off the centralized market if transacted in 
accordance with written rules of a contract market that have been 
certified to or approved by the Commission and that specifically 
provide for execution of such transactions away from the centralized 
market.
    (ii) Every person handling, executing, clearing, or carrying the 
trades, transactions or positions that are not executed on the 
centralized market, including transfer trades, office trades, block 
trades, or trades involving the exchange of futures for a commodity 
or for a derivatives position, shall comply with the rules of the 
applicable designated contract market and derivatives clearing 
organization.
    (iii) A designated contract market that determines to allow 
trades off the centralized market shall ensure that such trading 
does not operate in a manner that compromises the integrity of 
prices or price discovery on the centralized market.
    (b) Acceptable practices--(1) Matters relating to trade 
execution facilities. (i) General provisions. [Reserved]
    (ii) Electronic trading systems. (A) The guidelines issued by 
the International Organization of Securities Commissions (IOSCO) in 
1990 (which have been referred to as the ``Principles for Screen-
Based Trading Systems''), and adopted by the Commission on November 
21, 1990 (55 FR 48670), as supplemented in October 2000, are 
appropriate guidelines for a designated contract market to apply to 
electronic trading systems.
    (B) Any objective testing and review of the system should be 
performed by a qualified independent professional. A professional 
that is a certified member of the Information Systems Audit and 
Control Association experienced in the industry is an example of an 
acceptable party to carry out testing and review of an electronic 
trading system.
    (C) Information gathered by analysis, oversight, or any program 
of testing and review of any automated systems regarding system 
functioning, capacity and security must be made available to the 
Commission upon request.
    (iii) Pit trading. [Reserved]
    (2) Transactions off the centralized market--(i) General 
provisions. (A) Types of allowable trades off the centralized 
market.--Acceptable transactions off the centralized market include: 
transfer trades, office trades, block trades, or trades involving 
the exchange of futures for a commodity or for a derivatives 
position, if transacted in accordance with written rules of a 
contract market appropriately providing for execution away from the 
centralized market, that have been certified to or approved by the 
Commission.
    (B) Reporting. Acceptable contract market rules would require 
reporting of transactions off the centralized market to the contract 
market within a reasonable period of time.
    (C) Publication. Acceptable contract market rules would require 
the contract market to publicize details about transactions off the 
centralized market immediately upon the receipt of the transaction 
report.
    (D) Trade register. Acceptable contract market rules would 
require the contract market to identify transactions off the 
centralized market on its trade register.
    (E) Recordkeeping. Acceptable contract market rules would 
require parties to, and members facilitating, transactions off the 
centralized market to keep appropriate records. Appropriate records 
for transactions off the centralized market would comply with Core 
Principle 10 and Core Principle 17.
    (F) Identification of trades. Section 1.38(b) of this chapter 
establishes the guidance regarding the identification of all trades 
off the centralized market. It requires contract market rules to 
require every person handling, executing, clearing, or carrying 
trades, transactions or positions that are executed off the 
centralized market, including transfer trades, office trades, block 
trades or trades involving the exchange of futures for a commodity 
or for a derivatives position, to identify and mark by appropriate 
symbol or designation all such transactions or contracts and all 
orders, records, and memoranda pertaining thereto.
    (ii) Block transactions. (A) Include an acceptable minimum block 
size. An acceptable minimum block size would be no smaller than the 
customary size of large transactions in any relevant markets. A 
``large'' transaction is one that may affect the quality of the 
transaction price due to the significant impact of such a large 
order on the centralized market. An acceptable minimum block size, 
for example, would be a transaction size that is greater than 90 
percent of the trades in a relevant market. The relevant market 
should be the subject futures or options market, any related 
derivatives market, and/or the underlying cash market, as 
appropriate. If a contract market chooses to allow block 
participants to meet the minimum block size requirement by 
aggregating the component legs of a spread or combination position 
executed as a block trade, the acceptable size for each leg should 
be the size of a large transaction in the relevant market (that is, 
a size that is greater than 90 percent of the trades in the relevant 
market). For markets where transaction data in the relevant 
market(s) are unavailable, inadequate to conduct an analysis, or for 
markets where there is no underlying cash market, an acceptable 
minimum block size should be set initially at 100 contracts and 
adjusted thereafter as transaction data in the relevant market(s) 
become available.
    (B) Restrict access to appropriate parties. Acceptable block 
trade parties would be eligible contract participants. However, 
contract market rules could also allow a commodity trading advisor 
registered pursuant to section 4m of the Act, or a principal 
thereof, including any investment advisor who satisfied the criteria 
of Sec.  4.7(a)(2)(v) of this chapter, or a foreign person 
performing a similar role or function and subject as such to foreign 
regulation, to transact block trades for customers who are not 
eligible contract participants, if such commodity trading advisor, 
investment advisor or foreign person has total assets under 
management that exceed $25,000,000.
    (C) Aggregation of orders. Acceptable contract market rules 
would prohibit aggregation of orders for different accounts in order 
to satisfy the minimum size requirement except in appropriate 
circumstances. Aggregation of orders for different accounts in order 
to satisfy the minimum size requirement would be acceptable if done 
by a commodity trading advisor registered pursuant to section 4m of 
the Act, or a principal thereof, including any investment advisor 
who satisfies the criteria of Sec.  4.7(a)(2)(v) of this chapter, or 
a foreign person performing a similar role or function and subject 
as such to foreign regulation, where such commodity trading advisor, 
investment advisor or foreign person has more than $25,000,000 in 
total assets under management.
    (D) Acting for a customer. Acceptable contract market rules 
would prohibit a person from effecting a block trade on behalf of a 
customer, unless the person has received an instruction or prior 
consent to do so from the customer;
    (E) Recordkeeping. Acceptable contract market rules would 
require parties to, and members facilitating, a block trade to keep 
appropriate records. Appropriate block trade records would comply 
with Core Principle 10 and Core Principle 17. Records kept in 
accordance with the requirements of FASB Statement No. 133 
(``Accounting for Derivative Instruments and Hedging Activities'') 
would be acceptable records. Block trade orders must be recorded by 
the member and time-stamped with both the time the order was placed 
and the time the order was executed, and must indicate when block 
trades are between affiliated parties. When requested during an 
investigation, parties to, and members facilitating, a block trade 
shall provide records to document that the block trade is executed 
in conformance with contract market rules.
    (F) Reporting. Acceptable contract market rules would require 
reporting of the block trade to the contract market within a 
reasonable period of time. Reporting periods previously approved by 
the Commission would be considered reasonable time periods for 
reporting a block transaction to the contract market once the 
transaction is executed.
    (G) Publication. Acceptable contract market rules would require 
the contract market to publicize details about the block trade 
immediately upon its being reported to the contract market.
    (H) Identification of trades. Acceptable contract market rules 
would require the contract market to identify block trades as such 
on its trade register, and to identify when block trades are between 
affiliated parties.
    (I) Pricing. Acceptable contract market rules would require that 
the block trades be

[[Page 39886]]

at a price that is fair and reasonable. Consideration of whether a 
block transaction price is fair and reasonable could take into 
account: (i) The size of the block; and (ii) the price and size of 
other trades in any relevant markets at the applicable time, and the 
circumstances of the market or the parties to the block trade. 
Relevant markets could include, without limitation, the contract 
market itself, the underlying cash markets and/or other related 
futures markets. If a contract market rule requiring a fair and 
reasonable price includes the ``circumstances'' of the parties or of 
the market within its parameters, a block trade participant could 
execute a block transaction at a price that was away from the market 
provided that the participant retains documentation to demonstrate 
that the price was indeed fair and reasonable under the 
participant's or market's particular circumstances.
    (J) Arm's length transactions. Acceptable contract market rules 
would require that block trades be arm's length transactions. The 
following block trades will be presumed to be carried out at ``arm's 
length'' (1) Block trades transacted between separate counterparties 
(whether affiliated or not), where each counterparty has a separate 
account controller with its own responsibility to review and 
evaluate the terms and conditions and the potential risks and 
benefits of prospective transactions would be presumed to be carried 
out at ``arm's length;'' and (2) Block trades between affiliated 
parties if transacted under contract market rules that require, 
along with the requirements of paragraphs (b)(2)(i)(A)-(H) of this 
appendix: (i) execution during the contract's trading hours; and 
(ii) transaction prices that fall within the bid/ask spread on 
electronic trading systems or prices of contemporaneous related 
trading floor transactions, however, if the contract does not have a 
bid/ask spread or any floor transactions at the time of the block 
transaction, then the contemporaneous bid/ask spread or price of 
transactions on related futures or cash markets could be used.
    (iii) Exchange of futures for a commodity or for a derivatives 
position. Acceptable contract market rules for exchange of futures 
for a commodity or for a derivatives position would require that 
such trades include the following elements:
    (A) Separate but integrally related transactions, involving (1) 
the same or a related commodity; (2) price correlation of legs; and 
(3) quantitative equivalence;
    (B) A buyer of futures who is the seller of the corresponding 
commodity or derivatives position and a seller of futures who is the 
buyer of the corresponding commodity or derivatives position; and
    (C) An actual transfer of ownership, involving (1) separate 
parties; (2) possession, right of possession, or right to future 
possession of each leg prior to the trade; (3) an ability to 
perform; and (4) a transfer of title.
    (iv) Office trades. [Reserved]
    (v) Transfer trades. [Reserved]
* * * * *

    Issued in Washington, DC, on June 24, 2004, by the Commission.
Jean A. Webb,
Secretary of the Commission.

[FR Doc. 04-14815 Filed 6-30-04; 8:45 am]
BILLING CODE 6357-01-P