Futures Markets: Heightened Audit Trail Standards Not Met But Progress
Continues (Letter Report, 09/25/96, GAO/GGD-96-177).
Pursuant to a congressional request, GAO provided information on the
Commodity Futures Trading Commission's (CFTC) actions to enforce Futures
Trading Practices Act (FTPA) audit trail provisions.
GAO found that: (1) 7 U.S. futures exchanges are in compliance with FTPA
1-minute trade timing and sequencing standards; (2) CFTC is unable to
determine the status of four other exchanges until it reviews the
results of the audit trail tests; (3) audit trail test results for the
Chicago Board of Trade (CBT) and the Chicago Mercantile Exchange (CME)
are not precise enough to verify their compliance with existing audit
trail standards; (4) none of the exchanges fully complied with the
heightened audit trail standards as of October 28, 1995; (5) CFTC has
delayed requiring some audit trail enhancements to existing systems due
to assurances that electronic trading terminals would be in place by the
statutory deadline; (6) CFTC has granted the Coffee, Sugar & Cocoa
Exchange and the New York Mercantile Exchange temporary relief from the
FTPA statutory deadline; (7) CBT and CME were not in compliance with the
heightened FTPA guidelines after additional retests; (8) CFTC has not
determined the practicability of certain FTPA provisions, including the
requirement to capture broker receipt time for customer orders; (9) CFTC
plans to act on exchange petitions for exemption from the dual trading
ban; and (10) CFTC needs to keep Congress informed of its actions to
facilitate additional FTPA audit standards.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-96-177
TITLE: Futures Markets: Heightened Audit Trail Standards Not Met
But Progress Continues
DATE: 09/25/96
SUBJECT: Commodities exchanges
Securities regulation
Commodity futures
Brokerage industry
Securities fraud
Auditing standards
Self-regulatory organizations
Audit oversight
Noncompliance
Reporting requirements
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Cover
================================================================ COVER
Report to Congressional Requesters
September 1996
FUTURES MARKETS - HEIGHTENED AUDIT
TRAIL STANDARDS NOT MET BUT
PROGRESS CONTINUES
GAO/GGD-96-177
Audit Trail Standards
(233462)
Abbreviations
=============================================================== ABBREV
CBT - Chicago Board of Trade
CFTC - Commodity Futures Trading Commission
CME - Chicago Mercantile Exchange
COMEX - Commodity Exchange, Inc.
CSCE - Coffee, Sugar & Cocoa Exchange
FTPA - Futures Trading Practices Act of 1992
NYCE - New York Cotton Exchange
NYMEX - New York Mercantile Exchange
Letter
=============================================================== LETTER
B-261761
September 25, 1996
The Honorable Richard G. Lugar
Chairman
The Honorable Patrick J. Leahy
Ranking Minority Member
Committee on Agriculture, Nutrition,
and Forestry
United States Senate
The Honorable Pat Roberts
Chairman
The Honorable E (Kika) de la Garza
Ranking Minority Member
Committee on Agriculture
House of Representatives
In August 1989, the Department of Justice, in cooperation with the
Commodity Futures Trading Commission (CFTC), conducted an undercover
investigation at the Chicago Board of Trade (CBT) and the Chicago
Mercantile Exchange (CME). The investigation disclosed illegal
trading practices designed to enrich participants. In a September
1989 report to Congress,\1 we concluded that most of the types of
illegal practices disclosed could have been detected with improved
audit trails--the physical records of the price and time of each
trade.\2 We recommended that CFTC heighten audit trail standards by
requiring a more accurate and comprehensive record of trades.
Congress incorporated the then existing audit trail standards, as
well as heightened standards, in the Futures Trading Practices Act
(FTPA) of 1992 (P.L. 102-546). The FTPA required that, not later
than 2 years after its enactment, CFTC report to Congress on the
progress of U.S. futures exchanges in meeting the audit trail
standards and include recommendations on the appropriateness of
extending the October 28, 1995, deadline for meeting the standards or
for modifying them. CFTC addressed two issues in its November 1994
report to Congress: (1) exchange compliance with the existing trade
timing standards and (2) exchange progress toward complying with the
heightened standards.\3 CFTC did not recommend any extension of time
or modification to the standards. The FTPA further required that we
report our views on the issues CFTC addressed in its report. As
agreed with your committees, our objectives were to report on the
status of exchange compliance with the existing and heightened
standards as well as CFTC actions to enforce the FTPA audit trail
provisions.
--------------------
\1 Futures Markets: Strengthening Trade Practice Oversight
(GAO/GGD-89-120, Sept. 7, 1989).
\2 An audit trail generally consists of customer order tickets and
timestamps, trading cards, trade execution times, and exchange
records of price changes.
\3 Report to Congress on Futures Exchange Audit Trails (CFTC, Nov.
1994).
BACKGROUND
------------------------------------------------------------ Letter :1
Futures contracts obligate the holder to buy or sell a specific
amount or value of an underlying asset, reference rate, or index
(called the underlying)\4 at a specified price on a specified future
date. This obligation can be met through delivery of the underlying
or by cash settlement. Futures contracts are designed to manage the
risk of changes in the value of underlying assets, rates, and indexes
by allowing market users to economically replicate investments in
them. By buying and selling futures, users can either assume or
transfer the risk of price fluctuations. The futures markets also
serve a price discovery function by establishing a price at which a
buyer and seller will complete a transaction. These prices are often
used in setting the terms of other contracts.
Futures contracts are bought and sold at centralized auction markets
called exchanges. In the United States, futures contracts are
usually traded through a competitive system, called "open-outcry," in
which floor participants verbally make bids and offers to each other
at centralized exchange locations, called "trading pits or rings."\5
Two types of floor participants execute trades in these pits--floor
brokers and floor traders. Floor brokers execute trades for
customers and may also execute trades for their personal or employer
accounts. In contrast, floor traders execute trades only for their
personal accounts.
According to industry officials, U.S. futures markets are largely
used by institutions rather than individual "retail" investors.
These institutions include banks, insurance companies, mutual funds,
corporate pension plans, large corporations, and various federal,
state, and local governmental entities. Institutional users expect
near instantaneous execution of their orders to secure targeted
prices, especially when price movements in the futures markets become
rapid. Delays in order execution can increase the risk of a user not
obtaining a targeted price ("price slippage") and can thereby affect
the success of the user's market strategy.
The U.S. futures markets are self-regulated by the 11 active futures
exchanges,\6 with CFTC providing federal oversight. Weaknesses in
controls over futures trading can provide dishonest floor
participants with the opportunity to cheat customers and to conceal
this cheating by manipulating the recorded price and time of trades.
The FTPA requires that each exchange maintain and use controls to
monitor trading in order to deter and detect such illegal activities.
These controls must include audit trail systems that capture
essential data on trade participants, terms, times, and sequencing.
CFTC audit trail standards in effect prior to the enactment of the
FTPA required that exchange audit trail systems (1) assign trade
times accurate to within 1 minute of trade execution--referred to as
the 1-minute trade timing standard and (2) sequence trades for each
floor broker and floor trader. All U.S. futures exchanges were
required to comply with these standards. They were subsequently
written into the FTPA along with the heightened standards, which
required that audit trail data be continually provided to the
exchange in an unalterable manner and that it be precise, complete,
and independent.\7
The FTPA made compliance with most of the heightened requirements
subject to a CFTC determination on the practicability of
implementation. Also, exchanges having a minimum average daily
trading volume of less than 8,000 contracts in each of its contract
markets could qualify for an exemption from the heightened standards
if they could demonstrate substantial compliance with the act's audit
trail standards and trade monitoring requirements.
In November 1994, five exchanges were covered by the heightened
standards because of their trading volume: (1) CBT; (2) CME; (3) the
Coffee, Sugar & Cocoa Exchange (CSCE); (4) the Commodity Exchange,
Inc. (COMEX); and (5) the New York Mercantile Exchange (NYMEX). As
of the quarter ended on September 30, 1995, a sixth exchange--the New
York Cotton Exchange (NYCE)--exceeded the minimum volume criteria and
became subject to these standards. Because it had just recently
become subject to the standards, in October 1995, CFTC gave the
exchange additional time to demonstrate good faith progress towards
compliance with them.\8 CFTC plans to test NYCE's audit trail system
beginning in October 1996. As a result, this report does not discuss
NYCE compliance with the heightened standards.
Futures exchanges use one of four types of systems to meet audit
trail standards--manual, imputed timing, pit card timestamping, and
computer trade matching. Five of the 11 active U.S. futures
exchanges use manual systems to record trade times--COMEX, the Kansas
City Board of Trade, the Minneapolis Grain Exchange, NYCE, and the
New York Futures Exchange. Under these systems, floor traders and
brokers manually record the time of all trades in sequence on trading
cards. Four active exchanges--CBT, CME, CSCE, and the MidAmerica
Commodity Exchange--use imputed timing systems. These systems use
computer-based algorithms to assign times to trades after they have
occurred. They use information from audit trail documentation,
including data recorded by floor traders and brokers and data
generated independently of them.\9 NYMEX is the only exchange using
the pit card system. Under this system, the exchange assigns a time
to each trade by timestamping a card that the seller is required to
submit within 1 minute of trade execution. Finally, one active U.S.
exchange, the Philadelphia Board of Trade, uses computers to match
and execute trades.\10
Electronic systems for meeting audit trail requirements are currently
under development--including an electronic hand-held trading terminal
and electronic order routing systems. Although the FTPA does not
mandate the use of any particular system to meet the heightened
standards, Congress knew that three exchanges--CBT, CME, and
COMEX--had voluntarily committed to developing electronic hand-held
trading terminals when it considered the legislation. The exchanges
expected that these electronic terminals would help meet the FTPA
audit trail standards and also reduce costs by, among other things,
reducing trading errors and administrative expenses. The FTPA
legislative history indicates that Congress encouraged CFTC not to
require fundamental changes to existing audit trail systems if doing
so would cause disproportionate expense or might delay implementation
of electronic systems.\11
Under the FTPA, an exchange ultimately must demonstrate compliance
with the act's audit trail standards to continue acting as a market
in futures contracts. The act provides CFTC with the authority to
issue a deficiency order should an exchange fail to comply with its
audit trail standards. The act also sets forth conditions under
which dual trading\12 will be banned in high-volume markets.
However, it allows CFTC to grant an exemption from the ban to an
exchange that can show, among meeting other requirements, that it
complies with the act's audit trail standards. All exchanges covered
by the ban have filed petitions for an exemption, and these petitions
are still pending. Because the ban on dual trading takes effect when
CFTC acts to deny an exchange exemption petition, the ban has yet to
take effect on any covered exchange.\13
--------------------
\4 The underlyings include agricultural and other physical
commodities, bonds, interest rates, currency exchange rates, and
stock indexes.
\5 Some exchanges also use computerized trading systems that operate
during and/or outside regular exchange hours.
\6 A twelfth U.S. futures exchange, the AMEX Commodities
Corporation, is inactive.
\7 See page 9 for further details on the heightened standards.
\8 At this time, CFTC also addressed the status of the four active
low-volume exchanges that were eligible for exemption from the
heightened audit trail standards. It exempted three exchanges from
the standards--the Kansas City Board of Trade, the New York Futures
Exchange, and the Philadelphia Board of Trade--and deferred a
decision on the Minneapolis Grain Exchange until its trade monitoring
system was improved.
\9 Although exchange systems differ, data used to impute times
include exchange records of price changes, preprinted trading card
and line-sequence numbers, manually-recorded execution times for
certain trades, time bracket designations, and order ticket
timestamps.
\10 If active, the AMEX Commodities Corporation would also use
computers to match and execute trades.
\11 See 138 Cong. Rec. S17,868 (daily ed. Oct. 8, 1992)
(statement of Sen. Leahy).
\12 Dual trading allows floor brokers to trade for their own and
customer accounts in the same trading session.
\13 CME, however, voluntarily banned dual trading in all of its
high-volume contract months about 1-1/2 years before the enactment of
the FTPA.
RESULTS IN BRIEF
------------------------------------------------------------ Letter :2
Regarding the status of exchange compliance with the existing
standards, CFTC stated in its November 1994 report to Congress that 7
of 11 U.S. futures exchanges\14 were in compliance with the existing
1-minute trade timing and sequencing standards. CFTC stated that it
could not determine the status of the remaining four exchanges--CBT,
CME, CSCE, and NYMEX--until it reviewed the results of audit trail
tests that it directed the exchanges to conduct. CFTC reported in
June 1995\15 that, of the trade times assigned by the audit trail
systems of the four exchanges tested, CBT and CME test results were
not precise enough to verify compliance with the existing standards.
CFTC reported in August 1996 that the results of March 1996 retests,
although improved, were still not precise enough to verify compliance
with the existing standards.\16
Regarding the status of exchange compliance with the heightened
standards, CFTC did not find that any exchange fully complied with
the heightened audit trail standards as of the October 28, 1995,
statutory deadline. Consistent with congressional intent, CFTC had
delayed requiring some audit trail enhancements to existing systems
based on exchange assurances that electronic trading terminals would
be in place by the statutory deadline. However, these systems were
not operational as of October 28, 1995, and exchange officials raised
concerns about when they would be fully functional. In the absence
of electronic trading terminals and considering audit trail test
results, in June 1995, CFTC required CBT, CME, CSCE, and NYMEX to
make additional improvements to their existing systems. CFTC
subsequently concluded, based on exchange implementation of these
improvements, that CSCE and NYMEX had made good faith efforts to
comply with the heightened standards. As provided for by the FTPA,
CFTC determined that these exchanges, as well as COMEX, had qualified
for a safe harbor and thus for temporary relief from the act's
statutory deadline. CFTC did not indicate when this relief would
expire. It notified the remaining two exchanges--CBT and CME--that
further tests of their compliance with the 1-minute trade timing and
heightened standards were required. In August 1996, CFTC reported
that although the March 1996 retest results showed further
improvements in their audit trails, CBT and CME were not in
compliance with the heightened standards. CFTC did not address
whether the exchanges had made a good faith effort to comply with the
act and thereby qualified for a safe harbor. Instead, it gave them
until January 1, 1997, to make further improvements. In addition,
CFTC acknowledged that it has not yet determined the practicability
of certain provisions of the act, including the requirement to
capture the broker receipt time for customer orders. CFTC also
reported that it plans to act on exchange petitions for exemption
from the dual trading ban, beginning with COMEX in September 1996.
CFTC is responsible for ensuring exchange compliance with the audit
trail provisions of the FTPA and has taken steps to do so. CFTC
tested exchange audit trail systems to assess compliance and, where
they were found to be deficient, required the exchanges to implement
improvements. In the absence of full compliance, CFTC identified the
exchanges that had made good faith efforts to comply, as provided for
in the act. Also, the exchanges we reviewed agreed to implement
almost all of the improvements that CFTC recommended in June 1995.
Finally, in August 1996, CFTC reported on its additional plans for
enforcing compliance with the heightened standards. Thus far,
however, CFTC has not found any covered exchange to be in full
compliance with the FTPA heightened audit trail standards. In
addition, full implementation of electronic trading terminals is
uncertain, questions about the practicability of certain of the
heightened standards remain, and the dual trading provisions of the
act have not been fully implemented. Congress has been kept informed
of the status of compliance with the act's audit trail provisions, at
least in part, as a result of the reporting requirement and statutory
deadline established by the act. However, these have now expired.
Ensuring that Congress continues to be kept informed of exchange
progress and CFTC actions to facilitate that progress could be
pivotal to securing eventual compliance with the act's audit trail
standards.
--------------------
\14 CFTC included the AMEX Commodities Corporation, the inactive
exchange, in its report. CFTC excluded the MidAmerica Commodity
Exchange--a subsidiary of CBT--because this exchange uses the same
audit trail system as CBT.
\15 Report on Audit Trail Accuracy and Sequencing Tests (CFTC, June
1995).
\16 Report on Audit Trail Status and Re-Tests (CFTC, Aug. 1996).
OBJECTIVES, SCOPE, AND
METHODOLOGY
------------------------------------------------------------ Letter :3
To report on the status of exchange compliance with the existing and
heightened standards and CFTC actions to enforce the FTPA audit trail
provisions, we reviewed CFTC's (1) November 1994 report to Congress
on audit trails; (2) June 1995 report on the results of exchange
audit trail testing; (3) November 3, 1995, letters to four exchanges
with agency conclusions related to their good faith efforts to comply
with the FTPA; (4) August 1996 report on the status of exchange audit
trail compliance and the results of further exchange audit trail
testing; (5) other relevant CFTC studies and reports; and (6) the
legislative history of the FTPA. We interviewed officials at CFTC
headquarters in Washington, D.C., and at CFTC's Central Regional
Office to discuss the FTPA audit trail standards and CFTC efforts to
evaluate exchange compliance with them. We also interviewed CBT,
CME, CSCE, and NYMEX officials to discuss their views on the
standards and their efforts to comply with FTPA and CFTC
requirements. We chose these four exchanges because CFTC selected
them for initial audit trail testing. We also reviewed documents
from these exchanges that described their audit trail systems and the
results of exchange audit trail testing.
We conducted our audit work between March 1995 and August 1996,
primarily in Washington, D.C., and Chicago, in accordance with
generally accepted government auditing standards. We obtained
written comments on a draft of this report from CFTC, CBT, CME, and
CSCE. These comments are discussed at the end of this letter and are
reprinted in appendixes II through V. CFTC, CBT, CME, CSCE, and
NYMEX provided additional technical comments on the draft report,
which were incorporated as appropriate.
CFTC COULD NOT DETERMINE CBT OR
CME COMPLIANCE WITH THE
1-MINUTE TRADE TIMING STANDARD
------------------------------------------------------------ Letter :4
CFTC could not determine whether CBT or CME--the two largest futures
exchanges--complied with the 1-minute trade timing standard before
issuing its November 1994 report to Congress or after subsequent
testing of their audit trail systems. Before issuing its November
1994 report, CFTC required the exchanges to submit documentation of
their audit trail systems' compliance with the FTPA audit trail
standards. On the basis of this and other evidence, CFTC found that
7 of 11 exchanges were in compliance with the 1-minute trade timing
and sequencing standards. CFTC concluded that the remaining four
exchanges--CBT, CME, CSCE, and NYMEX\17 --had not yet proven their
audit trail systems met the standards. CFTC also required these
exchanges to conduct two tests in 1994 to measure the capabilities of
their audit trail systems. The first test addressed compliance with
the 1-minute trade timing and sequencing standards and required that
at least 90 percent of sampled trade execution times be consistent
with the timing information and sequence recorded on supporting trade
documents.\18 CFTC conducted another round of comparable tests at CBT
and CME in March 1996.
CFTC reported in June 1995 that CBT and CME test one results were too
imprecise to verify compliance with the 1-minute trade timing
standard. These two exchanges use computer-based algorithms to
impute or estimate trade execution times after the fact. The
computer, based on timing information recorded on trade
documentation, calculates a span of time, or timing window, during
which a trade probably took place and then selects a likely execution
time within that window. For exchanges with imputed timing systems,
CFTC required, as part of the test, that the average length of the
timing windows be 2 minutes or less to approximate the 1-minute trade
timing standard.\19 Although 90 percent of imputed trade times of
sampled trades at CBT and CME were found to be accurate (i.e.,
consistent with the supporting documentation), the length of many
timing windows was in excess of 2 minutes. At CBT, 41 percent of the
accurate trade times had timing windows of 2 minutes or less. At
CME, 72 percent of the accurate trade times had timing windows of 2
minutes or less. CFTC concluded that these results were too
imprecise to verify compliance with the 1-minute trade timing
standard and later, as discussed on page 12, recommended that CBT and
CME implement numerous audit trail improvements. The March 1996
retests at CBT and CME showed that these numbers had improved to 69
percent and 80 percent, respectively, but were still short of the
90-percent precision level CFTC sought.
Test one results at both CSCE and NYMEX exceeded the 90-percent
accuracy requirement. Further, at CSCE, which also uses an imputed
trade timing system, 91 percent of these accurately timed trades had
timing windows of less than 2 minutes, thus meeting the accuracy
requirement. At NYMEX, however, the sequence of trades determined by
times stamped on pit cards by exchange employees was often different
from the sequence recorded by traders and brokers on trading
cards.\20 NYMEX is addressing this problem with a new integrated
trading/pit card. (See app. I for details.)
--------------------
\17 These were four of the five exchanges covered by the heightened
standards at that time. CFTC did not require the fifth
exchange--COMEX--to test its audit trail system, because it provided
documentation of its compliance with the 1-minute trade timing
standard.
\18 The second test is discussed in the next section of this report.
\19 A trade time selected from within a 2-minute or shorter window
was considered likely to be within 1 minute of the actual time of
execution as required by the 1-minute trade timing standard.
\20 NYMEX does not use an imputed timing system, so timing windows do
not apply.
CFTC HAS NOT FOUND ANY EXCHANGE
IN FULL COMPLIANCE WITH THE
HEIGHTENED STANDARDS, BUT FOUND
THAT PROGRESS CONTINUED TO BE
MADE
------------------------------------------------------------ Letter :5
The heightened standards required additional improvements to exchange
audit trails. As of October 28, 1995, when the standards took
effect, the electronic trading terminals that exchanges had begun to
develop that might bring some exchanges into compliance with them
were not fully operational, and significant delays were envisioned.
In the absence of the terminals, CFTC did not find any of the
exchanges covered by the heightened standards to be in full
compliance with them.\21 Given this situation, the statute required
that CFTC consider any circumstances that prevented compliance
despite an exchange's good faith effort--thus qualifying an exchange
for a statutory safe harbor. COMEX received a de facto determination
that it had made a good faith effort in November 1994, when CFTC
determined its manual audit trail system did not require testing. In
November 1995, based on exchange audit trail test results and
implementation of recommended audit trail improvements, CFTC notified
CSCE and NYMEX that they had qualified for a safe harbor but deferred
a decision on CBT and CME until further testing. CFTC reported in
August 1996 that, although the results of further testing showed
considerable improvements, CBT and CME did not demonstrate compliance
with the heightened standards. CFTC gave the exchanges until January
1, 1997, to make further improvements. In addition, CFTC has yet to
address the practicability of certain of the audit trail provisions
of the act, including the broker receipt timing requirement, but
agency officials told us that CFTC plans to do so. It also plans to
act on exchange petitions for exemption from the dual trading ban
beginning in September 1996.
--------------------
\21 As discussed in the background section of this report, six
exchanges were covered by the heightened standards as of the
statutory deadline. Only five of these exchanges are discussed below
because CFTC does not plan to assess NYCE's compliance with the
heightened standards until October 1996.
THE HEIGHTENED STANDARDS
REQUIRE IMPROVED AUDIT
TRAILS
---------------------------------------------------------- Letter :5.1
In addition to meeting the requirements of the existing 1-minute
trade timing and sequencing standards, including capturing the
essential data on the participants, terms, times, and sequencing of
all trades, the heightened standards require that this information be
continually provided to the exchange in an unalterable manner and
that it be precise, complete, and independent. Continually providing
data to an exchange could reduce the opportunity for floor brokers
and traders to illegally alter the trading record.\22 The requirement
that the data be unalterable is to prevent floor brokers or traders
from changing a trading record without detection.
Also, while existing CFTC regulations required exchanges to sequence
trades, the act requires exchange audit trail systems to be
sufficiently precise to determine, to the extent practicable, the
sequence of all trades by each floor trader and floor broker. Exact
trade sequencing would help detect trading abuses, such as trading
ahead of customer orders.\23 In addition, the FTPA now requires the
exchanges to obtain, to the extent practicable, more complete timing
information for customer orders, including the time an order is
received on the exchange floor, received by the floor broker for
execution, and reported from the floor as executed. More complete
times could also improve an exchange's ability to accurately sequence
trades.
Finally, the act requires that the execution time for each trade be
recorded independently of the person making the trade or derived
through automatic or other similarly reliable means. Independent or
automatic trade recording could increase the reliability of the data
collected by preventing the broker or trader from falsifying the
record. The FTPA made compliance with this and most of its other
audit trail requirements subject to a CFTC determination on the
practicability of implementation. The FTPA authorized CFTC to defer
the deadline for compliance with the heightened standards if it
determined that circumstances beyond the control of an exchange
prevented compliance, despite affirmative good faith efforts to
comply. Also, the act required CFTC to exempt an exchange from the
heightened standards if the average daily trading volume in each of
its contract markets was less than 8,000 contracts and if it could
demonstrate substantial compliance with the act's audit trail
standards and trade monitoring requirements.
--------------------
\22 CFTC officials told us that the word "continual" implies
periodic, not continuous data provision, and that the current CFTC
requirement that exchanges collect trading cards and customer order
tickets within 15 minutes of the end of each exchange-designated
trading period (which lasts either 15 or 30 minutes, depending on the
exchange) plus multiple intraday trade matching are forms of
continual provision of trade data to the contract market.
\23 Trading ahead occurs when brokers buy (or sell) for their
personal accounts or an account in which they have an interest, while
having in hand any executable customer order to buy (or sell) for
others in the same contract month at the market or at the same price.
ELECTRONIC TRADING TERMINALS
WERE NOT FULLY OPERATIONAL
AND HAVE BEEN SIGNIFICANTLY
DELAYED
---------------------------------------------------------- Letter :5.2
Three of the exchanges covered by the heightened standards have
worked on electronic trading terminals for recording and processing
trades, but none of these terminals is fully operational. The
terminals were intended to provide the exchanges with continual and
unalterable audit trail data that would be more precise, complete,
and independent. However, they are limited in their ability to
create a "perfect" audit trail. For example, CFTC officials told us
that data could be altered before being entered into the terminals.
CME officials also indicated that, while the terminals can record the
precise time that a floor trader or broker begins to record a trade,
the floor trader or broker may be forced to delay entering trade
information in order to execute other customer or personal trades.
CFTC officials told us that, consistent with the FTPA, the agency has
never taken the position that electronic trading terminals are the
only way to meet the heightened standards. These officials also said
that the agency will determine the extent to which the terminals
satisfy the statutory standards based on the particulars of their
individual design and operation.
COMEX began developing a hand-held terminal in 1986 for recording and
timing trades. NYMEX acquired the rights to this project when it
merged with COMEX in 1994, making COMEX an operating division. NYMEX
subsequently decided not to pursue the project because of
developmental problems and because it believed that its manual audit
trail system met the requirements of the FTPA. After the initial
results of the CFTC/Department of Justice undercover investigation
were announced, CBT and CME began a joint venture to automate trade
recording and timing by developing a hand-held automated data input
terminal, called AUDIT. According to CBT and CME, as of June 30,
1996, they had incurred expenditures of $14.2 million and $9.1
million, respectively, in external and internal costs to develop
AUDIT.\24 The exchanges initially told CFTC that AUDIT would be
operational by the October 28, 1995, statutory deadline for
implementing the FTPA heightened audit trail standards. However, CBT
and CME informed CFTC before the issuance of its 1994 report that
AUDIT would not be operational by October 1995. The exchanges have
since indicated that further delays in implementation would occur and
that the planned capability of AUDIT to handle customer trades would
be delayed, perhaps significantly. CBT officials told us that they
expect delays in implementing the customer trade processing
capability of AUDIT because of the need to develop an order routing
system for a new trading floor that is under construction. CME
officials also told us that, although the exchange is continuing with
its efforts to implement AUDIT, it is now considering the use of
off-the-shelf technology for customer trade processing because of
AUDIT software development problems.
In addition to AUDIT, CBT and CME are developing other electronic
systems that could enhance audit trails and contribute to compliance
with the act's provisions. CBT and CME have jointly developed an
automated trade order processing system, called TOPS Route. Both
exchanges have also developed and continue to enhance universal
broker work stations, called Electronic Clerk at CBT and CUBS at CME.
CBT is also developing a booth work station called Computer Order
Management, Entry, and Timing, or COMET. TOPS Route rapidly
transmits orders from a firm's office to its booth on the trading
floor and records the time that an order is received at the booth and
the time it is filled. CUBS and Electronic Clerk organize orders
received on the floor and provide the time that the broker receives
an order, the time the order is filled, and the time the broker
confirms the order fill to the firm's booth on the trading floor.
COMET provides a mechanism for delivering and receiving order
information and other messages into and out of the trading pit.
According to CME, TOPS Route is expected to be implemented for most
clearing firms,\25 while the extent of CUBS implementation will
depend on space constraints and the differing needs of brokers. In
June 1996, CME began a 6-month pilot program in one of its markets
under which TOPS Route and CUBS are integrated to form a continuous
order routing system. CBT expects TOPS Route and COMET/Electronic
Clerk to be substantially implemented when its new trading floor
opens in February 1997.
These automated order routing systems could enhance audit trails by
meeting the FTPA requirements for recording the time an order reaches
the exchange floor, the time the broker receives an order, and the
time the order fill is recorded. According to CFTC officials, these
systems should result in better timing data for orders by augmenting
existing sequencing information.
--------------------
\24 In contrast to CBT, CME's internal costs include only direct
project costs.
\25 Clearing firms are members of an exchange clearing house. All
trades of nonclearing members must eventually be settled through a
clearing member.
CFTC GAVE CBT AND CME
ADDITIONAL TIME TO IMPROVE
THEIR AUDIT TRAILS
---------------------------------------------------------- Letter :5.3
CFTC determined that CSCE and NYMEX had made good faith efforts to
comply with the heightened standards, thus qualifying them for a
statutory safe harbor. COMEX was in effect granted a safe harbor in
November 1994 when it was not required to test its audit trail
system. CFTC reported that COMEX had produced evidence that its
manual system met the 1-minute trade timing standard. CFTC initially
deferred a decision on whether CBT and CME had made a good faith
effort to comply with the heightened standards until after a retest
of their audit trail systems. After its March 1996 retests, CFTC
gave the exchanges additional time to improve their audit trails
without determining whether they had qualified for a safe harbor.
To assess progress towards compliance with the heightened standards
in the absence of electronic systems, in 1994, CFTC required four
exchanges--CBT, CME, CSCE, and NYMEX--to perform a second test of
trade sequencing capabilities, using more exacting criteria than were
used for the first test. According to CFTC officials, these criteria
were designed to approximate the precision or enhanced sequencing
requirements of the heightened standards. As with the first test,
CFTC required that 90 percent of sampled trades be accurately
sequenced. The test results showed that only CSCE met the 90-percent
accuracy requirement for all samples tested. CFTC recommended that
NYMEX implement 9, CBT implement 17, and CME implement 18 additional
improvements to their audit trail systems to increase timing
precision and show progress towards compliance with the heightened
standards. Although CSCE passed the test, CFTC recommended that CSCE
implement six improvements to its audit trail system. At the same
time it made these recommendations, CFTC urged the exchanges to
continue efforts to implement electronic systems.\26 (See app. I for
a list of CFTC's recommendations.)
According to CFTC, prompt implementation of the recommended audit
trail improvements would demonstrate a good faith effort toward
meeting the heightened standards. A finding of good faith would mean
that an exchange had satisfied the statutory requirement for progress
and, therefore, was entitled to a safe harbor. CFTC found that both
CSCE and NYMEX had made good faith efforts to comply with the
standards by the statutory deadline. CSCE agreed to implement all
but one recommendation. However, CFTC concluded that this
recommendation did not relate to trade timing accuracy and,
therefore, was not material to a good faith finding. NYMEX agreed to
implement all but one audit trail recommendation but offered CFTC an
acceptable alternative. Both CBT and CME agreed to implement almost
all of CFTC's audit trail recommendations or offered alternatives.
CBT declined to implement two of CFTC's recommendations based on
tests it conducted. CBT said these tests indicated that the
recommendations disrupted trading, would increase trade processing
costs, or would not improve audit trail accuracy. CBT also offered
CFTC an acceptable alternative for one recommendation. CME declined
to implement one recommendation but informed CFTC that it would
continue to evaluate the recommendation. The exchange said it based
its decision on tests it conducted that indicated the recommendation
disrupted trading and would increase trade processing costs. CME
also offered CFTC an acceptable alternative for one recommendation.
(See app. I for details on the exchanges' responses to CFTC's
recommendations.)
The CFTC recommendation that both CBT and CME declined to implement,
based on their tests, was the requirement that floor traders manually
record the execution time for the first and either sixth or last
trade on every trading card. As discussed on page 4, these two
exchanges use computer-based algorithms to impute trade times after
the fact, rather than requiring floor traders or brokers to record
the times that personal or customer trades are executed.\27 CBT
reported that its own separate tests showed that adding manual times
to trading cards disrupted trading, increased clearing firms' trade
processing costs, and resulted in less accurate computer-imputed
times because traders were unable to record accurate times during
hectic trading. CME reported that traders involved in its separate
test had indicated that recording these times disrupted trading.
However, CME's tests did not show a reduction in audit trail
accuracy. Nonetheless, the exchange expressed concern that this
requirement would increase trade processing costs for clearing firms
and could result in delays in execution of customer orders or degrade
overall market efficiency.
In November 3, 1995, correspondence, CFTC notified CSCE and NYMEX
that they had qualified for the statutory safe harbor. Although CFTC
did not indicate when the safe harbor would end, CFTC told the
exchanges that it would retest them to evaluate whether the changes
they made brought them into compliance with the FTPA audit trail
standards. CFTC reported in August 1996 that it plans to assess CSCE
and NYMEX audit trail improvements during rule enforcement reviews in
1997.
CFTC also notified CBT and CME on November 3, 1995, that a decision
on whether they qualified for the statutory safe harbor would be
deferred until the results of another round of tests were obtained.
CFTC tested these exchanges in March 1996 to evaluate the effect of
the agreed-to improvements on their audit trails. The agency
reported in August 1996 that the test results showed improvements in
the precision of the exchanges' audit trails but that neither
exchange met the heightened standards. CFTC did not determine that
CBT and CME had demonstrated the good faith effort required to be
granted a safe harbor under the act. Instead, CFTC gave each
exchange until October 28, 1996, to report on how they intended to
improve their audit trails and until January 1997 to implement the
improvements.
Implementation of all CFTC recommendations will not necessarily
result in full compliance with the heightened standards. CFTC
reported in June 1995 that the exchanges may need to implement
additional improvements to their systems to achieve compliance.
According to CFTC officials, full compliance with the heightened
standards is an objective against which the exchanges must
continually be tested as the quality of audit trail data also depends
on other factors, such as the accuracy of data entry, the integrity
of pricing data, and the handling of trade errors. Ultimately, all
of the exchanges covered by the FTPA heightened standards must comply
with them or be subject to CFTC disciplinary action unless, as
discussed next, CFTC finds compliance with a standard impracticable.
--------------------
\26 Exchange officials told us that they had either implemented or
planned to implement and/or test some of the improvements prior to
CFTC's issuance of the test results and its recommendations in June
1995.
\27 CFTC regulations require that trade execution times be captured,
but do not require floor traders or brokers to manually record them.
CFTC HAS NOT FULLY ADDRESSED
THE PRACTICABILITY OF ALL OF
THE ACT'S PROVISIONS
---------------------------------------------------------- Letter :5.4
Several exchanges have raised concerns about CFTC's obligations under
the FTPA for determining the practicability of the heightened audit
trail requirements, including the need to assess the cost of
compliance as well as to address differences between the exchanges.
As previously discussed, the act requires CFTC to address the
practicability of most of the heightened standards and authorizes the
agency to promulgate standards, in some cases by either rule or
order. To date, CFTC has issued guidance on how orders "flashed"
into a trading pit can satisfy the broker receipt timing requirement
of the act,\28 but has not addressed the practicability of capturing
broker receipt times for nonflashed orders. According to CFTC, its
June 1995 recommendations to the four exchanges represent guidance on
how to demonstrate the good faith effort required by the FTPA in the
absence of full compliance.
In June 1996, the exchanges testified that the FTPA requirement to
capture broker receipt time was not currently practicable.\29
Separately, CBT and CSCE also expressed concern that due to
differences in trading volume and in the way customer orders are
routed, trades recorded, and execution times derived, audit trail
features that are practicable at one exchange may be impracticable at
another exchange without significantly disrupting trading. CBT told
us that the act contemplates that CFTC's practicability determination
would result from testing its proposed enhancements to audit trails
and conducting cost-benefit analyses of them. Both CBT and CME said
the act contemplates that CFTC would consider the cost of
enhancements and the effectiveness of reasonable alternatives to
proposed enhancements. CSCE was concerned that CFTC make its
practicability determination on an exchange-by-exchange basis and
that those determinations consider the financial capability of the
exchange.
CFTC officials told us that the agency intends to provide further
guidance on the practicability of the broker receipt time
requirement. They said that determining the practicability of this
requirement is a dynamic process that will be affected by ongoing
exchange initiatives to develop automated order routing systems.
They also said that further dialogue with the exchanges and the floor
broker community needs to occur before the agency can reach a
conclusion on the practicability of capturing broker receipt times
for nonflashed orders and that CFTC has scheduled an industry
roundtable discussion for October 1996 where this topic will be
addressed. CFTC also reported that it plans to address the
practicability of further integrating customer and personal trades at
CBT and CME.
According to CFTC, the FTPA does not require it to conduct a
cost-benefit analysis of audit trail enhancements. CFTC reported,
however, that the cost of achieving a perfect audit trail may be
prohibitive and that the costs of complying with the heightened
standards must be taken into account. Further, the agency reported
that the act does not specify the method of achieving compliance but
rather sets forth a performance standard that can be satisfied by any
means. CFTC has used testing to determine if exchange enhancements
bring them into compliance with the act's audit trail standards. As
part of this process, CFTC has let the exchanges decide whether to
implement electronic systems or lower-cost manual measures to meet
the standards. CFTC has also accepted certain lower-cost exchange
alternatives for demonstrating a good faith effort to comply with the
heightened audit trail standards. CFTC reported that the agency
accounted for exchange differences during audit trail testing at the
four exchanges. Our review of CFTC recommendations indicated that
CFTC generally tailored its recommended improvements to each
exchange.
--------------------
\28 CFTC has ruled that flashed orders (that is, orders rapidly
transmitted to and reported from the trading pit verbally or by hand
signal) can satisfy the broker receipt time requirement provided that
certain recordkeeping and enforcement provisions are met. Flashed
orders account for anywhere from 60 to nearly 100 percent of CBT and
CME customer orders in financial contracts.
\29 "Consolidated Testimony Of The Futures Exchanges Of The United
States Before The Senate Committee On Agriculture, Nutrition, And
Forestry," June 5, 1996. In addition to the four exchanges covered
by this report, the Kansas City Board of Trade, the Minneapolis Grain
Exchange, the NYCE, and the subsidiaries of these seven exchanges
submitted this testimony.
DUAL TRADING BAN EXEMPTION
PETITIONS ARE STILL PENDING
---------------------------------------------------------- Letter :5.5
The FTPA set forth conditions under which dual trading in contract
markets in which the average daily trading volume equals or exceeds
8,000 contracts would be banned. The statute also requires that dual
trading at an exchange be exempted from the ban if the exchange can
show that it has an effective trade monitoring system that includes
compliance with the act's audit trail standards. The FTPA included
the ban to limit the opportunity for trading abuses to occur.\30 It
linked an exemption from the ban to compliance with the act's audit
trail standards because an effective audit trail facilitates the
detection of trading abuses and, therefore, acts as a deterrent to
them.
The dual trading ban was to take effect 30 days after the effective
date of the dual trading regulations or whenever CFTC acted to deny
an exchange's exemption petition. On July 28, 1993, CFTC issued the
dual trading regulations, which required that a petition for
exemption from the dual trading ban be supported by evidence that,
among other things, at least 90 percent of the trade times assigned
by an exchange audit trail meet the 1-minute trade timing
standard.\31 The regulations, as required by the FTPA, also suspended
enforcement of the ban for all exchanges that filed timely exemption
petitions. According to the act and regulations, the suspension
would remain in effect until the agency ruled on the petitions. The
FTPA required CFTC to act on an exemption petition within 75 days of
receipt, or as soon as practicable. The exchanges covered by the ban
all filed petitions, but these petitions are still awaiting CFTC
action.\32 As a result, the exchanges are authorized to continue dual
trading.\33 CFTC officials told us the agency determined that given
the relationship between the dual trading ban and compliance with the
audit trail standards, it was essential to address the status of the
exchanges' audit trails first. According to CFTC, it plans to act on
the exemption petitions, which may be updated to reflect audit trail
enhancements, beginning with COMEX in September 1996, CBT and CME in
January 1997, and the remaining exchanges to follow.
--------------------
\30 While dual trading can provide benefits, including increasing
market liquidity, the practice makes it easier for a floor broker to
take advantage of knowledge about customer trades by trading ahead of
these orders.
\31 An exemption petition must also include evidence that the
exchange's trade monitoring system is sufficient to deter and detect
trading abuses attributable to dual trading.
\32 The exchanges covered by the ban are CBT, CME, COMEX, CSCE, NYCE,
and NYMEX.
\33 CME is the only exchange to voluntarily ban dual trading. See
footnote 13.
CONCLUSIONS
------------------------------------------------------------ Letter :6
CFTC has taken actions to enforce exchange compliance with the FTPA
audit trail standards. Also, the exchanges we reviewed have
continued to make progress toward compliance with them. Nonetheless,
we are concerned that the momentum toward achieving compliance could
be lost now that the legislatively mandated deadline has passed
without any covered exchange being found in full compliance. The
audit trails of CBT and CME--the two largest futures exchanges--do
not yet meet the heightened standards. CFTC also concluded that they
were insufficiently precise to verify compliance with the 1-minute
trade timing standard that predates the FTPA. In addition,
implementation of electronic trading terminals that have the
potential to bring these exchanges into compliance with the standards
is uncertain. Also, it is not clear when the exchanges currently
qualifying for the statutory safe harbor will achieve compliance with
the heightened standards through continued good faith efforts.
Further, CFTC has not yet fully addressed the practicability of all
the act's requirements as part of its ongoing effort to enforce the
heightened standards. Finally, the dual trading provisions of FTPA
have not yet been fully implemented. Thus, it is particularly
important that Congress be informed of exchange progress toward
meeting the heightened audit trail standards and other requirements
of the act as well as steps CFTC is taking to facilitate such
progress. The FTPA reporting requirement achieved this result, but
CFTC issued its report in 1994 and no further reporting requirements
exist.
RECOMMENDATION
------------------------------------------------------------ Letter :7
We recommend that the Chairperson, CFTC, inform Congress periodically
on exchange progress towards compliance with the FTPA heightened
audit trail standards and on implementation of the dual trading
ban--including any mitigating factors delaying compliance or
implementation and the steps CFTC is taking to encourage continued
progress. Such information could be provided annually in a report on
or about October 28, the anniversary of the statutory deadline for
compliance with the heightened standards, or through periodic
testimonies before congressional committees.
AGENCY COMMENTS AND OUR
EVALUATION
------------------------------------------------------------ Letter :8
We requested comments on a draft of this report from CFTC, CBT, CME,
CSCE, and NYMEX. CFTC supported our recommendation; the exchanges
did not address it in their written comments. Written comments from
CFTC, CBT, CME, and CSCE and our additional responses are contained
in appendixes II through V; NYMEX provided oral technical comments.
These technical comments as well as those provided by CFTC and the
other exchanges were incorporated into the report as appropriate.
We reported that the exchanges included in our review have continued
to make progress towards compliance with the heightened FTPA audit
trail standards, but no exchange has been found in full compliance
with them. CME indicated that, contrary to our report conclusions,
the exchange is in substantial compliance with the FTPA audit trail
requirements, either through direct compliance or because some
requirements of the act are impracticable. First, CME infers that we
made an assessment of its compliance with the act, reflecting a
misunderstanding of our review objectives and resulting conclusions.
Congress delegated responsibility for ensuring compliance with the
act's audit trail provisions to CFTC. We were responsible for
reporting on the status of compliance with the act, including CFTC
actions to enforce exchange compliance with it. Second, as stated in
our report, CFTC plans to work with the exchanges to address the
practicability of the act's provisions related to broker receipt time
and with CBT and CME to address the practicability of further
integrating customer and personal trades.
In addition to CME, the other three exchanges indicated varying
degrees of disagreement with CFTC's conclusions that their audit
trail systems were not yet in compliance with the act's requirements.
CFTC reached its initial conclusions about compliance with the act
based on testing of exchange audit trails and exchange implementation
of its subsequent recommendations. CFTC has done additional testing
and evaluation of CBT and CME audit trails and has reported that,
although improvements were made, the test results did not show
compliance with the heightened standards.
CME commented that we and CFTC have focused exclusively on
statistical measurement without reference to the underlying purpose
of an audit trail--deterring trade practice violations. We agree
that the ultimate measure of the effectiveness of an audit trail is
its ability to deter as well as detect such violations. However, the
effectiveness of an audit trail in these areas can be difficult to
verify. The use of statistical measures along with other relevant
information, provides a baseline against which progress toward
compliance with the audit trail standards can be measured. It also
provides a basis, given the differing exchange audit trail systems,
of comparing the progress of the exchanges to each other. The latter
provides some assurance that the standards are consistently and,
therefore, fairly applied.
---------------------------------------------------------- Letter :8.1
We are sending copies of this report to the Chairperson, CFTC, and
other interested parties. We will also make copies available to
others upon request.
Please contact me at (202) 512-8678 or Cecile O. Trop, Assistant
Director, at (312) 220-7705 if you or your staff have any questions.
Major contributors to this report are listed in appendix VI.
James L. Bothwell
Director, Financial Institutions
and Markets Issues
CFTC RECOMMENDATIONS TO FUTURES
EXCHANGES FOR IMPROVING THEIR
AUDIT TRAILS AND EXCHANGE
RESPONSES
=========================================================== Appendix I
The following are the audit trail improvements that CFTC recommended
in June 1995 to the Chicago Board of Trade (CBT), Chicago Mercantile
Exchange (CME), Coffee, Sugar & Cocoa Exchange (CSCE), and New York
Mercantile Exchange (NYMEX) and the exchanges' individual responses.
The exchanges indicated that they had either implemented or planned
to implement and/or test some of the improvements prior to CFTC's
issuance of the audit trail test results and its June 1995
recommendations.
RECOMMENDATIONS TO CBT AND CME
--------------------------------------------------------- Appendix I:1
CFTC recommended that CBT and CME implement 17 and 18 improvements,
respectively, to their audit trail systems. The following 11
recommendations were common to both exchanges:
(1) Limit the number of trades recorded on each trading card to six.
(2) Record and use manual execution times for at least the first and
sixth
trades on each trading card,\34 and use more manual times in the
lower volume markets.
(3) Use one-sided trading cards to record personal buys and sells in
sequence.
(4) Use a new trading card with the change of each bracket period.
(5) Use a special indicator to designate customer orders "flashed"
into the
trading pit.
(6) Use seconds in the imputed timing system where available,
including
seconds from customer order ticket timestamps.
(7) Add the time a customer trade is stamped as executed to the
imputed
timing system.
(8) Promptly supply members with information on audit trail data
inconsistencies and require corrections that reflect actual events.
(9) Aggressively enforce audit trail data recordation and submission
requirements, especially for spread trades,\35 and ensure that
timing data are entered correctly.
(10) Aggressively enforce order ticket timestamping procedures for
orders
flashed into the trading pit.
(11) Reprogram the imputed timing system to use all additional data
obtained as a result of CFTC's recommendations when assigning
execution times to trades.
CFTC recommended that CBT implement the following additional
improvements:
(12) Complete efforts to capture real-time quotes in the time and
sales
register\36 for trades executed during the opening of the trading
session.
(13) Include the identity of trade participants in the time and sales
register
for spread trades.
(14) Aggressively enforce requirements to record the correct
customer-type indicator codes.
(15) Upgrade timestamp clocks to record times to the second.
CBT was also required to implement two refinements to the
computer-based algorithm used by its imputed timing system to assign
times to trades.
CFTC recommended that CME implement the following additional
improvements:
(12) Use order-type information to derive times for trades.
(13) Use clearing receipt time in the imputed timing system.
(14) Synchronize timestamp clocks across the floor and upgrade
timestamp
clocks to record times to the second.
CME was also required to implement four refinements to the
computer-based algorithm used by its imputed timing system to assign
times to trades.
--------------------
\34 CFTC's recommendation to CME differed in that CME was to record
and use manual execution times for at least the first and either the
last or sixth trade on each trading card.
\35 Spread trades involve the simultaneous buying and selling of two
related contracts in the expectation that a profit will be made based
on changes in the price relationship when the position is offset.
\36 The time and sales register is a record maintained by the
exchange of price changes during trading and the time they occur.
The register is required as part of an exchange's audit trail by CFTC
regulation 1.35(h).
EXCHANGE RESPONSES
------------------------------------------------------- Appendix I:1.1
CBT agreed to implement 14 of the 17 recommendations and offered an
acceptable alternative for one recommendation. CME agreed to
implement 16 of the 18 recommendations and offered an acceptable
alternative for one recommendation. Both exchanges had planned to
test the recordation of manual execution times for certain trades on
each trading card (recommendation 2) and one-sided trading cards
(recommendation 3) prior to June 1995. CBT had also planned to test
recommendations 1, 4, 7, and 8 prior to this time.
Both CBT and CME declined to implement CFTC's recommendation to
record and use manual execution times for certain trades on each
trading card and use more manual times in the lower-volume markets
(recommendation 2) based on tests conducted separately at both
exchanges. CBT said that its own separate test results indicated
that requiring manual execution times decreased the accuracy level of
its imputed timing system because traders were unable to record
accurate execution times during hectic trading. According to CBT,
some traders commented that this requirement disrupted their trade
recordation efficiency, and that due to being focused on executing
trades, they frequently were unable to record execution times until
several minutes after the actual time of execution. CBT clearing
firms also indicated that this requirement would increase trade
processing costs.
CME declined to implement this recommendation but informed CFTC that
it would continue to evaluate the recommendation. The exchange's
separate tests indicated that the requirement impaired trading.
According to CME, some higher-volume floor traders complained that
they could not continue to trade at their accustomed pace while
having to manually record execution times during busy periods in the
market. The exchange was also concerned that this requirement would
increase trade processing costs for clearing firms and could result
in delays in execution of customer orders or degrade overall market
efficiency.
CBT also declined to include the identity of trade participants in
the time and sales register for spread trades (CBT recommendation 13)
based on tests conducted in two of its markets. These tests
indicated that this recommendation did not substantially improve
audit trail accuracy. According to CBT, reporting this information
to exchange price reporters also significantly reduced price
reporting efficiency and disrupted trading. The exchange is
integrating synchronized timestamp clocks that record times to the
nearest second (CBT recommendation 15) as clocks are replaced. CBT
indicated that it plans to use the upgraded devices on its new
trading floor, which is currently under construction. CBT also
offered an alternative to one of the recommended refinements to its
computer-based algorithm, which CFTC accepted.
CME offered an alternative to synchronizing timestamp clocks across
the exchange floor and upgrading timestamp clocks to record times to
the second (CME recommendation 14), which CFTC accepted. CME's
alternative was to conduct more frequent audits of timeclock
accuracy, apply more pressure on firms to ensure that timeclocks are
accurately set, and require firms to upgrade timeclocks as they are
replaced. The exchange believed that this approach satisfied CFTC's
recommendation without incurring excessive costs.
RECOMMENDATIONS TO CSCE
--------------------------------------------------------- Appendix I:2
CFTC recommended that CSCE implement the following six improvements
to its audit trail system:
(1) Complete upgrades to its price reporting system to include entry
of the
selling floor trader's or floor broker's identity in the time and
sales register.
(2) Manually record execution times for every fifth trade on each
trading
card.
(3) Aggressively enforce order ticket recordkeeping requirements.
(4) Place customer account numbers on the trade register.\37
(5) Use timestamp clocks that record times to the second at such time
as
the exchange moves to a new facility.
(6) Ensure that the imputed timing system derives only one possible
execution time for each trade.
--------------------
\37 The trade register is a comprehensive exchange record of cleared
or matched trades and is required as part of an exchange audit trail
by CFTC regulation 1.35(e). Among the entries on the register are,
for each transaction: the date and time; quantity; underlying
commodity; price; delivery month; and identity of the floor broker,
trader, and clearing member.
EXCHANGE RESPONSE
------------------------------------------------------- Appendix I:2.1
CSCE agreed to implement five of the six recommendations. CSCE
announced its plans to upgrade its price reporting system to include
the selling party's identity in the time and sales register
(recommendation 1) and began testing of recording manual times for
every fifth trade on a card (recommendation 2) prior to June 1995.
CSCE declined to implement the recommendation to place customer
account numbers on the trade register (recommendation 4) because it
would interfere with the exchange's ability to quickly process and
match trades. CFTC said that including account numbers on the trade
register provides a useful surveillance tool; however, it indicated
that because customer account numbers are not related to trade timing
accuracy, CSCE could come within the safe harbor without implementing
the recommendation.
According to CSCE, the recommendations related to enforcing order
ticket recordkeeping requirements (recommendation 3) and upgrading
timestamp clocks to record times to the second (recommendation 5)
will not impact trade timing and sequencing at the exchange because
its imputed timing system does not use order ticket timestamps to
derive trade execution times.
RECOMMENDATIONS TO NYMEX
--------------------------------------------------------- Appendix I:3
CFTC recommended that NYMEX implement the following nine improvements
to its audit trail system:
(1) Integrate pit card system times with trade sequence data on
trading
cards through manual or electronic means.
(2) Manually record execution times for the first and every fifth
trade
thereafter on each trading card.\38
(3) Limit the number of trades recorded on each trading card.
(4) Collect trading cards within 15 minutes after the end of each
30-minute
bracket period.
(5) Develop a time and sales register for spread trades.
(6) Enhance the timeliness of data entry for the pit card system.
(7) Aggressively enforce timeliness of pit card submissions and
trading
card sequencing requirements.
(8) Place customer account numbers on the trade register.
(9) Use timestamp clocks that record times to the second at such time
as the exchange moves to a new facility.
--------------------
\38 It is voluntary for floor traders and brokers to manually record
execution times for every fifth trade. CFTC approved this
alternative.
EXCHANGE RESPONSE
------------------------------------------------------- Appendix I:3.1
NYMEX agreed to implement eight of the nine recommendations. The
exchange offered an alternative to collecting trading cards within 15
minutes after the end of each bracket period (recommendation 4),
which CFTC accepted. Specifically, NYMEX agreed to introduce a new
integrated trading card that provides for concurrently recording
trade information on both a trading card and a pit card. The
exchange began developing the new card prior to June 1995. In
addition to recording trade information on trading cards, the selling
participant to each trade must record trade information on a separate
card called a pit card. The pit card is required to be thrown into a
net in the center of the trading pit within 1 minute of trade
execution where it is collected by an exchange employee. The
employee then timestamps the card, which establishes the official
trade execution time. Tests required by CFTC disclosed that the
sequence of trades as determined by this time stamp was frequently
different than the sequence as recorded on trading cards by brokers
and traders. According to CFTC, the new integrated card should also
address the sequencing inconsistencies between pit cards and trading
cards disclosed by testing.
(See figure in printed edition.)Appendix II
COMMENTS FROM THE COMMODITY
FUTURES TRADING COMMISSION
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)Appendix III
COMMENTS FROM THE CHICAGO BOARD OF
TRADE
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Chicago Board of Trade's
letter dated July 17, 1996.
GAO COMMENTS
--------------------------------------------------------- Appendix I:4
1. CBT commented that in wielding its exemptive powers under the
FTPA, CFTC broadly exempted the over-the-counter markets from
virtually all Commodity Exchange Act requirements, including those
related to audit trails. We are preparing a separate report on the
differences in regulatory oversight of the over-the-counter
derivatives and futures markets and possible challenges to regulatory
policy raised by these differences.
2. CBT commented that the FTPA requires CFTC to conduct cost-benefit
analyses to determine the practicability of the heightened audit
trail standards. CFTC has reported that the costs of complying with
the heightened standards must be taken into account, but the agency
has concluded, as reported on page 16 of our report, that the FTPA
does not require a formal cost-benefit analysis.
3. CBT noted that, in contrast to our draft report, the exchange has
adopted using seconds in its imputed timing system where available,
and it is integrating synchronized timeclocks to record times to the
nearest second. We corrected the report.
(See figure in printed edition.)Appendix IV
COMMENTS FROM THE CHICAGO
MERCANTILE EXCHANGE
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)Appendix V
COMMENTS FROM THE COFFEE, SUGAR &
COCOA EXCHANGE
=========================================================== Appendix I
(See figure in printed edition.)
MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI
Thomas J. McCool, Associate Director
Cecile O. Trop, Assistant Director
Roger E. Kolar, Evaluator-in-Charge
Cristine M. Marik, Evaluator
Daniel K. Lee, Evaluator
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