# Core Principles and Other Requirements for Designated Contract Markets > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2010-31458 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** December 22, 2010 - **Citation:** 75 FR 80572 ## Text COMMODITY FUTURES TRADING COMMISSION 17 CFR Parts 1, 16, and 38 RIN 3038-AD09 Core Principles and Other Requirements for Designated Contract Markets AGENCY: Commodity Futures Trading Commission. ACTION: Notice of proposed rulemaking. SUMMARY: The Commodity Futures Trading Commission (“Commission” or “CFTC”) is proposing new rules and amended guidance and acceptable practices to implement the new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The proposed rules, guidance and acceptable practices, which apply to the designation and operation of contract markets, implement the Dodd-Frank Act's new statutory framework that, among other things, amends Section 5 of the Commodity Exchange Act (“CEA”) concerning designation and operation of contract markets, and adds a new CEA Section 2(h)(8) to include the listing, trading and execution of swaps on designated contract markets. The Commission requests comment on all aspects of the proposed rules, guidance and acceptable practices. DATES: Comments must be received on or before February 22, 2011. ADDRESSES: You may submit comments, identified by RIN number 3038-AD09, by any of the following methods: • Agency Web site, via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments through the Web site. • Mail: David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. • Hand Delivery/Courier: Same as mail above. • Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments. Please submit your comments using only one method. All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to http://www.cftc.gov. You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that you believe is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures established in § 145.9 of the Commission's regulations, 17 CFR 145.9. The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from www.cftc.gov that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act. FOR FURTHER INFORMATION CONTACT: Nancy Markowitz, Assistant Deputy Director, 202-418-5453, nmarkowitz@cftc.gov, or Nadia Zakir, Attorney-Advisor, 202-418-5720, nzakir@cftc.gov, Division of Market Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. SUPPLEMENTARY INFORMATION: Table of Contents I. Background A. Overview B. The Current Statutory Framework C. The Dodd-Frank Act Amendments II. The Proposed Rules A. Proposed Repeal of Appendix A to Part 38 B. Adoption of New Regulations and Revised Guidance and Acceptable Practices C. Proposed Amendments to General Regulations Under Part 38 (New Subpart A) 1. Proposed § 38.1—Scope 2. Proposed § 38.2—Applicable Provisions 3. Proposed § 38.3—Procedures for Designation 4. Proposed § 38.4—Procedures for Listing Products and Implementing Designated Contract Market Rules 5. Proposed § 38.5—Information Relating to Contract Market Compliance 6. Proposed § 38.7—Prohibited Use of Data Collected for Regulatory Purposes 7. Proposed § 38.8—Listing of Swaps on a Designated Contract Market 8. Proposed § 38.9—Designated Contract Markets Operating as Swap Execution Facilities 9. Proposed § 38.10—Reporting of Swaps Traded on a Designated Contract Market D. Proposed New Regulations and Revised Guidance and Acceptable Practices for Compliance With Core Principles 1. Subpart B—Designation as Contract Market 2. Subpart C—Compliance With Rules i. Proposed § 38.151—Access Requirements ii. Proposed § 38.152—Abusive Trading Practices Prohibited iii. Proposed § 38.153—Capacity To Detect and Investigate Rule Violations iv. Proposed § 38.154—Regulatory Services Provided by a Third Party v. Proposed § 38.155—Compliance Staff and Resources vi. Proposed § 38.156—Automated Trade Surveillance System vii. Proposed § 38.157—Real-Time Market Monitoring viii. Proposed § 38.158—Investigations and Investigation Reports ix. Proposed § 38.159—Ability To Obtain Information x. Proposed § 38.160—Additional Rules Required 3. Subpart D-Contracts Not Readily Susceptible to Manipulation 4. Subpart E-Prevention of Market Disruption i. Proposed § 38.251—General Requirements ii. Proposed § 38.252—Additional Requirements for Physical Delivery Contracts iii. Proposed § 38.253—Additional Requirements for Cash-Settled Contracts iv. Proposed § 38.254—Ability to Obtain Information v. Proposed § 38.255—Risk Controls for Trading vi. Proposed § 38.256—Trade Reconstruction vii. Proposed § 38.257—Regulatory Service Provider viii. Proposed § 38.258—Additonal Rules Required 5. Subpart F—Position Limitations or Accountability 6. Subpart G—Emergency Authority 7. Subpart H—Availability of General Information i. Proposed § 38.401(a)—General ii. Proposed § 38.401(b)—Accuracy Requirement iii. Proposed § 38.401(c)—Notice of Regulatory Submissions iv. Proposed § 38.401(d)—Rulebook 8. Subpart I—Daily Publication of Trading Information 9. Subpart J—Execution of Transactions i. Proposed § 38.501—General Requirements ii. Proposed § 38.502—Minimum Centralized Market Trading Requirement a. Minimum Centralized Market Trading Percentage Requirement b. Centralized Market Trading Percentage Calculation c. Mandatory Delisting d. Treatment of Contracts Listed as of the Effective Date of this Section e. Exemptions iii. Proposed § 38.501—Block Trades on Futures Contracts iv. Proposed § 38.504—Block Trades on Swap Contracts v. Proposed § 38.505—Exchange of Derivatives For Related Positions vi. Proposed § 38.506—Office Trades and Transfer Trades 10. Subpart K—Trade Information i. Proposed § 38.551—Audit Trail Required ii. Proposed § 38.552—Elements of an Acceptable Audit Trail Program iii. Proposed § 38.553—Enforcement of Audit Trail Requirements 11. Subpart L—Financial Integrity of Transactions 12. Subpart M—Protection of Market Participants 13. Subpart N—Disciplinary Procedures i. Proposed § 38.701—Enforcement Staff ii. Proposed § 38.702—Disciplinary Panels iii. Proposed § 38.703—Review of Investigation Report iv. Proposed § 38.704—Notice of Charges v. Proposed § 38.705—Right to Representation vi. Proposed § 38.706—Answer to Charges vii. Proposed § 38.707—Admission or Failure to Deny Charges viii. Proposed § 38.708—Denial of Charges and Right to Hearing ix. Proposed § 38.709—Settlement Offers x. Proposed § 38.710—Hearings xi. Proposed § 38.711—Decisions xii. Proposed § 38.712—Right to Appeal xiii. Proposed § 38.13—Final Decisions xiv. Proposed § 38.714—Disciplinary Sanctions xv. Proposed § 38.715—Summary of Fines for Violations of Rules Regarding Timely Submission of Records, Decorum or Other Similar Activities xvi. Proposed § 38.716—Emergency Disciplinary Actions 14. Subpart O—Dispute Resolution 15. Subpart P—Governance Fitness Standards 16. Subpart Q—Conflicts of Interest 17. Subpart R—Composition of Governing Boards of Contract Markets 18. Subpart S—Recordkeeping 19. Subpart T—Antitrust Considerations 20. Subpart U—System Safeguards 21. Subpart V—Financial Resources i. Proposed § 38.1101(a)—General Requirements ii. Proposed § 38.1101(b)—Types of Financial Resources iii. Proposed § 38.1101(c)—Computation of Financial Resource Requirement iv. Proposed § 38.1101(d)—Valuation of Financial Resources v. Proposed § 38.1101(e)—Liquidity of Financial Resources vi. Proposed § 38.1101(f)—Reporting Requirements 22. Subpart W—Diversity of Boards of Directors 23. Subpart X—Securities and Exchange Commission III. Related Matters A. Regulatory Flexibility Act B. Paperwork Reduction Act 1. Additional Information Provided by Designated Contract Markets 2. Information Collection Comments C. Cost Benefit Analysis IV. Text of Proposed Rules I. Background A. Overview On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act 1 Title VII of the Dodd-Frank Act 2 amended the CEA 3 to establish a comprehensive, new regulatory framework for swaps and security-based swaps. The legislation was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (1) Providing for the registration and comprehensive regulation of swap dealers and major swap participants; (2) imposing clearing and trade execution requirements on standardized derivative products; (3) creating robust recordkeeping and real-time reporting regimes; and (4) enhancing the Commission's rulemaking and enforcement authorities with respect to, among others, all registered entities and intermediaries subject to the Commission's oversight. 1 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) (“Dodd-Frank Act”). The text of the Dodd-Frank Act may be accessed at http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf. 2 Pursuant to Section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.” 3 7 U.S.C. 1 et seq. (amended 2010). Section 735 of the Dodd-Frank Act amended Section 5 of the CEA pertaining to the designation and operation of contract markets, by: (i) Eliminating the stand-alone designation criteria contained in former Section 5(b) of the CEA; (ii) revising the existing core principles, including incorporating therein most of the substantive elements of the former designation criteria; and (iii) adding five new core principles, thereby requiring applicants and designated contract markets (“DCMs”) to comply with a total of 23 core principles as a condition of obtaining and maintaining designation as a contract market. In addition, Section 723(a)(3) of the Dodd-Frank Act added Section 2(h)(8) of the CEA to require, among other things, that execution of swaps subject to the clearing requirement of Section 2(h)(1) of the CEA must occur either on a DCM or on a new type of regulated facility called a Swap Execution Facility (“SEF”). 4 Also, Section 733 of the Dodd-Frank Act added Section 5h(a)(1), requiring that no person may operate a facility for the trading or processing of swaps unless the facility is registered as a SEF or as a DCM. Accordingly, the rules proposed in this release also implement provisions related to the processing, trading and execution of swaps on DCMs. 4 The Commission will be proposing rules governing the registration and operation of SEFs in a separate, forthcoming rulemaking. See CFTC Web site for additional information on the “SEF Registration Requirements and Core Principle Rulemaking, Interpretation & Guidance” rulemaking, at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_13_SEFRules/index.htm (last visited Dec. 14, 2010). In enacting the Dodd-Frank Act, Congress directed that rules and regulations required by the provisions of Title VII take effect the later of 360 days after enactment of the bill or to the extent that a rulemaking is required by the Dodd-Frank Act, not less than 60 days after the publication of that final rule. 5 Consistent with Congress' directive, this release proposes amendments to parts 38, 16 and 1 of the Commission's regulations to implement Section 5 of the CEA, as well as the requirements of Sections 2(h)(8) and 5h(a)(1) of the CEA, as amended by the Dodd-Frank Act, as applicable to DCMs. 5 See Section 754 of the Dodd-Frank Act. B. The Current Statutory Framework Section 5 of the CEA governs the designation and operation of DCMs. 6 DCMs were first established under the Commodity Futures Modernization Act of 2000 (“CFMA”) 7 as one of two forms of Commission-regulated markets for the trading of contracts for sale of a commodity for future delivery or commodity options. 8 6 7 U.S.C. 7; see also, Section 5 of the CEA, as amended by the Dodd-Frank Act. 7 Commodity Futures Modernization Act of 2000, Public Law 106-554, 114 Stat. 2763 (2000) (“CFMA”). 8 The CFMA established two tiers of regulated markets—designated contract markets and registered derivatives transaction execution facilities (“DTEFs”). In addition, the CFMA provided for two markets exempt from regulation, exempt boards of trade (“EBOTs”) and exempt commercial markets (“ECMs”). A description of the categories, requirements and functions of each of these markets as first established under the CFMA is provided in the Commission's notice of proposed rulemaking and final rulemaking implementing the CFMA. See A New Regulatory Framework for Trading Facilities, Intermediaries and Clearing Organizations, Notice of Proposed Rulemaking, 66 FR 14,262, March 9, 2001; Final Rulemaking, 66 FR 42,256, Aug. 10, 2001. In addition, a new type of regulated market was created under the CFTC Reauthorization Act of 2008 (“Farm Bill”), Incorporated as Title XIII of the Food, Conservation and Energy Act of 2008, Public Law 110-246, 122 Stat. 1651 (June 18, 2008). Under the Farm Bill, the Commission was required to determine and make public its determination whether a particular agreement, contract or transaction executed or traded on an ECM serves a significant price discovery function (“SPDC”). Once a contract was identified as a SPDC, the ECM on which the contract was traded was required to demonstrate to the Commission that the ECM had a regulatory system in place that satisfied the requirements of the core principles under current Section 2(h)(7) of the current CEA and the applicable provisions of § 36.3 of the Commission's regulations. Section 723 of the Dodd-Frank Act repealed the ECM SPDC provisions. The CEA, as amended by the CFMA, requires a DCM applicant to demonstrate that it satisfies each of eight designation criteria as a condition of obtaining designation as a contract market. 9 In addition, each applicant is required to demonstrate its ability to comply with 18 core principles at the time of application, and on an ongoing basis after designation. 10 9 The eight designation criteria under current Section 5(b) of the CEA are titled the following: (1) In General; (2) Prevention of Market Manipulation; (3) Fair and Equitable Trading; (4) Trade Execution Facility; (5) Financial Integrity of Transactions; (6) Disciplinary Procedures; (7) Public Access; and (8) Ability to Obtain Information. 10 7 U.S.C. 7(d). The Commission also undertakes due diligence reviews of each contract market's compliance with the core principles during rule and product certification reviews and periodic examinations of DCMs' compliance with the core principles under Rule Enforcement Reviews (“RERs”). C. The Dodd-Frank Act Amendments Applicable to Designated Contract Markets Section 735 of the Dodd-Frank Act amends Section 5 of the CEA by: (i) Eliminating the eight criteria for designation as a contract market; (ii) amending many of the core principles, including incorporating most of the substantive requirements of the current designation criteria, and requiring that all DCMs demonstrate compliance with each of the core principles as a condition of obtaining and maintaining designation as a contract market; and (iii) adding five new core principles, specifically Core Principle 13 (Disciplinary Procedures), Core Principle 20 (System Safeguards), Core Principle 21 (Financial Resources), Core Principle 22 (Diversity of Boards of Directors), and Core Principle 23 (Securities and Exchange Commission). 11 11 New Core Principle 13 is verbatim of current Designation Criterion 6. As noted above, the Dodd-Frank Act also specifically requires under Section 2(h)(8) of the CEA, as amended, 12 that execution of swaps that are required to be cleared must occur on either a DCM or a SEF, except where no DCM or SEF makes the swap available for trading. 13 Accordingly, unless otherwise specified in this release, each of the 23 core principles and the proposed regulations, guidance and acceptable practices, apply to all “contracts” listed on a DCM, which will include swaps, futures and options contracts. 12 See Section 723 of the Dodd-Frank Act. 13 Section 5h(a)(1) of the CEA, as amended by Dodd-Frank Act, also prohibits any person from operating a facility for the trading and processing of swaps unless the facility is registered as a SEF or DCM. In sum, the new and revised regulations, guidance and acceptable practices proposed in this release will implement the regulatory obligations that each DCM must meet in order to comply with Section 5 of the CEA, as amended by the Dodd-Frank Act, initially upon designation and thereafter on an ongoing basis. The Commission requests comments on all aspects of the proposed rules, guidance and acceptable practices. II. The Proposed Rules A. Proposed Repeal of Appendix A to Part 38 Section 735 of the Dodd-Frank Act eliminates the criteria for designation as a contract market in current CEA Section 5(b), creates a new core principle from one of the criterion, and incorporates most of the substance of the remaining designation criteria into the core principles. Because the designation criteria are eliminated under the Dodd-Frank Act, the Commission proposes to eliminate the guidance on compliance with the designation criteria for DCMs contained in Appendix A to part 38. As noted below, this release further proposes to redesignate Appendix A as the application form for contract market designation. B. Adoption of New Regulations and Revised Guidance and Acceptable Practices In implementing the provisions of the CFMA, the Commission adopted a regulatory framework for part 38 of its regulations that consisted largely of general application guidance and acceptable practices consistent with the CFMA's principles-based regime. 14 The Dodd-Frank Act amends Section 5(d)(1)(B) of the CEA generally to provide that the Commission, in its discretion, may determine by rule or regulation the manner in which boards of trade comply with the core principles. 15 Accordingly, the Commission undertook a comprehensive evaluation of its existing regulations, guidance and acceptable practices associated with each of the core principles in order to update those provisions and to determine which core principles would benefit from new or revised regulations and new or revised guidance or acceptable practices. Based on that review, the Commission is proposing both new and revised regulations and revised guidance and acceptable practices for some core principles, as set forth in this release. 14 Guidance provides DCMs and DCM applicants with contextual information regarding the core principles, including important concerns which the Commission believes must be taken into account in complying with specific core principles. In contrast, the acceptable practices are more specific than guidance and provide examples of how DCMs may satisfy particular requirements of the core principles; they do not, however, establish mandatory means of compliance. Acceptable practices are intended to assist DCMs by establishing non-exclusive safe harbors. The safe harbors apply only to compliance with specific aspects of the core principle, and do not protect the contract market with respect to charges of violations of other sections of the CEA or other aspects of the core principle. 15 Current Core Principle 1 states, among other things, that boards of trade “shall have reasonable discretion in establishing the manner in which they comply with the core principles.” This “reasonable discretion” provision underpins the Commission's use of core principle guidance and acceptable practices. Section 735 of the Dodd-Frank Act amends this provision to include the proviso that “[u]nless otherwise determined by the Commission by rule or regul ation * * *,” boards of trade shall have reasonable discretion in establishing the manner in which they comply with the core principles. See Section 735(b) of the Dodd-Frank Act, amending Section 5(d)(1)(B) of the CEA. The proposed new regulations codify certain requirements and practices that are commonly accepted in the industry and have been found, based on the Commission's administrative experience in overseeing the futures markets since passage of the CFMA, to represent the best practice means of complying with the core principles. 16 Indeed, some of these requirements are the off-shoot of the Rule Enforcement Reviews (“RERs”) periodically carried out by Commission staff. 16 The Commission's oversight of DCMs' compliance with the core principles includes the evaluation of applications for contract market designation, periodic RERs of DCMs' compliance with various statutory requirements, and the review of rule and product certifications implicating all aspects of the core principles. The RERs are the cornerstone of the Commission's oversight program, serving as a key tool for monitoring a DCM's compliance with the core principles, and also as a primary means for identifying industry trends and DCM best practices for self-regulation. Essentially, RER findings and recommendations communicate to the industry what Commission staff believes are best practices for compliance and such recommendations typically are then adopted industry-wide as the standard form of compliance. The RERs, which are conducted periodically at all DCMs, typically examine DCMs' compliance with specific core principles relating to audit trail, trade practice surveillance, market surveillance, disciplinary programs, and dispute resolution. 17 Commission staff's findings and any recommendations for improvement are included in a report that is presented to the Commission, and the Commission votes on whether to accept the report. The RER report is publicly released and published on the Commission's Web site and also sent to the DCM. Although a DCM may not fully agree with the Commission staff's findings, responses from DCMs, which are required within 30 days, almost always explain how the DCM intends to implement staff's recommendations, if any. Because RER reports are public, recommendations for one DCM invariably lead to all DCMs that suffer from the same identified shortfall taking timely corrective action. Such corrective action usually includes modifying compliance procedures and/or adopting or modifying existing rules. 17 Staff typically review a one-year target period and, depending on the core principles covered, thoroughly examine a DCM's audit trail reviews, trade practice and market surveillance investigations, investigation logs, hedge exemptions, surveillance systems, compliance manuals, summary fine schedules, disciplinary files, settlement agreements, and arbitration files. Staff also conducts on-the-record interviews with DCM compliance officials. The Commission believes that the promulgation of clear-cut and definite requirements or practices in those instances where a standard industry practice has developed would provide greater legal certainty to the industry in demonstrating compliance with the CEA. Accordingly, in certain circumstances, the Commission is proposing to replace the general application guidance and acceptable practices in part 38 with regulations that codify the relevant practices and requirements for those core principles. For some of the new core principles, the Commission also is proposing regulations that represent the best practice for complying with the core principle. For several core principles, the Commission is proposing to maintain the guidance and acceptable practices, albeit with proposed revisions that reflect developments in the industry since the passage of the CFMA, and the Commission's considerable experience since the passage of the CFMA with matters involving compliance with the core principles by a broad range of DCMs. C. Proposed Amendments to General Regulations Under Part 38 (New Subpart A) The Commission is proposing to reorganize part 38 to include new subparts A through X. Proposed subpart A would include the general regulation §§ 38.1 through 38.10, 18 applicable both to DCM applicants and to existing DCMs. Subparts B through X would each include relevant regulations applicable to each core principle. 19 18 This release does not propose any revisions to § 38.6 of the Commission's regulations. 19 Each of these subparts begins with a regulation containing the language of the core principle. 1. Proposed § 38.1—Scope The proposed revisions to § 38.1 are non-substantive as they simply eliminate cross-references to other sections of the Commission's regulations that are no longer applicable, and add references to sections, most of them new, that are now applicable. 2. Proposed § 38.2—Applicable Provisions Section 38.2 sets forth the Commission regulations that DCMs must comply with in addition to those in part 38. The proposed revisions to § 38.2 include a change to the title of the section to more accurately describe the regulation, and further updates the list of Commission regulations that are applicable to DCMs based on the new provisions under the Dodd-Frank Act, including the proposed provisions relating to real time reporting of swaps and the determination of appropriate block size for swaps which will be proposed under part 43, requirements for data element, recordkeeping and reporting of swap information to swap data repositories which will be proposed under part 45, business continuity and disaster recovery which will be proposed under part 46, designation requirements for swap data repositories which will be proposed under part 49, and position limits which will be proposed under part 151. 20 20 The Commission notes that because some of the proposed rulemakings are either ongoing or forthcoming, this proposed list of reserved sections under § 38.2 may be subject to further revisions pending the final rules for each respective rulemaking. 3. Proposed § 38.3—Procedures for Designation Current § 38.3 sets forth the application and approval procedures for new DCM applications. 21 The Commission is proposing in § 38.3 that all DCM applications, reinstatements, requests for transfer of designations, requests for withdrawal of application for designation, and vacation of designations be filed with the Secretary of the Commission in an electronic format, via the Internet, e-mail, or other means of direct electronic submission as approved by the Commission. 22 21 In addition to these substantive revisions, many of the proposed revisions to § 38.3 are non-substantive and are intended to clarify the rule. 22 This amendment also would ensure consistency with the electronic process used for filing rule and product submissions under parts 39 and 40 of the Commission's regulations. See 17 CFR parts 39 and 40. The Commission also is proposing to eliminate the expedited approval procedures for DCM applications, such that the timing of such reviews will be governed only by the 180-day statutory review period and procedures specified in Section 6(a) of the CEA. 23 Based upon its experience since 2001, the Commission has determined that the 90-day accelerated review process is inefficient and impracticable. Specifically, the Commission has found that applicants seeking expedited review often file incomplete or draft applications, without adequate supporting materials, in the interest of meeting the expedited approval timeline. This, in turn, has required Commission staff to expend significant amounts of time reviewing incomplete or draft applications, necessitating numerous follow-up conversations with applicants, usually resulting in removal of applications from the expedited review timeline. The Commission believes that by requiring all applications to be reviewed within the 180-day review period, applicants will have sufficient time to submit complete applications for review, and to respond to Commission staff requests for additional information, resulting in a more efficient review process. 24 23 7 U.S.C. 8(a); see also, Section 6(a) of the CEA, as amended by the Dodd-Frank Act. 24 This proposal also is consistent with the Commission's proposal to eliminate the 90-day expedited review procedures for derivatives clearing organization applications under part 39 in a separate rulemaking. To provide an applicant with more certainty of the types of information that are required to support its DCM application, the Commission proposes to redesignate Appendix A to part 38 25 to include a new application form with comprehensive instructions to guide DCM applicants and a specified lists of documents and information that must be provided as exhibits. 26 Other than the specific requirements necessitated by the revised and newly added core principles, the majority of information required under the form application consists of information that historically has been required by the Commission staff in its reviews of DCM applications under the Commission's regulations. Accordingly, proposed § 38.3(a)(1) requires that, at a minimum, all applicants must complete the application form and provide the necessary information and documentation, in accordance with the associated instructions, in order to initiate the 180-day designation review process. 25 Appendix A currently contains the stand alone designation criteria now eliminated under the Dodd-Frank Act. 26 The Commission also is requiring tailored application forms for the registration of Designated Clearing Organizations, Swap Execution Facilities and Swap Data Repositories. The Commission is proposing new § 38.3(d) to formalize the procedures that a DCM must follow when requesting the transfer of its DCM designation and positions comprising open interest, in anticipation of a corporate event ( e.g., a merger, corporate reorganization, or change in corporate domicile) which results in the transfer of all or substantially all of the DCM's assets to another legal entity. Under proposed § 38.3(d)(2), the DCM would submit to the Commission a request for transfer no later than three months prior to the anticipated corporate change, with a limited exception. 27 The request shall include: (1) The underlying agreement that governs the corporate change; (2) a narrative description of the corporate change, including the reason for the change and its impact on the DCM, including its governance and operations, and its impact on the rights and obligations of market participants holding the open positions; (3) a discussion of the transferee's ability to comply with the CEA, including the core principles applicable to DCMs, and the Commission's regulations thereunder; (4) the governing documents of the transferee, including but not limited to, articles of incorporation, bylaws, operating agreements and/or partnership agreements, as applicable; (5) the transferee's rules marked to show changes from the current rules of the DCM; and (6) a list of contracts, agreements, transactions or swaps for which the DCM requests transfer of open interest. 27 The proposed rule would require that where a DCM does not know or could not have reasonably known three months prior to the anticipated change, it shall be required to file the request as soon as it knows of the change. Proposed § 38.3(d) also would require, as a condition of approval, that the DCM submit a representation that it is in compliance with the CEA, including the DCM core principles, and the Commission's regulations. In addition, the DCM would have to submit various representations by the transferee, including but not limited to: (1) That the transferee will assume responsibility for complying with all applicable provisions of the CEA and the Commission's regulations promulgated thereunder, including part 38 and Appendices thereto; (2) that the transferee will assume, maintain and enforce all rules implementing and complying with these core principles, including the adoption of the transferor's rulebook; (3) upon the transfer, all open interest in all contracts listed on the transferor will be transferred to and represent equivalent open interest in all such contracts listed on the transferee, (4) that none of the proposed rule changes will affect the rights and obligations of any participant with open positions transferred to it; and (5) it will notify market participants of any changes to the rulebook and of the transfer. Proposed § 38.3(d) also provides that the Commission will review any requests for transfer of designation and open interest as soon as practicable, and such request will be approved or denied pursuant to a Commission order. Proposed § 38.3(g) 28 is a new rule that is intended to ensure that all DCMs designated before the effective date of the rules proposed in this part 38 are in compliance with both the five new core principles and the revised core principles. As noted above, the Dodd-Frank Act significantly changes some of the compliance obligations of DCMs under current Section 5 of the CEA by amending the majority of the existing core principles and adding five new core principles. 29 All DCMs, including existing DCMs, must comply with the requirements of Section 5 of the CEA, as amended, as well as the applicable requirements under the Commission's regulations, including this release, upon their effective date. Accordingly, in proposed § 38.3(g), the Commission would require that each existing DCM provide the Commission with a signed certification of its compliance with each of the 23 core principles and the Commission's regulations under part 38 as amended in this release, within 60 days of the effective date of the publication of the final rules proposed in this release. The failure of any existing DCM to provide such certification shall be grounds for revocation of the DCM's designation status. While the Commission believes that 60 days is a sufficient period of time for DCMs to have rules and procedures in place to ensure compliance with the core principles and the rules proposed in this release, the Commission requests comments on whether the 60 day period is sufficient, and if not, what period of time may be more appropriate and why. 28 In addition, proposed §§ 38.3(e) and 38.3(f) restate existing requirements with certain non-substantive, clarifying changes. 29 Compare 7 U.S.C. 7(d) with section 5(d) of the CEA, as amended by the Dodd-Frank Act. 4. Proposed § 38.4—Procedures for Listing Products and Implementing Designated Contract Market Rules The proposed amendments to § 38.4 are largely intended to conform this rule to the proposed changes to existing §§ 40.3 (Voluntary submission of new products for Commission review and approval) and 40.5(b) (Voluntary submission of rules for Commission review and approval). 30 The proposed amendments to those rules are made in the separate release pertaining to “Provisions Common to Registered Entities.” 31 30 Proposed § 40.3 is amended to require additional information to be provided by registered entities submitting new products for the Commission's review and approval. Proposed § 40.5(b) codifies a new standard for the review of new rules or rule amendments as established under the Dodd-Frank Act. 31 75 FR 67482, Nov. 2, 2010. 5. Proposed § 38.5—Information Relating to Contract Market Compliance On occasion, DCMs enter into equity interest transfers that result in a change in ownership. In those situations, Commission staff must determine whether the change in ownership will impact adversely the operations of the DCM or the DCM's ability to comply with the core principles and the Commission's regulations. The Commission is proposing to amend § 38.5 to ensure that DCMs remain mindful of their self-regulatory responsibilities when negotiating the terms of significant equity interest transfers, and to improve the Commission staff's ability to undertake a timely and effective due diligence review of the impact, if any, of such transfers. In this regard, proposed § 38.5(c) would require DCMs to file with the Commission a notice of the equity interest transfer of ten percent or more, no later than the business day, as defined in § 40.1, following the date on which the DCM enters into a firm obligation to transfer the equity interest. 32 The notification must include and be accompanied by: (i) Any relevant agreement(s), including preliminary agreements; (ii) any associated changes to relevant corporate documents; (iii) a chart outlining any new ownership or corporate or organizational structure; (iv) a brief description of the purpose and any impact of the equity interest transfer; and (v) a representation from the DCM that it meets all of the requirements of Section 5(d) of the Act and Commission regulations adopted thereunder. The proposed rule requires that the DCM keep the Commission apprised of the projected date that the transaction resulting in the equity interest transfer will be consummated, and must provide to the Commission any new agreements or modifications to the original agreement(s) filed pursuant to § 38.5(c). The DCM must notify the Commission of the consummation of the transaction on the day in which it occurs. The proposed rule will enable staff to consider whether any conditions contained in an equity transfer agreement(s) are inconsistent with the self-regulatory responsibilities of a DCM or with any of the core principles. 33 32 The Commission is proposing a 10 percent threshold because it believes that a change in ownership of such magnitude may have an impact on the operations of the DCM. The Commission believes that such impact may be present even if the change in ownership does not constitute a change in control. For example, if one entity holds a minority 10 percent equity share in the DCM, it may have a more significant voice in the operation of the DCM than five entities each with a minority 2 percent equity share. Given the potential impact that a change in ownership might have on the operations of a DCM, the Commission believes that it is appropriate to require such DCM to certify after such change that it continues to comply with all obligations under the CEA and Commission regulations. 33 The Commission also maintains the existing provisions of § 38.5 that allow the Commission at any time to request a DCM to file a written demonstration with the Commission that it is in compliance with one or more of the core principles. Section 38.5(d) currently requires that upon a change in ownership, an acquirer of an existing DCM must certify that the exchange meets all of the requirements of the current Sections 5(b) and 5(d) of the Act, and the provisions of part 38 of the Commission's regulations. The Commission believes when there is a 10% or greater change in ownership, the DCM itself is the more appropriate entity to provide a certification of its continued compliance with all regulatory obligations. Accordingly, proposed § 38.5(c)(3) 34 would require that if there is a change in ownership 35 the DCM must certify, no later than two business days following the date on which the change in ownership occurs, that the DCM meets all of the requirements of Section 5(d) of the CEA, as amended by the Dodd-Frank Act, and the provisions of part 38 of the Commission's regulations. The proposed rule also requires that the DCM include as part of its certification whether any aspects of the DCM's operations will change as a result of the change in ownership, and if so, the DCM must provide a description of the changes. Finally, proposed § 38.5(c) provides that the certification may rely on, and be supported by, prior materials and information submitted as part of an application for designation or a required product or rule filing or new filings if necessary to update its previous filings. 34 The Commission is proposing to redesignate § 38.5(d) as § 38.5(c). 35 The Commission's regulations consistently identify a financial or ownership interest of ten percent or more as material and indicative of the ability to influence the activities of an entity or trading in an account. See, e.g., Core Principle 5, Acceptable Practices, and Core Principle 14, Application Guidance, in appendix B to part 38 of the Commission's regulations. 17 CFR part 38, appendix B. 6. Proposed § 38.7 36 —Prohibited Use of Data Collected for Regulatory Purposes 36 Current § 38.6 (Enforceability) remains unchanged. To fulfill their regulatory and compliance obligations, DCMs often require market participants to provide proprietary data or personal information. Proposed § 38.7 would prohibit DCMs from using such information for business or marketing purposes. 37 The Commission notes that nothing in this provision should be viewed as prohibiting a DCM from sharing such information with another DCM or SEF for regulatory purposes, where necessary. 37 The Commission notes that in the recent notice of proposed rulemaking for Business Affiliate Marketing and Disposal of Consumer Information Rules, 75 FR 66018-01, Oct. 27, 2010 (to be codified at 17 CFR part 163) rules are proposed prohibiting FCMs (and other intermediaries) from using certain consumer information received from an affiliate to make a solicitation for marketing purposes. In addition, rules were proposed requiring FCMs to develop a written disposal program to the extent that such FCMs possess consumer information. The underlying policy for these rules is to protect the privacy of customer information. Similarly, this proposed rule is intended to protect market participant's information provided to a DCM for regulatory purposes from its use to advance the commercial interests of the DCM. 7. Proposed § 38.8—Listing of Swaps on a Designated Contract Market The Dodd-Frank Act permits existing DCMs to list, trade and execute swaps, provided that the DCMs do so in a manner that complies with the provisions of the CEA, as amended by the Dodd-Frank Act, and part 38, as amended. Proposed § 38.8(a) requires a DCM to notify the Commission, prior to or upon listing its first swap contract, of the manner in which it will fulfill each of the requirements under amended CEA and part 38 with respect to the listing, trading, execution and reporting of swap transactions. Proposed § 38.8(b) requires a DCM to request and obtain from the Commission a unique, extensible, alphanumeric code for the purpose of identifying the DCM before it lists swaps. A DCM will do so pursuant to the swap recordkeeping and reporting requirements under proposed part 45 of the Commission's regulations. This requirement stems from the Commission's authority, under Section 728 of the Dodd-Frank Act, to establish standards and requirements related to reporting and recordkeeping for swaps. 38 In particular, the Commission is required to adopt consistent data element standards for “registered entities,” which includes DCMs. part 45, which is being proposed in the separate Commission release “Data Recordkeeping and Reporting Requirements,” will set forth the recordkeeping and reporting requirements for DCMs with respect to swaps. 39 Proposed § 38.8(b) codifies the obligations of DCMs to comply with the provisions of proposed part 45. 38 See Section 21 of the CEA, as amended by the Dodd-Frank Act. 39 See “Swap Data Recordkeeping and Reporting Requirements,” Proposed Rule, 75 FR 76574 (Dec. 8, 2010). 8. Proposed § 38.9—Boards of Trade Operating Both a Designated Contract Market and a Swap Execution Facility As noted above, the Dodd-Frank Act created a new regulated entity, the SEF, for the listing, trading and processing of swaps. The registration and compliance requirements for SEFs will be proposed in redesignated part 37, in a forthcoming release. 40 Under the Dodd-Frank Act, a DCM may list and trade swaps pursuant to its designation as a contract market. In addition, a board of trade that operates a DCM also may operate a SEF, provided that the board of trade separately registers as a SEF and complies with the applicable SEF core principles and any Commission regulations thereunder. Proposed § 38.9 codifies the requirement that a board of trade that operates a DCM and that intends to operate a SEF must separately register pursuant to the SEF registration requirements and, on an ongoing basis, must separately comply with the SEF rules and core principles under Section 5h of the CEA, as amended by the Dodd-Frank Act, and part 37 of the Commission's regulations. 40 See CFTC Web site for additional information on the “SEF Registration Requirements and Core Principle Rulemaking, Interpretation & Guidance,” at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_13_SEFRules/index.htm (last visited Dec. 14, 2010). Moreover, section 5h(c) of the CEA, as amended by the Dodd-Frank Act, provides that any board of trade that is a DCM and intends to operate as an independent SEF may use the same electronic trade execution system for listing and executing swaps, provided that the board of trade makes it clear to market participants whether the electronic trading of such swaps is taking place on or through the DCM or the SEF. 41 Proposed § 38.9(b) codifies this statutory requirement. 41 Section 5h(c) of the CEA, as amended by the Dodd-Frank Act, provides: IDENTIFICATION OF FACILITY USED TO TRADE SWAPS BY CONTRACT MARKETS.—A board of trade that operates a contract market shall, to the extent that the board of trade also operates a swap execution facility and uses the same electronic trade execution system for listing and executing trades of swaps on or through the contract market and the swap execution facility, identify whether the electronic trading of such swaps is taking place on or through the contract market or the swap execution facility. 9. Proposed § 38.10—Reporting of Swaps Traded on a Designated Contract Market Section 727 of the Dodd-Frank Act directs the Commission to adopt rules providing for the public availability of swap transaction and pricing data in real-time. 42 To the extent that they make swaps available for trading and execution either on a SEF or a DCM, DCMs will have real-time public reporting obligations pursuant to the Dodd-Frank Act and, therefore, must comply with the applicable provisions governing real time reporting. The Commission is proposing regulations applicable to the real time swap reporting obligations of certain entities under a separate release. 43 The real time reporting regulations are proposed to be codified under part 43 of the Commission's regulations. In addition to the real time reporting obligations, the proposed rule also requires DCMs to comply with the swap reporting and recordkeeping requirements that are being proposed by the Commission in a separate release, and are proposed to be codified under part 45 of the Commission's regulations. Accordingly, proposed § 38.10 would codify the compliance obligations of DCMs with respect to real time reporting of swap transactions and swap data recordkeeping and reporting obligations, as may be required under proposed parts 43 and 45 of the Commission's regulations, respectively. 42 See Sections 2(a)(13)-(14) of the CEA, as amended by the Dodd-Frank Act. 43 See “Real Time Public Reporting of Swap Transaction Data,” Proposed Rule, 75 FR 76140 (Dec. 7, 2010). D. Proposed New Regulations and Revised Guidance and Acceptable Practices For Compliance With the Core Principles As noted above, this release proposes to reorganize part 38 to include subparts A through X. As proposed, each of subparts B through X will include relevant regulations applicable to the 23 core principles. In addition to the proposed new regulations, the Commission proposes to codify within each subpart the statutory language of the respective core principle. 44 44 In two instances, the language of the core principle, as codified, was slightly revised to add references to the CEA where the statutory language simply cited to the CEA section without citing to the statute. These non-substantive edits were made to §§ 38.100 and 38.1200. 1. Subpart B—Designation as Contract Market The Dodd-Frank Act amends Core Principle 1 to make clear that compliance with the core principles, and any other rule or regulation that the Commission may impose under Section 8a(5) of the CEA, is a necessary condition to obtain and maintain designation as a contract market. 45 Amended Core Principle 1 provides that unless otherwise determined by the Commission by rule or regulation, DCMs will continue to have reasonable discretion in establishing the manner in which they comply with the core principles. The Commission proposes to codify the statutory text of Core Principle 1 in proposed § 38.100. 45 7 U.S.C. 7; see also Section 5(d)(1) of the CEA, as amended by the Dodd-Frank Act. 2. Subpart C—Compliance With Rules Core Principle 2, as amended by the Dodd-Frank Act, requires that a DCM establish, monitor, and enforce its rules, including rules relating to access requirements, rules regarding the terms and conditions of any contract to be traded on the contract market, and rules prohibiting abusive trading practices. A DCM also must have the capacity to detect and investigate potential rule violations, and to sanction any person that violates its rules. 46 In addition, a DCM's rules must provide it with the ability and authority to perform the obligations and responsibilities required under Core Principle 2, including the capacity to carry-out such international information sharing agreements that the Commission may require. Proposed § 38.150 implements these requirements. 46 As noted above, Section 735 of the Dodd-Frank Act amends Section 5 of the CEA to eliminate DCM designation criteria and amends several core principles, including Core Principle 2. Core Principle 2 was amended to include language formerly found in Designation Criterion 8—Ability to Obtain Information, and to specifically require that a DCM have the ability to detect, investigate, and sanction rule violations. For the most part, the Commission is codifying: (1) Language found in the guidance and acceptable practices for Core Principle 2 and former designation criterion 8; (2) existing DCM compliance practices that the Commission believes constitute best practices; and (3) recommendations made over the past several years by the Commission in rule enforcement reviews. 47 In addition, the Commission is proposing some practices and requirements that are new for DCMs. The Commission also looked to and incorporated into the proposed rules for Core Principle 2 certain concepts that are currently contained in part 8 of its regulations— Exchange Procedures for Disciplinary, Summary, and Membership Denial Actions. In this regard, the Commission notes that most DCMs' compliance and enforcement practices relating to Core Principle 2 obligations historically have been consistent with the rules contained in part 8. 48 Each of the proposed rules under subpart C is discussed below. 47 Commission staff conducts periodic RERs of all DCMs. RERs examine DCM compliance with specific core principles over a one-year target period. Commission staff's analyses, conclusions and recommendations regarding any identified deficiencies are included in a publicly available written report. 48 Section 38.2 of the Commission's regulations exempts DCMs from all Commission rules not specifically reserved. The part 8 rules were not reserved. i. Proposed § 38.151—Access Requirements Proposed § 38.151 is an example of a rule in which the Commission proposes a new requirement for DCMs. 49 Proposed § 38.151(a) requires that prior to granting a member or market participant access to its markets, the DCM must require the member or market participant to consent to its jurisdiction. The growth of electronic trading in the futures industry and the transformation of futures exchanges from traditional membership organizations to demutualized for-profit entities has changed how individuals and firms access the markets and execute trades. When open outcry dominated trading, orders were typically called in to a desk on the trading floor and members on the floor executed trades. Today, on most DCMs, one does not need to be a “member” to enter an order on an electronic trading system. Rather, clearing members can provide their customers with access to a DCM's electronic trading system and customers can enter their own orders. Depending on the type of access granted by the clearing member, the customer's order either will go through the clearing member's system for risk management before hitting the DCM's electronic trading system or directly go into the DCM's trading system. 49 Generally, § 38.151 is being proposed pursuant to the Commission's general rulemaking authority under Section 8a(5) of the CEA (providing the authority to “promulgate such rules * * * reasonably necessary * * * to accomplish any of the purposes of” the CEA), and Section 3 of the CEA (providing that the purposes of the Act include the promotion of “fair competition among boards of trade, other markets and market participants”). 7 U.S.C. 5, 12a(5). DCMs generally require through rule and/or clearing firm connection agreements that prior to a clearing member granting a customer access to the DCM's electronic trading system, the clearing member secure its customer's agreement to abide by, and be subject to, the DCM's rules. Nevertheless, DCMs do not view themselves as having the jurisdiction needed to compel these market participants to participate in the investigation and disciplinary process. Although DCMs have the option of requiring a clearing firm to bar a customer from accessing the DCM if the DCM believes that the customer committed a rule violation, most DCMs will first request that the customer submit to its jurisdiction and participate in the investigation and disciplinary process before exercising this option. Trading on a DCM is a privilege that is subject to conditions and entails certain responsibilities. The Commission believes that if a participant is granted the privilege of trading on a DCM, the participant should not only be required to abide by the DCM's rules, but the participant also must consent to the DCM's jurisdiction and participate in both the investigatory and disciplinary process. The Commission recognizes that this requirement will require clearing firms to amend their existing customer agreements to secure customers' agreements to submit to a DCM's jurisdiction. Accordingly, although DCMs would be required to implement proposed § 38.151(a) either by rule and/or modification of connection agreements by the effective date of the final rule, the proposed rule permits DCMs to allow their clearing firms up to 180 days to secure the necessary modifications to existing customer agreements. Proposed § 38.151(b) requires that a DCM provide its members, market participants and ISVs with impartial access to its markets and services. This includes: 1) access criteria that are impartial, transparent, and applied in a non-discriminatory manner, and 2) comparable fee structures for members, market participants and independent software vendors (“ISV”), 50 receiving equal access to, or services from the DCM. The purpose of the proposed impartial access requirements is to prevent DCMs from using discriminatory access requirements as a competitive tool against certain participants. Access to a DCM should be based on the financial and operational soundness of a participant, rather than discriminatory or other improper motives. 51 Any participant should be able to demonstrate financial soundness either by showing that it is a clearing member of a DCO that clears products traded on that DCM or by showing that it has clearing arrangements in place with such a clearing member. Furthermore, granting impartial access to participants that satisfy a DCM's access requirements may enhance the DCM's liquidity and the overall transparency of the swaps and futures markets. 50 The Commission notes that examples of independent software vendors include: smart order routers, trading software companies that develop front-end trading applications, and aggregators of transaction data. Smart order routing generally involves scanning of the market for the best-displayed price and then routing orders to that market for execution. Software that serves as a front-end trading application is typically used by traders to input orders, monitor quotations and view a record of the transactions completed during a trading session. Aggregators of transaction data provide access to news, analytics and execution services. The Commission believes that transparency and trading efficiency would be enhanced as a result of innovations in this field for market services. For instance, certain providers of market services with access to multiple trading systems or platforms could provide consolidated transaction data from such trading systems or platforms to market participants. 51 The Commission believes that the requirement to provide impartial access requires DCMs to avoid the creation of exclusive membership standards that focus on high net worth. Therefore, any participant should be able to demonstrate financial soundness either by showing that it is a clearing member of a DCO that clears products traded on that DCM or by showing that it has clearing arrangements in place with such a clearing member. A DCM can satisfy the requirement that membership and participation criteria are impartial, transparent, and non-discriminatory by establishing clear and impartial guidelines and procedures for granting access to its facilities and publishing such guidelines and procedures on its Web site. Such requirements may establish different categories of market participants, but may not discriminate within a particular category. Fee structures may differ among categories if such fee structures are reasonably related to the cost of providing access or services to a particular category. For example, if a certain category requires greater information technology or administrative expenses on the part of the DCM, then a DCM may recoup those costs in establishing fees for that category of member or market participant. Proposed § 38.151(c) (Limitations on Access) requires a DCM to establish and impartially enforce rules governing any decision by the DCM to deny, suspend, or permanently bar a member's or market participant's access to the contract market. While paragraph (b) of proposed § 38.151 requires impartiality in a DCM's decision to grant access, paragraph (c) addresses the converse situation where a DCM wishes to deny access, or to revoke the access of members or market participants who already possess it. Proposed § 38.151(c) gives specific examples of when such situations might arise, including DCM disciplinary proceedings or emergency actions. As with decisions to grant access, any decision by a DCM to deny, suspend, or permanently bar a member's or market participant's access to the DCM must be impartial and applied in a non-discriminatory manner. ii. Proposed § 38.152—Abusive Trading Practices Prohibited Proposed § 38.152 requires that a DCM prohibit enumerated abusive trading practices. The listed practices are a compilation of abusive trading practices that DCMs already prohibit. A DCM permitting intermediation must prohibit specific trading practices, including trading ahead of customer orders, trading against customer orders, accommodation trading, and improper cross-trading. Specific trading practices that must be prohibited by all DCMs include front-running, wash trading, pre-arranged trading, fraudulent trading, money passes and any other trading practices that the DCM deems to be abusive. In addition, a DCM also must prohibit any other manipulative or disruptive trading practices prohibited by the CEA or by the Commission pursuant to Commission regulation. 52 52 Section 747 of the Dodd-Frank Act amends Section 4c(a) of the CEA by adding three disruptive practices which make it: unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that- (A) Violates bids or offers; (B) Demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (C) Is, is of the character of, or is commonly known to the trade as, `spoofing' (bidding or offering with the intent to cancel the bid or offer before execution). iii. Proposed § 38.153—Capacity To Detect and Investigate Rule Violations Proposed § 38.153 is based on the current application guidance for Core Principle 2. 53 The proposed rule requires that a DCM have arrangements and resources for effective rule enforcement. This includes the authority to collect information and examine books and records of members and market participants. 54 By its terms, Core Principle 2 requires a DCM to have, in addition to appropriate resources for trade practice surveillance programs, appropriate resources to enforce all of its rules. 53 17 CFR part 38, App. B, Core Principle 2, Application Guidance at ¶ 1. 54 The language in the current application guidance requires that a DCM “have arrangements and resources for effective trade practice surveillance programs[.]” Id. The proposed rule also requires a DCM to have the authority to examine books and records for all market participants rather than limiting that authority to “non-intermediated market participants” as such authority was limited in the former application guidance. A DCM can best administer its compliance and rule enforcement obligations if it has the ability to reach the books and records of all market participants, rather than a subset of market participants. iv. Proposed § 38.154—Regulatory Services Provided by a Third Party The CEA provides that a DCM may comply with applicable core principles by delegating relevant functions to a registered futures association or another registered entity. 55 The Commission also has described acceptable “contracting” arrangements for the performance of core principle functions by third-parties. 56 In this context, the term “contracting” implies a lesser transference of authority to the third-party than does “delegating.” In all cases, however, the Commission has specified, as required under the CEA, 57 that DCMs remain responsible for carrying out any function delegated or contracted to a third party and that DCMs must ensure that the services received will enable them to remain in compliance with the CEA's requirements. 55 7 U.S.C. 7a-2(b); see also, section 5c(b)(1) of the CEA, as amended by the Dodd-Frank Act. 56 See 66 FR 42256, 42266, Aug. 10, 2001. 57 See 7 U.S.C. 7a-2(b)(2); see also, Section 5c(b)(2) of the CEA, as amended by the Dodd-Frank Act. In recent years, the Commission has gained much experience in administering the delegation and contracting regime for regulatory services. Many DCMs, especially those that were designated after passage of the CFMA, employ third-party regulatory service providers to meet one or more core principle obligations. In administering this regime, the Commission has found that DCM applicants have questions as to the manner and degree to which their staffs must remain involved in regulatory decisions when they utilize third-party providers. Accordingly, the Commission is proposing new § 38.154 to supplement its previous guidance on delegation and contracting arrangements to clarify its expectations in this regard. The proposed rule is equally applicable to delegations and contracting, and to arrangements DCMs have with regulatory service providers that are registered futures associations or other registered entities. For purposes of proposed § 38.154, the applicable self-regulatory functions include: trade practice surveillance; market surveillance; real-time market monitoring; investigations of possible rule violations; and disciplinary actions. The proposed rule requires that DCMs utilizing third-party regulatory service providers must ensure that their providers have sufficient capacity and resources to render timely and effective regulatory services. The DCM also must oversee the quality of the contracted regulatory services and must retain exclusive authority with respect to certain regulatory decisions. These regulatory decisions include cancellation of trades, the issuance of disciplinary charges against members or market participants, and denials of access to the trading platform for disciplinary reasons. Conversely, the proposed rule also specifies that a decision to open an investigation of a possible rule violation must be made solely by a regulatory service provider, and all instances where a DCM's actions differ from those recommended by its regulatory provider must be documented and explained in writing. v. Proposed § 38.155—Compliance Staff and Resources As noted above, Core Principle 2 requires that a DCM enforce compliance with its rules and have the capacity to detect, investigate, and sanction violations. Having adequate staff to perform a DCM's compliance and enforcement responsibilities is essential to the effectiveness of its self-regulatory programs, including market surveillance, audit trail, trade practice surveillance, and disciplinary programs. A DCM's ability to enforce speculative limits, monitor for manipulation, complete timely investigations, conduct annual open outcry and electronic audit trail reviews, as well as perform other regulatory duties, is compromised if a DCM does not have sufficient staff. Thus, examining the size and experience of a DCM's compliance staff is a critical component of RERs carried out by Commission staff. In several RERs, staff has recommended, and the Commission has accepted, findings that DCMs: (1) increase their compliance staff levels, and (2) monitor the size of their staffs and increase the number of staff appropriately as trading volume increases, new responsibilities are assigned to compliance staff, or internal reviews demonstrate that work is not completed in an effective or timely manner. 58 58 See Rule Enforcement Review of the Minneapolis Grain Exchange (Aug. 27, 2009); Rule Enforcement Review of ICE Futures U.S. (Feb. 2, 2010); and Rule Enforcement Review of the Chicago Board of Trade and the Chicago Mercantile Exchange (Sep. 13, 2010). Those recommendations have formed the basis for proposed § 38.155. The proposed rule requires that a DCM maintain sufficient compliance resources to conduct effective audit trail reviews, trade practice surveillance, market surveillance, and real-time monitoring. It also requires that a DCM monitor its staff size annually to ensure that it is appropriate to effectively perform those functions. Staff size also must be sufficient to address market or trading events and to complete investigations in a timely manner. The Commission is not proposing that staff size be determined based on a specific formula. Rather, the Commission proposes to leave to the discretion of each individual DCM to determine the size of the staff it needs to effectively perform its self-regulatory responsibilities. In making this determination, the proposed rule requires that a DCM take into account specific facts and circumstances ( e.g., volume, the number of new contracts, etc. ), as well as any other factors suggesting the need for increased resources. Factors that may suggest the need for increased compliance resources are a prolonged surge in trading volume or a prolonged period of price volatility. A DCM must have sufficient staff to address unusual or unanticipated events while continuing to effectively conduct its routine self-regulatory duties. vi. Proposed § 38.156—Automated Trade Surveillance System All currently active DCMs, or their third-party service providers, maintain automated surveillance systems to conduct trade practice surveillance. These systems vary in degree of sophistication, but typically generate alerts on a trade date plus one day (T+1) basis to help staff focus on potential violations and anomalies found in trade data. 59 They also provide a DCM's compliance staff the ability to sort and query voluminous amounts of data. In performing their surveillance responsibilities, DCMs engage in various analyses to profile trading activity and conduct investigations to detect and prosecute possible trading abuses. These functions all require the collection of order and trade data and the ability to process that data in various ways for analysis. 59 These systems typically differ from those systems used for real-time market monitoring. The requirements for real-time market monitoring can be found in proposed § 38.157. Proposed § 38.156 reflects the substantial growth in U.S. futures trading volume since the CFMA was adopted in 2000. The approximate trading volume for U.S. futures exchanges (including futures and options on futures) was 596 million contracts in 2000, 2 billion contracts in 2005, and 3.2 billion contracts in 2010. In view of this growth in volume, combined with new participants in the markets, such as high frequency traders, it is critical that DCMs have automated tools that, at a minimum, have the capability to generate alerts, profile trading activity, and sort and query data to conduct trade practice surveillance. The Commission has found, in performing its oversight responsibility of monitoring the markets to ensure market integrity and customer protection, that effectively monitoring this large amount of volume requires automated tools. 60 A DCM's automated surveillance system must have specific characteristics for it to be able to detect and prosecute the abusive trading practices enumerated in proposed § 38.152. A DCM's automated surveillance system must maintain all trade and order data, including order modifications and cancellations. The system must process this data on a T+1 basis. In addition, a DCM's automated trade surveillance system must provide users with the ability to compute, retain and compare trading statistics; compute profit and loss; and reconstruct the sequence of trading activity. 60 In this regard, the Commission is in the midst of modifying its own automated surveillance systems for both trade practice surveillance and market surveillance. vii. Proposed § 38.157—Real-time Market Monitoring Proposed § 38.157 codifies existing practices at DCMs for real-time monitoring of electronic trading. The practices codified in proposed § 38.157 reflect the growth of electronic trading in the U.S. futures markets, as well as the Commission's experience in designating new contract markets since passage of the CFMA. All DCMs that were designated post-CFMA trade exclusively on electronic trading platforms. The purpose of real-time monitoring of electronic trading is to ensure orderly trading and to identify and correct any market or system anomalies promptly. The proposed rule requires that any DCM price adjustment or trade cancellation process be clear and transparent to the market and subject to clear, fair and publicly-available standards. viii. Proposed § 38.158—Investigations and Investigation Reports Proposed § 38.158 is largely a compilation of requirements found in §§ 8.06 and 8.07 of the Commission's regulations, with some modifications. Paragraph (a) of the proposed rule requires that a DCM have procedures to conduct investigations of possible rule violations. Paragraph (b) requires that an investigation be completed within a timely manner. A timely manner is defined to be 12 months after an investigation is opened, absent mitigating circumstances. This differs from § 8.06(b) of the Commission's regulations, which provides that an investigation be “completed within four months, unless significant reasons exist to extend it beyond such period.” In its experience in conducting RERs, the Commission has found that while simple, straight-forward investigations typically are completed in less than four months, many DCM investigations involve fact patterns requiring more in-depth and sophisticated analysis. Depending on the complexity of a matter, an investigation frequently may take between four and 12 months to complete. While it is not typical for an investigation to take longer than one year to complete, certain circumstances may justify an investigation taking longer than one year. These include the complexity of the investigation, the number of firms or individuals involved, the number of potential violations, the amount of trade data requiring analysis and, in some instances, the amount of video recordings to be reviewed and analyzed. 61 61 See Rule Enforcement Review of ICE Futures U.S. (Feb. 2, 2010), and Rule Enforcement Review of the Chicago Board of Trade and the Chicago Mercantile Exchange (Sep. 13, 2010). Some exchanges, such as CBOT and CME, have video cameras on their open outcry trading floors. Paragraphs (c) and (d) of proposed § 38.158 set forth the elements and information that must be included in an investigation report when there is or there is not a reasonable basis for finding a rule violation. While the proposed language is similar to §§ 8.07(a) and (b) of the Commission's regulations, there are two notable differences. First, proposed § 38.158(c) requires that when DCM compliance staff believes there is a reasonable basis for finding a violation, the investigation report must include the potential wrongdoer's disciplinary history. Second, proposed § 38.158(d) requires that if a DCM's compliance staff recommends that a warning letter be issued, the investigation report must also include the potential wrongdoer's disciplinary history. 62 Requiring disclosure of a member's or market participant's prior disciplinary history in the above-described circumstances is consistent with recommendations made in RERs. 63 The Commission believes that prior disciplinary history is critical information that a disciplinary committee should consider when either issuing a warning letter or assessing an appropriate penalty as part of any settlement decision or hearing. 64 In practice, when a DCM's compliance department believes there is a reasonable basis to find a violation, the investigation report is forwarded to a disciplinary committee for action. Therefore, the Commission believes that the investigation report is the most logical place to include disciplinary history. 62 In some instances, even though there is not sufficient evidence to recommend disciplinary action, a DCM's compliance staff may believe that a rule violation occurred. 63 See 2000 Rule Enforcement Review of the New York Mercantile Exchange. 64 As noted below in the discussion of proposed § 38.158(c), a DCM's disciplinary committee should review a member's complete disciplinary history when determining appropriate sanctions and impose meaningful sanctions on members who repeatedly violate the same or similar rules to discourage recidivist activity. Proposed § 38.158(e) provides that a DCM may authorize its compliance staff to issue a warning letter or to recommend that a disciplinary committee issue a warning letter. The proposed rule is substantively identical to Commission § 8.07(c), except that it prohibits a DCM from issuing more than one warning letter for the same violation during a rolling 12-month period. Currently, many DCMs use summary fine programs to enforce their audit trail rules. Typically, such programs allow compliance staff to issue summary fines for trade timing, order ticket and trading card violations. Such summary fine schemes generally start with a warning letter for the first offense. While a warning letter may be appropriate for a first-time violation, the Commission does not believe that more than one warning letter in a rolling 12-month period for the same or similar violation is ever appropriate. A policy of issuing repeated warning letters, rather than issuing meaningful sanctions, to members and market participants who repeatedly violate the same or similar rules denigrates the effectiveness of a DCM's rule enforcement program. 65 The proposed rule is consistent with what Commission staff has advised DCM applicants and recommendations made in RERs. 66 65 For purposes of this rule, the Commission does not consider a “reminder letter” or such other similar letter to be any different than a warning letter. 66 See 1998 Rule Enforcement Review of Kansas City Board of Trade; and, Rule Enforcement Review of the Minneapolis Grain Exchange (Aug. 27, 2009). ix. Proposed § 38.159—Ability To Obtain Information Proposed § 38.159 expands on the Core Principle 2 requirement that a DCM have the ability and authority to obtain necessary information to perform its rule enforcement obligations, including the capacity to carry out any international information sharing agreements required by the Commission. The proposed rule provides that information sharing agreements can be established with other DCMs or SEFs, or that the Commission can act in conjunction with a DCM to carry out such information sharing. This language is virtually identical to the language found in the guidance for former Designation Criterion 8. 67 67 17 CFR Part 38, App. A, Designation Criterion 8, Guidance. x. Proposed § 38.160—Additional Rules Required Proposed § 38.160 requires a DCM to adopt and enforce any additional rules that it believes are necessary to comply with the requirements of this subpart C. 3. Subpart D—Contracts Not Readily Subject to Manipulation The Dodd-Frank Act did not make any amendments to current Core Principle 3—Contracts Not Readily Subject to Manipulation. Historically, DCMs complied with the requirements of Core Principle 3 by using as guidance the provisions of Guideline No. 1, contained in Appendix A to part 40. The Commission proposes certain revisions to the former Guideline No. 1, including: (1) Amending the provision to include swap transactions, (2) re-titling the guidance as “Demonstration of compliance that a contract is not readily susceptible to manipulation,” and (3) redesignating the provision as Appendix C of part 38. Proposed § 38.201 refers applicants and DCMs to the guidance in Appendix C to part 38 for purposes of demonstrating to the Commission their compliance with the requirements of § 38.200. Proposed guidance under Appendix C to part 38 would replace Guideline No. 1 under Appendix A to part 40. The amended guidance provides greater detail to DCMs regarding the relevant considerations in demonstrating compliance with Core Principle 3 when designing a contract and submitting supporting documentation and data to the Commission at the time the DCM submits: (1) The terms and conditions of a new contract under §§ 40.2 or 40.3, or (2) amendments to terms and conditions under §§ 40.5 or 40.6. In general, the guidance provides that the settlement or delivery procedures adopted by a DCM for a futures contract should reflect the underlying cash market. The objective is to ensure that a given futures contract is not readily susceptible to manipulation and that it will provide a reliable pricing basis and promote cash/futures price convergence. Accordingly, the terms and conditions should conform to prevailing commercial practices and provide for adequate deliverable supply. For cash-settled contracts, the cash-settlement procedure should be based on a reliable price reference series that accurately reflects the underlying market value, is not readily susceptible to manipulation, and is commonly used by industry/market participants as a price reference. Therefore, the calculation methodology of the price reference series, if applicable, must be submitted as supporting documentation. In that regard, for a price reference series that is based on an index or survey of prices or rates, this would include the index or survey methodology used to determine the level of the index used as the price reference. Furthermore, the views and opinions of prospective market users of the contracts should be given considerable weight in the contract design process. The more accurately a listed contract's terms and conditions reflect the underlying cash market in that commodity, the more likely the contract will perform the intended risk management and/or price discovery functions. Finally, a DCM should ensure that the terms and conditions of listed contracts remain consistent with the guidance set forth herein. These concepts are set forth in the guidance in Appendix C to part 38. The guidance in Appendix C to part 38 is comprised of best practices that were developed over the past three decades by the Commission and other market regulators in their review of product submissions. The Commission first adopted a Guideline for product submissions on November 3, 1982 68 and since then has modified it from time to time. Furthermore, the Commission's Guideline served as the basis for “Guidance on Standards of Best Practice for the Design and/or Review of Commodity Contracts,” endorsed by the International Organization of Securities Commissioners (“IOSCO”) in its Tokyo Communiqué (October 1997). 69 The Guidance recognizes that the proper design of the terms and conditions of contracts reduces the susceptibility of such contracts to market abuses, including manipulation, and enhances the economic utility of such contracts to commercial users. Accordingly, the Guidance for designing futures contracts focuses on such issues as a contract's economic utility ( i.e., a contract should meet risk management needs of potential users and/or promote price discovery of the underlying commodity), the contract's correlation with the cash market ( i.e., the contract terms and conditions generally should reflect the operation of the underlying cash market and avoid impediments to delivery), a contract's settlement and delivery reliability ( i.e., the settlement and delivery procedures should reflect the underlying cash market and promote price convergence), the contract's responsiveness to the views of potential market users, and the contract's transparency ( i.e., the contract's terms and conditions, as well as relevant information concerning delivery and pricing, should be readily available to market authorities and to market users). 68 See 47 FR 49832, 49838, Nov. 3, 1982. 69 See Tokyo Commodity Futures Markets Regulators' Conference (October, 1997), http://www.cftc.gov/ucm/groups/public/@internationalaffairs/documents/file/oia_tokyorpt.pdf (last visited Oct. 25, 2010). Appendix C to part 38 is intended to act as a source for new and existing DCMs to reference for best practices when developing new products to list for trading. Specifically, Appendix C to part 38 provides guidance regarding: (1) The forms of supporting information a new contract submission should include; (2) how to estimate deliverable supplies; (3) the contract terms and conditions that should be specified for physically delivered contracts; (4) how to demonstrate that a cash-settled contract is reflective of the underlying cash market, is not readily subject to manipulation or distortion, and is based on a cash price series that is reliable, acceptable, publicly available and timely; (5) the contract terms and conditions that should be specified for cash-settled contracts; (6) the requirements for options on futures contracts; (7) the terms and conditions for non-price based futures contracts; and (8) the terms and conditions for swap contracts. Currently, DCMs generally conduct market research in a manner discussed in Appendix C. 4. Subpart E—Prevention of Market Disruption The Dodd-Frank Act amended current Core Principle 4 by: (i) Changing the title of the core principle from “Monitoring of Trading” to “Prevention of Market Disruptions;” and (ii) specifying the methods and procedures DCMs must employ in discharging their obligations under Core Principle 4. The amendments to Core Principle 4 emphasize that DCMs must take an active role, not only in monitoring trading activities within their markets, but in preventing market disruptions. Accordingly, the proposed rules under subpart E of part 38 codify the relevant provisions of the current Application Guidance and Acceptable Practices for Core Principle 4 in current Appendix B to part 38, and include new requirements that clarify and strengthen a DCM's responsibilities under the amended core principle. i. Proposed § 38.251—General Requirements As noted above, the Dodd-Frank Act amended Section 5(d)(4) of the CEA by adding new language to Core Principle 4 to require DCMs to conduct real-time monitoring of trading and to have the ability to comprehensively and accurately reconstruct trading. 70 Accordingly, proposed § 38.251 (General Requirements) would require that the DCM have the ability to conduct real-time monitoring of trading and comprehensive and accurate trade reconstructions. Intra-day trade monitoring must include the capacity to detect abnormal price movements, unusual trading volumes, impairments to market liquidity, and position-limit violations. 70 See Section 735 of the Dodd-Frank Act. As noted above in its discussion of the need for automated tools in connection with Core Principle 2 requirements, the Commission believes that it would be difficult, if not impossible, to monitor for market disruptions in contract markets with high transaction volume and a large number of trades unless the DCM has installed automated trading alerts to detect many types of potential violations of exchange or Commission rules. Accordingly, the Commission proposes in § 38.251 to require that, where the DCM cannot reasonably demonstrate that its manual processes are effective in detecting and preventing abuses, the DCM must implement automated trading alerts to detect potential problems. We invite comment on whether in any rule the Commission may adopt in this matter DCMs should be required to monitor the extent of high frequency trading, and whether automated trading systems should include the ability to detect and flag high frequency trading anomalies. ii. Proposed § 38.252—Additional Requirements for Physical Delivery Contracts The Commission has observed a number of physically-delivered futures contracts where the convergence of the futures price and the cash market price of the underlying commodity have been problematic. 71 Price convergence refers to the process whereby the price of a physically-delivered futures contract converges to the spot price of the underlying commodity, as the futures contract nears expiration (a cash-settled contract, by definition, converges to the underlying price series at expiration). The hedging effectiveness of a physically-delivered futures contract depends in part upon the extent to which the futures price reliably converges to the comparable cash market price, or to a predictable differential to the comparable cash market price. The delivery mechanism for physically-delivered futures contracts is the critical link that drives price convergence. To the extent that delivery of a commodity at futures expiration occurs and the delivered commodity is merchandised in the physical marketing channel, arbitrage should ensure that the price of the futures contract converges to the price of the commodity in the physical marketing channel. Impediments to futures delivery, or the delivery of an instrument that permits a long futures position holder to defer moving the physical commodity into normal marketing channels, may weaken the crucial link between cash markets and the futures market, resulting in a lack of reliable price convergence. 72 71 The Commission notes that the lack of convergence and its adverse impact on the ability to effectively hedge in some agricultural futures markets has been the subject of several meetings of the Commission's Agricultural Advisory Committee. Where there is a lack of convergence, this has resulted in extremely weak bases, i.e., cash prices well below equivalent futures prices, disadvantaging short hedgers and resulting in abnormally large quantities of futures deliveries that diverted grain from normal commercial channels and tied up warehouse space. The lack of convergence likely sends the wrong price discovery signals to the market. See, Materials from Meeting of the CFTC's Agricultural Advisory Committee (AAC) (October 29, 2009), http://www.cftc.gov/About/CFTCCommittees/AgriculturalAdvisory/aac_102909agenda.html; see also, the AAC Subcommittee on Convergence in Agricultural Commodity Markets Report and Recommendations (October 29, 2009), http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/reportofthesubcommitteeonconve.pdf. 72 For example, specifying a shipping certificate with an indefinite life as the futures delivery instrument that permits a long futures position holder to avoid taking delivery in the physical marketing channel, which, in certain circumstances, may result in weak or erratic convergence between the futures price and the cash price. Therefore, for physical delivery contracts, proposed § 38.252 specifically requires that, among other things, DCMs must monitor each contract's terms and conditions as to whether there is convergence of the futures price to the cash price of the underlying commodity and take meaningful corrective action, including to address conditions that interfere with convergence, or if appropriate, change contract terms and conditions, when lack of convergence impacts the ability to use the markets for making hedging decisions and for price discovery. The Commission requests comments on what other factors, in addition to the delivery mechanism, a DCM should be required to consider in determining whether convergence is occurring. iii. Proposed § 38.253—Additional Requirements for Cash-Settled Contracts Over the past several years, there has been a growth in markets that are linked, for example, where the settlement price of one market is linked to the prices established in another market. As a result, traders may have incentives to disrupt or manipulate prices in the reference market in order to influence the prices in the linked market. Accordingly, proposed § 38.253 would require that, where a DCM contract is settled by reference to the price of a contract or instrument traded in another venue, including a price or index derived from prices on another exchange, the DCM must have rules that require the traders on the DCM's market to provide the DCM with their positions in the reference market as the traders' contracts approach settlement. In the alternative, § 38.253 provides that the DCM may have an information sharing agreement with the other venue or designated contract market. iv. Proposed § 38.254—Ability To Obtain Information The current acceptable practice for Core Principle 4 provides that DCMs, at a minimum, should have routine access to the positions and trading of their market participants. To ensure that the DCM has the ability to properly assess the potential for price manipulation, price distortions, and the disruption of the delivery or cash-settlement process, proposed § 38.254 provides that each DCM require that traders in their market keep records, including records of their activity in the underlying commodity and related derivative markets and contracts, and make such records available, upon request, to the designated contract market. The Commission's own market surveillance staff, which has similar authority to obtain information from large traders (under § 18.05 for futures and options and proposed § 20.6 for swaps), has found that access to such information is vital to an effective surveillance program. v. Proposed § 38.255—Risk Controls for Trading Proposed § 38.255 requires that a DCM have effective risk controls to reduce the potential risk of market disruptions and ensure orderly market conditions. In the current futures markets, DCMs have implemented a variety of risk controls to avoid market disruptions through restrictions on order entry, including daily price limits, price/quantity bands, and trading pauses. Most commonly used by DCMs for futures contracts in physical commodities (outside of the spot month) and futures contracts in broad-based equity indexes (in coordination with circuit breakers on national security exchanges) are daily price limits, which restrict the total price movement allowed on any given trading day, calculated as a limit above and below the prior day's futures settlement price. 73 Under daily price limits, futures can continue to trade within the limit up/down prices, but no trading can take place above or below the daily price limit. Some DCMs also have rules for the automatic expansion of the daily price limit after consecutive days of limit bid/offer prices. Some electronic trading platforms also have “reasonability tests” and/or “price bands” for order entry, which do not allow an order to enter the trade matching system if it is outside a predetermined price range or is of a particularly large size. 74 Finally, some trading platforms use trading pauses to halt trading for a short period of time during certain market conditions. Trading pauses are used, 75 most commonly, for trading in equity index products. 73 Option contracts on futures may have different daily price limits than the underlying futures. 74 For example, the GLOBEX electronic trading system for the NYMEX crude oil futures contract generally will not accept an order 75 points above or below the last traded price nor will it accept an order for a quantity larger than 999 contracts. 75 The NYMEX Henry Hub Natural Gas (NG) futures has a 5 minute pause in trading when a daily price limit—up or down—is hit, then trading resumes at a higher limit. However, this provision does not apply during the last 60 minutes of regular trading hours. See NYMEX rule 220.08. The CME's GLOBEX system also has a risk control, commonly referred to as “stop logic functionality,” that implements a pause of a few seconds in the order matching system to protect against cascading stop orders—the domino effect of one stop order triggering others. The stop logic functionality pauses trading when the last transaction price would have triggered a series of stop loss orders that, if executed, would cause the market to trade outside of predefined values, which typically consist of values that are the same as the “no bust” range 76 established for a market. 76 Under most exchanges' trade cancellation rules, trades considered to have been executed in error may be cancelled. Where the trade is within the “no bust range” for the specified futures contract, which range is determined by the exchange under its rules, the exchange will allow the trade to stand. In order to prevent market disruptions due to sudden volatile price movements, proposed § 38.255 requires DCMs to have in place effective risk controls, including but not limited to pauses and/or halts to trading in the event of extraordinary price movements that may result in distorted prices or trigger market disruptions. Risk controls such as trading pauses and halts can, among other things, allow time for participants to analyze the market impact of new information that may have caused a sudden market move, allow new orders to come into a market that has moved dramatically, and allow traders to assess and secure their capital needs in the face of potential margin calls. Moreover, where a contract market can be a proxy or substitute for similar markets on the DCM or on other trading venues, including where a contract is based on the price of an equity security or the level of an equity index, risk controls should be coordinated with those on the similar markets or trading venues, to the extent possible. The desirability of coordination of various risk controls, for example, “circuit breakers” in equities and their various derivatives including futures and options, recently has been the subject of discussions by regulators and the industry. The Commission believes that pauses and halts are effective risk management tools and must be implemented by DCMs to facilitate orderly markets. These basic risk controls also have proven to be effective and necessary in preventing market disruptions. The Commission requests comments on what types of pauses and halts are necessary and appropriate for particular market conditions. The Commission recognizes that pauses and halts are only one category of risk controls and that additional controls may be necessary to further reduce the potential for market disruptions. Such controls may include price collars or bands, 77 maximum order size limits, 78 stop loss order protections, 79 kill button, 80 and others. The Commission is considering mandating in this rulemaking risk controls that are appropriate and/or necessary. Accordingly, the Commission invites comments on the appropriateness of these and other controls that could supplement trading halts or pauses. The Commission also invites comments on the following additional questions: 77 Price bands would prevent clearly erroneous orders from entering the trading system, including “fat finger” errors, by automatically rejecting orders priced outside of a range of reasonability. 78 Maximum order size limitations prevent entry into the trading system of an order that exceeds a maximum quantity established by the DCM. 79 Stop loss orders would be triggered if the market declines to a level pre-selected by the person entering the order. This mechanism would provide that when the market declines to the trader's pre-selected stop level for such an order, the order would become a limit order executable only down to a price within the range of reasonability permitted by the system, instead of becoming a market order. 80 The kill button gives clearinghouses associated with the DCM the ability to delete open orders and quotes and reject entry of new orders or quotes in instances where a trader breaches its obligations with the clearinghouse. FIA Market Access Risk Management Recommendations, p. 10 (April 2010). • What other DCM risk controls are appropriate or necessary to reduce the risk of market disruptions? • Which risk controls should be mandated and how? vi. Proposed § 38.256—Trade Reconstruction The Dodd-Frank Act added language to Core Principle 4 that designated contract markets must have the ability to comprehensively and accurately reconstruct all trading on its trading facility. These audit-trail data and reconstructions must also be made available to the Commission in a form, manner, and time as determined by the Commission. Proposed § 38.256 codifies these requirements. vii. Proposed § 38.257—Regulatory Service Provider Proposed § 38.257 provides that a designated contract market must comply with the regulations in this section through a dedicated regulatory department, or by delegation of that function to a regulatory service provider, over which the designated market has supervisory authority. viii. Proposed § 38.258—Additional Rules Required Proposed § 38.258 requires a DCM to adopt and enforce any additional rules that it believes are necessary to comply with the requirements of subpart E. 5. Subpart F—Position Limitations or Accountability Core Principle 5 under Section 5(d)(5) requires that DCMs adopt for each contract, as is necessary and appropriate, position limitations or position accountability. The Dodd-Frank Act amended Core Principle 5 by adding that for any contract that is subject to a position limitation established by the Commission pursuant to Section 4a(a) of the CEA, the DCM shall set the position limitation of the board of trade at a level not higher than the position limitation established by the Commission. The Federal position limits established by the Commission currently are codified in part 150. In a separate release, as required by the Dodd-Frank Act, the Commission will consider replacing part 150 (Limits on Positions) with new part 151 (Limits on Positions) to establish Federal position limits for certain exempt and agricultural commodities that currently are not subject to Federal position limits. 81 In that release, the Commission will propose to require that exchanges adopt their own position limits for all commodities (whether such commodities are subject to Federal limits or not), with an alternative of adopting position accountability rules in lieu of position limits for contracts in major currencies and certain excluded commodities. Proposed § 38.301 requires that each DCM must comply with the requirements of part 151 that the Commission adopts in order to be in compliance with Core Principle 5. 81 See CFTC Web site for additional information on the Position Limits rulemaking, at http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_26_PosLimits/index.htm (last visited Dec. 14, 2010). 6. Subpart G—Emergency Authority The Dodd-Frank Act made minor, non-substantive changes to Core Principle 6 under Section 5(d)(6) of the CEA. Based upon its experience, and in recognition of the fact that DCMs may have different procedures and guidelines for taking emergency action, the Commission believes that it is appropriate to maintain an expanded version of the existing guidance and add an acceptable practice under its regulations for purposes of complying with this core principle. As a result, the Commission proposes to retain most of the former Application Guidance found in Appendix B to part 38 of the Commission's regulations, with some revisions and additions. Proposed § 38.351 refers applicants and DCMs to the guidance and acceptable practices in Appendix B to part 38 for purposes of demonstrating to the Commission their compliance with the requirements of subpart G. Specifically, a DCM is required to have rules providing it with the authority to intervene as necessary to maintain fair and orderly trading and to prevent or address manipulation or disruptive trading practices, whether the need for intervention arises exclusively from the DCM's own market or as part of a coordinated, cross-market intervention. The increased tendency for similar, if not identical, contracts to be traded on more than one venue, that in the future may include a SEF, demonstrates the importance of coordinated interventions. Accordingly, the Commission believes that there should be an increased emphasis on cross-market coordination of emergency actions. The guidance also provides that the DCM rules should include procedures and guidelines to avoid conflicts of interest in accordance with new provisions proposed in § 40.9 and to include alternate lines of communication and approval procedures in order to be able to address, in real time, emergencies that may arise. This latter provision is a result of the expansion of electronic markets and the speed of order execution. As a result of fast-paced trading systems, there is a need for DCMs to be able to react quickly to market events and intervene without delay. Thus, the proposed guidance acknowledges this trend with this provision. The proposed guidance also clarifies that the DCM must also have rules that allow it to take such market actions as may be directed by the Commission. The Commission's experience and industry practice have demonstrated that there are some specific best practices that should be followed, and these best practices are incorporated in an acceptable practice. Specifically, the DCM should have procedures and guidelines for decision-making and implementation of emergency intervention in the market. The DCM should have the authority to liquidate or transfer open positions in the market, 82 suspend or curtail trading in any contract, require market participants in any contract to meet special margin requirements and allow it to take such market actions as the Commission may direct. 82 In situations where a swap is traded on more than one platform, emergency action to liquidate or transfer open interest must be directed, or agreed to, by the Commission or Commission staff. 7. Subpart H—Availability of General Information Core Principle 7 requires that DCMs make available to the public accurate information concerning the contract market's rules and regulations, contracts and operations. The Dodd-Frank Act amended Core Principle 7 by adding a provision requiring the board of trade to make public the rules and specifications describing the operation of the DCM's electronic matching platform or trade execution facility. 83 Since passage of the CFMA, the types of information and the various practices for providing information have become standardized across the industry as DCMs have adopted practices that comply with the current guidance and acceptable practices for Core Principle 7. Accordingly, proposed § 38.401 in subpart H codifies these practices. In addition, the Commission proposes several additional provisions to ensure that pertinent information is available to the Commission, market participants and the public, as described below. 83 This requirement, while new to the text of Core Principle 7, was previously required as part of former Designation Criteria 4. i. Proposed § 38.401(a)—General Proposed § 38.401(a) requires DCMs to have in place procedures, arrangements and resources for disclosing to market authorities, market participants and the public accurate and relevant information pertaining to: (i) Contract terms and conditions, (ii) rules and regulations applicable to the trading mechanism, and (iii) rules and specifications pertaining to the operation of the electronic matching platform or trade execution facility. Among other types of information, DCMs must ensure that market authorities, market participants and the public have available all material information pertaining to new product listings, new or amended governance, trading and product rules, or other changes to information previously disclosed by the DCM, within the time period prescribed in proposed § 38.401. As described in § 38.401(a) of the regulation, DCMs must provide the required information to market participants and the public by posting such information on their Web site, as set forth in proposed § 38.401(c). ii. Proposed § 38.401(b)—Accuracy Requirement Proposed § 38.401(b) requires that each DCM have procedures in place to ensure that any information or communication with the Commission is accurate and complete, and further that no false or misleading information is submitted and that no material information is omitted. Similarly, each DCM must have procedures in place to ensure the accuracy and completeness of any information made available to market participants and the public, including information that is made available on its Web site. iii. Proposed § 38.401(c)—Notice of Regulatory Submissions The Commission historically has required DCMs to update their rulebooks upon the effectiveness of a rule amendment, product listing or rule certification that has been filed with the Commission. While proposed § 38.401(c) maintains the general requirement for posting rules in the DCM rulebook upon their effectiveness, the Commission believes that market participants and the public would benefit from notifications of proposed rule amendments, product listing (or de-listings) and rule certifications in advance of their taking effect. 84 Accordingly, proposed § 38.401(c) requires each DCM to post on its Web site all rule filings and submissions that it makes to the Secretary of the Commission. This information should be posted on the DCM's Web site on the same day that such information is transmitted to the Commission. Where applicable, the DCM Web site should make clear that the posted submissions are pending before the Commission. For example, a DCM's Web site may contain a separate Web page for “regulatory filings” or “rule certifications” for posting submissions or certifications pertaining to new product listings, new rules, rule amendments or changes to previously-disclosed information. This requirement will provide market participants with advance notice of rule amendments and certifications, consistent with the goal of Core Principle 7 to make pertinent information available to market participants and the public. This posting requirement is in addition to the obligation of DCMs to update their Rulebooks upon the effectiveness of a rule submission or certification. 84 This is especially relevant when the Commission determines to stay the certification of a DCM submission, as provided by the Dodd-Frank Act, for a 90-day review period, thereby triggering a public comment period. To the extent that a DCM requests confidential treatment of certain information filed or submitted to the Commission, the proposed rule requires the DCM to post the public portions of the filing or submission. iv. Proposed § 38.401(d)—Rulebook As noted above, consistent with the current acceptable practices for Core Principle 7, all DCMs must post and routinely update their rulebooks, which appear on their Web sites. Currently, each DCM updates its rulebook the day that a new product is listed or a new or amended rule takes effect. The vast majority of DCM Web sites also are readily accessible to the public and the information is available by visitors to the Web site without requiring registration, log-in, or user name or password. Proposed § 38.401(d) merely codifies these existing practices. 85 85 As noted above, the requirement to maintain an accurate and updated rulebook does not relieve DCMs of their obligations under paragraph (c) to post on their Web sites all rule filings and submissions submitted to the Commission. 8. Subpart I—Daily Publication of Trading Information Core Principle 8 requires that DCMs make available to the public accurate information on settlement prices, volume, open interest, and opening and closing ranges for actively traded contracts on the contract market. The Dodd-Frank Act did not amend Core Principle 8. Accordingly, in proposed § 38.451, the Commission reiterates the current acceptable practice that requires mandatory compliance with § 16.01, “Trading volume, open contracts, prices and critical dates.” However, in order to conform to the Dodd-Frank Act, certain changes were made to § 16.01 regarding the information a reporting market will record and publish on futures and options contracts, and on swap and swaption contracts. Specifically, the Commission proposes to amend § 16.01(d) to require reporting markets to report information in paragraphs (a)(1) through (6) of § 16.01. Prior to the enactment of the Dodd-Frank Act, reporting markets were required only to report separately the following information enumerated in paragraphs (a)(1) through (5) of current § 16.01 for futures and options: The option delta, where delta system is used, total gross open contracts, excluding from futures those contracts against which notices have been stopped; for futures, open contracts against which delivery notices have been stopped on that business day; the total volume of trading, excluding transfer trades or office trades; and the total volume of futures exchanged for commodities or for derivatives positions that are included in the total volume of trading. The Commission proposes to require reporting markets to also report to the Commission the information found in paragraph (a)(6) that is “the total volume of block trades that are included in the total volume of trading.” Previously such information was only required to be reported to the public but not separately to the Commission. The Commission believes that having block trade volumes reported separately to it would be useful, particularly in analyzing whether a contract market is in compliance with Core Principle 9 (Execution of Transactions). Because reporting markets currently are required to make block trade volumes available to the public, it should not be an unreasonable burden for the reporting market to submit that information separately to the Commission. Under the Dodd-Frank Act, DCMs are able to list and trade swaps. Accordingly, amendments to part 16 specify the type of information that DCMs or SEFs must publish daily regarding the swaps contracts traded. Specifically, DCMs and SEFs would be required to publish for their swaps contracts all the information included in proposed § 16.01 (a) (1) through (6) for each trading day for each swap, class of swaps, swaption or class of swaptions as appropriate. For swap contracts that are standard-sized contracts (i.e., contracts that have a set contract size for all contracts), volume and open interest for swaps and swaptions shall be reported in terms of number of contracts traded, just as futures contracts currently are reported. For swap contracts that are non-standard-sized contracts (i.e., contracts whose contract size can vary for each transaction) the volume and open interest should be reported in terms of total notional value traded for that trading day. In addition, § 16.01(b) is amended to require each DCM or SEF to publish for each trading day, by commodity and contract month or by tenor of the swap, the opening price, high price, low price and settlement price of the swap or swaption contract. The Commission is seeking comments on end-of-day price reporting for swaps. Specifically, the Commission seeks comments on the following issues: • For interest rate swaps, because the tenor on an interest rate swap can be one of thousands of possible periods, what would be an appropriate manner to display end-of-day prices for each interest rate swap? • Would certain end-of-day swap price reporting be more meaningful than others? If so, which methods of price reporting would be more meaningful and why? • Would certain end-of-day swap price reporting be misleading? If so, which methods of price reporting would be misleading and why? 9. Subpart J—Execution of Transactions The Dodd-Frank Act amended Core Principle 9 to require, among other things, that a board of trade must provide a competitive, open and efficient market and mechanism for executing transactions “that protects the price discovery process of trading in the centralized market of the board of trade. 86 The amended core principle also provides that off exchange transactions are permitted for bona fide business purposes if authorized by the board of trade's rules. 87 86 7 U.S.C. 7; see also Section 5(d)(9) of the CEA, as amended by the Dodd-Frank Act. 87 This language was taken from former Designation Criterion 3. In assessing a DCM's initial and ongoing compliance with Core Principle 9, the Commission currently considers several criteria, including, among others, the methodology and mechanisms of the DCM's trading system to ensure fair and orderly trading and the rules the DCM may have for permissible transactions executed off the centralized market. In so doing, the Commission has looked at § 1.38 of the Commission's regulations, which 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 DCM should be executed by open and competitive methods. There is an exception to this “open and competitive” requirement if the transaction is in compliance with the rules of the DCM that specifically provide for the non-competitive execution of such transactions. 88 In addition, the current guidance for Core Principle 9 provides that a competitive, open and efficient market and mechanism for execution of transactions includes: (1) The DCM's methodology for entering orders and executing transactions; (2) that appropriate objective testing and review of automated systems should occur initially and periodically to ensure proper system functioning, adequate capacity and security; and (3) that a DCM that determines to allow block trades should ensure that such trades do not operate in a manner that compromises the integrity of prices or price discovery in the relevant market. 89 88 The Commission notes that the CFMA, which was enacted after promulgation of § 1.38, modified Section 3 of the current CEA to require that transactions subject to the CEA provide “a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities.” The CFMA also specifically listed some of the types of transactions that could be executed off the centralized market, including exchange of futures for swaps, and allowing 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. 7 U.S.C. 7(b)(3). 89 The current acceptable practice for Core Principle 9 identifies an example of the type of party that would be an acceptable party to carry out the testing and review of an electronic trading system. The Commission notes that under its proposed rulemaking, all rules relating to the type of testing and review required for trading systems would be set forth under new Core Principle 20, System Safeguards, discussed infra at Section II.D.20. In light of the Dodd-Frank Act amendments to Core Principle 9 and the Commission's experience in implementing Core Principle 9 since enactment of the CFMA, the Commission proposes to adopt certain regulations in subpart J of the Commission's regulations to establish requirements that a DCM must meet in order to comply with amended Core Principle 9. Specifically, new regulations are proposed to clarify the amended core principle's mandate requiring the protection of the price discovery function of trading on a DCM's centralized market. Other regulations codify practices that have become standard and adopted over the years by the industry. In addition, the Commission re-proposes certain guidance and acceptable practices that were published by the Commission in the September 2008 Notice of Proposed Rulemaking pertaining to “Execution of Transactions: Regulation 1.38 and Guidance on Core Principle 9” 90 (hereafter “2008 Core Principle 9 Proposed Rulemaking”) for purposes of informing DCMs of how they may comply with certain other aspects of amended Core Principle 9. 91 90 73 FR 54097, Sep. 18, 2008. That proposed rulemaking was a re-proposal of some rules, guidance and acceptable practices pertaining to Regulation 1.38 and Core Principle 9, initially proposed on July 1, 2004. See 69 FR 39880, July 1, 2004. There were no final rulemakings to either of these proposals. 91 In 2009, before those proposed rules were finalized, Congress initiated the legislative process that culminated in the Dodd-Frank Act. Accordingly, a number of the proposed rules contained in this release consist of regulations that wer [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2010-31458. Public record. Not legal advice.