Risk Disclosure by Futures Commission Merchants, Introducing Brokers, Commodity Pool Operators and Commodity Trading Advisors to Customers; Bankruptcy Disclosure

COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1, 30, 33, and 190

Risk Disclosure by Futures Commission Merchants, Introducing

Brokers, Commodity Pool Operators and Commodity Trading Advisors to

Customers; Bankruptcy Disclosure

AGENCY: Commodity Futures Trading Commission.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)

is requesting public comment on the text of a draft two page generic

risk disclosure statement currently being discussed among various

international futures regulators that potentially could be used to meet

the risk disclosure requirements for both domestic and foreign

commodity futures and commodity option products subject to regulation

by the CFTC. As contemplated by Commission rule 1.55(c), the text of

the generic risk disclosure statement is being published, in part, to

further these discussions relative to the development of one document

to satisfy the risk disclosure requirements of the CFTC and such

foreign jurisdictions as may choose to adopt its language for use in

their jurisdictions. Based on the comments received, the CFTC may be

better able to provide input to these discussions and to consider rule

amendments to permit the substitution of this statement under rule

1.55(c) and certain other rules for firms doing cross-border business.

DATES: Comments must be submitted on or before February 10, 1994.

ADDRESSES: Comments should be sent to the Secretariat, Commodity

Futures Trading Commission, 2033 K Street, NW., Washington, DC 20581.

Reference should be made to ``Generic Risk Disclosure--Advance

Notice.''

FOR FURTHER INFORMATION CONTACT: Jane C. Kang, Esq., or Robert H.

Rosenfeld, Esq., Division of Trading and Markets, Commodity Futures

Trading Commission, 2033 K Street, NW., Washington, DC 20581; telephone

(202) 254-8955.

SUPPLEMENTARY INFORMATION:

Background

On March 30, 1993, the Commission, among other things, adopted

final rule amendments to Commission rule 1.55(b) which simplified the

risk disclosure process by consolidating the risk disclosure statements

applicable to domestic futures transactions and foreign futures and

foreign commodity options transactions in rules 1.55 and 30.6,

respectively.\1\ The use of such a statement was intended to greatly

simplify the risk disclosure process for U.S. firms conducting cross-

border business.

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\1\58 FR 17496 (April 5, 1993). These amendments also:

--eliminated the requirement that the rule 190.10 disclosure

regarding treatment of non-cash margin be acknowledged by the

customer;

--clarified that the rule 1.55 risk disclosure statement may be

included in a booklet of account opening documents, provided it

appears on the cover page or following the cover page of such

booklet;

--provided that the Commission may approve a risk disclosure

statement that has been approved by a foreign jurisdiction or

foreign SRO for use in lieu of the Commission-required statement;

--permitted the use of a single acknowledgement for rule 1.55

and 33.7 statements and other elections, subject to specified

conditions; and

--simplified the disclosure requirements regarding the bulk

transfer of accounts.

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In response to Commission suggestions in the notice of proposed

rulemaking concerning rule 1.55 that it also was considering the

development of a ``plain language'' options disclosure statement,\2\

some commenters supported that course of action and further suggested

that the Commission not only shorten the rule 33.7 disclosure statement

applicable to exchange-traded commodity option transactions but also

consolidate it with the new combined domestic futures and foreign

futures and foreign commodity options statement. In response, the

Commission noted that certain international regulators were endeavoring

to develop a single risk disclosure statement that could be used in

multiple jurisdictions to satisfy the risk disclosure requirements

applicable to domestic and cross-border transactions in futures and

options. The Commission stated that if a universal statement were to be

developed, it would consider permitting the use of such a statement in

lieu of the new consolidated rule 1.55 risk disclosure statement as

well as the options risk disclosure statement required by current rule

33.7.\3\ Under amended rule 1.55(c), the Commission may permit the

substituted use of a risk disclosure statement approved by a foreign

regulatory or self-regulatory organization if the Commission determines

that such statement reasonably is calculated to provide the disclosure

required by Commission rule 1.55(b).\4\

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\2\See 57 FR 46101, 46108 (October 7, 1992).

\3\58 FR at 17497 and 17502 (April 5, 1993).

\4\58 FR at 17503-17504 (April 5, 1993).

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For some time, a working group\5\ of international regulators

worked towards developing a single risk disclosure statement which

could satisfy the risk disclosure requirements applicable, in the

multiple participating jurisdictions, to domestic and cross-border

transactions in futures and options (``generic disclosure

statement'').\6\ Following extensive discussions, the draft generic

disclosure statement set forth herein was developed and the draft text

was passed to those regulatory authorities (including the CFTC) who

were interested in taking the work forward. The text remains subject to

final discussion and approval by the regulatory authorities of the

participating jurisdictions.

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\5\The working group was composed of representatives from Canada

(Ontario Securities Commission), France (the French Conseil du

Marche a Terme), Switzerland (the Swiss Ministry of Finance), the

United Kingdom (the U.K. Securities and Investments Board, which

chaired the working group), and the United States (the CFTC).

\6\See 58 FR at 17496, 17497 and 17502 (April 5, 1993).

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It is intended that the generic disclosure statement would specify,

in an addendum on a third page, the participating jurisdictions and the

specific products for which it could be used. The addendum would be

updated periodically as new jurisdictions adopted the text. In the

United States, it is contemplated that such risk disclosure statement,

if ultimately proposed and adopted after further public comment, would

satisfy only those risk disclosure obligations set forth in Commission

rules 1.55 (which incorporates the risk-disclosure contained in

Commission rule 30.6),\7\ the special disclosures related to futures-

style margining of options permitted on certain foreign exchanges,\8\

and the special bankruptcy disclosures of Commission rule 190.10(c)

related to the acceptance of non-cash margin.

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\7\The Commission notes in this regard that pending resolution

of the Commission's determination on this draft generic risk

disclosure statement, firms operating pursuant to Commission rule

30.10 relief should continue to comply with the risk disclosure

requirements set forth in the relevant Commission orders and that

for these purposes may continue to use the text of rule 30.6 as

published prior to the 1993 revisions to Commission rules 1.55 and

30.6 (which incorporated the rule 30.6 disclosures for foreign

futures into the rule 1.55 disclosures for domestic futures) (see 58

FR 17496 (April 5, 1993)).

\8\See, e.g., CFTC Advisory No. 90-1 [1987-1990 Transfer Binder]

Comm. Fut. L. Rep. (CCH) 24,597 (disclosure statement relating to

the deferred payment of option premiums for options, superseding

separate disclosure addenda required by orders concerning the London

International Financial Futures Exchange (54 FR 37636 (September 12,

1989)), the International Petroleum Exchange (54 FR 50356 (December

6, 1989)), and the London Futures and Options Exchange (renamed as

the London Commodity Exchange) (54 FR 50348 (December 6, 1989)); and

55 FR 14238 (April 17, 1990) (Sydney Futures Exchange).

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Approach Taken By Working Group

The approach taken by the international working group with respect

to risk disclosure has been to develop a draft generic statement which

focuses on the major risks of trading and contains the basic generic

disclosures required by most jurisdictions.

Thus, the approach of the working group was to eliminate much of

the definitional and educational material which currently is required

to be disclosed by Commission rule 33.7 and to treat options disclosure

in a manner equivalent to disclosure for futures. As such, the

statement is intended to focus customer attention on the risks of

trading, as currently is the practice with futures risk disclosure.

Further, the statement would highlight the importance of obtaining

sufficient information as to the specifics of trading without

attempting to address the differences from market to market.

The elimination of a Commission mandated description of options

trading and other educational material from the mandated risk

disclosure statement does not mean, however, that firms do not have the

obligation to provide all material disclosures in compliance with

Commission and National Futures Association (NFA) rules.\9\

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\9\See, e.g., Commission rule 1.55(d), which provides that: This

section [requiring distribution of a risk disclosure statement] does

not relieve a futures commission merchant or introducing broker from

any other disclosure obligation it may have under applicable law.

See also, NFA Compliance Rule 2-30 (customer information and

risk disclosure).

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Additional Topics

As the working group's objective was not only to create a risk

disclosure statement that categorized existing disclosure requirements

in most jurisdictions but also to incorporate new matters deemed

relevant in an evolving marketplace, the generic statement also

contains the following additional topics.

1. Supporting Systems

The current draft generic disclosure statement would briefly

disclose the fact that most open-outcry and electronic trading

facilities are supported by computer-based component systems, which are

vulnerable to temporary disruption or failure.

2. Electronic Trading

Differences in electronic trading systems are such that a common

disclosure appropriate to the specifics of each such system may not be

feasible and, in the case of domestic contract market electronic

systems, the draft generic disclosure statement would not substitute

for disclosure requirements that currently are required by individual

contract markets for such systems. However, as the purpose of the draft

generic disclosure statement is to articulate general risks common to

futures and options trading, it is possible in the case of electronic

systems to identify the risks common to any such system, such as the

possibility of system failure and that the liability of the system

provider may be limited. No attempt has been made to describe in detail

the specifics of any one system. On the contrary, the proposed

disclosure text encourages the customer to ask the firm with which it

is dealing for details in this respect.

3. Off-Exchange Trading

The draft generic disclosure statement also contains a reference to

the risks of off-exchange trading. The international working group

drafting the consolidated disclosure statement concluded that such a

provision, if worded appropriately, would not mislead or confuse

customers in those jurisdictions which, for example, do not permit

retail customers to participate in off-exchange markets.

Request For Comment

The Commission is inviting public comment and suggestions generally

on the draft text of the generic risk disclosure statement so that any

material public concerns can be considered by the Commission. The

Commission also requests public comment on whether the use of a generic

disclosure statement to substitute for current disclosures contained in

rules 1.55, 33.7, 190.10 and Commission orders and Advisories regarding

disclosures related to futures-style margining of option premiums

allowed by certain foreign exchanges would be most useful if made

mandatory for certain categories of registrants, and if so, which

categories should be included, and whether use should be limited to

firms doing cross-border business or more broadly available.

Text of Draft Generic Risk Disclosure Statement

Risk Disclosure Statement for Futures and Options

This brief statement does not disclose all of the risks and other

significant aspects of trading in futures and options. In light of the

risks, you should undertake such transactions only if you understand

the nature of the contracts (and contractual relationships) into which

you are entering and the extent of your exposure to risk. Trading in

futures and options is not suitable for many members of the public. You

should carefully consider whether trading is appropriate for you in

light of your experience, objectives, financial resources and other

relevant circumstances.

Futures

1. Effect of ``Leverage'' or ``Gearing''

Transactions in futures carry a high degree of risk. The amount of

initial margin is small relative to the value of the futures contract

so that transactions are ``leveraged'' or ``geared.'' A relatively

small market movement will have a proportionately larger impact on the

funds you have deposited or will have to deposit: this may work against

you as well as for you. You may sustain a total loss of initial margin

funds and any additional funds deposited with the firm to maintain your

position. If the market moves against your position or margin levels

are increased, you may be called upon to pay substantial additional

funds on short notice to maintain your position. If you fail to comply

with a request for additional funds within the time prescribed, your

position may be liquidated at a loss and you will be liable for any

resulting deficit.

2. Risk-reducing Orders or Strategies

The placing of certain orders (e.g. ``stop-loss'' orders, where

permitted under local law, or ``stop-limit'' orders) which are intended

to limit losses to certain amounts may not be effective because market

conditions may make it impossible to execute such orders. Strategies

using combinations of positions, such as ``spread'' and ``straddle''

positions may be as risky as taking simple ``long'' or ``short''

positions.

Options

3. Variable Degree of Risk

Transactions in options carry a high degree of risk. Purchasers and

sellers of options should familiarize themselves with the type of

option (i.e. put or call) which they contemplate trading and the

associated risks. You should calculate the extent to which the value of

the options must increase for your position to become profitable,

taking into account the premium and all transaction costs.

The purchaser of options may offset or exercise the options or

allow the options to expire. The exercise of an option results either

in a cash settlement or in the purchaser acquiring or delivering the

underlying interest. If the option is on a future, the purchaser will

acquire a futures position with associated liabilities for margin (see

the section on Futures above). If the purchased options expire

worthless, you will suffer a total loss of your investment which will

consist of the option premium plus transaction costs. If you are

contemplating purchasing deep-out-of-the-money options, you should be

aware that the chance of such options becoming profitable ordinarily is

remote.

Selling (``writing'' or ``granting'') an option generally entails

considerably greater risk than purchasing options. Although the premium

received by the seller is fixed, the seller may sustain a loss well in

excess of that amount. The seller will be liable for additional margin

to maintain the position if the market moves unfavorably. The seller

will also be exposed to the risk of the purchaser exercising the option

and the seller will be obligated to either settle the option in cash or

to acquire or deliver the underlying interest. If the option is on a

future, the seller will acquire a position in a future with associated

liabilities for margin (see the section on Futures above). If the

option is ``covered'' by the seller holding a corresponding position in

the underlying interest or a future or another option, the risk may be

reduced. If the option is not covered, the risk of loss can be

unlimited.

Certain exchanges in some jurisdictions permit deferred payment of

the option premium, exposing the purchaser to liability for margin

payments not exceeding the amount of the premium. The purchaser is

still subject to the risk of losing the premium and transaction costs.

When the option is exercised or expires, the purchaser is responsible

for any unpaid premium outstanding at that time.

Additional Risks Common to Futures and Options

4. Terms and Conditions of Contracts

You should ask the firm with which you deal about the terms and

conditions of the specific futures or options which you are trading and

associated obligations (e.g. the circumstances under which you may

become obligated to make or take delivery of the underlying interest of

a futures contract and, in respect of options, expiration dates and

restrictions on the time for exercise). Under certain circumstances the

specifications of outstanding contracts (including the exercise price

of an option) may be modified by the exchange or clearing house to

reflect changes in the underlying interest.

5. Suspension or Restriction of Trading and Pricing Relationships

Market conditions (e.g. illiquidity) and/or the operation of the

rules of certain markets (e.g. the suspension of trading in any

contract or contract month because of price limits or ``circuit

breakers'') may increase the risk of loss by making it difficult or

impossible to effect transactions or liquidate/offset positions. If you

have sold options, this may increase the risk of loss.

Further, normal pricing relationships between the underlying

interest and the future, and the underlying interest and the option may

not exist. This can occur when, for example, the futures contract

underlying the option is subject to price limits while the option is

not. The absence of an underlying reference price may make it difficult

to judge ``fair'' value.

6. Deposited Cash and Property

You should familiarize yourself with the protections accorded money

or other property you deposit for domestic and foreign transactions,

particularly in the event of a firm insolvency or bankruptcy. The

extent to which you may recover your money or property may be governed

by specific legislation or local rules. In some jurisdictions, property

which had been specifically identifiable as your own will be pro-rated

in the same manner as cash for purposes of distribution in the event of

a shortfall.

7. Commission and Other Charges

Before you begin to trade, you should obtain a clear explanation of

all commission, fees and other charges for which you will be liable.

These charges will affect your net profit (if any) or increase your

loss.

8. Transactions in Other Jurisdictions

Transactions on markets in other jurisdictions, including markets

formally linked to a domestic market, may expose you to additional

risk. Such markets may be subject to regulation which may offer

different or diminished investor protection. Before you trade you

should enquire about any rules relevant to your particular

transactions. Your local regulatory authority will be unable to compel

the enforcement of the rules of regulatory authorities or markets in

other jurisdictions where your transactions have been effected. You

should ask the firm with which you deal for details about the types of

redress available in both your home jurisdiction and other relevant

jurisdictions before you start to trade.

9. Currency Risks

The profit or loss in transactions in foreign currency-denominated

contracts (whether they are traded in your own or another jurisdiction)

will be affected by fluctuations in currency rates where there is a

need to convert from the currency denomination of the contract to

another currency.

10. Trading Facilities

Most open-outcry and electronic trading facilities are supported by

computer-based component systems for the order-routing, execution,

matching, registration or clearing of trades. As with all facilities

and systems, they are vulnerable to temporary disruption or failure.

11. Electronic Trading

Trading on an electronic trading system may differ not only from

trading in an open-outcry market but also from trading on other

electronic trading systems. If you undertake transactions on an

electronic trading system, you will be exposed to risks associated with

the system including the failure of hardware and software. The result

of any system failure may be that your order is either not executed

according to your instructions or is not executed at all. Your ability

to recover certain losses which are particularly attributable to

trading on a market using an electronic trading system may be limited

to less than the amount of your total loss. Limits on liability may be

imposed by the system provider, the market, the clearing house and/or

member firms. Such limits may vary: You should ask the firm with which

you deal for details in this respect.

12. Off-exchange Transactions

In some jurisdictions, and only then in restricted circumstances,

firms are permitted to effect off-exchange transactions. The firm with

which you deal may be acting as your counterparty to the transaction.

It may be difficult or impossible to liquidate an existing position, to

assess the value, to determine a fair price or to assess the exposure

to risk. For these reasons, these transactions may involve increased

risks.

Off-exchange transactions may be less regulated or subject to a

separate regulatory regime. Before you undertake such transactions, you

should familiarize yourself with applicable rules.

This disclosure document meets the risk disclosure requirements in

the jurisdictions identified below ONLY for those instruments which are

specified:

Jurisdiction ``A'':

futures

options on futures

Jurisdiction ``B'':

futures

options on futures

options on commodities

Jurisdiction ``C'':

futures

options on futures

options on equities

etc.

Issued in Washington, DC. on January 5, 1994 by the Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 94-608 Filed 1-10-94; 8:45 am]

BILLING CODE 6351-01-P