Alternative Executive, or Block Trading, Procedures for the Futures Industry

COMMODITY FUTURES TRADING COMMISSION

Alternative Executive, or Block Trading, Procedures for the

Futures Industry

AGENCY: Commodity Futures Trading Commission.

ACTION: Advisory.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'') will

consider contract market proposals to adopt alternative executive

execution, or block trading, procedures for large size or other types

of orders on a case-by-case basis under a flexible approach to the

requirements of the Commodity Exchange Act (``Act'') and the

Commission's regulations. The Commission continues to be open to

further comments on the various issues surrounding potential

alternative execution procedures from industry participants.

EFFECTIVE DATE: This Advisory is effective upon issuance.

FOR FURTHER INFORMATION CONTACT:

Rebecca L. Creed, Attorney, Division of Trading and Markets, Commodity

Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,

NW, Washington, DC 20581. Telephone: (202) 418-5430.

SUPPLEMENTARY INFORMATION:

I. Introduction

After careful consideration of public comments and interviews with

interested securities and futures industry participants, the Commission

has decided to evaluate contract market proposals to adopt alternative

execution, or block trading, procedures for large size or other types

of orders on a case-by-case basis. As discussed below, the Commission

believes that the appropriate terms and conditions governing such

execution procedures are best addressed in the context of specific

proposals. The Commission stands ready to consider any rule proposal

submitted by a contract market that expressly allows such transactions

to be executed using any combination of competitive and noncompetitive

execution procedures. The Commission plans to take a flexible approach

in considering such proposals.

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II. The Commission Solicited Comments on Alternative Execution, or

Block Trading Procedures in its Concept Release Concerning the

Regulation of Noncompetitive Transactions Executed on or Subject to

the Rules of a Contract Market

On January 26, 1998, the Commission published a Concept Release in

the Federal Register for public comment concerning the regulation of

noncompetitive transactions executed on or subject to the rules of a

contract market.\1\ Among other things, the Concept release discussed a

wide range of issues concerning alternative execution procedures.\2\

Specifically, the Commission wished to explore whether certain

alternative execution procedures for large size or other types of

orders could be developed to satisfy the needs of market participants

while furthering the policies and purposes of the Act and the

Commission's regulations. Through the questions posed in the Concept

Release, commenters were asked whether the Commission should permit

alternative execution procedures pursuant to the rules of a contract

market; what general qualifying standards should govern a proposal's

eligibility for approval by the Commission; and whether additional

regulatory requirements should be imposed on these procedures to

maintain integrity and to provide guidance to self-regulatory

entities.\3\ Of the sixty-four comment letters the Commission received

in response to the Concept Release, fifty-seven specifically addressed

such execution procedures.\4\

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\1\ 63 FR 3708 (January 26, 1998).

Throughout the Concept Release and in this Advisory, the

Commission uses the term ``noncompetitive transaction'' to refer to

those transactions that are negotiated and executed by

counterparties other than through open outcry or other competitive

means, but in accordance with the written rules of a contract market

that have been submitted to and approved by the Commission. The

noncompetitive transactions discussed in the Concept Release are

distinguishable from those abusive trading practices prohibited by

section 4c(a) of the Act, such as wash sales, cross trades,

accommodation trades, and fictitious sales. Moreover, as noted by

many of the commenters responding to the Concept Release, these

noncompetitive transactions might be structured in such a manner

that promotes competitive pricing, transparency, or other beneficial

goals.

The Commission recognizes, however, that new execution

procedures for large size or other types of orders might utilize a

combination of competitive and noncompetitive trading practices. The

term ``alternative execution procedures'' is intended to embrace the

entire range of potential execution procedures that might be

proposed by a contract market including those referred to in the

Concept Release and comments thereon as block trading procedures.

This includes those procedures that provide some degree of exposure

of large size orders to the competitive pressures of the centralized

futures marketplace as well as those that are purely noncompetitive.

\2\ The Release also included questions concerning the oversight

of: (1) Exchanges of futures contracts for physicals (``EFPs''),

which are authorized under the Act and the Commission's regulations;

(2) other potential noncompetitive transactions, including exchanges

of futures contracts for qualifying swap agreements (``EFS

transaction'') and exchanges of option contracts for physicals

(``EOPs''); and (3) the use of execution facilities for

noncompetitive transactions. The overall purpose of the Concept

Release was to solicit comments on the current regulatory structure

governing noncompetitive transactions and whether this approach

should be modified in light of recent developments in the

marketplace.

On January 7, 1999, the Commission approved the New York

Mercantile Exchange's (``NYMEX'') proposal to adopt new Rule 6.21A,

which authorize EFS transactions pursuant to the terms and

conditions of a three-year pilot program. See Commission Press

Release No. 4228-99. Any contract market which is interested in

allowing EFS transactions in their designated markets may submit a

proposal to the Commission for its consideration, pursuant to

Section 5a(a)(12)(A) of the Act and Commission Regulation 1.41.

\3\ The comment period on the Concept Release originally was

scheduled to run from January 26, 1998, through March 27, 1998, but

was extended by the Commission until April 27, 1998. 63 FR 13640

(March 20, 1998). At the request of the Futures Industry

Association, the Commission further extended the comment period on

those parts of the Release that related to alternative execution

procedures until September 1, 1998. 63 FR 24164 (May 1, 1998).

\4\ Several comments submitted multiple and/or joint comment

letters.

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These comment letters revealed two divergent viewpoints concerning

the adoption of alternative execution procedures by contract markets.

Eleven commenters generally supported such procedures, while forty-nine

commenters generally opposed them. The supporting comment letters

indicated that alternative execution procedures should be implemented

in order to alleviate the current difficulties faced by institutional

market participants in executing large futures and option orders. These

commenters stated that execution procedures could be structured in such

a way as to minimize any negative impact on market volume, liquidity,

price discovery, transparency, or customer protection. Conversely, the

opposing comment letters generally stated that alternative execution

procedures would divert order flow away from the centralized,

competitive marketplace, thereby reducing liquidity and jeopardizing

the price discovery and hedging functions of the futures markets. These

commenters stated that such execution procedures would prevent floor

traders and certain other entities from participating in large

transactions between institutions and that customers ultimately would

be harmed by the lack of transparency associated with these procedures.

A. Current Contract Market Large Order Execution Procedures

Under the Act and the Commission's regulations, all futures and

option transactions generally must be executed openly and competitively

by open outcry, by posting of bids and offers, or by equally open and

competitive methods in the trading pit or ring or similar place

provided by a designated contract market.\5\ As noted in the Concept

Release, the Commission has approved or allowed into effect various

contract market rules which establish procedures for the execution of

large orders.\6\ These procedures generally preserve the competitive

forces available on a centralized market and thereby comply with the

open and competitive execution requirement. The Commission also has

taken steps to streamline its own regulations to facilitate the

adoption of large order execution (``LOX'') procedures by contract

markets.\7\

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\5\ See sections 4(a) and 4b of the Act; Commission Regulation

1.38(a). There are, however, certain limited exceptions to this

requirement. Section 4c(a) of the Act prohibits certain types of

noncompetitive or otherwise abusive trading practices, such as wash

sales, cross trades, accommodations trades, and fictitious sales,

but provides an exception for EFPs that are executed in accordance

with contract market rules that have been approved by the

Commission. An EFP involves simultaneous transactions in the futures

and cash commodity markets. One party buys the physical commodity

and simultaneously sells (or gives up long) futures contracts while

the other party sells the physical commodity and simultaneously buys

(or receives long) futures contracts. Subject to applicable contract

market rules, the futures transaction is negotiated privately by the

parties rather than being executed openly and competitively on a

centralized market. All domestic contract markets permit EFPs,

although there is some variation among the specific contract market

rule which govern these transactions.

\6\ See, e.g., Chicago Mercantile Exchange (``CME'') Rule 521

(``All-Or-None Transactions''); New York Cotton Exchange (``NYCE'')

Rule 1.10-B (``Block Order Execution''); New York Futures Exchange

(``NYFE'') Rule 312 (``Block Order Execution'').

CME also has developed request for quote (``RFQ'') procedures

which allow market participants to solicit transactions of a

particular size for any of the contracts traded through Globex2, its

electronic trading system. In addition, CMD allows firms to engage

in pre-execution discussions regarding Globex2 trades as long as the

solicited counterparty waits a reasonable period of the time before

entering an order opposite that of the initiating party.

\7\ Commission Regulation 1.39 generally sets forth the

conditions and requirements governing the crossing of simultaneous

buying and selling orders of different principals. Under Regulation

1.39(a), when trading is conducted in a pit or ring, a contract

market member may execute buying and selling orders from different

principals for the same commodity directly between such principals

at the market price, pursuant to the written rules of such contract

market which have been approved by the Commission, provided that the

member first offers both orders to the pit. In 1991, the Commission

amended Regulation 1.39 to allow a contract market member to follow

alternative procedures for the crossing of orders if these

procedures comply with contract market LOX rules that have been

approved by the Commission. 56 FR 12336 (March 25, 1991).

CME adopted, and the Commission approved, Rule 549 which

established LOX procedures for transactions involving 300 or more

futures contracts in the Standard & Poor's 500 Stock Price Index or

the Nikkei Stock Average. Despite allowing the pre-execution

solicitation of interest and discussion of price, these LOX

procedures were used by market participants on only one occasion in

the several years they were available. Ultimately, CME terminated

these procedures in April 1998.

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[[Page 31197]]

There is some debate, however, as to whether the existing

procedures meet the needs of futures market participants. Several

commenters responding to the Concept Release stated that the

availability of alternative execution procedures is crucial to

attracting and retaining institutional participation in the futures

markets: These participants increasingly need to trade large quantities

of futures contracts in connection with their securities activities.

According to commenters, such transactions would severely tax the

available liquidity of the centralized futures marketplace. These

commenters stated that alternative execution procedures would allow

large futures transactions, which require size and price certainty, to

be implemented in an efficient and cost effective manner.

B. Potential Alternative Execution Procedures Discussed in the Concept

Release

Pursuant to section 4(a) of the Act and Commission Regulation

1.38(a), the Commission has broad authority to approve contract market

rules which allow futures and option transactions to be executed in the

noncompetitive manner.\8\ The text of these provision does not limit

the types of noncompetitive transactions that may be approved by the

Commission. In light of this authority, the Concept Release sought to

identify new execution procedures that go beyond those that already

exist in the futures industry and to encourage debate on such

procedures. The Release described several scenarios which departed from

the usual open and competitive execution requirement in various

degrees. Certain examples envisioned market participants being allowed

to alert potential counterparties of their general interest in trading

a particular contract at a particular time, to divulge specific

information about quantity and price to potential counterparties, or to

negotiate the specific terms of futures and option transactions.

Another variation would adjust execution procedures to confer a degree

of priority on particular orders, such as market maker orders, that

they might not attain in the open and competitive trading

environment.\9\ Finally, the Release noted that market participants

might be permitted to execute certain transactions bilaterally, away

from the centralized marketplace, and to report them to the relevant

contract market and clearing organization in a manner similar to the

way EFPs are handled currently. These examples, while not exhaustive,

were intended to illustrate a range of possible execution procedures

that could be adopted by contract markets.

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\8\ Section 4(a) makes it unlawful for any person to enter into

a contract for the purchase or sale of a commodity for future

delivery ``unless such transaction is conducted on or subject to the

rules of board of trade which has been designated by the Commission

as a contract market for such commodity.'' Commission Regulation

1.38(a) provides that the open and competitive execution requirement

``shall not apply to transaction which are executed noncompetitively

in accordance with written rules of the contract market which have

been submitted to and approved by the Commission, specifically

providing for the noncompetitive execution of such transactions.''

As noted previously, the Commission exercised this authority in

approving NYMEX's proposal of EFS transactions.

\9\ The Commission already has approved several contract market

proposals establishing market maker programs. These programs, which

aim to encourage market participation in specified new or low volume

contracts, often provide market makers with certain trading

priorities that they would not otherwise obtain under traditional

open and competitive execution methods. See, e.g., Coffee, Sugar &

Cocoa Exchange (``CSCE'') Registered Market Maker Program (approved

by the Commission on April 30, 1991); Chicago Board of Trade

(``CBOT'') Modified Market Maker Program for the Wilshire Small Cap

Index Future Contract (allowed into effect without prior Commission

approval on June 18, 1993); CME Principal Market Maker Program

(approved by the Commission on April 10, 1995); NYMEX Specialist

Market Maker Program (approved by the Commission on July 8, 1998).

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The Concept Release also discussed how block trading procedures

operate in the securities markets.\10\ Generally speaking, with respect

to securities exchanges, the specific terms of a block transaction are

negotiated ``upstairs'' away from the exchange floor. Exchange rules

govern the manner in which such transactions ultimately are brought to

the floor for execution. Typically, a brokerage firm will arrange the

block transaction for its customer. After receiving a customer's order

to purchase or sell a block of securities, the firm must decide whether

to contact the exchange specialist.\11\ By contacting the specialist,

the firm can determine the prevailing price of the stock and as well as

the needs of the specialist. If the specialist is interested in taking

the opposite side of the entire block at a mutually agreeable price,

there is no need to utilize the block trading procedures.

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\10\ In the securities industry, a block trade is commonly

defined as a transaction involving 10,000 or more shares. Blocks may

be traded on securities exchanges, in over-the-counter markets, or

through ``principal-to-principal'' trade execution venues. 63 FR

3708, 3717-3718 (January 26, 1998).

\11\ Under New York Stock Exchange (``NYSE'') Rule 127(a), a

member organization that receives an order for the purchase or sale

of a block of stock is obligated to explore the market to determine

whether ti can absorb the order without a significant impact on

price. Unless professional judgment dictates otherwise, this

research should include contacting the specialist to ascertain the

extent of the specialist's interest in participating in the block at

a specific price or prices.

Each stock listed on the NYSE is allocated to a specialist. The

specialist, through his or her many roles, is responsible for

maintaining the market's fairness, competitiveness and efficiency.

At the beginning of each trading day, the specialist establishes a

fair market price for each of his or her assigned stocks. The

specialist also provides current market quotations to other brokers

throughout the day. The specialist executes limit and stop orders

for other brokers on a commission basis and maintains the limit

order book. Moreover, the specialist is obligated to maintain

``orderly markets'' in his or her assigned stocks by making sure

that trading occurs throughout the day with minimal price

fluctuations. Finally, the specialist acts as a dealer by buying

stocks from the trading crowd when other bids are available or

selling stocks to the trading crowd when other offers are not made.

The specialist's goal is to minimize the temporary imbalance between

public supply and demand.

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If block trading procedures are necessary, the brokerage firm must

then decide whether to ``position'' the block for its house account, to

``shop the block'' by contacting potential customers to take the

opposite side of the transaction, or to combine these strategies. Upon

agreement to a price for the block,\12\ the customer's order is

transmitted to the floor where it is crossed against the firm's house

account and/or against other customer orders, subject to applicable

exchange rules.\13\

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\12\ When positioning a block, the brokerage firm quotes a

tentative price for the stock. Barring an extreme and unexpected

movement in the price of the stock, the customer may be reasonably

assured of execution at the quoted price. In ``shopping the block,''

the firm contacts potential customers to take the opposite side at a

specified price. The firm might be willing to negotiate this price

depending on how interested other investors are in participating in

the transaction. The firm continues to contact potential customers

until there is a sufficient quantity of orders for the opposite side

at a single price. At this point, the firm returns to its original

customer to confirm his or her interest in the block transaction at

the negotiated price, also known as the ``clean-up price.

\13\ A block transaction that is proposed to be priced within

the current market bid-ask spread is subject to NYSE Rule 76, which

governs cross trades. Under this rule, when the floor broker has an

order to buy and an order to sell in the same security, the broker

must ``publicly offer such security at a price which is higher than

his bid by the minimum variation permitted in such security before

making a transaction with himself.'' All such bids and offers must

be clearly announced to the trading crowd before the floor broker

can proceed with the cross transaction.

A block transaction that is proposed to be priced outside of the

current market quotation is subject to NYSE Rule 127. Under this

rule, the floor broker must: (1) Inform the specialist of his or her

intention to cross the block orders at a specific price; (2) probe

the market to determine whether more stock would be lost to orders

in the trading crowd than is reasonable under the circumstances; (3)

fill at least a portion of the limit orders previously entered at

the trading post from the block orders; and (4) cross the remaining

block orders at the negotiated clean-up price. NYSE Rule 127 sets

forth the broker's obligation to fill the limit orders of the

specialist and the trading crowd. Such obligations depend, in part,

on whether the broker is handling agency orders for both sides of

the block transaction or whether all or a part of one side of the

block is for the brokerage firm's house account.

The Chicago Board Options Exchange (``CBOE'') also has

procedures which allow potential counterparties to negotiate the

terms and conditions of certain complex and large size option orders

prior to the time such orders are brought down to the trading floor.

Under CBOE Rule 6.9, a member or member organization representing an

order for an option traded on CBOE (``original order''), including

spread, combination, straddle, or stock-option orders, may solicit a

member, member organization, customer, or broker-dealer to transact

in person or by order (``solicited order'') with the original order.

The priority of the solicited order is dependent upon the degree of

disclosure of the original order to the trading crowd and upon

whether the solicited order improves the market price.

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[[Page 31198]]

The success of the block trading procedures described above is

dependent upon the particular market structure of the securities

industry. As noted above, the specialist plays an extremely important

role in managing the entire process. Moreover, the trading crowd for a

particular stock may be substantially smaller than the floor population

surrounding a designated contract market. Over the years, as well as in

response to the Commission's Concept Release, certain market

participants have suggested that the open and competitive execution

requirement be relaxed to permit block trading procedures similar to

those found in the securities industry. These commenters assert that

such procedures can be adopted by contract markets with minimal adverse

effects on market volume, liquidity, transparency, or customer

protection. However, given the significant differences in market

structure that exist between the securities and futures markets, it is

questionable whether securities block trading procedures could be

easily transferred to contract markets. Although the supporting comment

letters generally urged the Commission to allow block trading

procedures, they did not specify how these procedures should be

implemented, whether the specialist's role should be replicated on the

futures side, or the extent to which the trading crowd should be

allowed to participate in a block transaction.

III. The Commission's Approach to Alternative Execution Procedures

Given the lack of consensus among the commenters responding to the

Concept Release and among industry participants regarding the

appropriate terms and conditions which should govern alternative

execution procedures for large size or other types of orders, the

Commission has decided to evaluate such procedures on a case-by-case

basis. Under this approach, each contract market would, of course,

retain the discretion whether to permit alternative execution

procedures. Additionally, each contract market would have the ability

to develop procedures that reflect the particular characteristics and

needs of its individual markets and market participants. For example, a

contract market might decide to employ different execution procedures

for each of the individual contracts for which it is designated.

The Commission will consider proposals from contract markets to

permit alternative execution procedures. The Commission encourages

contract markets to solicit the input of, and coordinate with, various

interested parties in the development of such execution procedures for

large orders, including its membership, futures commission merchants,

end-users, and industry associations. The Commission also notes that

the ideas discussed in and the specific questions asked by the Concept

Release provide general guidance as to the various issues that should

be addressed by a contract market seeking Commission approval of

particular alternative execution procedures. For example, a contract

market should discuss the impact of its proposal on the usefulness of

the contract market as a vehicle for price discovery and risk transfer,

whether its proposal represents the least anticompetitive means of

achieving its objective,\14\ whether the proposed transactions fulfill

some need of market participants that traditional open outcry cannot

fulfill as well, and whether the transaction are structured in such a

way as to complement the competitive market.

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\14\ See section 15 of the Act.

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Based on its experience in reviewing contract market proposals for

alternative execution procedures, the Commission will determine whether

any further Commission action is appropriate. As stated above, the

Commission remains open to further written comments on the various

topics surrounding potential alternative execution procedures.

Moreover, Commission staff stands ready to discuss these issues with

industry representatives.

Issued in Washington, DC on June 4, 1999.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 99-14713 Filed 6-9-99; 8:45 am]

BILLING CODE 6351-01-M