|
|
On August 2, 2013, the US Commodity Futures Trading Commission released a Rule Enforcement Review of the Chicago Mercantile Exchange and the Chicago Board of Trade (collectively, "CME") for the period November 1, 2010 through October 31, 2011. In general the CFTC reviewed the exchanges' compliance with core principles related to market surveillance and generally found that the CME's routine market surveillance was adequate.
However the CFTC raised a number of concerns regarding the CME's monitoring of so-called EFRP transactions (Exchange of Futures for Related Positions) that should prompt traders and futures commission merchants to examine how they conduct and oversee ERFP transactions – not just in connection with CME products, but products of other contract markets too.
As background, on the CME EFRP transactions include EFPs (an Exchange of Futures for a corresponding cash market position), EFRs (an Exchange of Futures for a corresponding OTC swap or other OTC derivatives), and EOOs (an exchange of an exchange-trade options position for a corresponding OTC options position or an equivalent OTC contract). Normally EFRPs involve two different but related simultaneous transactions: one party is typically the buyer of the off-exchange market exposure and the seller of the related exchange contract, and the other party –unrelated ordinarily from the first (but there are permitted exceptions) — is typically the seller of the off-exchange market exposure and the buyer of the related exchange contract. The quantity covered by each leg of the related contracts must be approximately equal and there is specified documentation requirements related to such transactions. Clearing members are responsible under CME rules to exercise due diligence regarding the bona fide nature of EFRP transactions processed for their customers. What this means practically, according to the CME, is that,
"a firm that executes and submits an EFRP on behalf of a customer is responsible for exercising due diligence as to the bona fide nature of the EFRP. … A firm that accepts and clears an EFRP that is given-up may be liable for violation of [the relevant rule] if it accepts an EFRP that it knows, or should know, is not bona fide." (CME June 2010 FAQ, A.24.)
Other markets also authorize EFRP transactions and impose similar requirements on clearing members (eg, ICE Futures US Rule 4.06 related to EFRPs).
The starting point for an analysis of EFRP transactions begins with rules adopted by the CFTC that prohibit non-competitive off-exchange trades generally, except (1) for a few types of non-competitive trades – such as EFPs, -- conducted in accordance with exchange rules approved by the CFTC, and (2) that require parties to approved EFP transactions to maintain documentation in connection with such transactions,
"…in accordance with cash market practices which demonstrates the existence and nature of the underlying cash transactions, including but not limited to, contracts, confirmation statements, telex printouts, invoices and warehouse receipts or other documents of title." (CFTC Rule 1.35(a-2)(1).)
Under CFTC rules, contract markets, like the CME, are required to adopt rules that require its members, upon their request, to provide documentation of cash transactions in connection with their customers' EFPs. Independently, members of contracts markets are required, upon the request of a contract market, as well as the CFTC or US Department of Justice, to request documentation supporting EFPs from their customers, and provide them to the requesting organization.
In response, the CME adopted Rule 538, generally covering all aspects of EFRPs, and adopted a FAQ to provide additional guidance on June 11, 2010 (see below link).
According to the CFTC, during the relevant time period, the CME conducted investigations regarding too few EFRP transactions to ensure their validity, specifically only 16 comprehensive reviews in response to 484,218 transactions. As a result, the CFTC found that the CME procedures for monitoring EFRPs were insufficient and that the Exchange had an inadequate program for ensuring that parties to an EFRP transaction maintain required documents to verify that a sufficient sample of EFRPs are legitimate.
As a result, the CFTC stated that the CME needs a more "robust process for verifying clearing firms' compliance with…[EFRP] documentation requirements to ensure that EFRPs are bona fide. At a minimum, this enhancement should including subjecting all clearing firms to a more robust audit process. According to the CFTC,
"Market Surveillance should request documentation for and verify the bona fides of multiple EFRP transactions including all EFRP types…across every product category at least once every calendar year for every carrying clearing member firm that clears EFRPs on the Exchanges." (Emphasis added. CFTC Rule Review P. 69.)
The CFTC suggested that the CME specifically examine,
Where there is potentially problematic conduct, CME should expand its investigation of the relevant clearing member to check for other violations or patterns of violations. This should include:
What does this mean practically for traders? More EFRPs will be reviewed by contract markets. As a result they should review CME Rule 538 and the June 2010 FAQ, as well as equivalent rules and guidance of other contract markets, to ensure that their practices are fully in accordance with applicable requirements.
What does this mean for FCMs? It appears that clearing members likewise will be subject to heightened reviews regarding EFRP transactions they post for their customers. As a result, they too probably should augment or implement internal compliance programs to ensure that all EFRP transactions they post comply with all applicable requirements. Sales and Operations staff that physically handle such transactions should be alerted to indicia that may indicate potential issues with EFRPs and set up a process for consultation with the firm's Compliance Department in such circumstances. Periodically, firm's Compliance or Internal Audit departments should review the firm's compliance with relevant CFTC and contract market rules related to EFRPs.
Among other type of conduct and practices that should be on the radar of traders and clearing members to assess the bona fide nature of EFPs are potential:
All EFRPs must be accurately identified on client confirmation and monthly statements provided to customers. These should be reviewed too.
With heightened oversight of EFP activity looming, it pays to be pro-active.
For more information, see:
CFTC Rule Review of the CME
http://www.cftc.gov/ucm/groups/public/@iodcms/documents/file/rercmecbot072613.pdf
CME Market Regulation Advisory Notice re: EFRPs:
http://www.cmegroup.com/rulebook/files/RA1006-5.pdf
ICE Futures USA Exchange Notice re: New Rule related to EFRPs:
https://www.theice.com/publicdocs/futures_us/exchange_notices/08132012ExnotRule406.pdf
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of August 6, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
|
Social Media: |
September 17, 2014
September 07, 2014
September 04, 2014
Gary DeWaal
Katten Muchin Rosenman
575 Madison Avenue
New York 10022-2585
1 (212) 940-6558
Alphabet Soup Under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs (EFPs, EFRs, and EOOs) Suggests Tougher Times for Traders and FCMs; Time to be Pro-active!
Jump to: Compliance Weeds Between Bridges