Electronic futures trading systems are rapidly being developed and replacing open outcry floor trading systems, challenging global regulators to adopt new rules to protect investors, and to preserve the integrity of the markets while encouraging innovation. On March 24 1999, the US Commodity Futures Trading Commission (CFTC) solicited public comment for its proposed rules to permit the use of automated trading systems in the US that provide access to electronic commodity and financial futures exchanges operating primarily outside the country. Proposed Rule 30.11 would establish a procedure for a non-US electronic board of trade, ie, an exchange to petition the CFTC for an order permitting the use of automated trading systems that provide access to an exchange from within the US, without requiring it comply with the contract market, a lengthy economic and rules approval procedure applicable to a US futures exchange. Instead the CFTC would issue an order under Section 4(c) of the Commodity Exchange Act (CEA) allowing a member of the exchange or the member's affiliate to operate automated trading systems that provide US access through trading screens, the Internet, or other automated trading systems. The CFTC's order would require the exchange to satisfy minimum requirements and provide safeguards such as automated checks for customer trading, or position limits and credit limits.
Requirements for trading futures
Under Section 4(a) of the CEA, a futures contract may be traded lawfully in the US only if it is traded on or subject to the rules of a board of trade that has been direct execution systemignated as a contract market by the CFTC, unless the contract is traded on or subject to the rules of an exchange or market located outside the US or is exempted from the provisions of the CEA. With respect to the regulation of futures contracts traded on non-US exchanges, Section 4(b) of the CEA permits the CFTC to regulate persons who offer such futures contracts from within the US or to US investors, but prohibits the CFTC from adopting any rule or regulation that would require CFTC approval or regulation of any non-US exchange's contract, rules, regulation or action.
Automated trading systems make it possible to use computer terminals within the US to trade futures contracts on non-US exchanges. Systems have been developed that enable US customer orders to be submitted electronically to brokers and then routed for execution on foreign exchanges. The jurisdictional issue which the CFTC has had to address is at what point does a foreign exchange's presence within the US become indistinguishable from that of a US futures exchange, subjecting it to the CFTC's approval procedures and US regulatory authority.
In 1989, the staff of the CFTC issued a letter addressing automated trading in the US by foreign exchanges that involved trading through the Chicago Mercantile Exchange Globex system (Globex). CFTC staff took the view that the trading of contracts of foreign exchanges through Globex terminals in the US did not allow the CFTC to treat any foreign exchange whose products are listed through Globex as the equivalent of a US exchange designation. CFTC staff issued another letter in 1990 to the Marché a Terme International de France (MATIF) confirming that the regulator would not assert jurisdiction over MATIF or MATIF contracts traded on Globex.
In 1996, CFTC staff issued a letter to the Deutsche Terminbörse (DTB), since renamed Eurex Deutschland, permitting the placement in the US of computer terminals for execution of a direct execution system on DTB, without the DTB designated as a contract market. After analyzing, among other things, the German regulatory structure and DTB's order processing network, clearing process and trading system integrity and architecture, CFTC staff issued a letter subject to the following conditions:
DTB terminals must be located only in the US offices of DTB members;
only DTB members that also are US-registered futures commission merchants (FCMs) may trade for customers; non-FCM DTB members are limited to principal-only trading;
DTB members must (a) provide the CFTC and the National Futures Association with access to their books and records and the premises where DTB terminals are installed, and (b) consent to US jurisdiction with respect to compliance with relief provided in the no-action letter;
all DTB members that must operate pursuant to the relief granted must be identified to the CFTC and the National Futures Association;
upon request, DTB (a) must provide the CFTC with information received from its members regarding the location of DTB terminals in the US and (b) must update the information on a periodic basis;
DTB must continue to comply with the International Organization of Securities Commissions' Principles for Oversight of Screen-Based Trading Systems for Derivative Products (IOSCO Principles);
DTB must submit information on at least a quarterly basis reflecting the volume of a direct execution system from US based computer terminals compared to DTB's overall trading volume; and
DTB must provide the CFTC with prompt notice of all material changes to any DTB rules or German laws that may affect the provided relief.
CFTC staff concluded that no public interest would be affected adversely by DTB members having access to DTB terminals in the US, because no customer trading would be permitted from US-based terminals unless the DTB member firm is registered as a futures commission merchant and the CFTC's ability to inspect relevant books and records and the premises where DTB terminals are installed, in combination with information-sharing assurances received from the German Federal Securities Supervisory Office, provided an adequate basis for supervision of such trading.
The initial DTB no-action letter was modified in a 1997 no-action letter to the DTB, in which the CFTC agreed to permit DTB terminals to be placed in DTB member firm booths at the Chicago Merchantile Exchange if the firm was also an exchange member. Only DTB contracts permissible for trading by US persons are eligible to be traded from the terminals. No Chicago Merchantile Exchange contracts may be traded via the terminals and the Exchange may have no involvement in the clearance or settlement of the contracts. Pursuant to the DTB no-action letters, if a DTB member located in the US wishes to install a DTB terminal in its office, the DTB itself must make a written filing to the National Futures Association on behalf of that member, in which the member agrees to specific terms and conditions as required by the CFTC.
New categories of trading systems
Proposed Rule 30.11(a)(1) and (2) distinguishes between two types of automated trading systems, the direct execution and the automated order routing system. Order routing or other devices that are used to enter or to communicate a direct execution system to be executed on traditional open outcry exchanges are not covered by the proposed rule.
Proposed Rule 30.11(a)(1) defines a direct execution system as any system of computers, software or other devices that allows the entry of orders for products traded on an exchange's computer or other automated device where, without substantial human intervention, trade matching or execution takes place, except those systems that satisfy the definition of an automated order routing system. The CFTC does not view an electronic exchange's use of clerical or trivial human actions as involving substantial human intervention, whereas a traditional open outcry system is, in fact, based on substantial human intervention in the trade matching and execution process. The term direct execution system would also include any other device that provides direct execution system access to an exchange's automated matching engine, including computer software that facilitates access via a personal computer or other electronic device, an automated telephonic system that connects the main computer of an exchange primarily operated outside the US for order matching and execution and direct Internet access to the exchange through a personal computer, telephone or similar device.
An automated order routing system is defined as any system of computers, software or other devices that allows entry of orders through another party for transmission to an exchange's computer or other automated device where, without substantial human intervention, trade matching or execution takes place. Entry of orders for an automated order routing system could be via a screen-based or other automated system. A customer who transmits an order to a registered futures commission merchant or a futures broker located outside of the US that has received a Rule 30.10 exemption from the CFTC, alleviating it of the futures commission merchant registration requirement (an exempt merchant), would not be entering an order and the automated order routing system definition would not apply. The requirements concerning an automated order routing system would apply to orders made by a third-party broker for a US customer.
Proposed Rule 30.11 would not permit the customer use of a direct execution system but would allow a customer and its representative to obtain and enter orders via an automated order routing system. A customer order for a futures contract traded on or subject to the rules of an exempt exchange under proposed Rule 30.11 or a linked exchange that is made via an automated order routing system would be required to be made through a registered foreign commission merchant or an exempt merchant.
Petition procedure
Proposed Rule 30.11 establishes a procedure to enable an exchange that primarily is operating outside the US, to file a petition for the issuance of an exemption order to permit access, via a direct execution system or automated order routing system, to US customers without requiring the exchange to be designated as a US contract market. The fact of the filing of the petition will be made public and the CFTC will make available for public inspection non-confidential information set forth in the petition. Proposed Rule 30.11 would require that as a condition to any exemption order an exchange must provide to the CFTC on a quarterly basis, and upon request, the names and main business addresses in the US of exchange members that have a direct execution system in the US, indicating which allow their customers to use an automated order routing system and the names and main business addresses of exchange members that allow their US customers to use an automated order routing system but who do not have a direct execution system in the US. After the CFTC issues an exemption order, any exchange member may immediately accept US customer orders in reliance on the exemption order and any futures commission merchant or exempt merchant may provide US customers with an automated order routing system that provides direct execution system access to the futures products of the exempt exchange provided that the automated order routing system meets certain minimal requirements and safeguards.
The CFTC would be required to determine that:
the off-exchange futures trading prohibition set forth in the Commodity Exchange Act should not apply to the futures contracts traded on the foreign exchange for which the exemption is requested;
the exemption would be consistent with the public interest and the purposes of the Act;
the futures contracts will be entered into solely between specified categories of appropriate persons; and
the exemption will not have a material adverse effect on the ability of the CFTC or any US futures exchange to discharge its regulatory or self-regulatory duties under the Commodity Exchange Act. As a condition to issuing an exemption order under Proposed Rule 30.11, the CFTC must find that:
the petitioner is an established exchange seeking to place within the US an automated trading system permitting access to its products but whose activities are otherwise primarily located in a foreign country that has regulatory responsibility for regulation over the exchange;
the exchange's home country has a regulatory scheme that is generally comparable to that in the US;
except for certain incidental contracts with the US, the exchange is present in the US only by virtue of being accessible from within the US through its automated trading system;
the exchange is willing to submit itself to the jurisdiction of the CFTC and the US courts in connection with its activities conducted under an exemption order;
the exchange's automated trading system has been approved by the petitioner's home country regulator following a review of the system that applied the standards set forth in the IOSCO Principles or substantially similar standards; and
satisfactory information sharing arrangements are in effect between the CFTC, the exchange and the exchange's home regulatory authority.
If an exchange is subject to a regulatory structure in its home jurisdiction that the CFTC finds to be generally comparable to that in the US in terms of protecting customers and the integrity of markets, as well as meeting the IOSCO Principles or similar standards for screen-based trading, and the home regulator monitors and enforces compliance with its regulatory structure, then the CFTC can determine that automated trading by US customers is consistent with the public interest and the purposes of the Commodity Exchange Act. The exchange's home country regulatory regime must be generally comparable to that in the US in providing for prohibition of fraud, abuse and market manipulation relating to trading on the exchange; recordkeeping and reporting by the exchange and exchange members; fitness standards for intermediaries operating on the exchange's markets, its members or others; exchange membership financial standards; protection of customer funds, including procedures in the event of a clearing member's default or insolvency; trade practice standards; rule review or general review of its operations by a regulatory authority; surveillance, compliance, and enforcement mechanisms; and regulatory oversight of clearing facilities. The CFTC could permit any US person who can participate in a futures contract on the exchange to be deemed to be an appropriate person for such automated trading and therefore eligible to participate in the exchange's markets.
The exchange would be required to include the following basic business information:
its main business office and the name, address, telephone number, facsimile number and electronic mail address of a contact person;
its articles of association, constitution, or other similar organizational documents along with the date and place of its establishment;
the name and address of the exchange's home country regulatory; and
a complete description of the futures contracts that initially would be traded through direct execution systems or automated order routing systems located in the US.
The petition must also include a general description of the exchange's automated trading system, including its security features, information as to the length of time the particular system has been operating, a history of significant system failures or interruptions, and any differences from the IOSCO Principles. Proposed Rule 30.11 requires that a petitioning exchange specify the extent to which a technical review of the direct execution system and/or automated order routing system was performed by its home country regulator. The exchange must include a copy of any order or certification received from its home country regulator as a result of such a review.
Two important goals of the CFTC's regulatory scheme are the prevention of fraud and the protection of US customers and their investment funds. The existence of satisfactory information sharing arrangements between the petitioning exchange, its regulator and the CFTC is a prerequisite for an exemptive order. Under such arrangements, there must be an agreement to cooperate with respect to inquiries concerning trading on the exchange that affects US persons or markets. Relevant information includes direct execution system trade confirmation information necessary to trace funds related to trading futures products subject to regulation in the exchange's home country, and information on a firm's standing and financial requirements to do business in the exchange's home country.
Required conditions
Proposed Rule 30.11 requires that exemption orders be subject to the conditions that further the CFTC's goals of protecting US customers and maintaining continuing access to relevant data. The conditions to be included in every exemption order are:
reasonable steps must be enforced to prevent third parties from providing the exchange's direct execution system to other persons;
only a registered futures commission merchant or an exempt merchant may accept orders or margin from US customers;
the exempt exchange must notify the CFTC of (a) material changes, any changes in its rules or in the laws or rules of its home country that may have a material impact on the order; (b) any violation of the CFTC's order; (c) any disciplinary action that involves the use of a direct execution system or an automated order routing system in the US; (d) any new products to be traded through a direct execution system or automated order routing system located in the US; and (e) any significant system failure, interruption or an exchange member's default, insolvency or bankruptcy;
information sharing arrangements must remain in effect;
the exempt exchange must provide to the CFTC a current list that (a) identifies its US members and their affiliates that have direct execution systems and indicates which allow the use of automated order routing systems by US customers; and (b) identifies exchange members and their affiliates that allow the use of automated order routing systems by US customers, but which do not have direct execution systems in the US;
the exchange must appoint an agent for service of process in the US authorized to accept delivery and service of communications from the CFTC, the Department of Justice, any exchange member, or any US customer;
the exchange must submit to the jurisdiction of the CFTC and state and federal courts in the US with respect to its activities conducted under the exemption order; and
the exchange must provide the CFTC with relevant trade volume and commodity warehousing information.
Multiple exchange trading mechanisms
Proposed Rule 30.11 would apply where the products of more than one exchange are traded through a single system. Each exchange whose products are available through US-located automated trading systems would be required to comply with the requirements set out in Proposed Rule 30.11. If two or more exchanges share the same system and each wishes to place direct execution systems in the US for the use of their members, each would be required to receive an exemption order from the Commission before such a placement. If the products of one or more exchanges are available through the direct execution system of another exchange, each exchange whose products would be available in the US through such a direct execution system would be required to receive an exemption order. Each exchange whose products are available through an automated order routing system would have to comply with Rule 30.11 and receive an exemption order before a registered futures commission merchant or exempt merchant could allow its US customers to trade on the exchange via an automated order routing system. Excluded from being required to obtain an exemption order is any non-US exchange whose products are traded through an automated trading system located in the US, pursuant to an electronic trading arrangement with a US futures exchange which has been approved by the CFTC.
Global electronic futures trading must be subject to prudent financial, trading and execution regulations in the home countries of the exchanges, enforceable customer protection and marketing rules in the investors' jurisdictions, and coordinated cross-border market surveillance and antifraud oversight and enforcement. The CFTC's proposal would defer primary oversight responsibility to the foreign regulator that has authority over the petitioning electronic exchange and avoid adopting restrictive US requirements. The proposed exemption procedure, if adopted, should encourage global competition in the futures industry and provide a model for regulators to adopt reciprocal means for permitting cross-border access to automated futures exchanges.