To All Members and Member Firms:
Less than two months ago, Enron Corp.'s electronic trading platform was the largest of its kind in the world, accounting for a quarter of all the natural gas and electricity delivered in the U.S. Today, that system is shut down, and its guarantee is in question.
In light of the Enron debacle, many member firms have expressed interest in learning more about the CBOT®'s self-regulatory programs that serve to protect members, member firms and the integrity of the Exchange's markets.
We believe customers continue to use our markets because of the CBOT®'s integrity, liquidity and flexibility, and because of the AAA-rated Board of Trade Clearing Corporation (BOTCC), which guarantees all trades. Integrity at the CBOT® means we stand for timely information, open communication and market transparency, plus that AAA guarantee, which is a uniquely important asset in today's environment. We are committed to open, fair and transparent markets, with immediate reporting of all trades that are competitively executed.
The CBOT®'s self-regulatory programs are one of the cornerstones of the Exchange. The CBOT® has been in this business for over 154 years, and our market surveillance systems are unsurpassed. Our Office of Investigations and Audits' (OIA) financial surveillance, contract surveillance, audit trail supervision, and trade practice surveillance serve to ensure compliance with virtually all of the Commodity Exchange Act's Core Principles for Contract Markets. These principles include monitoring of trading; providing a competitive, open, and efficient market; enforcement of speculative position limits; recording and safe storage of trade information in order to assist in the prevention of customer and market abuses; ensuring the financial integrity of futures commission merchants and the protection of customer funds; and protection of market participants from abusive trade practices.
These programs make it possible for the CBOT® to maintain the integrity that draws individual and institutional customers to our markets. The financial surveillance programs continuously monitor the financial condition of member firms and their ability to comply with their obligations to customers. The contract surveillance programs are designed to ensure that prices are not distorted and that contracts expire in an orderly manner. The integrity of the data input into the CBOT®'s audit trail system is maintained through OIA's regulatory reporting function. In turn, the trade practice surveillance programs rely upon the audit trail to conduct regular surveillance, and to investigate customer and member complaints, to detect and deter trade practice abuses.
All of these programs together contribute to the CBOT®'s international reputation as an institution that protects its markets from manipulation and its market participants from abusive practices. For these reasons and with the three major factors of integrity, liquidity and flexibility that customers find every day in our markets, we have no doubt that customers will continue to place their business at the Chicago Board of Trade.
Attached is more information on the CBOT®'s self-regulatory programs outlined above. If you have any questions about them, please call Dean Payton, Vice President, OIA, Investigations and Market Surveillance Departments, at 312-435-3658, or Barbara Lorenzen, Vice President, OIA, Financial Surveillance and Audits Department, at 312-435-3683.
Sincerely,
Nickolas J. Neubauer
CBOT® Chairman
David J. Vitale
CBOT® President & CEO
Attachment below:
Financial Surveillance
Monthly Financial Reporting: Exchange member firms are required to submit monthly financial information to OIA. The majority of our firms submit a full 1-FR or Focus II electronically through WinJammer. The statements are then immediately analyzed by STAR (Statement Tracking Analysis and Review). The STAR system immediately alerts OIA's Financial Surveillance and Audits' (FSA) department's management, via e-mail, of significant financial concerns and the FSA department management takes appropriate follow-up action. The FSA department staff then completes a thorough analysis of the financial statements focusing on accurate reporting and unfavorable financial trends.
Yearly Examinations: OIA conducts a yearly examination for each member firm for which the CBOT® is the Designated Self-Regulatory Organization. These examinations use a "risk based" approach to ensure the FSA department's staff resources are most effectively utilized. For example, retail based firms will most likely have their margin collection procedures reviewed each year, whereas a firm that carries primarily institutional accounts and that has a strong compliance history, will have less emphasis placed on margin testing. The FSA department also monitors the results of firms that are audited by the CME or NYMEX. Additionally, through the Joint Audit Committee, the department is the liaison to all the other domestic exchanges with regard to financial-related matters of joint member firms.
Pay Collect Analysis: On a daily basis OIA reviews a report of each firm's settlement combined for all clearinghouses. The purpose of the pay collect review is to identify any firm that has a large pay in comparison to the firm's capital. If the daily pay meets the FSA department's criteria, OIA will call the firm to obtain key figures and will calculate a pro forma excess net capital. Additionally, the department will ensure that the firm is not undersegregated or undersecured. The department also questions the firm regarding unsecured debit /deficits and undermargined accounts. Additionally, the management of the FSA department monitors information throughout the day from the Board of Trade Clearing Corporation's near real-time pay/collect system.
Large Trader Analysis: In order to ensure the continuous financial stability of our member firms, the FSA department also monitors individual large traders. Each day a report is generated that calculates the gain or loss of an individual large trader's position based upon the price change from the previous day. An analyst reviews the program identifying individual large trader losses in relation to the clearing member firm's excess net capital. The analyst will also identify firms that have a concentration of large traders that may be experiencing losses. When warranted, a call is made to the firm to obtain information concerning the large trader's equity, current positions and margin requirements and to confirm that the individual was able to meet his financial obligation, if any, to the firm. The importance of early detection of individual losses is significant because if a customer defaults to the firm, the segregated funds pool is at risk as is the firm's own capital.
Market Simulation: When market conditions warrant, the FSA department runs a market simulation, using the large trader system described above. This system can be run in a matter of seconds on any contract or combination of contracts and any price movement can be simulated. If large losses are flagged, the department contacts the clearing member to ask additional questions about the account similar to those asked during routine large trader calls.
Contract Surveillance
Each day, FCMs are required to report the position of any account that is equal to or greater than the reportable position levels established by the Exchange for each contract. OIA staff monitors positions in all markets through the Exchange's Large Trader Reporting System. The system provides staff with immediate access to the identification of all large trader accounts and their positions, as well as the aggregated positions of different accounts under common ownership or control. Analysts use the system to identify concentrations in open interest and to review for compliance with regulations governing matters such as speculative position limits, open interest reporting and omnibus account reporting.
OIA staff continuously monitor conditions in each futures market and the related cash market for indications of possible congestion or other market situations that have the potential to distort prices or otherwise affect the orderly expiration of a contract. In addition to responding to congestion created by natural market conditions, the analysts' monitoring allows the Exchange to anticipate and respond to any attempt to manipulate prices and any other situations that may affect contract performance. In performing this function, OIA staff analyzes cash prices, basis and spread relationships, deliverable supplies, large trader positions, open interest and a variety of other factors. They also routinely contact cash market sources for timely market information and contact large market participants to gather information regarding trading strategies and the nature of positions.
Inspection of Facilities
OIA staff routinely inspects elevators and warehouses that are regular for delivery at the Exchange. The inspections ensure the integrity of the receipt/certificate instruments that are utilized for delivery against the Exchange's agricultural contracts. The staff also reviews all financial statements of regular firms to ensure that they are in sound financial condition.
Audit Trail
The Exchange maintains a precise and complete audit trail for every transaction executed on the Exchange. Included in the array of audit trail information captured for each transaction are, among other things, the order entry time, execution time, account identification, parties to the transaction and customer type indicator. The Exchange's electronic trading system provides detailed information on all order and trade activity to the hundredth of a second. For open outcry trading, the Computerized Trade Reconstruction System uses a sophisticated algorithm to impute an execution time to the nearest second for each transaction. OIA staff conduct regular reviews to ensure the integrity of the data input into these audit trail systems.
Trade Practice Surveillance
In addition to thoroughly investigating all complaints and conducting regular surveillance in the trading pits, OIA staff routinely conducts internal surveillance of the trading activity in all Exchange markets. The Exchange maintains a state-of-the-art surveillance system @ SMART (Sophisticated Market Analysis Research Technology) @ to detect and deter trading abuses in its open outcry markets and has a separate computerized surveillance system that serves the same function for its electronically traded markets.
The SMART system is comprised of five principal modules that include trader profiles, market profiles, pattern detection, anomaly detection and the analyst's workbench. The pattern detection module analyzes all open outcry trading activity at the Exchange each day for transaction patterns that may be indicative of trade practice abuses such as trading ahead of customer orders, matching orders or indirectly taking the other side of orders. Analysts can customize search parameters based upon the contract, individual trading characteristics, market conditions and a variety of other factors, as well as priority rank the system output by assigning different weights to specified parameters. The surveillance system for electronic trading performs similar types of pattern detection tailored to the differences in the electronic market.
The anomaly detection module allows the analyst to identify anomalies in an individual's trading activity @ for example, a 5-lot trader who executes a 50-lot transaction. The workbench module provides the analyst with on-line access to 18 months of trading activity and tools to review, filter or sort the activity in any manner desired; it also performs various other tasks such as sequencing transactions, calculating the profitability of each trade and tracking an individual's positions. The ability to instantaneously analyze and dissect trading activity by individual member, member firm, account, or any of numerous other configurations, helps to efficiently detect trade practice violations.
