Number: 5-01
Date: June 2001
Futures prices are widely quoted and disseminated throughout the U.S. and abroad. Business, agricultural, and financial enterprises use futures markets for pricing information and for hedging against price risk. The goals of the CFTC's market surveillance program are to preserve these economic functions of the futures and option markets under its jurisdiction by monitoring trading activity to detect and prevent manipulation or abusive practices, to keep the Commission informed of significant market developments, to enforce Commission and exchange speculative position limits, and to ensure compliance with Commission reporting requirements.
The Market Surveillance Mission
The primary mission of the market surveillance program is to identify situations that could pose a threat of manipulation and to initiate appropriate preventive actions. Each day, for all active futures and option contract markets, the Commission's market surveillance staff monitors the daily activities of large traders, key price relationships, and relevant supply and demand factors in a continuous review for potential market problems.
Despite the great diversity among the underlying commodities on which futures contracts are based, from a surveillance perspective markets can be grouped according to their settlement provisions.
Physical-delivery commodities. Futures contracts that require the delivery of a physical commodity are most susceptible to manipulation when the deliverable supply on such contracts is small relative to the size of positions held by traders, individually or in related groups, as the contract approaches expiration. The more difficult and costly it is to augment deliverable supplies within the time constraints of the expiring futures contract's delivery terms, the more susceptible to manipulation the contract becomes.
Pertinent surveillance questions for such markets include:
An excellent barometer for potential liquidation problems is the basis relationship (i.e., the cash and futures price difference). When the price of the liquidating future is abnormally higher than underlying cash prices or both the futures and underlying cash price are abnormally higher than comparable cash prices, there is ample reason to examine the causes and to assess the motives of traders holding long futures positions.
Financial instruments. Futures contracts that require the delivery of a financial instrument generally are less likely than futures on physical commodities to be subject to manipulation in the form of squeezes. This assertion is based on the premise that the underlying cash markets for financial instruments tend to be deeper, more liquid, more transparent, and more readily arbitraged than physical commodity markets. Nonetheless, certain of the questions specified above still pertain, particularly when the above-stated assumptions do not hold. For example, when the particular financial futures contract provides for a deliverable supply that either is of finite size or is a narrow segment of the broader cash market for the underlying financial instrument, all the questions raised in the prior section on physical commodities would apply.
In addition, price aberrations in the cash market for the underlying financial instrument may provide an indication of (or an opportunity for) an attempted manipulation. Surveillance staff monitor cash prices for the financial instrument specified for delivery on the futures contract in relation to cash prices for non-deliverable instruments that would be close, or identical, substitutes in the cash market. Relatively high prices for deliverable, as compared to nondeliverable, financial instruments may be an indication of an attempt to remove deliverable supplies from the futures market as part of an attempted manipulation. Also, to the extent participants in the markets take positions vastly beyond their financial means or capacity to take delivery or make settlement, this may be a sign of manipulative activity.
Several financial products involve U.S. Treasury or Agency instruments (e.g., bonds or, notes). The Commission surveillance staff, therefore, maintains open lines of communication with, among others, the U.S. Treasury Department, the Federal Reserve Bank of New York, and the Securities and Exchange Commission.
Cash-settled markets. The size of a trader's position at the expiration of a cash-settled futures contract cannot affect the price of that contract because the trader cannot demand or make delivery of the underlying commodity. The surveillance emphasis in cash-settled contracts, therefore, focuses on the integrity of the cash price series used to settle the futures contract. Since manipulation of the cash market can yield a profit in the futures contract, Commission staff monitor futures positions of significant size and are alert for unusual cash market activities on the part of large futures traders, especially in the period of time that the final cash price for futures settlement is determined.
Pertinent surveillance questions for those markets are:
Special concerns related to equity futures. Generally, equities and derivatives markets likely will be closely linked through intermarket arbitrage. Therefore, effective surveillance of equity futures markets requires coordination among the exchanges trading the underlying equities and equity options to address intermarket trading abuses, such as manipulation, frontrunning of customer orders and insider trading.
If the stock index underlying the futures and/or option contract is broad-based in terms of both the number and capitalization of the equities included in the index, intermarket price manipulation and insider trading (regarding information on individual stocks) concerns will be greatly reduced. Narrower indices and single-stock derivatives may require more aggressive surveillance and added protections with respect to misuse of information, especially to the extent that the market is, or acts like, a market in a single security. The Commission cooperates with the Securities and Exchange Commission and encourages intermarket cooperation on surveillance issues.
Sources of Market Information
To accomplish its objectives, the Commission's market surveillance program uses many sources of daily market information. Some of this information is publicly available, including data on the overall supply, demand, and marketing of the underlying commodity; futures, option and cash prices; and data on trading volume and open contracts. Some of the information is highly confidential, including data from exchanges, intermediaries and large traders.
Exchanges report to the Commission the daily positions and transactions of each clearing member. These data are transmitted electronically during the morning after the “as of” date. They show, separately for proprietary and customer accounts, the aggregate position and trading volume of each clearing member in each futures and option contract. These data are useful for quickly identifying the firms that clear the largest buy or sell volumes or hold the biggest positions in a particular market. The clearing member data, however, do not identify the beneficial owners of the positions.
To address this limitation, the Commission has at the heart of its market surveillance system a large-trader reporting system. Under this system, clearing members, futures commission merchants ("FCMs"), and foreign brokers (collectively called “reporting firms”) electronically file daily reports with the Commission. These reports contain the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations. (A list of current Commission reporting levels can be found at the Commission's website.) If, at the daily market close, a reporting firm has a trader with a position at or above the Commission's reporting level in any single futures month or option expiration, it reports that trader's entire position in all futures and options expiration months in that commodity, regardless of size.
Since traders frequently carry futures positions through more than one FCM and since individuals sometimes control or have a financial interest in more than one account, the Commission routinely collects information that enables its surveillance staff to aggregate related accounts. Reporting firms must file a CFTC Form 102 to identify each new account that acquires a reportable position. In addition, once an account reaches a reportable size, the account owner periodically is required to file a more detailed identification report, a CFTC Form 40, to further identify accounts and reveal any relationships that may exist with other accounts or traders.
To obtain more detailed and targeted information, the Commission may issue a “special call,” to a reporting trader or firm. The special call is designed to gain additional information on a participant's trading and delivery activity, and may include the trader's positions and transactions in the underlying commodity.
Regulatory Response When Problems Develop
Surveillance economists prepare weekly summary reports for futures and option contracts that are approaching their critical expiration periods. Regional surveillance supervisors immediately review these reports. Surveillance staff advise the Commission and senior staff of potential problems and significant market developments at weekly surveillance meetings so that they will be prepared to take prompt action when necessary.
The market surveillance process is not conducted exclusively at the CFTC. Surveillance issues are usually handled jointly by the CFTC and the affected exchange. Relevant surveillance information is shared and, when appropriate, corrective actions are coordinated. Potential problem situations are jointly monitored and, if necessary, verbal contacts are made with the brokers or traders who are significant participants in the market in question. These contacts may be for the purpose of asking questions, confirming reported positions, alerting the brokers or traders as to the regulatory concern for the situation, or warning them to conduct their trading responsibly. This “jawboning” activity by the Commission and the exchanges has been quite effective in resolving most potential problems at an early stage.
The Commission customarily gives the exchange the first opportunity to resolve problems in its markets, either informally or through emergency action. If an exchange fails to take actions that the Commission deems appropriate, the Commission has broad emergency powers under which it can order the exchange to take actions specified by the Commission. Such actions could include limiting trading to liquidating transactions, imposing or reducing limits on positions, requiring the liquidation of positions, extending a delivery period, or closing a market. Fortunately, most issues are resolved without the need to use the CFTC's emergency powers. The fact that the CFTC has had to take emergency actions only four times in its history demonstrates its commitment to not intervene in markets unless all other efforts have been unsuccessful.
Enforcement of Position Limits
The surveillance staff also monitors compliance with Commission or exchange speculative-limit rules. (See a separate backgrounder on “Speculative Limits, Hedging, and Aggregation in Commodity Futures and Options” available on the Commission's website.) These rules help prevent traders from accumulating concentrations of contracts of a size sufficient to possibly disrupt a market. To monitor those limits, the market surveillance staff reviews daily large-trader reports for potential violations. Although bona fide hedgers are exempt from speculative limits, Commission staff monitor hedgers' compliance with their exemption levels. Commercial traders that carry futures and option positions in excess of Commission speculative position limit levels are required to submit a monthly statement of cash positions. These statements show the total cash position of each trader, which reflects the amount of the trader's actual physical ownership of each commodity and the amount of the trader's fixed-price purchases and sales for which the trader has a legitimate cash risk. Commission staff compares each trader's cash position to the trader's futures and option positions.
In summary, the Commission has a comprehensive market surveillance program to detect and prevent corruption of the economic functions of the futures and option markets that it oversees.
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