A) Proposed Amendments to NFA Bylaw 301(i) (additions are underscored and deletions are stricken through):
* * *
MEMBERSHIP AND ASSOCIATION WITH A MEMBER
BYLAW 301. REQUIREMENTS AND RESTRICTIONS.
(i) Name and Address.
(a) Each Member shall at all times register and maintain with the Secretary its correct name and principal address, and the correct name and address of each registered Associate employed by the Member. Except as provided in subsection (b) of this Bylaw, t
The principal address of each Member and the address of each registered Associate currently on file with NFA shall be deemed by NFA the correct address for delivery to the Member or Associate of any written communication, document or notice from NFA. Delivery of any written communication, document or notice shall be complete upon mailing, delivery to a generally recognized overnight courier service or delivery to a messenger service. The failure of a Member to notify NFA of a change in the Member's principal address shall constitute grounds for summary suspension or termination of the NFA membership of such Member by order of the President on seven days' written notice.
(b) Each Member may provide to NFA, and if provided, shall maintain, in the manner required by NFA, one or more email addresses for the purpose of receiving communications, documents or notices from NFA. Unless a different method of delivery is specifically required, NFA may deliver any communication, document or notice to the email address or addresses currently on file. The email address or addresses currently on file shall be deemed by NFA the correct address or addresses for delivery to the Member of the communication, document or notice by email. Delivery of any communication, document or notice by email shall be complete upon sending.
B) Proposed Amendments to NFA Bylaw 1301(b) (additions are underscored and deletions are stricken through):
* * *
DUES AND ASSESSMENTS
BYLAW 1301. SCHEDULE OF DUES AND ASSESSMENTS
(b) FCM Members.
(i) Each FCM Member shall pay to NFA an assessment equal to:
(B) $.03 for each option contract traded on or entered into subject to the rules of a contract market on a per trade basis;
(C) $.04 for each security futures contract, as defined in Section 1a(31) of the Act, traded on a round-turn basis, carried by it in a commodity futures account, carried by it for a customer other than: (1) a person having privileges of membership on a contract market where such contract is entered; or (2) a business affiliate of such FCM that directly or indirectly owns 100 percent of or is owned 100 percent by or has 100 percent ownership in common with such FCM provided such FCM has privileges of membership on the contract market where such contract is entered; or (3) an omnibus account carried for another FCM Member for which assessments are payable to NFA by the other FCM;
(D) $.06 for each commodity futures contract traded on or entered into subject to the rules of a foreign board of trade (other than an option contract) on a round-turn basis;
(E) $.03 for each option contract traded on or entered into subject to the rules of a foreign board of trade on a per trade basis, carried by it for a customer other than on an omnibus account basis for another FCM Member for which assessments are payable to NFA by the other FCM; and
C) Proposed Amendments to NFA Interpretive Notices (additions are underscored and deletions are stricken through):
CFTC Regulation 1.35, which NFA Compliance Rule 2-10 adopts by reference CFTC Regulation 1.35, which, among other things, imposes on FCMs recordkeeping requirements relating to customer orders on futures and options on futures contracts. requires that each FCM receiving a customer order immediately prepare a written record of the order which includes an appropriate account identification. NFA Compliance Rule 2-4 requires CTA Members to provide FCMs with that required information. The purpose of the regulation is to prevent various forms of customer abuse, such as fraudulent allocation of trades, by providing an adequate audit trail that which allows customer orders to be tracked at every step of the order processing system. In general, Regulation 1.35 requires a futures commission merchant ("FCM") receiving a customer order to prepare a written record of the order immediately upon receipt, including an appropriate account identifier. Since this regulation was originally adopted, however, there have been dramatic changes in the way business is done. With the explosive growth of the managed funds business and the increasing use of "give-up" agreements, it is not at all uncommon for some CTAs to place block orders for hundreds of accounts on markets around the world, with orders executed by one or more FCMs and cleared by other FCMs. How the basic requirements of CFTC Regulation 1.35 apply to block orders for multiple accounts ("block or bunched order") has been the source of considerable difficulty and confusion. While this Notice does not attempt to address all of the issues which can arise in this context, it does provide guidance on commonly recurring questions.
With respect to ,
block bunched orders placed by an account manager on behalf of multiple clients, the CFTC had interpreted Regulation 1.35 has been interpreted to require that, at or before the time the order is placed, the account manager FCM must be provide d the FCM with information which that identifie sd the accounts included in the block bunched order and which specifie sd the number of contracts to be allotted to each account.1 2 An exception to this requirement was set forth in Regulation 1.35(a-1)(5), which authorized certain eligible account managers to enter bunched orders for a limited class of eligible clients and to allocate them to individual accounts no later than the end of the day ("post-execution allocation procedures"). In most instances, a CTA can verbally provide all of that information contemporaneously with the placement of the order. Some of the time, however, this is not practical. Verbal transmission of numerous account numbers and allocation information could result in price slippage in filling block market orders. Most CTAs can deal with this problem by pre-filing with the FCM standing instructions which contain all of the necessary information.
How the basic requirements of CFTC Regulation 1.35 applied to bunched orders for multiple accounts had been the source of considerable difficulty and confusion. In June 1997, therefore, NFA published an Interpretive Notice to provide guidance to its Members in complying with these requirements ("1997 Notice"). While this Notice did not attempt to address all of the issues that can arise in this context, it provided guidance on recurring questions.
The CFTC recently adopted an amendment to Regulation 1.35(a-1)(5). This amendment effectively removes the limitations on the account managers that may take advantage of post-execution allocation procedures as well as the limitations on the types of clients on whose behalf the account managers may employ post-execution allocation procedures. In particular, all registered commodity trading advisors ("CTAs") that are Members of NFA may take advantage of the procedures in Regulation 1.35(a-1)(5) for the accounts of all clients who grant written investment discretion to the CTA.
The amendment also clarifies the obligations imposed on account managers that wish to take advantage of these post-execution allocation procedures as well as the FCMs that execute or clear these transactions. Among other things, the rule requires that contracts executed pursuant to bunched orders be allocated in a fair and equitable manner so that no account or group of accounts consistently receives favorable or unfavorable treatment over time. The rule further provides that the account manager bears the responsibility for the fair and equitable allocation of bunched orders, while FCMs retain the responsibility to monitor for unusual allocation activity.
Because all NFA CTA Members may now take advantage of post-execution allocation procedures under Regulation 1.35(a-1)(5), NFA has determined to revise the 1997 Notice. This revised Notice sets out certain core principles that govern all allocation methodologies and the respective responsibilities of CTAs and FCMs that execute or carry the accounts of the CTAs' clients. The Notice then restates certain methodologies described in the 1997 Notice. Although these methodologies were developed to assure compliance with the requirement that a CTA provide allocation instructions at or before the time a bunched order is placed, they also apply to CTAs that elect to use post-execution allocation procedures.
For a limited number of larger and more sophisticated CTAs, however, pre-filing standing instructions may not be practicable either. For these CTAs, although their basic allocation methodology does not change, the specific allocation instructions produced by the methodology may change on a daily basis. For example, a large CTA with a dynamic trading program may regularly change its order size based upon market volatility and historical price data. Certainly, if a CTA changes its order size, then the precise number of contracts allocated to each account within the CTA's trading program will also change. Other factors could cause regular changes to a CTA's order size and/or allocation breakdowns such as the number of accounts which open and close and any additions and withdrawals made in existing accounts. In the above instances, although the specific application of a CTA's allocation methodology to the universe of its accounts may cause allocation adjustments, the allocation methodology itself remains constant. Because the methodology must meet the standards of this Notice, it must be designed to provide non-preferential treatment for all accounts. Though these CTAs could provide the allocation information to their FCMs in advance of each order, this information could disclose their trading strategies, which they are obviously reluctant to do.
In general, then, there are two alternatives to the verbal filing of all account identification data contemporaneously with order placement:
1) pre-filing of instructions for identification of accounts included in block orders and the allocation of executed block orders to accounts; and
2) under the stringent requirements described below, the contemporaneous filing of allocation instructions via electronic transmission.
This Interpretive Notice clarifies how either approach can be implemented consistent with the requirements of CFTC Regulation 1.35.
PRE-FILING OF ALLOCATION INSTRUCTIONS Core Principles and Responsibilities
Allocation instructions for trades made through
block bunched orders for multiple accounts must deal with two separate issues. The first, which arises in all such orders, involves the question of how the total number of contracts should be allocated to the various accounts included in the block bunched order. For some CTAs, this allocation may remain relatively constant. For others, although their basic allocation methodology does not change, the specific allocation instructions produced by the methodology may change on a daily basis.
The second issue involves the allocation of split or partial fills. For example, a CTA may place a
block bunched order of 100 contracts for multiple accounts. In many instances, however, a market order for 100 contracts may be filled at a number of different prices. Similarly, if an order is to be filled at a particular price, the FCM may be able to execute some but not all of the 100 lot order. In either example, the question arises of how the different prices or the contracts in the partial fill should be allocated among the accounts included in the block order.
The same set of core principles governs the procedures to be used in handling both of these issues. Any procedure for the general allocation of trades or the allocation of split and partial fills must be:
Although the CTA is responsible for the allocation of each bunched order, the FCM has certain obligations as well. In particular, each FCM must receive from an account manager sufficient information to allow it to perform its functions. For executing FCMs in a give-up arrangement, this includes, at a minimum, information that identifies the account manager at the time the order is placed and instructions, which the FCM may receive following execution of the order, for the contracts to be given up to each clearing FCM. Information concerning the number of contracts to be allocated to each account included in the bunched order along with instructions for the allocation of split and partial fills among accounts must be provided to the clearing FCM.5
Regulation 1.35(a-1)(5) requires each FCM that executes or carries accounts eligible for post-execution allocation to maintain records that, as applicable, identify each order subject to post-execution allocation and the accounts to which the contracts were allocated. One means by which an FCM can meet this recordkeeping requirement is to maintain a copy of the allocation instructions provided by the account manager by facsimile, e-mail, or other form of electronic transmission. If the allocation is provided orally, however, the FCM must create a written record and maintain that record.
Also, if the FCM has actual or constructive notice that allocations for its customers may be fraudulent, the FCM must take appropriate action. For example, if an FCM has notice of unusual allocation activity, the FCM must make a reasonable inquiry into the matter and, if appropriate, refer the matter to the proper regulatory authorities (e.g., the CFTC or NFA or its DSRO). Whether an FCM has such notice depends upon the particular facts involved.
Obviously, one of the most significant factors is the amount of information available to the FCM. An FCM that both executes and clears an entire bunched order will possess more information than an FCM that executes or clears only a portion of an order. Where there are multiple FCMs executing and clearing the bunched order, some FCMs may have more information available than others, and it is likely that no single FCM would have enough information to determine if there is unusual allocation activity. Likewise, in situations where an investment adviser uses bunched orders for hedging purposes, the FCM may not possess adequate information to evaluate the allocation activity. However, if the FCM has actual or constructive notice that the allocations may be fraudulent, the FCM must take appropriate action.
Examples of Allocation Methodologies
In the 1997 Notice, NFA set out the
In performing audits, we have noted that Members employ a wide variety of methods to allocate split and partial fills, some of which satisfy the standards stated above and some of which do not. The following examples of procedures for the allocation of split and partial fills that generally satisfy the core principles described standards stated above. These methodologies were the most common that NFA observed in performing audits. NFA believes they are still relevant. However, they are not the exclusive means of achieving compliance with Regulation 1.35(a-1)(5). The appropriateness of any particular method, of course, will depend on the CTA's trading strategy.6
Example #1 - Rotation of Accounts
One basic allocation procedure involves a rotation of accounts on a regular cycle, usually daily or weekly, which receive the most favorable fills. For example, if a firm has 100 accounts trading a particular trading program, in the first phase of the cycle, Account #1 receives the best fill, Account #2 the second best, etc. In phase 2 of the cycle, Account #2 receives the best fill and Account #1 moves to the end of the line and receives the least favorable fill.
Example #2 - Random Allocation
Some firms prepare on a daily basis a computer generated random order of accounts and allocate the best price to the first account on the list and the worst to the last. This method would satisfy the standards stated above.
Example #3 - Highest Prices to the Highest Account Numbers
Some firms rank accounts in order of their account numbers and then allocate the highest fill prices to the accounts with the highest account numbers. Any advantage the higher numbered accounts enjoy on the sell order are theoretically offset by the disadvantage on the buy orders. Although under certain market conditions this may not always be true, the method generally complies with the standards.
Example #4 - Average Price
With regard to split
and partial fills, allocations made pursuant to exchange rules which provide for the allocation of average prices and quantities in block orders for multiple accounts would, of course, be acceptable. In addition, certain firms may have internal programs which calculate the average price for each block bunched order. The program will then assign the average price to each allocated contract. In the alternative, the program will and allocate the actual fill prices among the accounts included in the order to approximate, as closely as possible, the average fill price. Either average price allocation method offers a consistent non-preferential method for allocating trades.
These internal programs must specifically satisfy the standards stated above and be documented by the Member firm.
Though the examples cited above are the ones NFA most commonly sees in audits, others may offer comparable treatment. We would also note that the appropriateness of any particular method for allocating split and partial fills depends on the CTA's overall trading approach. For example, a daily rotation of accounts may satisfy the general standards for CTAs who trade on a daily basis but inappropriate for CTAs who trade less frequently. In addition, certain variations of these basic methods would not satisfy those requirements. For example, it would not be acceptable for the CTA to deviate from the regular rotation to accommodate an account whose performance is lagging behind others in the same program. This would inject the CTA's subjective judgment into the process, would render the allocation impossible to duplicate in the audit process and would open the potential for customer abuse.
One related issue which has generated some confusion is whether the responsibility for the allocation of split and partial fills rests with the CTA or with the FCM. The CTA certainly has the sole responsibility for ensuring that the procedures are appropriate in light of its approach to trading. With respect to the actual implementation of the procedures, since the CTA is directing the trading in the accounts, the responsibility for allocating split and partial fills among the accounts should rest with the CTA. However, there is nothing under NFA rules to preclude an FCM from agreeing to undertake this responsibility, whether it clears or executes the trades, pursuant to either its own procedures or to those supplied by the CTA. Any division of responsibilities agreed to by the FCM and CTA should be clearly documented.
There is also a good deal of confusion on how the basic principles of CFTC Regulation 1.35 apply to block orders executed on a "give-up" basis, a process which was essentially unknown when Regulation 1.35 was originally adopted. Subject to exchange rules, in any given block order there may be multiple executing FCMs, multiple clearing FCMs or multiple FCMs serving each of these functions. The exact form of customer identification which the FCM must receive from the CTA under Regulation 1.35 may vary depending on the FCM's role in filling the order. Essentially, each FCM must receive sufficient information to allow it to perform its function. For executing FCMs, this includes, at a minimum, the number of contracts to be given up to each clearing FCM and instructions for allocation of split and partial fills among those FCMs. Information concerning the number of contracts to be allocated to each account included in the block order must be provided to the FCM which will carry out those instructions, which, in most cases, will be the FCM clearing the accounts. All of this information must be provided at or before the time the order is placed and could be provided by pre-filing a set of instructions. If the pre-filed instructions for the general allocation or the allocation of split and partial fills meet the standards set forth in this Notice, then the clerical task of implementing the instructions could be performed by either the FCM or the CTA.
If that clerical function is performed by the CTA, this does not suggest that the FCM is relieved of any further responsibility. The FCM has certain basic duties to its customers, including the duty to supervise its own activities in a way designed to ensure that it treats its customers fairly. Specifically, the FCM would violate this duty if it has actual or constructive notice that allocations for its customers may be fraudulent and fails to take appropriate action. The FCM with such notice must make a reasonable inquiry into the matter and, if appropriate, refer the matter to the proper regulatory authorities (e.g., the CFTC or the NFA or its DSRO). Obviously, whether an FCM has such notice depends upon the information that the FCM has or should have, which, in turn, is based upon the FCM's role in the executing and clearing process. For example, an FCM that both executes and clears an entire block order will possess more information than an FCM that executes or clears only a portion of an order. In order to fulfill its duties, an FCM at any level of the process should implement appropriate compliance measures. For example, an FCM may choose to spot check the allocations made to its customer accounts for conformity with the prefiled instructions it has received from the CTA and/or review the performance of accounts being traded pursuant to the same trading program.
CONTEMPORANEOUS FILING OF INSTRUCTIONS VIA ELECTRONIC TRANSMISSION
Instructions for the allocation of contracts to accounts included in a block order can also be given at the time the CTA places the trade. NFA notes, however, that as a general rule allocation procedures for split and partial fills should be pre-filed with the appropriate FCM. For instructions on the number of contracts to be assigned to each account in the block order, many CTAs simply provide the necessary allocation information by phone when they call in the block order. For certain CTAs, however, providing allocation instructions verbally when the block order is placed may not be a practicable option. These CTAs may have hundreds of accounts included in the block order and providing detailed allocation information by phone may be extremely time consuming. Delaying the execution of the order while that process drags on might ultimately harm customers through market price slippage. For most of these CTAs, the prefiling of instructions provides an adequate alternative. However, for a limited number of CTAs, it may not be practicable to pre-file with the FCM a standing set of allocation instructions. The trading programs used by these CTAs are complex and dynamic. Given the fine tuning adjustments that are made on a daily basis, the exact number of contracts these CTAs allocate to any given account may vary from one day to the next, and may make the prefiling of instructions impracticable.
Under these circumstances, one way the CTA may provide the account identification information required under CFTC Regulation 1.35 would be to send the FCM, by facsimile or other form of electronic transmission, the breakdown of contracts to be assigned to each account included in the block order. The CTA would have to begin to send that information at the time the order is placed. Given the possibility of busy signals, paper jams and other limitations of electronic transmissions, there may be momentary delays in the completion of the transmission. Such delays should be neither commonplace nor lengthy, and the CTA should maintain appropriate documentation whenever such delays occur. When those delays do occur, however, CFTC Regulation 1.35 does not necessarily require the FCM to delay execution of the order until the electronic transmission of the allocation information is completed. To avoid delays in execution due to such transmission difficulties, the CTA must have provided the FCM with a written certification that:
(2) prior to the placement of an order, the CTA has also generated a non-preferential allocation break-down for each order which has been computer time-stamped indicating the date on which the order is to be placed and the date and time the allocation breakdown was printed;
(3) the CTA maintains with either their executing or clearing FCMs a complete list of all accounts traded by the CTA, by trading program if applicable;
(4) if a bunched order does not include all accounts within a particular trading program, then prior to the execution of the order these CTAs will identify for their FCMs the accounts which are included, by account identifier or designation;
(5) on a daily basis, these CTAs confirm that all their accounts have the correct allocation of contracts; and
(6) at least once a month, these CTAs analyze each trading program to ensure that the allocation method has been fair and equitable. If divergent performance results exist over time, then such results must be shown to be attributable to factors other than the CTA's trade allocation or execution procedures. Additionally, a CTA must document its internal audit procedures and the results of its monthly analysis and maintain these audit procedures and results as firm records subject to review during an NFA audit.
An FCM which relies in good faith on the above certification would be deemed to be in compliance with CFTC Regulation 1.35. The CTA must also file a copy of that certification with NFA at least 30 days prior to implementing these procedures. This time period will provide NFA with an opportunity to review and verify the information contained in the certification.
For most block orders, the pre-filing of allocation instructions is the most practicable and preferred course of action. The procedure described herein relating to the contemporaneous filing of instructions via electronic transmission is an alternative available to those relatively few CTAs that can demonstrate a need for this alternative and meet the requirements of the certification. Each CTA availing itself of this alternative must not only adhere to the requirements of this Notice, but also demonstrate on a continuing basis to the appropriate regulator or self-regulator both its need to use this alternative and that the information in the certification is correct. If a CTA utilizes this alternative, it must adhere to this Notice's requirements or may face disciplinary action for its failure to do so.
If any Member has questions concerning how this Interpretive Notice would apply to its operations, please contact NFA's Compliance Department.
(Board of Directors, June 14, 1999)
In August 1998, the CFTC approved certain amendments to Regulation 1.35(a-1) to allow eligible account managers to place orders for a combined group of eligible customers ("block order") on a contract market without specific customer account identification at the time of either order placement or report of execution. These amendments permit orders entered on behalf of these eligible customers to be allocated after execution of the order, in accordance with exchange rules, but no later than the end of the day on which the order is executed. The definitions of eligible customers and eligible account managers are set forth in the rule. NFA Compliance Rule 2-10 adopts by reference CFTC Regulation 1.35, including these recent amendments. Regulation 1.35(a-1)(5)(iv)(B) requires an eligible account manager prior to placing the initial order eligible for post-execution allocation to notify each FCM carrying any part of the order of the identity of each eligible customer account to which fills may be allocated on a post-allocation basis. Eligible account managers may identify these accounts by several methods, for example by providing a list, a notice at the opening of the account, a letter if the determination that the account is eligible is made after the account is opened or by any similar method.
NFA has issued previous Interpretive Notices addressing an FCM's duty to supervise the handling of customer orders in general and, more specifically, the allocation of block orders. With respect to block orders, NFA has stated that the overriding regulatory objective is that allocations be non-preferential, such that no account or group of accounts receive consistently favorable or unfavorable treatment. That same objective applies to "end of day" allocations as well. To that end, an FCM carrying accounts which receive post execution allocations must have compliance procedures in place reasonably designed to ensure that only eligible accounts have received such allocations.
Please be aware that in certain situations a carrying FCM may need to obtain information from other sources to ensure that only eligible accounts receive such allocations. In such situations, a carrying FCM may choose to test on a regular basis a sample of its accounts receiving post execution allocations to ensure that only eligible accounts are included. For example, in "give-up" situations, the carrying FCM may not know which orders were allocated on a post execution basis. In this circumstance, the carrying FCM would be expected to obtain additional information that may be available to perform such a check. This information, which might be obtained from either the exchange or the executing FCM, would vary depending on the type and form of the information available.
In performing these regular checks, there are two important factors - the frequency and scope. Both of these factors will be influenced by how often an exchange or executing FCM is able to make information readily available to perform the check and the form of such information. For example, if an exchange or executing FCM is able to provide a list of accounts receiving post-execution allocations on a monthly basis to a carrying FCM, then it may be appropriate for the carrying FCM to perform its check on a monthly basis. Additionally, with regard to the scope of the check, the carrying FCM should utilize a sample size reasonably designed to ensure that only eligible accounts have received post-execution allocations. In determining this sample size, a carrying FCM should consider several factors, including the number of its eligible accounts receiving post-trade executions and the frequency of trading in these accounts. Please be advised that if an FCM carries only eligible accounts for a particular trading manager, then the fact that all such accounts receive "end of day" allocations imposes no additional supervisory responsibilities upon the FCM.
Any FCM that has actual or constructive notice that post-execution allocations have been made to accounts that have not been previously identified as eligible must make a reasonable inquiry into the matter and, if appropriate, refer to the matter to the proper regulatory authority (e.g., the CFTC, NFA or its DSRO). A carrying FCM's DSRO will review both the frequency and scope of the regular checks performed by the FCM during its annual exam of the FCM's operations. If any Member has questions concerning how this Interpretive Notice would apply to its operations, please contact NFA's Compliance Department.
1 Bunched orders can provide customers with the advantages of better pricing and more efficient execution of orders. With the explosive growth of the managed funds business, the frequency of "give-ups" and the increasing use of electronic order entry systems, it is not at all uncommon for some account managers to place bunched orders for hundreds of accounts on markets around the world, with orders executed by one or more FCMs and cleared by other FCMs.
2 Consistent with the provisions of CFTC Regulation 1.35(a-1)(1), account managers that place orders for a single account must still provide account identification information at the time of order entry.
3 Because customers must have access to information that allows them to assess the fairness of the allocation process, CTAs are required to make the following information available to customers upon request: (1) the general nature of the CTA's allocation methodology; (2) whether accounts in which the CTA may have an interest may be included with customer accounts in bunched orders; and (3) summary or composite data sufficient for that customer to compare its allocation results with the allocation results of other comparable customers and, if applicable, any account in which the account manager has an interest.
4 However, NFA rules do not preclude an FCM from agreeing to undertake this responsibility, whether it clears or executes the trades, pursuant to either its own procedures or to those supplied by the CTA. For example, the CTA and FCM may agree that the FCM will allocate a bunched order in accordance with instructions that the CTA files with the FCM either prior to or concurrently with placing the bunched order. Any division of responsibilities agreed to by the FCM and CTA should be clearly documented.
5 As noted, an account manager must provide all of this information to the appropriate FCM as soon as practicable after the order is filled and sufficiently before the end of the trading day during which the order is executed to ensure that clearing records identify the ultimate customer for each trade.
6 For example, certain allocation methodologies may satisfy the general standards for CTAs who trade on a daily basis but be inappropriate for CTAs who trade less frequently.