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(resubmitted to read as follows)
CFTC Regulation 1.35, which NFA Compliance Rule 2-10 adopts by reference, 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 which allows customer orders to be tracked at every step of the order processing system. 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 orders, CFTC Regulation 1.35 has been interpreted to require that, at or before the time the order is placed, the FCM must be provided with information which identifies the accounts included in the block order and which specifies the number of contracts to be allotted to each account. 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 prefiling with the FCM standing instructions which contain all of the necessary information.
For a limited number of larger and more sophisticated CTAs, however, prefiling 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:
- prefiling of instructions for identification of accounts included in block orders and the allocation of executed block orders to accounts; and
- 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.
PREFILING OF ALLOCATION INSTRUCTIONS
Allocation instructions for trades made through block 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 order. The second involves the allocation of split or partial fills. For example, a CTA may place a block 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 govern 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:
- designed to meet the overriding regulatory objective that allocations are non-preferential,
such that no account or group of accounts receive consistently favorable or unfavorable treatment;
- sufficiently objective and specific that the appropriate allocation for any given trade can
be verified in any audit by NFA, an exchange DSRO, the CFTC or the FCM's and CTA's own
- consistently applied by the Member firm.
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 generally satisfy the standards stated above.
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 two 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 and Quantity
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 order and allocate the actual fill prices among the accounts included in the order to approximate, as closely as possible, the average fill price. 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 prefiling a set of instructions. If the prefiled 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 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 prefiled 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:
- the CTA will begin the transmission to the FCM of the allocation breakdown contemporaneously with the placement of the order and will maintain appropriate documentation regarding any delays experienced in such transmission;
- prior to the placement of an order, the CTA has also generated a non-preferential allocation breakdown 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;
- 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;
- 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;
- on a daily basis, these CTAs confirm that all their accounts have the correct allocation of contracts; and
- 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 prefiling 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.