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Saturday, August 29, 2020 - Amended Interpretive Notice - Compliance Rule 2-13: Break-Even Analysis. An explanation of the amended interpretive notice can be found in the August 29, 2019 rule submission letter.
Saturday, August 29, 2020 - Amended Interpretive Notice - Compliance Rule 2-34 - CTA Performance Reporting and Disclosures. An explanation of the amended interpretive notice can be found in the August 29, 2019 rule submission letter.
9029 - NFA COMPLIANCE RULE 2-10: THE ALLOCATION OF BUNCHED ORDERS FOR MULTIPLE ACCOUNTS
(Board of Directors, June 9, 1997; revised September 15, 2003, March 21, 2014 and March 1, 2020)
INTERPRETIVE NOTICENFA Compliance Rule 2-10 adopts by reference CFTC Regulation 1.35, which, among other things, imposes on futures commission merchants (FCMs) and introducing brokers (IBs) recordkeeping requirements for customer orders in commodity interests. The purpose of the regulation is to prevent various forms of customer abuse, such as the fraudulent allocation of trades, by providing an adequate audit trail that allows customer orders to be tracked at every step of the order processing system. In general, Regulation 1.35 provides that FCMs and IBs receiving a customer order that cannot immediately be entered into a trade matching engine must prepare a written record of the order immediately upon receipt, including an appropriate account identifier.
With respect to bunched orders placed by an account manager on behalf of multiple clients, the CFTC has interpreted Regulation 1.35 to require that, at or before the time the order is placed, the account manager must provide the FCM with information that identified the accounts included in the bunched order and specified the number of contracts to be allotted to each account.1 CFTC Regulation 1.35(b)(5) provides an exception to this requirement that allows certain account managers, including registered commodity trading advisors (CTAs), FCMs and IBs that have been granted discretionary trading authority in writing (collectively, "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").
Both the Eligible Account Managers that take advantage of post-execution allocation procedures2 and the IBs that execute or the FCMs that execute or clear these transactions must satisfy several requirements set forth in CFTC Regulation 1.35(b)(5). Among other things, this regulation requires that 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 Eligible Account Managers bear the responsibility for the fair and equitable allocation of bunched orders. Eligible Account Managers are also required to receive written investment discretion, adhere to record retention requirements and make certain information regarding the allocation method available to customers upon request. FCMs that execute or clear orders eligible for post execution allocation and IBs that execute orders eligible for post execution allocation must maintain records that identify each order subject to post execution allocation and the accounts to which contracts executed for such order are allocated. Additionally, FCMs and IBs are prohibited by CFTC Regulation 155.3 and 155.4 from including proprietary trades in a bunched order with customer trades.
This Notice sets out certain core principles that govern all allocation methodologies and the respective responsibilities of Eligible Account Managers, as well as the FCMs or IBs that execute or carry the accounts of the Eligible Account Managers' clients. The Notice also describes certain methodologies that generally meet these core principles. Although these methodologies were developed to assure compliance with the requirement that allocation instructions be provided at or before the time a bunched order is placed, they also apply to post-execution allocation procedures.
Core Principles and Responsibilities
Allocation instructions for trades made through 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 bunched order. For some Eligible Account Managers, 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, an Eligible Account Manager may place a 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 that executes the trade 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 and are fair and equitable over time, such that no account or group of accounts receive consistently favorable or unfavorable treatment;3
- sufficiently objective and specific to permit independent verification of the fairness of the allocations over time and that the allocation methodology was followed for any particular bunched order; and
- timely, in that the Eligible Account Manager must provide the allocation information to FCMs that execute or clear the trade as soon as practicable after the order is filled and, in any event, sufficiently before the end of the trading day to ensure that clearing records identify the ultimate customer for each trade.
As noted above, the responsibility for allocating contracts executed through a bunched order rests solely with the Eligible Account Manager.4 The Eligible Account Manager must confirm, on a daily basis, that all its accounts have the correct allocation of contracts. An Eligible Account Manager must also analyze each trading program at least once a quarter to ensure that the allocation method has been fair and equitable (i.e., customers in the same trading program achieve similar allocation results over time). This quarterly review is also required for Eligible Account Managers that do not offer trading programs but routinely execute bunched orders on behalf of the same group of accounts (for example, an IB that maintains discretion over a group of customers who routinely trade in the same contracts and the IB bunches these orders together upon execution). Allocation fairness over time, rather than trade-by-trade, is the critical element in this evaluation. If materially divergent performance results exist over time among accounts in the same trading program, such results must be shown to be attributable to factors other than the Eligible Account Manager's trade allocation procedures. Applicable CFTC and NFA interpretations have addressed permitted reasons for divergent performance results among accounts in the same trading program. If those results indicate that the allocation method has not been fair and equitable over time, however, then the Eligible Account Manager must revise its allocation methodology or adopt a different allocation method for application on a prospective basis only. An Eligible Account Manager must document its internal audit procedures and results in writing and maintain these audit procedures and results as firm records subject to review during an NFA examination.
Examples of Allocation Methodologies
The following are examples of procedures for the allocation of split and partial fills that generally satisfy the core principles described above. These methodologies are the most common that NFA has observed in performing examinations. However, they are not the exclusive means of achieving compliance with Regulation 1.35(b)(5). The appropriateness of any particular method, of course, will depend on the Eligible Account Manager's trading strategy.5
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 fills, firms may have internal programs which calculate the average price for each bunched order. The program will then assign the average price to each allocated contract. In the alternative, the program will 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.
In certain instances, a bunched order may be filled at multiple prices and allocated to participating accounts at an average price. The average price of a bunched order allocation may be rounded up for a buy order (or down for a sell order) to the next price increment supported by the relevant clearing and accounting systems, provided that the residual created by the rounding process is paid to the customer. For example, if a buy order with an average price of $1.98 in a market with a tick increment of $.05 is rounded up to the nearest tick (e.g., $2.00) and a sell order with an average price of $1.98 is rounded down to the nearest tick (i.e., $1.95), a cash residual of $.02 for the buy orders and $.03 for the sell orders must be distributed to the participating customers. An average pricing system may produce prices that do not conform to whole cent increments. In such cases, any amounts less than one cent need not be distributed to the customer. NFA's Business Conduct Committee and Hearing Panels have found that failing to properly allocate cash residuals to customers can constitute a violation of NFA Rules.
FCM and IB Responsibilities
Although the Eligible Account Manager is responsible for the allocation of each bunched order, the IB that executes or FCM that executes or clears the trade has certain obligations as well. In particular, each IB that executes or FCM that executes or clears the trade must receive from an Eligible Account Manager sufficient information to allow it to perform its functions. For executing FCMs or IBs in a give-up arrangement, this includes, at a minimum, information that identifies the Eligible Account Manager at the time the order is placed and instructions, which the FCM or IB 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.6
Regulation 1.35(b)(5) requires each IB that executes or 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 or IB can meet this recordkeeping requirement is to maintain a copy of the allocation instructions provided by the Eligible Account Manager by facsimile, e-mail, or other form of electronic transmission. If the allocation is provided orally, however, the FCM or IB must create and maintain a written record.
Also, if the FCM or IB has actual or constructive notice that allocations for its customers may be fraudulent, the FCM or IB must take appropriate action. For example, if an FCM or IB has notice of unusual allocation activity, the FCM or IB must make a reasonable inquiry into the matter and, if appropriate, refer the matter to the proper regulatory authorities (e.g., the CFTC, NFA or the FCM's DSRO). Whether an FCM or IB 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 or IB. An FCM that both executes and clears an entire bunched order will possess more information than an IB that executes or an FCM that executes or clears only a portion of an order. Where there are multiple FCMs executing and clearing the bunched order or IBs involved in execution, some FCMs or IBs may have more information available than others, and it is likely that no single FCM or IB 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 or IB may not possess adequate information to evaluate the allocation activity. However, if the FCM or IB has actual or constructive notice that the allocations may be fraudulent, the FCM or IB must take appropriate action.
If any Member has questions concerning how this Interpretive Notice would apply to its operations, please contact NFA's Compliance Department.
1Consistent with the provisions of CFTC Regulation 1.35(b)(5), Eligible Account Managers that place orders for a single account must still provide account identification information at the time of order entry.
2Although this Interpretive Notice addresses the allocation of bunched futures or cleared swaps orders, an Eligible Account Manager that executes a bilateral swap transaction for post-execution allocation to individual clients must comply with the applicable sections of CFTC Regulation 1.35(b)(5) and is subject to discipline under NFA Compliance Rule 2-10 for failure to do so.
3Because customers must have access to information that allows them to assess the fairness of the allocation process, Eligible Account Managersare required to make the following information available to customers upon request: (1) the general nature of the Eligible Account Manager'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 Eligible Account Manager has an interest.
4However, 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 Eligible Account Manager. For example, the Eligible Account Manager and FCM that executes or clears the trade may agree that the FCM that executes or clears the trade will allocate a bunched order in accordance with instructions that the Eligible Account Manager files with the FCM that executes or clears the trade either prior to or concurrently with placing the bunched order. Any division of responsibilities agreed to by the FCM that executes or clears the trade and Eligible Account Manager should be clearly documented.
5For example, certain allocation methodologies may satisfy the general standards for Eligible Account Managers who trade on a daily basis but be inappropriate for Eligible Account Managers who trade less frequently.
6As noted, an Eligible 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.