Text only of letters sent from the Commerce Committee Democrats. |
August 3, 2000
The Honorable William J. Rainer
Chairman
Commodities Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington, D.C. 20581
The Honorable Arthur Levitt
Chairman
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20515
Dear Chairmen Rainer and Levitt:
We are writing with respect to recent press reports regarding alleged illegal frontrunning of customer orders or other unscrupulous trading activities on the Chicago Mercantile Exchange (CME) (see Kristina Zurla, "CME to Make Sweeping Changes to Volatile Nasdaq Contract Aug. 1," Bridge News, July 13, 2000; Mary Haffenberg, Jamie LaReau, and Kristina Zurla, "CME Rumors Escalate of Nasdaq Front-Running Buzzer Scam," Bridge News, July 24, 2000; and Melissa Allison, "Allegations of Improprieties Could Hinder MERC’s Future," Chicago Tribune, July 26, 2000).
According to these press reports, traders at the CME Nasdaq 100 stock index futures pit may have illegally front-run customer orders by using a system of vibrating pagers in their pockets to alert them to large impending institutional buy or sell orders. According to these reports, this information would then allow the trader to enter the market ahead of the institutional order in order to profit from the inside information they had about the impending order. These same press reports suggest that inquiries may have begun into these frontrunning activities as well as other unspecified allegations of fraudulent or unscrupulous trading practices.
Press reports further indicate that the CME sent a July 12, 2000 memorandum to its members which "outlined the permissible uses of pagers at the exchange," and that a July 13, 2000 letter was sent to CME members regarding changes that the exchange intends to implement in the Nasdaq pit "to ensure the orderly functioning of that market." These include increased use of video surveillance, limits on the questionable practice of dual trading, and assigning a CME Market Regulation and Trading Floor Operations staffer to serve as Vice Chairman of the Nasdaq Futures Pit Committee. Speculation is rampant that the CME ordered these changes in response to evidence of improper use of pagers at the Nasdaq futures trading pit, dual trading, and possibly other abuses that necessitated the intervention of the exchange.
These press reports, if true, raise deeply disturbing questions about possible fraud and manipulation of the Nasdaq 100 stock index futures contact, which could affect investor confidence in not only the market for this stock index future, but also the underlying Nasdaq stock market on which so many of the stocks in today’s high technology companies are being traded. A decade ago, an earlier wave of trading abuses in the commodities markets led to an FBI sting operation on the trading floors.
Congress is poised to repeal the current ban on trading of single-stock futures, which was enacted by Congress in 1982 to implement the terms of the Shad-Johnson accord. At the same time, Congress is considering adoption of a series of exclusions and exemptions from the commodities laws that may not provide adequate assurance that investors in such exempted or excluded products receive sufficient protections against fraudulent or manipulative activities. This could result in no regulator having sufficient authority to protect investors against frontrunning or other abuses.
As part of our ongoing legislative and oversight activities regarding securities and exchanges, in general and relating to this legislation, and in order to better understand the facts and circumstances surrounding the reported CME trading abuses, we hereby request your assistance and cooperation in responding to the attached questions. We request that a response to this inquiry be provided no later than the close of business on Thursday, August 31, 2000. Should you have any questions about this request, please have your staff contact Ms. Consuela Washington, (Minority Staff) at 202-225-3641, Mr. Alex Beckles (Rep. Towns) at 202-225-5936, or Mr. Jeffrey Duncan (Rep. Markey) at 202-225-2836. We look forward to reviewing your answers.
Sincerely,
| JOHN D. DINGELL RANKING MEMBER COMMITTEE ON COMMERCE |
EDOLPHUS TOWNS RANKING MEMBER SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS |
EDWARD J. MARKEY RANKING MEMBER SUBCOMMITTEE ON TELECOMMUNICATIONS, TRADE, AND CONSUMER PROTECTION |
cc: The Honorable Tom Bliley, Chairman
Committee on Commerce
The Honorable Michael G. Oxley, Chairman
Subcommittee on Finance and Hazardous Materials
The Honorable W.J. "Billy" Tauzin, Chairman
Subcommittee on Telecommunications, Trade, and
Consumer Protection
1. Please describe the laws and regulations which your agency, and the markets it regulates, apply with respect to the practice of frontrunning customer orders, including intermarket frontrunning. Over the last five years, how many enforcement actions have been brought against frontrunning at the CME and the CBOT, and what penalties have been imposed? How do these compare to the penalties imposed for frontrunning in the stock and options markets?
2. Please describe the surveillance systems, books and records requirements, and audit trails which your agency, and the markets it oversees, employ to detect such potential frontrunning abuses and support enforcement of anti-frontrunning prohibitions.
3. Please describe the facts and circumstances surrounding the alleged frontrunning on the CME.
4. A July 12, 2000 memorandum to CME members from the CME’s Managing Director for Regulatory Affairs states that "several questions have recently arisen regarding the permissible uses of the Trader Alert Beeper System (TABS) and other forms of person-to-person communication devices on the trading floors of the Exchange." This memorandum notes that "use of unauthorized communication equipment on the trading floors is prohibited and constitutes a violation of Exchange rules." Please describe the precise nature of the "questions" which have arisen regarding use of buzzers on the CME floor. Has unauthorized use of buzzers been occurring? If so, what actions are being taken with respect to those responsible?
5. A July 13, 2000 memorandum from the CME Chairman and the President and CEO states that beginning on August 1, the CME would "retain specific Video Trade Resolution System (VTRS) logging information indefinitely for regulatory and investigative purposes. Additionally, the Division will have authority to utilize both the VTRS and video surveillance cameras without obtaining prior approval of the President." Why weren’t these records already being retained for regulatory and investigative purposes, and why was it that prior approval from the President of the CME had previously been required to utilize these videos for investigative or surveillance purposes? What "logging information" is going to be retained under the CME proposal? Does this include the actual videos themselves? If not, what value does this logging information have from a regulatory or investigative standpoint?
6. Please provide a chronology stating when and how the CME, your respective agencies, and the Nasdaq learned of the trading activities described in the aforementioned press articles. Why was the SEC apparently not informed of any CME investigation into this matter prior to the time that our staffs contacted them to request information regarding the matters described in the aforementioned press reports? What does this say about the desirability of perpetuating a bifurcated regulatory scheme for futures based on securities?
7. What coordinated surveillance procedures exist today between the CME and the primary markets that trade the stocks underlying stock index futures products such as the Nasdaq 100 future? Are these procedures adequate?
8. Would improved futures exchange audit trails help deter and detect frontrunning? Isn't it critical to have a real-time audit trail to capture this type of behavior, like the types of audit trails in the securities markets? Why should we allow stock futures without these types of audit trails?
9. What procedures should be in place to detect and deter frontrunning schemes, such as that described in the aforementioned press articles, if stock futures are permitted?
10. Would the SEC have the ability to ensure such procedures are in place for stock futures under: (1) H.R 4541, as reported by the Commerce Committee; and, (2) H.R. 4541, as reported by the Agriculture Committee?
11. Does this behavior demonstrate the necessity of coordinated surveillance and oversight of stocks and stock derivative products? Would the need for coordinate surveillance overseen by a single regulatory authority be heightened by single stock futures?
12. Please describe how the SEC and CFTC coordinate surveillance and prosecution of fraud and manipulation involving stock-index based futures. Would those efforts be adequate if stock futures were permitted?
13. Would the SEC and the CFTC need additional funds to adequately perform the additional tasks imposed upon it by H.R. 4541?
14. Does the trading of stock index futures, such as the Nasdaq 100 futures contract, serve a price discovery function for the stock market? If so, do frontrunning schemes such as those described in the aforementioned press articles constitute a form of manipulation that could impact stock prices? Further, would the potential stock price impact caused by such schemes be more likely if employed with single stock futures?
15. The CME situation reportedly involved an index future, where the material non-public information involves a large futures trade. With single stock futures, material non-public information about a futures order as well as information about an order in the underlying stock can be used to frontrun with futures. If single stock futures were permitted, what effect would frontrunning involving futures have on the integrity of the underlying securities markets? In fact, wouldn’t single stock futures magnify the potential for this type of frontrunning?
16. If the alleged frontrunning scheme described in the aforementioned articles were carried out using single stock futures (under the regulatory structure permitted by H.R. 4541, as reported by the Agriculture Committee), would the SEC have the ability to ensure that futures exchanges have in place adequate surveillance and investigation procedures to police such manipulative activity? What about under H.R. 4541, as reported by the Commerce Committee?
17. Does the highly leveraged nature of stock index futures make it easy (at least compared to stocks and stock options) for manipulators to effect schemes such as that described in the aforementioned press articles? Would the answer be the same for single stock futures?
18. What is the impact of low stock index futures margin requirements on the ability to profit from a frontrunning scenario like this? If stock index futures margin requirements were equivalent to stock index options (premium plus 15%), would the ability to profit from this behavior be drastically reduced? Would low margins for single stock futures heighten the potential to profit from a frontrunning scheme? Please provide us with your opinion on the effect of high leverage on the ability to engage in frontrunning.
19. The aforementioned press reports indicate that the CME now plans to prohibit the practice of "dual trading" during the first and last hour of the trading day, and that the allowable percentage of personal trading by brokers throughout the day will be decreased to 10% from 15%? Are these reports accurate? If so, please explain why stricter restrictions – or a complete prohibition – on dual trading were not in place previously. Do you believe the proposed restrictions are adequate, or should more be done? Why, for example, should dual trading be barred in the first and last hour of the trading day, but then permitted at other times? How do the current and proposed dual-trading restrictions compare to the dual-trading restrictions contained in the Commerce Committee and Agriculture Committee versions of H.R. 4541?
20. The July 13, 2000 CME memorandum states that as of August 1, 2000, "quantity restrictions on GLOBEX®2 for the E-mini Nasdaq 100 futures contracts will be eliminated." One of the aforementioned press articles indicates that, while the CME was lifting current restrictions on the number of Nasdaq 100 futures contracts that can be traded via computer, similar restrictions were not being lifted with respect to certain S&P index futures contracts. The article goes on to suggest that while investors might benefit from a move to electronic trading, opposition from floor traders and technological capacity issues were preventing or delaying such a change. What capacity issues surround the trading of stock index futures? How are the futures exchanges planning and preparing for increases in capacity needs? Are these plans adequate? How would these plans be affected by allowing for the trading of single stock futures? How would they be affected by the decimal trading requirement contained in the Commerce Committee version of H.R. 4541? What oversight role should the SEC and CFTC have to assure that timely capacity upgrades are made in trading and information dissemination systems to assure that any market for single stock futures or stock index futures keep pace with demand?