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Opalesque Futures Intelligence

Regulators: Dodd-Frank rulemaking, palladium and platinum and increased enforcement actions by the CFTC.

Friday, October 22, 2010

Extensive Rules in the Works
Two events have opened the way to major rulemaking by the Commodity Futures Trading Commission. One is the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act by US Congress this year. The other is the Flash Crash, as the temporary but extreme market disruption on May 6th came to be known.

"We have dozens of rules to write and our job of regulating and enforcing these markets will be huge," says CFTC Commissioner Bart Chilton. "Congress gave regulators the responsibility to implement the law." Not surprisingly, he and other officials want a larger budget from Congress to pay for additional staff and technology. They complain about not getting more resources.

"We've experienced momentous regulatory reform-the biggest, to be sure, since the New Deal," says Scott O'Malia, another Commissioner.

The changes under the Dodd-Frank Act are extensive but many of the goals are vague, including the central idea of reducing systemic risk. "The essence of Dodd-Frank is the reduction of systemic risk, often cloaked in catchy, quotable terms like 'too big to fail,' 'too interconnected to fail,' and 'dark markets,'" Mr. O'Malia said at a meeting.

To put the notion into practice, he suggested thinking of the worst scenario. "In each rulemaking, I think it is important to ask and answer the following questions, "What is your worst day going to look like and how do we prevent that from happening?" he said.

Other provisions of the new law are focused on specific markets. For instance, the Act prohibits swaps in an agricultural commodity unless there is an exemption. To clarify what this means and develop rules for implementation, the CFTC is holding a meeting about how to define an "agricultural commodity" as well as other issues including what position reports to require for physical commodity swaps.

The Commission is taking public comments on the appropriate regulatory treatment of agricultural swaps.

Record Investigations
At the same time, the agency is clearly on a mission to show that it is an effective enforcer of existing regulation. It announced that its enforcement program filed 57 actions in Fiscal Year 2010 (which runs through September). This is 14% more than enforcement actions in FY 2009 and 42% more than those in FY 2008.

The CFTC got more than $186 million in civil penalties, restitution and disgorgement from defendants in these cases. Commodity pool frauds and retail foreign currency schemes accounted for the most actions (see table). In addition, the Division of Enforcement started an all-time high of 419 new investigations during the year, 66% more than the 251 investigations started in FY 2009.

---------------------------------------------------------------------------------------

Enforcement actions by the CFTC in Fiscal Year 2010

 

Commodity Pools, Hedge Funds, CTAs

15

Foreign Exchange Fraud

14

Trade Practice

11

Financial, Supervision, Compliance

and Recordkeeping

8

Manipulation,  False Reporting

or Concealing Material Facts

6

Fraud By Futures Commission Merchants,

Introducing Brokers and Associated Persons

2

Statutory Disqualification

1

-----------------------------------------------------------------------------------------

This trend of increased disciplinary actions is almost certain to continue. Dodd-Frank expanded the Commission's enforcement authority, which now covers swaps and certain disruptive trading practices. In addition the CFTC was given rulemaking powers for practices not yet identified. Under this authority, certain high-frequency or algorithmic trading practices could be prohibited.

Flash Crash Lessons
Regulators made a significant effort to understand and respond to the May 6th chain reaction that started with a futures contract and spread to multiple markets. A detailed report on the topic is the first step.

"It wasn't that the technology failed; in fact, just the opposite appears to be true," according to Commissioner O'Malia. "The algorithms operated as programmed, and the high frequency traders operated as usual. However, on that day, the market was very nervous over the Greek debt crisis and other bad economic news, just as a large sell order came into the S&P500 E-Mini futures contract, triggering a mass exodus of buy-side liquidity."

He says this was not a one-off event, computer-generated violations are a major regulatory loophole and whoever put the algorithm in motion should be fully liable for the harm it causes to the market and traders.

CFTC Chairman Gary Gensler says the questions to be considered include whether executing brokers have an obligation to enter and exit markets in an orderly manner and whether they should have to adopt certain restrictions such as price or volume limits when executing large orders by use of an algorithm. In addition, there is the issue of increasing the transparency of the full order book in futures markets and what technology to use for this purpose.

Working with the Securities and Exchange Commission, the CFTC is to develop cross-market circuit breakers and other restrictions to slow down falling markets and prevent chain reactions. Speed limits are a possibility.

Palladium and Platinum
Gold and silver-based exchange-traded funds have grown substantially-see Index Tracker. The CFTC granted exemptions that allow options and futures on gold and silver ETFs to be cleared as options on securities and security futures. Similar contracts are expected for other precious metal ETFs.

The Options Clearing Corporation has asked for a rule amendment that would permit options and futures on ETF Securities Ltd.'s Physical Palladium Shares and Physical Platinum Shares, both listed on NYSE Arca. This is the first time there is a request to trade and clear options and futures on palladium or platinum ETFs.

The Commission solicited comments and is examining the distinct characteristics of the palladium and platinum markets as compared to the gold and silver markets.



 
This article was published in Opalesque Futures Intelligence.
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