Commodity Exchange Act:

Issues Related to the Regulation of Electronic Trading Systems

GGD-00-99: Published: May 5, 2000. Publicly Released: May 5, 2000.

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Pursuant to a congressional request, GAO reviewed issues related to the regulation of electronic trading systems, focusing on: (1) how technology is being used in the exchange-traded futures market, and what concerns this use raises under the Commodity Exchange Act (CEA); (2) how technology is being used in the over-the-counter (OTC) derivatives market, and what concerns this use raises under the CEA; and (3) what alternatives have been suggested for addressing the concerns raised under the CEA by the use of technology in the exchange-traded futures and OTC derivatives markets.

GAO noted that: (1) automated order routing systems (AORS) have been used for over 10 years to route orders from futures commission merchants (FCM) to and within futures exchanges; (2) AORS can now transmit orders from the customer's computer to FCM's computer, and then to the exchange for execution; (3) to the extent that AORS provide for enhanced trade monitoring and control, more precise trading records, and more direct market access, their use can benefit the exchange-traded futures market and its participants and can reduce some regulatory concerns; (4) nonetheless, according to some futures market participants, the use of AORS without adequate controls can also raise regulatory concerns about the adequacy of system capacity and security as well as opportunities to engage in unauthorized trading; (5) electronic trade-matching systems are being used in place of or in addition to open outcry to execute orders; (6) similar to AORS, electronic trade-matching systems can offer many benefits and reduce some regulatory concerns; (7) electronic trading systems for OTC derivatives more directly link buyers to sellers that previously interacted through telephones and faxes; (8) to the extent that these systems enhance trader monitoring and control and interface with risk management software, they can reduce both firm-specific and systemic risk; (9) to the extent that these systems link multiple participants and transmit contract execution details electronically, they can improve market transparency and reduce the time and cost of trade execution and reporting; (10) nonetheless, without adequate controls, these systems can raise concerns about inadequate system security and unauthorized customer trading; (11) general agreement exists among regulators and market participants that the approach to regulation needs to be revised to better accommodate electronic trading systems for exchange-traded futures and OTC derivatives; and (12) market participants have suggested three approaches for accomplishing this objective: (a) drafting a separate section of the CEA to deal with electronic trading; (b) developing core principles to which all electronic trading systems must adhere; and (c) developing a flexible regulatory structure under which electronic systems are regulated based on the extent to which they raise specific public policy concerns under the CEA.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: In an August 30, 2000 letter to the Honorable Ted Stevens, Chairman of the Senate Committee on Appropriations, the member agencies of the President's Working Group on Financial Markets stated that they would follow GAO's recommendation to monitor the use of technology in derivatives markets and report to Congress, as appropriate, if any regulatory concerns arise. In December 2000, the Commodity Futures Modernization Act was passed. The Act incorporated a regulatory framework proposed by CFTC that was designed to incorporate most of the recommendations from the Working Group's 1999 report. The Act bases regulation of different trading facilities on the nature of the commodities traded and the sophistication of the participants, and should resolve the disparities in the treatment of electronic trading systems for exchange-traded derivatives and over-the-counter derivatives noted in the GAO report. CFTC is expected to issue final regulations based on the Act by September 2001.

    Recommendation: Recognizing the difficulty of ensuring that regulations appropriately address market risks in stable periods and the additional challenges that are likely to be presented by ongoing and rapid advances in technology, the Secretary of the Treasury; the Chairman, CFTC; the Chairman, Board of Governors of the Federal Reserve System; and the Chairman, SEC, as members of the President's Working Group on Financial Markets, should monitor and report to Congress, as appropriate, on regulatory concerns related to the application of technology in the derivatives markets. Such efforts should address: (1) the implementation status and market impact of the Working Group's 1999 recommendations related to electronic trading in the OTC derivatives and exchange-traded futures markets; (2) the need to impose a regulatory regime on OTC derivatives that are electronically traded to enhance market transparency and efficiency; and (3) the desirability of regulatory or legislative action to address concerns associated with electronic trading.

    Agency Affected: Federal Reserve System: Board of Governors

  2. Status: Closed - Implemented

    Comments: In an August 30, 2000 letter to the Honorable Ted Stevens, Chairman of the Senate Committee on Appropriations, the member agencies of the President's Working Group on Financial Markets stated that they would follow GAO's recommendation to monitor the use of technology in derivatives markets and report to Congress, as appropriate, if any regulatory concerns arise. In December 2000, the Commodity Futures Modernization Act was passed. The Act incorporated a regulatory framework proposed by CFTC that was designed to incorporate most of the recommendations from the Working Group's 1999 report. The Act bases regulation of different trading facilities on the nature of the commodities traded and the sophistication of the participants, and should resolve the disparities in the treatment of electronic trading systems for exchange-traded derivatives and over-the-counter derivatives noted in the GAO report. CFTC is expected to issue final regulations, based on the Act, by September 2001.

    Recommendation: Recognizing the difficulty of ensuring that regulations appropriately address market risks in stable periods and the additional challenges that are likely to be presented by ongoing and rapid advances in technology, the Secretary of the Treasury; the Chairman, CFTC; the Chairman, Board of Governors of the Federal Reserve System; and the Chairman, SEC, as members of the President's Working Group on Financial Markets, should monitor and report to Congress, as appropriate, on regulatory concerns related to the application of technology in the derivatives markets. Such efforts should address: (1) the implementation status and market impact of the Working Group's 1999 recommendations related to electronic trading in the OTC derivatives and exchange-traded futures markets; (2) the need to impose a regulatory regime on OTC derivatives that are electronically traded to enhance market transparency and efficiency; and (3) the desirability of regulatory or legislative action to address concerns associated with electronic trading.

    Agency Affected: Commodity Futures Trading Commission

  3. Status: Closed - Implemented

    Comments: Regarding the recommendation that CFTC monitor and report on industry efforts to develop and implement best practices for order routing systems, a CFTC-funded industry study was completed in March 2001. According to a CFTC official, the National Futures Association (NFA) incorporated the best practices identified by the study into industry guidelines that were approved by CFTC in June 2002. The CFTC official stated that these guidelines should be implemented by the end of 2002, and that CFTC is monitoring their implementation. CFTC's 2002 Annual Report to Congress describes how the agency is continuing to work with NFA on the implementation of these guidelines. Regarding the recommendation to monitor the status and impact of the regulatory framework proposed by the CFTC task force in February 2000, CFMA was passed in December 2000. The Act incorporated the regulatory framework proposed by the CFTC task force, which was designed to incorporate most of the recommendations of the President's Working Group. According to a CFTC official, the majority of the regulations implementing the Act have been implemented, and CFTC will continue to monitor the market impact of these regulations.

    Recommendation: Recognizing the difficulty of ensuring that regulations appropriately address market risks in stable periods and the additional challenges that are likely to be presented by ongoing and rapid advances in technology, the Chairman, CFTC, should monitor and report to Congress, as appropriate, on: (1) the status of the National Futures Association and Futures Industry Institute efforts to develop best practices for order routing that address AORS and the adequacy of industry efforts to implement these practices; and (2) the status and market impact of efforts to implement the regulatory framework proposed by the CFTC task force in its February 2000 report.

    Agency Affected: Commodity Futures Trading Commission

 

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