Chicago Futures Market: Emergency Action Procedures

Published by the Government Accountability Office on 1990-04-09.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United   States   General   Accounting   Office

GAO-            Report to Congressional Requesters

                Fmergency Action

                                                                  : .T .’ .‘.         ;
                                                                   --.          . ;

          United States
GAO       General Accounting  Office
          Washington, D.C. 20648

          General   Government        Division


          April   9,199O

          The Honorable Tom Harkin
          Chairman, Subcommittee on Nutrition
            and Investigations
          Committee on Agriculture,
            Nutrition, and Forestry
          United States Senate

          The Honorable Tom Tauke
          House of Representatives

          In response to your requests, we are providing you with the results of
          our examination of Commodity Futures Trading Commission (WE) and
          Chicago Board of Trade (CBT) policies, procedures, and practices related
          to emergency actions. As requested, we are including information on

      0   CIW   and CBT identify emergencies;
      l   CFX   and CBT use their emergency action authority;
      l   CBT controls leaks of nonpublic information related to emergency action
      l . CBT avoids conflicts of interest in emergency action decisionmaking,
          including how its approach differs from that in proposed CFX
          reauthorization legislation; and
      l   CFTC  reviews exchange emergency actions.

          Also, as agreed, we used the July 1989 soybean futures emergency
          action as a case study of how CFX and CBT follow their policies and

          On July 11,1989, the CBT Board of Directors ordered everyone holding
          July 1989 soybean futures positions’ in excess of the 3 million bushel
          speculative position limit? to liquidate those positions in a prescribed
          orderly manner to no more than 1 million bushels as of the expiration of
          trading on July 20, 1989. CBT officials said that they took this action to

          ‘A futures position is a market commitment associated with the purchase or sale of a futures

          ‘A speculative position limit LSa number of contracts, set by CFTC or an exchange, that a market
          participant cannot exceed except for the purpose of bona fide hedging as defined in CFK or
          exchange rules. Bona fide hedging, according to CFTC regulations, means transactions or positions
          that normally represent a substitute for transactions or positions to be made or taken at a later time
          in a physical commodity and that are appropriate for reducing certain risks in the conduct and man-
          agement of a commercial enterprise.

          Page 1                                                     GAO/GGDSO84 Chicago Futnres Market

                   affecting a commodity, or any other major market disturbance that pre-
                   vents the market from accurately reflecting supply and demand forces
                   for such a commodity. CBT rules define an emergency as all emergency
                   circumstances referenced in the Commodity Exchange Act and CFIY:reg-
                   ulations, and all other circumstances in which an emergency can be law-
                   fully declared by the Board of Directors. CBT rules also prohibit price
                   manipulations and corners, and CFK regulations require that exchanges
                   enforce their rules by actively monitoring the markets.

                   CFK and CBT officials said that they closely monitor the markets each
                   day. They said that although CFTC and CBT have independent market
                   surveillance programs, their market surveillance staffs freely share
                   information on a daily basis. According to CFTCofficials, CFK staff brief
                   the CFTCcommissioners on market developments at least weekly to keep
                   them informed of potential problems so that they will be prepared to
                   take prompt action when necessary. CBT officials said that their staff
                   also brief the CBT Business Conduct Committee on market developments
                   at least weekly. The Business Conduct Committee has broad oversight
                   responsibilities and can recommend that the CBT Board of Directors take
                   emergency action. The Board of Directors can, by a two-thirds vote of
                   the members voting, determine that an emergency exists and adopt
                   emergency measures.

                   Our review of CFK and CBT documents showed that CFTC and CBT began
                   reviewing extensive market information on July soybean contracts in
                   early June 1989. The information on the July soybean futures contract
                   covered cash and futures prices, deliverable supplies, and the positions
                   of large traders. The CFTC and CBT staffs prepared weekly summaries of
                   market conditions relating to the July soybean futures contracts and,
                   according to CITC and CBT meeting minutes, they presented weekly brief-
                   ings on the July soybean futures contract to the CFTC commissioners and
                   the CBT Business Conduct Committee. Additionally, CFK’S chronology of
                   the July soybean futures emergency shows that CFK and CBT frequently
                   exchanged market information.

                   The Commodity Exchange Act authorizes CFTC,if it determines an emer-
Using Emergency    gency exists, to direct an exchange to take such action as CFTC deems
Action Authority   necessary to maintain or restore orderly trading in, or liquidation of,
                   any futures contract. Under such authority, for example, the CFK sus-
                   pended grain futures trading for 2 days in 1980 after the President
                   announced an embargo on the sale of grain to the Soviet Union.

                    Page3                                    GAOPXXHO.64 Chicago Futures Market

                        Ferruzzi indicating that Ferruzzi would not cooperate with CBT'S request
                        to voluntarily liquidate its July soybean positions. The next day CBT
                        issued its emergency order.

                        CETC  regulations require exchanges to have and enforce rules against
Controlling Leaks of    their staffs and governing members using or disclosing material, non-
Nonpublic Information   public information. CBT has such rules. Also, according to CBT officials,
                        the exchange takes steps to prevent leaks or use of nonpublic informa-
                        tion related to emergency action decisionmaking by (1) reviewing
                        reports that identify the largest market participants to detect if staff
                        have positions in futures markets, (2) providing the information to com-
                        mittee members verbally rather than in writing, (3) securing confidenti-
                        ality oaths from staff and committee members, and (4) scheduling Board
                        of Directors’ emergency action meetings after the close of trading.
                        According to exchange officials, detection of improper use or disclosure
                        of material, nonpublic information would result in CBT disciplinary
                         action. CFTC officials said that CETC could also choose to take enforce-
                         ment action against the exchange or the violators if the exchange fails to

                        Our review showed that to the extent the activities of the CBT Business
                        Conduct Committee and Board of Directors were documented, the docu-
                        mentation indicated that CBT followed its steps for preventing leaks dur-
                        ing the July soybean emergency. For example, the written briefing
                        materials presented to the Business Conduct Committee, as well as the
                        committee’s and board’s minutes, did not contain any material nonpublic
                        information. Also, CBT had on file signed copies of confidentiality oaths
                        for members of the Business Conduct Committee. The July 11, 1989,
                        Board of Directors emergency action meeting was held at 2:15 p.m.,
                        after the 1:15 p.m. close of trading. However, CBT did not document its
                        confidentiality practices involving the exchange staff during the July
                        soybean futures emergency action.

                               Interpretative Letter 79-2, issued July 26, 1979, by CFTC'S Office of
Avoiding Conflicts of    CFK
                         General Counsel, seeks to ensure that exchange emergency actions are
Interest                 not taken in bad faith. The courts have ruled that a decision made in bad
                         faith is one in which directors, governors, and officers of an exchange
                         act in their self-interest and for personal gain.

                         CBT seeks to avoid bad faith in its emergency decisionmaking by exclud-
                         ing members with conflicts of interest from emergency action meetings.

                         Page6                                     GAO/GGLWO44 Chicago Futures Market
                                    __-     --__

                     diversity of the members making emergency action decisions. CRT offi-
                     cials added that this would be inconsistent with a Senate bill require-
                     ment that governing boards have meaningful representation of a
                     diversity of interests. A CBT official said that under the House act,
                     enough members could be excluded to prevent a quorum at decisionmak-
                     ing meetings.

                     Our review of CFX data indicated that the CBT July soybean emergency
                     action decision would not have been affected had the proposed House
                     conflict-of-interest standard been applied and been interpreted to
                     exclude from voting on the emergency action decision (1) all CBT Board
                     of Directors members with personal positions in July soybean futures;
                     or (2) members who were employees, officers, or owners of firms with
                     proprietary or customer positions in July soybean futures. However, a
                     CBT official said that the direct financial interest standard contained in
                     the House act could have been interpreted to include futures positions in
                     other soybean futures contract months in addition to July, as well as
                     cash market soybean positions. IJnder this interpretation, additional
                     members would have been excluded from the Board of Directors meet-
                     ing, thereby preventing a quorum.

                     Although the Senate bill requires exchange oversight committees and
                     governing boards to assess the proprietary and customer positions of
                     members’ affiliated firms in making recusal decisions, it gives the
                     exchanges discretion in determining who should be recused. CME officials
                     said that they currently follow a practice similar to the Senate proposal
                     by routinely reviewing the size of proprietary and customer positions of
                     members’ affiliated firms and using this information in deciding who
                     may attend Business Conduct Committee meetings. However, a CBT offi-
                     cial said that it does not support a discretionary standard because the
                     standard would make the exchange’s conflict-of-interest decisions con-
                     tingent on a subjective rather than an objective review standard and
                     would therefore put an additional, unnecessary burden of proof on the

                     Exchange emergency actions are to meet the requirements of CFTC regu-
Reviewing Exchange   lations and CFTCInterpretative Letter 79-2, including that (1) an emer-
Emergency Actions    gency existed and (2) exchange actions were necessary or appropriate to
                     meet the emergency. According to CFK officials, after an exchange takes
                     an emergency action, CFTC reviews the action to determine if the
                     exchange met these CFTC requirements. A CFE official told us that it
                     reviews a variety of data from sources that include exchange meeting

                      Page 7                                   GAO/GGD9064 Chicago Fut.ures Market
Page 9   GAO/GGD9964   Chicago Futuree Market


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Appendix 1

Major Contributors to This Report

                        Cecile 0. Trop, Assistant Director
General Government      Michael A. Burnett, Assistant Director
Division, Washington,   Edward J. Samario. Evaluator

                        Daniel M. Johnson, Evaluator-in-Charge
Chicago Regional
          -’            Arthur U. Ellis, Evaluator
Office                  Mary D. Feeley, Evaluator
                        Melvin Rodriguez, Evaluator

                        Lorna J. Macleod, Attorney
Office of General

(233266)                Page 10                                  GAO/GGMfO.64 Cklcqw fihuw   Market

minutes, trading records and interviews with exchange members,
exchange staff, and market participants to determine if CETC require-
ments are met.

Our review of CFK documents confirmed that CETC had analyzed rele-
vant data from these sources during its review of the July soybean
emergency. Our review also confirmed that the data supported CFTC’S
conclusion that CBT was in compliance with CETC requirements.

As arranged with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 2 days from
its issue date. At that time, we will provide copies of the report to other
interested Members of Congress and executive branch agencies. We will
also send copies to CRT and CME and will make copies available to others
upon request.

The major contributors to this report are listed in appendix I. Please
contact me at 275-8678 if you or your staffs have any questions con-
cerning this report.

Craig A. Simmons
Director, Financial Institutions
  and Markets Issues

Page8                                      GAO/GGD90.64 Chicago Futures Market

According to CBT officials, CBT requires Business Conduct Committee and
Board of Directors members to recuse themselves from emergency
action meetings if they own or control any positions in the futures con-
tract under review. CBT officials told us that they use this standard
because it prevents actual conflicts of interest and is unambiguous in its

Neither the Commodity Exchange Act, CFTCregulations, CFK Interpreta-
tive Letter 79-2, nor the judicial record provide a specific standard gov-
erning a member’s recusal from a board decision because of a potential
conflict of interest. Given the latitude the current law allows, we have
concluded that CBT'S recusal standard is legally acceptable.

Our review of CFTC data also showed that all CBT Business Conduct Com-
mittee and Board of Directors members owning or controlling positions
in the July soybean contract recused themselves from Business Conduct
Committee and Board of Directors meetings that discussed the emer-
gency action. OTC'S review of the July soybean emergency action con-
cluded that no CBT governing member participating in the emergency
action decision had a conflict of interest.

Both the House act and Senate bill include new conflict-of-interest stan-
dards. The House act would prohibit a member of a committee or gov-
erning board from voting on a proposed emergency action if (1) the
member; (2) a legal entity of which the member is an officer or
employee; (3) a legal entity in which the member owns a substantial
interest; or (4) a legal entity, which is the parent or subsidiary of any
legal entity specified in (2) or (3) had a direct financial interest in the
action under discussion. The Senate bill would require an exchange’s
disciplinary committees and governing board to consider whether any
exchange committee or board member must abstain from participating
in emergency action decisionmaking due to the (1) positions held by
such a member; or (2) positions, including customer positions, held at
any firm with which such a member is affiliated.

The effect of the House act on who may attend emergency action deci-
sionmaking meetings depends on how its direct financial interest provi-
sion is interpreted. A CRT official said that it could be interpreted to
exclude all members whose firms have any involvement in the market
under discussion. The official said that CBT opposes the House act
because, although the proposed standard might eliminate some per-
ceived conflicts of interest, it would lower the quality of exchange emer-
gency action decisionmaking by reducing the level of expertise and the

Page 6                                     GAO/GGD9064 Chica@ Futures Market

CFTCregulations give the exchanges even broader authority to declare
an emergency. The exchanges may intervene in the markets under any
circumstance that, in the opinion of the exchange governing board,
requires immediate action.

Although CETCand CBThave broad emergency action authority, their
officials said that they use it only as a last resort. Because of CFTC’S
emphasis on self-regulation, and because the circumstances under which
it can declare an emergency are more limited than those allowed to the
exchanges, CFK officials said they expect the exchanges to take needed
emergency actions and usually give them the opportunity to do so. CFTC
and CBTofficials said, however, that because they wish to minimize mar-
ket disruption, they prefer market participants to voluntarily comply
with requests to take steps to avert an emergency.

CETCdid not declare an emergency in the July soybean futures market
and did not direct CBTto intervene in the markets. Instead, between May
25, and July 11,1989, CFTCdocuments show that the agency asked a
major market participant, a group of subsidiaries of Ferruzzi Finanziaria
S.p.A. (Ferruzzi), at least 10 times to voluntarily reduce its large posi-
tion in July soybean futures. CFTCdocuments indicate that requests were
made by telephone and face-to-face. CFTCrecords also show that CFTC
contacted Ferruzzi at least three other times on matters related to the
July soybean market. Finally, on July 11, 1989, CFTCtold Ferruzzi that it
would not accept as bona fide hedging any of Ferruzzi’s July soybean
futures positions that were held against anticipated soybean processing
requirements during the last 3 days of trading. According to a CFTCoffi-
cial, the c~X action would have forced Ferruzzi to substantially reduce
its July soybean futures position even if CBThad not taken emergency
action on that same day. Also, according to CFK testimony, CFTCofficials
discussed emergency action alternatives with CBTofficials immediately
before CBT’Semergency action.

A CBTofficial told us that the exchange had not recommended emer-
gency action in the July soybean futures market prior to July 11, 1989,
because only then had it become clear that attempts to obtain voluntary
action would not succeed. CBTdocuments indicate that the exchange con-
tacted Ferruzzi at least six times to seek voluntary action. These con-
tacts were face-to-face and by letter. In addition, CBTofficials reported
that they made numerous additional telephone calls to Ferruzzi between
July 6, and July 10, 1989. Our review of CBTdocuments indicates that on
July 10,1989, 10 calendar days before the July soybean futures con-
tract expired, CBT’SBusiness Conduct Committee received a letter from

Page4                                     GAO/GGD-9@64 Chicago Futures Market

                        prevent a potential disorderly expiration and defaults in the July soy-
                        bean futures contract. Available data indicate that during the July soy-
                        bean futures emergency action, CFK and CBT followed their policies and
                        procedures concerning emergency actions.

                        To identify the policies, procedures, and practices that CFTCand CBT fol-
Objectives, Scope,and   low in market emergencies, we interviewed CFTC and CBT officials and
Methodology             reviewed a variety of materials and sources dealing with emergency
                        actions, including the Commodity Exchange Act, CFK regulations, CFTC
                        and CBT procedures, and CBT rules. We verified whether CFK and CBT
                        had followed these procedures and practices during the July 1989 soy-
                        bean market emergency by reviewing available documentation, includ-
                        ing CFTC and CBT market surveillance files, CBT minutes from
                        decisionmaking meetings, CFTC’Sanalysis of CBT members’ trading activ-
                        ity, and CFTC’Sdocumentation of interviews with CBT officials and

                        We also reviewed pending CFTC reauthorization legislation-the      House
                        act (H.R. 2869) and the Senate bill (S. 1729)-that includes new conflict-
                        of-interest provisions. In addition to discussing these provisions with
                        CBT officials, we interviewed Chicago Mercantile Exchange (CME) offi-
                        cials and reviewed their emergency action procedures to compare their
                        approach to handling conflicts of interest to the approach in the pro-
                        posed reauthorization legislation.

                        Our work was done at CETC’Sheadquarters and Chicago offices and at
                        CBT  and CME from October 1989 through January 1990. We did our
                        review in accordance with generally accepted government auditing stan-
                        dards. Responsible CFK, CRT, and CME officials reviewed a draft of this
                        report and were in general agreement with it. They also provided techni-
                        cal clarifications that are incorporated into the report.

                        For the purposes of CI”I% taking action, the Commodity Exchange Act
Identifying             defines emergencies as threatened or actual market manipulations:’ and
Emergencies             corners,4 as well as any act of the United States or a foreign government

                        ‘Market or price manipulation can be described as any intentional act or conduct that causes or main-
                        tains an artificial price.
                        ‘A corner can be described as someone having such control of the deliverable cash commodity that its
                        futures price can be manipulated.

                        Page 2                                                   GAO/GGD9064 Chicago Futures Market