The Commodity Futures Trading Commission and the exchanges it regulates have been having a little "misunderstanding."
Late last year, the commission set about rewriting record-keeping rules for exchanges to make it easier to determine if a broker has been cheating his customers.
The exchanges took the proposal as a major challenge, attacked it as technologically impossible, and raised a million-dollar defense fund to stave off the CFTC.
Today, however, after months of increasingly public conflict, at least one exchange says they might have "overreacted," and they are sure something can be worked out.
At issue are changes in the rules, approved by the CFTC in January, that require minute-by-minute records of trades made in futures and options markets.
The CFTC's concern is that, without a strict tracking system, brokers might be able to make trades on their own accounts at their customers' expense. For instance, a broker -- with a customer who planned to buy enough gold to push up the price -- might buy for his own account first. In doing so, the broker would be taking advantage of the knowledge of the pending trade to ride the market up and also would be cheating his customer out of the best price for the gold by delaying his customer's trade until he had made his own.
But, in the view of those who work in the exchanges, such abuses are unlikely, and are generally outlawed by the exchanges (where, unlike in the securities markets, brokers may trade for their own accounts and for customers accounts on the same day). And the CFTC cannot muster figures to prove the abuse exists: It isn't possible without the kind of detailed audit trail the commission has proposed, according to CFTC officials.
"Right now, in any kind of a busy market, we can't reconstruct what happened," said Commissioner Fowler West. "We can't answer inquiries about what may have happened in a given situation."
Exchange officials say they share the CFTC's concern about improving methods to detect abuse but are concerned that auditing methods not interfere with the main business of the exchanges -- executing orders.
"The way the media has expressed it, the CFTC wants audit trails and the exchange doesn't," said John F. Sandner, chairman of the Chicago Mercantile Exchange, who says that view is not accurate. Along with the Chicago Board of Trade, which announced last winter that it was forming a $1 million defense fund to deal with the CFTC on the audit trail and other issues, the Chicago Mercantile Exchange was an early and vocal critic of the proposal. More recently, however, the Chicago exchanges and the CFTC appear to be approaching a compromise on the audit trail issue.
Though Congress has no direct role to play in the regulatory issue, it became an issue during recent hearings on the CFTC's reauthorization, which is before Congress. The Senate Agriculture Committee, which last week approved a six-year reauthorization bill, included nonbinding language in that bill endorsing a proposal by the Chicago exchanges to develop a computerized system to comply with the CFTC's rule. The computerized system would marshall information about when trades are made and at what price to provide a better tracking system. The CFTC, which left it to the exchanges to develop their own means of complying, has said the Chicago proposal looks promising.
Sandner said that much of the earlier nastiness about the rule changes reflected a misunderstanding by the exchanges of what the CFTC was proposing, a belief that the commission wanted records kept manually, to the minute, of each trade made.
"The problems, and all the drama and all the passion maybe stemmed from a misinterpretation by us," he said. "I think we may have overreacted, but I really don't know. It's really folly to speculate at this point. We want to get it behind us."
The proposal to improve the audit trail came as no surprise to the exchanges. The issue has been pending in some form since 1975, and the commission had been talking more volubly about the need to improve audit trails since the fall of 1984.
In December 1975, the commission published proposed regulations that would permit dual trading (allowing brokers to trade for their own and for customers' accounts on the same day), but also called for a study of systems that would permit more precise recording of the time of execution of trades.
Over the years, there was a running debate about whether a stricter system of auditing was technologically feasible. In the meantime, traders were permitted to record trades, noting within which half hour they occurred. Orders also were stamped when they left the desk and went to the pit and when they returned. In addition, the exchanges could match that information against the price at which the order was executed. Changes in prices were recorded to the second at which they occurred. All those elements, taken together, made it possible to come close to pinpointing the timing of orders without one-minute stamping, the exchanges had said.
Their concern, they said, was that the CFTC's proposal might result in a slowdown on the trading floor that could hurt customers.
"The industry has expressed valid fear that market liquidity, not to mention the quality of executions, will suffer from this requirement," said Alan J. Brody, president of the Commodity Exchange Inc. (Comex) of New York. Brody testified at House Agriculture Committee hearings on the CFTC reauthorization this month.
"The agency has seemed to do little more than determine that more information is better than less, irrespective of cost to the trading public," he said. "At a minimum, the commission should be put to the task of supporting this intrusive new duty with a meaningful cost/benefit analysis."
The rhetoric about the audit trail issue has been somewhat tempered since the proposal by the Chicago exchanges for their system, which is called Computerized Trade Reconstruction. "We're pretty encouraged by what they have developed to date, but it's still in the concept stage," said CFTC Chairman Susan M. Phillips. "If it does all they say it would do, I think we have a pretty good system."
The exchanges have until July 1 to devise systems to comply with the CFTC rule. The systems must be implemented by October.
But some industry officials still are not satisfied with the CFTC responses. According to news accounts, Chicago Board of Trade Chairman John Gilmore, also testifying at the CFTC reauthorization hearings held by the House Agriculture Committee, said that Congress should revoke the CFTC's audit trail rule unless the commission approves the Computerized Trade Reconstruction system and that the CFTC's assurances on that subject have been too vague.
"Some of the exchanges don't want to do anything that really permits us to know that dual traders are not trading for themselves when they shouldn't be," said Rep. Neal Smith (D-Iowa). "I think the commission is doing the least that they can do. It's the first time that they really reached out and fulfilled their responsibility."