CFTC Market Surveillance Program

The Market Surveillance Mission
Physical Delivery Commodities
Financial Instruments
Cash Settled Markets
Equity Futures: Special Concerns
Sources of Market Information
Regulatory Response When Problems Develop
Enforcement of Position Limits

Futures prices are widely quoted and disseminated throughout the U.S. and abroad. Business, agricultural, and financial enterprises use futures markets for pricing information and for hedging price risk.

The CFTC's market surveillance program is intended to preserve the economic functions of U.S. futures and option markets under its jurisdiction by monitoring trading activity:

• to detect and prevent manipulation or abusive practices,
• to keep the Commission informed of significant market developments,
• to enforce Commission and exchange speculative position limits, and
• to ensure compliance with Commission reporting requirements.

The market surveillance program’s primary mission is to identify situations that could pose a threat of manipulation and to initiate appropriate preventive actions. Each day, for all active futures and option contract markets, the CFTC's market surveillance staff monitors the daily activities of large traders, key price relationships, and relevant supply and demand factors in a continuous review for potential market problems.

From the perspective of surveillance, markets can be grouped according to their settlement provisions despite the great diversity among the underlying commodities on which futures contracts are based.

Futures contracts that require the delivery of a physical commodity are most susceptible to manipulation when the deliverable supply on such contracts is small relative to the size of positions held by traders, individually or in related groups, as the contract approaches expiration.

The more difficult and costly it is to augment deliverable supplies within the time constraints of the expiring futures contract's delivery terms, the more susceptible to manipulation the contract becomes. Examples of some pertinent surveillance questions for these markets include:

• Are the positions held by the largest long trader(s) greater in size than deliverable supplies not already owned by such trader(s)?
• Are the long traders likely to demand delivery?
• Is taking delivery the least costly means of acquiring the commodity?
• To what extent are the largest short traders capable of making delivery?
• Is making futures delivery a better alternative than selling the commodity in the cash market?
• Is the futures price, as the contract approaches expiration, reflecting the cash market value of the deliverable commodity?
• Is the price spread between the expiring future and the next delivery month reflective of underlying supply and demand conditions in the cash market?

An excellent barometer for potential liquidation problems is the basis relationship (i.e., the difference between cash and futures price). When the price of the liquidating future is abnormally higher than underlying cash prices or both the futures and underlying cash price are abnormally higher than comparable cash prices, there is ample reason to examine the causes and to assess the motives of traders holding sizable long futures positions.

Futures contracts that require the delivery of a financial instrument generally are less likely than futures on physical commodities to be subject to manipulation in the form of squeezes. This assertion is based on the premise that the underlying cash markets for financial instruments tend to be deeper, more liquid, more transparent, and more readily arbitraged than physical commodity markets. Nonetheless, there are situations when the questions specified above still pertain to futures on financial instruments. For example, when a particular financial futures contract provides for a deliverable supply that either is of finite size or is a narrow segment of the broader cash market for the underlying financial instrument, then all the questions raised in the prior section on physical commodities would apply.

In addition, price aberrations in the cash market for the underlying financial instrument may provide an indication of (or an opportunity for) an attempted manipulation. Surveillance staff monitors cash prices of the financial instrument specified for delivery on the futures contract in relation to cash prices for non-deliverable instruments that are close, or identical substitutes. High deliverable prices relative to non-deliverable prices for financial instruments may signal an attempt to remove deliverable supplies from the futures market as part of an attempted manipulation.

To the extent participants in the markets take positions vastly beyond their financial capacity to take delivery or make settlement, this may also signal some manipulative activity.

Several financial products involve U.S. Treasury or agency instruments (e.g., bonds or notes). CFTC surveillance staff maintains open lines of communication with the U.S. Treasury Department, the Federal Reserve Bank of New York, the Securities and Exchange Commission, among others.

The surveillance emphasis in cash-settled contracts is on the integrity of the cash price series used to settle the futures contract. The size of a trader's position at the expiration of a cash-settled futures contract cannot affect the price of that contract because the trader cannot demand or make delivery of the underlying commodity.

Since manipulation of the cash market can yield a profit in the futures contract, CFTC staff monitors large reportable futures positions and is alert for any unusual cash market activity on the part of large futures traders. This is especially the case during the time that the final cash price for futures settlement is determined. Examples of some pertinent surveillance questions for these markets are:

• As the futures contract expiration approaches, is the cash price moving in a manner consistent with supply and demand factors and with other comparable cash prices, which are not used in the cash-settlement process?
• Do traders with large positions in the expiring future have the capacity and ability to affect the cash price series used to settle the futures contract?
• What information can be obtained from the organization that compiles the cash price series regarding how the price is determined? Is anyone reporting prices that appear to be out of line with prices reported by others? If yes, can it be determined that the party reporting those prices holds a futures position that would benefit by those prices?

Generally, equities and equity futures markets are closely linked through intermarket arbitrage. Therefore, effective surveillance of equity futures markets requires coordination with the exchanges trading the underlying equities and equity options to address intermarket trading abuses.

If the stock index underlying the futures and/or option contract is a broad-based index in terms of number of stocks and market capitalization, then intermarket price manipulation and insider trading concerns is greatly reduced. However, narrower indices and single-stock futures may require more vigilance with added protections with respect to misuse of information, especially to the extent that the market is, or acts like, a market in a single security. The Commission cooperates and works with the Securities and Exchange Commission on surveillance issues.

The CFTC's market surveillance program uses many sources of market information to accomplish its objectives. Some of this information is publicly available, including data on the overall supply, demand, and marketing of the underlying commodity; futures, option, and cash prices; and trading volume and open interest data. Some of the information is highly confidential, which includes data from exchanges, intermediaries, and large traders.

Exchanges report daily positions and transactions of each clearing member to the Commission. The data are transmitted electronically during the morning after the “as of” date. They show, separately for proprietary and customer accounts, the aggregate position and trading volume of each clearing member in each futures and option contract. The data is used to identify quickly the firms that clear the largest buy or sell volumes or hold the biggest positions in a particular market. The clearing member data, however, do not identify the beneficial owners of the positions. Beneficial owners are identified by our large trader reporting system, which is the heart of the CFTC’s market surveillance program.

Surveillance economists prepare weekly summary reports of futures and option contracts for regional surveillance supervisors, who immediately review these reports. Surveillance staff informs Commission and senior staff of potential problems and significant market developments at weekly surveillance meetings so that they will be prepared to take prompt action when necessary.

The market surveillance process is not conducted exclusively at the CFTC. Surveillance issues are usually handled jointly by the CFTC and the appropriate exchange. Relevant surveillance information is shared and corrective actions are taken, when appropriate. Potential problem situations are jointly monitored and, if necessary, verbal contacts are made with the participants in question. These contacts may be for the purpose of understanding their trading, confirming reported positions, alerting the brokers or traders as to the regulatory concern for the situation, or warning them to trade responsibly. This “jawboning” activity by the Commission and the exchanges has been effective in resolving most potential problems at an early stage.

The Commission customarily gives the exchange the first opportunity to resolve problems in its markets, either informally or through emergency action. If an exchange fails to take actions that the Commission deems appropriate, the Commission has broad emergency powers under which it can order the exchange to take actions specified by the Commission. Such actions could include imposing or reducing limits on positions, requiring the liquidation of positions, extending a delivery period, or closing a market. Fortunately, most issues are resolved without the need to use the CFTC's emergency powers. The fact that the CFTC has had to take emergency actions only four times in its history demonstrates its commitment not to intervene in markets unless all other efforts have been unsuccessful.

The CFTC surveillance staff also monitors compliance with Commission or exchange speculative limits. These rules help prevent traders from accumulating concentrated positions that could disrupt a market. To monitor those limits, the market surveillance staff reviews daily for potential violations. Although bona fide hedgers are exempt from speculative limits, Commission staff monitors hedgers' compliance with their exemption levels. Commercial traders that carry futures and option positions in excess of Commission speculative position limit levels are required to submit a monthly statement of cash positions. These statements show the total cash position of each trader, which reflects the amount of the trader's actual physical ownership of each commodity and the amount of the trader's fixed-price purchases and sales for which the trader has a legitimate cash exposure at risk. Commission staff compares each trader's cash position to the trader's futures and option positions.

The CFTC has a comprehensive market surveillance program to detect and prevent corruption of the economic functions of the futures and option markets that it oversees.