Key Quotes:
"The extraordinary number of orders and extreme price volatility contributed significantly to problems with order execution. Some FCMs and floor brokers stated that thousands of gold options orders sent to the pit were not executed, although one FCM stated that most of its orders were filled. Most of the unexecuted orders were limit or ?cancel and replace? orders, although some market orders also were not executed. One FCM stated that nearly 2,500 of its orders were not executed, mostly limit orders attempting to liquidate calls. One FCM said that in a few instances orders reported as executed in fact were not. "
"The Exchange considered this request, but decided not to call such a session"
REPORT ON GOLD OPTIONS TRADING
ON SEPTEMBER 28, 1999
I. INTRODUCTION
On Tuesday, September 28, 1999, an extraordinary spike in volume, volatility and price occurred in the gold options market at the Commodity Exchange, Inc. (?COMEX? or ?Exchange?), a Division of the New York Mercantile Exchange (?NYMEX?). Responding to a Sunday, September 26, 1999 announcement by 15 European central banks of a surprise five-year moratorium on all new sales of gold from their reserves, the gold options market traded a record volume of 81,317 contracts in a record number of trades, 15,044. This was more than double the previous volume record of 39,944 contracts set on March 7, 1995, and a more than a twelve-fold increase over the normal number of trades. Gold options volatility also was unusually high. For example, the price of the December 1999 $300 gold call, the most active contract, had an extremely wide trading range. The premium fluctuated between a low of $5 and a high of $29 before settling at $18, up $15.30 for the day.1
The gold options market was severely strained on September 28 with respect to execution and clearance of orders. This was due primarily to the tremendous influx of small-lot paper orders to the floor throughout the day, and the myriad of option series and strike prices traded. As a result, the Division of Trading and Markets (?Division?) received a large number of complaints, 69 in all, predominantly from retail customers who had entered or attempted to enter small-lot gold option orders on September 28. The complaints, in large part, involved the status of possible unfilled orders, including market orders; long delays in reporting or confirming fills, or no reports at all; and an inability to place limit or other contingent orders. In addition, press reports alleged that on September 28 gold options floor brokers may have given preference to the execution of large orders, that thousands of small orders may have gone unexecuted, and that many retail customers were left uninformed for days of their market positions.
In light of the many complaints from the public and the allegations in the press, the Division subsequently undertook a study of gold options trading at COMEX on September 28. The Division reviewed various market participants? activities of that date to determine whether orders were received and executed in accordance with relevant Exchange trading rules, whether clearing rules and procedures were observed, whether the events of September 28 revealed systemic problems, and what corrective steps, if any, should be recommended to ameliorate the impact of such market conditions should they recur.
In conducting its review, Division staff interviewed six floor brokers, officials at six futures commission merchants (?FCMs?), and COMEX compliance, legal, administrative, and operations personnel (collectively, ?Exchange staff?).2 In addition, Division staff observed a demonstration of the Exchange?s On Line Trade Entry (?OLTE?) system, and obtained written information from Exchange staff on aspects of OLTE?s functioning significant to this review. Division staff also conducted a trade practice investigation of September 28 gold options trading to determine whether there were any indications of possible trading violations.3
The report that follows includes: (1) a discussion of the events of the week of September 28; (2) an analysis of the issues raised by those events; and (3) the Division?s conclusions and recommendations. It does not, however, contain analysis or findings regarding individual broker trading activity.
II. FACTS
A. September 26: European Central Banks Announcement of Moratorium on New Gold Sales
As noted above, on Sunday, September 26, 1999, 15 European central banks announced a surprise five-year moratorium on all new sales of gold held in official reserves. Prior to this announcement, gold prices had been pressured by worries about central bank gold selling, caused by a May 1999 British Treasury announcement of plans to unload more than half of its $6.5 billion in gold reserves in exchange for world currencies. The May announcement had triggered concern that governments and central banks would soon be dumping bullion reserves, flooding the market and driving prices lower. Gold prices had reacted by falling swiftly and sharply. By July 6, 1999, the August 1999 futures contract had settled at a 20-year low of $257.80 per ounce.
The September 26 weekend announcement by the central banks removed a major uncertainty surrounding gold sales. In a statement, the banks pledged that gold ?will remain an important element in global monetary reserves? and vowed not to enter the market as sellers, except in cases for which a sale had already been agreed. They also announced that they would limit the amount of their gold lending. News sources reported that in light of the statement, the market knew exactly what would be available for sales and for lending for the next five years.4
B. September 27: Early Market Reaction
On Monday, September 27, 1999, in response to the announcement by the central banks, gold options volume, which had averaged approximately 6,434 contracts during the first seven business days of September 1999, quintupled to 34,893 contracts,5 and gold options price volatility began to increase.6
Floor brokers, FCMs, and Exchange staff interviewed by the Division generally did not see in the events of September 27 any indication of what was to occur on September 28 in the gold options market.7 The floor brokers and FCMs viewed September 27 as a ?busy day? which involved a volume increase, but was still somewhat within normal expectations. However, some floor brokers and FCMs experienced order routing and clearing difficulties which, as discussed below, may have been precursors of, or contributors to, the severe problems that arose the following day.
Specifically, several FCMs and floor brokers reported that the Trade Order Processing System (?TOPS?) electronic order routing system8 at COMEX malfunctioned at various times during the day on September 27. This resulted from problems with the TOPS link to the NYMEX building, where COMEX is located. Floor brokers stated that due to TOPS outages, order receipt was delayed for an hour or more during most of the day. Consequently, the normal timely execution of some orders was delayed. Some FCMs also reported receiving delayed fill reports from the floor on September 27.
Clearing difficulties also arose on September 27. Some floor brokers stated that, as the result of high volume and TOPS outages they found it more difficult than usual to reconcile trading card entries with order tickets and enter trades into OLTE. These brokers reported an inability to enter a significant number of their trades into OLTE before it was closed on the evening of September 27, despite the Exchange?s extension of OLTE input time to approximately 8:45 p.m. from its normal 5:00 p.m. close. One FCM with a significant share of gold options business reported that it did not receive data concerning outtrades from September 27 until approximately 10:00 p.m., several hours later than usual, and consequently had staff working all night to balance its books. As a result of these problems, before the opening on September 28, some floor brokers and FCMs had an unusually high number of unmatched trades from September 27.9
Exchange staff did not consider September 27 a problem day, although they did note the increase in volume. COMEX staff conducted routine market surveillance activities, including the review of large traders in gold options, and ascertained that variation margin payments were timely collected. Exchange staff did not view the number of outtrades on September 27 as a significant departure from the norm.
C. September 28: Major Market Event
On Tuesday, September 28, 1999, the COMEX gold options market experienced a major market event, involving record volume, extraordinary price volatility, and significant problems with order execution, fill reporting, clearing, and implementation of order restrictions.
1. Record Number of Trades
The floor brokers and FCMs interviewed stated that the number of orders sent to the floor on September 28 exceeded anything in their memory. As noted earlier, the number of gold options trades increased more than twelve-fold over normal levels, and trading volume increased more than eight-fold over normal levels. Floor brokers received an unusually large number of orders before the open, and encountered waves of new orders coming in by electronic transmission and telephone throughout the day. Most of this order surge consisted of small-lot orders in various option series and strike prices.10 Because the majority of these small-lot orders were received through the TOPS system, the amount of paper received by brokers was described as overwhelming. Telephone orders also poured in: brokers reported that all their phone lines were lit up constantly all day, and that customers who had not traded in years called them with orders.
Floor brokers could not physically handle the enormous volume of orders coming into the ring, even though they were present in greater numbers than on a typical day. On a normal trading day, as measured by the period from September 1 through September 10, 1999, an average of 28 floor brokers transact customer orders in the gold options ring. On September 28, 54 floor brokers, some from other futures and options trading rings, traded gold options contracts for customers.11 Even this doubling of floor broker participation, however, could not cope with the huge increase in the number of orders needing execution.
2. Extraordinary Volatility
Floor brokers? difficulties in filling the flood of orders on September 28 were further compounded by extreme price volatility. A review of the most active gold option contract, the December 1999 $300 call, illustrates how volatile market conditions may have contributed to unfilled orders and numerous outtrades.12 According to the Price Change Register for September 28, at the opening at 8:20 a.m. this strike traded between premiums of $5 and $7, up from the previous day?s settlement of $2.70. At 8:20:01 a.m., a ?fast market? was declared.13 The fast market continued for virtually the entire trading session. The price of the $300 call quickly spiraled higher, reaching the $15 level at 9:30:10 a.m. The market then traded between $10 and $15 until reaching $16 at 12:37:38 p.m. By 1:11:30 p.m., the market had rallied to $21, and at 1:31:26 p.m. it hit $29, the high of the day. Prices dropped to $22 level by 1:33:09 p.m., fell to $12 at 1:59:08 p.m., and fluctuated between $11 and $18 during the last half-hour of trading. The contract settled at $18, $15.30 higher than the previous day?s settlement.
3. Execution Problems
The extraordinary number of orders and extreme price volatility contributed significantly to problems with order execution. Some FCMs and floor brokers stated that thousands of gold options orders sent to the pit were not executed, although one FCM stated that most of its orders were filled. Most of the unexecuted orders were limit or ?cancel and replace? orders, although some market orders also were not executed. One FCM stated that nearly 2,500 of its orders were not executed, mostly limit orders attempting to liquidate calls. One FCM said that in a few instances orders reported as executed in fact were not. For orders that were executed, FCMs and floor brokers interviewed by Division staff said they had received very few complaints regarding fill quality.
A fundamental cause of execution problems was the sheer number of orders coming to the ring. Brokers and FCMs reported that their clerks had to deliver multiple, foot-high stacks of orders to the ring almost constantly throughout the day. Brokers stated that they frequently had stacks of orders in each hand and each pocket, and could not physically handle additional orders brought to them. Moreover, these order stacks were not prioritized,14 because orders came so rapidly that clerks had no time to sort them by type of order or time of receipt.15
Brokers and FCMs also stated that the TOPS printers for the gold options ring were incapable of printing orders as fast as they were entered into the system. As a result, TOPS orders were behind between 40 minutes to an hour or more all day.16 This contributed to order execution delays. One floor broker group reported that, as a result of these problems, some orders were diverted to TOPS printers at the New York Board of Trade, and that some may have been either delayed or misplaced in the process of transporting them to the COMEX floor.
Brokers? problems were compounded by the unusually high number of options contracts trading actively that day. According to the COMEX Daily Market Report for September 28, nine options contract months, comprising approximately 364 different strike prices, were available for trading. Floor brokers interviewed by Division staff reported that almost all of these strikes were trading actively on September 28. This combined with the absence of order prioritization and extreme price volatility to create extraordinarily difficult conditions for order execution. As one floor broker interviewed by Division staff observed, ?September 28 is the one day in this business no one in the pit will ever forget.?
4. Fill Reporting Problems
The FCMs interviewed by Division staff noted that on September 28, large numbers of fills were not reported by floor brokers to their customers in the normal course, leaving customers uncertain as to their positions in the market. This occurred because brokers and their clerks were occupied by the need to execute as many orders as possible in the face of overwhelming order flow. The steady stream of incoming orders made it difficult for floor brokers to take time to report fills either telephonically or by keying the requisite information into TOPS, and also forced them to delay order ticket endorsement.
One FCM with a large share of COMEX gold options business reported that many of its filled trades were not reported until Friday, October 1, 1999, and some were not reported until Monday, October 4, 1999 or Tuesday, October 5, 1999. Another large FCM reported that it did not obtain information on some fills until as late as Wednesday, October 6, 1999.
5. Clearing Problems
Market conditions also caused significant clearing problems, which persisted for a substantial period of time after September 28 and were a principal cause of the trade confirmation delays complained of by many customers. These clearing problems resulted from entry into OLTE of incorrect trade information. OLTE requires that both members involved in each trade enter complete information about the trade before the system will accept the trade as a matched trade. Erroneous or incomplete input by one or both members will cause either an unmatched or a miscleared trade.
COMEX had an exceptional number of unmatched trades in gold options on September 28. Unmatched trades occur either when one broker has not entered any information regarding his or her side of a transaction into OLTE, or when one broker enters information that is inconsistent with the opposite broker?s entry with respect to the opposite broker?s identity, the date, commodity, contract, quantity, or price of the trade, or (for options) the strike price and whether the trade is a put or call. During the more typical trading days of September 1 through September 24, 1999, COMEX averaged less than three unmatched gold options trades out of approximately 1,300 trades per day, for an average unmatched trade percentage of approximately 0.18 percent. In contrast, on September 28, 2,636 gold options trades out of a total of 15,044, or approximately 18 percent, were unmatched.17
COMEX also had an exceptional number of miscleared trades on September 28. Miscleared trades are those that match on all clearing criteria but are incorrectly cleared on one or both sides to the wrong clearing member. This occurs when a broker enters erroneous or incomplete information in the clearing member or customer account fields in OLTE. Miscleared trades caused the greatest difficulties for floor brokers and FCMs, and were the principal reason why an unusually long time was required to rectify clearing problems from September 28. Most FCMs interviewed by Division staff said their experience was that there were significantly more miscleared trades than unmatched trades from September 28, and that miscleared trades constituted the larger part of their clearing problems from that day. One FCM estimated that approximately 80 percent of its trades miscleared at other FCMs. Another FCM, whose principal COMEX business is as a primary clearing member (?PCM?)18 for floor brokers and local traders, said that on September 29 it not only received notice of more unmatched trades involving its guaranteed brokers than ever, but also had more miscleared trades than ever defaulted to it as a PCM.19
The Exchange attempted to help facilitate OLTE trade entry on the evening of September 28 by sending Exchange staff to assist floor brokers with the input process. However, floor brokers unanimously told Division staff that this well-intended effort unfortunately exacerbated the problem. According to the floor brokers, even though the Exchange staffers did their best, virtually all the data entries they made contained keypunch errors, due in part to Exchange staffers? unfamiliarity with brokers? handwriting. As a result, many of the affected trades did not match broker to broker, and even more were miscleared.
As part of their effort to enter as many trades as possible into OLTE on September 28, a number of floor brokers asked the Exchange to leave OLTE open for input and corrections past the normal 5:00 p.m. cutoff time. Exchange staff informed the Division that COMEX did keep the system open on September 28 until approximately 10:15 to 10:30 p.m., and similarly extended OLTE?s normal input hours for more than a week thereafter. Many brokers and FCMs said it would have been more helpful if the Exchange had left OLTE open longer, even for an hour or two.20 However, COMEX staff told the Division it is necessary to close OLTE no later than 11:00 p.m. to allow enough time for OLTE?s overnight processing cycle. OLTE must be reopened no later than 4:00 a.m., since the Eurotop 100 and Eurotop 300 contracts begin trading at 5:00 a.m. the next trading day. COMEX staff also noted that delay in closing OLTE for the evening would have caused problems for many FCMs, who rely on final clearing data from COMEX in their own overnight data processing cycles, and face similar world-wide start-up deadlines for the next day?s trading.
Exchange officers and staff also discussed internally, in part at the suggestion of a few COMEX members, the possibility of delaying the opening of gold options trading on Wednesday, September 29, in order to allow time to reduce the number of unmatched trades. However, the Exchange decided that a delay would not be in the best interest of either the trading public or the Exchange, particularly in the world gold market situation then existing. The majority of FCMs and floor brokers interviewed by the Division concurred in this decision.
D. The Week Following September 28: Order Restrictions And Weekend Clearing Session Request
1. Order Restrictions
Beginning at some point on September 28, many gold options brokers began accepting orders of various types only on a ?not held? basis.21 By September 29, and for approximately a week thereafter, virtually all brokers restricted the type of orders they would accept to market orders, and refused ?cancel and replace? orders other than ?replace to market.? Floor brokers interviewed by Division staff varied as to when they imposed order restrictions: one broker group notified its major FCM customers prior to the opening of trading on September 28 that it would take orders only on a not held basis, while another broker group first gave this notice to its customers on September 29. Shortly after September 28, both these broker groups restricted the orders they would accept to market orders only, one doing so on Wednesday, September 29, and the other on Thursday, September 30. One group did not lift this restriction until October 11, 1999. Most FCMs passed these restrictions on to customers through messages on proprietary electronic order entry systems, by fax and telephone calls, and by recorded messages on telephone lines used by their customers to place orders.
2. Request For Weekend Clearing Session
Virtually all the FCMs and floor brokers interviewed told Division staff that, in hopes of speeding resolution of both unmatched and miscleared trades from September 28 and the days immediately following, they asked the Exchange to hold a special weekend session to resolve those clearing problems. The Exchange has authority to do this under COMEX Rule 4.87.22 Brokers and FCMs stated that with mandatory attendance, to insure that all the people from whom information to correct a clearing problem was needed were available, and OLTE access, to allow correction in the clearing system, such a ?disaster recovery? session would have allowed most clearing problems to be resolved.23
The Exchange considered this request, but decided not to call such a session.24 As noted by Exchange staff in their interview with Division staff and in an Exchange letter to the Division dated January 13, 2000, the principal reason for the Exchange?s decision was that the Exchange feared that problems with OLTE could result. Although OLTE had been used as the Exchange trade processing system since February 1988, it had never been opened except for normal trading days. The system had never been tested to determine what might happen if it was opened for corrections on a day when there was no trading. Exchange staff thought it was possible that opening OLTE on a non-trading day might cause COMEX to be unable to open in a timely and fully functional way on Monday, October 4, at a time when volatile market conditions still existed. Exchange staff found this risk unacceptable.
III. ANALYSIS
A. Execution Problems
The FCMs interviewed by Division staff generally agreed, despite having each endured their share of execution problems on September 28, that the gold options floor brokers generally performed acceptably under the circumstances of the day in executing as many orders as they could. Floor brokers and FCMs interviewed by the Division agreed that the gold options pit was understaffed for handling the order volume seen on September 28. They also agreed, however, that the pit was appropriately staffed for the level of gold options trading seen during the four or five years preceding September 28, and that it would be economically infeasible to staff routinely for market events which occur as rarely as the events of September 28. This conclusion appears reasonable. As noted earlier, the number of floor brokers participating in gold options trading for customers on September 28 nearly doubled over normal levels. Exchange staff told the Division that the Exchange plans to request that floor brokers and FCMs develop contingency plans for added staffing in emergency situations like September 28 wherever possible. Although such plans are unlikely to prevent similar problems entirely in the future, they may be of some help.
Some customers alleged that large institutional orders received execution priority over smaller retail orders. The floor brokers and FCMs interviewed by the Division stated that few institutional orders were received on September 28, most institutional customers having reacted to the September 26 central banks announcement on September 27.25 There appears to be no indication that institutional customers received preferential executions. It is possible that in instances where floor brokers received orders by telephone from customers with whom they had ongoing relationships, some such telephone orders could have received priority over orders received on paper. However, floor brokers and FCMs reported that, regardless of how orders were received, the sheer number of orders made perfect prioritization of orders extremely difficult. As noted earlier, brokers? and firms? clerks did not have time to sort orders by type of order or time of receipt, since they were being overwhelmed by the flow of orders.
In situations where exceptional numbers of orders are received, there are several possible steps which the Exchange could take. Order deck prioritization problems can be alleviated through the use of electronic deck management systems, or other advanced technologies that may be available or appropriate for development, capable of sorting order decks instantly and continuously. Examples of order deck management systems currently in use at various domestic futures exchanges include the Electronic Clerk (?EC?) at the Chicago Board of Trade, the CME Universal Broker Station (?CUBS?) at the Chicago Mercantile Exchange, and the Lind-Waldock Order Book Management System (?LOBMS?), Lind-Waldock & Company?s proprietary system. These systems use small, stationary, wired terminals in the ring to receive orders. They organize the orders for execution, transmit fill information to the customer and the clearing member, and in some cases, simultaneously transmit trade information to the exchange clearing system. The Exchange has told the Division that it has now approved three pilot projects testing the use of different types of such devices. Early adoption of an electronic deck management system or similar technology by the Exchange would be an important step toward limiting problems like those of September 28 in the future.
The Exchange could also consider ways in which to ensure that dual trading members meet their obligations to fill executable customer orders before trading for their own accounts.26 When the capacity of the floor to execute orders is being exceeded, a question arises as to the obligation and practical ability of a broker to ascertain whether he has executable orders in his possession. Temporary trading halts could be one way to address this problem. The Floor Committee has authority to halt trading for up to an hour under Exchange rules.27 Implementation of trade suspension authority in situations like September 28 may require steps to ensure that the Exchange is made aware on a timely basis of the fact that order flow is exceeding execution capacity.
Another method of handling large numbers of orders can be side-by-side trading. In the event that the Exchange were to adopt such trading on its current NYMEX ACCESS© electronic trading system or a similar system, that system could serve as an outlet for execution of small orders that could not immediately be executed in the pit due to circumstances similar to those of September 28.
Lastly, TOPS system outages and the slow speed of TOPS printers caused substantial delays in orders reaching the gold options floor. Additionally, one firm rerouted orders to TOPS printers in other locations, and these orders may have been delayed or misplaced in the process of transporting them to the COMEX floor. Steps toward TOPS malfunction prevention, TOPS printer speed upgrades and installation of additional TOPS printers, and contingency plans for delivery of rerouted orders from other TOPS printer locations would also be useful in future situations involving exceptional numbers of orders.
B. Customer Communication Problems
Many customer and introducing broker complaints concerned their inability to ascertain the status of their orders. As noted earlier, fill reports were delayed on September 28 because floor brokers and their clerks gave first priority to accepting and filling executable orders, and as a result lacked time to report fills either telephonically or via TOPS. The Division believes that the brokers? decision to give order execution the highest priority was appropriate. However, the resulting delays alarmed customers, who had become accustomed to receiving fill reports within minutes of order execution. Fill reporting delays continued after trading closed on September 28, in some cases for days. Many customers also complained that they had not received confirmation statements reflecting fills reported to them from September 28. FCMs and brokers told the Division that customer communication issues of this type resulted in large part from the magnitude of the miscleared trade problem, discussed below.
Gold options customers who did not receive fill reports or did not see their trades listed on their confirmation statements faced the possibility of a double fill if they reentered the market. FCMs took disparate approaches in dealing with these customers. On the morning of September 29, one FCM which has a major share of retail gold options business at COMEX found that it had not received fill reports for approximately 3,000 orders placed on September 28. This FCM decided to inform its customers immediately that: (1) if they had not already received a report of a fill, they should consider their order ?unable,? and (2) they could reenter the market if they desired, and would not be held to the first order if, in fact, it was later discovered that it had been filled. In other words, this FCM swiftly advised its customers that the customers would not be held liable for possible double fills. The same approach was also taken by another FCM, which sent a memo to customers on September 29, advising them that if they had not already received a fill on orders that were executable, they should assume they were ?unable,? and the FCM would not later ?stick? them with a fill, resulting in a double fill in their accounts.
Another large retail FCM, which reported having several hundred unfilled orders, took a different approach. The FCM told customers inquiring about the status of their orders that a report on their orders had not been received by the firm, and that it would pursue the disposition of their orders. The FCM did not advise its customers that they would not be liable for possible double fills if they reentered the market.
Notwithstanding this disparate treatment, ultimately most customers were adjusted. FCMs interviewed by Division staff reported receiving varying numbers of customer complaints resulting from trading on September 28. Formal complaints, whether oral or written, ranged from approximately 50 at one large FCM to two or three at others. FCMs generally reported making financial adjustments for many customers, and assisting a few with the arbitration process. Most FCMs appear to have resolved most customer complaints in one of these fashions in a timely manner. This is borne out by the fact that as of February 1, 2000, the Commission had received only one reparations filing regarding COMEX gold options trading on September 28, and the fact that as of the same date, COMEX had received only three filings for Exchange arbitration on this subject.
C. Clearing Problems
As noted above, many of the delays in confirming fills to customers were connected to delays in trade data entry and clearing. The Division believes, based on the interviews it conducted with floor brokers and COMEX staff, as well as with FCMs, that FCMs generally used due diligence to work through the clearing problems that arose in connection with September 28 trading.28 Many FCMs reported that their staff worked extensive extra hours on September 28 and during the rest of the week that followed in order to deal with clearing problems, some working nearly all night and sleeping in the office rather than going home. FCMs with multiple offices brought in additional staff from o |
