Proposed Rules Would Change Definition of Foreign Stock Indices
After an arduous year of hammering out the terms of the Commodity Futures Modernization Act of 2000 with members of Congress and their staffs, neither U.S. regulators nor participants in the global derivatives markets have been able to afford any time to bask in the afterglow of their joint achievement. An enormous amount of work still needs to be done in a very tight timeframe to implement the sweeping changes authorized and ordained by Congress. Nowhere is that more evident than in respect to the regulations which Congress has expressly directed the Commodity Futures Trading Commission and the Securities and Exchange Commission to promulgate before the U.S. debut of security futures. And nowhere is that more acutely needed than in respect to products offered by exchanges outside the U.S. or based on securities registered outside the U.S.
The clock is ticking loudly on all of the rulemakings related to security futures, which the CFTC and SEC need to complete and have effective by August 21, the earliest date on which security futures are permitted to trade in the U.S. between eligible contract participants on a “principal-to-principal basis” (a phrase that has generated numerous questions to the SEC and CFTC), or, if they apply only to retail customers, December 21, the earliest date on which all other U.S. persons are permitted to trade security futures. Backing out mandatory comment, notice and publication periods from those deadlines leaves the CFTC and SEC minimal time to draft rules and revise them in response to industry comments. Market participants have even less time to prepare and file such comments. (Unless the CFTC and SEC have extended the deadlines for the rules each has proposed as of the date of this writing, the comment periods for most of the rules described in this article will have already expired by the time this issue is published.) Yet, in terms of competition in the global markets, the schedule prescribed by the CFMA may be too generous. Other exchanges around the world already offer futures on single stocks and narrow-based indices, and some, most notably The London International Financial Futures & Options Exchange, are about to introduce futures contracts on several of the most widely traded U.S. equities. Although U.S. persons may not yet legally trade such contracts on non-U.S. exchanges, those exchanges will have a significant head start in developing the market for some of the more popular security futures contracts.
A unique aspect of the shared jurisdiction over security futures that the CFMA grants to the CFTC and the SEC is the concept of “notice registration,” which is designed to mitigate the costs to exchanges and intermediaries inherent in complying with the registration requirements of both regulatory agencies. The CFMA amends the Commodity Exchange Act and the Securities Exchange Act of 1934 (Exchange Act) to provide that an exchange or an intermediary which is registered and in good standing with the CFTC or the SEC may register with the other regulatory agency for the limited purpose of trading security futures by filing a brief, informational notice. On May 15, the SEC issued for public comment its proposed rule prescribing the requirements for a designated contract market or a DTF registered with the CFTC to register with the SEC as a national securities exchange to trade security futures. Two days later, the CFTC proposed for public comment amendments to its rule 3.10 providing that a broker-dealer registered with the SEC may “notice register” as an FCM or IB for security futures by following the procedures for notice registration specified by the National Futures Association. Imminently expected as of this writing were the SEC’s proposed rules for notice registration of FCMs and IBs as broker-dealers and the CFTC’s proposed rules for notice registration of securities exchanges and automated trading systems as designated contract markets or DTFs.
Also on May 17, the CFTC and SEC published their first jointly proposed rules on security futures, as mandated by the CFMA, which were the most controversial of the new rules generated to date this year. The CFMA expressly directed both agencies to specify by joint rules the method for calculating “dollar value of average daily trading volume” and “market capitalization” for purposes of the new definition of “narrow-based security index” in the CEA and the Exchange Act.
The CFMA defines a “narrow-based security index” as one: (i) which is comprised of nine or fewer component securities; (ii) in which a component security comprises more than 30 per cent of its weighting; (iii) in which the five highest weighted componee securities in the aggregate comprise more than 60 percent of the index’s weighting; or (iv) in which the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50 million or $30 million if the index is comprised of 15 or more component securities.
Notwithstanding the foregoing, an index would not be considered a narrow-based security index if it is one: (i) which is comprised of nine or more securities; (ii) in which no component security comprises more than 30 percent of the index’s weighting; and (iii) in which each component security is (a) registered pursuant to section 12 of the Exchange Act; (b) is one of 750 securities with the largest market capitalization (of those registered under the Exchange Act); and (c) one of 675 securities with the largest dollar value of average daily trading volume (of those registered under the Exchange Act). This exception is not meaningful for indices offered on any non-U.S. equities, because those stocks are not registered under the Exchange Act (other than ADRs, which may not meet the trading volume test).
Any security index which falls outside the CFMA’s definition of a “narrow-based security index” would be considered broad-based and therefore subject to the CFTC’s exclusive jurisdiction. In addition, any security index underlying a futures contract traded on a designated contract market before the effective date of the CFMA would not be considered narrow-based. A foreign stock index contract would not be deemed narrow-based (i.e., qualify as broad-based) if (i) such contract meets the rule requirements which will be jointly established by the SEC and CFTC or (ii) within the first 18 months of enactment of the CFMA, a contract which had been authorized to trade on a foreign exchange before the enactment of the CFMA continues to meet the conditions of such authorization.
At first blush, at least from the perspective of a U.S. exchange, the joint rulemaking is merely a technical handbook for calculating the market terms specified in the CFMA to determine whether an index falls under the exclusive jurisdiction of the CFTC or the joint jurisdiction of the CFTC and SEC. From the perspective of exchanges located outside the U.S. and investors and their intermediaries who trade stock indices on those exchanges, however, the proposed rules loom as a formidable barrier to entry into the U.S. markets. The proposed rules under the CEA and the Exchange Act provide that a futures contract on a security index traded on a foreign board of trade would not be considered a narrow-based security index only if it would not be considered narrow-based under the statutory definition or exclusions from that definition.
Market participants claim that a significant share of the foreign stock indices which U.S. persons currently trade pursuant to CFTC no-action letters and other indices pending approval would not qualify as broad-based under the CFMA’s criteria, because five of the component securities of each such index exceed 60 percent of the index’s weighting or the trading volume threshold for the bottom quartile may not be appropriate for certain foreign markets. Therefore, unless the SEC and CFTC provide sufficient flexibility in the joint rules to address inherent discrepancies in size and composition between U.S. and certain major foreign markets, many foreign stock indices which currently trade in the U.S. subject to CFTC no-action letters may not continue to trade after the expiration of the 18-month sunset period prescribed by the CFMA. An index that no longer qualifies as broad-based may not in some cases automatically continue to trade as “narrow-based” in the U.S., because it may fail to meet all of the listing standards for security futures specified by the CFMA. Neither the CFMA nor the rules proposed by the SEC provide that a foreign board of trade may notice register with the SEC, and the rules proposed by the SEC.
If the agencies extend the comment period for their joint rules, the industry should draw on the expertise of global intermediaries and exchanges outside the U.S. to work with the SEC and CFTC to craft an alternative path around classification as a narrow-based stock index. Recognition by the SEC of other competent regulatory regimes in the “home” jurisdiction of the issuers and meaningful information-sharing arrangements may provide a starting point for finding a solution in the same way that the CFTC looks to other competent regulators in granting Part 30 relief.
As of this writing, the CFTC and SEC have yet to propose what may be even more controversial joint rules for security futures, margin requirements and listing standards. Although the CFMA provided an enormous boost to the U.S. derivatives markets and most who participate in them, industry representatives of the international derivatives markets should make every effort to continue to work closely with U.S. regulators during this frenetic period of rule making and implementation to maximize the potential advantages of this revolutionary legislation.
C. Robert Paul is attorney at law for the Washington, D.C.-based law firm of McDermott, Will & Emery. He was formerly general counsel for the Commodity Futures Trading Commission.
CFTC Implements CFMA
During the first five months of 2001, the staffs of the CFTC and the SEC have issued for public comment a number of significant regulations on the narrow time frames dictated by the CFMA. The first of those to become effective, on June 19, is the CFTC’s new rule 1.68 which permits eligible contract participants to opt out of having their funds segregated by their FCM for trades on a registered DTF. Taking a page from the U.K. Securities and Futures Authority rulebook, the CFMA provided that a DTF may authorize an FCM to offers its customers who are eligible contract participants the right not to have their funds that are carried for purposes of trading on the DTF separately accounted for and segregated. Rule 1.68 requires that any customer exercising its right must execute a written agreement electing to opt out of segregation and acknowledging the consequences, including forfeiture of the usual customer priority in bankruptcy ahead of the FCM’s general creditors.
Right on the heels of the “opting out” rules, the CFTC approved its new Part 160 privacy rules, which become effective on June 21, 2001. By adding the CFTC to the list of federal functional regulators under the Gramm-Leach-Bliley Financial Modernization Act of 1999, the CFMA directed the CFTC to prescribe rules requiring those under its jurisdiction (futures commission merchants, commodity trading advisors, commodity pool operators and introducing brokers) to disclose their privacy policies to their customers upon establishing the customer relationship (and annually thereafter) and to offer customers an opportunity to opt out of sharing nonpublic personal information with nonaffiliated third parties. Part 160 does not, however, apply to any foreign or nonresident FCM, CTA, CPO or IB that is not required to be registered with the CFTC.
Three days after publishing its final privacy rules, on May 14 the CFTC published for comment its proposed new Part 39 rules for the registration and regulation of derivatives clearing organizations (DCOs). Prior to the CFMA, the CFTC had no direct jurisdiction over clearing organizations per se. Instead the CFTC derived its jurisdiction over the clearing process primarily through its authority to regulate the execution and settlement of transactions on exchanges and to protect customer funds. The CFMA added a provision to the CEA requiring futures contracts, options on futures and commodity options to be cleared only on a DCO registered with the CFTC, unless the contract is excluded or exempted under the CEA or it is a security future cleared by a securities clearing agency. Contracts traded on a designated contract market must be cleared on a DCO, and excluded or exempted contracts traded on a DTF may be cleared on a DCO (which may voluntarily register with the CFTC). The CFMA also permits a DCO to clear other contracts or transactions, such as OTC derivatives and spot and forward contracts. Like the three categories of trading facilities, a registered DCO must comply with a set of core principles prescribed in the CFMA.
—C. Robert Paul