Agencies Clear Way For Trading Securities Future Products

Spurred on by the Chairman of the House Committee on Financial Services Rep. Michael G. Oxley, R-Ohio, regulators moved forward on several fronts to end the nearly 20-year ban on securities futures products. Both the Securities and Exchange Commission and the Commodities Futures Trading Commission adopted rules to permit principal-to-principal trading to commence.

Eyeing competition from overseas markets, Congress included in the Commodity Futures Modernization Act of 2000, which was enacted December 21, 2000, language authorizing the trading of futures on individual stocks and narrow-based stock indexes, including puts, calls, straddles, options, or privileges thereon. The law targeted August 21, 2001 as the starting date for principal-to-principal trading of stock futures products and permits retail trading to commence as soon as December 21, 2001.

Market veterans predict that if the remaining regulatory hurdles can be cleared, full-scale trading will begin early next year. The CFMA also permits the trading of options on stock futures, but market manipulation concerns prompted Congress to defer that authorization until December 21, 2003.

With the SEC and the CFTC's dissimilar regulatory styles and long history of knocking heads over matters of shared jurisdiction, the frenetic pace of the last two weeks with which the agencies poured out the necessary rules and took administrative actions was unexpected. However, before retail trading can commence, even thornier issues must be resolved. Those include margin requirements, examination and qualification requirements, dual trading prohibitions, and risk disclosure documentation. Also, the Treasury Department must reconcile the tax treatment of security futures and security option contracts.

Indicative of the regulatory struggle is that even the term principal-to-principal is in dispute. In an August 14 letter to Oxley, SEC Chairman Harvey L. Pitt revealed the SEC's rather restrictive position that only transactions between otherwise eligible members of an exchange that are also members of a clearing agency that clears the transactions on such exchange would qualify.

Regulatory Status Summary

On August 21 the SEC and CFTC issued joint rules and a joint order to permit the trading of security futures products to begin. Under the CFMA future contracts on broad-based indexes are under the exclusive jurisdiction of the CFTC. Narrow-based indexes fall under the joint regulation of the two agencies. The joint rules define how to determine if an index is narrow -based by taking into account such factors as market capitalization of each security in the index and the dollar value of that security's average trading volume. The rules would apply to indexes traded on or subject to foreign boards of trade. The joint order would permit an American Depository Receipt to underlie a security future and be a component security of a narrow-based security index underlying a security future.

On August 21 the SEC approved rules filed by the National Futures Association, the only registered futures self-regulatory organization, to meet the requirements for a Limited Purpose National Securities Association. The CFTC approved the rules on August 20. The action clears the way for members of the NFA to commence trading security futures products on a principal-to-principal basis. To meet the securities association status, the NFA had to have in place anti-fraud, anti-manipulation, and customer protection rules comparable to a fully registered national securities association and must meet other training and competence standards applicable to transactions in security futures products.

On August 20 the CFTC adopted regulations providing a streamlined procedure for national securities exchanges, national securities associations, and alternative trading systems to be "noticed-designated" as contract markets in security futures products. On August 13, the SEC adopted its half of the notice registration regulations prescribing the requirements for designated contract markets and derivative transaction execution facilities to register as national securities exchanges. As the CFMA requires, the pair of rules provide for designation contemporaneously with the filing of the notice.

A last minute burst of regulatory activity by the SEC and the CFTC opens the door for trading of securities futures products. Pressure by key Congressman motivates agencies to meet target date; however the two commissions have a narrow window of time to resolve a number of difficult problems before the more important second phase may begin. Retail trading of securities futures products is slated to commence as early as December 21. If the two agencies can reach agreement in a timely manner, marketers are expected to roll out their new products early next year.