CFTC and SEC: Issues Related to the Shad-Johnson Jurisdictional Accord
(Letter Report, 04/06/2000, GAO/GGD-00-89).
Pursuant to a congressional request, GAO reviewed the Securities and
Exchange Commission (SEC) and the Commodity Futures Trading Commission
(CFTC) and the issues the two have in relation to the Shad-Johnson
Jurisdictional Accord, focusing on: (1) the extent to which U.S.
securities, foreign futures, and over-the-counter (OTC) markets trade
stock-based derivatives that are economically similar to the futures
prohibited from trading by the accord; (2) the potential effect of the
accord trading prohibitions on derivatives market participants; (3)
concerns about calls to repeal the accord trading prohibitions; and (4)
jurisdictional and other approaches to addressing these concerns.
GAO noted that: (1) U.S. securities, foreign futures, and OTC markets
trade derivatives that are based on single stocks and stock indexes; (2)
however, the Shad-Johnson Jurisdictional Accord precludes U.S. futures
exchanges from trading futures on single stocks and certain stock
indexes; (3) specifically, U.S. securities exchanges trade options on
over 2,600 single stocks; (4) in addition, 9 foreign exchanges trade
single stock futures on at least 189 foreign stocks; (5) as of year-end
1998, the equity swaps market worldwide had an estimated total notional
value of $146 billion, accounting for a fraction of a percent of the
total notional value of the OTC derivatives market worldwide; (6)
although investors can use stock-based options and equity swaps to hedge
price risk, they cannot use stock-based futures to the same extent
because of the accord prohibitions on single stock and certain stock
index futures; (7) some futures industry officials have said that the
accord prohibitions should be repealed, because they have restricted
U.S. futures exchanges from competing with other markets that trade
derivatives on single stocks and narrow-based stock indexes; (8) in
response to calls to repeal the accord trading prohibitions, SEC, the
U.S. securities exchanges, the President's Working Group on Financial
Markets, and several members of Congress have expressed concerns about
doing so without first resolving applicable differences between
securities and commodities laws and regulations; (9) their concerns
center on the potential for single stock and certain stock index futures
to be used as substitutes for single stocks to circumvent federal
securities laws and regulations; (10) according to SEC and securities
exchange officials, the prohibited futures could be allowed to trade, if
they were regulated as securities; (11) these officials said that such
an approach would enable SEC to ensure that stocks and stock-based
derivatives were regulated consistently; (12) in response to
congressional requests for action, SEC and CFTC have agreed to an
approach that would allow single stock futures to be traded on both U.S.
securities and future exchanges; and (13) under this approach, the
agencies would jointly regulate such futures, the intermediaries that
offered them, and the markets that traded them.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-00-89
TITLE: CFTC and SEC: Issues Related to the Shad-Johnson
Jurisdictional Accord
DATE: 04/06/2000
SUBJECT: Derivative securities
Stock exchanges
Stocks (securities)
Securities regulation
Commodity futures
Futures
Restrictive trade practices
Jurisdictional authority
Hedging
IDENTIFIER: Shad-Johnson Jurisdictional Accord
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United States General Accounting Office
GAO
Report to Congressional Requesters
April 2000
GAO/GGD-00-89
CFTC AND SEC
Issues Related to the Shad-Johnson
Jurisdictional Accord
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Contents
Page 381 GAO/GGD-00-89 Shad-Johnson Accord
Letter 1
Appendix I 40
Comments From the
Securities and Exchange
Commission
Appendix II 42
GAO Contacts and Staff
Acknowledgments
Related GAO Products 44
Abbreviations
CBOE Chicago Board Options Exchange
CBT Chicago Board of Trade
CEA Commodity Exchange Act
CFTC Commodity Futures Trading Commission
CME Chicago Mercantile Exchange
FCM futures commission merchant
FIA Futures Industry Association
NFA National Futures Association
OTC over-the-counter
SEC Securities and Exchange Commission
B-284260
Page 36 GAO/GGD-00-89 Shad-Johnson Accord
B-284260
April 6, 2000
The Honorable Richard G. Lugar
Chairman, Committee on Agriculture,
Nutrition and Forestry
United States Senate
The Honorable Thomas W. Ewing
Chairman
Subcommittee on Risk Management,
Research, and Specialty Crops
Committee on Agriculture
House of Representatives
The Honorable John D. Dingell
Ranking Member
Committee on Commerce
House of Representatives
To clarify their respective jurisdictions over
securities-based derivatives,1 the Securities
and Exchange Commission (SEC) and Commodity
Futures Trading Commission (CFTC) reached an
agreement, called the Shad-Johnson
Jurisdictional Accord, in 1981. The accord was
enacted into law in January 1983 and, among
other things, prohibited futures2 trading on
single stocks, as well as on stock indexes that
did not meet specific requirements. These
prohibitions reflected concerns that such
futures could be used as substitutes for single
stocks to circumvent securities laws and
regulations. Given your interest in ensuring
that the U.S. financial markets remain
innovative, competitive, and, at the same time,
appropriately regulated, you asked us to review
certain issues related to the accord trading
prohibitions. In response, we analyzed
� the extent to which U.S. securities, foreign
futures, and over-the-counter (OTC)3 markets trade
stock-based derivatives that are economically
similar to the futures prohibited from trading by
the accord;
� the potential effect of the accord trading
prohibitions on derivatives market participants;
� concerns about calls to repeal the accord
trading prohibitions; and
� jurisdictional and other approaches to
addressing these concerns.
Results in Brief
U.S. securities, foreign futures, and OTC markets
trade derivatives that are based on single stocks
and stock indexes. However, the Shad-Johnson
Jurisdictional Accord precludes U.S. futures
exchanges from trading futures on single stocks
and certain stock indexes. The stock-based
derivatives that are trading in other markets can
be used, like futures, to hedge (i.e., shift the
risk of price changes to those more willing or
able to assume the risk) or to speculate (i.e.,
invest with the intent of profiting from price
changes). Specifically, U.S. securities exchanges
trade options4 on over 2,600 single stocks. These
options can be used to replicate the economic
function of single stock futures. U.S. securities
exchanges also trade options on a wide range of
narrow-based stock indexes.5 In addition, 9
foreign exchanges trade single stock futures on at
least 189 foreign stocks. In 1998, about 2.1
million single stock futures were traded,
accounting for less than 1 percent of the total
trading volume of the foreign futures market.
Finally, the OTC derivatives market offers equity
swaps6 that serve economic functions similar to
futures and that can be structured using virtually
any single stock or stock index. As of year-end
1998, the equity swaps market worldwide had an
estimated total notional value of $146 billion,
accounting for a fraction of a percent of the
total notional value of the OTC derivatives market
worldwide.
The accord trading prohibitions may have limited
investor choice and exposed some market
participants to legal uncertainty. Although
investors can use stock-based options and equity
swaps to hedge price risk, they cannot use stock-
based futures to the same extent because of the
accord prohibitions on single stock and certain
stock index futures. Also, some futures industry
officials have said that the accord prohibitions
should be repealed, because they have restricted
U.S. futures exchanges from competing with other
markets that trade derivatives on single stocks
and narrow-based stock indexes. Additionally,
other futures industry officials said that the
accord has limited the ability of U.S. investors
to use foreign exchange-traded stock index futures
to hedge risks associated with their foreign stock
investments. Finally, the accord has exposed
equity swaps counterparties to legal uncertainty.
If an equity swap falls within the judicially
crafted definition of a futures contract, it would
be in violation of the accord, making it illegal
and unenforceable.
In response to calls to repeal the accord trading
prohibitions, SEC, the U.S. securities exchanges,
the President's Working Group on Financial Markets
(Working Group),7 and several members of Congress
have expressed concerns about doing so without
first resolving applicable differences between
securities and commodities laws and regulations.
Their concerns center on the potential for single
stock and certain stock index futures to be used
as substitutes for single stocks to circumvent
federal securities laws and regulations. The most
significant differences identified were the lack
of comparable insider trading prohibitions, margin8
levels, and customer protection requirements. CFTC
and futures exchange officials have agreed that
the lack of comparable insider trading
prohibitions would need to be addressed so that
stock-based futures could not be used to
circumvent the insider trading prohibitions of the
federal securities laws that are lacking in the
Commodity Exchange Act (CEA). Also, while CFTC
and the Federal Reserve have recognized that the
U.S. futures exchanges have a record of setting
margins at levels that have protected the
financial integrity of the markets, futures
exchange officials have said that they would be
willing to set margin for single stock futures at
a level comparable to margin for single stock
options. Additionally, SEC and the U.S. securities
exchanges disagree with the National Futures
Association (NFA)9 on whether customer protection
requirements for the securities and futures
markets offer similar protections. Finally, other
differences between the securities and commodities
laws and regulations exist, such as restrictions
on short-term profits by corporate insiders, that
would need to be resolved, if the accord
prohibitions are to be lifted.
Pivotal to addressing legal and regulatory
concerns related to repealing the accord trading
prohibitions is resolving the jurisdictional
question of whether SEC, CFTC, or both agencies
should regulate futures on single stocks and
certain stock indexes. The answer to this question
would determine whether such futures were
regulated under the securities and/or the
commodities laws and, in turn, would affect the
type of legal and regulatory changes that would be
needed. According to SEC and securities exchange
officials, the prohibited futures could be allowed
to trade, if they were regulated as securities.
These officials said that such an approach would
enable SEC to ensure that stocks and stock-based
derivatives were regulated consistently. According
to futures exchange officials, if the prohibited
futures were allowed to trade, they could be
effectively regulated under the CEA. These
officials said that, under this approach, the CEA
could be amended and other steps taken to address
SEC and U.S. securities exchange concerns.
In response to congressional requests for action,
SEC and CFTC have tentatively agreed to an
approach that would allow single stock futures to
be traded on both U.S. securities and futures
exchanges. Under this approach, the agencies would
jointly regulate such futures, the intermediaries
that offered them, and the markets that traded
them. In reaching their tentative agreement, SEC
and CFTC noted the importance of avoiding the
imposition of unnecessarily burdensome or
duplicative regulation on the securities and
futures markets as well as on their participants.
Although the agencies have tentatively agreed on
the initial standards for trading single stock
futures, they have not yet agreed on which core
provisions of the securities and commodities laws
would apply to the markets and intermediaries. SEC
and CFTC officials said that one of their major
challenges is developing a process to ensure that
regulations applicable to the securities and
futures markets and intermediaries remain
consistent and appropriate as the markets evolve.
These officials said that the agencies plan to
continue working together with the goal of
providing a comprehensive legislative proposal to
Congress before it adjourns.
The SEC and CFTC joint approach for addressing the
issues surrounding the trading of the prohibited
futures as well as other approaches indicate that
such issues are resolvable. While SEC and CFTC
have begun working together to address these
issues, uncertainty remains about the outcome of
such efforts because of differences between the
SEC and CFTC perspectives as well as the
securities and commodities laws. Continued
congressional attention may be a key factor in the
ultimate resolution of the jurisdictional issues
involved. As a result, we are recommending that
SEC and CFTC (1) work together and with Congress
to develop and implement an appropriate legal and
regulatory framework for allowing the contracts to
trade and (2) submit to Congress legislative
proposals for repealing the accord trading
prohibitions.
Background
In the United States, SEC has authority over
securities trading and the securities markets, and
CFTC has authority over futures trading and the
futures markets. According to SEC and CFTC, three
amendments to the CEA in 1974 led to
jurisdictional disputes over securities-based
futures. First, the act was amended to expand the
definition of a commodity to include virtually
anything-tangible or intangible. Consequently, a
security fell within the definition of a
commodity. Second, the act was amended to provide
CFTC with exclusive jurisdiction over all
commodity futures transactions, including options
on futures. Third, the act was amended to preserve
SEC's preexisting authority over securities
trading and the securities markets.
These three CEA amendments led to a dispute
between SEC and CFTC that was eventually resolved
through the Shad-Johnson Jurisdictional Accord. In
1975, CFTC approved a Chicago Board of Trade (CBT)
application to trade futures on Government
National Mortgage Association pass-through
mortgage-backed certificates. In an exchange of
letters, SEC asserted that the contracts were
securities within its jurisdiction, and CFTC
responded that they were futures within its
exclusive jurisdiction. The dispute remained
unresolved, and in 1981, SEC approved rule changes
for the Chicago Board Options Exchange (CBOE) that
allowed the exchange to trade options on the
certificates. CBT petitioned the U.S. Seventh
Circuit Court of Appeals to set aside the SEC
order. The court prevented CBOE from trading the
options until it could render its decision.10 Under
these circumstances, SEC and CFTC reached the
accord to clarify their respective jurisdictions
over securities-based options and futures. In
February 1982, they submitted the accord to
Congress to be enacted into law. Congress codified
the accord substantially as proposed in the
federal securities laws as section 2 of the
Securities Act of 1933 and section 3 of the
Securities Exchange Act of 1934 and in the CEA as
section 2(a)(1)(B).11
The accord allocated jurisdiction between SEC and
CFTC for, among other things, securities-based
options and securities-based futures and options
on futures.12 First, it provided SEC with
jurisdiction over securities-based options,
including stocks and stock indexes. Second, the
accord prohibited futures (and options thereon) on
single corporate and municipal securities.
According to SEC and CFTC, the ban was intended to
be temporary, and both agencies were to complete a
study of the accord with a view toward lifting the
prohibition. SEC officials told us that the study
was to be undertaken 5 years after the accord was
reached. But, according to the officials, it was
never done because of the need to complete higher-
priority studies following the 1987 and 1989
market declines.
Finally, the accord provided CFTC with
jurisdiction over futures (and options thereon) on
exempted securities13 (other than municipal
securities) and stock indexes. The accord allowed
CFTC to approve a stock index futures contract for
trading if CFTC found that the contract was (1)
settled in cash; (2) not readily susceptible to
manipulation; and (3) based on an index that
either was a widely published measure of and
reflected the market as a whole or a substantial
segment of the market, or else was comparable to
such a measure. According to SEC and CFTC, these
three standards were intended to ensure that stock
index futures would not be readily susceptible to
manipulation, be used to manipulate the underlying
securities or related options markets, or serve as
a surrogate for a single stock futures contract.
The one substantial change that Congress made to
the accord in codifying it was to provide SEC with
veto authority over stock index futures. As
submitted to Congress, the accord would have only
required that CFTC consult with SEC before
approving a stock index futures contract; it would
not have provided SEC with veto authority over
such contracts. As codified by Congress, the
accord required CFTC to provide SEC with an
opportunity to review any proposed stock index
futures contract before approving it for trading.
If SEC determined that the proposed contract
failed to meet the accord standards, CFTC could
not approve the contract.14 According to the
accord's legislative history, Congress included
this provision to provide SEC an equal voice with
CFTC "in making certain threshold determinations
about the manipulative impact" of a stock index
futures contract. Under this arrangement, CFTC had
approved 57 stock index futures contracts for
trading as of January 12, 2000.
Scope and Methodology
To address each of our four objectives, we
reviewed the legislative history of the accord,
congressional hearings, federal securities and
commodities laws and regulations applicable to
stock-based derivatives, and legal cases involving
the accord, as well as studies and articles on the
regulation and economic function of the
securities, securities options, and futures
markets. In addition, to analyze the extent to
which U.S. securities, foreign futures, and OTC
markets trade stock-based derivatives that are
economically similar to the futures prohibited
from trading by the accord, we collected and
analyzed trading and related data on U.S.
securities options, foreign single stock futures,
and equity swaps. To analyze concerns about calls
to repeal the accord trading prohibitions, we also
attended congressional briefings by CFTC, SEC,
U.S. futures and securities exchanges, and
industry associations in which they presented
their views on the legal and regulatory concerns
associated with repealing the accord prohibitions.
To analyze jurisdictional and other approaches to
addressing these concerns, we reviewed the SEC and
CFTC March 2, 2000, letter to selected congressmen
that presented their joint approach for allowing
the trading of single stock futures in both U.S.
securities and futures markets.
In addition, to address each of our four
objectives, we interviewed officials of CFTC; SEC;
the Federal Reserve; three U.S. futures exchanges
(CBT, the Chicago Mercantile Exchange (CME), and
the New York Mercantile Exchange), which are self-
regulatory organizations;15 two U.S. securities
exchanges (CBOE and the New York Stock Exchange)
and the National Association of Securities
Dealers,16 which are self-regulatory organizations;
two other industry self-regulatory organizations
(the National Association of Securities Dealers
Regulation and NFA); four industry associations
(the Futures Industry Association (FIA),17
International Swaps and Derivatives Association,18
Securities Industry Association,19 and U.S.
Securities Markets Coalition);20 and two market
observers (a former CFTC chairperson and an expert
in securities law). We also interviewed officials
of two foreign regulatory authorities (the Swedish
Financial Supervisory Authority and U.K. Financial
Services Authority), two foreign exchanges (the
London International Financial Futures and Options
Exchange and OM Stockholm Exchange), and two
foreign companies (Ericsson and Nordbaken) whose
stock is subject to futures trading, to discuss
their experiences, as applicable, with trading and
regulating single stock futures. We included
Sweden in our review because it had one of the
most active markets in individual stock futures.
We included the United Kingdom in our review
because it did not prohibit single stock futures
from trading and because it had recently adopted a
single regulator for its futures and securities
markets. Information on foreign law in this report
does not reflect our independent legal analysis,
but rather is based on interviews.
We requested comments on a draft of this
report from the heads, or their designees, of
CFTC, SEC, the Department of the Treasury, and the
Federal Reserve Board. We also requested comments
from CBT, CME, FIA, the International Swaps and
Derivatives Association, NFA, the New York Stock
Exchange, the Securities Industry Association, and
the Securities Markets Coalition. SEC provided us
with written comments, which are discussed near
the end of this letter and reprinted in appendix
I. In discussions held in March 2000, the General
Counsel of CFTC; a financial economist of the
Department of the Treasury; an assistant director
of the Federal Reserve Board; and the Chief
Counsel of the Division of Market Regulation, SEC,
provided us with oral comments. Similarly, in
discussions held in March 2000, officials of CBT,
FIA, the New York Stock Exchange, the Securities
Industry Association, and the Securities Markets
Coalition provided us with comments. We did not
receive comments from CME, the International Swaps
and Derivatives Association, and NFA. The
technical comments that we received were
incorporated in the report as appropriate. The
substantive comments that we received are
discussed near the end of this letter. We did our
work in Chicago, IL; London, England; New York,
NY; Stockholm, Sweden; and Washington, D.C.,
between July 1999 and March 2000 in accordance
with generally accepted government auditing
standards.
U.S. Securities, Foreign Futures, and OTC Markets
Trade Stock-Based Derivatives
Domestic and foreign markets trade derivatives on
single stocks and stock indexes that have been
precluded from futures trading in the United
States under the accord. U.S. securities exchanges
trade options on single stocks. They also trade
options on a wide range of narrow-based stock
indexes. Additionally, some foreign exchanges
trade futures on single stocks. Finally, the OTC
derivatives market offers equity swaps on single
stocks and narrow-based stock indexes. Securities-
based options, foreign stock futures, and equity
swaps serve similar economic functions as would be
served by the futures prohibited from trading
under the accord.
U.S. Securities Exchanges Trade Options on Single
Stocks
U.S. securities exchanges, which are regulated by
SEC, trade options on single stocks that meet
certain minimum requirements related to, among
other things, the number of shares outstanding,
number of shareholders, and trading volume. SEC
first allowed exchange-traded options on single
stocks when it approved CBOE as a national
securities exchange in 1973. As of March 10, 2000,
CBOE and three other securities exchanges-the
American Stock Exchange, Pacific Stock Exchange,
and Philadelphia Stock Exchange-collectively
traded options on over 2,600 single stocks. In
1998, the trading volume in single stock options
totaled nearly 326 million contracts, accounting
for about 81 percent of total U.S. options trading
volume.
Options on single stocks serve similar economic
functions as would be served by futures on single
stocks. For example, both products could be used
to protect a stock position from a decline in
price, or to speculate on an anticipated price
change in the stock. Although options and futures
serve similar economic functions, they differ in
some ways, including their risk/return profiles. 21
Thus, it can be advantageous to use one product
instead of the other, depending on the particular
circumstances and preferences of the user. In
addition, options on single stocks can be used to
replicate prohibited futures on single stocks. For
example, by buying a call option22 on a single
stock and selling a put option23 on the same stock,
a single stock futures contract can be created
synthetically. Futures exchange officials said,
however, that single stock futures could be more
efficient and less costly than synthetic futures,
because they involve one futures transaction
instead of two options transactions. According to
CBOE officials, the extent to which single stock
options are used to create synthetic stock futures
cannot be accurately estimated.
U.S. Securities Exchanges Trade Options on Narrow-
Based Stock Indexes
U.S. securities exchanges trade options on a wide
range of narrow-based stock indexes, which
represent stocks in a single industry or a group
of related industries. These options are subject
to more stringent regulatory requirements, such as
higher margins and lower position limits,24 than
are options on broad-based stock indexes.25 As of
March 10, 2000, SEC had approved the American
Stock Exchange, CBOE, and the Philadelphia Stock
Exchange to trade options on at least 59 narrow-
based stock indexes. These indexes are composed of
securities representing a single industry or
sector, such as airline, Internet, and
biotechnology companies. In 1998, the securities
exchanges traded over 5 million narrow-based stock
index options, accounting for around 1 percent of
the total U.S. options trading volume.
Stock index options and stock index futures serve
similar economic functions and can compete with
and complement each other. These products can be
used for hedging or speculative purposes. Given
their similar economic functions, they can be used
as substitutes in some cases. For example, either
the Standard & Poor's 500 index options or its
futures contract-two of the most actively traded
stock index options and futures26 -can be used to
protect stock holdings from a decline in price, or
to benefit from a rise or fall in the stock
market. In addition, stock index options and stock
index futures can serve a complementary function.
For example, market participants can use stock
index futures to hedge risk related to their stock
index options positions and vice versa. More
specifically, a market participant using Standard
& Poor's 500 index options to take a position that
gains when the market falls can hedge that
position by using Standard & Poor's 500 index
futures to take a position that gains when the
market rises.
Some Foreign Exchanges Trade Single Stock Futures
Some foreign exchanges, including Sweden's OM
Stockholm Exchange, trade futures on single
stocks, but trading volume in these futures has
been relatively low. Although foreign exchanges
trade single stock futures, the accord prohibits
them from selling such futures to U.S. customers.
Some Foreign Exchanges Trade Single Stock Futures,
But Trading Volume Is Relatively Low
Some foreign futures and/or stock exchanges have
been trading futures on single stocks since at
least 1988. According to data compiled by CBT and
FIA, 9 foreign exchanges27 trade single stock
futures on over 189 stocks. In contrast to the
United States, in at least five of these
countries, the regulator that oversees the futures
market also oversees the stock market. The
existence of a single regulator in these countries
may have facilitated the introduction of futures
on single stocks in their markets.
In 1998, the trading volume in foreign single
stock futures totaled about 2.1 million contracts
and accounted for less than 1 percent of the total
trading volume of the foreign futures market. The
Helsinki Stock and Derivatives Exchanges, Bolsa de
Derivados do Porto, and OM Stockholm Exchange
accounted for around 96 percent of the total
trading volume in single stock futures.
We visited the OM Stockholm Exchange, which was
created through a 1998 merger between the OM
Exchange and the Stockholm Stock Exchange. The OM
Exchange began trading futures on single stocks in
1988, after being created in 1985 to
electronically trade options on single stocks.
According to exchange officials, the principal
reason that the exchange listed single stock
futures was to compete directly with the Stockholm
Stock Exchange by offering stock substitutes. The
officials added that single stock futures would
also complement stocks and options by providing an
additional means for hedging stock and options
positions.
According to officials of Sweden's Financial
Supervisory Authority,28 the Stockholm Stock
Exchange initially opposed the OM Exchange's
trading of single stock options and, to a lesser
extent, single stock futures, because it viewed
the trading of such products as a competitive
threat. According to these officials, the conflict
between the stock and futures exchanges subsided
after 2 to 3 years, in part because options
trading led to an increase in trading volume for
stocks. They added that the conflict between the
exchanges effectively ended in 1998, when the OM
Exchange purchased and merged with the Stockholm
Stock Exchange.
According to OM Stockholm Exchange officials, the
exchange offered single stock futures based on the
belief that if the underlying stock market could
support trading in single stock options, it could
also support trading in single stock futures.
However, the exchange has had limited trading of
single stock futures compared with single stock
options. For example, in 1998, the exchange traded
about 533,500 single stock futures compared to
about 20.6 million single stock options. Although
single stock futures trading volume represented
about an 85 percent increase over the previous
year, it accounted for about 1 percent of the
total derivatives trading volume of the OM
Stockholm Exchange.
The OM Stockholm Exchange officials said that
single stock futures are not actively traded for
at least two reasons. First, exchange members do
not market these products to retail customers, in
part because doing so would reduce the revenue
they earn from selling stocks. Brokers earn
commissions and interest from stocks purchased on
margin; with futures, they earn only commissions.
Moreover, brokers are cautious about selling
futures to customers because of their risk of
unlimited loss. Second, market makers and other
professionals use single stock futures to hedge,
but only to a limited extent because cheaper
hedging alternatives are available. For example,
the exchange officials said that options market
makers29 typically use the more liquid cash market
to hedge their risk.
The Accord Prohibits Foreign Exchanges From
Selling Single Stock Futures to U.S. Customers
Although foreign exchanges trade single stock
futures, the accord prohibits the offer or sale of
single stock futures based on either foreign or
U.S. stocks to customers located in the United
States. In addition to trading single stock
futures on their domestic stocks, some foreign
exchanges trade single stock futures on foreign
stocks. For example, the OM Stockholm Exchange
offers single stock futures on Swedish and Finnish
stocks. However, foreign exchanges generally do
not trade single stock futures on U.S. stocks.30
According to CFTC officials, they are not aware of
any laws that prohibit foreign exchanges from
trading single stock futures on U.S. stocks.
However, they noted that even if a foreign
exchange did so, the accord would prohibit
customers in the United States from purchasing
them.31 According to Securities Industry
Association officials, it is unlikely that a
foreign exchange could generate significant
trading volume in futures on U.S. single stocks
without U.S. customer participation in its market.
As a result, these officials said that even if a
foreign exchange were to trade futures on U.S.
single stocks, such trading would not likely
affect the stability of the U.S. stock market.
The OTC Market Offers Equity Swaps
The OTC derivatives market offers stock-based
derivatives, including equity swaps on single
stocks and narrow-based stock indexes.32 These
derivatives serve economic functions that are
similar to those served by the stock-based futures
that are prohibited under the accord. Both equity
swaps and futures can be used to manage risk
related to stock positions or to speculate on
anticipated stock movements. However, equity swaps
and futures are not perfect substitutes because of
potential differences between their contract
terms, transaction costs, and other factors. Also,
retail customers are generally precluded from
participating in the equity swaps market. In
contrast, retail customers are allowed to
participate in the exchange-traded futures market,
but according to market observers, they only
account for an estimated 5 to 10 percent of the
market. The Bank for International Settlements33
has estimated that the equity swap market
worldwide had a total notional value of $146
billion34 as of year-end 1998-an increase of about
180 percent since March 1995. At year-end 1998,
the equity swaps market accounted for a fraction
of 1 percent of the notional value of the OTC
derivatives market worldwide.
The Accord May Have Limited Investor Choice and
Has Exposed Market Participants to Legal
Uncertainty
The Shad-Johnson Jurisdictional Accord may have
limited investor choice and has exposed market
participants to legal uncertainty. Although
investors can use stock-based options and equity
swaps to hedge price risk, they cannot use stock-
based futures to the same extent because of the
accord trading prohibitions. Also, according to
futures industry officials, the accord has limited
the ability of U.S. investors to use foreign
exchange-traded stock index futures to hedge the
price risk associated with their foreign stock
investments. Finally, counterparties to equity
swaps have faced legal uncertainty because of the
potential for such swaps to fall within the
judicially crafted definition of a futures
contract35 and thus become subject to claims of
illegality and unenforceability under the accord.
The Accord May Have Limited Available Hedging
Instruments and Restricted Competition
The accord prohibitions may have limited investor
choice by precluding U.S. exchanges from trading
and investors from using futures on single stocks
and certain stock indexes. Additionally, the
accord prohibitions may have restricted U.S.
futures exchanges from competing against other
domestic and foreign markets trading stock-based
derivatives.
The Accord May Have Limited the Range of Available
Hedging Instruments
The accord trading prohibitions may have limited
the range of stock-based derivatives that
investors can use to hedge price risk associated
with their stock investments. As previously
discussed, investors can hedge price risk using
options on single stocks and stock indexes,
including narrow-based stock indexes. Also, a more
limited range of investors can hedge such risk
using equity swaps based on single stocks and
stock indexes. However, investors cannot use
futures on single stocks and certain stock indexes
for such purposes because of the accord
prohibitions. First, the accord prohibits the
trading of futures on single stocks. Second, it
allows futures exchanges to trade futures on stock
indexes, provided that CFTC and SEC find that such
contracts meet the accord's three standards.36 CFTC
and SEC have had few difficulties reaching
agreement on whether a futures contract on a
diversified, or broad-based, stock index meets the
accord standards.37 But they have had difficulties
reaching agreement on whether a futures contract
on a stock index representing a single industry
meets these standards and, thus, may be traded. In
light of their difficulties, SEC and CFTC issued
joint guidelines in 1984 to use in making such
determinations.
The Accord May Have Restricted Futures Exchanges
From Competing Against Other Derivatives Markets
The accord trading prohibitions may have
restricted the ability of the U.S. futures
exchanges to compete against other markets trading
stock-based derivatives. First, U.S. futures
exchange officials have said that the accord
prohibition on single stock futures has prevented
them from competing against securities exchanges
trading single stock options and foreign exchanges
trading single stock futures. Second, futures
exchange and FIA officials have said that the
accord prohibition on certain stock indexes has
placed the futures exchanges at a competitive
disadvantage relative to the securities exchanges.
According to these officials, SEC has allowed
securities exchanges to trade options on a number
of U.S. stock indexes that may not have been
allowed to trade on futures exchanges. In 1994,
SEC approved exchange rules to allow securities
exchanges to trade options on a single industry
stock index that is, among other things, composed
of 10 or more stocks. In contrast, SEC and CFTC,
under their joint guidelines (which are not a
rule), have stated that a single industry stock
index should, among other things, be composed of
at least 25 stocks to be traded on a futures
exchange. Although CFTC has approved U.S. futures
exchanges to trade futures on single industry
stock indexes,38 the exchanges only recently have
been allowed to trade futures on such indexes that
are composed of fewer than 25 stocks. In
comparison, SEC has approved securities exchanges
to trade options on at least 35 single industry
stock indexes composed of fewer than 25 stocks.
According to futures exchange officials, SEC's
objection to a CBT application to trade futures on
the Dow Jones transportation and utilities indexes
illustrates how futures exchanges have been
restricted from competing with securities
exchanges. In September 1997, SEC approved CBOE to
trade options on these two Dow Jones stock
indexes-concluding that such approval would remove
impediments to a free and open securities market
by providing investors with an additional means to
hedge market risk. In contrast, in July 1998, SEC
exercised its authority under the accord and
objected to the CBT application to trade futures
on the same Dow Jones indexes. In objecting to the
CBT application, SEC determined that the proposed
futures failed to meet the accord's third
standard, the substantial segment requirement. SEC
noted, among other things, that the indexes had a
small number of stocks (fewer than 25), raising
concerns about the potential for the indexes to be
used either to manipulate the market or as a
substitute for single stocks.
In July 1998, CBT challenged SEC's decision in the
U.S. Court of Appeals for the Seventh Circuit. In
August 1999, the federal court vacated SEC's
decision, concluding that it was not adequately
supported, and left CFTC with the decision of
whether to approve the proposed CBT futures
contracts on the Dow Jones stock indexes.39 In
October 1999, CFTC approved the contracts. In
November 1999, the Working Group reported that the
court decision, along with the lack of an SEC
objection to a recent sector index futures
contract on the Internet stock price index,
advanced the ability of the U.S. futures exchanges
to offer a greater variety of stock index futures.40
The Accord May Have Restricted U.S. Investors From
Hedging Foreign Stock Investments
According to FIA officials, the accord
unnecessarily restricts the ability of U.S.
investors to use foreign stock index futures that
are traded on foreign exchanges to hedge their
foreign stock investments in the most effective
and efficient manner. Before a foreign exchange-
traded stock index futures contract may be sold to
U.S. investors, CFTC must first issue a no-action
letter41 to the foreign exchange for that contract.42
According to FIA officials, the accord does not
specifically require CFTC approval of foreign
exchange-traded stock index futures. Instead, the
officials said CFTC has interpreted the
legislative history of the accord as requiring its
approval.43 According to the legislative history,
CFTC may certify a foreign securities index
futures contract under such criteria as it deems
appropriate.
CFTC officials said that they review foreign
exchange-traded stock index futures to address
concerns about manipulation and investor
protection. For example, U.S. investors could be
harmed if they bought a foreign exchange-traded
stock index futures contract that was readily
subject to manipulation. To facilitate the sale of
such futures to U.S. investors, CFTC has initiated
a procedure for issuing no-action letters for
foreign stock index contracts that meet the accord
requirements. As part of this procedure, CFTC has
elected to consult with SEC. As of March 6, 2000,
CFTC had issued no-action relief for 28 foreign
stock index futures, and it had requests pending
for 23 others.
According to FIA, the accord should be amended to
facilitate foreign stock index futures
transactions that are executed on a foreign
exchange on behalf of U.S. investors. These
officials said CFTC's no-action procedure for
foreign stock index futures hinders the ability of
U.S. futures commission merchants (FCM)44 to meet
the needs of their institutional investors, by
preventing U.S. investors from trading many
foreign stock index futures. Additionally, FIA
officials said that no public policy purpose is
served by preventing U.S. investors from trading
certain foreign stock index futures, because U.S.
investors are free to invest in foreign stocks.
FIA officials said that the no-action procedure
for foreign stock index futures is often lengthy,
and that many stock-index products of foreign
exchanges have not yet been granted no-action
relief. The officials said that, as a result of
the restriction, U.S. investors are often limited
in their ability to hedge their foreign stock
portfolios using the most efficient and effective
foreign stock index futures. According to SEC and
CFTC officials, some of the delays in issuing no-
action letters have resulted from the length of
time foreign exchanges have taken to respond to
CFTC information requests.
The Accord Has Been a Source of Legal Uncertainty
for Equity Swaps
Under the Futures Trading Practices Act of 1992,
Congress provided CFTC with the authority to
enhance legal certainty for swaps by exempting any
contract from all CEA provisions, except those of
the accord-section 2(a)(1)(B). Until this time,
all swaps-including equity swaps-faced the
possibility of falling within the judicially
crafted definition of a futures contract, because
of their similarities to exchange-traded futures.
If found to be futures, swaps could have been
deemed illegal and unenforceable, because they
would not have been traded on an exchange as
required by the CEA. Before CFTC was granted its
exemptive authority, it issued a swaps policy
statement in 1989 to reduce the legal risk faced
by swaps by clarifying the conditions under which
it would not regulate swaps as futures. However,
the policy statement did not eliminate all legal
risk, because it left open the possibility that a
swaps counterparty might try to have a court
invalidate a swap as an illegal, off-exchange
futures contract.
In January 1993, CFTC used its exemptive authority
under the 1992 act to exempt a broad group of
swaps from the CEA's exchange-trading and other
requirements, thereby reducing or eliminating the
legal risk that such swaps could be unenforceable.
However, because CFTC could not exempt swaps from
the accord, equity swaps have continued to face
legal risk. According to market observers, if
equity swaps were found to be futures, they would
be in violation of the accord-making them illegal
and unenforceable.45 First, equity swaps on
individual stocks that were deemed to be futures
would violate the accord prohibition on single
stock futures. Second, equity swaps on stock
indexes that were deemed to be futures would
violate the CEA requirement that stock index
futures be traded on an exchange. According to
CFTC, swaps counterparties can still rely on its
swaps policy statement, and according to
International Swaps and Derivatives Association
officials, equity swaps counterparties routinely
do so.
In its November 1999 report, the Working Group
noted that CFTC cannot grant exemptions from the
restrictions of the Shad-Johnson Accord and,
therefore, recommended that swaps-including equity
swaps-meeting certain conditions be specifically
excluded from the CEA.46 In support of its
recommendation, the Working Group reported that
swaps involve sophisticated counterparties, who do
not require the same protections under the CEA as
those required by retail customers. It also
reported that swaps generally are not susceptible
to manipulation and do not serve a price discovery47
function. Likewise, U.S. securities exchanges have
supported excluding equity swaps from the CEA to
resolve legal uncertainty. However, the New York
Stock Exchange stated that equity swaps should be
subject to SEC jurisdiction to ensure that such
swaps will not be used for regulatory arbitrage or
to circumvent the insider trading, fraud, and
manipulation prohibitions of the securities laws.
The exchange further stated that regulating equity
swaps as securities would promote regulatory
parity between such products and single stock
futures, which it stated should also be regulated
as securities. U.S. futures exchanges have also
supported providing legal certainty to swaps under
the CEA. However, they stated that regulatory
parity between the exchange-traded futures and OTC
derivatives markets first needs to be achieved so
that the exchange-traded market can compete with
the OTC market on a level playing field. For
example, CME testified in February 2000 that if
equity swaps are allowed to trade in the OTC
market outside of the CEA, single stock futures
should be allowed to trade on U.S. futures
exchanges.
Concerns Exist About Repealing the Accord
Prohibitions
SEC and U.S. securities exchange officials have
expressed concerns about repealing the accord
trading prohibitions without first resolving the
differences between the securities and commodities
laws and regulations. They are concerned that, as
a result of the differences, the prohibited
futures could be used as substitutes for single
stocks to circumvent compliance with federal
securities laws and regulations. The most
significant legal and regulatory differences that
they identified include the lack of comparable
insider trading prohibitions, margin levels, and
customer protection requirements. In its November
1999 report, the Working Group cited these as well
as other legal and regulatory differences that
will need to be resolved if the accord
prohibitions are repealed. Also, several members
of Congress identified concerns for SEC to address
before submitting to Congress any legislative
proposals related to the accord.
The CEA Does Not Prohibit Insider Trading
According to SEC and the U.S. securities
exchanges, the CEA's lack of insider trading
prohibitions comparable to those included in the
securities laws would pose significant risk to the
integrity of the stock market if the accord
prohibitions were repealed. In contrast to the
CEA, the federal securities laws broadly prohibit
insider trading-that is, the trading of securities
on the basis of material nonpublic information
about a corporate issuer.48 According to SEC
officials, unless single stock futures are deemed
securities, the securities law insider trading
prohibitions and the extensive body of case law
interpreting those prohibitions would not apply.
SEC officials stated that simply grafting insider
trading prohibitions on the CEA would not solve
the problem. They said that the prohibited futures
must be considered securities to be subject to the
insider trading prohibitions developed over the
years by SEC and the courts.
SEC and securities exchange officials have
expressed concern that if single stock futures
were allowed to trade without being subject to
insider trading prohibitions, they could be used
to circumvent federal securities laws and to
profit legally in the futures market based on
inside information. For example, a person with
positive material nonpublic information about a
stock issuer could buy a futures contract on the
stock. When the information was disclosed to the
market, the value of the stock and, in turn, the
futures contract could rise. Because the CEA does
not prohibit futures trading based on material
nonpublic information, the trader would not be in
violation of the CEA, and any resulting profit
from the futures contract would not be illegal. In
contrast, if the profit were obtained through the
purchase of stock or an options contract, it would
be a violation of the federal securities laws.
According to SEC officials, because the accord has
allowed CFTC to approve only futures on stock
indexes that reflect a substantial market segment,
the potential that an individual might profit from
inside information when trading futures on the
approved stock indexes has been minimized. As a
result, the absence of insider trading
prohibitions in the futures market has not been an
issue for the currently traded stock index
futures.
CFTC and U.S. futures exchanges agree that the
lack of insider trading prohibitions under the CEA
that are comparable to those included in the
securities laws would need to be addressed if the
accord prohibitions are repealed. In addition,
futures exchange officials said that they could
use their existing reporting and surveillance
systems, with modifications, to help deter and
detect insider trading involving stock-based
futures. For example, CFTC has large trader
reporting requirements and systems that enable
CFTC and the futures exchanges to track traders
holding large futures positions. Futures exchange
officials said that these reports and systems,
which are absent in the securities markets, allow
CFTC and the exchanges to detect unusual trading
activity in stock index futures. New York Stock
Exchange officials told us that the securities
exchanges have spent years and millions of dollars
developing systems to deter and detect insider
trading, and that the futures exchanges could not
readily match the capabilities of these systems.
Margins on Stock, Security Options, and Futures
Differ
Margins for stock, stock-based options, and
futures differ in terms of their purpose, source,
and computation. According to SEC and the U.S.
securities exchanges, should the accord trading
prohibitions be lifted, lower margins on single
stock futures compared to stocks would allow
investors to make greater use of leverage, thereby
increasing the risk of customer loss, market
manipulation, and systemic risk. CFTC, the Federal
Reserve, and the U.S. futures exchanges disagree
with SEC and U.S. securities exchanges about the
potential effect of margin differences. However,
to alleviate concerns, the futures exchanges have
said that they would be willing to set margins on
single stock futures at a level comparable to
margins on single stock options.
Margins Differ in Terms of Purpose, Source, and
Computation
Traditionally, stock margin has been used to
control the allocation of credit, reduce the risk
of price instability, and protect investors from
becoming overly leveraged. For stocks, margin is
the minimum down payment that a customer must pay
to a broker to fund a stock purchase. The
remainder of the purchase price can be borrowed
from the broker, with the broker then retaining
the stock as collateral on the loan. Brokers do
not typically require customers to pay the margin
until 5 days after the trade,49 during which time
the broker is exposed to the risk that the
customer will not make payment. Under Regulation
T, the Federal Reserve set minimum margin for
purchasing stock in 1974 at 50 percent of the
current market price of a stock, limiting the
amount of credit a broker may extend to a customer
to 50 percent of the stock purchase price. This
requirement is a minimum; securities brokers may
set a higher requirement. Additional margin
payments would be required to maintain a margined
stock position if the stock's market price, and
thus the value of the collateral, significantly
declined before the loan was repaid.50 The Federal
Reserve allows securities exchanges to set
additional margin requirements for maintaining a
margined stock position, subject to SEC approval.
For securities-based options, margin is a
performance bond and, unlike stock margin, does
not typically involve an extension of credit. In
contrast to stock margins, the primary purpose of
options margin is to protect the financial
integrity of the firm and the market, not
customers. Options margin is paid only by the
option seller,51 to ensure contract performance
should the option be exercised.52 The Federal
Reserve is authorized to set margins for options
but has incorporated by reference in Regulation T
the margin rules of the options exchanges, subject
to SEC approval. Margin for stock option sellers
(puts and calls) is currently set by exchange
rules at the current market value of the option
(the premium) plus 20 percent of the current
market value of the underlying stock (i.e., 100
shares per option contract), minus the amount (if
any) that the option is out-of-the-money.53 These
requirements are minimums; securities brokers may
set higher requirements. Additional margin
payments would be required if the market value of
the stock option changed and the customer's margin
account balance fell below minimum requirements
before the option exercise date.54 Because the
computation of options margin varies depending on
several factors, including the exercise price and
expiration date, comparing options and futures
margins is difficult.55
For futures, margin is also a performance bond and
does not involve the extension of credit. Also,
the purpose of futures margin is to protect the
financial integrity of firms and the market, not
customers. Futures margin is paid by both the
buyer and seller of a futures contract when the
position is established, to ensure that they can
fulfill their contractual obligations. The Federal
Reserve is authorized to set margin levels for
stock index futures but has delegated the
authority to CFTC. Subject to CFTC oversight,
futures exchanges set margin for stock index
futures. Margin levels are set using a portfolio
margining system based on the historical price
volatility of the underlying, current and
anticipated market conditions, and other factors.
They are typically set to cover at least 95
percent of historical 1-day price moves for the
contract's underlying commodity or index. For
example, as of February 9, 2000, the margin on
CME's E-Mini Standard & Poor's 500 index futures
contract was about $4,700, approximately 6.6
percent of the value of the futures contract.
These requirements are minimums; futures brokers
may set higher requirements. In futures margining,
payments are made at least daily from the margin
accounts of those futures contracts decreasing in
value to those increasing in value, to reflect net
gains or losses. This process, called marking-to-
market, ensures that losses on futures positions
do not accumulate over more than one day.
Additional margin is collected, if a margin
account balance falls below minimum requirements,
to bring the account back to its original balance.
Concerns Exist About Leverage and Customer Losses
SEC and securities exchange officials have stated
that highly leveraged customers in single stock
futures could experience significant losses during
volatile markets. These customers would be
required to make significant daily margin payments
to cover their losses. According to Federal
Reserve officials, margins can be used to limit
the amount of customer leverage, but more
effective tools exist to protect customers, such
as disclosure and suitability requirements
(discussed below). In addition, they said daily
futures margin calls due to adverse price changes
can serve to limit customer losses by prompting
customers to liquidate losing positions before
more significant losses can accumulate.
Concerns Exist About Manipulation
The U.S. Securities Markets Coalition has stated
that the high degree of leverage that might be
available in connection with single stock futures
could also increase the potential for manipulation
of stock prices. Specifically, the potential for
greater profit from a highly leveraged futures
position because of even a small price movement in
the underlying stock could encourage attempts to
manipulate stock prices. That is, investors may
acquire a large futures position in a single stock
and then attempt to artificially drive up the
price of the stock by buying the stock or through
other means. However, SEC said that such
manipulation could be attempted with less economic
risk using single stock options.56
According to CFTC officials, SEC and CFTC have
agreements to share surveillance information, and
these agreements have been effective in detecting
intermarket abuses involving stock index futures
and stocks. In addition, securities and futures
exchanges have also entered into agreements to
share surveillance and investigative information
on a bilateral basis and through the Intermarket
Surveillance Group.57 The goal of these agreements
is to coordinate the sharing of such information
involving securities, options, and futures to
deter and detect intermarket trading abuses, such
as manipulation. For example, CBT officials said
that CBT and the New York Stock Exchange share
trading data under a bilateral information-sharing
agreement to assist in detecting manipulation
involving stocks and futures. The officials said
that the agreement could be expanded to cover
additional stocks, should single stock futures be
allowed to trade. In addition, CFTC and futures
exchange officials said that their large trader
reporting systems allow them to identify market
participants who are overexposed to the market, a
capability SEC and the securities exchanges lack.
Concerns Exist About Systemic Risk
The U.S. Securities Markets Coalition has stated
that, during periods of extreme market volatility,
the overuse of leverage could significantly impair
the integrity of the stock market, creating
systemic risk. According to Federal Reserve and
CFTC officials, the futures exchanges have a
record of setting margins at levels that have
protected the financial integrity of the market,
and thereby have limited systemic risk. Moreover,
the Federal Reserve has noted that margins are but
one component of sophisticated risk control
systems that include frequent marking-to-market of
customer positions, market surveillance, and
active risk management. Consistent with this view,
the Working Group concluded in its 1988 study of
the 1987 market decline that the then existing
margins for stocks, stock index futures, and
options provided an adequate level of protection
to the financial system.58 The Working Group also
concluded that "harmonious" margins for stocks and
futures do not imply that margins must be equal.
It noted that margin adequacy depends on the
volatility of prices and the length of the grace
period following a margin call. Finally, a 1996
Federal Reserve study found that the margining
systems used by securities and futures exchanges
for Standard & Poor's 500 index options and
futures, respectively, differ in their approach
but provide substantially the same market risk
protections. The study also found that the
portfolio-based margining system used by the
futures exchanges is more efficient than the
strategy-based margining system used by securities
exchanges, because it achieves the same result but
with a lower level of collateral (i.e., margin).
Futures Margins Are Risk-Based, but Exchanges Are
Willing to Match Option Margins to Address
Concerns
The futures market margining system sets margin
levels based on risk. As a result, margins set for
single stock futures would be expected to be
higher than those currently required for
traditionally less volatile and, therefore, less
risky stock index futures. For example, using the
same margining system as U.S. futures exchanges,
the OM Stockholm Exchange has set margins for
single stock futures at 7.5 to 25 percent of the
value of the futures contract, based on the
volatility of the underlying stock. These levels
are higher than the amount set by the CME for the
E-Mini Standard & Poor's 500 stock index futures
contract. Margin levels for some futures on single
U.S. stocks could be in the same range as those
set for single stock options by U.S. securities
exchanges. To address SEC and securities exchange
concerns about margins, futures exchange officials
have said that they would be willing to set
margins on single stock futures at a level
comparable to the margins securities exchanges
have set for single stock options.
Customer Protection Requirements for Securities
and Futures Differ in Approach
The securities and futures markets approach to
customer protection differs. SEC and securities
exchange officials are concerned that the lack of
a futures market suitability rule would expose
customers to risk, if the accord prohibitions on
futures on single stocks and certain stock indexes
are repealed. According to NFA, although the
futures industry does not have a suitability rule,
customer protection regulations do not differ
significantly between the securities and futures
markets, and the basic type of protection afforded
by each market is the same.
SEC and U.S. Securities Exchanges Are Concerned
About the Futures Market's Lack of a Suitability
Rule
SEC and U.S. securities exchanges have expressed
concern that without the benefit of a suitability
rule, single stock and certain stock index futures
would be marketed to unsophisticated and
unsuitable retail customers as cheap substitutes
for stocks and stock options. Securities self-
regulatory organizations have imposed suitability
requirements on exchange members and other
registered brokers. Under these requirements,
brokers that make recommendations to their
customers may only recommend those securities
(including options) that they believe are suitable
in light of the financial position and investment
goals of the customers. According to the New York
Stock Exchange, these requirements apply whenever
recommendations are made, not just when an account
is opened. However, these requirements do not
apply when brokers do not make recommendations to
customers, such as may occur when trades are made
either through discount brokers or directly
online. Brokers are also required to provide
additional written risk disclosures to options
customers, but only when they initially open an
account.
According to SEC and U.S. securities exchanges,
without a suitability rule, FCMs could recommend
single stock futures to retail customers without
determining whether the recommendation is suitable
for them. SEC and U.S. securities exchanges are
concerned that retail customers buying or selling
stock-based futures would be exposed to the risk
of unlimited loss associated with an adverse price
change in a futures contract. In contrast, the
risk of loss to options buyers (but not to
sellers) is limited to the price of the option
premium. Also, as discussed previously, SEC and
U.S. securities exchanges are concerned that
retail customers would be exposed to the risk of
loss associated with high leverage. Industry
representatives have expressed additional concern
that a large number of retail customer losses in
the futures market could undermine investor
confidence in all financial markets, including the
stock market.
Swedish regulatory officials told us that they
have not had any cases of customer abuse involving
single stock futures. They noted, however, that
the lack of any such cases might be due to the
limited number of retail customers who use such
products. According to Swedish exchange officials,
few brokers market single stock futures to retail
customers, in part because futures pose greater
risks than do stocks. According to CME officials,
if single stock futures were allowed to trade, the
exchange would be interested in marketing them to
retail customers.
NFA Officials Said That Futures and Securities
Rules Afford the Same Protections
According to NFA officials, customer protection
regulations do not differ significantly between
the securities and futures markets. NFA officials
said that the basic type of protection afforded by
each is the same. According to CFTC officials,
sales practice requirements under the CEA focus on
providing a full disclosure of the risks
associated with futures trading. Accordingly, CFTC
and NFA require FCMs to provide customers with
written risk disclosure statements when they open
an account. This and other sales practice
requirements are predicated on the belief that all
futures trading is highly risky, irrespective of
the type of underlying. In contrast to futures,
individual securities possess varying degrees of
risk. As a result, according to NFA, the
suitability of particular products for an
individual customer varies with the customer's
ability to assume the risk associated with the
products.
According to NFA, because all futures involve a
high degree of risk, little or no basis exists for
assuming that one type of futures contract would
be suitable for a particular customer, while
another type would be unsuitable for the same
customer. For this reason, according to NFA, CFTC
decided against adopting a suitability rule that
had been proposed for the futures industry in
1978. NFA stated that the more appropriate focus
is on whether the customer should be trading
futures at all. To that end, NFA has adopted a
"know your customer rule" that requires its
members to obtain the same type of information
about their customers as is required by the
securities suitability requirements. However,
according to SEC and securities exchange
officials, this obligation exists only when an
account is initially opened, and the futures rule
does not require a continuous assessment of
suitability, as does the securities rule.
According to NFA, if a firm determines that a
customer should not be trading futures, the firm
is obligated to so inform the customer. However,
if a customer decides to ignore this information,
the firm can elect to complete the customer's
transactions after documenting that the firm
alerted the customer to its determination. A CFTC
official said that FCMs are financially liable if
a customer defaults and, thus, have an incentive
to ensure that a customer is not overextended.
Other Concerns Exist About the Differences Between
the Securities and Commodities Laws
In addition to the three issues discussed
previously, SEC, the U.S. securities exchanges,
the Working Group, and several members of Congress
have identified other provisions of securities and
commodities laws that will need to be reviewed to
determine how they should apply to single stock
futures, if at all, should the accord trading
prohibitions be repealed. These provisions include
various requirements or restrictions to combat
fraud and market manipulation or to facilitate
market transparency and disclosure.
According to SEC and securities exchange
officials, additional provisions of the securities
laws that are of concern include (1) restrictions
on short-term profits by large shareholders or
corporate insiders on the purchase or sale of
corporate stock, (2) limitations on stock
repurchases by issuers, (3) restrictions on stock
purchases during stock distributions, and (4)
requirements to notify SEC when acquiring a large
block of stock. These officials said that the
remainder of the securities and commodities laws
and regulations would also need to be reviewed to
determine how they should apply to single stock
futures, if at all, should the accord trading
prohibitions be repealed.
In its November 1999 report, the Working Group
concluded that the accord trading prohibition on
single stock futures "can be repealed if issues
about the integrity of the underlying securities
market and regulatory arbitrage are resolved."
According to the Working Group, from the
perspective of the securities laws, the issues
raised by the trading of single stock futures
include margin levels, insider trading, sales
practices, real-time trade reporting, activities
of floor brokers, and CFTC's exclusive
jurisdiction over futures. The Working Group also
stated that from the perspective of the
commodities laws, the issues raised by such
products include clearing, segregation, large
trader reporting, and direct surveillance.59 The
Working Group recommended that SEC and CFTC work
together and with Congress to determine whether
single stock futures should be permitted to trade
and, if so, under what conditions.
In a February 9, 2000, letter, Representatives
Dingell, Markey, and Towns asked SEC to respond to
a list of questions concerning the potential
impact of repealing the accord prohibitions on the
U.S. securities market. Their request reflected
concerns about the conditional nature of the
Working Group's recommendation and the
complexities involved in resolving the issues
raised by single stock futures. Their letter
explained that they were not certain that the
issues identified by the Working Group could be
resolved in a manner consistent with the public
interest, the protection of investors, and the
maintenance of fair and orderly markets,
especially if done in haste and within the
confines of a regulatory structure that bifurcates
regulation over certain financial derivatives
between SEC and CFTC. In addition, they asked SEC
to satisfactorily address their questions before
submitting any legislative proposals related to
the accord to Congress.
Resolving the Jurisdictional Question Is Key to
Addressing Concerns
Pivotal to addressing the legal and regulatory
concerns related to repealing the current trading
prohibitions is resolving the jurisdictional
question of whether SEC, CFTC, or both agencies
should regulate single stock and certain stock
index futures. The answer to this question would
determine whether such futures are regulated under
the securities and/or commodities laws. In turn,
the answer would affect the types of legal and
regulatory changes that would be needed. According
to securities exchange officials, futures on
single stocks and certain stock indexes could be
allowed to trade, if such futures were regulated
as securities. According to futures exchange
officials, if the prohibited futures were allowed
to trade, CFTC could effectively regulate them
under the CEA. In response to congressional
requests, SEC and CFTC have tentatively agreed on
an approach to allow single stock futures to be
traded on both U.S. securities and futures
exchanges. Regardless of whether SEC, CFTC, or
both agencies regulate such futures, some of the
regulatory concerns could be addressed by trading
them electronically and/or under a pilot program.
SEC Could Be the Primary Regulator of the
Prohibited Futures
According to SEC and securities exchange
officials, futures on single stocks and certain
stock indexes could be allowed to trade, if such
futures were regulated as securities. For example,
under this approach, single stock and certain
stock index futures would be made subject to the
insider trading prohibitions of the federal
securities laws and covered by the margin and
sales practice requirements of the securities
exchanges. These officials also said that such an
approach would enable SEC to ensure that stocks,
stock-based options, and stock-based futures were
consistently regulated under the federal
securities laws. According to SEC officials, the
prohibitions on single stock and certain stock
index futures were not based on any economic
differences between options and futures. Rather,
SEC officials said the prohibitions were based on
regulatory differences that could allow such
futures, unlike single stock options, to be used
as stock substitutes to circumvent securities laws
and regulations. Similarly, the securities
exchange officials said that they do not question
the potential economic utility of single stock
futures.
According to CFTC officials, the regulatory scheme
created by the accord is consistent with the
overall approach embraced by Congress to separate
securities and futures regulations. CFTC officials
said that providing SEC with jurisdiction over
both stocks and stock-based futures could
undermine this approach and fragment the
regulatory environment by having futures
regulation turn on the underlying commodity rather
than the economic function served by the product.
The former CFTC chairman responsible for
negotiating the accord stated that the accord
sought to avoid regulation of futures based on the
underlying commodity, because such an approach
could create a fragmented regulatory environment.
This approach was consistent with the decision by
Congress in 1974 to replace the Department of
Agriculture with CFTC as the futures market
regulator. NFA officials have also questioned the
need for SEC to regulate futures based on stocks
when CFTC does not regulate the underlying
commodity of any traded futures contract.
According to securities exchange officials, stocks
are different from other commodities underlying
futures contracts. These officials said that SEC
regulates stocks under a comprehensive body of
securities law that should not be undermined.
Also, they said that, unlike other derivatives in
which the underlying has a poorly developed cash
market and the derivative serves a price discovery
function, the cash market for stock-based futures
is well developed and serves a price discovery
function.
CFTC Could Be the Primary Regulator of the
Prohibited Futures
According to futures exchange officials, if the
prohibited futures are allowed to trade, CFTC
could effectively regulate them under the CEA.
These officials said that the CEA could be amended
and other steps could be taken to address the
legal and regulatory concerns involving the
prohibited futures. For example, as a means of
addressing SEC concerns about insider trading, CBT
and CME have proposed providing SEC with the
authority to enforce insider trading prohibitions
for stock-based futures to the same extent that it
does for stock-based options. Similarly, CFTC
officials said that they would support amending
the CEA if the accord prohibitions were lifted, so
that CFTC could share its exclusive jurisdiction
over single stock futures with SEC in regulatory
matters, such as setting margins and market
surveillance.
CFTC officials said that their experience with the
currently traded stock index futures has shown
that the division of securities (including stock-
based options) and futures regulation between SEC
and CFTC has worked well. These officials said
that each has effectively regulated its respective
market. According to the CFTC officials, to the
extent that intermarket problems have arisen, SEC
and CFTC have been able to develop mechanisms to
address them. For example, the officials said that
the securities and futures exchanges, at the
recommendation of the Working Group,60 established
circuit breakers61 to address market emergencies
involving stocks and stock index futures. As
previously discussed, futures exchange officials
said that they could use their reporting and
surveillance systems, with modification, to help
deter and detect insider trading and manipulation
involving the prohibited futures.
Securities exchange officials said that dividing
regulation of stocks and the prohibited futures
between SEC and CFTC would be less effective and
efficient than having SEC regulate both products.
These officials said that using a single regulator
instead of two regulators would eliminate the need
to coordinate securities and futures market
oversight. Furthermore, securities officials said
that dividing regulation between SEC and CFTC
could create opportunities for regulatory
arbitrage. These officials said that investors
could decide to use single stock futures, instead
of stocks or stock options, based on regulatory
reasons rather than on the economic merits of the
competing products. For example, securities
exchange officials have expressed concern that
margins for the prohibited futures would be lower
than margins for stocks and stock-based options.
As a result, these officials said that the
prohibited futures would have a competitive
advantage in terms of transaction costs.62 As
previously discussed, futures exchange officials
said that they would address this concern by
setting margins for single stock futures at a
comparable level to margins for options on single
stocks.
SEC and CFTC Could Share Jurisdiction Over the
Prohibited Futures
In light of the Working Group's conclusions and
recommendation, several members of Congress asked
SEC and CFTC to study various issues related to
the accord. In December 1999, Senators Gramm and
Lugar asked SEC and CFTC to study the desirability
of lifting the accord trading prohibition on
single stock futures. They also asked the agencies
to provide any legislative proposals for taking
such action to Congress no later than February 21,
2000, a date that was subsequently extended to
March 2, 2000. Likewise, in January 2000,
Representatives Bliley, Combest, Ewing, and
Stenholm made a similar request to the agencies.
Responding to the congressional requests, on March
2, 2000, SEC and CFTC presented a tentative
approach for allowing single stock futures to be
traded on both U.S. securities and futures
exchanges. Although SEC and CFTC had not yet
developed a legislative proposal for repealing the
accord prohibition, they agreed that any such
legislation should allow both agencies, acting as
equal principals, to consistently regulate single
stock futures, the intermediaries that offer them,
and the markets that trade them. Accordingly, the
agencies noted that any legislation in this area
should empower SEC and CFTC to cooperate and
coordinate their respective regulations to the
extent practicable. They also noted the importance
of avoiding the imposition of unnecessarily
burdensome or duplicative regulation on the
securities and futures markets as well as their
participants. According to SEC and CFTC officials,
one of their major challenges is developing a
process to ensure that regulation of the
securities and futures markets as well as
intermediaries remains consistent and appropriate
as the markets evolve. These officials said that
the agencies plan to continue working together
with the goal of providing a comprehensive
legislative proposal to Congress before it
adjourns.
SEC and CFTC have tentatively agreed on the
initial standards for trading single stock
futures, such as harmonizing margin requirements,
restricting dual trading,63 testing sales and
supervisory personnel, and establishing uniform
listing standards. They have also agreed that SEC
would take the lead in detecting, deterring, and
prosecuting insider trading involving single stock
futures. Additionally, the agencies would seek to
avoid duplicative oversight in areas where their
regulations are equivalent.
SEC and CFTC have explored using a "notice
registration" process to avoid duplicative
regulation of their registered intermediaries
(e.g., broker-dealers and FCMs) and registered
markets. Under this process, entities registered
with one regulator would be required only to file
a form to alert the other regulator of their
single stock futures activities. As such,
registered intermediaries and markets would not be
required to go through a duplicative registration
process. Nonetheless, such entities would be
subject to "core provisions" of the federal
securities and commodities laws. SEC and CFTC have
not yet agreed on the scope or application of the
core provision. They have identified and discussed
a variety of issues relating to the trading of
single stock futures that may need to be addressed
in their regulatory proposal, including customer
suitability and disclosure as well as large trader
reporting.
Although unresolved issues remain, the agencies
have agreed to develop a memorandum of
understanding to implement the regulatory
framework. The memorandum would provide a
regulatory blueprint that would allow single stock
futures to be traded on securities and futures
exchanges and by intermediaries currently
regulated by only one agency, without undermining
investor protection and market integrity, imposing
duplicative regulation, and promoting regulatory
arbitrage. In addition, the agencies agreed to
develop a coordinating committee to address
ongoing issues regarding their shared regulation
of markets and intermediaries trading single stock
futures.
Some of the Regulatory Concerns Could Be Addressed
by Trading the Prohibited Futures Electronically
and/or Under a Pilot Program
Some of the regulatory concerns surrounding the
prohibited futures could be addressed by trading
such futures electronically64 and/or under a pilot
program. For example, CFTC officials and others
have said that electronic trading systems can
provide unalterable audit trails that record
precisely when, where, and by whom an order was
placed. They said that such information could be
used to deter and detect market abuses, including
manipulation, and customer abuses, such as
frontrunning.65 Similarly, electronic trading
systems could enhance customer protections by
improving the ability of FCMs to monitor and
control customer activities. According to
securities exchange officials, trading single
stock futures electronically would not address
many other concerns, including concerns about
insider trading, margins, and sales practices.
Futures exchange officials told us that they would
likely trade these futures through electronic
trading systems, but would also like the
flexibility to trade them through open outcry.66
According to a market observer specializing in the
securities laws, a pilot program could be used to
allow trading of the prohibited futures on a trial
basis. CFTC used such an approach to reintroduce
the trading of options on futures. Using a pilot
program to introduce trading in the prohibited
futures could provide regulators with a way to
test the adequacy of responses to specific
regulatory concerns. Also, to address concerns
about sales practices and retail customer losses,
regulators could restrict access to the pilot
program to sophisticated market participants, such
as those defined as "eligible swap participants"
in CFTC regulations.67 Similarly, the market
observer suggested that a pilot program could be
used to test the trading of stock index futures
not currently allowed under the accord. He said
that this approach might be an effective and
efficient way to test the market for these
products, while minimizing the potential for
insider trading and manipulation. He said that
such stock index futures would probably appeal
only to institutions and other market
professionals, avoiding existing concerns that
single stock futures would be marketed to
unsuitable retail investors. However, one drawback
of a pilot program is that its potentially
temporary status may deter participation.
According to securities exchange officials,
another drawback is that SEC and CFTC would first
need to resolve most of the jurisdictional and
regulatory issues before single stock and certain
stock index futures could be traded under a pilot
program. As a result, the officials said such an
approach would not be likely to expedite trading
of the prohibited futures.
Conclusions
Repealing the accord trading prohibitions on
single stock and certain stock-based index futures
raises challenging legal and regulatory issues
because of (1) the potential to use the prohibited
futures as stock substitutes and (2) differences
between securities and commodities laws and
regulations. SEC, CFTC, and others have identified
approaches for addressing such issues, with each
approach pivoting on the jurisdictional question
of whether SEC, CFTC, or both should regulate
single stock and certain stock index futures.
These approaches indicate that the legal and
regulatory issues are resolvable. To that end, SEC
and CFTC have begun working together to address
these issues. However, uncertainty remains about
the outcome of such efforts. Differences in SEC
and CFTC perspectives, as well as in the
securities and commodities laws, could continue to
impede efforts aimed at reaching the compromises
necessary to repeal the accord prohibitions.
The existence of active securities option and OTC
equity derivatives markets, coupled with a very
small but growing foreign market in single stock
futures, indicates that the prohibited futures
might serve a useful economic purpose. At the same
time, the experience of these markets indicates
that demand for the prohibited futures might be
limited. Nonetheless, repealing the trading
prohibitions could enhance the ability of the U.S.
financial markets to compete and to develop
innovative contracts. First, such action would
allow U.S. exchanges to introduce additional stock-
based futures and, in turn, let the marketplace
determine their economic utility. Second, such
action could allow U.S. futures exchanges to
compete against other derivatives markets. Third,
by eliminating the accord prohibition on certain
stock index futures, U.S. firms could offer
customers in the United States foreign stock index
futures that could be used to hedge foreign stock
investments. Fourth, the legal certainty of equity
swaps could be addressed, thereby facilitating the
growth of this market. We recognize, however, that
the legal certainty for equity swaps could also be
addressed separately by excluding such products
from the CEA, as recommended by the Working Group.
Congressional interest has been instrumental in
bringing SEC and CFTC together to discuss the
legal and regulatory issues involved in repealing
the accord trading prohibitions. Recognizing that
the resolution of the legal and regulatory issues
pivots on the jurisdictional question of which
agency or agencies should regulate single stock
and certain stock index futures, continued
congressional attention may be a key factor in the
ultimate resolution of issues related to the
repeal of the accord prohibitions.
Recommendations
Given the potential benefits of repealing the
accord trading prohibitions and the potential for
jurisdictional differences to continue to impede
such efforts, we recommend that the Chairmen of
SEC and CFTC (1) work together and with Congress
to develop and implement an appropriate legal and
regulatory framework for allowing the trading of
futures on single stocks and all stock indexes,
and (2) submit to Congress legislative proposals
for repealing the accord trading prohibitions.
Agency and Industry Comments and Our Evaluation
Overall, the federal financial regulators and the
securities and futures industry commentators
generally agreed with, or did not comment on, our
conclusions and recommendations. However, SEC, the
New York Stock Exchange, the Securities Industry
Association, and the Securities Markets Coalition
commented that our draft report did not address
all of the concerns and issues associated with
trading single stock futures. They said that the
report, in some instances, oversimplified the
complex solutions required to bridge the
disparities that exist between securities and
futures regulation. We agree that repealing the
accord trading prohibitions involves more than
resolving the three regulatory and legal
differences that we discuss in our report-that is,
the lack of comparable insider trading
prohibitions, margin levels, and customer
protection requirements. We expanded our
discussion of the differences between the
securities and commodities laws and regulations to
clarify that other differences exist that would
need to be addressed if the accord prohibitions
were lifted.
Technical comments provided by CFTC, SEC, the
Federal Reserve Board, Treasury, CBT, FIA, the New
York Stock Exchange, the Securities Industry
Association, and the Securities Markets Coalition
were incorporated in this report, as appropriate.
We are sending copies of this report to Senator
Tom Harkin, Ranking Minority Member, Senate
Committee on Agriculture, Nutrition and Forestry;
Representative Larry Combest, Chairman, and
Representative Charles Stenholm, Ranking Minority
Member, House Committee on Agriculture;
Representative Gary A. Condit, Ranking Minority
Member, Subcommittee on Risk Management, Research,
and Specialty Crops, House Committee on
Agriculture; Representative Tom Bliley, Chairman,
House Committee on Commerce; the Honorable William
Rainer, Chairman, CFTC; the Honorable Arthur
Levitt, Chairman, SEC; and other interested
parties. We will also make copies available to
others upon request.
If you or your staff have any questions regarding
this report, please contact me at (202) 512-8678
or Cecile O. Trop at (312) 220-7600. Key
contributors to this report are acknowledged in
appendix II.
Thomas J. McCool
Director, Financial Institutions
and Markets
_______________________________
1 Derivatives are contracts that have a market
value determined by the price of an underlying
asset, reference rate, or index (called the
underlying). Underlyings include stocks, bonds,
agricultural and other physical commodities,
interest rates, foreign currency rates, and stock
indexes.
2 Futures are agreements that obligate the holder
to buy or sell a specific amount or value of an
underlying asset, reference rate, or index at a
specified price on a specified date. These
contracts may be satisfied by delivery or by
offset with another contract.
3 The OTC market offers contracts that are
privately negotiated outside of organized
exchanges.
4 Options contracts are derivatives that give the
purchaser the right to buy (call option) or sell
(put option) a specified quantity of an underlying
asset, reference rate, or index at a particular
price (the exercise price) on or before a certain
future date.
5 Narrow-based stock indexes generally are indexes
that represent stocks in a single industry or a
group of related industries.
6 Equity swaps are OTC derivatives that have a
market value determined by the price of a single
stock or stock index. Swaps are privately
negotiated contracts that typically require
counterparties to make periodic payments to each
other for a specified time period. The calculation
of these payments is based on an agreed-upon
amount, called the notional amount, that typically
is not exchanged.
7 The Working Group is composed of the Secretary
of the Treasury, the Chairman of the Board of
Governors of the Federal Reserve System, the
Chairman of SEC, and the Chairman of CFTC.
8 Margin refers to funds that are deposited with a
securities broker or futures commission merchant
in conjunction with stock, options, or futures
transactions.
9 NFA is a self-regulatory organization that is
responsible, under CFTC oversight, for qualifying
commodity futures professionals and for regulating
the sales practices, business conduct, and
financial condition of its member firms.
10 In Board of Trade of the City of Chicago v.
Securities and Exchange Commission, 677 F. 2d 1137
(7th Cir. 1982), the Seventh Circuit Court of
Appeals subsequently found that SEC lacked the
authority to approve CBOE to trade the options,
because the options fell within CFTC's exclusive
jurisdiction.
11 The accord was codified in the Securities Act
Amendments of 1982, which amended the federal
securities laws, and the Futures Trading Act of
1982, which amended the CEA.
12 The accord also clarified SEC and CFTC
jurisdiction over options and futures on, among
other things, certificates of deposit and foreign
currencies.
13 Exempted securities include securities issued or
guaranteed by the United States, the District of
Columbia, or any U.S. state.
14 The accord afforded futures exchanges an
opportunity for a hearing on the record before SEC
and judicial review in cases where SEC determined
that a proposed futures contract failed to meet
the accord standards.
15 Self-regulatory organizations are private
membership organizations that are given the power
and responsibility under federal law and
regulations to adopt and enforce rules of member
conduct. Self-regulatory organizations play an
extensive role in the regulation of the U.S.
futures and securities industries and include all
of the U.S. futures and securities exchanges, NFA,
and the National Association of Securities
Dealers.
16 Although the National Association of Securities
Dealers and its subsidiary, the NASDAQ Stock
Market, are not registered securities exchanges,
for simplicity we include them in our references
to the U.S. securities exchanges in the remainder
of this report.
17 FIA is the national trade association of the
futures industry.
18 The International Swaps and Derivatives
Association is a trade association that represents
financial institutions worldwide. Its members
include investment, commercial, and merchant banks
that deal in OTC derivatives contracts.
19 The Securities Industry Association is the
national trade association of the securities
industry.
20 The U.S. Securities Markets Coalition is
composed of the American Stock Exchange, Boston
Stock Exchange, Chicago Stock Exchange, CBOE,
Cincinnati Stock Exchange, NASDAQ Stock Market,
National Securities Clearing Corporation, Pacific
Stock Exchange, Philadelphia Stock Exchange, and
Options Clearing Corporation.
21 The buyers and sellers of futures contracts,
like the sellers of options contracts, are
exposed, in some cases, to unlimited risk of loss
from an adverse price change. In contrast, the
buyers (but not the sellers) of options contracts
are exposed to risk of loss that is limited to the
amount of the premium paid for the contracts.
22 A call option (American style) is a contract
that gives the purchaser the right, but not the
obligation, to buy a specified quantity of the
underlying asset, reference rate, or index on or
before a specified date at a price fixed at the
initiation of the contract.
23 A put option (American style) is a contract that
gives the purchaser the right, but not the
obligation, to sell a specified quantity of the
underlying asset, reference rate, or index on or
before a specified date at a price fixed at the
initiation of the contract.
24 Position limits are imposed by the exchange and
limit the number of options contracts that any
person, or persons acting in concert, may hold on
the same side of the market.
25 Broad-based stock indexes generally are indexes
that represent the market as a whole or a group of
stocks in unrelated industries.
26 In 1998, CBOE traded about 25.7 million options
contracts on the Standard & Poor's 500 index,
while CME traded about 31.4 million futures
contracts on the same index. The CBOE and CME
contracts are not entirely comparable, because the
CBOE contract is based on the amount of the index
times $100, while the CME contract is based on the
amount of the index times $250.
27 The nine exchanges are the Budapest Stock
Exchange (Hungary), Bolsa de Derivados do Porto
(Portugal), FUTOP Clearing Centre (Denmark),
Helsinki Stock and Derivatives Exchanges
(Finland), Hong Kong Futures Exchange (Hong Kong),
Mexican Derivatives Market (Mexico), OM Stockholm
Exchange (Sweden), South African Futures Exchange
(South Africa), and Sydney Futures Exchange
(Australia).
28 The Financial Supervisory Authority is Sweden's
regulator of financial markets, including the
insurance, credit, securities, and futures
markets. Under the Swedish regulatory approach,
all organized exchanges are subject to the same
laws and regulations and may trade any financial
product, provided they have the necessary rules to
maintain a fair and orderly market. Also, all
financial institutions are subject to the same
laws and regulations and may sell any financial
products to investors.
29 Market makers stand ready to buy or sell
financial instruments, providing both a bid and
offer price to the market.
30 The OM Stockholm Exchange trades single stock
futures on Pharmacia and Upjohn, which was formed
through a November 1995 merger between Pharmacia
(a Swedish company) and Upjohn (a U.S. company).
31 In the United Kingdom, futures exchanges are
allowed to trade single stock futures, but do not
do so. However, betting houses legally offer
"spread bets" on, among other things, U.S. single
stocks. Spread bets are economically equivalent to
off-exchange futures transactions, and U.S.
customers are prohibited from entering into such
transactions, according to a CFTC official.
32 Other OTC derivatives that are economically
similar to stock-based futures are OTC equity
options and equity forwards.
33 The Bank for International Settlements was
established in 1930 in Basle, Switzerland, by six
Western European central banks and a U.S.
financial institution. One of its functions is to
provide a forum for cooperative efforts by central
banks of major industrial countries.
34 The Bank for International Settlements estimate
includes equity forwards, which are different from
equity swaps.
35 The term "futures contract" is not defined by
the CEA. Thus, the definition has evolved through
judicial and agency interpretations.
36 As previously discussed, under the accord
standards, a stock index futures contract must be
(1) settled in cash; (2) not readily susceptible
to manipulation; and (3) based on an index that
either is a widely published measure of and
reflects the market as a whole or a substantial
segment of the market, or else is comparable to
such a measure.
37 As of January 12, 2000, CFTC had approved
futures contracts on 47 diversified stock indexes.
38 As of January 12, 2000, CFTC had approved
futures contracts on 10 single industry stock
indexes.
39See Board of Trade of the City of Chicago v.
Securities and Exchange Commission, 189 F. 3d 713
(7th Cir. 1999).
40 See Over-the-Counter Derivatives Markets and the
Commodity Exchange Act, the President's Working
Group on Financial Markets (November 1999).
41 A no-action letter is issued by CFTC staff to
indicate that they will not recommend enforcement
action for violation of law or regulation if
certain conditions are met. The letter does not
reflect official Commission views.
42 With the exception of securities-based futures
and options, the CEA and CFTC regulations
generally do not restrict the sale of foreign
exchange-traded futures and options in the United
States.
43 According to FIA, CEA section 4(b) prohibits
CFTC from adopting any rule or procedure that
authorizes CFTC, in effect, to approve the terms
or conditions of any futures contract traded on a
foreign exchange, and the accord does not
supersede or preempt section 4(b). CFTC disagrees
with FIA. According to CFTC, while section 4(b)
does not permit the Commission to regulate the
terms and conditions of foreign futures, the
legislative history of the section nevertheless
makes clear that Congress expected the Commission
to certify or otherwise review the offer or sale
of foreign futures in the United States under such
criteria as the Commission deems appropriate.
44 FCMs are individuals, corporations,
associations, partnerships, and trusts that
solicit or accept orders to buy or sell futures
and accept payment from or extend credit to those
whose orders are accepted.
45 As with equity swaps, hybrid instruments that
reference nonexempt securities face legal
uncertainty, because a court could find them to be
subject to the accord prohibition on single stock
futures. Hybrid instruments possess, in varying
combinations, characteristics of futures, options,
securities, and/or bank deposits. To enhance the
legal certainty of hybrids that reference
nonexempt securities, the Working Group
recommended that a provision be enacted in the CEA
to clarify that the accord shall not be construed
to apply to hybrid instruments that have been
exempted from the CEA.
46 The Working Group recommended that bilateral
swaps entered into by eligible swaps participants,
on a principal-to-principal basis, should be
excluded from the CEA, provided that the
transactions are not conducted on a multilateral
transaction execution facility in which bids and
offers are open to all participants. The Working
Group recommended that certain types of electronic
trading systems be excluded from the CEA, even if
bids and offers are open to all participants,
provided that the participants are acting for
their own account.
47 Price discovery is the process of determining
price on the basis of supply and demand factors.
48 According to CFTC officials, under limited
circumstances, insider trading involving the
futures market might be covered under the CEA
antifraud provisions.
49 Under Regulation T, the customer payment period
is the number of days in the standard security
settlement cycle, which is set by SEC and is 3
business days from the date of the contract, plus
2 business days.
50 According to New York Stock Exchange and
National Association of Securities Dealers rules,
margin accounts must contain at least 25 percent
of the current market value of all purchased
securities in a customer's account.
51 The option buyer pays only a nonrefundable
premium-an amount that is determined by the
market.
52 To exercise an option is to invoke the right
granted to the owner of an option contract. In the
case of a call, the option owner buys the
underlying stock. In the case of a put, the option
owner sells the underlying stock.
53 An option is out-of-the-money when its exercise
price is above (call) or below (put) the current
market price.
54 According to a National Association of
Securities Dealers rule, margin for the option
seller cannot be less than the current market
value of the option plus 10 percent of either the
current market value (call) or the option's
aggregate exercise price (put).
55 CBOE is currently attempting to develop a pilot
program that would implement risk-based margining
for portfolios of broad-based index options traded
by institutional or high net-worth/sophisticated
investors. The pilot program would require SEC
approval; however, CBOE has not yet submitted the
program to SEC for review. CBOE anticipates that,
under the pilot program, margin requirements for
eligible portfolios of index options generally
will be lowered to better reflect the risk
associated with such portfolios. The futures
exchanges currently use a risk-based portfolio
margining system.
56 As previously discussed, because an option buyer
has the right but not the obligation to buy or
sell the underlying, an option buyer's risk is
limited.
57 The Intermarket Surveillance Group membership is
composed of U.S. securities and options exchanges,
with futures exchanges participating as affiliate
members.
58 The SEC Chairman disagreed with the other
Working Group members and said that margins on
futures and options should be increased.
59 The Department of the Treasury noted that
questions as to the appropriate tax treatment of
single stock futures would also need to be
addressed.
60 See Interim Report of the Working Group on
Financial Markets (May 1988).
61 Circuit breakers are a coordinated system of
trading halts and price limits on stock and
derivatives markets that are designed to provide a
cooling-off period during large, intraday market
declines.
62 Recognizing that futures, options, and stocks
could be used as substitutes in some cases,
Federal Reserve officials said that margin cost is
just one of the factors that market participants
consider in making an investment decision.
However, the officials said that the significance
of this cost is unclear.
63 Dual trading occurs when (1) a floor broker
executes customer orders and, on the same day,
trades for his or her own account or an account in
which he or she has an interest, or (2) an
intermediary carries customers accounts and also
trades, or permits its employees to trade, on the
same trading day, in accounts in which it has a
proprietary interest.
64 We are currently reviewing the use of electronic
trading systems for exchange-traded and OTC
derivatives and will report our findings
separately.
65 Frontrunning is taking a futures or options
position based on nonpublic information regarding
an impending transaction by another person in the
same or a related futures or options contract.
66 Open outcry is a method of public auction under
which futures are traded by floor participants who
verbally or through hand signals make bids and
offers to each other at centralized exchange
locations.
67 Eligible swap participants include banks,
securities firms, insurance companies, commercial
firms with a net worth exceeding $1 million, and
individuals with total assets exceeding $10
million. 17 C.F.R. 35.1(b)(2)(1999).
Appendix I
Comments From the Securities and Exchange
Commission
Page 41 GAO/GGD-00-89 Shad-Johnson Accord
See p. 35.
Appendix II
GAO Contacts and Staff
AcknowledgmentspictureId65536pictureActive0fLine0
Related GAO Products
Page 44 GAO/GGD-00-89 Shad-Johnson Accord
The Commodity Exchange Act: Issues Related to the
Commodity Futures Trading Commission's
Reauthorization (GAO/GGD-99-74, May 5, 1999).
OTC Derivatives: Additional Oversight Could Reduce
Costly Sales Practice Disputes (GAO/GGD-98-5, Oct.
2, 1997).
The Commodity Exchange Act: Legal and Regulatory
Issues Remain (GAO/GGD-97-50, Apr. 7, 1997).
Financial Market Regulation: Benefits and Risks of
Merging SEC and CFTC (GAO/GGD-95-153, May 3,
1995).
*** End of Document ***