FINANCIAL INFORMATION FORUM
VERSION 3.0
JUNE 2001
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The Commodity Futures Modernization Act and Single Stock Futures
The Financial Information Forum (FIF) was founded in 1996 to address the issues of its
component groups - exchanges, broker-dealers, futures commission merchants (FCM) and
vendors. Anticipating that single stock futures will begin trading in the U.S. soon, the FIF
initiated a dialog among these component groups to determine what changes these new
instruments may require of the industry��s information systems. The first meeting was held in
early April 2001.
Background and History
In 1974, Congress expanded the definition of a ��commodity�� creating a conflict of
jurisdictions for the Securities and Exchange Commission (SEC) and Commodities Futures
Trading Commission (CFTC). The two organizations reached a political compromise over
these issues in the early 1980s, the
Shad-Johnson Accord. The Shad-Johnson Accord
prohibited the sale of futures on single stocks and on narrow-based indices in order to allow
the SEC and CFTC the time to resolve regulatory and philosophical differences. The ban on
this especially troublesome, low demand hybrid was described as a ��moratorium�� at the
time. In December 2000, the Commodities Futures Modernization Act (CFMA) lifted this
moratorium. Many of the original philosophic/regulatory differences still exist, creating a
regulatory and technical challenge for all players in the industry.
Prior to CFMA, several foreign exchanges offered single stock futures products, among
them Sydney, Hong Kong, OM Stockholm and Montreal. These single stock futures
products have experienced limited success. Analysts suggest this is due to 1) a small market
for the underlying, 2) physical rather than cash settlement, and/or 3) the fact that a long
futures position can be replicated by a long call/short put option combination. Nonetheless,
the Futures Industry Association��s statistics on single stock futures traded at five exchanges
show volume in 2000 increased to 2.6 million from 1.4 in 1999.
In January 2001, the London International Financial Futures Exchange (LIFFE) introduced
single stock futures on 30 stocks, seven of which are for U.S. based firms. Within the first
twelve weeks of trading over 326,000 single stock futures were traded, the equivalent of 87
million of the underlying shares. On May 14, 2001 LIFFE added 25 contracts to the existing
40, thus listing a total of 65 single stock futures on global stocks with a combined market
capitalization of EUR 7.2 trillion.
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On January 31, 2001 Bourse de Montreal Inc. began trading single stock futures on Nortel
Networks Corporation. The contract, carrying the symbol "FNT", trades on SAM (Montreal
Automated System), the Bourse's electronic trading platform.
Regulatory Status
Deadlines and Dates
As of August 21, 2001, the CFMA permits ��eligible contract participants�� (banks, trust
companies and individuals with more than $5 million in assets) to trade on a principal-to-
principal basis. Principal-to-principal will involve a clearinghouse. Transactions will have to
occur on exchanges - no upstairs trading is allowed. However, the Act itself does not define
��upstairs trading.�� Retail trading will not be allowed until December 21, 2001. Options on
single stock futures and narrow-based indices will not be allowed until August 21, 2003.
The Act requires linked clearing approximately two years after trading begins. The industry
is currently waiting for the SEC and CFTC to settle many regulatory issues for the new
products, but neither the Act nor the two agencies have set a deadline for themselves other
than those set by the start dates for trading.
On May 10, 2001 the CFTC and the SEC announced that they proposed joint rules to
implement new statutory provisions relating to security futures products. The joint rules
proposed by the CFTC and SEC relate to the distinction between broad-based and narrow-
based security indexes. Futures contracts on broad-based indexes are under the exclusive
jurisdiction of the CFTC. The CFMA defines the criteria for an index to be considered
narrow-based, including, among other factors, the market capitalization of each security in
the index and the dollar value of that security's average daily trading volume. The statute
requires the two agencies to jointly specify the methods that must be used to determine these
values. The proposed rules are designed to fulfill that statutory mandate, as well as to
address other issues that arise in the application of the definition of narrow-based security
index. The proposed joint rules can be found on the SEC website at www.sec.gov/rules/
proposed/34.44288.htm
Notice-Registration Process
As intended by the Shad-Johnson Accord, securities and futures products have lived
duplicate and separate lives. The CFMA forces the SEC and CFTC to reconcile regulatory
differences and resolve jurisdictional disputes.
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For the notice-registration process, FCM��s will have to notice-register with SEC; broker-
dealers will have to notice-register with CFTC. All exchanges/intermediaries will be
regulated by both organizations, but only each agency��s core provisions will apply to notice-
registrants. In cases where disparities between the SRO��s rules exist, the primary regulator
determines what rules apply but both have jurisdiction. The regulatory agencies have taken a
��hands off approach�� to market issues, leaving market forces to sort out the specifics.
Notice of Risk
Single stock futures will not require a prospectus. A risk document similar to that used in the
futures industry will be required before trading. If an existing customer has already signed a
risk document, they will have to sign the parallel single stock futures risk document. The
National Futures Association, National Association of Securities Dealers, SEC, and CTFC
are jointly working on a new risk document modeled after the Options Disclosure Document
used in the equities options markets.
Margining
Margins will be the higher of that required for comparable options, or the amount required
by the listing exchange.
Tax Issues
For tax purposes, single stock futures will be treated like listed equity options rather than as
other futures contracts. The 60/40 rule is limited to single stock futures dealers performing
functions similar to options market makers.
The Product
While futures exchanges had been lobbying for single stock futures, the December
legislation took exchanges somewhat by surprise given the very brief congressional session
held after the presidential election. Presently, in order to design their products, the
exchanges are busy researching the potential markets. The general consensus is that the
market will be like a land-rush come August. Whoever comes up with the ��right�� product
will grab the liquidity. The CBOT, CBOE, CME, NYMEX, NASDAQ and AMEX have all
stated their intention to trade single stock futures. Information on product specifications is
sparse at this time. The comments from industry participants indicate the following:
1. Contract Size: 100 shares is a realistic contract size.
2. Months: Expirations should go at least year out (market will dictate).
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3. Physical vs. cash settlement: The integrity of the closing price is the key to cash
settlement. Cash settlement opens up manipulation concerns; physical settlement
opens up squeeze concerns.
4. Margining: Futures margining percentages will likely apply.
5. Symbology: Ideally, the futures contract symbol should include the underlying
equity symbol. However, this will be very difficult given current symbol conventions
and the possibility that single stock futures may be multiply-listed. Unlike, the
equities area, there has been little effort to coordinate symbol assignments in the
futures markets. Since traders operate with symbol and not numeric issue identifiers,
symbology is a major issue that needs to be addressed. The OCC has been looking at
this problem, but hasn��t yet figured out how to construct a working group to address
standardization.
6. Fungibility: This is another major area of concern. While investors will see
fungibility as desirable, the exchanges will probably not see it as beneficial to them.
The consensus seems to be that fungibility will be difficult to achieve at start-up but
will develop over time. Cross margining could create quasi-fungibility.
7. Corporate Actions: Such actions will produce the same operational adjustments for
futures as they do for equity options. Dividend payments will not be a factor.
Investor Considerations
Investors are beginning to inquire about single stock futures. However, firms have no
information to give them since there is little product or regulatory data available yet. Some
investor benefits that have been discussed are:
- Use single stock futures as a surrogate for equities investing. It requires less
capital and settlement is simpler.
- Use single stock futures as an alternative to short selling.
- Use single stock futures for hedging equity positions.
- Global investing could be much simpler.
Order Processing and Trading Systems
Since the SEC and CFTC have operated in separate and duplicate worlds, these new hybrid
products have no existing environment and infrastructure in which to develop. Firms see the
magnitude of the coming changes, but cannot plan without more information.
•
Liquidity access: What happens when a FCM wants to send order flow to a fully
registered securities exchange? Other market access issues will certainly arise.
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•
Decimalization: Prices are required to be in decimals nine months out, however, prices
may be stated in decimals from the start.
•
Level playing field: Since futures exchanges currently have data feeds to vendors, they
may get a head start at liquidity. It is not clear how securities exchanges would
disseminate market data. If vendors have to wait for new circuits from SIAC and other
distributors, the future exchanges could have a head start. However, there is no reason
that the securities exchanges have to use SIAC.
•
Legacy systems vs. new development: Since these hybrids won��t fit into either the
futures or securities current environments, should a third infrastructure be developed
for these products? If all firms look at this as something new, perhaps it would be
better than using legacy systems.
•
Multiple trading sessions: Floor trading looks impractical for this product. All trading
will probably be electronic and there will probably be multiple daily sessions to
accommodate different geographic segments of investors. Different sessions can create
different markets.
Market Data
Like all other parties, vendors need more information. Vendors are not only faced with
legacy vs. development issues, but also regulatory issues such as requirements for
transparency and the need to consolidate data. Consolidation could involve not only multiple
markets but also correlation with pricing for the underlying security and its options. How
much will be required? What will investors want?
Symbology is, of course, a major issue. The industry needs exchanges to keep the level of
complexity in mind when developing their products and would like to see some guidelines
or standardization. However, exchanges cannot talk without risking antitrust violation and
the regulatory agencies have taken a hands-off attitude. Perhaps this is the arena in which
the FIF can make a contribution.
Next Steps
Concurrently, the markets are developing their products and a rush of announcements will
follow the regulatory promulgations. Clearing organizations are also making preliminary
announcements regarding their processes for single stock futures.
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• On March 22, 2001 the Options Clearing Corporation announced that it had filed with
the Securities and Exchange Commission to clear single-stock futures transactions from
non-member exchanges, "OCC anticipates that some or all of OCC's five participants
exchanges will trade securities futures,�� the OCC said in its filing to the SEC. If the
government grants OCC its request that would in effect give futures exchanges
fungibility, something they don't currently have. In other words, a market player could
buy a single stock future at one futures exchange and sell it at another, clearing through
OCC. Such transactions are common for stock options. Although the OCC can handle
fungibility, it is not yet known if the markets will design their products to be fungible.
• On March 26, 2001 the Nasdaq Stock Market and the London International Financial
Futures and Options Exchange (LIFFE) announced a partnership to develop the single
stock futures market, based on global stocks, for US and European customers. These
products will be listed on LIFFE CONNECT™, LIFFE��s electronic trading platform.
Nasdaq and LIFFE will form a US-regulated entity and intend to develop links with US
and European clearing organizations to maximize efficiencies for their customers.
• On May 14, 2001 the Chicago Mercantile Exchange (CME) and Chicago Board Options
Exchange (CBOE) announced they will team up to offer single-stock futures trading.
The CBOE and CME signed a letter of intent to create a joint venture to introduce
single-stock futures, following approval by the boards of directors of both exchanges.
The Chicago Board of Trade will participate in the joint venture with a limited stake.
The products will be traded electronically, with orders entered either through the new
CBOEdirect electronic platform or through the CME��s Globex 2 electronic trading
system, the exchanges said. The joint venture will be a for-profit company, will have its
own management and board, and will be separately organized as a regulated exchange.
CME and CBOE officials said they are engaged in negotiations with the Options
Clearing Corporation, which clears all CBOE transactions, to clear the new products.
The CBOE and CME each have a 45% stake in the joint venture, while the Chicago
Board of Trade has a limited stake of 10%.
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The Financial Information Forum plans to monitor single stock futures closely as regulatory
requirements and products are defined. Important concerns which FIF will continue to
address include futures contract identifiers, market data dissemination, order systems and
brokerage processing.
For additional information, contact:
Eileen M. McBlain
Director of Communications
Financial Information Forum
40 Exchange Place, Suite 600
New York, NY 10005
(212) 652-4464
