Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

Joint Order on Futures Products Based Upon Volatility Indices
Volatility indices seek to measure the variability of daily returns on an underlying broad-based security index (Underlying Index), as reflected in the prices of options on the Underlying Index. Futures contracts on volatility indices that are deemed to be “broad-based” security indices are not security futures and, therefore, come within the exclusive jurisdiction of the CFTC. By contrast, futures contracts on volatility indices that are deemed to be “narrow-based” security indices are considered to be security futures, and thus subject to the joint jurisdiction of the CFTC and the SEC.

Provisions of the CEA and 1934 Act grant the CFTC and SEC joint authority to establish
requirements that permit more indices to be deemed a broad-based security index than would be the case under the specific criteria set forth in those statutes. In the first 2009 Joint Order, the CFTC and SEC expanded the definition of a broad-based security index to include the VDAX-NEW® volatility index developed by the German exchange Eurex.

The CFTC and the SEC had previously considered this issue and published an earlier Joint Order on March 31, 2004, which set seven conditions for a volatility index to be considered a broad-based security index. 

• The volatility index must measure changes in the level of an Underlying Index using (i) the standard deviation, or (ii) the variance, of price changes in options on the Underlying Index, two commonly recognized statistical measurements that show the degree to which an individual value tends to diverge from an average value.
   
• The volatility index must meet specific statutory criteria applicable to the number and weighting of the securities comprising any broad-based index:
  
  
  • The volatility index must include at least 10 component securities, all of which are options on the Underlying Index;
  • No component security of the volatility index may comprise more than 30 percent of the index’s weighting; and
  • The five highest-weighted component securities in the aggregate may not comprise more than 60 percent of the volatility index’s weighting.

• The Underlying Index must meet the statutory criterion for liquidity applicable to any broad-based security index. In addition, there must be aggregate average daily trading volume of 10,000 contracts in options on the Underlying Index. These two liquidity criteria were added to allay concerns that futures contracts on a volatility index might be susceptible to manipulation because of a thin market in the Underlying Index.
   
• Finally, the 2004 Joint Order required that the options comprising the volatility index be listed and traded on a “national securities exchange” as defined in the CEA and the 1934 Act. Only U.S. exchanges are included in this definition.

In 2006, the German exchange Eurex requested that the CFTC and SEC determine that its product, the VDAX-NEW® volatility index, is a broad-based security index. Given the requirement of the 2004 Joint Order that the options comprising the volatility index be listed and traded on a “national securities exchange,” no volatility index based on index options traded on a non-U.S. exchange could qualify as “broad-based.”

To resolve this issue, the CFTC and SEC determined, in the 2009 Joint Order, to eliminate the requirement that the options comprising the volatility index be listed and traded on a national securities exchange. That determination is consistent with the provisions of the CEA and 1934 Act, which only require that a broad-based security index be traded on a board of trade. In lieu of that condition in the 2004 Joint Order, the new Joint Order requires that (i) the index options used to calculate the magnitude of change in the level of the Underlying Index are listed for trading on an exchange, and (ii) pricing information for the Underlying Index, and options on such index, is computed and disseminated in real-time through major market data vendors.

The general nature of the Joint Order means that exchanges will not need to obtain separate relief for their particular volatility index, but can rely upon the conditions set forth in the recent Joint Order.

The issuance of the first 2009 Joint Order suggests several more broadly important points.

• The CFTC and SEC demonstrated that they can work together to establish standards that should benefit investors as well as the markets. Rather than adhering to the prior requirement that particular securities be listed and traded on a national securities exchange registered under Section 6(a) of the 1934 Act, the CFTC and SEC focused their determination on what should be important to investors – that relevant pricing information is current, accurate and publicly available. By expanding the definition of broad-based security index beyond the minimum criteria set forth in the CEA and the 1934 Act, the agencies permitted more products to come within the CFTC’s exclusive jurisdiction.
  
   
  • This ability to cooperate may take on greater significance if pending legislation that would require significantly more joint rulemaking by these agencies becomes law. Such legislation currently is under consideration with regard to the regulation of over-the-counter derivatives.
     
• The Joint Order also suggests that the SEC may be taking a more open approach that will permit U.S. persons to invest in a wider array of international products, even where such products are not registered under the 1934 Act, which could have implications for other aspects of trading in security futures.

• Beyond that, the Joint Order should make it easier for U.S. persons to trade futures on non-U.S. volatility indices. If the condition requiring options comprising a volatility index to be traded on a national securities exchange had been retained, the VDAX-NEW® volatility index would be considered narrow-based, and futures contracts thereon would be treated as security futures. As discussed in a previous article, the SEC has been reluctant to permit U.S. persons to trade security futures on non-U.S. markets, so the new Joint Order clears the way for greater participation by U.S. investors in the trading of international volatility index futures.

Joint Order on Corporate Debt Securities
The second Joint Order issued last month significantly expands the range of security futures products by eliminating certain restrictions as to the types of securities that may underlie such products. This will permit securities futures on a wide range of corporate debt issues that were previously not eligible to underlie a futures contract.

The CEA and the 1934 Act provide that any security underlying a security future must be registered under Section 12 of the 1934 Act, unless the CFTC and SEC, by rule, regulation or order, jointly modify the criteria for such underlying securities. In 2001 and 2002, the agencies issued Joint Orders permitting certain non-equity securities as underlying securities for security futures: (1) depositary shares; (2) shares of exchange-traded funds; (3) trust issued receipts; and (4) shares of closed-end management investment companies.

The second Joint Order eliminates the requirement that a security underling a security future be registered under Section 12 of the 1934 Act, instead providing that:

• the underlying security must be registered under the Securities Act of 1933;
   
• the issuer of the underlying security must have at least one class of common or preferred equity security registered under Section 12(b) of the 1934 Act and listed on a national securities exchange;
   
• the transfer agent for the underlying security must be registered under Section 17A of the 1934 Act; and
   
• the underlying security has been issued under a trust indenture qualified under the Trust Indenture Act of 1939.

These conditions are intended to provide that (a) investors in security futures will have sufficient information about the corporate debt securities and the issuer thereof, (b) the issuer of the underlying securities is subject to oversight by a national securities exchange, and (c) the transfer agent of the underlying securities is subject to oversight by the SEC. As with the first Joint Order, the general nature of the conditions applied to trading security futures on corporate debt securities makes individual relief requests unnecessary.

With the second Joint Order, like the first, the CFTC and the SEC went beyond the minimum requirements of their respective statutes, cooperating in the exercise of their discretion so as to permit trading in security futures on an expanded array of underlying securities. Investors should benefit from the fact that security futures may now be traded on a wide range of corporate debt issues, as well as from the potential for new financial instruments to be created that may be hedged with these new security futures. Benefits should also result from the fact that the Joint Order permits security futures to be traded on any security that may underlie an exchange-listed security option. Price discovery for these underlying securities should be facilitated, and competition between option and futures exchanges should be enhanced.