Security Futures Products Overview

The term security futures product (SFP) encompasses security futures and options on security futures. The term security future includes both futures on a single security (called single stock futures) and futures on narrow-based security indexes.

The Commodity Futures Modernization Act of 2000 (CFMA) lifted the ban on trading of futures contracts based on single stocks. Previously, these products were prohibited from being offered in the United States. Instead, futures contracts based on securities (other than exempt securities that are not municipal securities) were allowed only on diversified indexes that contained many securities and could not be used as a surrogate for trading in a single security or small group of securities. With the passage of the CFMA, broad-based security index futures, which are not considered security futures products, continue to trade under the sole jurisdiction of the CFTC, while security futures products are subject to the joint jurisdiction of the CFTC and the Securities Exchange Commission (SEC).

Methods for determining when an index is broad or narrow-based are discussed below.

A securities index is classified as a narrow-based security index if it meets any one of the following criteria:

• The index has nine or fewer component securities;
• Any one of the component securities comprises more than 30 percent of the index’s weighting;
• The five highest weighted component securities together comprise more than 60 percent of the index’s weighting; or
• The lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume (ADTV) of less than $50 million (or $30 million in the case of an index with 15 or more component securities). The dollar value of ADTV is calculated as of the preceding six full calendar months.

Contract markets that have been designated by the CFTC (DCMs) may trade security futures products if they notice register with the SEC and comply with certain requirements of the Securities Exchange Act of 1934. Likewise, national securities exchanges and national securities associations registered with the SEC may trade security futures products if they notice register with the CFTC and comply with certain requirements of the Commodity Exchange Act (CEA).

Since an SFP is both a futures contract and a security, an entity effecting SFP transactions must be registered both as a futures commission merchant (FCM) with the CFTC and as a broker-dealer with the SEC. The CFTC and the SEC provide notice registration procedures for certain persons that are required to register with the respective agency solely because they are effecting SFP transactions. The notice registration procedures provide an entity that previously engaged exclusively in either the futures or securities business with the ability to participate in SFP business without having to go through a second full registration process.

To avoid conflicting or duplicative regulation, notice-registered FCMs are exempt from certain provisions of the CEA (including CFTC segregation requirements), and notice-registered broker-dealers are exempt from certain provisions of the Securities Exchange Act of 1934 (including SEC Rule 15c3-3).

The CEA and the Securities Exchange Act of 1934 require that securities underlying security futures products must be common stock or other equity securities as the CFTC and the SEC jointly deem appropriate. The CFTC and the SEC have jointly determined that certain American Depositary Receipts, Exchange Traded Funds, Trust Issued Receipts, closed-end funds, and debt securities also are eligible to underlie security futures products.

Broad-based Security Index
Although not defined in the CEA, a broad-based security index generally refers to any security index that would not be classified as a narrow-based security index under the definitions or exclusions set forth in the CEA and the Securities Exchange Act of 1934 or that meet certain criteria specified jointly by the CFTC and the SEC. Unlike SFPs, which are jointly regulated by the CFTC and the SEC, futures on broad-based security indexes are under the exclusive jurisdiction of the CFTC.

For a security index to be classified as broad-based, it must either:

• Meet all of the criteria associated with any one of two definitions, sometimes referred to as Path A and Path B, or
• Be excluded under one of several special provisions.

Indexes defined not to be narrow-based

• Path A: Under Path A, which derives from Section 1a(25)(A) of the CEA, 7 USC 1a(25)(A), a security index is classified as broad-based if it has all of the following characteristics:
• The index has ten or more component securities;
• No single component security comprises more than 30 percent of the index’s weighting;
• The five highest weighted component securities together comprise no more than 60 percent of the index’s weighting; and
• The lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume (ADTV) of $50 million or more (or in the case of an index with 15 or more component securities, $30 million or more).
• Path B: Under Path B, which derives from Section 1a(25)(B) of the CEA, an index is classified as broad-based if:
• The index has nine or more component securities;
• No single component security comprises more than 30 percent of the index’s weighting;
• All of the component securities are registered under Section 12 of the Securities Exchange Act of 1934; and
• Each component security is one of the 750 securities with the largest market capitalization and one of the 675 securities with the largest dollar value of ADTV. The CFTC maintains a list, Stocks Eligible for Inclusion in a Broad-Based Security Index Under Path B (PDF, as of January 2, 2013); a list of those securities that meet both the market capitalization and trading volume requirements.

• Indexes Underlying Contracts Approved by the CFTC Pre-CFMA
  Any security index underlying a futures contract or futures option contract that was approved by the CFTC before the date when the CFMA was enacted is broad-based (Section 1a(25)(B)(ii) of the CEA).
• Any security index futures contract traded on or subject to the rules of a foreign board of trade that meets such requirements that are jointly established by rule or regulation by the CFTC and SEC is excluded from the definition of narrow-based (Section 1a(25)(B)(iv) of the CEA and Section 3(a)(55)(C)(iv) of the Securities Exchange Act of 1934). This provision grants the CFTC and SEC the authority to jointly establish further exclusions from the definition of narrow-based security index for boards of trade outside of the U.S.
• Indexes Underlying Contracts of Foreign Boards of Trade Authorized by the CFTC Pre-CFMA
  Any security index underlying a futures contract traded on or subject to the rules of a foreign board of trade that was authorized by the CFTC before the CFMA was enacted is broad-based. The CFMA provided that this exclusion was to expire on June 21, 2002; however, pursuant to Section 1a(25)(B)(iv) of the CEA and Section 3(a)(55)(C)(iv) of the Securities Exchange Act of 1934, the CFTC and SEC issued a joint order in which the Commissions permanently extended this exclusion. Hence, these security indexes will continue to be treated as broad-based security indexes. List of indexes meeting this exclusion.

The CEA and the Securities Exchange Act of 1934 require that securities underlying security futures products must be common stock or other equity securities as the CFTC and the SEC jointly deem appropriate. The CEA and Securities Exchange Act also authorized the CFTC and the SEC to permit trading in non-equity securities.

The CFTC and the SEC jointly determined in three actions that certain non-common-stock securities also are eligible to underlie security futures products.

• August 20, 2001: American Depositary Receipts (ADRs)
• June 25, 2002: Shares of Exchange-Traded Funds (ETFs); Trust-Issued Receipts (TIRs); Shares of Registered Closed-end Investment Companies (Closed-End Funds)
• July 13, 2006: Debt securities