Thank you, Gary, for the invitation to participate on this panel. The majority of the comments from panelists today will be related to market participant impressions and ideas about exchange traded funds (ETFs) and their relationship to security futures products (SFPs). However, my talk will focus on the regulatory side of things and give some background on how the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) have looked at these products.
It has been almost nine months since I was sworn in as a Commissioner of the CFTC. I came to the Commission from the staff of Senator Richard Lugar on the Senate Agriculture Committee. In this capacity, I staffed the passage of the Commodity Futures Modernization Act of 2000 (CFMA), legislation that significantly reformed the approach to regulating the futures markets and that lifted the ban on trading security futures products. Although not as versed in these markets as many on this panel, my insights with this legislation as a former legislative aide and currently as a regulator might lend perspective behind the provisions we are discussing today.
SEC/CFTC Order on Security Futures on ETFs
The CFMA provided for an end to the 19-year-old ban on single stock and narrow-based stock index futures in the US. Specifically, the Act provided that the agencies develop joint rules for trading SFPs on “common stock.” Because many ETFs may not be “common stock,” the agencies had to issue a specific order to allow SFP trading on ETFs, whether or not the underlying ETF was common stock.
In June 2002, the agencies issued a final order, at the request of Amex and NQLX, specifically providing that SFPs on ETFs could be traded, requiring: (1) the underlying ETF is registered under Section 12 of the ’34 Act, and is nationally listed; (2) there are a minimum of 7,000,000 publicly-owned ETF shares; (3) total trading volume in the ETF shares has been at least 2,400,000 shares in the preceding 12 months; (4) the market price per share of the ETF has been at least $7.50 for the majority of the business days during the three calendar months preceding trading in the original listing market; and (5) the ETF is in compliance with all applicable rules under securities laws. The agencies put these provisions into place to minimize the chances that individuals could use these products to manipulate the underlying securities market.
The two security futures exchanges, NQLX and OneChicago, currently trade security futures products on ETFs. For example, NQLX trades SFPs on the QQQ (NASDAQ 100) and the Russell 2000 and OneChicago trades SFPs on Diamonds. In fact, security futures ETFs are among the more active contracts trading on the SFP exchanges. For the first two weeks of this month, ETFs accounted for 30 percent of the total volume at NQLX and 15 percent of the total volume at OneChicago. Overall, from the start of trading in November 2002, ETFs have accounted for 18% of total trading volume at NQLX, and 14% of total trading volume at OneChicago.
ETFs became popular among institutional users in recent years primarily because the product was a useful tool for portfolio rebalancing. Unlike mutual funds, users can rebalance their books by trading in and out of ETFs during the day, and can more easily short their equity positions. Instruments like the QQQ became enormously popular, and there was widespread interest in enhancing the utility of the product by developing an SFP on such products.
Although the ETF markets took a significant dip in 2001, and one or two funds have recently unwound, it appears from some recently published figures that asset values rebounded in 2002, and have continued that upward trend in 2003.
It is interesting to note that, at the time industry participants were requesting approval to trade SFPs on ETFs, they were also considering an alternative product-- a broad-based index mirroring the underlying components of the ETF benchmark. However, it is my understanding that the ETF route was chosen primarily because of the large securities sales force already in place to offer the product.
Whether structured as a security futures product on an ETF or a broad based index, regulators must ensure that its rules are market neutral and do not favor one product over another. In meeting our public mission, we must be careful not to create a regulatory environment that stifles market innovation.
Remaining Issues with CFMA Implementation
There are two primary substantive areas, and one administrative area, that the agencies still need to address in relation to SFPs. Chairman Newsome has tasked me to oversee completion of these projects on behalf of the CFTC, and I have been discussing these issues with commissioners at the SEC to help guide our staffs to get these efforts completed in a timely fashion.
-Memorandum of Understanding on Exams and Audits
A salient point in the CFMA regarding the joint regulatory scheme for SFPs was that there should be coordination of oversight responsibilities. The worst of all possible worlds would be to have two regulators simultaneously carrying out the same activities. As such, Congress included Section 204 of the CFMA to “avoid unnecessary regulatory duplication or undue regulatory burdens.”
Accordingly, the CFTC and the SEC staffs have developed a draft memorandum of understanding that reflects the Congressional intent to have a primary and a secondary regulator of SFP intermediaries and exchanges. The basic idea behind this memorandum is to ensure that only the primary regulator conducts routine, periodic examinations, and that the secondary regulator may only examine on a “for cause” basis.
This is a point of particular interest in the ETF world, given that the only two exchanges currently trading SFPs on ETFs are registered futures exchanges and as such have the CFTC as their primary regulator. I hope and expect to see a document forthcoming on this issue in the near future.
Another joint regulatory issue affecting these markets is the implementation of portfolio margining. The issue of margining was one of the most difficult to tackle during implementation of SFP regulations. The CFMA required that SFP margins be “consistent with comparable options” and each word of that statutory requirement became the subject of rigorous and exhaustive debate. However, the agencies did finally reach a consensus, with a little help from the Fed, which allowed the products to begin to trade domestically.
One issue that came up in the margin discussion, and continues to be debated, is that of portfolio margining. In the futures world, we have used SPAN portfolio margining for decades, and this is the industry standard. However, in the securities world, portfolio margining has not generally been used between the customer and the clearing firm, and so this issue became a focal point when attempting to develop margin rules for a product that is both a future and a security.
In the case of SFPs, the agencies finally agreed on a margin rule that allowed only two offsetting scenarios (out of a possible 16 that were detailed in the Commissions’ margin release) to benefit from portfolio margining. This was certainly not optimal, but it was a start, and as more market participants use these products and as users and the regulators become more familiar with them, it’s my hope that we can improve our joint regulatory scheme, and move more toward across-the-board portfolio margining.
The Fed has urged the SEC to continue to work toward development of portfolio margining for the securities industry, and the SEC is currently considering a proposal for a pilot program of portfolio margining. I am encouraged by the SEC’s serious consideration of the current pilot program proposal, and I hope that the SEC moves forward expeditiously.
-US Customer Access to Foreign SFPs
The CFMA directed the CFTC and SEC to issue rules to provide for the offer and sale to US customers of futures on narrow-based and broad-based foreign securities indices. The Act provided that rules for broad-based foreign products should be in place by December 21, 2001, a deadline the agencies have obviously failed to meet. While there was no specific deadline for rules on SFPs on foreign narrow-based indices, Congress also mandated that similar regulations be promulgated to allow them to be offered in the U.S.
SEC staff has indicated that broader issues relating to foreign market access need to be addressed by the SEC before any foreign SFP issues will be tackled. Having been involved with the passage of the CFMA, I personally believe that the agencies have not met with Congressional intent in this area.
Congress intended that both sets of rules be developed in a timely fashion. While, I understand the complexity of the issues facing the SEC in the area of foreign market access (indeed, the CFTC went through a similarly difficult process during its foreign terminals debate in 1998 and 1999), I continue to maintain that the agencies must move forward as Congress directed in the area of foreign index products.
Moving forward on the foreign rules would allow these markets to develop competing products that consumers may desire, including foreign ETFs. I think that providing choice, both in terms of products and in terms of regulation, was at the heart of the CFMA. Accordingly, I hope our Commission works closely with the SEC commissioners to develop, propose, and adopt such regulations in as prompt a manner as possible.
I have highlighted the major issues affecting these products, which I hope the agencies will pursue vigorously. As always, industry input is vital to sensible resolution of market issues, and we welcome your comments on the appropriate way to proceed on each of these topics. With that, I’ll turn the microphone back to you, Gary, for some more in-depth discussion of ETF market issues.
Last Updated: July 22, 2007