Publications: Regulatory Perspective: New Life for Futures on Securities Indexes

Derivative products—futures, forwards, options, swaps and so forth—are subject to a regulatory scheme that is, by turns, rigid, irrational and uncertain. Examples supporting this harsh indictment of a key part of this country’s financial regulatory pattern are readily available. Derivative regulation is rigid because a financial product that is determined to be a “contract of sale of a commodity for future delivery,” a so-called “futures contract,” is subject to the exclusive jurisdiction of the Commodity Futures Trading Commission (CFTC) even if the “commodity” involved is a security and regulation of that product by the Securities and Exchange Commission (SEC) would make a great deal more sense. It is irrational because futures on security indexes, such as the S&P 500 index, are subject to CFTC jurisdiction, while options on the identical indexes, which may be used as synthetic equivalents of the futures contracts, are subject to the SEC’s jurisdiction. And derivatives regulation is uncertain because we simply do not know whether, and if so which, over-the-counter derivatives are futures contracts.

Among the many peculiar aspects of derivatives regulation, one of the most bizarre is the procedure by which a futures exchange obtains, or is refused, permission to trade a futures contract on a securities index. The Commodity Exchange Act (CEA) was amended in 1974 to give exclusive jurisdiction over all futures contracts to the CFTC. While some, including most certainly those at the SEC, were slow to understand the full significance of this change, in a celebrated 1982 decision (celebrated, at least, among those of us that pay attention to such things), the Seventh Circuit Court of Appeals made clear that a futures contract on an individual security is subject to the CFTC’s jurisdiction, and not that of the SEC. [i] Immediately following this decision, the Congress amended the CEA in an attempt to “rationalize” the respective jurisdictions of the CFTC and the SEC. But rather than assigning regulatory jurisdiction over securities and all options and futures on them to a single agency, the Congress enacted an “accord” previously reached between the two agencies that divided their respective jurisdictions in a “politically” acceptable manner.

Under this “accord,” the SEC was assigned jurisdiction over all securities and all options on individual (nongovernment) securities and groups or indexes of securities. The CFTC was assigned jurisdiction over all futures on all commodities (including securities) and all options on futures. Futures on individual stocks were banned outright, but futures on groups or indexes of securities were permitted subject to two conditions.

The first condition is that the CFTC must find that: (a) the futures contract is cash settled; (b) the futures contract is not “readily susceptible” to being used to manipulate the price of any of the underlying securities; and (c) the group or index of securities is a “widely published measure of, and shall reflect, the market for all publicly traded equity or debt securities or a substantial segment thereof, or shall be comparable to such measure.” The second condition is that the SEC must also find that the same identical requirements have been met.

Thus, under the “accord” written into the CEA in 1982, a futures exchange may never trade a futures contract on an individual stock, but it may trade a futures contract on a group or index of securities if the CFTC and SEC both make the requisite three findings. What this means in practice is that the SEC holds a veto over whether futures contracts on securities indexes trade at all. Wholly apart from the sheer goofiness of this dual agency approval process, the power that the process gives to the SEC to constrain the aspirations of futures exchanges in their efforts to compete with SEC regulated stock and options exchanges is obviously fraught with the risk of abuse. Now, in a stinging rebuke of the SEC, the Seventh Circuit Court of Appeals has held, in an opinion issued on August 10, 1999, that, in denying a futures exchange’s application to trade futures on an index, the SEC did, in fact, abuse its veto authority in circumstances that “seem to illustrate the well-known tendency of regulators to identify with those that they regulate.” [ii]

The case in point grew out of Dow Jones & Co.’s agreement to license its trademarked market indexes to the Chicago Board of Options Exchange (CBOE) and the Chicago Board of Trade (CBOT). The CBOE was authorized to trade options on the Dow Jones Industrial Average (DJIA), the Dow Jones Transportation Average (DJTA) and the Dow Jones Utilities Average (DJUA). The CBOT was authorized to trade futures contracts on the same indexes. The SEC approved the CBOE’s application to trade options on all three Dow Jones indexes. [iii] When the CBOT application came before it, however, the SEC approved futures trading only on the DJIA, concluding that neither the DJUA nor the DJTA satisfied the statutory requirements that an index must be “a widely published measure of, and shall reflect, the market for all publicly traded equity or debt securities or a substantial segment thereof[.]”

The SEC started its analysis by accepting the CBOT’s claim that the market segments that the DJUA and DJTA purport to measure are “substantial.” But the SEC then rejected the CBOT’s claim that these indexes “measured” or “reflected” their respective market segments. In reaching this conclusion, the SEC made clear that it was not relying, and would not rely, solely on statistical correlations in determining whether an index measured or reflected a relevant market segment. Such an approach was inappropriate, according to the SEC, because it would not identify those securities indexes that, while reflecting a market segment, might permit futures contracts to serve as surrogates for transactions in an individual security underlying the index (so-called “surrogate trading”). In the SEC’s view, the prevention of surrogate trading was the Congress’s principal reason for imposing the “substantial segment requirement” in the first place. Therefore, in order to determine whether an index measures or reflects a market segment, the SEC viewed it as necessary to employ a “totality of the circumstances approach,” encompassing a wide variety of factors designed to identify whether the index under review might lend itself to surrogate trading. If, using this approach, the SEC were to determine that an index was susceptible of surrogate trading, then that index would not be deemed to “measure” or “reflect” the relevant market segment regardless of the statistical correlation between the index and the segment. [iv]

Using this “totality of the circumstances approach,” but looking primarily at the number of securities comprising the index (which must not be “small”) and the diversification of the stocks in the index (which must be “adequate” to assure that the index itself is “broad based”), the SEC concluded that the DJUA and DJTA (composed of 15 and 20 stocks respectively) were susceptible to surrogate trading and, therefore, did not satisfy the “substantial segment requirement” in the CEA.

The Seventh Circuit Court of Appeals, without saying so directly, concluded that the SEC’s entire approach to assessing an index’s compliance with applicable statutory standards was wrong-headed. In the court’s view, the statute is straightforward: if an index “reflects” a substantial market segment, that is the end of the matter. “The index must reflect a substantial [market] segment…the index [itself need not] be a substantial segment.” Furthermore, despite the SECs disparagement of statistical correlations, the court concluded,

[O]n the record it is undisputed that the indexes do reflect the stock-market performance of the industries they are designed to measure. The long-term correlation between the indexes and the larger portfolios of stocks in the industries exceeds 92% for both indexes.
Accordingly, the SEC’s rejection of the DJUA and the DJTA because the 15 or 20 stocks in the index are not themselves a substantial segment of the market “cannot be reconciled with the language or structure of the statute.”

The SEC justified its view that an index, as well as the market segment that it represents, must be “substantial” and “broad based” on (1) its reading of the legislative history and (2) the need to prevent surrogate trading. The court dismissed the SEC’s appeal to legislative history as no more than the “agency’s wishful thinking.” As for the SEC’s concern for surrogate trading, the court recognized that it was appropriate for the SEC to ask whether the number of stocks in an index was high enough to make surrogate trading difficult, but it found that the SEC had had no “evidentiary support” for concluding that the DJTA and the DJUA could be used as surrogates for trading a single stock.

Columbia Gas accounts for approximately 12 percent of the DJUA. No other stock accounts for more than 10 percent of either index. In the court’s view, therefore,“ [u]nless an investor could make a profit trading a future contract on the [DJUA] as a surrogate for holding Columbia Gas stock, there is no reason to be concerned about the possibility of surrogate trading in these two indexes.” A financial expert called by the CBOT had testified that surrogate trading in either index would not be profitable and would incur uncompensated risk. The SEC rejected this testimony by asserting that “a trader would hedge much of this market risk with a position in a market index.” But the court found that even if the possibility of hedging was assumed, the SEC had failed to refute the expert’s conclusion that “investors would not find it economically attractive to use any of the Dow Jones indexes as a surrogate for any single stock.” Therefore, the SEC’s assertions that futures trading in the DJUA and DJTA poses a genuine threat of surrogate trading was “not supported by substantial evidence, and must be called arbitrary and capricious.”

For the court, that was the end of the legal controversy. Nevertheless, because the SEC had made a number of other observations in the course of its “totality of the circumstances” analysis, the court went on to discuss several of these other points. First, the SEC had objected to the DJUA and DJTA because they, like the DJIA, are price-weighted rather than volume-weighted indexes. The court found this point “irrelevant” unless it could be demonstrated, which it clearly could not be, that the indexes did not “reflect” the segments of the market they are supposed to measure.

Second, the SEC found it a matter of concern that future changes might occur in the composition or structure of the DJUA and DJTA such that either of these indexes might cease to reflect its market segment. The court found that the SEC simply had no authority over, or responsibility for, future changes in an index. “The SEC is not entitled to block trading today on a contract that satisfies [the CEA] just because the SEC fears that the CFTC will not perform its regulatory tasks tomorrow.”

Third, the SEC included among the “totality of the circumstances” that had led it to disapprove futures trading in the DJUA and DJTA the low margin levels for futures contracts, presumably because these margin levels would magnify the gains from, and thereby increase the incentive for, surrogate trading. The court, however, concluded that lower margin requirements for futures contracts had no bearing “on any of the criteria in [the CEA].”

Fourth, the SEC expressed concern over the adequacy of the CFTC’s regulatory approach. But the court again stated that such views are irrelevant for purposes of the applicable statutory standards. “Congress has entrusted the CFTC with the task of regulating futures markets, and the SEC is not entitled to adopt a ‘my way or the highway’ view by using its approval power ...as a lever.”

Fifth, the SEC objected that the DJUA is not sufficiently diverse, and hence is more susceptible to surrogate trading, because telecommunication firms are excluded from both the index and the market segment the index measures. But the court found that “[t]he more different proxies for ‘utilities’ are available, the easier it is to hedge or balance a particular portfolio. There’s no right definition of the commodity underlying a futures contract.”

Finally, while the SEC did not find that a futures contract on either of the Dow Jones averages would be “readily susceptible to manipulation,” the SEC’s order, in the court’s words, “contains an under current of misgiving.” With respect to this misgiving, the court responded, “to the extent the SEC believes that trading in a futures contract should be forbidden when manipulation is a possibility, rather than a high probability (which we take the word ‘readily’ to signify) ...it should present that view openly to Congress, rather than engage in self-help measures that cannot be reconciled with the statute.” Going beyond this dismissal of the SEC’s “misgivings,” the court went out of its way to make clear just how heavy a burden the SEC would have if it should ever attempt to veto futures trading on an index because it would be “readily susceptible to manipulation.”

Although it is impossible to rule out the use of financial futures contracts to affect the price in the underlying securities, it is hard to see how the effort would be profitable to the would-be manipulator[.] If someone was determined to drive the price of stocks up or down, buying and selling thousands of futures contracts on the [CBOT] would be like pouring a Dixie cup of water into Lake Michigan; there would be an effect, but it would not be detectable.

Because “manipulation of stock prices through transactions in index futures contracts is hard to do,” any finding by the SEC that these markets are “readily susceptible to manipulation” would, at a minimum, have to contain a discussion, and presumably a refutation of, “the vast empirical literature about the effects of options, futures contracts, and other derivatives on market efficiency.”

The Seventh Circuit’s opinion in CBOT v. SEC is important as more than a voyeuristic exposure to a stunning put-down of a proud and sometimes overly self-certain agency. Going forward, this case will change the entire regulatory context within which new index futures contracts are considered for approval. The SEC’s hoary requirement that the index itself must be substantial and broad-based is gone. The consideration of factors not directly related to the statutory Standards—the SEC’s “totality of the circumstances” approach—is no longer acceptable. The disregard of expert opinion based on references to the SEC’s contrary but nonspecific “experience” will not be sustainable. And a rejection of a proposed index future on the ground that it is “readily susceptible to manipulation” will be very difficult, if not impossible, to justify.

The question now is whether, given this new regulatory context, the futures exchanges will be able to identify additional securities indexes that, by offering investors sufficiently attractive trading opportunities, will develop into viable, long-term futures contracts.

Endnotes

[i] Board of Trade of the City of Chicago v. Securities and Exchange Commission, CA-7, 677 F.2d 1137.

[ii] Board of Trade of the City of Chicago v. Securities and Exchange Commission, CA-7, 187 F3d 713 (concurring opinion). Rehearing denied, 10/7/99.

[iii] Exchange Act Rels. Nos. 39012 and 39013 (Sept. 3, 1997).

[iv] This exposition of the SEC’s reasoning is largely conjectural because the SEC does not explain in its order precisely how it connects its “totality of the circumstances approach” with its conclusion that the DJUA and DJTA do not “measure or reflect” their respective market segments.

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