Publications: Regulatory Perspective: Single Stock Futures—How Not to Regulate the Financial Markets

In the Premier Edition of this journal, I wrote about a then recent decision by the Seventh Circuit Court of Appeals that opened the door to a more flexible approach to the design of futures contracts on “narrow” securities indexes. [i] As a result of this decision, cash-settled futures on such indexes may be freely traded so long as the indexes “reflect” a substantial market segment and are not “readily susceptible” to being used to manipulate the price of any underlying security. What the decision did not change, however, is the explicit prohibition in the Commodity Exchange Act (CEA) against the trading of futures contracts on individual stocks (“single stock futures”). If single stock futures are to become a reality in the United States, [ii] the Congress will have to amend the CEA.

It now appears that the Congress may be prepared to do precisely that. This would be hard to accomplish in any circumstance given the divergent, competitive interests of securities exchanges and broker-dealers on the one hand and of commodity exchanges and futures commission merchants (FCMs) on the other. But in this particular case, the legislative stew contains an even more potent and divisive ingredient: two jealous, feuding federal agencies.
Unless endorsed by both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), any legislative proposal to permit the trading of single stock futures would be certifiably dead on arrival. But we now have such an endorsed proposal and, thus, the very real prospect that the Congress will amend the CEA to permit the trading of single stock futures. The interesting question, however, is not whether the proposed legislation will pass—that is anybody’s guess—but whether the regulatory approach devised for single stock futures by the SEC and CFTC is sound and sensible. In a word, the answer to that question is “no.”

The SEC and the CFTC have waged a long running war over their respective jurisdictions. In 1975 and 1978 the SEC actively lobbied to limit the CFTC’s jurisdictional reach, and the agencies fought major legal battles over jurisdiction in 1982, 1988 and 1999. These inter-agency conflicts have drawn sharp criticism. One judge stated he “did not appreciate seeing two federal agencies expend their time and resources fighting a jurisdictional dispute in court. ... [Particularly given that] the SEC’s headstrong [challenge of the CFTC’s authority] represents inexcusable intransigence and misguided priorities. [iii] And last year, another judge commented that the jurisdictional squabbles between the SEC and CFTC “illustrate the well-known tendency of regulators to identify with those that they regulate.” [iv]

Yet the very length of the agencies’ jurisdictional battles, fought as they have been under the generalship of so many different individuals, suggests that the sources of the conflict are not personal but institutional. Indeed, jurisdictional conflict appears to be programmed into the agencies’ respective statutory schemes. The fault, thus, is not willful commissioners at either the SEC or CFTC but a badly flawed allocation of jurisdictional responsibility for the securities and derivatives market as a whole.

The CFTC, on the one hand, is allocated jurisdiction—“exclusive jurisdiction” no less—over the trading of all futures contracts (and all options on futures contracts) on all commodities,” which include securities. The SEC, on the other hand, is allocated jurisdiction over the trading of all securities (and all options on securities). It is in the overlapping, ambiguous nature of this jurisdictional scheme that is to be found the roots of the legislative and judicial battles between the agencies. But those characteristics have also caused the SEC and CFTC to attempt to cooperate in drawing more precise jurisdictional lines. The most important of these line-drawing efforts was the Shad-Johnson Accord, enacted into law in 1982. Through this Accord, the SEC and CFTC sought to divvy up the jurisdictional turf between them in a mutually acceptable, if not always logically defensible, way. As Judge Easterbrook has remarked, however, “[l]ike many an agreement resolving a spat, the Accord addressed a symptom rather than the problem. ... Only merger of the agencies or functional separation in the statute can avoid continual conflict.” [v]

As part of the Shad-Johnson Accord, single stock futures were banned outright. Because neither a functional separation nor a merger of the agencies appears to be possible politically, if that ban ever is to be lifted there will need to be another “accord” between the CFTC and the SEC. And that is what we now have. On September 14, 2000, the SEC and the CFTC informed the Congress that they had reached “agreement ... to permit the trading of single-stock futures[.]” Just over a month later, on October 19, 2000, the House of Representatives passed the Commodity Futures Modernization Act of 2000 (CFMA), which incorporated, with only minor changes, this new CFTC/SEC “Agreement.”

Regardless of whether the Congress passes the CFMA this year, it is worthwhile to look at the provisions of the bill to get some sense of the price that must to be paid in regulatory efficiency in order for single stock futures to begin to trade in the United States. The Agreement proceeds from a simple premise: Single stock futures (and security indexes that include less than 10 securities) are securities and futures, and should be regulated by both the SEC and CFTC. Hence, the CFMA coins a new term, “security future.” Security futures can be traded on either a securities exchange, the Nasdaq or an ECN regulated by the SEC or a contract market (or a, yet to be established, derivative transaction execution facility) regulated by the CFTC. In either case, however, an exchange or other market that trades security futures would have to be registered with, and regulated by, both the SEC and CFTC. Likewise, the National Futures Association (NFA) would have to register with the SEC as a securities association, although the National Association of Securities Dealers would not be required to register with the CFTC as a futures association. Broker-dealers trading security futures would have to register with the CFTC as FCMs, and FCMs and introducing brokers trading security futures would have to register with the SEC as broker-dealers. Thankfully, investment advisers and commodity trading advisors would not have to be dually registered, unless, that is, their advisory activities “primarily” concern security futures.

The problems with this proposed regulatory scheme are many but may be generally grouped under three broad headings: (1) unnecessary, duplicative regulation; (2) inevitable regulatory conflicts and (3) inappropriate substantive regulation. [vi] Let me give examples of each of these.
First, with respect to duplicative regulation, markets and financial intermediaries (e.g., broker-dealers and FCMs) trading security futures would have to be registered with and subject to regulation by both the SEC and CFTC. The CFMA attempts to make the registration process less burdensome than it might otherwise be—a market or intermediary registered with one agency could become immediately registered with the other through “notice registration”—and to reduce regulatory requirements by subjecting notice registrants only to “the core provisions” of the federal securities laws or the CEA, as the case may be. As admirable as this attempt may be, as a practical matter, regulatory life for dually registered markets and intermediaries will be much more burdensome, complicated and confused than it is now.

As an example, look at the process for review of rule filings by a dually registered commodity exchange or the NFA. Such a self-regulatory organization (SRO) would have to file its proposed rule changes with respect to most aspects of its security futures activities with both the SEC and the CFTC. Such proposed rule changes would become effective upon (1) the CFTC either approving the rule change or determining that review of the rule change is not necessary, or (2) the SRO filing the proposed rule change certifying that it “complies” with the CFA. Once effective, however, the rule change “may be enforced” by the SRO only “to the extent” that it is “not inconsistent” with the securities laws—and the SEC will not have ruled as to that. Further, at any time within 60 days of its effectiveness, the SEC may, “after consultation with” the CFTC, “summarily” abrogate the rule change. If that happens, the proposed rule change is published again in the Federal Register and comments are solicited again. This time, however, the proposed rule change must be either approved or disapproved by the SEC after it has “consult[ed] with and consider[ed] the views of” the CFTC.

It should be apparent that this rule review process will be a regulatory nightmare. Surely the NFA, for example, would be leery of enforcing, say, rules with respect to sales practices for security futures if the SEC has not approved them. Despite having been approved by the CFTC, such rules would be subject to summary abrogation by the SEC and, in any event, would be valid only to the extent they were “not inconsistent” with the securities law. In such circumstances, the NFA would be acting at its peril by enforcing such rules. As a result, what will undoubtedly develop will be an informal “no action” practice, whereby proposed rule changes filed by commodities exchanges and the NFA are pre-cleared by the SEC before being put into effect. Such extra-statutory regulation would be not only burdensome and duplicative but also subject to easy abuse without any judicial control.

Second, with respect to inevitable regulatory conflicts, the CFMA contains many grants of substantive authority that can be exercised by one or the other of the agencies only after there has been “consultation” between them. The CFMA is largely silent, however, as to the expected nature of that consultation, the level at which it is to occur and the justification required by one agency to proceed in the face of objections by the other. One almost expects, but looks in vain for, an obligation similar to that under the labor laws for the parties “to bargain in good faith.”
As problematic as the requirement of “consultation” is, in several instances regulatory action depends on the joint initiative of the CFTC and SEC. For example, exemptions from the listing standards for security futures require joint action, as does a decision to permit trading in options on security futures. Perhaps most significantly, margin requirements for security futures must be “jointly prescribe[d].” Such joint action requirements are unquestionably a prescription for continuing conflict between the SEC and CFTC.

Perhaps the most telling example of the inevitable regulatory conflicts that would be created by the CFMA is the grant to the SEC of wide ranging power over the trading of security futures on commodity exchanges. Under the proposed legislation, the Securities Exchange Act would be amended to provide that “notwithstanding the Commodity Exchange Act, the [SEC] shall have the authority to regulate the trading of any security futures product to the extent provided in the securities laws.” One can see the lawyers for the two agencies heading off to court now.

Third, with respect to inappropriate substantive regulation, perhaps the best (worst?) example is the dramatic change the CFMA would make in the nature of competition among exchanges trading futures contracts. At present, each futures exchange has it own unique clearing arrangements, as a result of which each exchange is the sole market for the contracts it trades. That is, a future contract entered into on one exchange cannot be closed out on another even if that other exchange trades a similar or identical contract. Therefore, there is currently no fragmentation in the futures markets. All trading in a given contract is concentrated in one place, assuring the maximum possible depth, liquidity and price transparence. The CFMA would change that pattern for security futures. Under the proposed legislation no exchange could trade security futures products unless those products were cleared by a clearing agency that was “linked” to clearing agencies for other exchanges, such that any security futures product “purchased on one market [could be] offset on another market that [also] trades such product.”

The CFMA would, thus, mandate for the trading of security futures the same competitive model that the SEC has imposed on the trading of security options. In simplest terms, options exchanges regulated by the SEC all trade identical contracts—there is so-called “multiple trading.” Thus, a contract opened on one exchange can be closed on any other. The problem with this competitive model is that it fragments trading, thereby diminishing liquidity, decreasing customer limit order protection, and reducing price transparence. To correct these problems the SEC has called for expensive and questionably effective market linkages and even more stringent standards of “best execution.” Furthermore, under this competitive model, the most effective way for an exchange to compete is to pay more for order flow than its competitors. And so, among the options exchanges, we are now witnessing the bizarre regulatory spectacle of a SEC-sanctioned bidding war for order flow.

There is not a doubt in my mind that with respect to intermarket competition, the futures market has it right and the options market has it wrong. But the CFMA, because of the SEC’s insistence, adopts the options model. In doing so the CFMA would put competition in the trading of single stock futures on the wrong track and legislate away a key strength of the futures market.

In summary, the trading of single stock futures is a good idea that under the SEC/CFTC Agreement would be regulated in a bad way. Unfortunately, the Congress is unlikely to have either the political will or interest to change that agreement. Therefore, it is worth noting that as unseemly as the jurisdictional battles between the SEC and CFTC may be, allowing the two agencies to decide how they will jointly regulate a new derivative product may be far worse.

Endnotes 
[i] Board of Trade of the City of Chicago v. Securities and Exchange Commission, CA-7,187 F3d 713 (1999).

[ii] The London International Financial Futures and Options Exchange (LIFFE) has announced that it will commence trading in single stock futures on January 29, 2001.

[iii] Board of Trade of the City of Chicago v. Securities and Exchange Commission, CA-7, 677 F2d 1137, 1167 (1982) (Judge Campbell concurring).

[iv] Board of Trade of the City of Chicago v. Securities and Exchange Commission, CA-7, 187 F3d 713 (1999) (Judge Cudahy concurring).

[v] Chicago Mercantile Exchange v. Securities and Exchange Commission, CA 7, 883 F2d 537, 543 (1989).

[vi] This country’s securities and options exchanges, the NASD, and the principal securities and options clearing agencies have criticized the SEC/CFTC Agreement on the ground that it would “remove the equivalent treatment of stock futures and stock options in many key areas so that stock futures would enjoy government created cost and regulatory advantages over stock and stock options.” Whatever the validity of these criticisms, my own concerns with the proposed legislation arise for entirely different reasons. 

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