WASHINGTON (HedgeWorld.com)–The Commodity Futures Trading Commission and Securities Exchange Commission jointly issued final rules to permit exchange-based trading of futures on debt indexes and securities.
One of the difficulties they sought to address in the rules announced July 10 is that debt indexes are almost always “narrow-based” under the statutory definition. Under the applicable statutes, an index is a narrow-based securities index if it meets any one of four conditions: nine or fewer components; any one component comprising more than 30% of the weighting; any group of five comprising more than 60% of the weighting; or the lowest weighted component securities comprising in the aggregate 25% of the weighting having an average daily trading volume (ADTV) of less than $50 million (or, in the case of an index with 15 or more components, less than $30 million).
This fourth prong, the ADTV test, is the troublemaker, a measure of the underlying instruments’ liquidity, devised on the theory that illiquidity creates opportunities for manipulation. The “narrow-based” designation in turn becomes a kiss of death for exchange-traded futures contracts on a particular proposed index.
Debt securities don’t trade in the same way as equity securities, and few debt securities would meet the ADTV test, so any index for which such securities are the underlying assets will remain “narrow.”
The statutes also provide, though, that an index isn’t narrow-based if it is traded on or subject to the rules of a board of trade and meets such requirements as are jointly set by the SEC and CFTC.
Accordingly, in late March 2006 the two agencies jointly proposed rules, which would exempt certain debt securities and the indexes based on them from the ADTV test. This will render futures contracts on those indexes within the exclusive jurisdiction of the CFTC, which in turn will set the stage for the exchange listing of such contracts.
The number and weighting criteria continue to apply. Also, each security listed in an index will have to have a minimum remaining outstanding principal amount of at least $250 million–an alternative, debt-markets-appropriate, measure of liquidity.
“Today, we take an important step toward fulfilling the promise of the Commodity Futures Modernization Act by clarifying the standards for broad-based and narrow-based debt [indexes],” said CFTC Chairman Reuben Jeffery III, quoted in the CFTC’s statement on the final rule. “These standards will free exchanges to offer, and investors to trade, these important risk management products.”
The agencies made a change to the proposal in response to a comment received from the Chicago Board of Trade. CBOT said that the minimum remaining principal amount of $250 million was higher than it had to be, and proposed $100 million as a better figure. The agencies didn’t accept this change when they published the final rule, but they did concede that $250 million might be insufficiently flexible in the case of municipal securities, for which they settled on an alternate minimum of $200 million.
Contact Bob Keane with questions or comments at firstname.lastname@example.org.