capital markets newsletter article June 2001

1. The 23rd Annual FIA Law & Compliance Division Workshop
The 23rd annual FututesandIndustryAssociationLaw & Compliance DivisionWorkshop, heldrecentlyin
Baltimore,attractedawide array of industrypractitionersalongwithregulatorsand,asexpected,a
pronouncedparticipationof lawprofessionals.Thisarticle will highlightsome of the more significant
issuesthatemergedoverthe course of the conference suchassecurityfutures,accesstoforeign
exchanges,andblocktrading.
Security Futures
Issuessurroundingeffortstodevelopanew regulatoryframeworkonsecurityfuturesandfutureson
narrow-basedindiceswere aprominenttopicthroughoutthe workshop.The CommodityFutures
ModernizationAct(CFMA) viewssecurityfuturesasbothcommoditiesandsecurities,creatingan
entirelynewregulatorystructure underthe CommodityExchange Act("CEA") andsecuritieslawsto
accommodate the tradingof securityfuturesproductsonindividualsecuritiesoronnarrow-based
indices.1
The regulatoryapproachtakenestablishesasystemof cross-designationandnotice registration
whichallowstradingof these productsoneithersecuritiesorfuturesexchanges.2
Itmandates
coordinatedregulatoryoversightbyboththe SECand the CFTC,3
and requiresthe SECto consultwith
the CFTC before suspendingtradinginsecurityfuturesproducts(circuitbreakers) ortakingemergency
actionwithrespectto these products.Discussionsbetweenthe SECandCFTC in harmonizingthe
regulatoryframeworkforsecurityfutureshave centered,amongothertopics,4
onmarginrequirements,
segregationandSIPCissues,andfinancial responsibility.Althoughthe derivativesmarketsare intricately
linkedtothe underlyingcashmarkets,the Actfailstoaddressthose modificationstothe regulationof
cash marketsecuritiesactivitiesthatmaybe necessaryorappropriate inlightof the adventof security
futurestrading.
The Act empowersthe Federal Reserve Boardtosetmarginrequirementsforsecurityfuturesproducts,
and allowsthe Boardto delegate thisauthoritytothe CFTCandSEC. Margin levelsforsecurityfutures
productsmust:
• be set at levelsthatpreservethe financial integrityof the markets;
• preventsystemicrisk;and
• be consistentwithmarginrequirementsforcomparable exchange-tradedoptioncontractsto
restrainexcessive speculationandensure thatsecurityfuturesproductsdonothave an unfair
competitiveadvantage overstockoptions.
In particular,initial andmaintenance marginlevelsforsecurityfuturesproductsmaynotbe lowerthan
the lowestlevelof margin,exclusive of premium,requiredforcomparable exchange-tradedoption
contracts. The statute doesnotpermitsecurityfuture productmarginlevelstobe basedonoption
maintenance marginlevels.Securityfuturesproductswill be subjecttoa federal assessmentfee,which
will be laterreduced.
Rulemakingwill be requiredbythe SEC and the CFTC to harmonize customerpropertysegregation
requirementsunderthe CEA andthe regime of the SecuritiesInvestorProtectionAct.5
Securityfutures
productsare consideredsecuritiesunderthe SecuritiesInvestorProtectionAct,andcustomerfunds
heldfortransactionsinsecurityfuturesproductsgenerallywouldbe protectedbythe Securities

2. InvestmentsProtectionCorporation("SIPC") insurance.6
Nevertheless,questionsremainastowhether
intermediarieswhocarrysingle stockfutureswill be requiredtocarry positionsandtheirassociated
marginfundsina securitiesaccountsubjecttothe jurisdictionof the SIPCorina CFTC segregated
account.
Tradingof securityfuturesproductsmaynotcommence until late December
2001, the one-yearanniversaryof the enactmentof the CFMA or, inthe case of principal-to-principal
transactions,August21, 2001. The SEC and CFTC are jointlypermittedtoallow the tradingof optionson
securityfuturesthree yearsafterthe effective date of the ModernizationAct.The Act providesforjoint
rulemakingbythe SECand CFTC withrespecttothe offerand sale of securityfuturestradedona non-
US exchange.
Access to Foreign Exchanges7
Domesticandforeignbroker-dealersandfuturescommissionmerchants(FCMs) provideUScustomers
withtechnologytodirectlytrade ona foreignexchange throughamember'sinterface.Foreign
exchangeswelcome the increaseinvolume affordedbydirectcustomeraccess.Recently,the Sydney
FuturesExchange (SFE) hasprovidedexemplary,comprehensive rulesgoverningthisprocess.
The CFTC and SEC stand insharp contrastin articulatinganautomatedorderroutingsystems("AORSs")
policy.InJuly2000, the CFTC adoptedRule 30.12, whicharticulatesthe Commission's currentpolicyon
AORSs.8
Underthe newrule,the CFTC permitsthe use of AORSsbyall foreignbrokers,eitheraffiliatesof
a US FCMor subjectto regulationintheirforeignjurisdiction,toacceptordersdirectlyfromauthorized
US customersof qualifyingFCMs.Authorizedcustomersare able toplace ordersdirectlywithaforeign
brokerwhoeithercarriesthe FCM's customeromnibusaccountor transfersthe trade pursuantto a
give-upagreementtoanotherforeignbroker.
Under 30.12, an FCMis requiredto establishcontrolsgoverningthe directcontractsbetweenits
customersandforeignbrokers,andtomonitoritsown riskrelative toitscustomers'exposures.In
contrast to itsearlierpositionexpressedinthe March 1999 proposedrules,9
the CFTCdidnotexplicitly
place a requirementforpre-trade creditandpositionfiltersforall accounts.Instead,firmsshould
adhere tobestpracticesin theiruse of AORSsto safeguardtheirfinancial andoperational viability,
includingthe abilitytoblockorrestrictcustomeruse of AORSs.Firmsshouldaddressunauthorized
access andunauthorizedtrading,andadhere toregulatoryrequirementsof recordkeepingand
reporting.
The SEC hastraditionallyhadadifferentfocusthanthe CFTC onAORSs,placingprimaryimportance on
attainingthe bestprice.Consistentwiththisposture,the SEChasnotestablishedspecificstandards
governingAORSs,buthasonlyaddressedissuesof operational capabilityandcapacity.InNovember
2000 the SEC adoptedthree newruleswhichaddressdisclosure requirementsforbothmarketcenters
and brokersrelatingtoorderexecutionandroutingpractices. 10
The rulesseektoensure attainingthe
bestpossible price forinvestorordersbymakingexecutionqualitymore transparent.
The CFTC and the SEC also differinopeningupthe US marketto foreignexchanges.The CFTChasissued
no-actionletterstoforeignexchangestopermitthemtoplace theirelectronictradingandorder
matchingsystemsinthe US. EUREX, Euronext,HKFE,IPE,LIFFE, LME, OM/London, the Singapore
Exchange,andSFE/NZFEhave receivedno-actionlettersfromthe Commission,grantedonthe basisof:

3. • comparabilitybetweenthe home regulatoryenvironmentof the exchange andthe CFTC;
• technical standardscomplyingwithIOSCOprinciples forscreen-basedtrading;
• the exchange'sintendedUSactivities;and
• the Commission'sabilitytoaccessnecessaryinformation.
In contrastto the CFTCregulation,the SECdoesnotallow foreignexchanges todirectlyaccessthe US
market.Underthe currentSEC regulatoryframework,aforeignexchange thattradesproductssubjectto
SEC jurisdictionmustregisterasa national securitiesexchange toplace itsterminalsinthe US.The only
exceptionremainsTradepoint,PLC,aUK RecognizedInvestmentExchange whichobtainedexemption
fromregistrationrequirementsbasedonlow volume.
Block trading 11
Blocktradinghas a long historyinUS securitiesmarketsbuthasemergedonlyasrecentlyasthe year
2000 inthe futuresmarkets.Ina 1999 response toa requestfromthe industrytoallow blocktrading,
the CFTC issuedanadvisoryindicatingthatitwouldleave ituptothe exchangestodetermine ruleson
blocktradingthat wouldsuittheirmarkets,andwouldconsidereachapplicationonacase bycase basis.
The Commissionstudiedblocktradinginthe securitiesmarketsinsearchof anappropriate template.On
the NYSE, the role of the specialistiscentral totradingand allowsforfloorparticipationinblocktrading.
12
While opportunitiesforfloor participationare alsopresentinblocktradingatthe CBOE, thistemplate
couldnot be directlyappliedtothe futuresmarkets.Inreviewingthe firstapplicationforblocktrading
submittedbythe CantorFinancial FuturesExchange,asetof standardsbegan to evolve dictatedby
transparency,the needforthe price of the blockto be integratedintothe pricingof the marketas
quicklyaspossible,andexerciserequirements.These standardsneededtobe sufficientlybroadintheir
underpinningstobe applied todifferentmarkets.Inapplyingthese standardsinitsreview of block
tradingapplications,the Commissionfocuseditsattentiononissuesof liquidity,transactionsize,
reasonable pricing,transparency,limitingparticipationtosophisticatedparticipants,andhavingthe
price of the blockreportedaspromptlyaspossible.
In 2000 blocktradingwasapprovedforthe CX(CantorFinancial Futures Exchange),the CME(Chicago
Mercantile Exchange),andONXBOT(the on-Exchange Boardof Trade),while twoadditionalapplications
fromthe CBOT (ChicagoBoardof Trade) andBTEX (BrokerTecFuturesExchange) are currentlypending.
Outside the US, 13
LIFFE has a blocktradingfacilitylimitedtowholesale participantswhichslightly
precededthe introductionof block tradinginthe US. The blocktradingrule for LIFFE wasverymuch a
reflectionof the regulatoryphilosophyof the FSA,emphasizingtransparency,the integrationof block
tradingintothe vitalityof the markets,assuringafairand reasonable price withintolerancelimits,and
promptreporting.Volume requirementsforeachcontractand non-aggregationrules,though,continue
to be controversial.14
As a formof essentiallynon-competitive trading,blocktradingshouldnotcompromisethe integrityof
the marketsand the processof price discovery.The potential formispricingdoesexist,asblocktrading
proceduresgive participantsconsiderableflexibilityinprivatelynegotiatingaprice outside acompetitive
setting.Assuch,end-usersmay(falsely) assumethatthe price isreasonable since the trade was
executedonaregulatedcontractmarket.There isalsothe potential thatblocktradeswill be traded
outside the pittofacilitate moneypassesfortax purposes,dressingupthe balance sheet,orfixing

4. tradingerrors.Giventhat a prearrangement,collusion,andcollaborationisneededtoengineerawash
trade,blocktradesmay be the perfecttool for contemporaneousbuyandsell inthe same marketfora
single customer.There are alsopotentialfrontrunningissueswithblocktrading;forexample,pre-
positioninginthe futuresmarketsdoesnotviolatethe tradingaheadrequirement,butwouldviolatethe
frontrunningprohibitioninCBOE.If futuresexchangespermitpre-positioninginsecurityfutures
products,theywill have acompetitiveadvantage oversecuritiesandoptionsexchanges,unlessthe
latteraltertheirrules.
Althoughthe CFMA doesnot directlyaddressblocktrading,withthe changesin the structure of the
marketsenabledbythe newlegislation,blocktradingmightbecome asignificantcatalystinalteringthe
traditional competitive nature of the futures markets.15
Conclusion
The Law & Compliance Workshoppresentedavaluable opportunityforindustrypractitionersand
regulatorstomeetand discusschangesprecipitatedbythe CFMA,update theirunderstandingof new
ruleseffectedorpending,establishadirectandopendialogue withregulators,andgainprecious
insightsintowhatthe future mightholdforthe exchanges.
1
Until the CFMA, onlyfuturesonbroad-basedstockindexedcouldbe traded.The definitionof a broad-
basedsecuritiesindex hasprovedcontroversialoverthe years,the controversycomingintosharper
focusmost recentlywitheffortsbythe CBOTto trade futuresoncertainDow Jonesindices.Inthe new
regulatoryframework,the SECwill nolongerhave anyregulatoryinterestinbroad-basedindex
contracts, whichnowcome underthe exclusivejurisdictionof the CFTC. All stockindex contractstraded
on US futuresexchangesonthe effectivedate of the Acthave beengrandfathered.Foreignstockindex
contracts authorizedtobe offeredinthe USon the date of the Actwere grandfatheredforaperiodof
18 months,pending adoptionof rulestobe jointlyestablishedbythe SECand the CFTC.
In the CFMA, the term"securityfuture"isdefinedtomeanacontract of sale,forfuture delivery,of a
single securityorof a narrow-basedsecurityindex.A narrow-basedsecurityindex isanindex thathas
nine or fewercomponentsinwhichnosingle componentaccountsformore than300% of the index's
weighting,andthe aggregate contributionof the topfive componentsdoesnotexceed60%.The lowest
weighted componentsaccountingfor25% of the index'sweightinghave intermsof aggregate dollar
value,lessthan$50M.
2
The Act establishesanotice registrationprocedure underwhichexchanges orintermediariesregistered
underone of the acts may registerunderthe otherforthe limitedpurposeof tradingsecurityfutures.
Withrespectto regulatoryoversight,the National FuturesAssociation("NFA''),aself-regulatory
organizationforfuturesintermediaries,will needtoqualifyasa "limitedpurpose"nationalsecurities
associationunderthe SecuritiesExchange Actof 1934.
3
The SEC andthe CFTCare requiredtoissue regulationstoavoidduplicative orconflictingregulationof
duallyregisteredPCM/broker-dealersandexchanges.

5. 4
ElizabethFox,attorney-advisorof the Office of General Counselof the CFTC,indicatedthatmattersof
financial responsibilityandthe equivalencyrule betweenfloorbrokersandmarketmakersreceived
considerable attentionindiscussionsbythe SECand CFTC.
5
Withcertainlimitedexceptions,broker-dealersmustbe membersof the SecuritiesInvestorProtection
Corporation,whichadministersaninsurance fundestablishedbyassessmentsof memberstoprotect
customersof insolventbroker-dealers.The SIPCliquidationplanisdesignedtoreturnsecuritiesto
customers.SIPCfundsare available tosatisfyclaimsof eachcustomeruptoa maximumof $500,000
withrespecttosecuritiesandcashin custodyat the broker-dealer.
7
Thissectionisbasedon the presentationbyJane KangThorpe of the law firmof Brown& Wood,LLP in
a sessiononorderhandling.
8
Priorto thisrule,onlyforeignaffiliatesof USFCMs withPart 30 relief were permittedtoacceptforeign
futuresandoptionsordersfromcustomersof the FCMs.
9
These rulesmetwithconsiderable oppositionfromthe industryandwere withdrawn.
10
SEC Rule 11Ac1-5 formarketcentersand SEC rules11Ac1-6 and11Ac1-7 forbrokers.
11
In a sessionentitled"BlockTrades,EFPsandGive-Ups;'AlanSeifert,DeputyDirectorof CFTCthe
Divisionof TradingandMarkets providedthe historyof blocktradingtransactionsinthe futuresand
securitiesmarkets.MichaelMPhillipof the law firmKattenMuchinZavispresentedhisviewson
potential mispricing,frontrunning,manipulationandfraudrelatingtoblocktrading.
12
On the NYSE,the specialistcanmanage the market,manage participants,andestablishthe price in
that marketat any moment intime withnouncer-taintyandnoambiguityasto whohas priority.When
a blocktrade iseffectedonthe NYSE,there issubstantial opportunityforfloorparticipationpredicated
on the principle thatthe floorshouldinclude the price of the blockand the discrete requirementof
knowingwhoisoneach side of the trade.
13
In contrast toLIFFE, blocktradingat Eurex is treatedasan OTC transactionbasicallybookedfor
clearingwithoutarequirementforpromptprice dissemination.
14
Nonaggregation rulesdonotallowto aggregate contractsto meetthresholdrequirementsforblock
trading.Accordingto NickWeinreb,DirectorandMarketSecretariat,of LIFFE,blocktradingat LIFFE
accounts for5-10% of the volume.There isnoconsistentpatterninusage.
15
The pendingapplicationforblocktradingbyBTEX addressesthe factorsof minimumsize,timely
applicationof informationonblock transaction,andappropriate participantlimitations.However,it
doesnotaddressthe issue of fairand reasonable price andpromptreportingrequirements.BTEX
minimumtransactionreportingtime couldrange from15 tradingsessionminutesfor transactionsof
fewerthan500 contracts up to 500 tradingsessionminutesfor transactionsof greaterthan10,000
contracts. A tradingsessionatBTEX comprises1320 minutes.A blocktradedeffectedduringone trading
sessionmightnotbe reporteduntil sometimeduringthe nextsession.There is,clearly,anissue isof
reportingandmaterialityinthe marketplaceastiedtoprice requirements.