Designated Contract Markets in Security Futures Products: Notice-Designation Requirements, Continuing Obligations, Applications for Exemptive Orders, and Exempt Provisions

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Final rulemaking.

SUMMARY:

The Commodity Futures Trading Commission hereby adopts new regulations providing notice procedures for a national securities exchange, a national securities association, or an alternative trading system to become a designated contract market in security futures products, in accordance with the Commodity Futures Modernization Act of 2000. Such notice-designated contract markets would be subject to certain limited filing requirements, based on various provisions of the Commodity Exchange Act. Notice-designated contract markets may apply for exemptive relief from any section of the Commodity Exchange Act or regulations thereunder, to the extent such an exemption is necessary or appropriate in the public interest and is consistent with the protection of investors.

EFFECTIVE DATE:

August 21, 2001.

FOR FURTHER INFORMATION CONTACT:

Joshua R. Marlow, Attorney-Advisor, or David P. Van Wagner, Associate Director, Division of Trading and Markets, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581, (202) 418-5490, electronic mail: jmarlow@cftc.gov or dvanwagner@cftc.gov.

SUPPLEMENTARY INFORMATION:

I. Background

The Commodity Futures Modernization Act of 2000 (“CFMA”) amended the Commodity Exchange Act (“Act”) to permit the trading of security futures products, subject to the joint jurisdiction of the Commodity Futures Trading Commission (“Commission” or “CFTC”) and the Securities and Exchange Commission (“SEC”). Security futures products may be traded on any board of trade either designated as a contract market (“DCM”) by the Commission pursuant to section 5 of the Act or registered with the Commission as a derivatives transaction execution facility (“DTF”) pursuant to section 5a of the Act.

Alternatively, section 5f of the Act permits certain entities that are otherwise regulated by the SEC to become designated contract markets for the limited purpose of trading security futures products. Specifically, any board of trade registered with the SEC as a national securities exchange pursuant to section 6(a) of the '34 Act or as a national securities association pursuant to section 15A(a) of the '34 Act, or that operates as an alternative trading system (“ATS”) as defined by section 1a(1) of the Act, shall be a designated contract market in security futures products (“SFPCM”) if:

(1) Such national securities exchange, national securities association, or alternative trading system lists or trades no other contracts of sale for future delivery, except for security futures products;

(2) such national securities exchange, national securities association, or alternative trading system files written notice with the Commission in such form as the Commission, by rule, may prescribe containing such information as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of customers; and

(3) the registration of such national securities exchange, national securities association, or alternative trading system is not suspended pursuant to an order by the Securities and Exchange Commission.

The designation “shall be effective contemporaneously with the submission of notice * * * to the Commission.” Moreover, section 5f(b)(4) of the Act permits the Commission to exempt SFPCMs from any provision of the Act or regulations thereunder, and requires that the Commission determine procedures which would allow SFPCMs to apply to the Commission for such an exemption, “to the extent [any] such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors.”

Accordingly, on May 31, 2001, the Commission proposed new regulations 41.31, 41.32, 41.33, and 41.34, which would apply to boards of trade seeking notice-designation as an SFPCM. In addition to these rule proposals, the Commission sought comment on a variety of related issues, including a potential disparity between the Commission's proposed notice-designation procedures and related notice-registration procedures proposed by the SEC. The Commission received two comment letters.

II. Final Rules

A. Regulation 41.1—Definitions

To implement the procedures identified in regulations 41.31 through 41.34, the Commission proposed to establish regulation 41.1, which would contain six definitions: “alternative trading system”; board of trade”; “national securities association”; “national securities exchange”; “rule”; and “security futures product.” The definitions of “alternative trading system,” “board of trade,” and “security futures product” would be taken verbatim from section 1a of the Act. The terms “national securities exchange” and “national securities association” would have the same meanings as in the “34 Act, and the definition of “rule” would be identical to the definition found in Commission regulation 40.1. No comments were received regarding this rule, and the Commission has determined to adopt it as proposed.

B. Regulation 41.31—Notice—Designation

Section 5f(a)(2) of the Act states that a board of trade may obtain designation as a contract market in security futures products by filing “written notice with the Commission in such form as the Commission, by rule, may prescribe containing such information as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of customers.” The Commission therefore proposed new regulation 41.31, which would establish notice-designation procedures for any board of trade which operates as a national securities exchange, national securities association, or alternative trading system and which seeks designation as an SFPCM.

The proposed content requirements of the notice include contact information, a description of the security futures products that would be traded, a copy of the rules of the board of trade, and five certifications derived from various requirements found in sections 5f and 2(a)(1)(D)(vii) of the Act. The Commission believes that this information is necessary in order to maintain communication with a board of trade and to receive information about its operations, two functions that are “necessary or appropriate in the public interest or for the protection of customers.” CBT is supportive of this proposed rule, stating that the Commission's approach is “reasonable and consistent with the intent of the CFMA.” The Commission has determined to adopt regulation 41.31 as proposed.

C. Regulation 41.32—Continuing Obligations

Proposed regulation 41.32 would establish a mechanism for the Commission to receive the following from an SFPCM:

(1) Notification of any change in its regulatory status with the SEC or with a futures association registered under section 17 of the Act;

(2) a certification consistent with the requirements of section 2(a)(1)(D)(vii) of the Act each time the board of trade lists a new security futures product for trading;

(3) a copy of any new rules or rule amendments that relate to the trading of security futures products, including any operational rules and the terms and conditions of any security futures products;

(4) upon request, information related to its business as a designated contract market in security futures products; and

(5) upon request, a written demonstration, including supporting data, that the board of trade is in compliance with a specified provision of the Act or regulations thereunder.

This information would facilitate the Commission's efforts in carrying out its market oversight responsibilities under the Act and would help ensure that SFPCMs continue to comply with the conditions of designation under section 5f(a) of the Act and regulation 41.31.

As stated in the proposing release, these requirements are authorized by various recordkeeping and reporting provisions of the Act that are applicable to all designated contract markets. In particular, section 4g(b) of the Act requires that “[e]very registered entity * * * maintain daily trading records * * * includ[ing] such information as the Commission shall prescribe by rule,” and section 4g(d) of the Act continues, “[d]aily trading records shall be maintained in a form suitable to the Commission * * * . Reports shall be made from the records maintained * * * in such form as the Commission may prescribe.” Moreover, sections 8(a)(1) and 2(a)(1)(D)(iv)(I) of the Act, respectively, permit the Commission to “make such investigations as it deems necessary to ascertain the facts regarding the operations of boards of trade * * * subject to the provisions of this Act” and to make “such reasonable periodic or special examinations * * * as the Commission deems necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of this Act.” Under section 3 of the Act, the Commission also has general responsibilities to prevent manipulation and other disruptions to market integrity, to ensure the financial integrity of all transactions subject to the Act, and to protect all market participants from fraud.

The Commission stated in the proposing release, and reiterates now, that regulation 41.32 is not an exhaustive list of SFPCM regulatory requirements meant to supplant SFPCMs' statutory and other regulatory obligations. AMEX commented that SFPCMs would face regulatory uncertainties because the Commission “did not identify the particular* * * regulations with which SFPCMs were expected to comply.” Because AMEX's concern in this instance is bound up with its concerns over proposed regulation 41.34, the Commission will address the AMEX comment below in section II.D. AMEX did not, however, take issue with any of the particular requirements of regulation 41.32, and the Commission has decided to adopt regulation 41.32 in substantially the same form as proposed.

Additionally, the proposing release noted the Commission's authority under Section 4i of the Act to collect information on the positions of large traders. This information ordinarily is provided to the Commission by futures commission merchants (“FCMs”), clearing members, and foreign brokers, pursuant to Part 17 of the Commission's regulations. Because Part 17 will apply to the trading of security futures products, but might fail to capture large trader information under certain circumstances, the Commission requested comment on amending Part 17. No comments were received on this issue. The Commission plans to address this issue separately in the near future.

D. Regulations 41.33(a)-(f), 41.34, and 140.99—Exemptions

Section 5f(b)(4)(A) of the Act provides that the Commission “by rule, regulation or order, may conditionally or unconditionally exempt” any board of trade designated as an SFPCM from any provisions of the Act or regulations thereunder, to the extent that the exemption is necessary or appropriate in the public interest and is consistent with the protection of investors. Section 5f(b)(4)(B) directs the Commission to determine the procedures by which an exemptive order under section 5f(b)(4)(A) shall be granted, and vests the Commission with sole discretion to decline to entertain any application for such an order.

Accordingly, the Commission proposed regulation 41.33, which would require an SFPCM seeking an exemption to file an application with the Commission containing various information, including: the name and address of the SFPCM requesting relief, and a contact person at the SFPCM; a certification that the SEC registration of the SFPCM is not suspended pursuant to an order of the SEC; an identification of the provision(s) from which the SFPCM is requesting relief and, if applicable, whether the SFPCM is subject to similar SEC provisions; the type of relief sought; and an explanation of the need for relief, including the extent to which such relief is necessary or appropriate in the public interest and consistent with the protection of investors.

The Commission proposed that it would have 90 days to review the application, but could stay the review period at any time if it determined that the application was materially incomplete. Moreover, the Commission could, in its sole discretion, decline to entertain an application for any reason, without explanation, at any time during the review period. These exemptive order procedures would become an enumerated exception to the applicability of Commission Regulation 140.99, which governs generally the form and manner of requests for exemptive letters.

AMEX objected to the discretion that would be afforded Commission staff under this exemption process. It asserted that the Commission should modify proposed regulation 41.33:

(1) To require Commission review of SFPCM requests for exemptive orders using the CFMA standard, that is, the “necessary or appropriate in the public interest and is consistent with the protection of investors'' standard; and

(2) To require the preparation of a written explanation upon request of the reasons for a denial of a request for an exemptive order.

(emphasis in original)

The Commission notes that proposed regulation 41.33(a) already requires that requests for exemptive orders be reviewed using the CFMA standard. Moreover, paragraphs (b) and (e) of proposed regulation 41.33 would require that the Commission notify the board of trade of any decision in writing. The Commission believes that this is appropriate in light of section 5f(b)(4)(B) of the Act, which states that “the Commission shall, by rule or regulation, determine the procedures under which an exemptive order under this section is granted and may, in its sole discretion, decline to entertain any application for an order of exemption under this section.” This grant of exemptive authority by Congress gives the Commission “sole discretion” whether to decline to entertain exemptive order applications. If the Commission were to bind itself to a requirement that a written explanation be provided, it would effectively undermine its authority to decline to entertain an application; a formal, written explanation under such circumstances would be indistinguishable from a denial of the application. In order to maintain conformity between the statutory and regulatory provisions, the Commission has determined that it will adopt regulation 41.33 as proposed. Nonetheless, as discussed below, the Commission welcomes any suggestions concerning potential exemptions, and is committed to providing a thorough, expeditious review to any petitions filed pursuant to these provisions.

The Commission also proposed regulation 41.34, which would list the provisions of the Act from which SFPCMs would be exempted. Paragraph (a) lists each of the statutory provisions enumerated in section 5f(b)(1) of the Act. Paragraph (b), which originally contained only section 6(a) of the Act, has been expanded to include Parts 38 and 40 of the regulations. Because SFPCMs are exempted from sections 5 and 5c of the Act, which are the source for much of the authority for Parts 38 and 40, the Commission has modified regulation 41.34 to reflect that SFPCMs also are exempt from the provisions of Parts 38 and 40.

Regarding paragraph (a) of proposed regulation 41.34, AMEX commented that the Commission did not identify the particular regulations with which SFPCMs were expected to comply. AMEX also noted that it may be difficult to ascertain which Commission requirements were promulgated pursuant to provisions of Act from which SFPCMs are exempt. The Commission understands this predicament, and requested comment on precisely these two issues. However, no commenters, including AMEX, offered any specific examples of which Commission requirements were duplicative of SEC obligations.

As discussed above, the Commission has identified section 6(a) of the Act and Parts 38 and 40 of the regulations as additional provisions from which SFPCMs are exempted. Moreover, in the spirit of the general intent of the CFMA to reduce the burdens of shared jurisdiction, the Commission remains open to suggestions regarding any provisions from which SFPCMs should be exempted. The Commission believes that SFPCMs are in the best position to determine which Commission requirements are duplicative of their other regulatory obligations. Accordingly, regulation 41.34(a) will be adopted as proposed. Commission staff is always available to consult with any board of trade that seeks or accomplishes notice-designation and is unsure of its regulatory and compliance responsibilities.

E. Regulation 41.33(g)—Delegation of Authority

Finally, the Commission proposed to delegate to the Director of the Division of Trading and Markets and the Director of the Division of Economic Analysis, jointly, with the concurrence of the Commission's General Counsel, the authority to grant or deny applications for exemptive orders under regulation 41.33. This delegation of authority is intended to expedite the procedures described in proposed regulation 41.33 and to place responsibility for them with those Commission staff members most directly involved in the relevant matters. No comments were received on this issue, and the Commission will adopt the delegation of authority as proposed. The Commission believes that this delegation will maximize regulatory efficiency with respect to the processing of regulation 41.33 exemption applications.

III. Administrative Procedure Act

Section 553(d) of the Administrative Procedure Act generally provides that a substantive rule may not be made effective less than 30 days after notice is published in the Federal Register. One exception to the 30-day requirement, among others, is an agency's finding of good cause for providing a shorter effective date.

The CFMA provides that principal-to-principal transactions in security futures products between ECPs may commence on August 21, 2001. Prior to passage of the CFMA, there was no need for the Commission to have rules providing for the expedited designation of certain boards of trade as contract markets in security futures products. Since passage of the CFMA, the Commission has moved quickly to adopt rules that would facilitate notice-designation. The Commission, after reviewing and considering the comments received, is now adopting these rules in substantially the same form as proposed. By allowing certain principal-to-principal transactions to commence on August 21, 2001, Congress, in essence, established a statutory deadline for the promulgation of these rules. If the effective date is delayed for 30 days, then those boards of trade that wish to notice-designate as contract markets in security futures products would not be able to begin listing products for trading, assuming the various other conditions for the commencement of trading would have been met before the 30 days expired.

The primary purpose of delaying effectiveness of new rules for 30 days is to give affected parties a reasonable period of time to adjust. In this instance, parties that might be affected would not be harmed by immediate effectiveness of the rules because they would only be subject to the rules voluntarily. Moreover, to the extent that these rules have been promulgated in substantially the same form as the proposed rules and were published for comment, any affected boards of trade are already familiar with the rules. Finally, the 30-day delay in effectiveness could interfere with the goals and mandates of the CFMA. Therefore, the Commission concludes that there is good cause for making these rules effective immediately upon publication.

IV. Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (“RFA”) requires that agencies, in proposing regulations, consider the impact of those regulations on small businesses. The regulations discussed herein affect boards of trade seeking to be designated as contract markets in security futures products under notice procedures promulgated pursuant to section 5f(a) of the Act. The Commission has previously established certain definitions of “small entities” to be used by the Commission in evaluating the impact of its regulations on such entities in accordance with the RFA. The Commission determined that contract markets are not small entities for the purpose of the RFA.

The Commission further notes that section 252 of the CFMA requires the Commission to promulgate these regulations. Moreover, the regulations promulgated herein would not impose any new burdens upon entities seeking to be designated as an SFPCM pursuant section 5f(a) of the Act. Rather, these regulations would facilitate exemptive relief from the more burdensome requirements in sections 5 and 5a of the Act, and regulations thereunder, that otherwise would be applicable to entities seeking to list security futures products for trading. Therefore, the Commission believes that the adoption of these regulations reduces the burden of compliance by such entities.

Accordingly, the Acting Chairman, on behalf of the Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the regulations herein will not have a significant economic impact on a substantial number of small entities.

B. Paperwork Reduction Act

This rulemaking contains information collection requirements within the meaning of the Paperwork Reduction Act of 1995 (“PRA”). As required by the PRA, the Commission has submitted a copy of this part to the Office of Management and Budget (“OMB”) for its review. In response to the Commission's invitation in the notice of proposed rulemaking to comment on any potential paperwork burdens associated therewith, no comments were received.

The final rules do not contain any disclosure requirements or any consumer reporting requirements. It does, however, require the collection of certain information from boards of trade seeking to be notice-designated as contract markets in security futures products, and from notice-designated contract markets in security futures products which seek an exemption from the Act or regulations thereunder. The Commission may not conduct or sponsor, and a person is not required to respond to, an information collection unless it displays a currently valid OMB control number. The Commission has received a control number for this information collection from OMB.

C. Cost-Benefit Analysis

Section 15 of the Act, as amended by section 119 of the CFMA, requires the Commission, before promulgating a new regulation under the Act, to consider the costs and benefits of the Commission's action. The Commission recently applied the cost-benefit provisions of section 15 for the first time with respect to a final rulemaking, and understands that although section 15, as amended, requires the Commission to consider the costs and benefits of a new regulation, it does not require the Commission to quantify those costs and benefits or determine whether the benefits of the regulation outweigh its costs.

The amended Section 15 further specifies that costs and benefits shall be evaluated in light of five broad areas of market and public concern: (1) Protection of market participants and the public; (2) efficiency, competitiveness, and financial integrity of futures markets; (3) price discovery; (4) sound risk management practices; and (5) other public interest considerations. The Commission may, in its discretion, give greater weight to any one of the five enumerated areas of concern and may, in its discretion, determine that, notwithstanding its costs, a particular regulation was necessary or appropriate to protect the public interest or to effectuate any of the provisions or to accomplish any of the purposes of the Act.

The main areas of concern relevant to this rulemaking are the first two set forth in the Act, “protection of market participants and the public” and “efficiency, competitiveness and financial integrity of the futures markets.” The Commission notes that the CFMA specifically mandates that certain boards of trade be notice-designated by the Commission as a contract market if they seek to list or trade security futures products only, and that procedures be established by the Commission for such entities to apply for exemptions from the Act or regulations thereunder. Further, the Commission believes that these additional registrants may promote the efficiency and competitiveness of those futures markets on which security future products may be traded and, in turn, may serve to promote the financial integrity of those markets. The Commission has endeavored to impose minimal costs—i.e., only necessary disclosure and recordkeeping—on any of the entities involved, so that the benefits of the notice-designation and exemptive processes intended by Congress can be fully realized. Furthermore, submission of an application for exemptive relief is not required of SFPCMs, but elected on a voluntary basis.

AMEX commented that the costs and benefits of applying the Commission's regulations to SFPCMs should have been assessed in the proposed rulemaking. The Commission notes that SFPCMs' exposure to CFTC regulatory requirements has been imposed by Congress, by virtue of its passage of CFMA, rather than as a result of this rulemaking. The applicability of Commission regulations to SFPCMs is implicit in section 5f(b) of the Act, which exempts SFPCMs from only a limited number of provisions of the Act and regulations thereunder. If Congress intended that SFPCMs be exempt from additional provisions of the Act and regulations thereunder, the list of enumerated exemptions in section 5f(b)(1) would have been longer. Moreover, the fact that Congress contemplated procedures to exempt SFPCMs “from any provision of this Act or of any rule or regulation thereunder” further demonstrates that it intended for any requirements not enumerated under section 5f(b)(1) to apply initially. Therefore, the Commission disagrees that SFPCMs are subjected to new regulatory requirements as a result of this rulemaking; the imposition of any new regulatory requirements result directly from passage of the CFMA.

List of Subjects

17 CFR Part 41

• Contract markets, reporting and recordkeeping requirements, security futures products

17 CFR Part 140

• Authority delegations

For the reasons discussed in the preamble, the Commission hereby amends Chapter I of Title 17 of the Code of Federal Regulations as follows:

1. The heading for Part 41 is revised to read as follows:

PART 41—SECURITY FUTURES PRODUCTS

2. The authority citation for Part 41 is revised to read as follows:

Authority: Sections 251 and 252, Pub. L. 106-554, 114 Stat. 2763; 7 U.S.C. 1a, 2, 6f, 6j, 7a-2, 12a.

3. Section 41.1 is amended by adding paragraphs (a) and (b) and (f) through (i) as follows:

4. Subpart D (§§ 41.31 through 41.34) is added as follows:

Subpart D—Notice-Designated Contract Markets in Security Futures Products

(ii) Is registered with the Securities and Exchange Commission as a national securities exchange, national securities association, or alternative trading system, and such registration is not suspended pursuant to an order by the Securities and Exchange Commission;

(iii) Will meet the criteria specified in subclauses (I) through (XI) of section 2(a)(1)(D)(i) of the Act, except as otherwise provided in section 2(a)(1)(D)(vi) of the Act, for each specific security futures product that the board of trade intends to make available for trading;

(iv) Will comply with the conditions for designation under this section and section 5f of the Act, including a specific representation by any alternative trading system that it is a member of a futures association registered under section 17 of the Act; and

(v) Will comply with the continuing obligations of regulation 41.32.

(b) A board of trade which files notice with the Commission under this section shall be deemed a designated contract market in security futures products upon the Commission's receipt of such notice. Accordingly, the Commission shall send prompt acknowledgment of receipt to the filer.

(c) Designation as a contract market in security futures products pursuant to this section shall be deemed suspended if the board of trade:

(1) Lists or trades any contracts of sale for future delivery, except for security futures products; or

(2) Has its registration as a national securities exchange, national securities association, or alternative trading system suspended pursuant to an order by the Securities and Exchange Commission.

PART 140—ORGANIZATION, FUNCTIONS, AND PROCEDURES OF THE COMMISSION

5. The authority citation for Part 140 continues to read as follows:

Authority: 7 U.S.C. 4a and 12a.

6. Section 140.99(i) is amended by revising paragraphs (i)(1) and (2) and adding new paragraph (i)(3) as follows: