CFTC AND SEC

Issues Related to the

Shad-Johnson

Jurisdictional Accord

United States General Accounting Office

GAO Report to Congressional Requesters

April 2000

GAO/GGD-00-89

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-00-89 Shad-Johnson Accord

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April 6, 2000

The Honorable Richard G. Lugar

Chairman, Committee on Agriculture,

Nutrition and Forestry

United States Senate

The Honorable Thomas W. Ewing

Chairman

Subcommittee on Risk Management,

 Research, and Specialty Crops

Committee on Agriculture

House of Representatives

The Honorable John D. Dingell

Ranking Member

Committee on Commerce

House of Representatives

To clarify their respective jurisdictions over securities-based derivatives,1

the Securities and Exchange Commission (SEC) and Commodity Futures

Trading Commission (CFTC) reached an agreement, called the ShadJohnson Jurisdictional Accord, in 1981. The accord was enacted into law in

January 1983 and, among other things, prohibited futures2

 trading on single

stocks, as well as on stock indexes that did not meet specific

requirements. These prohibitions reflected concerns that such futures

could be used as substitutes for single stocks to circumvent securities laws

and regulations. Given your interest in ensuring that the U.S. financial

markets remain innovative, competitive, and, at the same time,

appropriately regulated, you asked us to review certain issues related to

the accord trading prohibitions. In response, we analyzed

 

1

 Derivatives are contracts that have a market value determined by the price of an underlying asset,

reference rate, or index (called the underlying). Underlyings include stocks, bonds, agricultural and

other physical commodities, interest rates, foreign currency rates, and stock indexes.

2

 Futures are agreements that obligate the holder to buy or sell a specific amount or value of an

underlying asset, reference rate, or index at a specified price on a specified date. These contracts may

be satisfied by delivery or by offset with another contract.
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• the extent to which U.S. securities, foreign futures, and over-the-counter

(OTC)3

 markets trade stock-based derivatives that are economically similar

to the futures prohibited from trading by the accord;

• the potential effect of the accord trading prohibitions on derivatives

market participants;

• concerns about calls to repeal the accord trading prohibitions; and

• jurisdictional and other approaches to addressing these concerns.

U.S. securities, foreign futures, and OTC markets trade derivatives that are

based on single stocks and stock indexes. However, the Shad-Johnson

Jurisdictional Accord precludes U.S. futures exchanges from trading

futures on single stocks and certain stock indexes. The stock-based

derivatives that are trading in other markets can be used, like futures, to

hedge (i.e., shift the risk of price changes to those more willing or able to

assume the risk) or to speculate (i.e., invest with the intent of profiting

from price changes). Specifically, U.S. securities exchanges trade options4

on over 2,600 single stocks. These options can be used to replicate the

economic function of single stock futures. U.S. securities exchanges also

trade options on a wide range of narrow-based stock indexes.5

 In addition,

9 foreign exchanges trade single stock futures on at least 189 foreign

stocks. In 1998, about 2.1 million single stock futures were traded,

accounting for less than 1 percent of the total trading volume of the foreign

futures market. Finally, the OTC derivatives market offers equity swaps6

that serve economic functions similar to futures and that can be structured

using virtually any single stock or stock index. As of year-end 1998, the

equity swaps market worldwide had an estimated total notional value of

$146 billion, accounting for a fraction of a percent of the total notional

value of the OTC derivatives market worldwide.

 

3

 The OTC market offers contracts that are privately negotiated outside of organized exchanges.

4

 Options contracts are derivatives that give the purchaser the right to buy (call option) or sell (put

option) a specified quantity of an underlying asset, reference rate, or index at a particular price (the

exercise price) on or before a certain future date.

5

 Narrow-based stock indexes generally are indexes that represent stocks in a single industry or a

group of related industries.

6

 Equity swaps are OTC derivatives that have a market value determined by the price of a single stock

or stock index. Swaps are privately negotiated contracts that typically require counterparties to make

periodic payments to each other for a specified time period. The calculation of these payments is based

on an agreed-upon amount, called the notional amount, that typically is not exchanged.

Results in Brief
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The accord trading prohibitions may have limited investor choice and

exposed some market participants to legal uncertainty. Although investors

can use stock-based options and equity swaps to hedge price risk, they

cannot use stock-based futures to the same extent because of the accord

prohibitions on single stock and certain stock index futures. Also, some

futures industry officials have said that the accord prohibitions should be

repealed, because they have restricted U.S. futures exchanges from

competing with other markets that trade derivatives on single stocks and

narrow-based stock indexes. Additionally, other futures industry officials

said that the accord has limited the ability of U.S. investors to use foreign

exchange-traded stock index futures to hedge risks associated with their

foreign stock investments. Finally, the accord has exposed equity swaps

counterparties to legal uncertainty. If an equity swap falls within the

judicially crafted definition of a futures contract, it would be in violation of

the accord, making it illegal and unenforceable.

In response to calls to repeal the accord trading prohibitions, SEC, the U.S.

securities exchanges, the President’s Working Group on Financial Markets

(Working Group),7

 and several members of Congress have expressed

concerns about doing so without first resolving applicable differences

between securities and commodities laws and regulations. Their concerns

center on the potential for single stock and certain stock index futures to

be used as substitutes for single stocks to circumvent federal securities

laws and regulations. The most significant differences identified were the

lack of comparable insider trading prohibitions, margin8

 levels, and

customer protection requirements. CFTC and futures exchange officials

have agreed that the lack of comparable insider trading prohibitions would

need to be addressed so that stock-based futures could not be used to

circumvent the insider trading prohibitions of the federal securities laws

that are lacking in the Commodity Exchange Act (CEA). Also, while CFTC

and the Federal Reserve have recognized that the U.S. futures exchanges

have a record of setting margins at levels that have protected the financial

integrity of the markets, futures exchange officials have said that they

would be willing to set margin for single stock futures at a level

comparable to margin for single stock options. Additionally, SEC and the

U.S. securities exchanges disagree with the National Futures Association

 

7

 The Working Group is composed of the Secretary of the Treasury, the Chairman of the Board of

Governors of the Federal Reserve System, the Chairman of SEC, and the Chairman of CFTC.

8

 Margin refers to funds that are deposited with a securities broker or futures commission merchant in

conjunction with stock, options, or futures transactions.
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(NFA)9 on whether customer protection requirements for the securities

and futures markets offer similar protections. Finally, other differences

between the securities and commodities laws and regulations exist, such

as restrictions on short-term profits by corporate insiders, that would need

to be resolved, if the accord prohibitions are to be lifted.

Pivotal to addressing legal and regulatory concerns related to repealing the

accord trading prohibitions is resolving the jurisdictional question of

whether SEC, CFTC, or both agencies should regulate futures on single

stocks and certain stock indexes. The answer to this question would

determine whether such futures were regulated under the securities and/or

the commodities laws and, in turn, would affect the type of legal and

regulatory changes that would be needed. According to SEC and securities

exchange officials, the prohibited futures could be allowed to trade, if they

were regulated as securities. These officials said that such an approach

would enable SEC to ensure that stocks and stock-based derivatives were

regulated consistently. According to futures exchange officials, if the

prohibited futures were allowed to trade, they could be effectively

regulated under the CEA. These officials said that, under this approach,

the CEA could be amended and other steps taken to address SEC and U.S.

securities exchange concerns.

In response to congressional requests for action, SEC and CFTC have

tentatively agreed to an approach that would allow single stock futures to

be traded on both U.S. securities and futures exchanges. Under this

approach, the agencies would jointly regulate such futures, the

intermediaries that offered them, and the markets that traded them. In

reaching their tentative agreement, SEC and CFTC noted the importance

of avoiding the imposition of unnecessarily burdensome or duplicative

regulation on the securities and futures markets as well as on their

participants. Although the agencies have tentatively agreed on the initial

standards for trading single stock futures, they have not yet agreed on

which core provisions of the securities and commodities laws would apply

to the markets and intermediaries. SEC and CFTC officials said that one of

their major challenges is developing a process to ensure that regulations

applicable to the securities and futures markets and intermediaries remain

consistent and appropriate as the markets evolve. These officials said that

the agencies plan to continue working together with the goal of providing a

comprehensive legislative proposal to Congress before it adjourns.

 9

 NFA is a self-regulatory organization that is responsible, under CFTC oversight, for qualifying

commodity futures professionals and for regulating the sales practices, business conduct, and financial

condition of its member firms.
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The SEC and CFTC joint approach for addressing the issues surrounding

the trading of the prohibited futures as well as other approaches indicate

that such issues are resolvable. While SEC and CFTC have begun working

together to address these issues, uncertainty remains about the outcome of

such efforts because of differences between the SEC and CFTC

perspectives as well as the securities and commodities laws. Continued

congressional attention may be a key factor in the ultimate resolution of

the jurisdictional issues involved. As a result, we are recommending that

SEC and CFTC (1) work together and with Congress to develop and

implement an appropriate legal and regulatory framework for allowing the

contracts to trade and (2) submit to Congress legislative proposals for

repealing the accord trading prohibitions.

In the United States, SEC has authority over securities trading and the

securities markets, and CFTC has authority over futures trading and the

futures markets. According to SEC and CFTC, three amendments to the

CEA in 1974 led to jurisdictional disputes over securities-based futures.

First, the act was amended to expand the definition of a commodity to

include virtually anything—tangible or intangible. Consequently, a security

fell within the definition of a commodity. Second, the act was amended to

provide CFTC with exclusive jurisdiction over all commodity futures

transactions, including options on futures. Third, the act was amended to

preserve SEC’s preexisting authority over securities trading and the

securities markets.

These three CEA amendments led to a dispute between SEC and CFTC

that was eventually resolved through the Shad-Johnson Jurisdictional

Accord. In 1975, CFTC approved a Chicago Board of Trade (CBT)

application to trade futures on Government National Mortgage Association

pass-through mortgage-backed certificates. In an exchange of letters, SEC

asserted that the contracts were securities within its jurisdiction, and

CFTC responded that they were futures within its exclusive jurisdiction.

The dispute remained unresolved, and in 1981, SEC approved rule changes

for the Chicago Board Options Exchange (CBOE) that allowed the

exchange to trade options on the certificates. CBT petitioned the U.S.

Seventh Circuit Court of Appeals to set aside the SEC order. The court

prevented CBOE from trading the options until it could render its

decision.10 Under these circumstances, SEC and CFTC reached the accord

to clarify their respective jurisdictions over securities-based options and

 10 In Board of Trade of the City of Chicago v. Securities and Exchange Commission, 677 F. 2d 1137 (7th

Cir. 1982), the Seventh Circuit Court of Appeals subsequently found that SEC lacked the authority to

approve CBOE to trade the options, because the options fell within CFTC’s exclusive jurisdiction.

Background
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futures. In February 1982, they submitted the accord to Congress to be

enacted into law. Congress codified the accord substantially as proposed

in the federal securities laws as section 2 of the Securities Act of 1933 and

section 3 of the Securities Exchange Act of 1934 and in the CEA as section

2(a)(1)(B).11

The accord allocated jurisdiction between SEC and CFTC for, among other

things, securities-based options and securities-based futures and options

on futures.12 First, it provided SEC with jurisdiction over securities-based

options, including stocks and stock indexes. Second, the accord prohibited

futures (and options thereon) on single corporate and municipal securities.

According to SEC and CFTC, the ban was intended to be temporary, and

both agencies were to complete a study of the accord with a view toward

lifting the prohibition. SEC officials told us that the study was to be

undertaken 5 years after the accord was reached. But, according to the

officials, it was never done because of the need to complete higher-priority

studies following the 1987 and 1989 market declines.

Finally, the accord provided CFTC with jurisdiction over futures (and

options thereon) on exempted securities13 (other than municipal

securities)and stock indexes. The accord allowed CFTC to approve a

stock index futures contract for trading if CFTC found that the contract

was (1) settled in cash; (2) not readily susceptible to manipulation; and (3)

based on an index that either was a widely published measure of and

reflected the market as a whole or a substantial segment of the market, or

else was comparable to such a measure. According to SEC and CFTC,

these three standards were intended to ensure that stock index futures

would not be readily susceptible to manipulation, be used to manipulate

the underlying securities or related options markets, or serve as a

surrogate for a single stock futures contract.

The one substantial change that Congress made to the accord in codifying

it was to provide SEC with veto authority over stock index futures. As

submitted to Congress, the accord would have only required that CFTC

consult with SEC before approving a stock index futures contract; it would

not have provided SEC with veto authority over such contracts. As

 

11 The accord was codified in the Securities Act Amendments of 1982, which amended the federal

securities laws, and the Futures Trading Act of 1982, which amended the CEA.

12 The accord also clarified SEC and CFTC jurisdiction over options and futures on, among other things,

certificates of deposit and foreign currencies.

13 Exempted securities include securities issued or guaranteed by the United States, the District of

Columbia, or any U.S. state.
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codified by Congress, the accord required CFTC to provide SEC with an

opportunity to review any proposed stock index futures contract before

approving it for trading. If SEC determined that the proposed contract

failed to meet the accord standards, CFTC could not approve the

contract.14 According to the accord’s legislative history, Congress included

this provision to provide SEC an equal voice with CFTC “in making certain

threshold determinations about the manipulative impact” of a stock index

futures contract. Under this arrangement, CFTC had approved 57 stock

index futures contracts for trading as of January 12, 2000.

To address each of our four objectives, we reviewed the legislative history

of the accord, congressional hearings, federal securities and commodities

laws and regulations applicable to stock-based derivatives, and legal cases

involving the accord, as well as studies and articles on the regulation and

economic function of the securities, securities options, and futures

markets. In addition, to analyze the extent to which U.S. securities, foreign

futures, and OTC markets trade stock-based derivatives that are

economically similar to the futures prohibited from trading by the accord,

we collected and analyzed trading and related data on U.S. securities

options, foreign single stock futures, and equity swaps. To analyze

concerns about calls to repeal the accord trading prohibitions, we also

attended congressional briefings by CFTC, SEC, U.S. futures and securities

exchanges, and industry associations in which they presented their views

on the legal and regulatory concerns associated with repealing the accord

prohibitions. To analyze jurisdictional and other approaches to addressing

these concerns, we reviewed the SEC and CFTC March 2, 2000, letter to

selected congressmen that presented their joint approach for allowing the

trading of single stock futures in both U.S. securities and futures markets.

In addition, to address each of our four objectives, we interviewed officials

of CFTC; SEC; the Federal Reserve; three U.S. futures exchanges (CBT, the

Chicago Mercantile Exchange (CME), and the New York Mercantile

Exchange), which are self-regulatory organizations;15 two U.S. securities

exchanges (CBOE and the New York Stock Exchange) and the National

 14 The accord afforded futures exchanges an opportunity for a hearing on the record before SEC and

judicial review in cases where SEC determined that a proposed futures contract failed to meet the

accord standards.

15 Self-regulatory organizations are private membership organizations that are given the power and

responsibility under federal law and regulations to adopt and enforce rules of member conduct. Selfregulatory organizations play an extensive role in the regulation of the U.S. futures and securities

industries and include all of the U.S. futures and securities exchanges, NFA, and the National

Association of Securities Dealers.

Scope and

Methodology
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Association of Securities Dealers,16 which are self-regulatory organizations;

two other industry self-regulatory organizations (the National Association

of Securities Dealers Regulation and NFA); four industry associations (the

Futures Industry Association (FIA),17 International Swaps and Derivatives

Association,18 Securities Industry Association,19 and U.S. Securities Markets

Coalition);20 and two market observers (a former CFTC chairperson and an

expert in securities law). We also interviewed officials of two foreign

regulatory authorities (the Swedish Financial Supervisory Authority and

U.K. Financial Services Authority), two foreign exchanges (the London

International Financial Futures and Options Exchange and OM Stockholm

Exchange), and two foreign companies (Ericsson and Nordbaken) whose

stock is subject to futures trading, to discuss their experiences, as

applicable, with trading and regulating single stock futures. We included

Sweden in our review because it had one of the most active markets in

individual stock futures. We included the United Kingdom in our review

because it did not prohibit single stock futures from trading and because it

had recently adopted a single regulator for its futures and securities

markets. Information on foreign law in this report does not reflect our

independent legal analysis, but rather is based on interviews.

We requested comments on a draft of this report from the heads, or their

designees, of CFTC, SEC, the Department of the Treasury, and the Federal

Reserve Board. We also requested comments from CBT, CME, FIA, the

International Swaps and Derivatives Association, NFA, the New York

Stock Exchange, the Securities Industry Association, and the Securities

Markets Coalition. SEC provided us with written comments, which are

discussed near the end of this letter and reprinted in appendix I. In

discussions held in March 2000, the General Counsel of CFTC; a financial

economist of the Department of the Treasury; an assistant director of the

Federal Reserve Board; and the Chief Counsel of the Division of Market

 

16 Although the National Association of Securities Dealers and its subsidiary, the NASDAQ Stock

Market, are not registered securities exchanges, for simplicity we include them in our references to the

U.S. securities exchanges in the remainder of this report.

17 FIA is the national trade association of the futures industry.

18 The International Swaps and Derivatives Association is a trade association that represents financial

institutions worldwide. Its members include investment, commercial, and merchant banks that deal in

OTC derivatives contracts.

19 The Securities Industry Association is the national trade association of the securities industry.

20 The U.S. Securities Markets Coalition is composed of the American Stock Exchange, Boston Stock

Exchange, Chicago Stock Exchange, CBOE, Cincinnati Stock Exchange, NASDAQ Stock Market,

National Securities Clearing Corporation, Pacific Stock Exchange, Philadelphia Stock Exchange, and

Options Clearing Corporation.
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Regulation, SEC, provided us with oral comments. Similarly, in discussions

held in March 2000, officials of CBT, FIA, the New York Stock Exchange,

the Securities Industry Association, and the Securities Markets Coalition

provided us with comments. We did not receive comments from CME, the

International Swaps and Derivatives Association, and NFA. The technical

comments that we received were incorporated in the report as

appropriate. The substantive comments that we received are discussed

near the end of this letter. We did our work in Chicago, IL; London,

England; New York, NY; Stockholm, Sweden; and Washington, D.C.,

between July 1999 and March 2000 in accordance with generally accepted

government auditing standards.

Domestic and foreign markets trade derivatives on single stocks and stock

indexes that have been precluded from futures trading in the United States

under the accord. U.S. securities exchanges trade options on single stocks.

They also trade options on a wide range of narrow-based stock indexes.

Additionally, some foreign exchanges trade futures on single stocks.

Finally, the OTC derivatives market offers equity swaps on single stocks

and narrow-based stock indexes. Securities-based options, foreign stock

futures, and equity swaps serve similar economic functions as would be

served by the futures prohibited from trading under the accord.

U.S. securities exchanges, which are regulated by SEC, trade options on

single stocks that meet certain minimum requirements related to, among

other things, the number of shares outstanding, number of shareholders,

and trading volume. SEC first allowed exchange-traded options on single

stocks when it approved CBOE as a national securities exchange in 1973.

As of March 10, 2000, CBOE and three other securities exchanges—the

American Stock Exchange, Pacific Stock Exchange, and Philadelphia

Stock Exchange—collectively traded options on over 2,600 single stocks.

In 1998, the trading volume in single stock options totaled nearly 326

million contracts, accounting for about 81 percent of total U.S. options

trading volume.

Options on single stocks serve similar economic functions as would be

served by futures on single stocks. For example, both products could be

used to protect a stock position from a decline in price, or to speculate on

an anticipated price change in the stock. Although options and futures

serve similar economic functions, they differ in some ways, including their

risk/return profiles. 21 Thus, it can be advantageous to use one product

 

21 The buyers and sellers of futures contracts, like the sellers of options contracts, are exposed, in some

cases, to unlimited risk of loss from an adverse price change. In contrast, the buyers (but not the

U.S. Securities,

Foreign Futures, and

OTC Markets Trade

Stock-Based

Derivatives

U.S. Securities Exchanges

Trade Options on Single

Stocks
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instead of the other, depending on the particular circumstances and

preferences of the user. In addition, options on single stocks can be used

to replicate prohibited futures on single stocks. For example, by buying a

call option22 on a single stock and selling a put option23 on the same stock,

a single stock futures contract can be created synthetically. Futures

exchange officials said, however, that single stock futures could be more

efficient and less costly than synthetic futures, because they involve one

futures transaction instead of two options transactions. According to

CBOE officials, the extent to which single stock options are used to create

synthetic stock futures cannot be accurately estimated.

U.S. securities exchanges trade options on a wide range of narrow-based

stock indexes, which represent stocks in a single industry or a group of

related industries. These options are subject to more stringent regulatory

requirements, such as higher margins and lower position limits,24 than are

options on broad-based stock indexes.25 As of March 10, 2000, SEC had

approved the American Stock Exchange, CBOE, and the Philadelphia

Stock Exchange to trade options on at least 59 narrow-based stock

indexes. These indexes are composed of securities representing a single

industry or sector, such as airline, Internet, and biotechnology companies.

In 1998, the securities exchanges traded over 5 million narrow-based stock

index options, accounting for around 1 percent of the total U.S. options

trading volume.

Stock index options and stock index futures serve similar economic

functions and can compete with and complement each other. These

products can be used for hedging or speculative purposes. Given their

similar economic functions, they can be used as substitutes in some cases.

For example, either the Standard & Poor’s 500 index options or its futures

contract—two of the most actively traded stock index options and

 sellers) of options contracts are exposed to risk of loss that is limited to the amount of the premium

paid for the contracts.

22 A call option (American style) is a contract that gives the purchaser the right, but not the obligation,

to buy a specified quantity of the underlying asset, reference rate, or index on or before a specified

date at a price fixed at the initiation of the contract.

23 A put option (American style) is a contract that gives the purchaser the right, but not the obligation,

to sell a specified quantity of the underlying asset, reference rate, or index on or before a specified date

at a price fixed at the initiation of the contract.

24 Position limits are imposed by the exchange and limit the number of options contracts that any

person, or persons acting in concert, may hold on the same side of the market.

25 Broad-based stock indexes generally are indexes that represent the market as a whole or a group of

stocks in unrelated industries.

U.S. Securities Exchanges

Trade Options on NarrowBased Stock Indexes
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futures26 —can be used to protect stock holdings from a decline in price, or

to benefit from a rise or fall in the stock market. In addition, stock index

options and stock index futures can serve a complementary function. For

example, market participants can use stock index futures to hedge risk

related to their stock index options positions and vice versa. More

specifically, a market participant using Standard & Poor’s 500 index

options to take a position that gains when the market falls can hedge that

position by using Standard & Poor’s 500 index futures to take a position

that gains when the market rises.

Some foreign exchanges, including Sweden’s OM Stockholm Exchange,

trade futures on single stocks, but trading volume in these futures has been

relatively low. Although foreign exchanges trade single stock futures, the

accord prohibits them from selling such futures to U.S. customers.

Some foreign futures and/or stock exchanges have been trading futures on

single stocks since at least 1988. According to data compiled by CBT and

FIA, 9 foreign exchanges27 trade single stock futures on over 189 stocks. In

contrast to the United States, in at least five of these countries, the

regulator that oversees the futures market also oversees the stock market.

The existence of a single regulator in these countries may have facilitated

the introduction of futures on single stocks in their markets.

In 1998, the trading volume in foreign single stock futures totaled about 2.1

million contracts and accounted for less than 1 percent of the total trading

volume of the foreign futures market. The Helsinki Stock and Derivatives

Exchanges, Bolsa de Derivados do Porto, and OM Stockholm Exchange

accounted for around 96 percent of the total trading volume in single stock

futures.

We visited the OM Stockholm Exchange, which was created through a

1998 merger between the OM Exchange and the Stockholm Stock

Exchange. The OM Exchange began trading futures on single stocks in

1988, after being created in 1985 to electronically trade options on single

stocks. According to exchange officials, the principal reason that the

 

26 In 1998, CBOE traded about 25.7 million options contracts on the Standard & Poor’s 500 index, while

CME traded about 31.4 million futures contracts on the same index. The CBOE and CME contracts are

not entirely comparable, because the CBOE contract is based on the amount of the index times $100,

while the CME contract is based on the amount of the index times $250.

27 The nine exchanges are the Budapest Stock Exchange (Hungary), Bolsa de Derivados do Porto

(Portugal), FUTOP Clearing Centre (Denmark), Helsinki Stock and Derivatives Exchanges (Finland),

Hong Kong Futures Exchange (Hong Kong), Mexican Derivatives Market (Mexico), OM Stockholm

Exchange (Sweden), South African Futures Exchange (South Africa), and Sydney Futures Exchange

(Australia).

Some Foreign Exchanges

Trade Single Stock Futures

Some Foreign Exchanges Trade

Single Stock Futures, But

Trading Volume Is Relatively

Low
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exchange listed single stock futures was to compete directly with the

Stockholm Stock Exchange by offering stock substitutes. The officials

added that single stock futures would also complement stocks and options

by providing an additional means for hedging stock and options positions.

According to officials of Sweden’s Financial Supervisory Authority,28 the

Stockholm Stock Exchange initially opposed the OM Exchange’s trading of

single stock options and, to a lesser extent, single stock futures, because it

viewed the trading of such products as a competitive threat. According to

these officials, the conflict between the stock and futures exchanges

subsided after 2 to 3 years, in part because options trading led to an

increase in trading volume for stocks. They added that the conflict

between the exchanges effectively ended in 1998, when the OM Exchange

purchased and merged with the Stockholm Stock Exchange.

According to OM Stockholm Exchange officials, the exchange offered

single stock futures based on the belief that if the underlying stock market

could support trading in single stock options, it could also support trading

in single stock futures. However, the exchange has had limited trading of

single stock futures compared with single stock options. For example, in

1998, the exchange traded about 533,500 single stock futures compared to

about 20.6 million single stock options. Although single stock futures

trading volume represented about an 85 percent increase over the previous

year, it accounted for about 1 percent of the total derivatives trading

volume of the OM Stockholm Exchange.

The OM Stockholm Exchange officials said that single stock futures are

not actively traded for at least two reasons. First, exchange members do

not market these products to retail customers, in part because doing so

would reduce the revenue they earn from selling stocks. Brokers earn

commissions and interest from stocks purchased on margin; with futures,

they earn only commissions. Moreover, brokers are cautious about selling

futures to customers because of their risk of unlimited loss. Second,

market makers and other professionals use single stock futures to hedge,

but only to a limited extent because cheaper hedging alternatives are

 

28 The Financial Supervisory Authority is Sweden’s regulator of financial markets, including the

insurance, credit, securities, and futures markets. Under the Swedish regulatory approach, all

organized exchanges are subject to the same laws and regulations and may trade any financial product,

provided they have the necessary rules to maintain a fair and orderly market. Also, all financial

institutions are subject to the same laws and regulations and may sell any financial products to

investors.
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available. For example, the exchange officials said that options market

makers29 typically use the more liquid cash market to hedge their risk.

Although foreign exchanges trade single stock futures, the accord

prohibits the offer or sale of single stock futures based on either foreign or

U.S. stocks to customers located in the United States. In addition to

trading single stock futures on their domestic stocks, some foreign

exchanges trade single stock futures on foreign stocks. For example, the

OM Stockholm Exchange offers single stock futures on Swedish and

Finnish stocks. However, foreign exchanges generally do not trade single

stock futures on U.S. stocks.30 According to CFTC officials, they are not

aware of any laws that prohibit foreign exchanges from trading single

stock futures on U.S. stocks. However, they noted that even if a foreign

exchange did so, the accord would prohibit customers in the United States

from purchasing them.31 According to Securities Industry Association

officials, it is unlikely that a foreign exchange could generate significant

trading volume in futures on U.S. single stocks without U.S. customer

participation in its market. As a result, these officials said that even if a

foreign exchange were to trade futures on U.S. single stocks, such trading

would not likely affect the stability of the U.S. stock market.

The OTC derivatives market offers stock-based derivatives, including

equity swaps on single stocks and narrow-based stock indexes.32 These

derivatives serve economic functions that are similar to those served by

the stock-based futures that are prohibited under the accord. Both equity

swaps and futures can be used to manage risk related to stock positions or

to speculate on anticipated stock movements. However, equity swaps and

futures are not perfect substitutes because of potential differences

between their contract terms, transaction costs, and other factors. Also,

retail customers are generally precluded from participating in the equity

swaps market. In contrast, retail customers are allowed to participate in

the exchange-traded futures market, but according to market observers,

 

29 Market makers stand ready to buy or sell financial instruments, providing both a bid and offer price

to the market.

30 The OM Stockholm Exchange trades single stock futures on Pharmacia and Upjohn, which was

formed through a November 1995 merger between Pharmacia (a Swedish company) and Upjohn (a U.S.

company).

31 In the United Kingdom, futures exchanges are allowed to trade single stock futures, but do not do so.

However, betting houses legally offer “spread bets” on, among other things, U.S. single stocks. Spread

bets are economically equivalent to off-exchange futures transactions, and U.S. customers are

prohibited from entering into such transactions, according to a CFTC official.

32 Other OTC derivatives that are economically similar to stock-based futures are OTC equity options

and equity forwards.

The Accord Prohibits Foreign

Exchanges From Selling Single

Stock Futures to U.S. Customers

The OTC Market Offers

Equity Swaps
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Page 14 GAO/GGD-00-89 Shad-Johnson Accord

they only account for an estimated 5 to 10 percent of the market. The Bank

for International Settlements33 has estimated that the equity swap market

worldwide had a total notional value of $146 billion34 as of year-end 1998—

an increase of about 180 percent since March 1995. At year-end 1998, the

equity swaps market accounted for a fraction of 1 percent of the notional

value of the OTC derivatives market worldwide.

The Shad-Johnson Jurisdictional Accord may have limited investor choice

and has exposed market participants to legal uncertainty. Although

investors can use stock-based options and equity swaps to hedge price

risk, they cannot use stock-based futures to the same extent because of the

accord trading prohibitions. Also, according to futures industry officials,

the accord has limited the ability of U.S. investors to use foreign exchangetraded stock index futures to hedge the price risk associated with their

foreign stock investments. Finally, counterparties to equity swaps have

faced legal uncertainty because of the potential for such swaps to fall

within the judicially crafted definition of a futures contract35 and thus

become subject to claims of illegality and unenforceability under the

accord.

The accord prohibitions may have limited investor choice by precluding

U.S. exchanges from trading and investors from using futures on single

stocks and certain stock indexes. Additionally, the accord prohibitions

may have restricted U.S. futures exchanges from competing against other

domestic and foreign markets trading stock-based derivatives.

The accord trading prohibitions may have limited the range of stock-based

derivatives that investors can use to hedge price risk associated with their

stock investments. As previously discussed, investors can hedge price risk

using options on single stocks and stock indexes, including narrow-based

stock indexes. Also, a more limited range of investors can hedge such risk

using equity swaps based on single stocks and stock indexes. However,

investors cannot use futures on single stocks and certain stock indexes for

such purposes because of the accord prohibitions. First, the accord

prohibits the trading of futures on single stocks. Second, it allows futures

 

33 The Bank for International Settlements was established in 1930 in Basle, Switzerland, by six Western

European central banks and a U.S. financial institution. One of its functions is to provide a forum for

cooperative efforts by central banks of major industrial countries.

34 The Bank for International Settlements estimate includes equity forwards, which are different from

equity swaps.

35 The term “futures contract” is not defined by the CEA. Thus, the definition has evolved through

judicial and agency interpretations.

The Accord May Have

Limited Investor

Choice and Has

Exposed Market

Participants to Legal

Uncertainty

The Accord May Have

Limited Available Hedging

Instruments and Restricted

Competition

The Accord May Have Limited

the Range of Available Hedging

Instruments
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Page 15 GAO/GGD-00-89 Shad-Johnson Accord

exchanges to trade futures on stock indexes, provided that CFTC and SEC

find that such contracts meet the accord’s three standards.36 CFTC and

SEC have had few difficulties reaching agreement on whether a futures

contract on a diversified, or broad-based, stock index meets the accord

standards.37 But they have had difficulties reaching agreement on whether a

futures contract on a stock index representing a single industry meets

these standards and, thus, may be traded. In light of their difficulties, SEC

and CFTC issued joint guidelines in 1984 to use in making such

determinations.

The accord trading prohibitions may have restricted the ability of the U.S.

futures exchanges to compete against other markets trading stock-based

derivatives. First, U.S. futures exchange officials have said that the accord

prohibition on single stock futures has prevented them from competing

against securities exchanges trading single stock options and foreign

exchanges trading single stock futures. Second, futures exchange and FIA

officials have said that the accord prohibition on certain stock indexes has

placed the futures exchanges at a competitive disadvantage relative to the

securities exchanges. According to these officials, SEC has allowed

securities exchanges to trade options on a number of U.S. stock indexes

that may not have been allowed to trade on futures exchanges. In 1994,

SEC approved exchange rules to allow securities exchanges to trade

options on a single industry stock index that is, among other things,

composed of 10 or more stocks. In contrast, SEC and CFTC, under their

joint guidelines (which are not a rule), have stated that a single industry

stock index should, among other things, be composed of at least 25 stocks

to be traded on a futures exchange. Although CFTC has approved U.S.

futures exchanges to trade futures on single industry stock indexes,38 the

exchanges only recently have been allowed to trade futures on such

indexes that are composed of fewer than 25 stocks. In comparison, SEC

has approved securities exchanges to trade options on at least 35 single

industry stock indexes composed of fewer than 25 stocks.

According to futures exchange officials, SEC’s objection to a CBT

application to trade futures on the Dow Jones transportation and utilities

indexes illustrates how futures exchanges have been restricted from

 

36 As previously discussed, under the accord standards, a stock index futures contract must be (1)

settled in cash; (2) not readily susceptible to manipulation; and (3) based on an index that either is a

widely published measure of and reflects the market as a whole or a substantial segment of the market,

or else is comparable to such a measure.

37 As of January 12, 2000, CFTC had approved futures contracts on 47 diversified stock indexes.

38 As of January 12, 2000, CFTC had approved futures contracts on 10 single industry stock indexes.

The Accord May Have Restricted

Futures Exchanges From

Competing Against Other

Derivatives Markets
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Page 16 GAO/GGD-00-89 Shad-Johnson Accord

competing with securities exchanges. In September 1997, SEC approved

CBOE to trade options on these two Dow Jones stock indexes—

concluding that such approval would remove impediments to a free and

open securities market by providing investors with an additional means to

hedge market risk. In contrast, in July 1998, SEC exercised its authority

under the accord and objected to the CBT application to trade futures on

the same Dow Jones indexes. In objecting to the CBT application, SEC

determined that the proposed futures failed to meet the accord’s third

standard, the substantial segment requirement. SEC noted, among other

things, that the indexes had a small number of stocks (fewer than 25),

raising concerns about the potential for the indexes to be used either to

manipulate the market or as a substitute for single stocks.

In July 1998, CBT challenged SEC’s decision in the U.S. Court of Appeals

for the Seventh Circuit. In August 1999, the federal court vacated SEC’s

decision, concluding that it was not adequately supported, and left CFTC

with the decision of whether to approve the proposed CBT futures

contracts on the Dow Jones stock indexes.39 In October 1999, CFTC

approved the contracts. In November 1999, the Working Group reported

that the court decision, along with the lack of an SEC objection to a recent

sector index futures contract on the Internet stock price index, advanced

the ability of the U.S. futures exchanges to offer a greater variety of stock

index futures.40

According to FIA officials, the accord unnecessarily restricts the ability of

U.S. investors to use foreign stock index futures that are traded on foreign

exchanges to hedge their foreign stock investments in the most effective

and efficient manner. Before a foreign exchange-traded stock index

futures contract may be sold to U.S. investors, CFTC must first issue a noaction letter41 to the foreign exchange for that contract.42 According to FIA

officials, the accord does not specifically require CFTC approval of foreign

exchange-traded stock index futures. Instead, the officials said CFTC has

 

39See Board of Trade of the City of Chicago v. Securities and Exchange Commission, 189 F. 3d 713 (7th

Cir. 1999).

40 See Over-the-Counter Derivatives Markets and the Commodity Exchange Act, the President’s

Working Group on Financial Markets (November 1999).

41 A no-action letter is issued by CFTC staff to indicate that they will not recommend enforcement

action for violation of law or regulation if certain conditions are met. The letter does not reflect official

Commission views.

42 With the exception of securities-based futures and options, the CEA and CFTC regulations generally

do not restrict the sale of foreign exchange-traded futures and options in the United States.

The Accord May Have

Restricted U.S. Investors

From Hedging Foreign

Stock Investments
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Page 17 GAO/GGD-00-89 Shad-Johnson Accord

interpreted the legislative history of the accord as requiring its approval.43

According to the legislative history, CFTC may certify a foreign securities

index futures contract under such criteria as it deems appropriate.

CFTC officials said that they review foreign exchange-traded stock index

futures to address concerns about manipulation and investor protection.

For example, U.S. investors could be harmed if they bought a foreign

exchange-traded stock index futures contract that was readily subject to

manipulation. To facilitate the sale of such futures to U.S. investors, CFTC

has initiated a procedure for issuing no-action letters for foreign stock

index contracts that meet the accord requirements. As part of this

procedure, CFTC has elected to consult with SEC. As of March 6, 2000,

CFTC had issued no-action relief for 28 foreign stock index futures, and it

had requests pending for 23 others.

According to FIA, the accord should be amended to facilitate foreign stock

index futures transactions that are executed on a foreign exchange on

behalf of U.S. investors. These officials said CFTC’s no-action procedure

for foreign stock index futures hinders the ability of U.S. futures

commission merchants (FCM)44 to meet the needs of their institutional

investors, by preventing U.S. investors from trading many foreign stock

index futures. Additionally, FIA officials said that no public policy purpose

is served by preventing U.S. investors from trading certain foreign stock

index futures, because U.S. investors are free to invest in foreign stocks.

FIA officials said that the no-action procedure for foreign stock index

futures is often lengthy, and that many stock-index products of foreign

exchanges have not yet been granted no-action relief. The officials said

that, as a result of the restriction, U.S. investors are often limited in their

ability to hedge their foreign stock portfolios using the most efficient and

effective foreign stock index futures. According to SEC and CFTC officials,

some of the delays in issuing no-action letters have resulted from the

length of time foreign exchanges have taken to respond to CFTC

information requests.

 

43 According to FIA, CEA section 4(b) prohibits CFTC from adopting any rule or procedure that

authorizes CFTC, in effect, to approve the terms or conditions of any futures contract traded on a

foreign exchange, and the accord does not supersede or preempt section 4(b). CFTC disagrees with

FIA. According to CFTC, while section 4(b) does not permit the Commission to regulate the terms and

conditions of foreign futures, the legislative history of the section nevertheless makes clear that

Congress expected the Commission to certify or otherwise review the offer or sale of foreign futures in

the United States under such criteria as the Commission deems appropriate.

44 FCMs are individuals, corporations, associations, partnerships, and trusts that solicit or accept

orders to buy or sell futures and accept payment from or extend credit to those whose orders are

accepted.
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Page 18 GAO/GGD-00-89 Shad-Johnson Accord

Under the Futures Trading Practices Act of 1992, Congress provided CFTC

with the authority to enhance legal certainty for swaps by exempting any

contract from all CEA provisions, except those of the accord—section

2(a)(1)(B). Until this time, all swaps—including equity swaps—faced the

possibility of falling within the judicially crafted definition of a futures

contract, because of their similarities to exchange-traded futures. If found

to be futures, swaps could have been deemed illegal and unenforceable,

because they would not have been traded on an exchange as required by

the CEA. Before CFTC was granted its exemptive authority, it issued a

swaps policy statement in 1989 to reduce the legal risk faced by swaps by

clarifying the conditions under which it would not regulate swaps as

futures. However, the policy statement did not eliminate all legal risk,

because it left open the possibility that a swaps counterparty might try to

have a court invalidate a swap as an illegal, off-exchange futures contract.

In January 1993, CFTC used its exemptive authority under the 1992 act to

exempt a broad group of swaps from the CEA’s exchange-trading and

other requirements, thereby reducing or eliminating the legal risk that such

swaps could be unenforceable. However, because CFTC could not exempt

swaps from the accord, equity swaps have continued to face legal risk.

According to market observers, if equity swaps were found to be futures,

they would be in violation of the accord—making them illegal and

unenforceable.45 First, equity swaps on individual stocks that were deemed

to be futures would violate the accord prohibition on single stock futures.

Second, equity swaps on stock indexes that were deemed to be futures

would violate the CEA requirement that stock index futures be traded on

an exchange. According to CFTC, swaps counterparties can still rely on its

swaps policy statement, and according to International Swaps and

Derivatives Association officials, equity swaps counterparties routinely do

so.

In its November 1999 report, the Working Group noted that CFTC cannot

grant exemptions from the restrictions of the Shad-Johnson Accord and,

therefore, recommended that swaps—including equity swaps—meeting

certain conditions be specifically excluded from the CEA.46 In support of

 

45 As with equity swaps, hybrid instruments that reference nonexempt securities face legal uncertainty,

because a court could find them to be subject to the accord prohibition on single stock futures. Hybrid

instruments possess, in varying combinations, characteristics of futures, options, securities, and/or

bank deposits. To enhance the legal certainty of hybrids that reference nonexempt securities, the

Working Group recommended that a provision be enacted in the CEA to clarify that the accord shall

not be construed to apply to hybrid instruments that have been exempted from the CEA.

46 The Working Group recommended that bilateral swaps entered into by eligible swaps participants, on

a principal-to-principal basis, should be excluded from the CEA, provided that the transactions are not

conducted on a multilateral transaction execution facility in which bids and offers are open to all

The Accord Has Been a

Source of Legal Uncertainty

for Equity Swaps
B-284260

Page 19 GAO/GGD-00-89 Shad-Johnson Accord

its recommendation, the Working Group reported that swaps involve

sophisticated counterparties, who do not require the same protections

under the CEA as those required by retail customers. It also reported that

swaps generally are not susceptible to manipulation and do not serve a

price discovery47 function. Likewise, U.S. securities exchanges have

supported excluding equity swaps from the CEA to resolve legal

uncertainty. However, the New York Stock Exchange stated that equity

swaps should be subject to SEC jurisdiction to ensure that such swaps will

not be used for regulatory arbitrage or to circumvent the insider trading,

fraud, and manipulation prohibitions of the securities laws. The exchange

further stated that regulating equity swaps as securities would promote

regulatory parity between such products and single stock futures, which it

stated should also be regulated as securities. U.S. futures exchanges have

also supported providing legal certainty to swaps under the CEA.

However, they stated that regulatory parity between the exchange-traded

futures and OTC derivatives markets first needs to be achieved so that the

exchange-traded market can compete with the OTC market on a level

playing field. For example, CME testified in February 2000 that if equity

swaps are allowed to trade in the OTC market outside of the CEA, single

stock futures should be allowed to trade on U.S. futures exchanges.

SEC and U.S. securities exchange officials have expressed concerns about

repealing the accord trading prohibitions without first resolving the

differences between the securities and commodities laws and regulations.

They are concerned that, as a result of the differences, the prohibited

futures could be used as substitutes for single stocks to circumvent

compliance with federal securities laws and regulations. The most

significant legal and regulatory differences that they identified include the

lack of comparable insider trading prohibitions, margin levels, and

customer protection requirements. In its November 1999 report, the

Working Group cited these as well as other legal and regulatory

differences that will need to be resolved if the accord prohibitions are

repealed. Also, several members of Congress identified concerns for SEC

to address before submitting to Congress any legislative proposals related

to the accord.

 participants. The Working Group recommended that certain types of electronic trading systems be

excluded from the CEA, even if bids and offers are open to all participants, provided that the

participants are acting for their own account.

47 Price discovery is the process of determining price on the basis of supply and demand factors.

Concerns Exist About

Repealing the Accord

Prohibitions
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Page 20 GAO/GGD-00-89 Shad-Johnson Accord

According to SEC and the U.S. securities exchanges, the CEA’s lack of

insider trading prohibitions comparable to those included in the securities

laws would pose significant risk to the integrity of the stock market if the

accord prohibitions were repealed. In contrast to the CEA, the federal

securities laws broadly prohibit insider trading—that is, the trading of

securities on the basis of material nonpublic information about a corporate

issuer.48 According to SEC officials, unless single stock futures are deemed

securities, the securities law insider trading prohibitions and the extensive

body of case law interpreting those prohibitions would not apply. SEC

officials stated that simply grafting insider trading prohibitions on the CEA

would not solve the problem. They said that the prohibited futures must be

considered securities to be subject to the insider trading prohibitions

developed over the years by SEC and the courts.

SEC and securities exchange officials have expressed concern that if

single stock futures were allowed to trade without being subject to insider

trading prohibitions, they could be used to circumvent federal securities

laws and to profit legally in the futures market based on inside

information. For example, a person with positive material nonpublic

information about a stock issuer could buy a futures contract on the stock.

When the information was disclosed to the market, the value of the stock

and, in turn, the futures contract could rise. Because the CEA does not

prohibit futures trading based on material nonpublic information, the

trader would not be in violation of the CEA, and any resulting profit from

the futures contract would not be illegal. In contrast, if the profit were

obtained through the purchase of stock or an options contract, it would be

a violation of the federal securities laws.

According to SEC officials, because the accord has allowed CFTC to

approve only futures on stock indexes that reflect a substantial market

segment, the potential that an individual might profit from inside

information when trading futures on the approved stock indexes has been

minimized. As a result, the absence of insider trading prohibitions in the

futures market has not been an issue for the currently traded stock index

futures.

CFTC and U.S. futures exchanges agree that the lack of insider trading

prohibitions under the CEA that are comparable to those included in the

securities laws would need to be addressed if the accord prohibitions are

repealed. In addition, futures exchange officials said that they could use

 

48 According to CFTC officials, under limited circumstances, insider trading involving the futures

market might be covered under the CEA antifraud provisions.

The CEA Does Not Prohibit

Insider Trading
B-284260

Page 21 GAO/GGD-00-89 Shad-Johnson Accord

their existing reporting and surveillance systems, with modifications, to

help deter and detect insider trading involving stock-based futures. For

example, CFTC has large trader reporting requirements and systems that

enable CFTC and the futures exchanges to track traders holding large

futures positions. Futures exchange officials said that these reports and

systems, which are absent in the securities markets, allow CFTC and the

exchanges to detect unusual trading activity in stock index futures. New

York Stock Exchange officials told us that the securities exchanges have

spent years and millions of dollars developing systems to deter and detect

insider trading, and that the futures exchanges could not readily match the

capabilities of these systems.

Margins for stock, stock-based options, and futures differ in terms of their

purpose, source, and computation. According to SEC and the U.S.

securities exchanges, should the accord trading prohibitions be lifted,

lower margins on single stock futures compared to stocks would allow

investors to make greater use of leverage, thereby increasing the risk of

customer loss, market manipulation, and systemic risk. CFTC, the Federal

Reserve, and the U.S. futures exchanges disagree with SEC and U.S.

securities exchanges about the potential effect of margin differences.

However, to alleviate concerns, the futures exchanges have said that they

would be willing to set margins on single stock futures at a level

comparable to margins on single stock options.

Traditionally, stock margin has been used to control the allocation of

credit, reduce the risk of price instability, and protect investors from

becoming overly leveraged. For stocks, margin is the minimum down

payment that a customer must pay to a broker to fund a stock purchase.

The remainder of the purchase price can be borrowed from the broker,

with the broker then retaining the stock as collateral on the loan. Brokers

do not typically require customers to pay the margin until 5 days after the

trade,49 during which time the broker is exposed to the risk that the

customer will not make payment. Under Regulation T, the Federal Reserve

set minimum margin for purchasing stock in 1974 at 50 percent of the

current market price of a stock, limiting the amount of credit a broker may

extend to a customer to 50 percent of the stock purchase price. This

requirement is a minimum; securities brokers may set a higher

requirement. Additional margin payments would be required to maintain a

margined stock position if the stock’s market price, and thus the value of

 49 Under Regulation T, the customer payment period is the number of days in the standard security

settlement cycle, which is set by SEC and is 3 business days from the date of the contract, plus 2

business days.

Margins on Stock, Security

Options, and Futures Differ

Margins Differ in Terms of

Purpose, Source, and

Computation
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Page 22 GAO/GGD-00-89 Shad-Johnson Accord

the collateral, significantly declined before the loan was repaid.50 The

Federal Reserve allows securities exchanges to set additional margin

requirements for maintaining a margined stock position, subject to SEC

approval.

For securities-based options, margin is a performance bond and, unlike

stock margin, does not typically involve an extension of credit. In contrast

to stock margins, the primary purpose of options margin is to protect the

financial integrity of the firm and the market, not customers. Options

margin is paid only by the option seller,51 to ensure contract performance

should the option be exercised.52 The Federal Reserve is authorized to set

margins for options but has incorporated by reference in Regulation T the

margin rules of the options exchanges, subject to SEC approval. Margin for

stock option sellers (puts and calls) is currently set by exchange rules at

the current market value of the option (the premium) plus 20 percent of

the current market value of the underlying stock (i.e., 100 shares per

option contract), minus the amount (if any) that the option is out-of-themoney.53 These requirements are minimums; securities brokers may set

higher requirements. Additional margin payments would be required if the

market value of the stock option changed and the customer’s margin

account balance fell below minimum requirements before the option

exercise date.54 Because the computation of options margin varies

depending on several factors, including the exercise price and expiration

date, comparing options and futures margins is difficult.55

 50 According to New York Stock Exchange and National Association of Securities Dealers rules, margin

accounts must contain at least 25 percent of the current market value of all purchased securities in a

customer’s account.

51 The option buyer pays only a nonrefundable premium—an amount that is determined by the market.

52 To exercise an option is to invoke the right granted to the owner of an option contract. In the case of

a call, the option owner buys the underlying stock. In the case of a put, the option owner sells the

underlying stock.

53 An option is out-of-the-money when its exercise price is above (call) or below (put) the current

market price.

54 According to a National Association of Securities Dealers rule, margin for the option seller cannot be

less than the current market value of the option plus 10 percent of either the current market value

(call) or the option’s aggregate exercise price (put).

55 CBOE is currently attempting to develop a pilot program that would implement risk-based margining

for portfolios of broad-based index options traded by institutional or high net-worth/sophisticated

investors. The pilot program would require SEC approval; however, CBOE has not yet submitted the

program to SEC for review. CBOE anticipates that, under the pilot program, margin requirements for

eligible portfolios of index options generally will be lowered to better reflect the risk associated with

such portfolios. The futures exchanges currently use a risk-based portfolio margining system.
B-284260

Page 23 GAO/GGD-00-89 Shad-Johnson Accord

For futures, margin is also a performance bond and does not involve the

extension of credit. Also, the purpose of futures margin is to protect the

financial integrity of firms and the market, not customers. Futures margin

is paid by both the buyer and seller of a futures contract when the position

is established, to ensure that they can fulfill their contractual obligations.

The Federal Reserve is authorized to set margin levels for stock index

futures but has delegated the authority to CFTC. Subject to CFTC

oversight, futures exchanges set margin for stock index futures. Margin

levels are set using a portfolio margining system based on the historical

price volatility of the underlying, current and anticipated market

conditions, and other factors. They are typically set to cover at least 95

percent of historical 1-day price moves for the contract’s underlying

commodity or index. For example, as of February 9, 2000, the margin on

CME’s E-Mini Standard & Poor’s 500 index futures contract was about

$4,700, approximately 6.6 percent of the value of the futures contract.

These requirements are minimums; futures brokers may set higher

requirements. In futures margining, payments are made at least daily from

the margin accounts of those futures contracts decreasing in value to those

increasing in value, to reflect net gains or losses. This process, called

marking-to-market, ensures that losses on futures positions do not

accumulate over more than one day. Additional margin is collected, if a

margin account balance falls below minimum requirements, to bring the

account back to its original balance.

SEC and securities exchange officials have stated that highly leveraged

customers in single stock futures could experience significant losses

during volatile markets. These customers would be required to make

significant daily margin payments to cover their losses. According to

Federal Reserve officials, margins can be used to limit the amount of

customer leverage, but more effective tools exist to protect customers,

such as disclosure and suitability requirements (discussed below). In

addition, they said daily futures margin calls due to adverse price changes

can serve to limit customer losses by prompting customers to liquidate

losing positions before more significant losses can accumulate.

The U.S. Securities Markets Coalition has stated that the high degree of

leverage that might be available in connection with single stock futures

could also increase the potential for manipulation of stock prices.

Specifically, the potential for greater profit from a highly leveraged futures

position because of even a small price movement in the underlying stock

could encourage attempts to manipulate stock prices. That is, investors

may acquire a large futures position in a single stock and then attempt to

artificially drive up the price of the stock by buying the stock or through

Concerns Exist About Leverage

and Customer Losses

Concerns Exist About

Manipulation
B-284260

Page 24 GAO/GGD-00-89 Shad-Johnson Accord

other means. However, SEC said that such manipulation could be

attempted with less economic risk using single stock options.56

According to CFTC officials, SEC and CFTC have agreements to share

surveillance information, and these agreements have been effective in

detecting intermarket abuses involving stock index futures and stocks. In

addition, securities and futures exchanges have also entered into

agreements to share surveillance and investigative information on a

bilateral basis and through the Intermarket Surveillance Group.57 The goal

of these agreements is to coordinate the sharing of such information

involving securities, options, and futures to deter and detect intermarket

trading abuses, such as manipulation. For example, CBT officials said that

CBT and the New York Stock Exchange share trading data under a

bilateral information-sharing agreement to assist in detecting manipulation

involving stocks and futures. The officials said that the agreement could be

expanded to cover additional stocks, should single stock futures be

allowed to trade. In addition, CFTC and futures exchange officials said that

their large trader reporting systems allow them to identify market

participants who are overexposed to the market, a capability SEC and the

securities exchanges lack.

The U.S. Securities Markets Coalition has stated that, during periods of

extreme market volatility, the overuse of leverage could significantly

impair the integrity of the stock market, creating systemic risk. According

to Federal Reserve and CFTC officials, the futures exchanges have a

record of setting margins at levels that have protected the financial

integrity of the market, and thereby have limited systemic risk. Moreover,

the Federal Reserve has noted that margins are but one component of

sophisticated risk control systems that include frequent marking-to-market

of customer positions, market surveillance, and active risk management.

Consistent with this view, the Working Group concluded in its 1988 study

of the 1987 market decline that the then existing margins for stocks, stock

index futures, and options provided an adequate level of protection to the

financial system.58 The Working Group also concluded that “harmonious”

margins for stocks and futures do not imply that margins must be equal. It

noted that margin adequacy depends on the volatility of prices and the

 

56 As previously discussed, because an option buyer has the right but not the obligation to buy or sell

the underlying, an option buyer’s risk is limited.

57 The Intermarket Surveillance Group membership is composed of U.S. securities and options

exchanges, with futures exchanges participating as affiliate members.

58 The SEC Chairman disagreed with the other Working Group members and said that margins on

futures and options should be increased.

Concerns Exist About Systemic

Risk
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length of the grace period following a margin call. Finally, a 1996 Federal

Reserve study found that the margining systems used by securities and

futures exchanges for Standard & Poor’s 500 index options and futures,

respectively, differ in their approach but provide substantially the same

market risk protections. The study also found that the portfolio-based

margining system used by the futures exchanges is more efficient than the

strategy-based margining system used by securities exchanges, because it

achieves the same result but with a lower level of collateral (i.e., margin).

The futures market margining system sets margin levels based on risk. As a

result, margins set for single stock futures would be expected to be higher

than those currently required for traditionally less volatile and, therefore,

less risky stock index futures. For example, using the same margining

system as U.S. futures exchanges, the OM Stockholm Exchange has set

margins for single stock futures at 7.5 to 25 percent of the value of the

futures contract, based on the volatility of the underlying stock. These

levels are higher than the amount set by the CME for the E-Mini Standard

& Poor’s 500 stock index futures contract. Margin levels for some futures

on single U.S. stocks could be in the same range as those set for single

stock options by U.S. securities exchanges. To address SEC and securities

exchange concerns about margins, futures exchange officials have said

that they would be willing to set margins on single stock futures at a level

comparable to the margins securities exchanges have set for single stock

options.

The securities and futures markets approach to customer protection

differs. SEC and securities exchange officials are concerned that the lack

of a futures market suitability rule would expose customers to risk, if the

accord prohibitions on futures on single stocks and certain stock indexes

are repealed. According to NFA, although the futures industry does not

have a suitability rule, customer protection regulations do not differ

significantly between the securities and futures markets, and the basic

type of protection afforded by each market is the same.

SEC and U.S. securities exchanges have expressed concern that without

the benefit of a suitability rule, single stock and certain stock index futures

would be marketed to unsophisticated and unsuitable retail customers as

cheap substitutes for stocks and stock options. Securities self-regulatory

organizations have imposed suitability requirements on exchange

members and other registered brokers. Under these requirements, brokers

that make recommendations to their customers may only recommend

those securities (including options) that they believe are suitable in light of

the financial position and investment goals of the customers. According to

Futures Margins Are Risk-Based,

but Exchanges Are Willing to

Match Option Margins to

Address Concerns

Customer Protection

Requirements for Securities

and Futures Differ in

Approach

SEC and U.S. Securities

Exchanges Are Concerned

About the Futures Market’s Lack

of a Suitability Rule
B-284260

Page 26 GAO/GGD-00-89 Shad-Johnson Accord

the New York Stock Exchange, these requirements apply whenever

recommendations are made, not just when an account is opened. However,

these requirements do not apply when brokers do not make

recommendations to customers, such as may occur when trades are made

either through discount brokers or directly online. Brokers are also

required to provide additional written risk disclosures to options

customers, but only when they initially open an account.

According to SEC and U.S. securities exchanges, without a suitability rule,

FCMs could recommend single stock futures to retail customers without

determining whether the recommendation is suitable for them. SEC and

U.S. securities exchanges are concerned that retail customers buying or

selling stock-based futures would be exposed to the risk of unlimited loss

associated with an adverse price change in a futures contract. In contrast,

the risk of loss to options buyers (but not to sellers) is limited to the price

of the option premium. Also, as discussed previously, SEC and U.S.

securities exchanges are concerned that retail customers would be

exposed to the risk of loss associated with high leverage. Industry

representatives have expressed additional concern that a large number of

retail customer losses in the futures market could undermine investor

confidence in all financial markets, including the stock market.

Swedish regulatory officials told us that they have not had any cases of

customer abuse involving single stock futures. They noted, however, that

the lack of any such cases might be due to the limited number of retail

customers who use such products. According to Swedish exchange

officials, few brokers market single stock futures to retail customers, in

part because futures pose greater risks than do stocks. According to CME

officials, if single stock futures were allowed to trade, the exchange would

be interested in marketing them to retail customers.

According to NFA officials, customer protection regulations do not differ

significantly between the securities and futures markets. NFA officials said

that the basic type of protection afforded by each is the same. According

to CFTC officials, sales practice requirements under the CEA focus on

providing a full disclosure of the risks associated with futures trading.

Accordingly, CFTC and NFA require FCMs to provide customers with

written risk disclosure statements when they open an account. This and

other sales practice requirements are predicated on the belief that all

futures trading is highly risky, irrespective of the type of underlying. In

contrast to futures, individual securities possess varying degrees of risk.

As a result, according to NFA, the suitability of particular products for an

NFA Officials Said That Futures

and Securities Rules Afford the

Same Protections
B-284260

Page 27 GAO/GGD-00-89 Shad-Johnson Accord

individual customer varies with the customer’s ability to assume the risk

associated with the products.

According to NFA, because all futures involve a high degree of risk, little

or no basis exists for assuming that one type of futures contract would be

suitable for a particular customer, while another type would be unsuitable

for the same customer. For this reason, according to NFA, CFTC decided

against adopting a suitability rule that had been proposed for the futures

industry in 1978. NFA stated that the more appropriate focus is on whether

the customer should be trading futures at all. To that end, NFA has

adopted a “know your customer rule” that requires its members to obtain

the same type of information about their customers as is required by the

securities suitability requirements. However, according to SEC and

securities exchange officials, this obligation exists only when an account is

initially opened, and the futures rule does not require a continuous

assessment of suitability, as does the securities rule.

According to NFA, if a firm determines that a customer should not be

trading futures, the firm is obligated to so inform the customer. However,

if a customer decides to ignore this information, the firm can elect to

complete the customer’s transactions after documenting that the firm

alerted the customer to its determination. A CFTC official said that FCMs

are financially liable if a customer defaults and, thus, have an incentive to

ensure that a customer is not overextended.

In addition to the three issues discussed previously, SEC, the U.S.

securities exchanges, the Working Group, and several members of

Congress have identified other provisions of securities and commodities

laws that will need to be reviewed to determine how they should apply to

single stock futures, if at all, should the accord trading prohibitions be

repealed. These provisions include various requirements or restrictions to

combat fraud and market manipulation or to facilitate market

transparency and disclosure.

According to SEC and securities exchange officials, additional provisions

of the securities laws that are of concern include (1) restrictions on shortterm profits by large shareholders or corporate insiders on the purchase or

sale of corporate stock, (2) limitations on stock repurchases by issuers, (3)

restrictions on stock purchases during stock distributions, and (4)

requirements to notify SEC when acquiring a large block of stock. These

officials said that the remainder of the securities and commodities laws

and regulations would also need to be reviewed to determine how they

Other Concerns Exist About

the Differences Between the

Securities and Commodities

Laws
B-284260

Page 28 GAO/GGD-00-89 Shad-Johnson Accord

should apply to single stock futures, if at all, should the accord trading

prohibitions be repealed.

In its November 1999 report, the Working Group concluded that the accord

trading prohibition on single stock futures “can be repealed if issues about

the integrity of the underlying securities market and regulatory arbitrage

are resolved.” According to the Working Group, from the perspective of

the securities laws, the issues raised by the trading of single stock futures

include margin levels, insider trading, sales practices, real-time trade

reporting, activities of floor brokers, and CFTC’s exclusive jurisdiction

over futures. The Working Group also stated that from the perspective of

the commodities laws, the issues raised by such products include clearing,

segregation, large trader reporting, and direct surveillance.59 The Working

Group recommended that SEC and CFTC work together and with

Congress to determine whether single stock futures should be permitted to

trade and, if so, under what conditions.

In a February 9, 2000, letter, Representatives Dingell, Markey, and Towns

asked SEC to respond to a list of questions concerning the potential

impact of repealing the accord prohibitions on the U.S. securities market.

Their request reflected concerns about the conditional nature of the

Working Group’s recommendation and the complexities involved in

resolving the issues raised by single stock futures. Their letter explained

that they were not certain that the issues identified by the Working Group

could be resolved in a manner consistent with the public interest, the

protection of investors, and the maintenance of fair and orderly markets,

especially if done in haste and within the confines of a regulatory structure

that bifurcates regulation over certain financial derivatives between SEC

and CFTC. In addition, they asked SEC to satisfactorily address their

questions before submitting any legislative proposals related to the accord

to Congress.

Pivotal to addressing the legal and regulatory concerns related to repealing

the current trading prohibitions is resolving the jurisdictional question of

whether SEC, CFTC, or both agencies should regulate single stock and

certain stock index futures. The answer to this question would determine

whether such futures are regulated under the securities and/or

commodities laws. In turn, the answer would affect the types of legal and

regulatory changes that would be needed. According to securities

exchange officials, futures on single stocks and certain stock indexes

 

59 The Department of the Treasury noted that questions as to the appropriate tax treatment of single

stock futures would also need to be addressed.

Resolving the

Jurisdictional Question

Is Key to Addressing

Concerns
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Page 29 GAO/GGD-00-89 Shad-Johnson Accord

could be allowed to trade, if such futures were regulated as securities.

According to futures exchange officials, if the prohibited futures were

allowed to trade, CFTC could effectively regulate them under the CEA. In

response to congressional requests, SEC and CFTC have tentatively agreed

on an approach to allow single stock futures to be traded on both U.S.

securities and futures exchanges. Regardless of whether SEC, CFTC, or

both agencies regulate such futures, some of the regulatory concerns could

be addressed by trading them electronically and/or under a pilot program.

According to SEC and securities exchange officials, futures on single

stocks and certain stock indexes could be allowed to trade, if such futures

were regulated as securities. For example, under this approach, single

stock and certain stock index futures would be made subject to the insider

trading prohibitions of the federal securities laws and covered by the

margin and sales practice requirements of the securities exchanges. These

officials also said that such an approach would enable SEC to ensure that

stocks, stock-based options, and stock-based futures were consistently

regulated under the federal securities laws. According to SEC officials, the

prohibitions on single stock and certain stock index futures were not

based on any economic differences between options and futures. Rather,

SEC officials said the prohibitions were based on regulatory differences

that could allow such futures, unlike single stock options, to be used as

stock substitutes to circumvent securities laws and regulations. Similarly,

the securities exchange officials said that they do not question the

potential economic utility of single stock futures.

According to CFTC officials, the regulatory scheme created by the accord

is consistent with the overall approach embraced by Congress to separate

securities and futures regulations. CFTC officials said that providing SEC

with jurisdiction over both stocks and stock-based futures could

undermine this approach and fragment the regulatory environment by

having futures regulation turn on the underlying commodity rather than

the economic function served by the product. The former CFTC chairman

responsible for negotiating the accord stated that the accord sought to

avoid regulation of futures based on the underlying commodity, because

such an approach could create a fragmented regulatory environment. This

approach was consistent with the decision by Congress in 1974 to replace

the Department of Agriculture with CFTC as the futures market regulator.

NFA officials have also questioned the need for SEC to regulate futures

based on stocks when CFTC does not regulate the underlying commodity

of any traded futures contract. According to securities exchange officials,

stocks are different from other commodities underlying futures contracts.

These officials said that SEC regulates stocks under a comprehensive body

SEC Could Be the Primary

Regulator of the Prohibited

Futures
B-284260

Page 30 GAO/GGD-00-89 Shad-Johnson Accord

of securities law that should not be undermined. Also, they said that,

unlike other derivatives in which the underlying has a poorly developed

cash market and the derivative serves a price discovery function, the cash

market for stock-based futures is well developed and serves a price

discovery function.

According to futures exchange officials, if the prohibited futures are

allowed to trade, CFTC could effectively regulate them under the CEA.

These officials said that the CEA could be amended and other steps could

be taken to address the legal and regulatory concerns involving the

prohibited futures. For example, as a means of addressing SEC concerns

about insider trading, CBT and CME have proposed providing SEC with

the authority to enforce insider trading prohibitions for stock-based

futures to the same extent that it does for stock-based options. Similarly,

CFTC officials said that they would support amending the CEA if the

accord prohibitions were lifted, so that CFTC could share its exclusive

jurisdiction over single stock futures with SEC in regulatory matters, such

as setting margins and market surveillance.

CFTC officials said that their experience with the currently traded stock

index futures has shown that the division of securities (including stockbased options) and futures regulation between SEC and CFTC has worked

well. These officials said that each has effectively regulated its respective

market. According to the CFTC officials, to the extent that intermarket

problems have arisen, SEC and CFTC have been able to develop

mechanisms to address them. For example, the officials said that the

securities and futures exchanges, at the recommendation of the Working

Group,60 established circuit breakers61 to address market emergencies

involving stocks and stock index futures. As previously discussed, futures

exchange officials said that they could use their reporting and surveillance

systems, with modification, to help deter and detect insider trading and

manipulation involving the prohibited futures.

Securities exchange officials said that dividing regulation of stocks and the

prohibited futures between SEC and CFTC would be less effective and

efficient than having SEC regulate both products. These officials said that

using a single regulator instead of two regulators would eliminate the need

to coordinate securities and futures market oversight. Furthermore,

securities officials said that dividing regulation between SEC and CFTC

 60 See Interim Report of the Working Group on Financial Markets (May 1988).

61 Circuit breakers are a coordinated system of trading halts and price limits on stock and derivatives

markets that are designed to provide a cooling-off period during large, intraday market declines.

CFTC Could Be the Primary

Regulator of the Prohibited

Futures
B-284260

Page 31 GAO/GGD-00-89 Shad-Johnson Accord

could create opportunities for regulatory arbitrage. These officials said

that investors could decide to use single stock futures, instead of stocks or

stock options, based on regulatory reasons rather than on the economic

merits of the competing products. For example, securities exchange

officials have expressed concern that margins for the prohibited futures

would be lower than margins for stocks and stock-based options. As a

result, these officials said that the prohibited futures would have a

competitive advantage in terms of transaction costs.62 As previously

discussed, futures exchange officials said that they would address this

concern by setting margins for single stock futures at a comparable level

to margins for options on single stocks.

In light of the Working Group’s conclusions and recommendation, several

members of Congress asked SEC and CFTC to study various issues related

to the accord. In December 1999, Senators Gramm and Lugar asked SEC

and CFTC to study the desirability of lifting the accord trading prohibition

on single stock futures. They also asked the agencies to provide any

legislative proposals for taking such action to Congress no later than

February 21, 2000, a date that was subsequently extended to March 2, 2000.

Likewise, in January 2000, Representatives Bliley, Combest, Ewing, and

Stenholm made a similar request to the agencies.

Responding to the congressional requests, on March 2, 2000, SEC and

CFTC presented a tentative approach for allowing single stock futures to

be traded on both U.S. securities and futures exchanges. Although SEC

and CFTC had not yet developed a legislative proposal for repealing the

accord prohibition, they agreed that any such legislation should allow both

agencies, acting as equal principals, to consistently regulate single stock

futures, the intermediaries that offer them, and the markets that trade

them. Accordingly, the agencies noted that any legislation in this area

should empower SEC and CFTC to cooperate and coordinate their

respective regulations to the extent practicable. They also noted the

importance of avoiding the imposition of unnecessarily burdensome or

duplicative regulation on the securities and futures markets as well as their

participants. According to SEC and CFTC officials, one of their major

challenges is developing a process to ensure that regulation of the

securities and futures markets as well as intermediaries remains consistent

and appropriate as the markets evolve. These officials said that the

 62 Recognizing that futures, options, and stocks could be used as substitutes in some cases, Federal

Reserve officials said that margin cost is just one of the factors that market participants consider in

making an investment decision. However, the officials said that the significance of this cost is unclear.

SEC and CFTC Could Share

Jurisdiction Over the

Prohibited Futures
B-284260

Page 32 GAO/GGD-00-89 Shad-Johnson Accord

agencies plan to continue working together with the goal of providing a

comprehensive legislative proposal to Congress before it adjourns.

SEC and CFTC have tentatively agreed on the initial standards for trading

single stock futures, such as harmonizing margin requirements, restricting

dual trading,63 testing sales and supervisory personnel, and establishing

uniform listing standards. They have also agreed that SEC would take the

lead in detecting, deterring, and prosecuting insider trading involving

single stock futures. Additionally, the agencies would seek to avoid

duplicative oversight in areas where their regulations are equivalent.

SEC and CFTC have explored using a “notice registration” process to avoid

duplicative regulation of their registered intermediaries (e.g., brokerdealers and FCMs) and registered markets. Under this process, entities

registered with one regulator would be required only to file a form to alert

the other regulator of their single stock futures activities. As such,

registered intermediaries and markets would not be required to go through

a duplicative registration process. Nonetheless, such entities would be

subject to “core provisions” of the federal securities and commodities

laws. SEC and CFTC have not yet agreed on the scope or application of the

core provision. They have identified and discussed a variety of issues

relating to the trading of single stock futures that may need to be

addressed in their regulatory proposal, including customer suitability and

disclosure as well as large trader reporting.

Although unresolved issues remain, the agencies have agreed to develop a

memorandum of understanding to implement the regulatory framework.

The memorandum would provide a regulatory blueprint that would allow

single stock futures to be traded on securities and futures exchanges and

by intermediaries currently regulated by only one agency, without

undermining investor protection and market integrity, imposing

duplicative regulation, and promoting regulatory arbitrage. In addition, the

agencies agreed to develop a coordinating committee to address ongoing

issues regarding their shared regulation of markets and intermediaries

trading single stock futures.

 

63 Dual trading occurs when (1) a floor broker executes customer orders and, on the same day, trades

for his or her own account or an account in which he or she has an interest, or (2) an intermediary

carries customers accounts and also trades, or permits its employees to trade, on the same trading day,

in accounts in which it has a proprietary interest.
B-284260

Page 33 GAO/GGD-00-89 Shad-Johnson Accord

Some of the regulatory concerns surrounding the prohibited futures could

be addressed by trading such futures electronically64 and/or under a pilot

program. For example, CFTC officials and others have said that electronic

trading systems can provide unalterable audit trails that record precisely

when, where, and by whom an order was placed. They said that such

information could be used to deter and detect market abuses, including

manipulation, and customer abuses, such as frontrunning.65 Similarly,

electronic trading systems could enhance customer protections by

improving the ability of FCMs to monitor and control customer activities.

According to securities exchange officials, trading single stock futures

electronically would not address many other concerns, including concerns

about insider trading, margins, and sales practices. Futures exchange

officials told us that they would likely trade these futures through

electronic trading systems, but would also like the flexibility to trade them

through open outcry.66

According to a market observer specializing in the securities laws, a pilot

program could be used to allow trading of the prohibited futures on a trial

basis. CFTC used such an approach to reintroduce the trading of options

on futures. Using a pilot program to introduce trading in the prohibited

futures could provide regulators with a way to test the adequacy of

responses to specific regulatory concerns. Also, to address concerns about

sales practices and retail customer losses, regulators could restrict access

to the pilot program to sophisticated market participants, such as those

defined as “eligible swap participants” in CFTC regulations.67 Similarly, the

market observer suggested that a pilot program could be used to test the

trading of stock index futures not currently allowed under the accord. He

said that this approach might be an effective and efficient way to test the

market for these products, while minimizing the potential for insider

trading and manipulation. He said that such stock index futures would

probably appeal only to institutions and other market professionals,

avoiding existing concerns that single stock futures would be marketed to

unsuitable retail investors. However, one drawback of a pilot program is

 

64 We are currently reviewing the use of electronic trading systems for exchange-traded and OTC

derivatives and will report our findings separately.

65 Frontrunning is taking a futures or options position based on nonpublic information regarding an

impending transaction by another person in the same or a related futures or options contract.

66 Open outcry is a method of public auction under which futures are traded by floor participants who

verbally or through hand signals make bids and offers to each other at centralized exchange locations.

67 Eligible swap participants include banks, securities firms, insurance companies, commercial firms

with a net worth exceeding $1 million, and individuals with total assets exceeding $10 million. 17

C.F.R. § 35.1(b)(2)(1999).

Some of the Regulatory

Concerns Could Be

Addressed by Trading the

Prohibited Futures

Electronically and/or Under

a Pilot Program
B-284260

Page 34 GAO/GGD-00-89 Shad-Johnson Accord

that its potentially temporary status may deter participation. According to

securities exchange officials, another drawback is that SEC and CFTC

would first need to resolve most of the jurisdictional and regulatory issues

before single stock and certain stock index futures could be traded under a

pilot program. As a result, the officials said such an approach would not be

likely to expedite trading of the prohibited futures.

Repealing the accord trading prohibitions on single stock and certain

stock-based index futures raises challenging legal and regulatory issues

because of (1) the potential to use the prohibited futures as stock

substitutes and (2) differences between securities and commodities laws

and regulations. SEC, CFTC, and others have identified approaches for

addressing such issues, with each approach pivoting on the jurisdictional

question of whether SEC, CFTC, or both should regulate single stock and

certain stock index futures. These approaches indicate that the legal and

regulatory issues are resolvable. To that end, SEC and CFTC have begun

working together to address these issues. However, uncertainty remains

about the outcome of such efforts. Differences in SEC and CFTC

perspectives, as well as in the securities and commodities laws, could

continue to impede efforts aimed at reaching the compromises necessary

to repeal the accord prohibitions.

The existence of active securities option and OTC equity derivatives

markets, coupled with a very small but growing foreign market in single

stock futures, indicates that the prohibited futures might serve a useful

economic purpose. At the same time, the experience of these markets

indicates that demand for the prohibited futures might be limited.

Nonetheless, repealing the trading prohibitions could enhance the ability

of the U.S. financial markets to compete and to develop innovative

contracts. First, such action would allow U.S. exchanges to introduce

additional stock-based futures and, in turn, let the marketplace determine

their economic utility. Second, such action could allow U.S. futures

exchanges to compete against other derivatives markets. Third, by

eliminating the accord prohibition on certain stock index futures, U.S.

firms could offer customers in the United States foreign stock index

futures that could be used to hedge foreign stock investments. Fourth, the

legal certainty of equity swaps could be addressed, thereby facilitating the

growth of this market. We recognize, however, that the legal certainty for

equity swaps could also be addressed separately by excluding such

products from the CEA, as recommended by the Working Group.

Congressional interest has been instrumental in bringing SEC and CFTC

together to discuss the legal and regulatory issues involved in repealing the

Conclusions
B-284260

Page 35 GAO/GGD-00-89 Shad-Johnson Accord

accord trading prohibitions. Recognizing that the resolution of the legal

and regulatory issues pivots on the jurisdictional question of which agency

or agencies should regulate single stock and certain stock index futures,

continued congressional attention may be a key factor in the ultimate

resolution of issues related to the repeal of the accord prohibitions.

Given the potential benefits of repealing the accord trading prohibitions

and the potential for jurisdictional differences to continue to impede such

efforts, we recommend that the Chairmen of SEC and CFTC (1) work

together and with Congress to develop and implement an appropriate legal

and regulatory framework for allowing the trading of futures on single

stocks and all stock indexes, and (2) submit to Congress legislative

proposals for repealing the accord trading prohibitions.

Overall, the federal financial regulators and the securities and futures

industry commentators generally agreed with, or did not comment on, our

conclusions and recommendations. However, SEC, the New York Stock

Exchange, the Securities Industry Association, and the Securities Markets

Coalition commented that our draft report did not address all of the

concerns and issues associated with trading single stock futures. They said

that the report, in some instances, oversimplified the complex solutions

required to bridge the disparities that exist between securities and futures

regulation. We agree that repealing the accord trading prohibitions

involves more than resolving the three regulatory and legal differences that

we discuss in our report—that is, the lack of comparable insider trading

prohibitions, margin levels, and customer protection requirements. We

expanded our discussion of the differences between the securities and

commodities laws and regulations to clarify that other differences exist

that would need to be addressed if the accord prohibitions were lifted.

Technical comments provided by CFTC, SEC, the Federal Reserve Board,

Treasury, CBT, FIA, the New York Stock Exchange, the Securities Industry

Association, and the Securities Markets Coalition were incorporated in this

report, as appropriate.

We are sending copies of this report to Senator Tom Harkin, Ranking

Minority Member, Senate Committee on Agriculture, Nutrition and

Forestry; Representative Larry Combest, Chairman, and Representative

Charles Stenholm, Ranking Minority Member, House Committee on

Agriculture; Representative Gary A. Condit, Ranking Minority Member,

Subcommittee on Risk Management, Research, and Specialty Crops, House

Committee on Agriculture; Representative Tom Bliley, Chairman, House

Committee on Commerce; the Honorable William Rainer, Chairman, CFTC;

Recommendations

Agency and Industry

Comments and Our

Evaluation
B-284260

Page 36 GAO/GGD-00-89 Shad-Johnson Accord

the Honorable Arthur Levitt, Chairman, SEC; and other interested parties.

We will also make copies available to others upon request.

If you or your staff have any questions regarding this report, please contact

me at (202) 512-8678 or Cecile O. Trop at (312) 220-7600. Key contributors

to this report are acknowledged in appendix II.

Thomas J. McCool

Director, Financial Institutions

and Markets
Page 37 GAO/GGD-00-89 Shad-Johnson Accord
Page 38 GAO/GGD-00-89 Shad-Johnson Accord

Contents

1 Letter

Appendix I 40

Comments From the

Securities and

Exchange Commission

Appendix II 42

GAO Contacts and

Staff

Acknowledgments

Related GAO Products 44

Abbreviations

CBOE Chicago Board Options Exchange

CBT Chicago Board of Trade

CEA Commodity Exchange Act

CFTC Commodity Futures Trading Commission

CME Chicago Mercantile Exchange

FCM futures commission merchant

FIA Futures Industry Association

NFA National Futures Association

OTC over-the-counter

SEC Securities and Exchange Commission
Page 39 GAO/GGD-00-89 Shad-Johnson Accord
Appendix I

Comments From the Securities and Exchange

Commission

Page 40 GAO/GGD-00-89 Shad-Johnson Accord
Appendix I

Comments From the Securities and Exchange Commission

Page 41 GAO/GGD-00-89 Shad-Johnson Accord

See p. 35.
Appendix II

GAO Contacts and Staff Acknowledgments

Page 42 GAO/GGD-00-89 Shad-Johnson Accord

Thomas McCool, (202) 512-8678

Cecile O. Trop, (312) 220-7600

In addition to those named above, Roger E. Kolar, Richard S. Tsuhara, and

Sindy Udell made key contributions to this report.

GAO Contacts

Acknowledgments
Page 43 GAO/GGD-00-89 Shad-Johnson Accord
Related GAO Products

Page 44 GAO/GGD-00-89 Shad-Johnson Accord

The Commodity Exchange Act: Issues Related to the Commodity Futures

Trading Commission’s Reauthorization (GAO/GGD-99-74, May 5, 1999).

OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice

Disputes (GAO/GGD-98-5, Oct. 2, 1997).

The Commodity Exchange Act: Legal and Regulatory Issues Remain

(GAO/GGD-97-50, Apr. 7, 1997).

Financial Market Regulation: Benefits and Risks of Merging SEC and CFTC

(GAO/GGD-95-153, May 3, 1995).
Page 45 GAO/GGD-00-89 Shad-Johnson Accord
Page 46 GAO/GGD-00-89 Shad-Johnson Accord
Page 47 GAO/GGD-00-89 Shad-Johnson Accord
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