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[Federal Register: March 31, 2004 (Volume 69, Number 62)]
[Notices]
[Page 16900-16901]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr31mr04-53]


[[Page 16900]]

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COMMODITY FUTURES TRADING COMMISSION

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49469]


Joint Order Excluding Indexes Comprised of Certain Index Options
From the Definition of Narrow-Based Security Index Pursuant to Section
1a(25)(B)(vi) of the Commodity Exchange Act and Section 3(a)(55)(C)(vi)
of the Securities Exchange Act of 1934

AGENCIES: Commodity Futures Trading Commission and Securities and
Exchange Commission.

ACTION: Joint order.

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SUMMARY: The Commodity Futures Trading Commission (``CFTC'') and the
Securities and Exchange Commission (``SEC'') (collectively,
``Commissions'') by joint order under the Commodity Exchange Act
(``CEA'') and the Securities Exchange Act of 1934 (``Exchange Act'')
are excluding certain security indexes from the definition of ``narrow-
based security index.'' Specifically, the Commissions are excluding
from the definition of the term ``narrow-based security index'' certain
indexes comprised of series of options on broad-based security indexes.

EFFECTIVE DATE: March 25, 2004.

FOR FURTHER INFORMATION CONTACT:

CFTC: Thomas Leahy, Assistant Branch Chief, Market and Product Review
Section, Division of Market Oversight, Commodity Futures Trading
Commission, 1155 21st Street NW., Washington, DC 20581. Telephone (202)
418-5278.
SEC: Elizabeth K. King, Associate Director, at (202) 942-0140, or
Theodore R. Lazo, Senior Special Counsel, at (202) 942-0745, Division
of Market Regulation, Securities and Exchange Commission, 450 Fifth
Street, NW., Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

I. Background

    Futures contracts on single securities and on narrow-based security
indexes (collectively, ``security futures'') are jointly regulated by
the CFTC and the SEC.\1\ To distinguish between security futures on
narrow-based security indexes, which are jointly regulated by the
Commissions, and futures contracts on broad-based security indexes,
which are under the exclusive jurisdiction of the CFTC, the CEA and the
Exchange Act each includes an objective definition of the term
``narrow-based security index.'' A futures contract on an index that
meets the definition of a narrow-based security index is a security
future. A futures contract on an index that does not meet the
definition of a narrow-based security index is a futures contract on a
broad-based security index.\2\
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    \1\ See section 1a(31) of the CEA and section 3(a)(55)(A) of the
Exchange Act, 7 U.S.C. 1a(31) and 15 U.S.C. 78c(a)(55)(A).
    \2\ See 17 CFR 41.1(c).
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    Section 1a(25) of the CEA \3\ and section 3(a)(55)(B) of the
Exchange Act \4\ provide that an index is a ``narrow-based security
index'' if, among other things, it meets one of the following four
criteria:
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    \3\ 7 U.S.C. 1a(25).
    \4\ 15 U.S.C. 78c(a)(55)(B).
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    (i) The index has nine or fewer component securities;
    (ii) Any component security of the index comprises more than 30
percent of the index's weighting;
    (iii) The five highest weighted component securities of the index
in the aggregate comprise more than 60 percent of the index's
weighting; or
    (iv) The lowest weighted component securities comprising, in the
aggregate, 25 percent of the index's weighting have an aggregate dollar
value of average daily trading volume of less than $50,000,000 (or in
the case of an index with 15 or more component securities,
$30,000,000), except that if there are two or more securities with
equal weighting that could be included in the calculation of the lowest
weighted component securities comprising, in the aggregate, 25 percent
of the index's weighting, such securities shall be ranked from lowest
to highest dollar value of average daily trading volume and shall be
included in the calculation based on their ranking starting with the
lowest ranked security.

The first three criteria evaluate the composition and weighting of the
securities in the index. The fourth criterion evaluates the liquidity
of an index's component securities.
    Section 1a(25)(B)(vi) of the CEA and section 3(a)(55)(C)(vi) of the
Exchange Act provide that, notwithstanding the initial criteria, an
index is not a narrow-based security index if a contract of sale for
future delivery on the index is traded on or subject to the rules of a
board of trade and meets such requirements as are jointly established
by rule, regulation, or order by the Commissions. Pursuant to that
authority, the Commissions may jointly exclude an index from the
definition of the term narrow-based security index.\5\
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    \5\ See, e.g., Joint Order Excluding from the Definition of
Narrow-Based Security Index those Security Indexes that Qualified
for the Exclusion from that Definition under Section 1a(25)(B)(v) of
the Commodity Exchange Act and Section 3(a)(55)(C)(v) of the
Securities Exchange Act of 1934 (May 31, 2002), 67 FR 38941 (June 6,
2002).
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    In September 2003, CBOE Futures Exchange, LLC (``CFE''), a
designated contract market approved by the CFTC, announced plans to
trade futures contracts on certain ``volatility indexes'' created by
the Chicago Board Options Exchange, Inc. (``CBOE'').\6\ Each of these
volatility indexes is designed to measure the variability of daily
returns on a security index (``Underlying Broad-Based Security
Index''), as reflected in the prices of options on the Underlying
Broad-Based Security Index. Accordingly, the component securities of a
volatility index are put and call options on a security index.\7\ In
light of CFE's announcement, the Commissions have considered whether
volatility indexes are narrow-based security indexes.
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    \6\ See CBOE News Release, ``CBOE Announces Launch of Futures on
VIX: First Tradable Volatility Product Will be Offered on New CBOE
Futures Exchange'' (September 5, 2003). The news release is
available at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cboe.com" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cboe.com.

    \7\ CBOE has published a White Paper describing the calculation
and methodology of its volatility indexes, which is available at
 href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cboe.com/micro/vix/vixwhite.pdf" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cboe.com/micro/vix/vixwhite.pdf.

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II. Discussion

    The statutory definition of the term narrow-based security index is
designed to distinguish among indexes comprised of individual stocks.
As a result, certain aspects of that definition are designed to take
into account the trading patterns of individual stocks rather than
those of other types of exchange-traded securities, such as options.
However, the Commissions believe that the definition is not limited to
indexes on individual stocks. In fact, section 1a(25)(B)(vi) of the CEA
and section 3(a)(55)(C)(vi) of the Exchange Act give the Commissions
joint authority to make determinations with respect to security indexes
that do not meet the specific statutory criteria without regard to the
types of securities that comprise the index.
    Subject to the conditions set forth below, the Commissions believe
that it is appropriate to exclude certain indexes comprised of options
on broad-based security indexes from the definition of the term narrow-
based security index. An index must satisfy all of the following
conditions to qualify for the exclusion.
    The first condition limits the exclusion to indexes that measure

[[Page 16901]]

changes in the level of an Underlying Broad-Based Security Index over a
period of time using the standard deviation or variance of price
changes in options on the Underlying Broad-Based Security Index. The
Commissions believe this condition is necessary to limit the exclusion
to indexes calculated using one of two commonly recognized statistical
measurements that show the degree to which an individual value tends to
vary from an average value. The second, third, and fourth conditions
provide that the exclusion applies to indexes that qualify as broad-
based security indexes under the statutory criteria that evaluate the
composition and weighting of the securities comprising an index. The
fifth condition provides that the exclusion applies only if the
Underlying Broad-Based Security Index qualifies as a broad-based
security index under the statutory criterion that evaluates the
liquidity of the securities comprising an index. The Commissions
believe at this time that this condition is appropriate so that any
such Underlying Broad-Based Security Index, including those that are
not narrow-based under any of the exclusions to the definition under
sections 1(a)(25)(B) of the CEA and 3(a)(55)(C) of the Exchange Act,
meets the statutory liquidity criterion. The sixth condition provides
that the exclusion applies if the options comprising the index are
listed and traded on a national securities exchange. Given the novelty
of volatility indexes, the Commissions believe at this time that it is
appropriate to limit the component securities to those index options
that are listed for trading on a national securities exchange where the
Commissions know pricing information is current, accurate and publicly
available. Finally, the seventh condition provides that the exclusion
applies only if the options comprising the index have an aggregate
average daily trading volume of 10,000 contracts. The Commissions
believe that this condition limits the exclusion to indexes for which
there is a liquid market on a national securities exchange for the
options on the Underlying Broad-Based Security Index, which contributes
to the Commissions' view that futures on such indexes should not be
readily susceptible to manipulation.
    The Commissions believe that indexes satisfying these conditions
are appropriately classified as broad based because they measure the
magnitude of changes in the level of an underlying index that is a
broad-based security index. In addition, the Commissions believe that
futures contracts on indexes that satisfy the conditions of this
exclusion should not be readily susceptible to manipulation because of
the composition, weighting, and liquidity of the securities in the
Underlying Broad-Based Security Index and the liquidity that the
options comprising the index must have to qualify for the exclusion.
Specifically, these factors should substantially reduce the ability to
manipulate the price of a future on an index satisfying the conditions
of the exclusion using the options comprising the index or the
securities comprising the Underlying Broad-Based Security Index.
    Accordingly,
    It is ordered, pursuant to section 1a(25)(B)(vi) of the CEA and
Section 3(a)(55)(C)(vi) of the Exchange Act, that an index is not a
narrow-based security index, and is therefore a broad-based security
index, if:
    (1) The index measures the magnitude of changes in the level of an
Underlying Broad-Based Security Index that is not a narrow-based
security index as that term is defined in Section 1(a)(25) of the CEA
and Section 3(a)(55) of the Exchange Act over a defined period of time,
which magnitude is calculated using the prices of options on the
Underlying Broad-Based Security Index and represents (a) an annualized
standard deviation of percent changes in the level of the Underlying
Broad-Based Security Index; (b) an annualized variance of percent
changes in the level of the Underlying Broad-Based Security Index; or
(c) on a non-annualized basis either the standard deviation or the
variance of percent changes in the level of the Underlying Broad-Based
Security Index;
    (2) The index has more than nine component securities, all of which
are options on the Underlying Broad-Based Security Index;
    (3) No component security of the index comprises more than 30% of
the index's weighting;
    (4) The five highest weighted component securities of the index in
the aggregate do not comprise more than 60% of the index's weighting;
    (5) The average daily trading volume of the lowest weighted
component securities in the Underlying Broad-Based Security Index upon
which the index is calculated (those comprising, in the aggregate, 25%
of the Underlying Broad-Based Security Index's weighting) has a dollar
value of more than $50,000,000 (or $30,000,000 in the case of a
Underlying Broad-Based Security Index with 15 or more component
securities), except if there are two or more securities with equal
weighting that could be included in the calculation of the lowest
weighted component securities comprising, in the aggregate, 25% of the
Underlying Broad-Based Security Index's weighting, such securities
shall be ranked from lowest to highest dollar value of average daily
trading volume and shall be included in the calculation based on their
ranking starting with the lowest ranked security;
    (6) Options on the Underlying Broad-Based Security Index are listed
and traded on a national securities exchange registered under section
6(a) of the Exchange Act; and
    (7) The aggregate average daily trading volume in options on the
Underlying Broad-Based Security Index is at least 10,000 contracts
calculated as of the preceding 6 full calendar months.

    By the Commodity Futures Trading Commission.

    Dated: March 25, 2004.
Jean Webb,
Secretary.

    By the Securities and Exchange Commission.

    Dated: March 25, 2004.
Margaret H. McFarland,
Deputy Secretary.
FR Doc. 04-7141 Filed 3-30-04; 8:45 am]
BILLING CODE 6351-01-P, 8010-01-P
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