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SEC and CFTC Seek Comment on Rules for Trading Debt Security Index Contracts

The SEC and the CFTC have issued a joint proposal that will permit the trading of futures on debt indexes (Rel. No. 34-53560, March 29, 2006). The SEC noted in a news release that the proposal advances the goal of the President's Working Group on Financial Markets to create a new class of tradable derivatives contracts. SEC Chairman Christopher Cox said that the new products that will be created as a result of the proposal will provide additional ways to diversify and manage risk. The comment period is open for 30 days.

Under the proposal, the CFTC will adopt a new rule and amend an existing rule and the SEC will adopt two new rules under the 1934 Act. Their rules will exclude from the definition of a narrow-based security index those debt securities indexes that can satisfy certain criteria. A future on a debt securities index that meets the exclusion criteria will be subject to the jurisdiction of the CFTC.

The two agencies explained that the definition of a narrow-based security index was designed for indexes composed of equity securities and not debt securities. The liquidity criterion in the definition, for instance, may not be appropriate for indexes composed of debt securities. Debt securities do not trade in the same way as equity securities, according to the release, so regardless of the number or amount of underlying component securities in a debt index, most would fall within the definition of a narrow-based index. Few debt securities meet the average daily trading volume criterion in the definition.

The SEC and the CFTC propose new criteria for a debt securities index that would not be considered a narrow-based security index based on the type of security in the index, the maximum weighting and concentration of securities of any issuer, the eligibility conditions of an issuer of any security in the index that is not exempted under the 1934 Act and the minimum remaining outstanding principal amount of the security in the index. Each component security of the index must be a security that is a note, bond, debenture or evidence of indebtedness. None of the securities of an issuer included in the index could be an equity security.

The agencies also propose conditions for the number and weighting of the component securities. The index must be comprised of more than nine securities issued by more than nine nonaffiliated issuers. No issuer's securities may account for more than 30% of the index's weighting. The securities of any five nonaffiliated issuers cannot comprise more than 60% of the index's weighting. These conditions are nearly identical to the criteria that are used to determine if a security index would not be a narrow-based security index.

For securities that are not exempted under the 1934 Act, the issuer must satisfy one of four criteria. The issuer must be required to file reports under 1934 Act section 13 or 15(d), have a worldwide market value of its outstanding common equity held by non-affiliates of $700 million or more, have outstanding securities that are notes, bonds, debentures or evidences of indebtedness having a total remaining principal amount of at least $1 billion, or be a government or a political subdivision of a foreign country. Each index component would have to have a total remaining principal amount of at least $250 million.

The SEC and the CFTC request comments on whether the proposed rules establish the appropriate criteria for identifying debt securities indexes that are not narrow-based and, if not, what other criteria might be appropriate. Commenters are welcome to submit their views on any other matters raised by the proposed rules, but the agencies asked that they provide empirical data and analysis to support their views.