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Facing congressional pressure, regulators slid in under the wire last week with a bare-bones plan for governing a new breed of financial products set to debut Tuesday. Single-stock futures and narrow-based stock index futures — high-risk investment vehicles similar to stock options — have been banned in the United States since 1982. The prohibition was lifted with the passage of the Commodity Futures Modernization Act in December, placing the new products under the joint regulation of the Commodity Futures Trading Commission and the Securities and Exchange Commission. Trading in the controversial stock futures may begin as early as Tuesday between institutional investors; general retail trading should commence Dec. 21. Futures are typically associated with products such as corn, oil, and gold. But investors have also long been able to purchase futures linked to broad market indices, such as the Dow Jones Industrial Average. They will now be allowed to buy futures in individual stocks and more narrowly constructed indices on both stock markets and futures exchanges. On Aug. 13 — with just one week before their deadline — the CFTC and the SEC finalized the first round of rules relating to the new stock future products. Despite the last-minute push, some industry leaders and lawmakers wonder whether the CFTC, SEC, and other responsible agencies have created a sufficient road map for regulating the new financial hybrids. “No one on August 21 is going to start trading,” predicts Larry Dyekman, spokesman for the National Futures Association, a self-regulatory organization for the futures industry. “There are still some very basic questions that the agencies have to answer.” Specific concerns include what constitutes a narrow-based stock index, what margin rates will be applied to stock futures, how the new products will be taxed, and whether investors need added protections from the risks associated with trading stock futures. In addition, it is still unclear what type of transaction is qualified to commence Aug. 21. On Aug. 15, Rep. Michael Oxley, R-Ohio, chairman of the House Financial Services Committee, urged the CFTC, SEC, and Internal Revenue Service to speed their rule-making initiatives. Oxley reiterated concerns raised in a July 29 letter that the agencies “appear to be well behind the deadlines for action contained” in the Commodity Futures Modernization Act. “Were investors’ ability to use these products hampered by the failure of governmental agencies to meet statutorily imposed deadlines, it would not only harm U.S. investors, but also substantially undermine Congressional intent,” Oxley wrote. In a written response delivered last week, SEC Chairman Harvey Pitt stated that his agency is “working diligently … to ensure the necessary regulatory infrastructure is in place to enable the development of, and trading in, these products within the time frames envisioned” in the act. Neither the CFTC nor the IRS provided a formal response to Oxley’s letter. TRADING PLACES Roughly speaking, stock futures allow an investor — at relatively low expense — to bet on a stock he or she believes will rise. In a single-stock futures transaction, an investor agrees to purchase stock at a set price on a specified future date. For example, an investor would enter into a contract to buy 100 shares of stock from Company X at $10 per share, one year from now, betting that the share price will go up during that time. The investor would pay only a small percentage of the purchase price upfront; the full $1,000 would be due in one year. At the one-year mark, the investor would be paid the difference between the $10 per share purchase price and the actual, presumably higher, price. Of course, if the price has dropped below $10, the investor would still be obligated to pay $10 per share. Rather than actually fulfilling the contract, the parties calculate the profit or loss on paper and settle the matter in cash. In contrast, a stock option gives an investor the right — but not the obligation — to buy a specific stock at a set price and time. Typically, there are certain advantages associated with futures contracts, such as lower margin requirements and tax rates. But these will not exist under the modernization act, which requires stock futures and stock options to be offered on a level playing field. Still, in the hands of a sophisticated investor, stock futures can be a powerful tool for hedging risk or quickly gaining or minimizing exposure to a specific stock. Because the hybrid products defy strict definition as either securities or futures, the SEC and CFTC have long bickered over which agency should have jurisdiction. Back in 1982, then-SEC Chairman John Shad and then-CFTC Chairman Philip McBride Johnson prohibited the controversial products after failing to compromise on a scheme for their regulation. Facing mounting pressure from investors and the futures industry, Congress lifted the longstanding ban as part of the 2000 modernization act. The CFTC and SEC, historic rivals, were left to work out the details. “You’ve got a system where a new product is subject to regulation as a futures contract and a security, and we’ve never seen that before. Clearly, there are a lot of issues to work out,” says Stuart Kaswell, general counsel of the Securities Industry Association. “I think the regulators have demonstrated a willingness to work together. I don’t see this turning into a zero-sum game.” The rule issued last week by the CFTC spells out the registration procedure for securities broker-dealers wishing to trade stock futures on futures exchanges. The SEC has not finalized a parallel rule for futures merchants wishing to trade on securities exchanges. But in his letter to Oxley, Pitt anticipated that the SEC would adopt such a rule shortly. The new SEC rule relates to the oversight of futures markets trading stock futures, which will be answering to the SEC for the first time. Both the National Futures Association and the Chicago Board of Trade have complained that the SEC rules are substantially more burdensome than those prescribed by the CFTC. “There will certainly be additional compliance costs,” agrees former CFTC Chairman Johnson, now of counsel in the D.C. office of New York’s Skadden, Arps, Slate, Meagher & Flom. “The compliance officer now has to ask two questions: What does the CFTC think? What does the SEC think?” Kaswell says his group is just beginning to digest the implications of the new rules. “You have to go through, rule by rule, and look for areas of concern where the two regimes are saying different things,” he says. “It’s a painstaking process.”

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