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NFA prepares to regulate security futures products

By lifting the 18-year ban on trading single-stock futures, the Commodity Futures Modernization Act of 2000 (CFMA) ushers in an exciting new era for the futures industry and challenging new opportunities for NFA. The CFMA authorizes principal-to-principal futures transactions in single securities and narrow-based security indices to begin trading on August 21, 2001. The legislation also allows exchange-traded, intermediated futures transactions to begin on December 21, 2001.

Both of these dates are contingent on NFA's qualifying as a limited purpose national securities association (limited purpose NSA). NFA's registration as a limited purpose NSA is "automatic" if NFA meets certain requirements, including amending its rules regarding suitability, sales practices and fair dealing.

According to the CFMA, security futures products will be regulated as both futures and securities. FCMs and IBs that intend to offer these products must register as broker-dealers through a notice filing with the Securities and Exchange Commission (SEC). They do not, however, have to join NASD Regulation, Inc. (NASDR). Instead, NFA will regulate their activities subject to SEC oversight.

"We have met with representatives from the SEC and the CFTC to get a full understanding of the rule changes we need to make to fulfill the SEC's requirements," says Kathryn Camp, associate general counsel. "We have also had ongoing discussions with NASDR to avoid imposing conflicting regulations on dual members."

To expedite the process, Camp and other NFA staff members prepared a regulatory comparison which analyzes NASDR and NFA rules for suitability, sales practices and fair dealing. From that comparison, NFA staff determined what rule amendments or adoptions, if any, would be necessary in order to demonstrate to the SEC that NFA's rules are reasonably comparable to NASDR's rules in these areas.

The CFMA requires NFA to adopt a suitability rule for security futures products comparable to that in the securities industry. NFA's Know Your Customer Rule requires members to obtain certain basic information about their customers and, based on that information, provide adequate risk disclosure. NASDR has a general suitability rule prohibiting members from making unsuitable recommendations. Additionally, NASDR has a rule relating to options that requires members to specifically approve the account for options trading.

"NFA will need to amend Compliance Rule 2-30 to require Member firms to specifically approve accounts to trade security futures products in light of a customer's financial situation," says Camp. "Member firms will also have to ensure that specific security futures recommendations are suitable for the customer."

Sales Practices
Although NFA's and NASDR's sales practice rules are comparable for the most part, the SEC has asked NFA to adopt some of the more specific NASDR requirements for promotional material. NFA plans to amend Compliance Rule 2-29 to apply some of these requirements to all contracts and to add a new section for those requirements that apply only to security futures products.

"We are also drafting a proposed Interpretive Notice to include some specifics not in Rule 2-29 and to make sure that Members and Associates understand their obligations," says Camp.

Fair Dealing
NFA's compliance rules are for the most part comparable to NASDR's rules relating to dealing fairly with customers and other market participants. However, there are areas where the SEC has asked NFA to make its rules more explicit or to adopt interpretive guidance to ensure that Members and Associates understand their obligations.

To address these concerns, NFA is proposing a new Compliance Rule 2-37 that relates only to security futures products. NFA is also drafting an Interpretive Notice that explicitly prohibits trading ahead (for all futures contracts) and clarifies what it means to trade on material, non-public information (for security futures contracts).

"We have discussed our rule proposals with each of our FCM, CPO/CTA and IB Advisory Committees," says Camp. "They provided us with valuable feedback which we will incorporate in to our final rule proposals. We are also soliciting feedback from other industry professionals."

In addition to rule development, NFA is collaborating with the NASDR on a separate risk disclosure statement for security futures products and a joint approach to testing and proficiency issues.

"The introduction of security futures products has presented NFA with a complex and challenging project," says Camp. "However, in all of our efforts, we are committed to minimizing unnecessary regulatory burdens on our Members."

NFA is the premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets.
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