In this commentary written for MarketVoice, two legal experts discuss an unusual set of regulatory complications that affected US investors in one of the most popular international stock index futures contracts.
Even the legendary magician and escape artist Harry Houdini would have been dumbfounded by two transformations of the widely followed Kospi 200 stock index futures contract listed on the Korea Exchange since it was initially authorized for offer and sale to US persons in 2008.
At that time, this contract was considered a futures contract on a broad-based security index from the perspective of US regulators. And for the next 12 years, it was subject to the exclusive oversight of the Commodity Futures Trading Commission under US law.
From a practical perspective, this allowed institutional investors and other market participants in the US to use the Kospi 200 futures to manage their exposures to the Korean stock market, one of the largest in Asia. Kospi 200 futures are one of the most actively traded stock index futures contracts in the world, and more than half of the volume comes from entities based outside of Korea.
However, beginning in late 2019 an increase in the value of one security in the index – Samsung Electronics Co. – relative to the other companies in the index changed the nature of the contract. At one point the share price of Samsung rose so much that it accounted for more than a third of the index's value. As a result of the relative increase in value of Samsung, the Kospi 200 stock index transformed under US laws from a broad-based index to a narrow-based security index. Consequently, the futures on that index became a “security futures contract” beginning on April 1, 2020, and subject to oversight by both the CFTC and the Securities and Exchange Commission.
No longer was this contract available to any US person; now it was only potentially available in the US to a class of sophisticated persons known as “qualified institutional buyers” (QIBs) and "eligible contract participants" (ECPs). A QIB is defined by the SEC as, among other things, an institutional investor that owns or manages on a discretionary basis at least $100 million worth of securities.
This change in regulatory status also affected what types of intermediaries could offer the contract to US investors. From 2008 through 2020, Kospi contracts could be offered and sold to US persons solely by CFTC-registered futures commission merchants and introducing brokers (or certain non-US entities lawfully exempt from such registration by the CFTC). Beginning in 2020, Kospi contracts could only be offered and sold potentially to QIBs in the US by intermediaries registered as both a broker-dealer with the SEC and an FCM with the CFTC.
In other words, the change in the Kospi 200's status from broad- to narrow-based index triggered a substantial increase in the complexity of the compliance obligations for US market participants interested in trading the Kospi 200 futures. If the story had stopped there, it might have been a challenging but not a novel issue in the history of cross-border trading. But the financial alchemy surrounding the Kospi 200 did not end in 2020.
Last year, because of another change in the weighting of the underlying index, the Kospi 200 contract reverted to the status of a broad-based security index futures contract under US law, and as of December it returned to the exclusive authority of the CFTC.
Initially, staff of the CFTC’s Division of Market Oversight temporarily authorized access to these contracts within the US solely to US persons who qualified as QIBs. However, in January 2022 the CFTC officially certified the Kospi 200 contract as a broad-based security index futures contract available to any US person.
In other words, the contract was returned to the universe of foreign stock index futures that are subject to regulation only by the CFTC. Customers no longer had to qualify as QIBs under the rules of the SEC, and intermediaries no longer had to meet the registration requirements of both agencies.
Could the Kospi 200 futures contract engage in regulatory shapeshifting again? Yes!
Different approaches of CFTC and SEC
The origin of the ability of a single futures contract to morph from the status of a futures contract to a security futures contract and then back and forth again and again with different regulatory consequences began with the creation of the CFTC in 1974 and subsequent disagreement between the CFTC and the SEC over which agency had jurisdiction to approve futures on certain securities.
In 1982, the respective chairmen of the CFTC and the SEC – Philip McBride Johnson and John Shad – carved out a blueprint to divide jurisdiction between the two agencies. Their agreement subsequently was enacted into law in 1983. This amendment to the Commodity Exchange Act provided for the CFTC to have exclusive jurisdiction over any futures contract based on a broad-based stock index provided that the contract was (1) cash settled, (2) not readily susceptible to manipulation, and (3) based on a broad-based security index. Futures on indices that did not meet these characteristics, as well as futures on single securities, were banned for access by US persons.
This ban was lifted in December 2000, however, when Congress enacted the Commodity Futures Modernization Act. This law provided a framework for the joint oversight by the CFTC and SEC of futures on narrow-based security indices as well as individual securities.
Under CFTC and SEC rules, a futures contract is based on a broad-based security index if the security index is not narrow based. A security index is considered narrow-based if (1) it has nine or fewer component securities, (2) any component security has 30% or more of the index’s weighting, (3) the five highest weighted securities in total more than 60% of the index’s weighting, or (4) the lowest weighted securities comprising in total 25% of the index’s weighting have a total dollar value of aggregate trading volume of less than $50 million, or in the case of an index with 15 or more individual securities, $30 million.
Initially, the CFTC began authorizing futures contracts on broad based security indices listed on non-US exchanges through issuance of staff no-action letters, and beginning in October 2011, through a formal certification process. KRX was granted such a no-action letter for Kospi 200 futures contracts in November 2008. Likewise, the CFTC certified the Kospi 200 mini futures contract as eligible for all US persons in August 2017.
The SEC did not provide a framework for authorizing security futures contracts on narrow-based security indices or individual securities listed on non-US exchanges until it issued an order providing a methodology in June 2009. Shortly thereafter, CFTC staff issued an advisory clarifying that qualifying security futures contracts may be traded in accordance with the SEC’s June 2009 order. It was under this authority that qualified US persons could begin trading Kospi 200 security futures contracts once the CFTC withdrew its Kospi 200 certification on April 1, 2020.
Under the SEC’s June 2009 order, qualified institutions can potentially offer and sell non-US issued security futures based on narrow-based security indices to QIBs but only if certain additional conditions were met, including the following: (1) 90% of the underlying securities in the index at the time of the transaction, both in terms of the number of underlying securities and their weighting in the index, was issued by foreign private issuers; (2) the security futures was traded on a non-US exchange that had its principal place of business outside the US and was not required to register with the SEC as a national securities exchange; (3) the security futures would not require physical delivery of any security underlying the index in the US; and (4) the security futures would solely be cleared and settled on an exchange or clearing entity that was not required to register with the SEC. (The CFTC also requires that such QIBs be ECPs.)
Security indexes moving from broad to narrow, and narrow to broad
Because the results of the test for broad-based and narrow-based security indices could change daily, the CFTC and SEC agreed to a framework to eliminate the potential for very frequent changes in regulatory consequences following changes in the characteristic of a security index underlying a futures contract.
Generally, if a broad-based security index futures contract has been approved by the CFTC for trading by US persons, and the underlying security index morphs to meet the definition of a narrow-based security index for more than 45 business days over three consecutive calendar months, then the futures contract referencing the security index will enter a three-calendar month grace period beginning the first day of the next calendar month. During this grace period, any US person can trade the contract as a futures contract on a broad-based security index. At the end of the three-month grace period, the contract will be deemed a narrow-based security index futures contract and subject to all requirements of a security futures contract, including potential limited eligibility to US persons.
The Kospi 200 futures contract was subject to this phasing process beginning late 2019 through April 1, 2020, when the CFTC terminated the contract's certification as a futures contract based on a broad-based security index and the contract became subject to the joint oversight by the CFTC and the SEC. The principal cause of this index morphing was the change in the weighting of the component stocks of the Kospi 200 index due to the relative increase in the value of Samsung.
Likewise, this phasing process can happen in reverse. If a security futures contract based on a narrow-based security index meets the definition of a broad-based index for more than 45 business days over three consecutive calendar months, then the futures contract referencing the security index will enter a three-calendar month grace period beginning the first day of the next calendar month. During this grace period, qualified US persons can trade the contract as a security futures contract on a narrow-based security index as permitted by the SEC’s 2009 order. At the end of the three-month grace period, the contract will be deemed a broad-based security index futures contract and be subject to the exclusive jurisdiction of the CFTC.
The Kospi 200 security futures contract was subject to this phasing process from June through December 1, 2020, when it ceased being a security futures contract on a narrow-based security index. The principal cause of this index morphing was another change in weighting of the Kospi 200 due to a relative decrease in the value of Samsung. Because it was unclear that the CFTC could certify the Kospi 200 futures contract as based on a broad-based security index prior to December 1, staff of the CFTC’s Division of Market Oversight granted KRX no-action relief to offer and sell its contracts to QIBs beginning on December 1. The CFTC certified the Kospi 200 futures contract as eligible for access by any US person as of 15 January.
Because the weighting of one or more component securities in a security index could materially change over time, it is possible that KRX futures on the Kospi 200 security index could again change its regulatory classification under US law, blocking certain US persons from being able to access this contract or requiring them to access this product in a materially different way.
This morphing potential of a non-US futures on a security index requires both non-US exchanges and intermediaries offering such products as well US market participants trading such products to continually monitor the characteristics of the underlying index to plan for potential changes in the US regulatory environment.
Despite his mastery of contortion and escape, even Harry Houdini would have been challenged to find an easy way to navigate this complex regulatory transformation process.
About the Authors: Gary DeWaal is special counsel and chair of the Financial Markets and Regulation practice group at Katten. Previously, he worked as group general counsel for the world's largest exchange-traded derivatives broker and, before that, as a senior trial attorney with the CFTC's enforcement division. James Brady works at Katten as counsel on financial markets and funds. He works with buy-side and sell-side clients, trading facilities and clearinghouses on matters related to securities and derivatives regulatory obligations, registrations and related corporate and transactional issues.
