USFE’s letter to the US CFTC – Binary Event Derivatives

USFE – PDF file (formatting is weird, sorry):

U.S. Futures Exchange, LLC (“USFE” or the “Exchange”) intends to list new
binary Event Futures (“Event Futures” or “Contracts”) on April 20, 2007. The
purpose of this letter is to outline the Contracts. Additionally, USFE certifies that
the proposed Event Futures comply with the Commodity Exchange Act and
regulations thereunder.
Design
Event Futures are intended to provide a transparent, liquid and easy means of
acquiring protection against the risk of the occurrence or non-occurrence of a
specified event. As such, USFE intends to extend the benefits of exchange-traded
products to commodity or asset classes that have previously either not existed or
have only been available in non-exchange traded contexts, such as the over-thecounter
(“OTC”) derivatives markets.
The Contracts are designed to dovetail with current futures accounting practices,
i.e., they require an initial performance bond deposit and are subsequently
marked-to-market (MTM) on a daily basis. As the expiration date of an Event
Futures contract draws near, the entire value of the protection will have been paid
from long to short through the MTM process. If an Event occurs prior to the
expiration date, Event Futures will terminate and the short position is marked-tomarket
at a fixed amount as defined by the Exchange.
Binary Event Futures Concept – Event Futures call for a final cash
settlement which is binary in character. In the absence of the occurrence of the
specified event, the Final Settlement Price of the contract will be established at
zero ($0) as of the Final Settlement Date. However, if the event occurs as defined
in the product specifications, the Final Settlement Price will be established at a
fixed amount as set by the contract specifications.
Thus, these futures contracts may be characterized as a form of binary Event
Futures. The “event” is carefully defined in each particular Contract’s terms and
conditions.
We have constructed the Contracts so that none of them may be characterized as a
security futures contract. In particular, none will be a contract for future delivery
of a single security; or, for delivery of any measure of value based on the price of
a single security. The Final Settlement Price is binary in nature and fixed in
advance of listing and does not vary based upon the price or value of any security.
Event Definitions – Event Futures will be triggered by defining the occurrence or
extent of the occurrence, which is the event underlying the contract. Specifically,
the Contracts will rely upon event definitions that will be validated by
independent, transparent sources and not within the control of any person or
persons trading the contract.
Specifically, a certificate of merger is the official document required to be filed
under state corporate law to effect a merger. For Delaware corporations, a
certificate of merger is filed with the Delaware Secretary of State on the day of
the closing of the merger. The certificate of merger is effective once it is filed
with and approved by the State of Delaware. Absent any errors that may delay
the filing, a certificate of merger is generally filed and deemed effective on the
same business day it is submitted to the Secretary of State of Delaware. The
certificate of merger, as evidence of the occurrence of the merger, becomes
publicly available on the Delaware Secretary of State’s website on the day it is
filed.
In the alternative, the SEC’s tender offer rules require that a final amendment to
the Schedule TO be filed promptly to report the results of the tender offer. The
final amendment is filed when the bidder accepts the shares for payment in the
tender offer at the expiration of the tender offer. The final amendment is filed
under the tag “TO-T/A” on the SEC’s EDGAR system and is available the day it
is filed with the SEC.
Since the underlying event will be validated by independent, transparent sources,
it cannot be subject to manipulation or distortion. Because of the binary nature of
this contract, it does not rely upon a cash price series per se for purposes of final
cash settlement. Therefore, the value of the contract on settlement is not subject
to manipulation or distortion, consistent with the requirements of Guideline No. 1,
Appendix A to Part 40 of the Commission’s Regulations.
Cash Flows – From a cash flow perspective, Event Futures operate akin to
other cash settled futures contracts. One may buy or sell a contract, at which
point, one is required to post an initial performance bond (or “initial margin”).
Subsequently, the price of the contract may fluctuate up or down resulting in
variation margin payments on a daily mark-to-market (“MTM”) basis.
Unlike other contracts, however, the contract may terminate early if the event
should occur prior to the regularly scheduled maturity date. At this point, the
contract is promptly settled during the next clearing cycle at the fixed payment
amount.
It is reasonable to anticipate that the market prices will tend to rise in anticipation
of the occurrence of an event (i.e., the market should be efficiently priced). As
such, the daily MTM process will have the effect of transferring the value of the
protection associated with the contract from protection seller to protection buyer.
Effectively, shorts will pay longs an amount equal to the Final Settlement Price
less the original transaction price through the accumulation of daily MTM pays
and collects. Since this process will tend to be gradual in nature, risks to the
clearinghouse are mitigated.
Event Futures are quoted as the percentage of probability of the occurrence of the
event in minimum increments of 0.5% probability points. In the case of an Event
Future with a Notional Value established at $1,000, this equates to $5 (= 0.5% x
$1,000) or $10 per full probability point . Daily MTM procedures ensure that the
value of the protection is transferred from buyer to seller as maturity approaches
in the absence of an event. Or, that the value of the fixed payout is
transferred from seller to buyer as contracts are cash settled early, triggered by an
event.
Settlement at Zero – Assume it is June 19, 2007 and you purchase one (1) Event
Future tied to the occurrence of a particular event, with a Notional Value
established at $1,000, at a price of 30% maturing October 19,2007 (4-month
term). While the price of 30% represents $300 (= 30% x $1,000), the buyer does
not actually pay $300 in cash but rather secures this transaction with funds
sufficient to cover the initial performance bond requirement.
Assume that the initial performance bond requirement equals $250. Although
our example is constructed from the perspective of the buyer, both buyer and
seller must post the initial performance bond and both are MTM as market values
fluctua te. Assume that the likelihood of the event’s occurrence falls throughout
the 4 month full term. Under these circumstances, one would expect the market
price to wind down to zero by the time the contract matures. Upon final
settlement at a price of 0.0 %, the initial performance bond is released back to
buyer and seller. both buyer and seller retain their long and short
positions, respectively, and do not offset them during the next 4 months, the
contract value winds down to 0.0 % perhaps taking a circuitous path but winding
down to zero nevertheless. As such, the buyer, through a series of MTM pays and
collects, compensates the seller with the original 30% or $300.
Occurrence of Event – Assume that one buys the same Event Future tied to the
occurrence of a particular event, with a Notional Value established at $1,000,
and at a price of 30% maturing 4 months hence. But this time, expectations of the
occurrence of the event begin to rise. The price of the Event Future increases
as the market factors in a higher probability for the occurrence of the event.
What if the event should occur? Assume that by October 1, 2007, the event
is imminent. By the time the event is declared and final settlement occurs, the
buyer has effectively received from the seller the entire $1,000 (= 100% x $1,000)
less the original 30% ($30) or $700 net through the MTM process.
Position Accountability – USFE Rule 414, Position Accountability, provides that
“the Exchange may establish a Position Accountability level for any Contract.
Any Person, including a Member, who owns or controls Contracts in excess of the
applicable Position Accountability level shall provide to the Exchange at its
request any information regarding the nature of the position, trading, strategy, or
hedging activities, if applicable, and if ordered by the Exchange, shall not
increase the size of such position. ”
USFE intends to set appropriate position accountability levels for its individual
Event Futures pursuant to Commission guidance and its own research and
experience.
Reporting Level – The reporting level for Event Futures shall be established at
a level equal to levels specified in Commission Regulation §15.03.
Trading Prohibition – The rules prohibit directors and employees of the
respective companies identified in the Contracts, i.e., CBOT, CME and ICE from
trading, directly or indirectly, any of the Contracts. USFE will enforce this rule
through its surveillance arrangement with the National Futures Association
(“NFA”) and the reporting requirements associated with the Contracts. Every
trader that carries a position over 25 contracts would be required to report such
position to the Exchange and the CFTC under their Large Trading Reporting
Rules. Such information will include the ultimate or beneficial owner of the large
position. NFA staff will then be able to cross-reference the large trader accounts
with the directors and employees of the respective companies to determine
compliance with the trading prohibition rule.
Block Trades – The Exchange shall permit block trading to be conducted in Event
Futures with a 250 contract minimum.
Event Futures are Commodities
Section 1a(4) of the Act defines “commodity” as “Wheat, cotton, rice. . . and all
other goods and articles, except onions. . . , and all services, rights and interests in
which contracts for future delivery are presently or in the future dealt in .”
Section 1a(13) defines “excluded commodity,” in pertinent part as:
(iv) an occurrence, extent of an occurrence, or contingency (other than a
change in the price, rate, value or level of a commodity not described in
clause (i)) that is—
(I) beyond the control of the parties to the relevant contract,
agreement, or transaction; and
(II) associated with a financial, commercial, or economic
consequence.
The occurrences or contingencies underlying the initial USFE Event Futures
contracts are: 1) whether the Chicago Board of Trade will conclude a merger with
the Chicago Mercantile Exchange and 2) whether the Chicago Board of Trade
will conclude a merger with the InterContinental Exchange. The verification of
these events are beyond the control of those who might enter into such contracts
on USFE.
Moreover, the events are associated with a financial, commercial or economic
consequence. Consummation of the CBOT/CME merger or the CBOT/ICE
merger has a myriad of potential financial, commercial or economic effects.
Many persons may wish to make use of USFE’s contracts as a means of hedging
these financial, economic and commercial risks. For example, consummation of a
merger between the CBOT and CME may have significant economic
consequences for commercial interests in Chicago. By way of further example, a
service vendor, such as a technology provider, may wish to use USFE’s contract
to hedge against a loss of business that it might expect to experience as a result of
one or the other combination of exchanges. Thus, there can be no question that
USFE’s Event Futures on their face meet the statutory description of
“commodity” as being an occurrence beyond the control of the parties to the
relevant contract and that is associated with an economic consequence.
The Commission has heretofore determined certain events to be commodities that
can be traded under the terms of the Commodity Exchange Act. For example,
contracts on the occurrence of certain physical events, such as the occurrence of
certain weather conditions have been traded on exempt boards of trade.
Moreover, the Commission has recently approved for trading by the Chicago
Mercantile Exchange a binary futures contract on the possible occurrence of a
bankruptcy filings by a named company. Like the CME contract, the USFE
contract has a fixed pay-out if the reference entity experiences the event which
underlies the contract. In the case of the USFE contract, rather than the event
being a filing for bankruptcy by the reference entity, it is the consummation of a
merger of the reference entity.
Although the initial USFE contracts relate to a possible merger of the reference
entity, USFE’s Event Futures are not limited to possible mergers by reference
entities. The events that USFE may list for trading may encompass any
occurrence which is associated with a financial, economic or commercial
consequence. However, USFE will not list for trading any contract in which the
event is predicated on the price level or value of an equity or debt security of a
company.
Please let us know if you have any comments or questions on the USFE Event
Futures contracts – or anything related to our business. You can either reach me
at 312-544-1074, Jim Falvey at 312-544-1067 or Matt Lisle at 312-544-1076.
Best regards,
Satish S. Nandapurkar
Chief Executive Officer