CFTC Staff Letter 05-08: No-Action Relief for TAIFEX Futures on TE and TF Indices

U.S. COMMODITY FUTURES TRADING COMMISSION
Three Lafayette Centre
1155 21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5120
Facsimile: (202) 418-5524
Office of General Counsel

CFTC letter No. 05-08
May 16, 2005
No-Action
Office of General Counsel
Michael S. Sackheim, Esq.
Sidley Austin Brown & Wood, LLP
787 Seventh Avenue
New York, NY 10019
Re: Requests for No-Action Relief in Connection with the Offer and Sale in the United States of Futures Contracts Based on the Taiwan Stock Exchange Electronic Sector Index and the Taiwan Stock Exchange Finance Sector Index Traded on the Taiwan Futures Exchange Dear Mr. Sackheim:
This is in response to letters, attachments, facsimiles and electronic mail dated from January 3, 2005 to March 4, 2005, requesting on behalf of your client, the Taiwan Futures Exchange (“TAIFEX”), that the Office of General Counsel (“Office”) of the Commodity Futures Trading Commission (“Commission” or "CFTC") issue a “no-action” letter concerning the offer and sale in the United States (“US”) of TAIFEX’s futures contracts based on, respectively, the Taiwan Stock Exchange Electronic Sector Index (“TE”) and the Taiwan Stock Exchange Finance Sector Index (“TF”) (collectively, “Indices”). We understand the facts to be as follows. TAIFEX is a futures exchange in Taiwan founded in 1997 pursuant to the joint efforts of the Taiwanese government and the private sector.1 Originally named the Taiwan International Mercantile Exchange, the exchange’s name was changed to TAIFEX in 1999. TAIFEX was granted a corporate license, and its Board of Directors was selected as the highest executive body of the exchange. The principal regulatory authority in Taiwan having oversight over TAIFEX 1 See letter from Michael S. Sackheim, Sidley Austin Brown & Wood, LLP, to Patrick J. McCarty, General Counsel, CFTC, dated January 3, 2005, at 2 and letter from Michael S. Sackheim, Sidley Austin Brown & Wood, LLP, to Patrick J. McCarty, General Counsel, CFTC, dated January 12, 2005, at 2. Commission staff recently issued no￾action relief to TAIFEX with regard to its futures contracts on the Taiwan Stock Exchange Capitalization Weighted Stock Index. See CFTC Staff Letter No. 04-16 [2003-2004 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 29,781 (June 2, 2004).

was the Taiwan Securities and Futures Commission (“SFC”). To achieve the goal of consolidating financial supervision, on June 30, 2004, the Taiwan Legislative Yuan enacted the “Organic Act of the Financial Supervisory Commission, Executive Yuan,” creating the new department of “Financial Supervisory Commission, Executive Yuan” (“FSC”). As a result, the SFC became subordinate to the FSC effective on July 1, 2004, and the SFC changed its name to “Securities and Futures Bureau, Financial Supervisory Commission” (“SFB”). The SFB has broad supervisory responsibility for all aspects of securities and futures trading in Taiwan, including inspection, supervision, surveillance and enforcement. The Futures Trading Law of 1997 (“FTL”), enforced by the SFB, is the principal statute under which TAIFEX operates.2 The TE and TF are broad-based, market capitalization-weighted indices maintained by the Taiwan Stock Exchange Corporation (“TSEC”).3 The TE covers all electronics related stocks listed on the TSEC, and the TF covers all finance related TSEC listed stocks.4 Both Indices exclude preferred stocks, full-delivery stocks5 and newly listed stocks that are listed for less than one calendar month.6 Based on data supplied by TAIFEX, the total adjusted market capitalizations of the TE and TF were approximately US$ 195.56 billion and US$ 85.55 billion, respectively, as of November 30, 2004.7 Also as of that date, stocks of 289 companies were components of the TE

2 Id.
3 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 5 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 4. 4 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 5 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 5. Unlike trading of regular common stocks in which transactions are settled or closed on the first business day immediately after the transaction day and in which stocks bought and sold, and consideration thereof, on the same day, can be offset against each other, “full delivery” stocks as declared by TSEC can only be traded by “full payment” in advance and no offset is permitted during the intra-day transactions. Margin trades are not permitted for the transaction of “full delivery” shares. The main purpose of this measure is to restrict the liquidity of the stocks of financially troubled companies, and thus these “full delivery” shares are excluded from computation of the Indices. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 5-6 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 5. 6 Id. 7 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 9 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 9.

and 43 companies were components of the TF.8
The largest single security by weight represented 17.53% of the TE and 18.77% of the TF.9 The five most heavily weighted securities represented 43.13% and 51.40% of the TE and TF, respectively.10 The securities comprising the lowest 25% of the respective Indices had six-month aggregate dollar values of average daily trading volume in excess of US$ 30 million:
approximately US$ 421.9 million for the TE and US$ 125.1 million for the TF for the 6- month period ending November 2004.11 The Indices are calculated in real time and are disseminated by electronic means through major data vendors, such as Bloomberg and Reuters.12 TAIFEX’s TE futures contract and TF futures contract both commenced trading on July 21, 1999.13 Both contracts provide for cash settlement. Prices are quoted in Index points with each Index point equal to NT$ 4,000 for the TE futures contract and NT$ 1,000 for the TF futures contract.14 The minimum price fluctuation is 0.05 Index point per TE contract and 0.2 Index point per TF contract. The remaining terms and conditions of the TE and TF contracts are identical. The contracts are listed for trading from 8:45 AM to 1:45 PM Taiwan time Monday through Friday. TAIFEX lists for trading the spot month, the next calendar month, and the next three quarter months. The last trading day is the third Wednesday of the delivery month. Cash settlement occurs on the first business day after the last trading day. The final cash settlement price for the contracts is calculated based on the first fifteen minute volume-weighted average of each component stock’s prices on the final settlement day.15

8 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 5 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 5. 9 See electronic mail from Mr. Sackheim dated March 1, 2005, Exhibit C, and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, Exhibit C. 10 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 17 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 16. 11 Id. 12 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 9-10 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 9. 13 See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 3-4 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 3-4. 14 “NT$” is a symbol for New Taiwan Dollars, the Taiwanese currency. 15 For those component stocks that are not traded during the beginning fifteen minute interval on the final settlement day, their last closing prices would be applied. Id.

The Commodity Exchange Act (“CEA”),16 as amended by the Commodity Futures Modernization Act of 2000 (“CFMA”),17 provides that the offer or sale in the United States of futures contracts based on a group or index of securities, including those contracts traded on or subject to the rules of a foreign board of trade, is subject to the Commission's exclusive jurisdiction,18 with the exception of security futures products,19 over which the Commission shares jurisdiction with the Securities and Exchange Commission (“SEC”).20 Thus, the Commission’s jurisdiction remains exclusive with regard to futures contracts on a group or index of securities that are broad-based pursuant to CEA Section 1a(25).21 CEA Section 2(a)(1)(C)(iv) generally prohibits any person from offering or selling a futures contract based on a security index in the United States, except as permitted under CEA Section 2(a)(1)(C)(ii) or CEA Section 2(a)(1)(D).22 By its terms, CEA
Section 2(a)(1)(C)(iv) applies to futures contracts on security indices traded on both
domestic and foreign boards of trade. CEA Section 2(a)(1)(C)(ii) sets forth three criteria to govern the trading of futures contracts on a group or index of securities on designated contract markets and registered derivatives transaction execution facilities (“DTFs”):
(1) the contract must provide for cash settlement; (2) the contract must not be readily susceptible to manipulation nor to being used to manipulate any underlying security; and

16 7 U.S.C. § 1 et seq.
17 Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).
18 See CEA Section 2(a)(1)(C)(ii).
19 Security futures products are defined as a security future or any put, call, straddle, option, or privilege on any security future. See CEA Section 1a(32). A security future is defined as a contract of sale for future delivery of a single security or of a narrow-based security index, including any interest therein or based on the value thereof, with certain exceptions. See CEA Section 1a(31). 20 See CEA Section 2(a)(1)(D). 21 See CEA Section 2(a)(1)(C)(ii). 22 CEA Section 2(a)(1)(D) governs the offer and sale of security futures products.

(3) the group or index of securities must not constitute a narrow-based security index.23 While Section 2(a)(1)(C)(ii) provides that no board of trade or DTF may trade a security index futures contract unless it meets the three criteria noted above, it does not explicitly address the standards to be applied to a foreign security index futures contract traded on a foreign board of trade. This Office has applied those same three criteria in evaluating requests by foreign boards of trade to allow the offer and sale within the United States of their foreign security index futures contracts when those foreign boards of trade do not seek designation as a contract market or registration as a DTF to trade those products.24 Accordingly, this Office has examined the TE and TF and TAIFEX’s respective futures contracts based thereon to determine whether the Indices and the futures contracts meet the requirements enumerated in CEA Section 2(a)(1)(C)(ii). Based on the information noted herein and as set forth in the letters, attachments, facsimiles and electronic mail noted above, we have determined that the TE and TF, and TAIFEX’s respective futures contracts based thereon, conform to these requirements.25

23 The first two criteria under CEA Section 2(a)(1)(C)(ii) were unchanged by the CFMA. With regard to the third criterion, an index is a “narrow-based security index” under both the CEA and the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. § 78a et seq., if it has any one of the following four characteristics: (1) it has nine or fewer component securities; (2) any one of its component securities comprises more than 30% of its weighting; (3) the five highest weighted component securities in the aggregate comprise more than 60% of the index’s weighting; or (4) the lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting, have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million). See CEA
Section 1a(25)(A)(i)-(iv); Exchange Act Section 3(a)(55)(B)(i)-(iv). Thus, an index that
does not have any of these elements is not a narrow-based security index for purposes of CEA Section 2(a)(1)(C)(ii). See also CEA Section 1a(25)(B); Exchange Act Section 3(a)(55)(C). 24 With regard to the third criterion, the CFTC and SEC jointly promulgated Rule 41.13 under the CEA and Rule 3a55-3 under the Exchange Act, governing security index futures contracts traded on foreign boards of trade. These rules provide that “[w]hen a contract of sale for future delivery on a security index is traded on or subject to the rules of a foreign board of trade, such index shall not be a narrow-based security index if it would not be a narrow-based security index if a futures contract on such index were traded on a designated contract market or registered derivatives transaction execution facility.” CFTC Rule 41.13, 17 C.F.R. § 41.13; Exchange Act Rule 3a55-3, 17 C.F.R. § 240.3a55-3. 25 In making this determination, the Commission staff has concluded that neither the TE nor the TF have any of the elements of a narrow-based security index as enumerated in

In determining whether a foreign futures contract based on a foreign security index is not readily susceptible to manipulation or being used to manipulate any underlying security, one preliminary consideration is the requesting exchange’s ability to access information regarding the securities underlying the index. All of the stocks underlying the TE and TF are traded on the TSEC.26 On June 30, 2000, TAIFEX entered into a joint surveillance and information sharing agreement with the TSEC, as well as the GreTai Securities Market (the Taiwan over-the-counter market) and the Taiwan Securities Central Depository Co., Ltd., for the exchange of market and surveillance information.27 Thus, TAIFEX should have access to information necessary to detect and deter manipulation.28 In the event that TAIFEX is unable to obtain access

CEA Section 1a(25)(A), and accordingly the Indices would not be narrow-based security indices if traded on a designated contract market or DTF. 26 TAIFEX represents that the TSEC has access to all material information necessary to conduct proper surveillance of securities traded on the TSEC. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 13 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 12. 27 Pursuant to this agreement, all parties are required to share with each other information regarding (i) domestic and foreign material political and economic extraordinary events, (ii) major trading defaults, and (iii) failures or interruptions of trading systems. TSEC is required to provide the other contracting parties information regarding (i) financial crises or material fraud of securities firms, (ii) material delay in settlement by securities firms, (iii) material illegal trading by securities firms or investors or the initiation of material litigation concerning securities firms, and (iv) listed company involvement in financial crises or material fraud. TAIFEX is required to provide the other contracting parties information regarding (i) financial crisis or material fraud by futures commission merchants (“FCMs”), introducing brokers (“IBs”), or its clearing members, (ii) open positions that reach certain threshold amounts, (iii) clearing members’ material default in making the applicable margin payments and (iv) material illegal trading by FCMs, IBs, and clearing members or investors, or the initiation of material litigation concerning FCMs, IBs and clearing members. In addition, all parties to the agreement have agreed to notify each other of other matters deemed as potential threats to the structural security of cross-market operations, and to share additional information with each other pursuant to written requests. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 13-14 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 13. 28 TAIFEX represents that it has access to all material information necessary to conduct proper surveillance of futures contracts traded on TAIFEX. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 13 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 12.

to adequate surveillance data in this regard, or is unable to share such data with the CFTC, this Office reserves the right to reconsider the position we have taken herein.29 In light of the foregoing, this Office will not recommend any enforcement action to the Commission based on Sections 2(a)(1)(C)(iv), 4(a), or 12(e) of the CEA, as amended, if TAIFEX’s futures contracts based on, respectively, the TE and TF are offered or sold in the US. Because this position is based upon facts and representations contained in the letters, attachments, facsimiles and electronic mail cited above, it should be noted that any different, omitted or changed facts or conditions might require a different conclusion. This position also is contingent on the continued compliance by TAIFEX with all regulatory requirements imposed by the SFB, and the applicable laws and regulations of Taiwan. In addition, this position may be affected by any rules that the Commission may adopt regarding futures contracts based on non￾narrow-based security indices. The offer and sale in the US of TAIFEX’s futures contracts on the TE and TF is, of course, subject to Part 30 of the Commission’s regulations, which governs the offer and sale of foreign futures and foreign option contracts in the US.30

29 In this regard, TAIFEX represents that there are no blocking statutes in Taiwan that could impact the ability of the CFTC or other US government agencies from obtaining information concerning the trading of TAIFEX’s futures contracts. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 15 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 14. Moreover, TAIFEX has agreed to cooperate with any CFTC requests for information regarding its futures contracts on the TE and TF. See letter from Mr. Sackheim to Mr. McCarty, dated January 3, 2005, at 13 and letter from Mr. Sackheim to Mr. McCarty, dated January 12, 2005, at 12. TAIFEX also is a signatory to the International Information Sharing Memorandum of Understanding and Agreement signed on March 15, 1996, at Boca Raton, Florida. On January 11, 1993, a Memorandum of Understanding between the American Institute in Taiwan and the Coordination Council for North American Affairs on the Exchange of Information Concerning Commodity Futures and Options Matters (“MOU”), was entered into by The American Institute in Taiwan, on behalf of the CFTC, and the Coordination Council for North American Affairs, now the Taipei Economic and Cultural Representative Office in the US, on behalf of Taiwan’s regulator, now the SFB. The MOU established arrangements to exchange supervisory, surveillance, and investigatory information between the regulatory authorities in Taiwan and the US in securing compliance with laws, rules and regulations regarding futures matters. In connection with TAIFEX’s requests for no-action relief, the SFB has represented that the SFB is willing and able to exchange information with the CFTC pursuant to the MOU. See letter from Sherry Wang, Director, Division of Futures and Options Markets, SFB, to David R. Merrill, Deputy General Counsel, CFTC, dated March 4, 2005. The SFB, through its predecessor, the SFC, also is a signatory to the Declaration on Cooperation and Supervision of International Futures Markets and Clearing Organizations, as amended, signed on March 15, 1996, at Boca Raton, Florida.

Sincerely,
Patrick J. McCarty
General Counsel
30 See 17 C.F.R. Part 30.