[Federal Register Volume 67, Number 201 (Thursday, October 17, 2002)]
[Notices]
[Pages 64151-64162]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-26366]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46612; File No. SR-NASD-2002-128]


Self-Regulatory Organizations; Notice of Filing and Summary 
Effectiveness of Proposed Rule Change by the National Association of 
Securities Dealers, Inc. Relating to the Security Futures Risk 
Disclosure Statement

October 7, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on September 25, 2002, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by NASD. The Commission 
is publishing this notice to solicit comments on the proposed rule 
change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is filing with the Commission the security futures risk 
disclosure statement. The text of the proposed rule change appears 
below. All text is new.
* * * * *

Risk Disclosure Statement for Security Futures Contracts

    This disclosure statement discusses the characteristics and risks 
of standardized security futures contracts traded on regulated U.S. 
exchanges. At present, regulated exchanges are authorized to list 
futures contracts on individual equity securities registered under the 
Securities Exchange Act of 1934 (including common stock and certain 
exchange-traded funds and American Depositary Receipts), as well as 
narrow-based security indices. Futures on other types of securities and 
options on security futures contracts may be authorized in the future. 
The glossary of terms appears at the end of the document.
    Customers should be aware that the examples in this document are 
exclusive of fees and commissions that may decrease their net gains or 
increase their net losses. The examples also do not include tax 
consequences, which may differ for each customer.

Section 1--Risks of Security Futures

1.1. Risks of Security Futures Transactions
    Trading security futures contracts may not be suitable for all 
investors. You may lose a substantial amount of money in a very short 
period of time. The amount you may lose is potentially unlimited and 
can exceed the amount you originally deposit with your broker. This is 
because futures trading is highly leveraged, with a relatively small 
amount of money used to establish a position in assets having a much 
greater value. If you are uncomfortable with

[[Page 64152]]

this level of risk, you should not trade security futures contracts.
1.2. General Risks
    [sbull] Trading security futures contracts involves risk and may 
result in potentially unlimited losses that are greater than the amount 
you deposited with your broker. As with any high risk financial 
product, you should not risk any funds that you cannot afford to lose, 
such as your retirement savings, medical and other emergency funds, 
funds set aside for purposes such as education or home ownership, 
proceeds from student loans or mortgages, or funds required to meet 
your living expenses.
    [sbull] Be cautious of claims that you can make large profits from 
trading security futures contracts. Although the high degree of 
leverage in security futures contracts can result in large and 
immediate gains, it can also result in large and immediate losses. As 
with any financial product, there is no such thing as a ``sure 
winner.''
    [sbull] Because of the leverage involved and the nature of security 
futures contract transactions, you may feel the effects of your losses 
immediately. Gains and losses in security futures contracts are 
credited or debited to your account, at a minimum, on a daily basis. If 
movements in the markets for security futures contracts or the 
underlying security decrease the value of your positions in security 
futures contracts, you may be required to have or make additional funds 
available to your carrying firm as margin. If your account is under the 
minimum margin requirements set by the exchange or the brokerage firm, 
your position may be liquidated at a loss, and you will be liable for 
the deficit, if any, in your account. Margin requirements are addressed 
in section 4.
    [sbull] Under certain market conditions, it may be difficult or 
impossible to liquidate a position. Generally, you must enter into an 
offsetting transaction in order to liquidate a position in a security 
futures contract. If you cannot liquidate your position in security 
futures contracts, you may not be able to realize a gain in the value 
of your position or prevent losses from mounting. This inability to 
liquidate could occur, for example, if trading is halted due to unusual 
trading activity in either the security futures contract or the 
underlying security; if trading is halted due to recent news events 
involving the issuer of the underlying security; if systems failures 
occur on an exchange or at the firm carrying your position; or if the 
position is on an illiquid market. Even if you can liquidate your 
position, you may be forced to do so at a price that involves a large 
loss.
    [sbull] Under certain market conditions, it may also be difficult 
or impossible to manage your risk from open security futures positions 
by entering into an equivalent but opposite position in another 
contract month, on another market, or in the underlying security. This 
inability to take positions to limit your risk could occur, for 
example, if trading is halted across markets due to unusual trading 
activity in the security futures contract or the underlying security or 
due to recent news events involving the issuer of the underlying 
security.
    [sbull] Under certain market conditions, the prices of security 
futures contracts may not maintain their customary or anticipated 
relationships to the prices of the underlying security or index. These 
pricing disparities could occur, for example, when the market for the 
security futures contract is illiquid, when the primary market for the 
underlying security is closed, or when the reporting of transactions in 
the underlying security has been delayed. For index products, it could 
also occur when trading is delayed or halted in some or all of the 
securities that make up the index.
    [sbull] You may be required to settle certain security futures 
contracts with physical delivery of the underlying security. If you 
hold your position in a physically settled security futures contract 
until the end of the last trading day prior to expiration, you will be 
obligated to make or take delivery of the underlying securities, which 
could involve additional costs. The actual settlement terms may vary 
from contract to contract and exchange to exchange. You should 
carefully review the settlement and delivery conditions before entering 
into a security futures contract. Settlement and delivery are discussed 
in section 5.
    [sbull] You may experience losses due to systems failures. As with 
any financial transaction, you may experience losses if your orders for 
security futures contracts cannot be executed normally due to systems 
failures on a regulated exchange or at the brokerage firm carrying your 
position. Your losses may be greater if the brokerage firm carrying 
your position does not have adequate back-up systems or procedures.
    [sbull] All security futures contracts involve risk, and there is 
no trading strategy that can eliminate it. Strategies using 
combinations of positions, such as spreads, may be as risky as outright 
long or short positions. Trading in security futures contracts requires 
knowledge of both the securities and the futures markets.
    [sbull] Day trading strategies involving security futures contracts 
and other products pose special risks. As with any financial product, 
persons who seek to purchase and sell the same security future in the 
course of a day to profit from intra-day price movements (``day 
traders'') face a number of special risks, including substantial 
commissions, exposure to leverage, and competition with professional 
traders. You should thoroughly understand these risks and have 
appropriate experience before engaging in day trading. The special 
risks for day traders are discussed more fully in section 7.
    [sbull] Placing contingent orders, if permitted, such as ``stop-
loss'' or ``stop-limit'' orders, will not necessarily limit your losses 
to the intended amount. Some regulated exchanges may permit you to 
enter into stop-loss or stop-limit orders for security futures 
contracts, which are intended to limit your exposure to losses due to 
market fluctuations. However, market conditions may make it impossible 
to execute the order or to get the stop price.
    [sbull] You should thoroughly read and understand the customer 
account agreement with your brokerage firm before entering into any 
transactions in security futures contracts.
    [sbull] You should thoroughly understand the regulatory protections 
available to your funds and positions in the event of the failure of 
your brokerage firm. The regulatory protections available to your funds 
and positions in the event of the failure of your brokerage firm may 
vary depending on, among other factors, the contract you are trading 
and whether you are trading through a securities account or a futures 
account. Firms that allow customers to trade security futures in either 
securities accounts or futures accounts, or both, are required to 
disclose to customers the differences in regulatory protections between 
such accounts, and, where appropriate, how customers may elect to trade 
in either type of account.

Section 2--Description of a Security Futures Contract

2.1. What Is a Security Futures Contract?
    A security futures contract is a legally binding agreement between 
two parties to purchase or sell in the future a specific quantity of 
shares of a security or of the component securities of a narrow-based 
security index, at a certain price. A person who buys a security 
futures contract enters into a contract to

[[Page 64153]]

purchase an underlying security and is said to be ``long'' the 
contract. A person who sells a security futures contract enters into a 
contract to sell the underlying security and is said to be ``short'' 
the contract. The price at which the contract trades (the ``contract 
price'') is determined by relative buying and selling interest on a 
regulated exchange.
    In order to enter into a security futures contract, you must 
deposit funds with your brokerage firm equal to a specified percentage 
(usually at least 20 percent) of the current market value of the 
contract as a performance bond. Moreover, all security futures 
contracts are marked-to-market at least daily, usually after the close 
of trading, as described in section 3 of this document. At that time, 
the account of each buyer and seller reflects the amount of any gain or 
loss on the security futures contract based on the contract price 
established at the end of the day for settlement purposes (the ``daily 
settlement price'').
    An open position, either a long or short position, is closed or 
liquidated by entering into an offsetting transaction (i.e., an equal 
and opposite transaction to the one that opened the position) prior to 
the contract expiration. Traditionally, most futures contracts are 
liquidated prior to expiration through an offsetting transaction and, 
thus, holders do not incur a settlement obligation.
    Examples:

Investor A is long one September XYZ Corp. futures contract. To 
liquidate the long position in the September XYZ Corp. futures 
contract, Investor A would sell an identical September XYZ Corp. 
contract.
Investor B is short one December XYZ Corp. futures contract. To 
liquidate the short position in the December XYZ Corp. futures 
contract, Investor B would buy an identical December XYZ Corp. 
contract.

    Security futures contracts that are not liquidated prior to 
expiration must be settled in accordance with the terms of the 
contract. Some security futures contracts are settled by physical 
delivery of the underlying security. At the expiration of a security 
futures contract that is settled through physical delivery, a person 
who is long the contract must pay the final settlement price set by the 
regulated exchange or the clearing organization and take delivery of 
the underlying shares. Conversely, a person who is short the contract 
must make delivery of the underlying shares in exchange for the final 
settlement price.
    Other security futures contracts are settled through cash 
settlement. In this case, the underlying security is not delivered. 
Instead, any positions in such security futures contracts that are open 
at the end of the last trading day are settled through a final cash 
payment based on a final settlement price determined by the exchange or 
clearing organization. Once this payment is made, neither party has any 
further obligations on the contract.
    Physical delivery and cash settlement are discussed more fully in 
section 5.
2.2. Purposes of Security Futures
    Security futures contracts can be used for speculation, hedging, 
and risk management. Security futures contracts do not provide capital 
growth or income.

Speculation

    Speculators are individuals or firms who seek to profit from 
anticipated increases or decreases in futures prices. A speculator who 
expects the price of the underlying instrument to increase will buy the 
security futures contract. A speculator who expects the price of the 
underlying instrument to decrease will sell the security futures 
contract. Speculation involves substantial risk and can lead to large 
losses as well as profits.
    The most common trading strategies involving security futures 
contracts are buying with the hope of profiting from an anticipated 
price increase and selling with the hope of profiting from an 
anticipated price decrease. For example, a person who expects the price 
of XYZ stock to increase by March can buy a March XYZ security futures 
contract, and a person who expects the price of XYZ stock to decrease 
by March can sell a March XYZ security futures contract. The following 
illustrates potential profits and losses if Customer A purchases the 
security futures contract at $50 a share and Customer B sells the same 
contract at $50 a share (assuming 100 shares per contract).

------------------------------------------------------------------------
                                            Customer A      Customer B
      Price of XYZ at  liquidation          profit/loss     profit/loss
------------------------------------------------------------------------
$55.....................................            $500           -$500
$50.....................................               0               0
$45.....................................            -500             500
------------------------------------------------------------------------

    Speculators may also enter into spreads with the hope of profiting 
from an expected change in price relationships. Spreaders may purchase 
a contract expiring in one contract month and sell another contract on 
the same underlying security expiring in a different month (e.g., buy 
June and sell September XYZ single stock futures). This is commonly 
referred to as a ``calendar spread.''
    Spreaders may also purchase and sell the same contract month in two 
different but economically correlated security futures contracts. For 
example, if ABC and XYZ are both pharmaceutical companies and an 
individual believes that ABC will have stronger growth than XYZ between 
now and June, he could buy June ABC futures contracts and sell June XYZ 
futures contracts. Assuming that each contract is 100 shares, the 
following illustrates how this works.

----------------------------------------------------------------------------------------------------------------
                                                     Price at                        Price at
                Opening position                    liquidation    Gain or loss     liquidation    Gain or loss
----------------------------------------------------------------------------------------------------------------
Buy ABC at 50...................................             $53            $300             $53            $300
Sell XYZ at 45..................................              46            -100              50            -500
                                                                 ----------------                ---------------
    Net Gain or Loss............................  ..............             200  ..............            -200
----------------------------------------------------------------------------------------------------------------

    Speculators can also engage in arbitrage, which is similar to a 
spread except that the long and short positions occur on two different 
markets. An arbitrage position can be established by taking an 
economically opposite position in a security futures contract on 
another exchange, in an options contract, or in the underlying 
security.

Hedging

    Generally speaking, hedging involves the purchase or sale of a 
security future to reduce or offset the risk of a position in the 
underlying security or group of securities (or a close economic 
equivalent). A hedger gives up the potential to profit from a favorable 
price change in the position being hedged in order to minimize the risk 
of loss from an adverse price change.

[[Page 64154]]

    An investor who wants to lock in a price now for an anticipated 
sale of the underlying security at a later date can do so by hedging 
with security futures. For example, assume an investor owns 1,000 
shares of ABC that have appreciated since he bought them. The investor 
would like to sell them at the current price of $50 per share, but 
there are tax or other reasons for holding them until September. The 
investor could sell ten 100-share ABC futures contracts and then buy 
back those contracts in September when he sells the stock. Assuming the 
stock price and the futures price change by the same amount, the gain 
or loss in the stock will be offset by the loss or gain in the futures 
contracts.

----------------------------------------------------------------------------------------------------------------
                                                             Value of 1,000    Gain or loss on      Effective
                    Price in September                        shares of ABC        futures        selling price
----------------------------------------------------------------------------------------------------------------
$40.......................................................           $40,000           $10,000           $50,000
$50.......................................................            50,000                 0            50,000
$60.......................................................            60,000           -10,000            50,000
----------------------------------------------------------------------------------------------------------------

    Hedging can also be used to lock in a price now for an anticipated 
purchase of the stock at a later date. For example, assume that in May 
a mutual fund expects to buy stocks in a particular industry with the 
proceeds of bonds that will mature in August. The mutual fund can hedge 
its risk that the stocks will increase in value between May and August 
by purchasing security futures contracts on a narrow-based index of 
stocks from that industry. When the mutual fund buys the stocks in 
August, it also will liquidate the security futures position in the 
index. If the relationship between the security futures contract and 
the stocks in the index is constant, the profit or loss from the 
futures contract will offset the price change in the stocks, and the 
mutual fund will have locked in the price that the stocks were selling 
at in May.
    Although hedging mitigates risk, it does not eliminate all risk. 
For example, the relationship between the price of the security futures 
contract and the price of the underlying security traditionally tends 
to remain constant over time, but it can and does vary somewhat. 
Furthermore, the expiration or liquidation of the security futures 
contract may not coincide with the exact time the hedger buys or sells 
the underlying stock. Therefore, hedging may not be a perfect 
protection against price risk.

Risk Management

    Some institutions also use futures contracts to manage portfolio 
risks without necessarily intending to change the composition of their 
portfolio by buying or selling the underlying securities. The 
institution does so by taking a security futures position that is 
opposite to some or all of its position in the underlying securities. 
This strategy involves more risk than a traditional hedge because it is 
not meant to be a substitute for an anticipated purchase or sale.
2.3. Where Security Futures Trade
    By law, security futures contracts must trade on a regulated U.S. 
exchange. Each regulated U.S. exchange that trades security futures 
contracts is subject to joint regulation by the Securities and Exchange 
Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
    A person holding a position in a security futures contract who 
seeks to liquidate the position must do so either on the regulated 
exchange where the original trade took place or on another regulated 
exchange, if any, where a fungible security futures contract trades. (A 
person may also seek to manage the risk in that position by taking an 
opposite position in a comparable contract traded on another regulated 
exchange.)
    Security futures contracts traded on one regulated exchange might 
not be fungible with security futures contracts traded on another 
regulated exchange for a variety of reasons. Security futures traded on 
different regulated exchanges may be non-fungible because they have 
different contract terms (e.g., size, settlement method), or because 
they are cleared through different clearing organizations. Moreover, a 
regulated exchange might not permit its security futures contracts to 
be offset or liquidated by an identical contract traded on another 
regulated exchange, even though they have the same contract terms and 
are cleared through the same clearing organization. You should consult 
your broker about the fungibility of the contract you are considering 
purchasing or selling, including which exchange(s), if any, on which it 
may be offset.
    Regulated exchanges that trade security futures contracts are 
required by law to establish certain listing standards. Changes in the 
underlying security of a security futures contract may, in some cases, 
cause such contract to no longer meet the regulated exchange's listing 
standards. Each regulated exchange will have rules governing the 
continued trading of security futures contracts that no longer meet the 
exchange's listing standards. These rules may, for example, permit only 
liquidating trades in security futures contracts that no longer satisfy 
the listing standards.
2.4. How Security Futures Differ From the Underlying Security
    Shares of common stock represent a fractional ownership interest in 
the issuer of that security. Ownership of securities confers various 
rights that are not present with positions in security futures 
contracts. For example, persons owning a share of common stock may be 
entitled to vote in matters affecting corporate governance. They also 
may be entitled to receive dividends and corporate disclosure, such as 
annual and quarterly reports.
    The purchaser of a security futures contract, by contrast, has only 
a contract for future delivery of the underlying security. The 
purchaser of the security futures contract is not entitled to exercise 
any voting rights over the underlying security and is not entitled to 
any dividends that may be paid by the issuer. Moreover, the purchaser 
of a security futures contract does not receive the corporate 
disclosures that are received by shareholders of the underlying 
security, although such corporate disclosures must be made publicly 
available through the SEC's EDGAR system, which can be accessed at 
www.sec.gov. You should review such disclosures before entering into a 
security futures contract. See section 9 for further discussion of the 
impact of corporate events on a security futures contract.
    All security futures contracts are marked-to-market at least daily, 
usually after the close of trading, as described in section 3 of this 
document. At that time, the account of each buyer and seller is 
credited with the amount of any gain, or debited by the amount of any 
loss, on the security futures contract, based on the contract price 
established at the end

[[Page 64155]]

of the day for settlement purposes (the ``daily settlement price''). By 
contrast, the purchaser or seller of the underlying instrument does not 
have the profit and loss from his or her investment credited or debited 
until the position in that instrument is closed out.
    Naturally, as with any financial product, the value of the security 
futures contract and of the underlying security may fluctuate. However, 
owning the underlying security does not require an investor to settle 
his or her profits and losses daily. By contrast, as a result of the 
mark-to-market requirements discussed above, a person who is long a 
security futures contract often will be required to deposit additional 
funds into his or her account as the price of the security futures 
contract decreases. Similarly, a person who is short a security futures 
contract often will be required to deposit additional funds into his or 
her account as the price of the security futures contract increases.
    Another significant difference is that security futures contracts 
expire on a specific date. Unlike an owner of the underlying security, 
a person cannot hold a long position in a security futures contract for 
an extended period of time in the hope that the price will go up. If 
you do not liquidate your security futures contract, you will be 
required to settle the contract when it expires, either through 
physical delivery or cash settlement. For cash-settled contracts in 
particular, upon expiration, an individual will no longer have an 
economic interest in the securities underlying the security futures 
contract.
2.5. Comparison to Options
    Although security futures contracts share some characteristics with 
options on securities (options contracts), these products are also 
different in a number of ways. Below are some of the important 
distinctions between equity options contracts and security futures 
contracts.
    If you purchase an options contract, you have the right, but not 
the obligation, to buy or sell a security prior to the expiration date. 
If you sell an options contract, you have the obligation to buy or sell 
a security prior to the expiration date. By contrast, if you have a 
position in a security futures contract (either long or short), you 
have both the right and the obligation to buy or sell a security at a 
future date. The only way that you can avoid the obligation incurred by 
the security futures contract is to liquidate the position with an 
offsetting contract.
    A person purchasing an options contract runs the risk of losing the 
purchase price (premium) for the option contract. Because it is a 
wasting asset, the purchaser of an options contract who neither 
liquidates the options contract in the secondary market nor exercises 
it at or prior to expiration will necessarily lose his or her entire 
investment in the options contract. However, a purchaser of an options 
contract cannot lose more than the amount of the premium. Conversely, 
the seller of an options contract receives the premium and assumes the 
risk that he or she will be required to buy or sell the underlying 
security on or prior to the expiration date, in which event his or her 
losses may exceed the amount of the premium received. Although the 
seller of an options contract is required to deposit margin to reflect 
the risk of its obligation, he or she may lose many times his or her 
initial margin deposit.
    By contrast, the purchaser and seller of a security futures 
contract each enter into an agreement to buy or sell a specific 
quantity of shares in the underlying security. Based upon the movement 
in prices of the underlying security, a person who holds a position in 
a security futures contract can gain or lose many times his or her 
initial margin deposit. In this respect, the benefits of a security 
futures contract are similar to the benefits of purchasing an option, 
while the risks of entering into a security futures contract are 
similar to the risks of selling an option.
    Both the purchaser and the seller of a security futures contract 
have daily margin obligations. At least once each day, security futures 
contracts are marked-to-market and the increase or decrease in the 
value of the contract is credited or debited to the buyer and the 
seller. As a result, any person who has an open position in a security 
futures contract may be called upon to meet additional margin 
requirements or may receive a credit of available funds.

    Example:
Assume that Customers A and B each anticipate an increase in the market 
price of XYZ stock, which is currently $50 a share. Customer A 
purchases an XYZ 50 call (covering 100 shares of XYZ at a premium of $5 
per share). The option premium is $500 ($5 per share x 100 shares). 
Customer B purchases an XYZ security futures contract (covering 100 
shares of XYZ). The total value of the contract is $5000 ($50 share 
value x 100 shares). The required margin is $1000 (or 20% of the 
contract value).

------------------------------------------------------------------------
                                                 Customer A   Customer B
          Price of XYZ at expiration            profit/loss  profit/loss
------------------------------------------------------------------------
65............................................        $1000        $1500
60............................................          500         1000
55............................................            0          500
50............................................         -500            0
45............................................         -500         -500
40............................................         -500        -1000
35............................................         -500        -1500
------------------------------------------------------------------------

The most that Customer A can lose is $500, the option premium. Customer 
A breaks even at $55 per share, and makes money at higher prices. 
Customer B may lose more than his initial margin deposit. Unlike the 
options premium, the margin on a futures contract is not a cost but a 
performance bond. The losses for Customer B are not limited by this 
performance bond. Rather, the losses or gains are determined by the 
settlement price of the contract, as provided in the example above. 
Note that if the price of XYZ falls to $35 per share, Customer A loses 
only $500, whereas Customer B loses $1500.
2.6. Components of a Security Futures Contract
    Each regulated exchange can choose the terms of the security 
futures contracts it lists, and those terms may differ from exchange to 
exchange or contract to contract. Some of those contract terms are 
discussed below. However, you should ask your broker for a copy of the 
contract specifications before trading a particular contract.
    2.6.1. Each security futures contract has a set size. The size of a 
security futures contract is determined by the regulated exchange on 
which the contract trades. For example, a security futures contract for 
a single stock may be based on 100 shares of that stock. If prices are 
reported per share, the value of the contract would be the price times 
100. For narrow-based security indices, the value of the contract is 
the price of the component securities times the multiplier set by the 
exchange as part of the contract terms.
    2.6.2. Security futures contracts expire at set times determined by 
the listing exchange. For example, a particular contract may expire on 
a particular day, e.g., the third Friday of the expiration month. Up 
until expiration, you may liquidate an open position by offsetting your 
contract with a fungible opposite contract that expires in the same 
month. If you do not liquidate an open position before it expires, you 
will be required to make or take delivery of the underlying security or 
to settle the contract in cash after expiration.
    2.6.3. Although security futures contracts on a particular security 
or a narrow-based security index may be

[[Page 64156]]

listed and traded on more than one regulated exchange, the contract 
specifications may not be the same. Also, prices for contracts on the 
same security or index may vary on different regulated exchanges 
because of different contract specifications.
    2.6.4. Prices of security futures contracts are usually quoted the 
same way prices are quoted in the underlying instrument. For example, a 
contract for an individual security would be quoted in dollars and 
cents per share. Contracts for indices would be quoted by an index 
number, usually stated to two decimal places.
    2.6.5. Each security futures contract has a minimum price 
fluctuation (called a tick), which may differ from product to product 
or exchange to exchange. For example, if a particular security futures 
contract has a tick size of 1[cent], you can buy the contract at $23.21 
or $23.22 but not at $23.215.
2.7. Trading Halts
    The value of your positions in security futures contracts could be 
affected if trading is halted in either the security futures contract 
or the underlying security. In certain circumstances, regulated 
exchanges are required by law to halt trading in security futures 
contracts. For example, trading on a particular security futures 
contract must be halted if trading is halted on the listed market for 
the underlying security as a result of pending news, regulatory 
concerns, or market volatility. Similarly, trading of a security 
futures contract on a narrow-based security index must be halted under 
such circumstances if trading is halted on securities accounting for at 
least 50 percent of the market capitalization of the index. In 
addition, regulated exchanges are required to halt trading in all 
security futures contracts for a specified period of time when the Dow 
Jones Industrial Average (``DJIA'') experiences one-day declines of 10-
, 20- and 30-percent. The regulated exchanges may also have discretion 
under their rules to halt trading in other circumstances--such as when 
the exchange determines that the halt would be advisable in maintaining 
a fair and orderly market.
    A trading halt, either by a regulated exchange that trades security 
futures or an exchange trading the underlying security or instrument, 
could prevent you from liquidating a position in security futures 
contracts in a timely manner, which could prevent you from liquidating 
a position in security futures contracts at that time.
2.8. Trading Hours
    Each regulated exchange trading a security futures contract may 
open and close for trading at different times than other regulated 
exchanges trading security futures contracts or markets trading the 
underlying security or securities. Trading in security futures 
contracts prior to the opening or after the close of the primary market 
for the underlying security may be less liquid than trading during 
regular market hours.

Section 3--Clearing Organizations and Mark-to-Market Requirements

    Every regulated U.S. exchange that trades security futures 
contracts is required to have a relationship with a clearing 
organization that serves as the guarantor of each security futures 
contract traded on that exchange. A clearing organization performs the 
following functions: matching trades; effecting settlement and 
payments; guaranteeing performance; and facilitating deliveries.
    Throughout each trading day, the clearing organization matches 
trade data submitted by clearing members on behalf of their customers 
or for the clearing member's proprietary accounts. If an account is 
with a brokerage firm that is not a member of the clearing 
organization, then the brokerage firm will carry the security futures 
position with another brokerage firm that is a member of the clearing 
organization. Trade records that do not match, either because of a 
discrepancy in the details or because one side of the transaction is 
missing, are returned to the submitting clearing members for 
resolution. The members are required to resolve such ``out trades'' 
before or on the open of trading the next morning.
    When the required details of a reported transaction have been 
verified, the clearing organization assumes the legal and financial 
obligations of the parties to the transaction. One way to think of the 
role of the clearing organization is that it is the ``buyer to every 
seller and the seller to every buyer.'' The insertion or substitution 
of the clearing organization as the counterparty to every transaction 
enables a customer to liquidate a security futures position without 
regard to what the other party to the original security futures 
contract decides to do.
    The clearing organization also effects the settlement of gains and 
losses from security futures contracts between clearing members. At 
least once each day, clearing member brokerage firms must either pay 
to, or receive from, the clearing organization the difference between 
the current price and the trade price earlier in the day, or for a 
position carried over from the previous day, the difference between the 
current price and the previous day's settlement price. Whether a 
clearing organization effects settlement of gains and losses on a daily 
basis or more frequently will depend on the conventions of the clearing 
organization and market conditions. Because the clearing organization 
assumes the legal and financial obligations for each security futures 
contract, you should expect it to ensure that payments are made 
promptly to protect its obligations.
    Gains and losses in security futures contracts are also reflected 
in each customer's account on at least a daily basis. Each day's gains 
and losses are determined based on a daily settlement price 
disseminated by the regulated exchange trading the security futures 
contract or its clearing organization. If the daily settlement price of 
a particular security futures contract rises, the buyer has a gain and 
the seller a loss. If the daily settlement price declines, the buyer 
has a loss and the seller a gain. This process is known as ``marking-
to-market'' or daily settlement. As a result, individual customers 
normally will be called on to settle daily.
    The one-day gain or loss on a security futures contract is 
determined by calculating the difference between the current day's 
settlement price and the previous day's settlement price.
For example, assume a security futures contract is purchased at a price 
of $120. If the daily settlement price is either $125 (higher) or $117 
(lower), the effects would be as follows:
(1 contract representing 100 shares)

------------------------------------------------------------------------
     Daily settlement value         Buyer's account    Seller's account
------------------------------------------------------------------------
$125............................  $500 gain (credit)  $500 loss (debit)
$117............................  $300 loss (debit).  $300 gain (credit)
------------------------------------------------------------------------


[[Page 64157]]

The cumulative gain or loss on a customer's open security futures 
positions is generally referred to as ``open trade equity'' and is 
listed as a separate component of account equity on your customer 
account statement.
    A discussion of the role of the clearing organization in effecting 
delivery is discussed in section 5.

Section 4--Margin and Leverage

    When a broker-dealer lends a customer part of the funds needed to 
purchase a security such as common stock, the term ``margin'' refers to 
the amount of cash, or down payment, the customer is required to 
deposit. By contrast, a security futures contract is an obligation and 
not an asset. A security futures contract has no value as collateral 
for a loan. Because of the potential for a loss as a result of the 
daily market-to-market process, however, a margin deposit is required 
of each party to a security futures contract. This required margin 
deposit also is referred to as a ``performance bond.''
    In the first instance, margin requirements for security futures 
contracts are set by the exchange on which the contract is traded, 
subject to certain minimums set by law. The basic margin requirement is 
20% of the current value of the security futures contract, although 
some strategies may have lower margin requirements. Requests for 
additional margin are known as ``margin calls.'' Both buyer and seller 
must individually deposit the required margin to their respective 
accounts.
    It is important to understand that individual brokerage firms can, 
and in many cases do, require margin that is higher than the exchange 
requirements. Additionally, margin requirements may vary from brokerage 
firm to brokerage firm. Furthermore, a brokerage firm can increase its 
``house'' margin requirements at any time without providing advance 
notice, and such increases could result in a margin call.
    For example, some firms may require margin to be deposited the 
business day following the day of a deficiency, or some firms may even 
require deposit on the same day. Some firms may require margin to be on 
deposit in the account before they will accept an order for a security 
futures contract. Additionally, brokerage firms may have special 
requirements as to how margin calls are to be met, such as requiring a 
wire transfer from a bank, or deposit of a certified or cashier's 
check. You should thoroughly read and understand the customer agreement 
with your brokerage firm before entering into any transactions in 
security futures contracts.
    If through the daily cash settlement process, losses in the account 
of a security futures contract participant reduce the funds on deposit 
(or equity) below the maintenance margin level (or the firm's higher 
``house'' requirement), the brokerage firm will require that additional 
funds be deposited.
    If additional margin is not deposited in accordance with the firm's 
policies, the firm can liquidate your position in security futures 
contracts or sell assets in any of your accounts at the firm to cover 
the margin deficiency. You remain responsible for any shortfall in the 
account after such liquidations or sales. Unless provided otherwise in 
your customer agreement or by applicable law, you are not entitled to 
choose which futures contracts, other securities or other assets are 
liquidated or sold to meet a margin call or to obtain an extension of 
time to meet a margin call.
    Brokerage firms generally reserve the right to liquidate a 
customer's security futures contract positions or sell customer assets 
to meet a margin call at any time without contacting the customer. 
Brokerage firms may also enter into equivalent but opposite positions 
for your account in order to manage the risk created by a margin call. 
Some customers mistakenly believe that a firm is required to contact 
them for a margin call to be valid, and that the firm is not allowed to 
liquidate securities or other assets in their accounts to meet a margin 
call unless the firm has contacted them first. This is not the case. 
While most firms notify their customers of margin calls and allow some 
time for deposit of additional margin, they are not required to do so. 
Even if a firm has notified a customer of a margin call and set a 
specific due date for a margin deposit, the firm can still take action 
as necessary to protect its financial interests, including the 
immediate liquidation of positions without advance notification to the 
customer.
    Here is an example of the margin requirements for a long security 
futures position.
    A customer buys 3 July EJG security futures at 71.50. Assuming each 
contract represents 100 shares, the nominal value of the position is 
$21,450 (71.50 x 3 contracts x 100 shares). If the initial margin rate 
is 20% of the nominal value, then the customer's initial margin 
requirement would be $4,290. The customer deposits the initial margin, 
bringing the equity in the account to $4,290.
    First, assume that the next day the settlement price of EJG 
security futures falls to 69.25. The marked-to-market loss in the 
customer's equity is $675 (71.50-69.25 x 3 contacts x 100 shares). The 
customer's equity decreases to $3,615 ($4,290-$675). The new nominal 
value of the contract is $20,775 (69.25 x 3 contracts x 100 shares). If 
the maintenance margin rate is 20% of the nominal value, then the 
customer's maintenance margin requirement would be $4,155. Because the 
customer's equity had decreased to $3,615 (see above), the customer 
would be required to have an additional $540 in margin ($4,155--
$3,615).
    Alternatively, assume that the next day the settlement price of EJG 
security futures rises to 75.00. The mark-to-market gain in the 
customer's equity is $1,050 (75.00--71.50 x 3 contacts x 100 shares). 
The customer's equity increases to $5,340 ($4,290 + $1,050). The new 
nominal value of the contract is $22,500 (75.00 x 3 contracts x 100 
shares). If the maintenance margin rate is 20% of the nominal value, 
then the customer's maintenance margin requirement would be $4,500. 
Because the customer's equity had increased to $5,340 (see above), the 
customer's excess equity would be $840.
    The process is exactly the same for a short position, except that 
margin calls are generated as the settlement price rises rather than as 
it falls. This is because the customer's equity decreases as the 
settlement price rises and increases as the settlement price falls.
    Because the margin deposit required to open a security futures 
position is a fraction of the nominal value of the contracts being 
purchased or sold, security futures contracts are said to be highly 
leveraged. The smaller the margin requirement in relation to the 
underlying value of the security futures contract, the greater the 
leverage. Leverage allows exposure to a given quantity of an underlying 
asset for a fraction of the investment needed to purchase that quantity 
outright. In sum, buying (or selling) a security futures contract 
provides the same dollar and cents profit and loss outcomes as owning 
(or shorting) the underlying security. However, as a percentage of the 
margin deposit, the potential immediate exposure to profit or loss is 
much higher with a security futures contract than with the underlying 
security.
    For example, if a security futures contract is established at a 
price of $50, the contract has a nominal value of $5,000 (assuming the 
contract is for 100 shares of stock). The margin requirement may be as 
low as 20%. In

[[Page 64158]]

the example just used, assume the contract price rises from $50 to $52 
(a $200 increase in the nominal value). This represents a $200 profit 
to the buyer of the security futures contract, and a 20% return on the 
$1,000 deposited as margin. The reverse would be true if the contract 
price decreased from $50 to $48. This represents a $200 loss to the 
buyer, or 20% of the $1,000 deposited as margin. Thus, leverage can 
either benefit or harm an investor.
    Note that a 4% decrease in the value of the contract resulted in a 
loss of 20% of the margin deposited. A 20% decrease would wipe out 100% 
of the margin deposited on the security futures contract.

Section 5--Settlement

    If you do not liquidate your position prior to the end of trading 
on the last day before the expiration of the security futures contract, 
you are obligated to either (1) make or accept a cash payment (``cash 
settlement'') or (2) deliver or accept delivery of the underlying 
securities in exchange for final payment of the final settlement price 
(``physical delivery''). The terms of the contract dictate whether it 
is settled through cash settlement or by physical delivery.
    The expiration of a security futures contract is established by the 
exchange on which the contract is listed. On the expiration day, 
security futures contracts cease to exist. Typically, the last trading 
day of a security futures contract will be the third Friday of the 
expiring contract month, and the expiration day will be the following 
Saturday. This follows the expiration conventions for stock options and 
broad-based stock indexes. Please keep in mind that the expiration day 
is set by the listing exchange and may deviate from these norms.
5.1. Cash Settlement
    In the case of cash settlement, no actual securities are delivered 
at the expiration of the security futures contract. Instead, you must 
settle any open positions in security futures by making or receiving a 
cash payment based on the difference between the final settlement price 
and the previous day's settlement price. Under normal circumstances, 
the final settlement price for a cash-settled contract will reflect the 
opening price for the underlying security. Once this payment is made, 
neither the buyer nor the seller of the security futures contract has 
any further obligations on the contract.
5.2. Settlement by Physical Delivery
    Settlement by physical delivery is carried out by clearing brokers 
or their agents with National Securities Clearing Corporation 
(``NSCC''), an SEC-regulated securities clearing agency. Such 
settlements are made in much the same way as they are for purchases and 
sales of the underlying security. Promptly after the last day of 
trading, the regulated exchange's clearing organization will report a 
purchase and sale of the underlying stock at the previous day's 
settlement price (also referred to as the ``invoice price'') to NSCC. 
If NSCC does not reject the transaction by a time specified in its 
rules, settlement is effected pursuant to the rules of NSCC within the 
normal clearance and settlement cycle for securities transactions, 
which currently is three business days.
    If you hold a short position in a physically settled security 
futures contract to expiration, you will be required to make delivery 
of the underlying securities. If you already own the securities, you 
may tender them to your brokerage firm. If you do not own the 
securities, you will be obligated to purchase them. Some brokerage 
firms may not be able to purchase the securities for you. If your 
brokerage firm cannot purchase the underlying securities on your behalf 
to fulfill a settlement obligation, you will have to purchase the 
securities through a different firm.

Section 6--Customer Account Protections

    Positions in security futures contracts may be held either in a 
securities account or in a futures account. Your brokerage firm may or 
may not permit you to choose the types of account in which your 
positions in security futures contracts will be held. The protections 
for funds deposited or earned by customers in connection with trading 
in security futures contracts differ depending on whether the positions 
are carried in a securities account or a futures account. If your 
positions are carried in a securities account, you will not receive the 
protections available for futures accounts. Similarly, if your 
positions are carried in a futures account, you will not receive the 
protections available for securities accounts. You should ask your 
broker which of these protections will apply to your funds.
    You should be aware that the regulatory protections applicable to 
your account are not intended to insure you against losses you may 
incur as a result of a decline or increase in the price of a security 
futures contract. As with all financial products, you are solely 
responsible for any market losses in your account.
    Your brokerage firm must tell you whether your security futures 
positions will be held in a securities account or a futures account. If 
your brokerage firm gives you a choice, it must tell you what you have 
to do to make the choice and which type of account will be used if you 
fail to do so. You should understand that certain regulatory 
protections for your account will depend on whether it is a securities 
account or a futures account.
6.1. Protections for Securities Accounts
    If your positions in security futures contracts are carried in a 
securities account, they are covered by SEC rules governing the 
safeguarding of customer funds and securities. These rules prohibit a 
broker/dealer from using customer funds and securities to finance its 
business. As a result, the broker/dealer is required to set aside funds 
equal to the net of all its excess payables to customers over 
receivables from customers. The rules also require a broker/dealer to 
segregate all customer fully paid and excess margin securities carried 
by the broker/dealer for customers.
    The Securities Investor Protection Corporation (SIPC) also covers 
positions held in securities accounts. SIPC was created in 1970 as a 
non-profit, non-government, membership corporation, funded by member 
broker/dealers. Its primary role is to return funds and securities to 
customers if the broker/dealer holding these assets becomes insolvent. 
SIPC coverage applies to customers of current (and in some cases 
former) SIPC members. Most broker/dealers registered with the SEC are 
SIPC members; those few that are not must disclose this fact to their 
customers. SIPC members must display an official sign showing their 
membership. To check whether a firm is a SIPC member, go to 
www.sipc.org, call the SIPC Membership Department at (202) 371-8300, or 
write to SIPC Membership Department, Securities Investor Protection 
Corporation, 805 Fifteenth Street, NW., Suite 800, Washington, DC 
20005-2215.
    SIPC coverage is limited to $500,000 per customer, including up to 
$100,000 for cash. For example, if a customer has 1,000 shares of XYZ 
stock valued at $200,000 and $10,000 cash in the account, both the 
security and the cash balance would be protected. However, if the 
customer has shares of stock valued at $500,000 and $100,000 in cash, 
only

[[Page 64159]]

a total of $500,000 of those assets will be protected.
    For purposes of SIPC coverage, customers are persons who have 
securities or cash on deposit with a SIPC member for the purpose of, or 
as a result of, securities transactions. SIPC does not protect customer 
funds placed with a broker/dealer just to earn interest. Insiders of 
the broker/dealer, such as its owners, officers, and partners, are not 
customers for purposes of SIPC coverage.
6.2. Protections for Futures Accounts
    If your security futures positions are carried in a futures 
account, they must be segregated from the brokerage firm's own funds 
and cannot be borrowed or otherwise used for the firm's own purposes. 
If the funds are deposited with another entity (e.g., a bank, clearing 
broker, or clearing organization), that entity must acknowledge that 
the funds belong to customers and cannot be used to satisfy the firm's 
debts. Moreover, although a brokerage firm may carry funds belonging to 
different customers in the same bank or clearing account, it may not 
use the funds of one customer to margin or guarantee the transactions 
of another customer. As a result, the brokerage firm must add its own 
funds to its customers' segregated funds to cover customer debits and 
deficits. Brokerage firms must calculate their segregation requirements 
daily.
    You may not be able to recover the full amount of any funds in your 
account if the brokerage firm becomes insolvent and has insufficient 
funds to cover its obligations to all of its customers. However, 
customers with funds in segregation receive priority in bankruptcy 
proceedings. Furthermore, all customers whose funds are required to be 
segregated have the same priority in bankrutpcy, and there is no 
ceiling on the amount of funds that must be segregated for or can be 
recovered by a particular customer.
    Your brokerage firm is also required to separately maintain funds 
invested in security futures contracts traded on a foreign exchange. 
However, these funds may not receive the same protections once they are 
transferred to a foreign entity (e.g., a foreign broker, exchange or 
clearing organization) to satisfy margin requirements for those 
products. You should ask your broker about the bankruptcy protections 
available in the country where the foreign exchange (or other entity 
holding the funds) is located.

Section 7--Special Risks for Day Traders

    Certain traders who pursue a day trading strategy may seek to use 
security futures contracts as part of their trading activity. Whether 
day trading in security futures contracts or other securities, 
investors engaging in a day trading strategy face a number of risks.
    [sbull] Day trading in security futures contracts requires in-depth 
knowledge of the securities and futures markets and of trading 
techniques and strategies. In attempting to profit through day trading, 
you will compete with professional traders who are knowledgeable and 
sophisticated in these markets. You should have appropriate experience 
before engaging in day trading.
    [sbull] Day trading in security futures contracts can result in 
substantial commission charges, even if the per trade cost is low. The 
more trades you make, the higher your total commissions will be. The 
total commissions you pay will add to your losses and reduce your 
profits. For instance, assuming that a round-turn trade costs $16 and 
you execute an average of 29 round-turn transactions per day each 
trading day, you would need to generate an annual profit of $111,360 
just to cover your commission expenses.
    [sbull] Day trading can be extremely risky. Day trading generally 
is not appropriate for someone of limited resources and limited 
investment or trading experience and low risk tolerance. You should be 
prepared to lose all of the funds that you use for day trading. In 
particular, you should not fund day trading activities with funds that 
you cannot afford to lose.

Section 8--Other

8.1. Corporate Events
    As noted in section 2.4, an equity security represents a fractional 
ownership interest in the issuer of that security. By contrast, the 
purchaser of a security futures contract has only a contract for future 
delivery of the underlying security. Treatment of dividends and other 
corporate events affecting the underlying security may be reflected in 
the security futures contract depending on the applicable clearing 
organization rules. Consequently, individuals should consider how 
dividends and other developments affecting security futures in which 
they transact will be handled by the relevant exchange and clearing 
organization. The specific adjustments to the terms of a security 
futures contract are governed by the rules of the applicable clearing 
organization. Below is a discussion of some of the more common types of 
adjustments that you may need to consider.
    Corporate issuers occasionally announce stock splits. As a result 
of these splits, owners of the issuer's common stock may own more 
shares of the stock, or fewer shares in the case of a reverse stock 
split. The treatment of stock splits for persons owning a security 
futures contract may vary according to the terms of the security 
futures contract and the rules of the clearing organization. For 
example, the terms of the contract may provide for an adjustment in the 
number of contracts held by each party with a long or short position in 
a security future, or for an adjustment in the number of shares or 
units of the instrument underlying each contract, or both.
    Corporate issuers also occasionally issue special dividends. A 
special dividend is an announced cash dividend payment outside the 
normal and customary practice of a corporation. The terms of a security 
futures contract may be adjusted for special dividends. The 
adjustments, if any, will be based upon the rules of the exchange and 
clearing organization. In general, there will be no adjustments for 
ordinary dividends as they are recognized as a normal and customary 
practice of an issuer and are already accounted for in the pricing of 
security futures.
    Corporate issuers occasionally may be involved in mergers and 
acquisitions. Such events may cause the underlying security of a 
security futures contact to change over the contract duration. The 
terms of security futures contracts may also be adjusted to reflect 
other corporate events affecting the underlying security.
8.2. Position Limits and Large Trader Reporting
    All security futures contracts trading on regulated exchanges in 
the United States are subject to position limits or position 
accountability limits. Position limits restrict the number of security 
futures contracts that any one person or group of related persons may 
hold or control in a particular security futures contract. In contrast, 
position accountability limits permit the accumulation of positions in 
excess of the limit without a prior exemption. In general, position 
limits and position accountability limits are beyond the thresholds of 
most retail investors. Whether a security futures contract is subject 
to position limits, and the level for such limits, depends upon the 
trading activity and market capitalization of the underlying security 
of the security futures contract.

[[Page 64160]]

    Position limits apply are required for security futures contracts 
that overlie a security that has an average daily trading volume of 20 
million shares or fewer. In the case of a security futures contract 
overlying a security index, position limits are required if any one of 
the securities in the index has an average daily trading volume of 20 
million shares or fewer. Position limits also apply only to an expiring 
security futures contract during its last five trading days. A 
regulated exchange must establish position limits on security futures 
that are no greater than 13,500 (100 share) contracts, unless the 
underlying security meets certain volume and shares outstanding 
thresholds, in which case the limit may be increased to 22,500 (100 
share) contracts.
    For security futures contracts overlying a security or securities 
with an average trading volume of more than 20 million shares, 
regulated exchanges may adopt position accountability rules. Under 
position accountability rules, a trader holding a position in a 
security futures contract that exceeds 22,500 contracts (or such lower 
limit established by an exchange) must agree to provide information 
regarding the position and consent to halt increasing that position if 
requested by the exchange.
    Brokerage firms must also report large open positions held by one 
person (or by several persons acting together) to the CFTC as well as 
to the exchange on which the positions are held. The CFTC's reporting 
requirements are 1,000 contracts for security futures positions on 
individual equity securities and 200 contracts for positions on a 
narrow-based index. However, individual exchanges may require the 
reporting of large open positions at levels less than the levels 
required by the CFTC. In addition, brokerage firms must submit 
identifying information on the account holding the reportable position 
(on a form referred to as either an ``Identification of Special 
Accounts Form'' or a ``Form 102'') to the CFTC and to the exchange on 
which the reportable position exists within three business days of when 
a reportable position is first established.
8.3. Transactions on Foreign Exchanges
    U.S. customers may not trade security futures on foreign exchanges 
until authorized by U.S. regulatory authorities. U.S. regulatory 
authorities do not regulate the activities of foreign exchanges and may 
not, on their own, compel enforcement of the rules of a foreign 
exchange or the laws of a foreign country. While U.S. law governs 
transactions in security futures contracts that are effected in the 
U.S., regardless of the exchange on which the contracts are listed, the 
laws and rules governing transactions on foreign exchanges vary 
depending on the country in which the exchange is located.
8.4. Tax Consequences
    For most taxpayers, security futures contracts are not treated like 
other futures contracts. Instead, the tax consequences of a security 
futures transaction depend on the status of the taxpayer and the type 
of position (e.g., long or short, covered or uncovered). Because of the 
importance of tax considerations to transactions in security futures, 
readers should consult their tax advisors as to the tax consequences of 
these transactions.

Section 9--Glossary of Terms

    This glossary is intended to assist customers in understanding 
specialized terms used in the futures and securities industries. It is 
not inclusive and is not intended to state or suggest the legal 
significance or meaning of any word or term.
    Arbitrage--taking an economically opposite position in a security 
futures contract on another exchange, in an options contract, or in the 
underlying security.
    Broad-based security index--a security index that does not fall 
within the statutory definition of a narrow-based security index (see 
Narrow-based security index). A future on a broad-based security index 
is not a security future. This risk disclosure statement applies solely 
to security futures and generally does not pertain to futures on a 
broad-based security index. Futures on a broad-based security index are 
under exclusive jurisdiction of the CFTC.
    Cash settlement--a method of settling certain futures contracts by 
having the buyer (or long) pay the seller (or short) the cash value of 
the contract according to a procedure set by the exchange.
    Clearing broker--a member of the clearing organization for the 
contract being traded. All trades, and the daily profits or losses from 
those trades, must go through a clearing broker.
    Clearing organization--a regulated entity that is responsible for 
settling trades, collecting losses and distributing profits, and 
handling deliveries.
    Contract--(1) the unit of trading for a particular futures contract 
(e.g., one contract may be 100 shares of the underlying security), (2) 
the type of future being traded (e.g., futures on ABC stock).
    Contract month--the last month in which delivery is made against 
the futures contract or the contract is cash-settled. Sometimes 
referred to as the delivery month.
    Day trading strategy--an overall trading strategy characterized by 
the regular transmission by a customer of intra-day orders to effect 
both purchase and sale transactions in the same security or securities.
    EDGAR--the SEC's Electronic Data Gathering, Analysis, and Retrieval 
system maintains electronic copies of corporate information filed with 
the agency. EDGAR submissions may be accessed through the SEC's Web 
site, www.sec.gov.
    Futures contract--a futures contract is (1) an agreement to 
purchase or sell a commodity for delivery in the future; (2) at a price 
determined at initiation of the contract; (3) that obligates each party 
to the contract to fulfill it at the specified price; (4) that is used 
to assume or shift risk; and (5) that may be satisfied by delivery or 
offset.
    Hedging--the purchase or sale of a security future to reduce or 
offset the risk of a position in the underlying security or group of 
securities (or a close economic equivalent).
    Illiquid market--a market (or contract) with few buyers and/or 
sellers. Illiquid markets have little trading activity and those trades 
that do occur may be done at large price increments.
    Liquidation--entering into an offsetting transaction. Selling a 
contract that was previously purchased liquidates a futures position in 
exactly the same way that selling 100 shares of a particular stock 
liquidates an earlier purchase of the same stock. Similarly, a futures 
contract that was initially sold can be liquidated by an offsetting 
purchase.
    Liquid market--a market (or contract) with numerous buyers and 
sellers trading at small price increments.
    Long--(1) the buying side of an open futures contact, (2) a person 
who has bought futures contracts that are still open.
    Margin--the amount of money that must be deposited by both buyers 
and sellers to ensure performance of the person's obligations under a 
futures contract. Margin on security futures contracts is a performance 
bond rather than a down payment for the underlying securities.
    Mark-to-market--to debit or credit accounts daily to reflect that 
day's profits and losses.
    Narrow-based security index--in general, and subject to certain 
exclusions, an index that has any one of the following four 
characteristics: (1) It has nine or fewer component securities; (2) any 
one of its component securities

[[Page 64161]]

comprises more than 30% of its weighting; (3) the five highest weighted 
component securities together comprise more than 60% of its 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). A 
security index that is not narrow-based is a ``broad-based security 
index.'' (See Broad-based security index).
    Nominal value--the face value of the futures contract, obtained by 
multiplying the contract price by the number of shares or units per 
contract. If XYZ stock index futures are trading at $50.25 and the 
contract is for 100 shares of XYZ stock, the nominal value of the 
futures contract would be $5025.00.
    Offsetting--liquidating open positions by either selling fungible 
contracts in the same contract month as an open long position or buying 
fungible contracts in the same contract month as an open short 
position.
    Open interest--the total number of open long (or short) contracts 
in a particular contract month.
    Open position--a futures contract position that has neither been 
offset nor closed by cash settlement or physical delivery.
    Performance bond--another way to describe margin payments for 
futures contracts, which are good faith deposits to ensure performance 
of a person's obligations under a futures contract rather than down 
payments for the underlying securities.
    Physical delivery--the tender and receipt of the actual security 
underlying the security futures contract in exchange for payment of the 
final settlement price.
    Position--a person's net long or short open contracts.
    Regulated exchange--a registered national securities exchange, a 
national securities association registered under section 15A(a) of the 
Securities Exchange Act of 1934, a designated contract market, a 
registered derivatives transaction execution facility, or an 
alternative trading system registered as a broker or dealer.
    Security futures contract--a legally binding agreement between two 
parties to purchase or sell in the future a specific quantity of shares 
of a security (such as common stock, an exchange-traded fund, or ADR) 
or a narrow-based security index, at a specified price.
    Settlement price--(1) the daily price that the clearing 
organization uses to mark open positions to market for determining 
profit and loss and margin calls, (2) the price at which open cash 
settlement contracts are settled on the last trading day and open 
physical delivery contracts are invoiced for delivery.
    Short--(1) the selling side of an open futures contract, (2) a 
person who has sold futures contracts that are still open.
    Speculating--buying and selling futures contracts with the hope of 
profiting from anticipated price movements.
    Spread--(1) holding a long position in one futures contract and a 
short position in a related futures contract or contract month in order 
to profit from an anticipated change in the price relationship between 
the two, (2) the price difference between two contracts or contract 
months.
    Stop limit order--an order that becomes a limit order when the 
market trades at a specified price. The order can only be filled at the 
stop limit price or better.
    Stop loss order--an order that becomes a market order when the 
market trades at a specified price. The order will be filled at 
whatever price the market is trading at. Also called a stop order.
    Tick--the smallest price change allowed in a particular contract.
    Trader--a professional speculator who trades for his or her own 
account.
    Underlying security--the instrument on which the security futures 
contract is based. This instrument can be an individual equity security 
(including common stock and certain exchange-traded funds and American 
Depositary Receipts) or a narrow-based index.
    Volume--the number of contracts bought or sold during a specified 
period of time. This figure includes liquidating transactions.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. NASD has prepared summaries, set forth in sections A, B, 
and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    NASD has developed sales practice rules governing security 
futures.\3\ Several of these rules--NASD Rule 2856 and IM-2110-7--
reference a security futures risk disclosure statement (``Statement''). 
The proposed rule change contains the text of the Statement to be used 
by members in complying with these rules, and any other NASD rules that 
may subsequently reference the Statement. The Statement is a joint 
effort of NASD, the National Futures Association (``NFA''), the New 
York Stock Exchange, the Chicago Board Options Exchange, The Options 
Clearing Corporation, Nasdaq Liffe Markets, OneChicago, and the 
American Stock Exchange. Comments on this Statement also have been 
provided by the staffs of the Commission and Commodity Futures Trading 
Commission (``CFTC'').
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    \3\ See Securities Exchange Act Release No. 46186 (July 11, 
2002), 67 FR 47412 (July 18, 2002) (SR-NASD-2002-40).
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2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of section 15A(b)(6) of the Act,\4\ which requires, among 
other things that the NASD's rules be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. The NASD believes that the proposed rule change, which 
will be provided to customers, will help inform customers of the 
potential risks of security futures.
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    \4\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    NASD requests that the proposed rule change be granted summary 
effectiveness pursuant to section

[[Page 64162]]

19(b)(3) of the Act \5\ because it believes that such approval is 
necessary for the maintenance of fair and orderly markets. Under NASD's 
proposed security futures rule (NASD Rule 2865), a member must deliver 
the Statement to a customer prior to opening or approving a customer's 
account to trade security futures. In addition, NASD's proposed 
Guidelines for Communications with the Public Regarding Security 
Futures (IM-2210-7) require, with certain limited exceptions, that all 
communications concerning security futures shall be accompanied or 
preceded by the Statement. A delay in the effectiveness of the proposed 
rule change hinders the ability of members to open customer accounts 
for security futures and to communicate with customers concerning these 
new products.
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    \5\ 15 U.S.C. 78s(b)(3)
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    NASD requests that the Commission coordinate its summary approval 
of the proposed rule change with an identical filing made by the NFA 
with the CFTC. NASD's understanding is that under CFTC procedures, 
NFA's proposed rule change will become effective on October 7, 2002.
    On preliminary consideration, it appears to the Commission that 
summary effectiveness is necessary for the maintenance of fair and 
orderly markets. Accordingly, the foregoing rule change has been put 
into effect summarily, pursuant to section 19(b)(3)(B) of the Act.\6\ 
At any time within sixty days of the filing of such proposed rule 
change, the Commission may summarily abrogate such rule change if it 
appears to the Commission that such action is necessary or appropriate 
in the public interest, for the protection of investors, or otherwise 
in furtherance of the Act.
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    \6\ 15 U.S.C. 78s(b)(3)(B).
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    Section 19(b)(3)(B) of the Act \7\ requires that any proposed rule 
change put into effect summarily shall be filed promptly thereafter in 
accordance with the provisions of section 19(b)(1) of the Act.\8\ NASD 
has filed the proposed rule change \9\ under section 19(b)(1) of the 
Act,\10\ and the Commission has issued a notice of the proposed rule 
change.\11\
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    \7\ Id.
    \8\ 15 U.S.C. 78s(b)(1).
    \9\ File No. SR-NASD-2002-129.
    \10\ 15 U.S.C. 78s(b)(1).
    \11\ See Securities Exchange Act Release No. 46614 (October 7, 
2002) (SR-NASD-2002-129).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street NW., Washington DC 20549-0609. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filings will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to File No. SR-NASD-2002-128 and 
should be submitted by November 7, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-26366 Filed 10-16-02; 8:45 am]
BILLING CODE 8010-01-P