Broker-dealer/FCMs! You need to have a talk with your clients about AEX Index Futures

Last month, Euronext published a notice to clients that will be of interest to US broker-dealers and FCMs who facilitate client execution and clearing of futures contracts listed on Euronext.  The notice advises that from 20 April 2023, the index underlying AEX futures contracts (specifically, the AEX Index future, the AEX Index mini future, and the AEX Index weekly future) will transition to narrow-based from broad-based “within the meaning of applicable US regulations.”  This means, as the notice further advises, the AEX futures contracts will be, as of that transition date, “foreign security futures” within the meaning of US law. 

The Euronext notice touches on a uniquely complex knot of US regulation of exchange-traded derivatives – not coincidentally, that knot congeals over the vexed intersection of SEC and CFTC jurisdiction over such products.  In this case, and by way of example, when a futures contract listed on a non-US exchange (e.g., Euronext) is based on an underlier that is a “narrow-based” security index (to keep the example simple, let’s define that to mean that the top five constituents of the index by weight make up more than 60 percent of the index’s total weight), then the futures contract is also a security (and specifically, a “foreign security future”) for purposes of US law, subject thereby to regulatory requirements prescribed by both the SEC and the CFTC.

The SEC’s prescription for these products is a lot more complicated than the CFTC’s.  The CFTC basically requires that FCMs only offer execution and clearing services for these products to customers that are “eligible contract participants,” as defined under the Commodity Exchange Act.  The SEC specifies additional eligibility criteria for broker-dealers offering the same services (the customer must also be a qualified institutional buyer, a non-US person within the meaning of Reg S, or a bank or broker-dealer facilitating execution and clearing for such entities).  But the SEC also spells out additional product criteria that foreign security futures must satisfy (again, in order to be offered for execution and clearing by registered broker-dealer/FCMs). 

Of particular relevance here, the SEC requires that before offering a foreign security future based on a narrow-based security index, the broker-dealer/FCM must confirm that the index passes a “primary market test” (the “PTM test,” for short).  That is, each of at least 90% of the securities in the index (by both volume and by weight in the index) must satisfy the following condition: that at least 55% of the worldwide trading volume in the security took place (in the issuer’s most recently completed fiscal year) on a securities market or markets located either (i) in a single non-US jurisdiction, or (ii) in no more than two non-US jurisdictions.  Notably, American Depository Receipts count for purposes of the PTM test. 

The AEX index includes names that are heavily weighted in the index, and with substantial ADR trading volume.  It’s quite possible, as a result, that the AEX index will not satisfy the PTM test.  This is an objective, factual determination, and fortunately for the industry there is a golden source for the information – namely the FIA Tech’s Foreign Security Futures Database (for which, see the link below). 

If the AEX index does not satisfy the PTM test, broker-dealer/FCMs that are executing and clearing client positions in the affected AEX futures contracts will need to tell those clients that as of 20 April 2023 (the day before expiration of the April 2023 contracts) they will no longer be permitted to do so.  Clients eligible to establish accounts with non-US broker-dealers may be able to continue transacting in the contracts; and eligible clients of US broker-dealer/FCMs may be able to reproduce the relevant exposures by swap (subject to applicable swap and security-based swap regulations).

Additional information about the FIA Tech Foreign Security Futures Database is available here.  The SEC’s 2009 Order on Foreign Security Futures is available here.  A summary of applicable CFTC requirements is available here.  The full definition of “narrow-based security index” is available at Section 1a(35) of the Commodity Exchange Act.