In recent years a variety of derivative products based on stock indices have developed worldwide, and will continue to be developed in the future. It is important to ensure that the design of such derivative products, both in relation to the composition of the index and the contract specification, does not impair orderly pricing in either the cash or derivative market and is appropriate to avoid the risk of disruption, including manipulation, in both markets.

In the U.S., in order to address such concerns regarding futures and options on futures, the CFTC, in the first instance is required to judge whether the underlying index meets the following requirements before it (subject to a contrary determination by the SEC) approves the introduction of the trading in such products:

i. settlement of or delivery on such contract is effected in cash or by means other than the transfer or receipt of the securities;

ii. the index is predominantly composed of the securities of unaffiliated issuers and is a widely published measure of, and reflects the market for all publicly traded equity or debt securities or a substantial segment thereof; and

iii. the trading in the futures contracts based on such index is not readily susceptible to manipulation of the prices of such contract or the price of any underlying security.

A similar analysis is applied by the SEC in evaluating stock index options.

In France, a new derivative product may not be introduced on the MATIF until the COB has expressed its opinion on the product. While examining the new contract, the COB investigates whether or not this product might exert a disruptive influence on the cash market. The COB is a member of a panel which has responsibility for determining when a component stock should be replaced and by what alternative stock.

In Japan, the MOF has the authority to approve the listing of stock index derivative products on exchanges. Prior to such approval, the MOF examines the product design in terms of the susceptibility to manipulation and the extent of influence on the cash market.

In the U.K., the composition of the FT-SE 100 is determined by a steering committee comprising representatives from the exchanges and senior practitioners. The steering committee has developed and operates guidelines for the composition of the index.

One method of minimizing disruption in either market is through contract specification. For example, in the U.S. and Japan, a "special quotation" is used as the settlement price for certain stock index futures contracts. (In addition, in the U.S. a closing quotation is used as the settlement price for other stock index futures contracts.) A similar system is adopted in France.

U.K. provisions include extending the period during which the settlement price for futures and options is determined from the cash market index values.

Other countries have introduced similar criteria and procedures in introducing new derivative products.

Contract Design of Derivative Products on Stock Indices

The needs of both investors and markets should be taken into account when a new derivative product is introduced. For stock index futures, regulatory authorities and / or exchanges also need to examine the appropriateness of product design to ensure that such design does not impair orderly pricing in either the cash or derivative market and is appropriate to avoid the risk of disruption, including manipulation, in those markets. In such examination, they need to consider whether the underlying index addresses the points specified below. Although these points should be taken into account in the design of all indices, the application of any particular point may vary depending on whether the index is broad ­ or narrow­based.

i. The Method of Calculation

Whether the index is calculated in an appropriate way including the weight given to component stocks so that the price movements of a few particular component stocks do not exert undue influence on the movement of the index. In addition, the index calculation formula should be available to the public.

ii. The Number of Component Stocks

Whether the index is composed of a sufficient number of stocks of non-affiliated issuers so that the price movements of a few particular component stocks do not exert undue influence on the movement of the index.

iii. The Liquidity of Component Stocks

While there may be great differences in the liquidity of component stocks, whether each component stock has sufficient liquidity so that the trading of such stock does not exert undue influence on the movement of the index.

iv. The Dispersion of Component Stocks Within a Business Sector or Across Sectors

Whether the component stocks are broadly based so that the price movement of the stocks belonging to a certain business sector does not exert undue influence on the movement of the index.

v. The Replacement of Component Stocks

Whether there is a non-arbitrary and well publicized procedure for reconsideration of the appropriateness of continuing to include component stocks, either on a regular basis or as occasion demands.

vi. The Selection of Component Stocks

In order to prevent the index from being unduly influenced by price movements of particular component stocks, whether such stocks are selected in full consideration of items (i) through (iv) above.

vii. Clearance and Settlement

Whether the procedures for clearance and settlement are prudentially designed and interact effectively with the cash market.

In addition it is necessary to pay attention to the fact that derivative products based on foreign stock indices are traded in some countries. In light of these circumstances, international cooperation of regulatory authorities and related cash and derivative markets by means of information exchange and discussion are valuable in order not to impair orderly pricing in either the cash or derivative market and to avoid the risk of disruption, including manipulation, in both markets.