[Federal Register Volume 64, Number 20 (Monday, February 1, 1999)]
[Notices]
[Pages 4911-4915]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-2251]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40969; File No. SR-CBOE-98-23]
Self-Regulatory Organizations; Chicago Board Options Exchange,
Inc.; Order Granting Approval to Proposed Rule Change and Notice of
Filing and Order Granting Accelerated Approval to Amendment Nos. 1, 2
and 3 Relating to an Elimination of Position and Exercise Limits for
Certain Broad-Based Index Options
January 22, 1999.
I. Introduction
On June 11, 1998, the Chicago Board Options Exchange, Inc.
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange
Commission (``SEC'' or ``Commission''), pursuant to Section
[[Page 4912]]
19(b)(1) of the Securities Exchange Act of 1934 (``Exchange Act'' or
``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to
establish a two year pilot program eliminating position and exercise
limits for certain broad-based index options.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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The proposed rule change was published for comment in the Federal
Register on July 9, 1998.\3\ CBOE filed amendments to the proposed rule
change on August 19, 1998, November 13, 1998, and January 21, 1999,
respectively.\4\ One comment letter was received on the proposal.\5\
This order approves the proposal, as amended.
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\3\ See Exchange Act Release No. 40158 (July 1, 1998), 63 FR
37153.
\4\ See Letter to Christine Richardson, Attorney, Division of
Market Regulation, Commission, from Timothy Thompson, CBOE, dated
August 18, 1998 (``Amendment No. 1''). CBOE's original submission
proposed to eliminate position and exercise limits for all broad-
based index options on a permanent basis. Amendment No. 1 limited
the proposal to a two year pilot program. Amendment No. 1 also
limited the proposal to those broad-based indexes meeting the
following criteria: (1) a total capitalization of at least $2
trillion or (2) an average capitalization of at least $15 billion.
Amendment No. 1 also stated that, near the end of the program, CBOE
would provide a report detailing the size and different types of
strategies employed with respect to positions established in those
classes not subject to position limits. The report would also
indicate whether any problems resulted from the no limit approach
and provide any other information that may be useful in evaluating
the effectiveness of the pilot program.
See Letter to Michael Walinskas, Deputy Associate Director,
Division of Market Regulation, Commission, from Mary Bender, CBOE,
dated October 28, 1998 (``Amendment No. 2''). Superseding the index
criteria set forth in Amendment No. 1, Amendment No. 2 limited the
proposal to three specific broad-based indexes. Specifically, the
proposal was limited to options on the S&P 500 (``SPX''), options on
the S&P 100 (``OEX''), and options on the Dow Jones Industrial
Average (``DJX''). Amendment No. 2 also clarified that OEX and SPX
options would be subject to a 100,000 contract reporting threshold
requirement and DJX options, 1/10th the size of a full value index
contract, would be subject to a 1 million contract reporting
threshold requirement. Amendment No. 2 also stated that the contract
thresholds, which would trigger an inquiry into whether additional
margin should be imposed, were being changed to 100,000 contracts
for OEX and SPX options and 1 million contracts for DJX options.
See Letter to Michael Walinskas, Deputy Associate Director,
Division of Market Regulation, Commission, from Mary Bender, CBOE,
dated January 20, 1999 (``Amendment No. 3''). Amendment No. 3
deleted the margin review thresholds proposed in Amendment No. 2.
Amendment No. 3 also clarified that the elimination of position
limits for FLEX broad-based index options will apply only to FLEX
options on the SPX, OEX and DJX, and not to all broad-based index
options as originally proposed. Furthermore, SPX, OEX and DJX FLEX
options contracts will be subject to a 100,000 reporting
requirement, and DJX will be subject to a 1 million contract
reporting thresholds. Language was also added to reflect that the
Exchange has the authority, pursuant to CBOE Rule 12.10, to impose
additional margin upon and account maintaining an underhedged FLEX
SPX, OEX or DJX option position. Finally, Amendment No. 3 specified
that that CBOE would provide a report to the Commission detailing
the impact of the pilot program no later than three months prior to
the expiration of the two year pilot program, containing certain
data from the first eighteen month period of the pilot.
\5\ See Letter to Jonathan G. Katz, Secretary, Commission, from
Kathryn N. Natale, Deputy General Counsel/Director of Compliance-
Americas, Credit Suisse First Boston, dated September 23, 1998
(``CSFB Letter''). CSFB general supported the proposal.
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II. Description
CBOE proposes to eliminate position and exercise limits for certain
broad-based index options on a two year pilot basis. Specifically, CBOE
proposes to eliminate position and exercise limits for SPX, OEX, and
DJX options.\6\ The proposal would also apply to FLEX broad-based index
options on SPX, OEX, and DJX. These indexes will be subject to new
reporting thresholds.\7\ OEX, SPX and all FLEX broad-based index
options will be subject to a 100,000 contract reporting requirement and
DJX options, which are 1/10th the size of a full value index contract,
will be subject to a 1 million contract reporting threshold. These
reporting thresholds reflect an increase from the current levels (i.e.,
45,000 for SPX and 65,000 for OEX).\8\ The proposal also reiterates
that the Exchange has the authority, pursuant to CBOE Rule 12.10, to
impose additional margin as it deems necessary upon an account
maintaining an under-hedged option position in SPX, OEX, DJX or FLEX
options on these indexes. Finally, three months prior to completion of
the pilot program, CBOE will provide a report to the Commission,
including data for the first eighteen months of the pilot. The report
will detail the size and different types of strategies employed with
respect to positions established in those classes not subject to
position limits. The report will also discuss whether any problems
resulted from the no limit approach and any other information that may
be useful in evaluating the effectiveness of the pilot program.
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\6\ The current position limits for SPX, OEX and DJX are 100,000
contracts, 150,000 contracts, and 1,000,000 contracts, respectively.
See CBOE Rule 24.4.
\7\ Reporting thresholds are the contract levels at which
members are required to report certain information regarding
customer positions to the Exchange.
\8\ Currently, DJX is not subject to an index reporting
requirement. Because DJX is part of the proposal, CBOE is imposing
new reporting requirement for DJX options.
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III. Discussion
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular, with the requirements of Section 6 of the Act.\9\
Specifically, the Commission believes the proposed rule change is
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to foster cooperation
and coordination with persons engaged in facilitating transactions in
securities, and to remove impediments to and perfect the mechanism of a
free and open market and a national market system.
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\9\ See 15 U.S.C. 78f(b). In approving this rule change, the
commission notes that it has considered the proposal's impact on
efficiency, competition, and capital formation, consistent with
Section 3 of the Act. Id. at 78c(f).
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Position limits serve as a regulatory tool designed to address
potential manipulative schemes and adverse market impact surrounding
the use of options. In the past, the Commission has stated that:
Since the inception of standardized options trading, the options
exchanges have had rules imposing limits on the aggregate number of
options contracts that a member or customer could hold or exercise.
These rules are intended to prevent the establishment of options
positions that can be used or might create incentives to manipulate
or disrupt the underlying market so as to benefit the options
position. In particular, position and exercise limits are designed
to minimize the potential for mini-manipulations and for corners or
squeezes of the underlying market. In addition such limits serve to
reduce the possibility for disruption of the options market itself,
especially in illiquid options classes.\10\
\10\ Exchange Act Release Nos. 39489 (December 24, 1997), 63 FR
276 (January 5, 1998) (SR-CBOE-97-11) (order approving an increase
in OEX position and exercise limits); 31330 (October 16, 1992), 57
FR 48408 (October 23, 1992) (SR-Amex-91-13) (order approving an
increase in Institutional Index Options position and exercise
limits).
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In general, the Commission has taken a gradual, evolutionary
approach toward expansion of position and exercise limits.\11\ The
Commission has been careful to balance two competing concerns when
considering the appropriate level at which to set option position and
exercise limits. The Commission has recognized that the limits must be
sufficient to prevent investors from disrupting the market in the
component securities comprising
[[Page 4913]]
the indexes. At the same time, the Commission has determined that
limits must not be established at levels that are so low as to
discourage participation in the options market by institutions and
other investors with substantial hedging needs or to prevent
specialists and market-makers from adequately meeting their obligations
to maintain a fair and orderly market.\12\
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\11\ This gradual approach to increasing position limits is
evident with both the SPX and OEX. See Exchange Act Release Nos.
37676 (September 13, 1996), 61 FR 49508 (September 20, 1996) (order
approving SR-CBOE-96-01; increasing position limits for the SPX from
45,000 to 100,000 contracts); 39789 (December 24, 1997), 63 FR 276
(January 5, 1998) (order approving SR-CBOE-97-11; increasing
position limits for the OEX from 75,000 to 150,000 contracts).
\12\ See H.R. No. IFC-3, 96th Cong., 1st Sess. at 189-91 (Comm.
Print 1978).
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The Commission has carefully considered the CBOE's proposal. At the
outset, the Commission notes that it still believes the fundamental
purposes of position and exercise limits are being served by their
existence. Nevertheless, the Commission believes that the current
experience with the trading of index options as well as the
surveillance capabilities of the CBOE have made it permissible to
consider other, less prophylactic alternatives to regulating the index
options market while still ensuring that large positions in such index
options will not unduly disrupt the options or underlying cash markets.
At this time, the Commission believes that it is appropriate to allow
for an elimination of position and exercise limits for certain broad-
based index options on a two-year pilot basis.
The Commission believes that an elimination of position and
exercise limits for certain broad-based index options on a pilot basis
is appropriate for several reasons. Overall, the Commission believes
that the pilot will allow the CBOE to allocate certain of its
surveillance resources differently, focusing on enhanced reporting and
surveillance of trading to detect potential manipulation and risky
positions that may unduly affect the cash market, rather than focusing
on the strict enforcement of position limits. Although this regulatory
approach deviates from the current structure that has been in place
since the beginning of index options trading, the Commission believes
that the enhanced reporting and surveillance CBOE is providing, as well
as the fact that the pilot is limited to the CBOE's three most highly
capitalized and actively traded index options, provides a sound basis
for approving a two year pilot program eliminating position and
exercise limits.
The Commission notes first that the proposal is limited to options
on three broad-based indexes, the SPX, OEX, DJX, and FLEX options on
those indexes. The Commission believes that the enormous capitalization
of and deep, liquid markets for the underlying securities contained in
these indexes significantly reduces concerns regarding market
manipulation or disruption in the underlying market.\13\ Removing
position and exercise limits for these index options may also bring
additional depth and liquidity, in terms of both volume and open
interest, to the affected index options classes without significantly
increasing concerns regarding intermarket manipulations or disruptions
of the options or the underlying securities.
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\13\ SPX is a capitalization-weighted index composed of 500
stocks from a broad range of industries. As of August 1998, the
total market capitalization value for SPX was $8.5 trillion. See
Amendment No. 1. OEX is a capitalization-weighted index composed of
100 stocks from a broad range of industries. As of August 1998, the
total market capitalization value for OEX was $3.8 trillion. Id. DJX
is a price-weighted index composed of 30 of the largest, most liquid
New York Stock Exchange-listed stocks. As of August 1998, the total
market capitalization value for DJX was $2.2 trillion. Id.
In addition, the average trading volume for the underlying
components of these indexes for the six months preceding January 20,
1999, demonstrates the substantial liquidity of the index components
as a group. The average trading share volume underlying the SPX is
757.5 million shares. The average trading share volume underlying
the OEX is 244.3 million shares. Finally, the average trading share
volume underlying the DJX is 94.77 million shares. Telephone call
between Patricia Cerny, CBOE, and Christine Richardson, Commission,
on January 21, 1999.
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Second, eliminating position and exercise limits for these
specified indexes should better serve the hedging needs of institutions
that engage in trading strategies different from those covered under
the index hedge exemption policy (e.g., delta hedges, OTC vs. listed
hedges).\4\ Furthermore, eliminating position and exercise limits for
the SPEX, OEX and DJX options will alleviate the regulatory burdens
related to the current index hedge exemption, which involves a daily
monitoring of positions and reports to the Exchange at the current
levels.
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\14\ CSFB notes that many institutional traders conduct
substantial hedging activity similar to that of the listed options
market in other markets that are not restricted by position and
exercise limits, e.g., by trading off-shore or in the U.S. treasury
bond futures and Eurodollar futures market. See CSFB Letter.
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Third, the Commission believes that financial requirements imposed
by CBOE and by the Commission adequately address concerns that a CBOE
member or its customer may try to maintain an inordinately large
unhedged position in a broad-based index option. Current margin and
risk-based haircut methodologies serve to limit the size of positions
maintained by any one account by increasing the margin and/or capital
that a member must maintain for a large position held by itself or by
its customer.\15\ CBOE also has the authority under its rules to impose
a higher margin requirement upon the member or member organization when
it determines a higher requirement is warranted. Monitoring accounts
maintaining large positions should provide the Exchange with the
information necessary to determine whether to impose additional margin
and/or whether to assess capital charges upon a member organization
carrying the account. In addition, the Commission's net capital rule,
Rule 15c3-1 under the Exchange Act, imposes a capital charge on members
to the extent of any margin deficiency resulting from the higher margin
requirement. The significant increases in unhedged options capital
charges resulting from the September 1997 adoption of risk-based
haircuts and CBOE's margin requirements applicable to these products
under Exchange rules serves as an additional form of protection.\16\
The Commission also notes that the OCC will serve as the counter-party
guarantor in every exchange-traded transaction.
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\15\ Exchange Act Rule 15c3-1 requires a capital charge equal to
the maximum potential loss on a broker-dealer's aggregate index
position over a +(-) 10% market move. Exchange margin rules require
margin on naked index options which are in or at-the-money equal to
a 15% move in the underlying index; and a minimum 10% charge for
naked out-of-the money contracts. At an index value of 9,000 this
approximates to a $135,000 to $90,000 requirement per each unhedged
contract.
\16\ See Exchange Act Release No. 38248 (February 6, 1997), 62
FR 6474 (February 12, 1997)(adopting Risk Based Haircuts), and CBOE
Rule 24.11 Margins.
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Fourth, the Commission notes that the index options and other types
of index-based derivatives (e.g., forwards and swaps) are not subject
to position and exercise limits in the OTC market. The Commission
believes that eliminating position and exercise limits for the SPX,
OEX, and DJX options on a two-year pilot basis will better allow CBOE
to compete with the OTC market.
Fifth, the Commission believes that CBOE has adopted important
enhanced surveillance and reporting safeguards that will allow it to
detect and deter trading abuses arising from the elimination of
position and exercise limits for SPX, OEX, DJX, and FLEX options on
those indexes. These safeguards will also allow CBOE to monitor large
positions in order to identify instances of potential risk and to
assess additional margin and/or capital charges, if deemed necessary.
Specifically, CBOE will subject SPX, OEX and FLEX options on those
indexes to a 100,000 contract hedge reporting requirement, and DJX,
which is one-tenth the size of a full value index contract, and FLEX
options on the DJX will be subject to a 1 million contract
[[Page 4914]]
hedge reporting threshold.\17\ Each member or member organization that
maintains a position on the same side of the market in excess of these
contract thresholds for its own account of for the account of a
customer must file a report that includes, but is not limited to, data
related to the option position, whether such position is hedged and if
so, a description of the hedge. If applicable, the report must contain
information concerning collateral used to carry the position. Exchange
market makers would continue to be exempt from this reporting
requirement. Although the new reporting thresholds are higher for SPX
and OEX, the new levels will enable CBOE to allocate its surveillance
resources on those accounts maintaining larger, potentially riskier,
positions. CBOE has submitted to the Commission a detailed description
of enhanced surveillance procedures the Exchange will implement in
order to monitor accounts maintaining large positions. The Commission
also believes that CBOE's new surveillance procedures should enable the
Exchange to assess and respond to market concerns at an early stage.
Although it is inappropriate to discuss the details of CBOE's enhanced
surveillance program, the Commission notes that these enhanced
procedures were critical in its determination to approve the proposed
rule change.\18\
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\17\ The current hedge reporting thresholds for SPX and OEX are
45,000 contracts and 65,000 contracts, respectively. DJX is not
currently subject to a reporting requirement.
\18\ Disclosure of specific surveillance procedures could
provide market participants with information that could aid
potential attempts at avoiding regulatory detection of inappropriate
trading activity.
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Finally, the Commission notes the lack of any discernible problems
at existing levels. Although it is difficult to compare a market with
position limits and one without, the Commission notes that the lack of
any significant problems at existing levels, which are relatively high
for these three index options compared to other similar products does
provide some basis for going forward with the CBOE's proposal. The
Commission further believes that, if problems were to occur during the
pilot period, the enhanced market surveillance of large positions
should help CBOE to take the appropriate action in order to avoid any
manipulation or market risk concerns.
With regard to the elimination of position and exercise limits for
FLEX options on the SPX, OEX and DJX, the Commission believes that,
given the size and sophisticated nature of the FLEX options market for
these indexes, along with the reporting requirements, eliminating
position and exercise limits for FLEX options on the SPX, OEX and DJX
for a two-year pilot period should not substantially increase
manipulative concerns.
Notwithstanding the protections that have been built into CBOE's
proposal, the Commission believes a prudent approach is warranted with
respect to the elimination of position limits for these indexes. In
this regard, the Commission cannot rule out the potential for adverse
effects on the securities markets for the component securities
underlying the effected broad-based indexes. To address this concern,
the Commission is approving the proposal for a two-year pilot period
and limiting the proposal to SPX, OEX, DJX options, and FLEX options on
those indexes.19 Furthermore, three months prior to the end
of the pilot program, CBOE will provide the Commission with a report
detailing the size and different types of strategies employed with
respect to positions established in those classes not subject to
position limits. In addition, the report will note whether any problems
resulted due to the no limit approach and any other information that
may be useful in evaluating the effectiveness of the pilot
program.20 The Commission expects that CBOE will take prompt
action, including timely communication with the Commission and other
marketplace self-regulatory organizations responsible for oversight of
trading in component stocks, should any unanticipated adverse market
effects develop.
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\19 \Cf. Exchange Act Release No. 30932 (September 9, 1997), 62
FR 48683 (September 16, 1997) (order approving the elimination of
position and exercise limits for FLEX equity options on a two year
pilot basis).
\20 \See Amendment No. 1.
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The Commission finds good cause to approve Amendment No. 1 to the
proposed rule filing prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Specifically, by restricting the elimination of position and exercise
limits for certain broadbased index options to a two-year pilot period,
the proposed rule change is more restrictive than the original
proposal, which was published for the entire twenty-one day comment
period and generated only one response.21 Amendment No. 1
also stated that CBOE will provide a report to the Commission three
months prior to the end of the pilot period,22 detailing any
resulting problems, as well as the size and different types of
strategies employed with respect to positions established in those
classes of options not subject to position limits. This report will
help CBOE and the Commission to assess the effects of eliminating
position and exercise limits on the effected index options.
Accordingly, the Commission believes that good cause exists, consistent
with Sections 6(b)(5) and 19(b) of the Act to approve Amendment No. 1
to the proposed rule change on an accelerated basis.23
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\21 \See CSFB Letter.
\22 \See Amendment No. 3.
\23 \The Commission notes that Amendment No. 1 also limited the
proposal to all broad-based indexes meeting the following criteria:
(1) a total capitalization of at least $2 trillion or (2) an average
capitalization of at least $15 billion. Although this provision
narrowed the application of the proposed rule change, at the request
of the Commission, CBOE filed Amendment No. 2 which replaced this
provision and further narrowed application of the proposed rule
change to SPX, OEX, and DJX options.
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The Commission finds good cause to approve Amendment No. 2 to the
proposed rule filing prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Specifically, Amendment No. 2 limited the proposal to three specific
broad-based indexes--SPX, OEX, and DJX options. By restricting the
elimination of position and exercise limits to SPX, OEX, and DJX
options, the proposed rule change is more restrictive than the original
proposal, which was published for the entire twenty-one day comment
period and generated only one response.24 Amendment No. 2
also imposed new reporting thresholds on members holding large
positions in the effected options. These reporting requirements will
better enable CBOE to detect and deter trading abuses arising from the
elimination of position and exercise limits. In addition, the
Commission notes that CBOE's proposal reiterates the Exchange's ability
to impose margin and/or assess capital charges an important safeguard
to address concerns regarding potential manipulation or other market
disruptions. Accordingly, the Commission believes that good cause
exists, consistent with Sections 6(b)(5) and 19(b) of the Act to
approve Amendment No. 2 to the proposed rule change on an accelerated
basis.
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\24 \See CSFB Letter.
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The Commission finds good cause to approve Amendment No. 3 to the
proposed rule filing prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Specifically, the Commission believes that deleting the proposed margin
review thresholds of 100,000 contracts for SPX and OEX and 1 million
for DJX is appropriate to avoid possible a misinterpretation that the
[[Page 4915]]
Exchange may only impose additional margin under CBOE Rule 12.10 when
these thresholds are reached. Amendment No. 3 clarifies that the
Exchange may impose additional margin as it deems necessary. The
Commission also believes that narrowing the elimination of position and
exercise limits to FLEX options on the SPX, OEX, and DJX, rather than
all FLEX broad-based index options is appropriate because it is more
restrictive than the original proposal and it will allow the Exchange
to focus initially on a smaller number of accounts maintaining
positions in FLEX SPX, OEX and DJX options. Amendment No. 3 also
appropriately clarifies when the CBOE will provide the Commission with
a report concerning the impact of the pilot program. Accordingly, the
Commission believes that good cause exists, consistent with Sections
6(b)(5) and 19(b) of the Act to approve Amendment No. 3 to the proposed
rule change on an accelerated basis.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendments No. 1, 2 and 3, including whether the
proposal 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. 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 inspecting and copying at the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
Exchange. All submissions should refer to File No. SR-CBOE-98-23 and
should be submitted by February 22, 1999.
V. Conclusion
It is therefore Ordered, pursuant to section 19(b)(2) of the
Act,\25\ that the proposed rule change (SR-CBOE-98-23) is approved, as
amended, on a two-year pilot basis until January 22, 2001.
\25\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\26\
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\26\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-2251 Filed 1-29-99; 8:45 am]
BILLING CODE 8010-01-M
