[Federal Register Volume 63, Number 15 (Friday, January 23, 1998)]
[Notices]
[Pages 3601-3611]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-1552]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39549; File No. SR-Phlx-96-38]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 2, 4 and 5 to the Proposed Rule Change by the
Philadelphia Stock Exchange, Inc., Relating to the Listing of Flexible
Exchange Traded Equity and Index Options
January 14, 1998.
I. Introduction
On August 21, 1996, the Philadelphia Stock Exchange, Inc. (``Phlx''
or ``Exchange'') filed a proposed rule change with the Securities and
Exchange Commission (``SEC'' or ``Commission''), pursuant to Section
19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\ and Rule
19b-4 thereunder,\2\ to provide for the listing and trading of Flexible
Exchange Options (``FLEX options'') on specified indexes (``FLEX index
options'') and equity securities (``FLEX equity options'').
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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Notice of the proposal was published for comment and appeared in
the Federal Register on September 24, 1996.\3\ The Phlx submitted to
the Commission Amendment No. 1 to its proposal on March 6, 1997.\4\
Notice of Amendment No. 1 was published for comment and appeared in the
Federal Register on April 24, 1997.\5\ The Phlx submitted to the
Commission Amendment No. 2 to its proposal on July 1, 1997.\6\ The Phlx
submitted Amendment No. 3, on August 27, 1997,\7\ which was
subsequently replaced in its entirety by Amendment No. 4, which the
Phlx submitted to the Commission on November 7, 1997.\8\
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\3\ See Securities Exchange Act Release No. 37691 (September 17,
1996), 61 FR 50060.
\4\ In Amendment No. 1 to its proposed rule change, the Phlx
restated the original proposal and proposed several changes as set
forth in detail in Section III of this release.
\5\ See Securities Exchange Act Release No. 38519 (April 17,
1997), 62 FR 20048.
\6\ In Amendment No. 2, the Exchange amended the Request for
Quote process to require a Requesting Member to indicate the size of
an order and the intention to cross, if applicable. In addition, the
Phlx proposes specific position limits of 22,000 contracts for Super
Cap Index options. See Letter from Edith Hallahan, Director and
Special Counsel, Regulatory Services, Phlx, to Sharon Lawson, Senior
Special Counsel, Office of Market Supervision (``OMS''), Division of
Market Regulation (``Market Regulation''), Commission, dated June
25, 1997 (``Amendment No. 2'').
\7\ See Letter from Theresa McCloskey, Vice President, Phlx, to
Sharon Lawson, Senior Special Counsel, OMS, Market Regulation,
Commission, dated August 26, 1997 (``Amendment No. 3'').
\8\ The Phlx replaces Amendment No. 3, in its entirety, with
Amendment No. 4, and proposes to: (1) eliminate the application of
position and exercise limits to FLEX equity options; (2) reduce the
minimum size applicable to a Request-for-Quote for a closing
transaction in already-opened FLEX equity options from 100 to 25
contracts; (3) clarify the parity and priority principles for FLEX
options transactions; (4) amend the proposed rule change to refer
consistently to ``FLEX index and equity options'' (as opposed to
index FLEX options); (5) correct the text of proposed Rule
1079(b)(6) regarding the crossing procedure to reflect that the
crossing intention has already been announced as part of the RFQ, as
amended by Amendment No. 2; and (6) amend proposed Rule 1079(a)(1)
to clearly state that any options-eligible security pursuant to Rule
1009 is eligible to underlie FLEX equity options trading and any
index underlying Non-FLEX options trading is also eligible for FLEX
index options trading. These proposed changes are described more
fully herein. See Letter from Philip H. Becker, Senior Vice
President, General Counsel and Chief Regulatory Officer, Phlx, to
Sharon Lawson, Senior Special Counsel, OMS, Market Regulation,
Commission, dated November 3, 1997.
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The Phlx submitted Amendment No. 5 to the Commission on January 6,
1998.\9\
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\9\ The Phlx proposes in Amendment No. 5 to replace section 3 of
Amendment No. 4 and withdraw the examples provided in Amendment 4.
In Amendment No. 5, the Phlx clarifies: (1) the parity and priority
principles for FLEX options transactions; and (2) that each assigned
ROT or assigned Specialist is not required to respond with a quote
in every instance, unless requested by a Floor Official. See Letter
from Michele R. Weisbaum, Vice President and Associate General
Counsel, Phlx, to Sharon Lawson, Senior Special Counsel, OMS, Market
Regulation, Commission, dated December 9, 1997 (``Amendment No.
5'').
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No comment letters were received on the proposed rule change or on
Amendment No. 1 to the proposed rule change. This order approves the
Exchange's proposal, as amended by Amendment Nos. 1 through 5.
II. Background
The purpose of the Exchange's proposal is to provide a framework
for the Exchange to list and trade equity and index options that give
investors the ability, within specified limits, to designate certain of
the terms of the options. In recent years, an over-the-counter
(``OTC'') market in customized options has developed which permits
participants to designate the basic terms of the options, including
size, term to expiration, exercise style, exercise price, and exercise
settlement value, in order to meet their individual investment needs.
Participants in this OTC market are typically institutional investors,
who buy and sell options in large-size transactions through a
relatively small number of securities dealers. To compete with this
growing OTC market in customized options, the Exchange
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proposes to adopt rules \10\ to permit the introduction of trading in
FLEX options in an exchange auction market environment, with The
Options Clearing Corporation (``OCC'') as issuer and guarantor.\11\
Thus, FLEX options are structured with a minimum size reflecting the
larger-sized trades of these institutional users. The Exchange's
proposal will allow FLEX option market participants to designate the
following contract terms: (1) exercise price (except for certain
limitations for FLEX equity call options); \12\ (2) exercise style
(i.e., American \13\ or European,\14\; (3) expiration date; \15\ (4)
option type (put, call, or hedge order); and (5) form of settlement
(for index options--A.M., P.M. or average).
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\10\ See Phlx Rule 1079.
\11\ For a discussion of clearance and settlement procedure for
FLEX options, see Securities Exchange Act Release No. 37318 (June
18, 1996) (SR-OCC-96-03). For example, OCC may depart from regular
expiration date procedures and deadlines in the case of equity FLEX
options, pursuant to OCC Rule 805, Interpretation and Policy .03.
\12\ The Exchange believes that the flexible exercise price
feature could result in an available call option that would not be
eligible to be a qualified covered call (``QCC'') under Section
1092(c)(4) of the Internal Revenue Code, thus jeopardizing a modest
tax benefit currently enjoyed by writers of standardized non-FLEX
equity call options. Accordingly, the Phlx's rules will restrict
exercise prices for FLEX equity call options. See also Securities
Exchange Act Release No. 37726 (September 25, 1996) (File No. SR-
Amex-96-29; SR-CBOE-96-56; and SR-PSE-96-31).
\13\ An American-style equity option is one that may be
exercised at any time on or before the expiration date.
\14\ A European-style equity option is one that may be exercised
only during a limited period of time prior to expiration of the
option.
\15\ The proposal, however, requires that the expiration date of
a FLEX equity option may not fall on a day that is on, or within two
business days of the expiration date of a Non-FLEX equity option. In
addition, FLEX index options must have an expiration date within 5
years of issuance, and FLEX equity options within 3 years of
issuance.
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The proposed rule, Rule 1079, is based upon the Exchange's Rule
1069, Customized Foreign Currency Options, and Exchange experience with
trading this product since November, 1994.\16\ Generally, FLEX options
shall be traded in accordance with many existing option and index
option rules; however, Rule 1079 contains certain new trading
procedures unique to FLEX options. In addition, the Exchange believes
that the proposal is similar to the rules and proposals of other
exchanges respecting flexible options.\17\
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\16\ Securities Exchange Act Release No. 34925 (November 1,
1994) (SR-Phlx-94-18).
\17\ See, e.g., CBOE Rules 24A.1-24A.17; Amex Rules 900G, et.
seq.; and PSE Rules 8.100-8.115.
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OCC will be the issuer and guarantor of all FLEX index and equity
options. Similarly, the Commission has previously, designated FLEX
index and equity options as standardized options for purposes of the
options disclosure framework established under Rule 9b-1 of the
Act.\18\
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\18\ FLEX index options and FLEX equity options have been deemed
``standardized options'' for purposes of the Rule 9b-1 options
disclosure framework. See e.g., Securities Exchange Act Release Nos.
31920 (February 24, 1993) (Order approving FLEX options based on the
S&P 100 and 500 Indexes); 31910 (February 23, 1993) (FLEX index
option 9b-1 order); and 36841 (February 14, 1996) (Order approving
FLEX equity options for CBOE and PCX, and designating FLEX equity
options, and FLEX index options traded and settled in certain
designated foreign currencies, as ``standardized options''). See
also Securities Exchange Act Release No. 37824 (October 15, 1996)
(FLEX equity option 9b-1 order).
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III. Description of the Proposal\19\
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\19\ The original proposal was published for comment in
Securities Exchange Act Release No. 37691 (September 17, 1996) (File
No. SR-Phlx-96-38).
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The Phlx proposes to adopt Rule 1079, FLEXTM index and
equity\20\ options, which would govern the trading of FLEX index and
equity options on the Exchange. The Exchange proposes to designate all
Phlx index options as eligible for FLEX options trading.\21\ Thus, the
Phlx is proposing to trade FLEX options on industry (narrow-based)
index options pursuant to the proposed rule, in addition to market
(broad-based) index options. Further, the Phlx is proposing to trade
FLEX equity options on securities which are options-eligible pursuant
to Rule 1009.
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\20\ The term ``FLEX'' is a trademark of the Chicago Board
Options Exchange, Inc. (``CBOE'').
\21\ The following are the current Phlx market index options:
Value Line Composite Index (``VLE''), National Over-the-Counter
Index (``XOC''), and U.S. Top 100 Index (``TPX''). The following are
the current Phlx industry index options: OTC Industrial Average
Index (``OTZ''), Bank Index (``BKX''), Gold/Silver Index (``XAU''),
Semiconductor Index (``SOX'') and Utility Index (``UTY''), Forest
and Paper (``FPP''), Plane (``PLN''), Phone (``PNX''), and Oil
Service (``OSX''). Because the Super Cap Index (``HFX'') is neither
a market or an industry index, the Exchange applies a position limit
of 5,500 contracts for the non-FLEX overlying option. This position
limit is lower than the position limit tiers for standardized non-
FLEX industry index options. In addition, the Exchange proposes to
delete the provision that requires approval by the Options Committee
prior to listing an otherwise eligible FLEX product. See Amendment
No. 4, supra note 8.
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Proposed Rule 1079 contains the characteristics, trading procedure
and other provisions applicable to trading FLEX options. All FLEX
options must be quoted and traded in the trading crowd of the
corresponding non-FLEX option. The Exchange notes that the Automated
Options Market (``AUTOM'') system will not be available for FLEX
options. Proposed Rule 1079 also states that although FLEX options are
generally subject to the rules in the options section,\22\ to the
extent that the provisions of Rule 1079 are inconsistent with other
applicable Exchange rules, Rule 1079 takes precedence with respect to
FLEX options.
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\22\ See Phlx Rules 1000, et. seq.
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Because FLEX options would not be continuously quoted, nor are
series pre-established, the variable terms of FLEX options shall be
established by the following process. In order to initiate a
transaction, a Requesting Member must submit an RFQ to the appropriate
trading crowd, announcing the terms of the quote sought. The
characteristics, including which terms and to what degree customization
will be available, are outlined in Rule 1079(a).\23\ For example, the
exercise strike price respecting FLEX index options can be specified at
the time the quote is requested in terms of a specific index value
number (e.g., 553.5), a method for fixing such number (e.g., 10 basis
points over the index value at a certain time, or with the future
trading at a certain price), or a percentage of index value calculated
as of the open or close of trading on the Exchange on the trade date
(e.g., 5% above the close).\24\ Similarly, respecting FLEX equity
options, the exercise strike price can be specified in terms of a
specific dollar amount rounded to the nearest one-eighth of a dollar,
or a percentage of the underlying security rounded to the nearest tick.
However, the Exchange proposes to amend its original proposal to state
that customization of FLEX equity option strike prices for calls will
not be permitted; only strikes that may be listed pursuant to Rule 1012
are eligible, such that the strike price must be consistent with strike
price intervals permissible for standardized non-FLEX equity
options.\25\
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\23\ The Exchange represents that Rule 1079 generally parallels
the provisions of Rule 1069 governing customized foreign currency
options.
\24\ Initially, the exercise strike price will not be available
for customization as a percentage, pending systems enhancements.
\25\ See Rule 1012, Commentary .05.
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The exercise style can be either American or European,\26\
regardless of the exercise style of the listed option.\27\ The
expiration date can also be customized, specifying any business day
(non-holiday)--any month, day and year within five years for Flex index
options and three years for FLEX equity options.
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However, FLEX options may not expire on any day that falls on or within
two business days of (prior or subsequent to) a mid-month expiration
day for a non-FLEX option on the same underlying index or security
(other than a quarterly expiring index option). \28\ In addition, a
FLEX option cannot expire on the same day that series is established at
OCC.\29\
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\26\ An American style option may be exercised at any time up to
its expiration, while a European style option can only be exercised
on its expiration day. See Phlx Rule 1000(b)(35).
\27\ In certain circumstances, European style FLEX equity
options may be adjusted to require the delivery upon exercise of a
fixed amount of cash. See OCC By-Law, Article VI, Section 11,
Interpretation and Policy. 08.
\28\ Quarterly expiring index options expire on the first
business day of the month following the end of the calendar quarter.
\29\ This provision replaces language in Rule 1079(a)(6)(C) of
the original proposal stating that a new series cannot be opened on
the day of exercise.
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With respect to the minimum size of FLEX market index option
quotes, if there is no open interest in the particular series when an
RFQ is submitted, the minimum value size of an RFQ is $10 million
underlying equivalent value; if there is open interest, the minimum
value size of an RFQ for an opening or closing transaction is $1
million underlying equivalent value, or the remaining underlying
equivalent value on a closing transaction, whichever is less. The
underlying equivalent value is defined as the aggregate underlying
value of a FLEX index option (index multiplier times the current index
value) multiplied by the number of FLEX index options. The minimum
value size for a responsive quote in FLEX market index options is $1
million underlying equivalent value, or the remaining underlying
equivalent value on a closing transaction, whichever is less.
With respect to the minimum size of FLEX industry index option
quotes, if there is no open interest in the particular series when an
RFQ is submitted, the minimum value size of an RFQ is $5 million
underlying equivalent value; this amount is one-half of the minimum
size proposed by the Phlx and currently in place on other options
exchanges for flexible broad-based index options. Where there is open
interest, the minimum value size of an RFQ for an opening or closing
transaction is $1 million underlying equivalent value, or the remaining
underlying equivalent value on a closing transaction, whichever is
less. The minimum value size for a responsive quote is $1 million
underlying equivalent value, or the remaining underlying equivalent
value on a closing transaction, whichever is less.
With respect to the minimum size of FLEX equity option quotes, if
there is no open interest in the particular series when an RFQ is
submitted, the minimum value size of an RFQ is 250 contracts; if there
is open interest, the minimum value size of an RFQ is 100 contracts in
the case of an opening transaction; and 25 contracts, or the remaining
size on a closing transaction, whichever is less. The minimum value
size for a responsive quote in FLEX equity options is 25 contracts, or
the remaining size on a closing transaction, whichever is less.\30\ The
Phlx also proposes that the minimum size for FLEX equity options
exercises is reduced from the originally proposed 100 contracts to 25
contracts.
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\30\ The Exchange originally proposed minimum closing (if there
is open interest) and responsive transaction sizes of 100 contracts.
See Amendment No. 4, supra note 8.
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The Exchange proposes to lower the minimum size from 100 to 25
contracts under such circumstances, in part, to conform to the rules of
other options exchanges.\31\ Further, the Exchange believes that the
ability to close positions in increments smaller than 100 contracts
should attract additional FLEX trading interest. The Exchange notes
that market participants wanting to execute an opening transaction in a
particular series of FLEX equity options will continue to be required
to meet the 250 or 100 minimum contract requirement.
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\31\ See, e.g., Securities Exchange Act Release No. 38839 (July
15, 1997), 62 FR 39040 (July 21, 1997) (order approving File No. SR-
CBOE-97-10).
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Assigned ROTs and assigned Specialists, who respond to an RFQ, are
required to respond to each RFQ with a certain minimum size. Respecting
FLEX market index options, assigned ROTs and assigned Specialist, who
respond to an RFQ, are required to respond with at least $10 million
underlying equivalent value or the dollar amount requested in the RFQ,
whichever is less. Respecting FLEX industry index options, assigned
ROTs and assigned Specialists, who respond to an RFQ, are each required
to respond with at least $5 million underlying equivalent value or the
dollar amount requested in the RFQ, whichever is less. Respecting FLEX
equity options, assigned ROTs and assigned Specialist, who respond to
an RFQ, are required to respond with a market of at least 250 contracts
or the size amount requested in the RFQ, whichever is less.
The settlement value for FLEX index options may be specified as the
value reported on the Exchange at the: (i) close of trading (P.M.-
settled), (ii) opening of trading (A.M.-settled), or (iii) as an
average over a specified period of time, within parameters established
by the Exchange.\32\ For example, the third category includes the
average of the index's opening and closing settlement values on the
expiration date, the average of the index's high and low values on the
expiration date, or the average of the index's opening, closing, high
and low values on the expiration date. However, American style FLEX
index options exercised prior to the expiration date can only settle
based on the closing value on the exercise date.\33\ FLEX index options
maybe designated for settlement in U.S. dollars, British pounds,
Canadian dollars, Deutsche marks, European Currency Units, French
francs, Japanese yen or Swiss francs. With respect to the settlement
process applicable to FLEX equity options, exercise settlement shall be
by physical delivery of the underlying security pursuant to Rule 1044.
Also, FLEX equity options will be subject to the exercise-by-exception
procedures of OCC.\34\
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\32\ The Exchange proposes to retain its existing securities
information vendor as the reporting authority for FLEX index
options, respecting any additional index value calculations required
due to the type of customization offered by FLEX options. The
Exchange is not proposing, at this time, to utilize its own Index
Calculation Engine (``ICE'') System as the reporting authority for
FLEX options. See Securities Exchange Act Release No. 38292 at n.4
(February 15, 1997) (SR-Phlx-96-36).
\33\ This limitation is currently in place on other exchanges
trading FLEX options and with respect to other American style A.M.-
settled index options. See Characteristics and Risks of Standardized
Options Trading, February 1994, at page 48.
\34\ OCC Rule 805 provides for automatic exercise of in-the-
money options at expiration without the submission of an exercise
notice to OCC if the price of the security underlying the option is
at or above a certain price (for calls) or at or below a certain
price (for puts); and the non-exercise of an option at expiration if
the price of the security underlying the option does not satisfy
such price levels.
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With respect to the quote format of FLEX options, a bid and/or
offer in the form of a specific dollar amount reflected as a fractional
price (e.g., \1/8\, \1/4\), or a percentage of the underlying security
or underlying equivalent value, rounded to the nearest minimum tick
shall be acceptable. The option type may be a put, call or hedge
order.\35\
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\35\ See Rules 1000(b)(7) and 1066(f).
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The quoting and trading procedure for FLEX options, beginning with
the RFQ, is enumerated in Rule 1079(b). Submitting an RFQ is the first
step in quoting FLEX options. The Requesting Member must first
announced the RFQ to the trading crowd of the non-FLEX option and then
submit an RFQ ticket, containing the following: (1) Underlying index or
security, (2) type, (3) exercise style, (4) expiration date, (5)
exercise price, and, respecting FLEX index options, (6) settlement
value (e.g., A.M. or P.M.), and (7) the designated settlement currency.
Thereafter, on receipt of an RFQ in proper form, the assigned
Specialist or the Requesting
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Member shall cause the terms of the RFQ to be disseminated as an
administrative text message through the Options Price Reporting
Authority (``OPRA'').\36\ RFQs, responsive quotes, booked orders and
completed trades will be promptly reported to OPRA and disseminated as
an administrative text message. The Exchange notes that although
certain information is not required to be part of the RFQ (such as
account type, crossing intention, response time and size), this
information will be reflected on the final order ticket. Further, the
size and crossing intention must be voiced as part of voicing the
RFQ.\37\
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\36\ Operationally, the Requesting Member provides this
information to data entry personnel, who enter it into Exchange
systems.
\37\ See Amendment No. 2, supra note 6, and Amendment No. 4,
supra note 8.
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Following the RFQ announcement, a preset response time will begin,
during which members may provide responsive quotes. As stated in
paragraph (b)(2), the response time, between two and 15 minutes, will
be determined by the Options Committee.\38\ During the response time,
qualified members may provide responsive quotes to the RFQ, which may
be entered, modified or withdrawn during such response time. At the end
of the response time, the assigned Specialist, or if none, the
Requesting Member shall determine the best bid and offer (``BBO''),
based on price, disseminating such market with reference to the
corresponding RFQ. However, where two or more bids/offers are at
parity, proposed Phlx Rule 1079(b)(3) states that bids/offers submitted
by an assigned Specialist, assigned ROT or customer will have priority
over the bids/offers submitted by non-assigned ROTs and by controlled
accounts as defined in Phlx Rule 1014(g)(i).\39\ The Exchange has also
explicitly set forth in the text of the proposed rule and Advice F-28
stating that all transactions must be in compliance with Section 11 of
the Act and the rules promulgated thereunder.
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\38\ Initially, the Options Committee has established a response
time of ten minutes. Although this Committee will be authorized to
change the response time within the permissible range, any such
change will be preceded by notice to the Exchange membership. See
also CBOE Rule 24A.4(a)(3)(iii).
\39\ In Amendment No. 5, the Phlx states that assigned
Specialist and Assigned ROTs generally should not receive priority
over customer orders in FLEX options transactions, because of their
duty under the Act and Exchange rules to assist in the maintenance
of a fair and orderly market by responding to temporary disparities
between supply and demand, a lack of price continuity or a temporary
distortion in pricing relationships. See Amendment No. 5, supra note
9.
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Following the determination of the BBO, a BBO Improvement Interval
may be invoked if the Requesting Member rejects the BBO or the BBO is
for less than the entire size requested. The BBO Improvement Interval
is a two minute time period during which the BBO may be matched or
improved. As a result of the Improvement Interval, a new BBO is
established, which is disseminated with reference to the corresponding
RFQ. An assigned ROT and the assigned Specialist who responded with a
market during the response time may immediately join the new BBO.
A trade in FLEX options cannot be executed until the end of the
response time or BBO Improvement Interval. Once the response time or
BBO Improvement Interval ends, the Requesting Member is given the first
opportunity to trade on the market by voicing a bid/offer in the
trading crowd.\40\ The Requesting Member has no obligation to accept
any bid or offer for a FLEX option. If the Requesting Member rejects
the BBO or the BBO size exceeds the entire size requested, another
member may accept such BBO or the unfilled balance of the BBO.
Acceptance of a bid/offer creates a binding contract under Exchange
rules.
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\40\ Thus, when a Requesting Member seeks to trade on the
established BBO, an assigned ROT/Specialist cannot participate. For
example, where the BBO is 6-7, if the Requesting Members seek to
sell 500 contracts at 6, the Requesting Member has priority for that
purpose.
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Once the BBO is established, the RFQ remains open that trading day,
unless a trade occurs, and a member may re-quote the market with
respect to the open RFQ without submitting an additional RFQ. If a
trade occurs, a new RFQ is required. Only an assigned ROT or assigned
Specialist who responded to the open RFQ during the response time or
BBO Improvement Interval may immediately join the re-quoted market,
thus matching for parity purposes. Neither the Requesting Member, nor
the re-quoting member, is given the first opportunity to trade on the
re-quoted market.
Further, there will be a limit order book for FLEX options. The
Specialist in the listed non-FLEX equity or index option, whether or
not assigned in FLEX options, must accept FLEX orders on the FLEX book
after completion of the RFQ process. Only customer day limit orders may
be placed on the FLEX index or FLEX equity option book. Booked orders
expire at the end of each trading day. The limit price and size must be
written on the RFQ ticket and disseminated as an administrative text
message through OPRA. In order to trade with the book, an executing
member must quote the market and announce the trade. The Exchange
proposes to delete the provision that the executing member has priority
over other members, including assigned ROTs and the assigned
Specialist, seeking to trade with the booked order. The purpose of this
change is to trade FLEX options off the book similarly to non-FLEX
options, noting that this consistency should prevent confusion.
Generally, on the Phlx options floor, a cross may take place in
accordance with Rule 1064. The Requesting Member must voice the
crossing intention as part of voicing the RFQ. With respect to FLEX
options, after the BBO has determined, the Requesting Member intending
to cross must bid (or offer) at or better than the BBO. If the
Requesting Member's bid/offer is at the BBO, the Requesting Member may
execute 25% or a fair split, whichever is greater, of the contra-side
of the order that is the subject of the RFQ. For instance, if there are
two members on parity at the BBO, the Requesting Member and an assigned
ROT, the Requesting Member is entitled to receive 50% of the contra-
side contracts, which is a fair split, not just the 25% guaranteed
minimum right of participation. The remainder of the contra-side is
split in accordance with the parity/priority provision applicable to
determining the BBO, such that assigned ROTs/Specialists may be
afforded priority.
If the Requesting Member's bid/offer improves the existing BBO, an
assigned ROT or assigned Specialist who responded with a market during
the response time or BBO Improvement Interval, may immediately join the
Requesting Member's improved bid or offer, thus matching for parity
purposes. However, the Requesting Member may execute 25% or a fair
split, whichever is greater, of the contra-side of the order that is
the subject of the RFQ. The remainder of the contra-side is split in
accordance with the parity/priority provision applicable to determining
the BBO, such that assigned ROTs/Specialists may be afforded priority.
However, broker-dealer crosses and solicited orders, as defined in Rule
1064, are not eligible for the split afforded by these crossing
provisions. Broker-dealer crosses and solicited orders must be
announced and bid/offered, under the FLEX crossing provision. No 25%
minimum guaranteed right of participation applies to solicited orders
or broker-dealer/broker-dealer crosses. In addition, crossing
transactions may not be subject to a minimum right of participation,
because a customer-to-customer cross would not be required to yield the
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remainder (75%) to assigned ROTs/Specialists.
The Exchange notes that an ROT and Specialist may trade FLEX
options as an assigned ROT/Specialist or as a non-assigned ROT/
Specialist. However, the FLEX assigned Specialist must be the
specialist in the non-FLEX option. ROTs and Specialists must apply on
the appropriate Exchange form to be assigned in FLEX options. An
assigned ROT or assigned Specialist may choose to be assigned in a
particular FLEX option, but must respond with a market respecting any
FLEX option upon request by a Floor Official.
Assigned ROTs and the assigned Specialist will be subject to
certain obligations respecting the trading of FLEX options. For
example, the affirmative and negative market making obligations of Rule
1014(c) apply. Further, as noted above, assigned ROTs and the assigned
Specialist, who respond to an RFQ, are required to respond with a
market of the minimum size.\41\ At least two Exchange members (ROTs
and/or a Specialist) shall be assigned to each FLEX option. If there is
an assigned Specialist and an assigned ROT, the FLEX option will trade
pursuant to the specialist system, just as non-FLEX options currently
do on the Exchange. If, however, there is no assigned Specialist in a
FLEX option, two assigned ROTs are required for that FLEX option to
trade.
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\41\ However, assigned ROTs and assigned Specialists are not
required to provide continuous quotes or markets at a certain
minimum bid-ask differential (quote spread parameter).
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Assigned ROTs and the assigned Specialist who responded with a
market during the response time may join a new bid/offer voiced during
the Improvement Interval and prior to a cross, provided they do so
immediately and subject to preserving the priority of customer orders.
Enabling assigned ROTS and the assigned Specialist to join such new
bid/offer affords them parity at that new BBO.
Generally, FLEX option positions are not taken into account when
calculating position limits for non-FLEX index options on the same
index.\42\ Accordingly, FLEX market index options currently approved
for non-FLEX options trading will be subject to a separate position
limit of 200,000 contracts on the same side of the market.\43\ FLEX
industry index options will be subject to a position limit of four
times the current position limit--36,000, 48,000 or 60,000 contracts on
the same side of the market.\44\
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\42\ However, positions in P.M.-settled customized index options
shall be aggregated with positions in quarterly expiring options
(``QIXs'') on the same index, if the customized option expires at
the close of trading on or within two business days of the last
trading day in a quarter. The Exchange is authorized to trade QIXs
on certain index options pursuant to Rule 1101A(b)(iv), although
none currently trade.
\43\ The following are the current Phlx market (broad-based)
index options: Value Line Composite Index (``VLE''), National Over-
the-Counter Index (``XOC''), and U.S. Top 100 Index (``TPX''). If
the Exchange wants to list and trade FLEX options on a broad-based
index subsequently approved for non-FLEX options trading, the
Exchange must submit a Rule 19b-4 filing with the Commission
proposing appropriate FLEX market index options position limits.
\44\ The following are the current Phlx industry (narrow-based)
index options: OTC Industrial Average Index (``OTZ''), Bank Index
(``BKX''), Gold/Silver Index (``XAU''), Semiconductor Index
(``SOX''), Utility Index (``UTY''), Forester and Paper (``FPP''),
Plane (``PLN''), Phone (``PNX''), and Oil Service (``OSX''). Because
the Super Cap Index (``HFX'') is neither a market or an industry
index, the Exchange applies a position limit (5,500 contracts) that
is lower than the position limit tiers for standardized non-FLEX
industry index options. Accordingly, the position limit for FLEX
options overlying the Super Cap Index will be 22,000 contracts (4
times 5,500 contracts--the existing non-FLEX position limit). See
Amendment No. 2, supra note 6.
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The Exchange notes that FLEX market index option limits are the
same as the provisions of other exchanges.\45\ The Exchange also
believes that four times the non-FLEX limit is an appropriate limit for
FLEX industry index options.\46\
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\45\ See e.g., CBOE Rule 24A.7(b).
\46\See Phlx rule 1001A(b). In 1996, these limits were raised
from 6,000, 9,000 or 12,000 contracts to 9,000, 12,000 or 15,000
contracts. Securities Exchange Act Release No. 37863 (October 24,
1996) (File No. SR-Phlx-96-33). Thus, the proposed change in the
corresponding FLEX limits is a change from the original proposal
reflecting four times the previous limits.
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Respecting FLEX equity options, the Exchange proposes to eliminate
the application of position and exercise limits under a two-year pilot
program.\47\ Rule 1079(d)(2) would continue to state that position
limits for non-FLEX equity options shall not be taken into account when
calculating position limits for non-FLEX equity options, or FLEX or
non-FLEX index options.
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\47\ See Amendment No. 4., supra note 8. The Exchange originally
proposed position limits of three times the position limit
applicable to non-FLEX equity options, pursuant to Rule 1001. The
Phlx will provide the Commission with status report after one-and-a-
half years of the pilot for the Commission to assess the effects on
the markets of the elimination of position and exercise limits on
FLEX equity options.
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The Exchange is proposing to add that each member or member
organization (other than a Specialist or Registered Options Trader)
that maintains a position on the same side of the market in excess of
three times the level established pursuant to Rule 1001 for non-FLEX
equity options of the same class on behalf of its own account of a
customer shall report information on the FLEX equity option position,
positions in any related instrument, the purpose or strategy for the
position and the collateral used by the account. This report shall be
in the form and manner prescribed by the Exchange. In addition,
whenever the Exchange determines that a higher margin requirement is
necessary in light of the risks associated with a FLEX equity option
position in excess of three times the level established for non-FLEX
equity options of the same class, the Exchange may impose such higher
margin requirement and/or may assess capital charges upon the member
organization carrying the account to the extent of any margin
deficiency resulting from the higher margin requirement.
The Exchange notes that the purpose of the amendment is to compete
with the other option exchanges' that have been approved for identical
position limit treatment for FLEX equity options,\48\ and to attract
additional investor interest, and to structure FLEX equity options in a
more flexible fashion. There will still, however, be position and
exercise limits for FLEX index options, as described above.
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\48\See Securities Exchange Act Release No. 39032 (September 9,
1997) (File Nos. SR-Amex-96-19; SR-CBOE-96-79; SR-PCX-97-09) (``FLEX
Equity Option Position Limit Approval Order'').
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The Exchange believes that the elimination of position/exercise
limits for FLEX equity options is appropriate in light of the
institutional nature of the product. Phlx states that one particular
potential institutional use of FLEX options is for stock repurchase
programs, which can be utilized by stock issuers in the form of put
sales. The Exchange believes that eliminating position limits may
attract this business, and thus, bring significant options volume into
the realm of exchange trading.\49\
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\49\ The Commission notes that issuers would, of course, need to
comply with all applicable provisions of the federal securities laws
in conducting their share repurchase programs.
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The Exchange believes that attracting additional market
participation to FLEX equity options should improve liquidity and the
quality of FLEX markets for all participants. The amendment would
require member organizations to report positions exceeding three times
the non-FLEX position limit in that option. Whenever a member files
such a report with the Exchange, the Exchange may request a higher
margin requirement in light of the risks associated with such a FLEX
equity options position. Thus, the Exchange believes that the amendment
is reasonable and consistent with the market protection and anti-
manipulation purposes of position/exercise limits. Enhanced reporting
is
[[Page 3606]]
intended to facilitate the Exchange's surveillance function respecting
larger FLEX positions.
The exercise limit for FLEX index options would apply, equivalent
to the applicable FLEX index option position limit. The minimum
exercise size, however, would be the lesser of $1 million or the
remaining size of the position respecting index options, and the lesser
of 25 contracts or the remaining size of the position respecting equity
options.
The proposal requires any ROT and Specialist to submit a Letter of
Guarantee \50\ issued by a clearing member organization, specifically
accepting financial responsibility for all FLEX option transactions
made by such person. Moreover, an assigned Specialist in FLEX index
options shall be required to maintain a minimum of $1,000,000 in net
capital. An assigned ROT in FLEX index options will be required to
maintain a minimum of $100,000 in net liquid assets. Floor Brokers must
maintain a minimum of $50,000 in net capital to qualify to trade FLEX
options. Assigned ROTs, the assigned Specialist and Floor Brokers must
immediately notify the Exchange's Examinations Department upon failure
to be in compliance with these requirements. The Exchange may waive the
financial requirements of this Rule in unusual circumstances. Assigned
Specialists/ROTs in FLEX equity options, as well as non-assigned ROTs/
Specialists in FLEX options, are required to comply with Exchange
financial requirements.\51\
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\50\ See Phlx Rule 703.
\51\ See Phlx Rule 703.
---------------------------------------------------------------------------
The Exchange also proposes to adopt Floor Procedure Advice F-28,
Trading FLEX Index and Equity Options, to parallel most of the
provisions of Rule 1079(b), including those pertaining to requesting
quotations, responses, determining the BBO, the BBO Improvement
Interval, executing a trade and crossing. Advice F-28 is not proposed
to contain a fine schedule, such that it does not require inclusion in
the Exchange's minor rule violation enforcement and reporting plan.
There will be no trading rotations in FLEX options, either at the
opening or at the close of trading. The Exchange has determined that,
initially, FLEX options will begin trading at 10:00 a.m., one half hour
after the normal opening of trading non-FLEX options on the Exchange,
in order to limit the burden on the trading crowd. FLEX industry index
and equity options will trade until 4:02 p.m., to correspond to the
non-FLEX options similar to FLEX market index options, which would
trade until 4:15 p.m. The Exchange may establish other trading times
for FLEX options within the regular trading hours for the non-FLEX
options, including coordination with FLEX trading hours on other
exchanges and reflecting new trading hours for non-FLEX options.\52\
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\52\ Under this proposal, expanding and narrowing FLEX trading
hours within the regular trading hours of the particular product
would not require a proposed rule change pursuant to Section 19(b)
of the Act. The Exchange, however, will notify its members, in
advance, prior to making any such change. Any proposal to expand
trading hours outside of established regular trading hours would
have to be submitted as a proposed rule change to the Commission
pursuant to Section 19(b) of the Act.
---------------------------------------------------------------------------
In addition, the RFQ process, which allows a set period of time for
bids and offers to be determined, is also designed to create an orderly
trading environment, recognizing that greater variation in option terms
requires sufficient time to respond with a quote. The Phlx believes,
therefore, that the response time and the BBO Improvement Interval
should thus promote depth and liquidity.
In order to provide adequate liquidity in FLEX options, two
assigned members, whether ROTs or Specialists, are required for each
FLEX option, and must be present for a trade to occur.\53\ In addition,
the minimum size requirements are intended to attract depth and
liquidity to FLEX options.
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\53\ See Floor Procedure Advices A-10, Specialist Trading with
Book, and C-1, Ascertaining the Presence of ROTs in a Trading Crowd,
which require that, in addition to the Specialist, a ROT be present
during a transaction.
---------------------------------------------------------------------------
Other FLEX provisions are intended to minimize the market impact of
this product. For one, the expiration date may not fall on or within
two business days before or after the normal mid-month Friday
expiration for options. Because the expiration date of FLEX options may
not correspond to a non-FLEX expiration, FLEX options should not affect
the market for the underlying securities at the same time. This, in
turn, minimizes the impact of FLEX options on the marketplace.
Second, position and exercise limits will apply to FLEX index
options, although separate from those applicable to non-FLEX index
options. The Exchange believes that separate, higher limits and non-
aggregation are appropriate for FLEX index options, which are intended
to compete with OTC options that are not subject to such limits. The
higher limits reflect the institutional nature and resulting larger
size of FLEX index options.
Although FLEX options are characterized by variable terms, not all
FLEX option terms can be customized. As stated above, the expiration
date cannot fall on certain days. Customization of FLEX equity option
strike prices for calls will not be permitted, due to tax issues
arising out of the definition of a qualified covered call. Thus, only
equity option call strikes that may be listed pursuant to Rule 1012 are
eligible, such that the strike price must be consistent with strike
price intervals permissible for equity options. In addition, American-
style FLEX index options exercised prior to the expiration date can
only settle based on the closing value on the exercise date. Despite
these restrictions on customization, the Phlx believes FLEX options
should nevertheless address a market need for variation in contract
terms.
The Exchange believes that FLEX options not only combine variable
terms with an auction marketplace and OCC guarantee, but FLEX options
will also offer transparency of quotes and trades, because the proposal
requires prompt and complete quotation and transaction reporting.
Although flexible options will not be continuously quoted, once an RFQ
is received, its terms, as well as the responding quotes, will be
disseminated by Exchange systems. The terms of any resulting trade will
also be disseminated. Specifically, the assigned Specialist, or if
none, the Requesting Member will ensure immediate dissemination to OPRA
in the form of an administrative text message, which will, in turn,
disseminate the information to subscribing vendors.
The Exchange expects to implement a separate computer system to
handle FLEX index and equity options, similar to the system utilized
for customized foreign currency options. The Exchange expects that
initially FLEX options will be entered into this system at a limited
number of locations on the trading floor, which will be described in
detail by notice to the options trading floor.
The Exchange proposes to utilize a limit order book for FLEX option
orders resulting from the RFQ process. The purpose of the book is to
accommodate customers who have specified a limit price for a FLEX
option order that is away from the market established during the RFQ
process. The limit order book will be limited to customer day limit
orders, which much be accepted by the Specialist, whether or not that
Specialist is assigned in FLEX options. As such, the Specialist must
monitor FLEX markets for any booked orders. The Exchange is requiring
all Specialists, whether acting as an assigned FLEX Specialist or not,
to maintain a FLEX book for consistency with the procedures for non-
FLEX
[[Page 3607]]
options and to prevent investor confusion. The Exchange believes that
the FLEX order book should serve as a useful tool for customers, as
does the current limit order book respecting non-FLEX options. With
respect to booked orders for the same FLEX option (identical terms),
Rule 1014 will apply to determine priority and parity among such
orders.\54\ When trading with a booked order, a member must re-quote
the market and announce the trade.
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\54\ The Exchange notes that although the principles of price/
time priority and simultaneous bids/offers at parity of Rule 1014
apply, the enhanced specialist participation of sub-paragraphs (g)
(ii) and (iii) are not applicable to FLEX options.
---------------------------------------------------------------------------
The Exchange proposes to delete the provision in the original
proposal that the executing member has priority over other members,
including assigned ROTs and the assigned Specialist, seeking to trade
with the booked order. The purpose of this change is to trade booked
FLEX options similarly to non-FLEX options, noting that this
consistency should prevent confusion.
The Exchange also proposes that an RFQ remain open that trading
day, as opposed to expiring immediately, as long as a trade has not
occurred. The market must be re-quoted before a member attempts to
trade on an existing RFQ. The advantage of an RFQ remaining open is
that a re-quote does not require the submission of a new RFQ, thereby
avoiding the delay of a new response time where such time may not be
needed due to a recent quote. Because an option quoted earlier in the
trading day should be easier to price, such that a new response time is
not required, the Exchange believes that it may be burdensome to repeat
the RFQ process. Thus, RFQs remaining open streamlines FLEX trading and
eliminates unnecessary delays. Any time a market is re-quoted that day,
the new BBO and any resulting trade are disseminated with reference to
the original RFQ. However, once a trade occurs, a new RFQ is
required.\55\
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\55\ The Exchange notes that the Options Committee may determine
to established an abbreviated response time for a new RFQ, because
the full ten minutes may not be required for pricing determinations.
---------------------------------------------------------------------------
Certain aspects of proposed Rule 1079 differ from FLEX provisions
of other exchanges. For instance, discretionary transactions would not
be permitted in FLEX index and equity options.\56\ Thus, the existing
provisions of Rule 1065 will apply to prohibit such transactions.
---------------------------------------------------------------------------
\56\ See e.g., CBOE Rule 24A.6, which states that a Floor Broker
may be given discretion with respect to the number of FLEX contracts
to be purchased or sold.
---------------------------------------------------------------------------
Second, the Exchange also notes that there may not be a Specialist
in FLEX options. Where there is an assigned FLEX Specialist, that FLEX
option will trade pursuant to the Phlx's specialist system. Where there
is no assigned FLEX Specialist, two assigned ROTs are required. Only
the assigned Specialist in the non-FLEX (listed) option may apply to be
an assigned Specialist in the FLEX option.\57\ but is not required to
do so in order to participate. Instead, the non-FLEX Specialist may be
an assigned ROT in the FLEX option, or not assigned at all. The current
responsibilities of a Specialist to determine a market based on the
bids and offers voiced as well as to disseminate bids/offers and trades
may be handled by the Requesting Member, where there is no assigned
Specialist in that FLEX option. If a trade occurs where the Requesting
Member is not a participant and there is no assigned Specialist, the
responsibility to submit the trade falls upon the seller or largest
participant, in accordance with existing trading procure.\58\
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\57\ If the option is not listed on the Exchange, specialist
functions may be allocated by the Exchange pursuant to Phlx Rules
500 et seq.
\58\ See Floor Procedure Advice F-2, Time Stamping, Matching and
Access to Matched Trades.
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Third, the Exchange has also determined that FLEX options will
trade in the crowd of the non-FLEX option in order to facilitate
participation by assigned ROTs who will most likely be located in that
crowd. The Exchange believes that encouraging market making activity,
whether or not assigned, should foster liquidity in FLEX options.
IV. Discussion
The Commission finds that the proposals are consistent with the
requirements of the Act and the rules and regulations thereunder
applicable to a national securities exchange, and, in particular, the
requirements of Sections 6(b)(5) \59\ and 11A \60\ of the Act.
Specifically, the Commission finds that the Exchange's proposal is
designed to provide investors with a tailored or customized product for
eligible index and equity options that may be more suitable to their
investment needs. Moreover, consistent with Section 11A of the Act, the
proposal should encourage fair competition among brokers and dealers
and exchange markets, by allowing the Exchange to compete with the
growing OTC market in customized index and equity options.
---------------------------------------------------------------------------
\59\ 15 U.S.C. 78f(b)(5).
\60\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------
The Commission believes the Exchange's proposal reasonably
addresses its desire to meet the demands of sophisticated portfolio
managers and other institutional investors who are increasingly using
the OTC market in order to satisfy their hedging needs. Additionally,
the Commission believes that the Exchange's proposal will help promote
the maintenance of a fair and orderly market, consistent with Sections
6(b)(5) and 11A of the Act, because the purpose of the proposal is to
extend the benefits of a listed, exchange market to index and equity
options that are more flexible than current listed options and that
currently trade OTC. The benefits of the Exchange's options market
include, but are not limited to, a centralized market center, an
auction market with posted transparent market, quotations and
transaction reporting, parameters and procedures for clearance and
settlement, and the guarantee of OCC for all contracts traded on the
Exchange.\61\
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\61\ In approving this rule, the Commission notes that it has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
The Commission believes the Exchange's trading procedures for FLEX
index and equity options are reasonably designed to provide some of the
benefits of an Exchange auction market along with features of a
negotiated transaction between investors. In approving the proposal,
the Commission recognizes that the Exchange's proposed FLEX option
trading program will allow the trading of option contracts of
substantial value, for which continuous quotations may be difficult to
sustain. The Commission believes that the Exchange has adequately
addressed these concerns by establishing procedures for quotes upon
request, which must be firm for a designated period of time and which
will be disseminated through OPRA.
The Commission also believes that it is reasonable that an RFQ
remain open for that particular trading day once a BBO is established.
Specifically, the Commission believes that if the Requesting Member
does not accept the BBO, it is reasonable for the Exchange to allow the
RFQ to remain open so that the trading crowd may re-quote the market in
response to the same contract set forth in the existing RFQ without
submitting another RFQ.
The Commission notes that this provision only allows a member to
re-quote the market later in the day with respect to the open RFQ from
which a trade has not been executed.
The Commission also believes that it is reasonable for the Exchange
to allow for FLEX orders to be accepted onto a FLEX limit order book.
As noted above, the Specialist in the listed non-FLEX equity or index
option, whether or not
[[Page 3608]]
assigned in FLEX options, will maintain a FLEX limit order book. The
Commission believes that a FLEX limit order book, maintained by a
Specialist, should help to accommodate FLEX options trading.
The Commission notes that the Phlx is the first exchange to create
a limit order book for FLEX options. The Commission believes that by
establishing both a FLEX and non-FLEX limit order book for the same
option classes, the Exchange should monitor the use of the FLEX limit
order book to ensure that members are not using the limit order book to
trade ahead of non-FLEX limit orders for the same options class. The
Commission believes that this concern is minimized because FLEX options
should generally have an expiration date at least two days before or
after the expiration date for the corresponding non-FLEX option, thus
FLEX and non-FLEX option contracts are not fungible.
Additionally, the Commission believes that the Exchange's proposal
to provide a minimum right of participation of at least 25% of the
trade to Exchange members who initiate Requests for Quotes in respect
of FLEX options and indicate an intention to cross or act as principal
on the trade, is consistent with the Act. In addition, under Phlx
rules, all FLEX options transactions must be in compliance with the
priority, parity, and precedence requirements of Section 11 of the
Act,\62\ and Rules 11a1-1(T) \63\ and 11b-1,\64\ promulgated
thereunder. These provisions set forth, among other things, the
conditions in which members must yield priority to public customers'
bids and offers at the same price.
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\62\ 15 U.S.C. 78k.
\63\ 17 CFR 240.11a1-1(T).
\64\ 17 CFR 240.11b-1.
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The Commission also believes that the Exchange's proposal to
require at least two assigned ROTs, or an assigned specialist and an
assigned ROT for each FLEX option class, is consistent with the Act.
The Commission notes that the Exchange's rules currently provide a
framework that encourages assigned ROTs and specialists, to actively
make responsive quotes to provide liquidity in FLEX options. In fact,
assigned ROTs and specialists, who respond to an RFQ, must do so with a
market of the minimum size in response to the RFQ. Further, assigned
ROTs and specialists must provide a market in any FLEX option when
requested by a Floor Official. Accordingly, the Commission believes
that this requirement should be sufficient to provide quotations in
response to an RFQ and generally accommodate FLEX options trading.
The Commission also believes that the Exchange's proposal to permit
FLEX equity options trading on any options-eligible security regardless
of whether Non-FLEX equity options overlie that security and trade on
the Exchange is reasonable, in that it promotes fair competition among
exchanges, consistent with Section 11A of the Act, and will perfect the
mechanism of a free and open market and serve to protect investors and
the public interest in accordance with Section 6(b)(5) of the Act. The
Commission notes that Phlx FLEX equity options must still meet the
eligibility requirements and criteria set forth in Phlx Rule 1009.
In addition, the Commission believes that the Exchange's proposal
to designate all currently approved Phlx index options as eligible for
FLEX index options trading is consistent with the Act. The Commission
notes, however, that when submitting a Section 19(b) proposal to list
and trade a new non-FLEX index options product, the Exchange must, in
the same filing, specifically propose to list and trade the FLEX index
options in the same proposed rule change. If the Exchange is not
prepared at that time to seek approval for the listing of FLEX options
overlying the proposed index, then the Exchange should submit a rule
filing pursuant to Section 19(b) of the Act proposing to list FLEX
options on that index at an appropriate time in the future.
The Commission believes it is consistent with Section 6(b)(5) of
the Act for the Phlx to establish trading hours for FLEX options that
begin thirty minutes after the non-FLEX market trading hours, and end
at the same time as normal non-FLEX market trading hours. The
Commission also believes that because of the nature of the FLEX market,
in contrast to the Non-FLEX market, it is reasonable to permit the
Exchange, in its discretion, to restrict or expand trading hours for
FLEX options, so long as such trading hours occur within the normal
options trading hours of the Exchange.\65\
---------------------------------------------------------------------------
\65\ See supra note 52.
---------------------------------------------------------------------------
The Commission believes that the Exchange's proposal to restrict
exercise prices for calls on FLEX equity options, as described above,
reasonably balances the desire of sophisticated portfolio managers and
other institutional investors to trade flexible equity options
products, with the need to eliminate the potential that the trading of
such options could inadvertently impact a tax benefit currently
provided to writers of standardized call options that qualify as
QCCs.\66\ In approving this provision, the Commission recognizes that
the Exchange will restrict the flexibility of investors in determining
an essential term of FLEX equity call options contracts (i.e., the
exercise price). Nevertheless, investors will still be able to
designate contract terms for exercise style (i.e., American or
European) and expiration date.\67\ Based on this and the current tax
framework for QCCs, the Commission believes the limitations imposed by
the proposal is appropriate and should still provide investors with a
more flexible product than one with standardized option terms while
protecting investors in the standardized equity call options
market.\68\
---------------------------------------------------------------------------
\66\ The Commission notes that the Exchange must file a proposed
rule change with the Commission, pursuant to Section 19(b) of the
Act, to withdraw or modify this exercise price policy regarding FLEX
equity call options.
\67\ Of course, investors will also be able to designate
exercise price for FLEX equity put options and FLEX index call and
put options.
\68\ The Commission notes, that OCC, in the approved FLEX equity
option 9b-1 ODD supplement, informs investors of the limitation of
exercise price intervals when writing FLEX equity call options. See
FLEX equity options 9b-1 order, supra note 18.
---------------------------------------------------------------------------
The Commission also believes that it is reasonable for the Exchange
to propose to eliminate position and exercise limits for FLEX equity
options on a two-year pilot basis. While the Commission has generally
taken a gradual, evolutionary approach toward expansion of position and
exercise limits, the Commission is willing to approve the two-year
pilot program for FLEX equity options for several reasons. First, the
FLEX equity options market is characterized by large, sophisticated
institutional investors (or extremely high net worth individuals), who
have both the experience and ability to engage in negotiated,
customized transactions. For example, with a required minimum size of
250 contracts to open a transaction in a new series, FLEX equity
options are designed to appeal to institutional investors, and it is
unlikely that many retail investors would be able to engage in options
transactions at that size. Second, the Exchange's other rules and
provisions governing FLEX equity options will remain applicable. Third,
the OCC will serve as the counter-party guarantor in every exchange-
traded transaction. Fourth, the proposed elimination of position and
exercise limits for FLEX equity options could potentially expand the
depth and liquidity of the FLEX equity market without significantly
increasing concerns regarding intermarket manipulations or
[[Page 3609]]
disruptions of the options or the underlying securities. Finally, the
Exchange's surveillance programs will be applicable to the trading of
FLEX equity options and should detect and deter trading abuses arising
from the elimination of position and exercise limits.
As described above, the Exchange have adopted important safeguards
that will allow them to monitor large positions in order to identify
instances of potential risk and to assess additional margin and/or
capital charges, if necessary. By monitoring accounts in excess of
three times the Non-FLEX equity option position limit in this manner,
the Exchange should be provided 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, this information should allow the Exchange to determine
whether a large position could have an undue effect on the underlying
market and to take the appropriate action.
Given the size and sophisticated nature of the FLEX equity options
market, along with the new reporting and margin requirements, the
Commission believes that eliminating position and exercise limits for
FLEX equity options for a two-year pilot period should not
substantially increase manipulative concerns. Nevertheless, the
Commission will be able to assess the effects on the markets of the
Exchange's proposals during the two-year pilot period. If problems were
to arise during such pilot period, the Commission believes that the
enhanced market surveillance of large positions should help the
Exchange to take the appropriate action in order to avoid any
manipulation or market risk concerns.
Nevertheless, because the Commission has only recently agreed to
eliminate position and exercise limits for a derivative product, the
Commission cannot rule out the potential for adverse effects on the
securities markets for the component securities underlying FLEX equity
options. To address this concern, the Commission has approved the
proposal for a two-year pilot period. The Exchange will undertake to
monitor, among other things, open interest and potential adverse market
effects and to report to the Commission on the status of the program no
later than eighteen months after the order's date of effectiveness. The
reporting of the Exchange's experiences should include, among other
things, such information as:
(i) The type of strategies used by FLEX equity options market
participants and whither FLEX equity options are being used in lieu
of existing standardized equity options;
(ii) the type of market participants using FLEX equity options
during the pilot program;
(iii) the average size of the FLEX equity option contract during
the pilot program, the size of the largest FLEX equity option
contract on any given day during the pilot program, and the size of
the largest FLEX equity option held by a single customer/member
during the pilot program; and
(iv) any impact on the prices of underlying stocks during the
establishment or unwinding of FLEX positions that are greater than
three times the standard non-FLEX equity option position limits.\69\
\69\ For a more complete discussion of the Commission's findings
regarding the elimination of FLEX equity options position limits,
see FLEX Equity Option Position Limit Approval Order, supra note 50.
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The Commission also believes that it is reasonable for the Exchange
to conform its rules to the rules of other options exchanges to reduce
from 100 contracts to 25 contracts the minimum value size of closing
transactions in and exercises of FLEX equity options. The Commission
notes that market participants wanting to execute an opening
transaction in a particular series of FLEX equity options will continue
to be required to meet the 250 (if no open interest in a particular
FLEX series) or 100 (if open interest in a particular FLEX series)
minimum contract requirement. The Commission believes that this should
help to ensure that transactions in FLEX equity options remain of
substantial size and, therefore, the product is geared to an
institutional, rather than a retail market.
The Commission also believes that the Phlx's proposal to include
certain designated foreign currencies in the list of variable FLEX
index option contract terms is a reasonable response by the Exchange to
meet the demands of sophisticated portfolio managers and other
institutional investors. Additionally, the Commission believes that the
Phlx's proposal will help to promote the maintenance of a fair and
orderly market because it extends the benefits of a listed exchange
market to FLEX index options that trade and settle in certain
designated foreign currencies.
The Commission believes that investors should benefit from the
additional flexibility by permitting them to designate quotation and
settlement terms in various foreign currencies while continuing to
ensure adequate investor protection in the trading of these products.
The potential risk of settling FLEX options in foreign currencies
rather than U.S. dollars is also disclosed in the ODD pursuant to Rule
9b-1 of the Act.\70\
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\70\ See Securities Exchange Act Release No. 33582 (February,
1994).
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The Commission also notes that FLEX index options can be
constructed with expiration exercise settlement based on the closing
values of the component securities, which could potentially result in
adverse effects for the markets in these securities.\71\ Although the
Commission continues to believe that basing the settlement of index
products on opening as opposed to closing prices on Expiration Friday
helps alleviate stock market volatility,\72\ these market impact
concerns are reduced in the case of FLEX options because expiration of
these options will not correspond to the normal expiration of Non-FLEX
options, stock index futures, and options on stock index futures. In
particular, FLEX options, will never expire on any ``Expiration
Friday.'' More specifically, the expiration date of a FLEX option may
not occur on a day that is on, or within, two business days of the
expiration date of a Non-FLEX option. The Commission believes that this
should reduce the possibility that the exercise of FLEX options at
expiration will cause any additional pressure on the market for
underlying securities at the same time that Non-FLEX options expire.
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\71\ See, e.g., Securities Exchange Act Release No. 30944 (July
21, 1992), 57 FR 33376 (July 28, 1992).
\72\ Id.
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In addition, the proposal would limit the effect on securities
markets by addressing the relationship between FLEX index options and
QIXs. As proposed, Phlx Rule 1079(d)(1) requires P.M.-settled FLEX
options to be aggregated with QIXs that are based on the same index and
have the same expiration date. In such a case, the FLEX options would
be aggregated two days prior to expiration subject to the position
limits for the QIX options on the applicable index. The Commission
believes that these rules should help prevent an investor from using
FLEX options for the purpose of avoiding the position limits applicable
to QIXs.
Nevertheless, because the position limits for both FLEX index
options are much higher than those currently existing for outstanding
exchange-traded index options (and FLEX equity options have no position
limit requirements) and open interest in one or more FLEX option series
could grow to significant levels, it is possible that FLEX options
might have an impact on the securities markets for the securities
underlying FLEX options. The Commission expects the Exchange to
[[Page 3610]]
monitor the actual effect of FLEX options once trading commences and
take prompt action (including timely communication with the self-
regulatory organizations responsible for oversight of trading in the
underlying securities) should any unusual market effects develop.
The Exchange represents that FLEX options will allow them to
compete with OTC markets and help meet the demand for customized
options products by institutional investors. The minimum value sizes
for opening transactions in FLEX options are designed to appeal to
institutional investors, and it is unlikely that most retail investors
would be able to engage in options transactions at that size.
Nevertheless, the FLEX equity option minimum size for opening
transactions \73\ is much smaller than that for FLEX index options. The
Commission also notes that, in approving the proposal to establish 25
contracts as the minimum contract requirement for closing transactions
in, and exercises of, FLEX equity options, adequate surveillance
guidelines should be in place to ensure that only sophisticated
investors with the necessary financial resources to sustain the
possible losses arising from transactions in the requisite FLEX options
class size are utilizing this product. The Commission's staff has
reviewed Phlx's surveillance program and believes it provides a
reasonable framework in which to monitor such investor open interest.
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\73\ The minimum size for an opening transaction in FLEX equity
options is 250 contracts for any FLEX series in which there is no
open interest, and 100 contracts in any currently opened FLEX
series.
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Because of these established minimum contract requirements for both
opening and closing transactions in FLEX equity options, the Commission
requests that the Exchange monitor its respective comparative levels of
institutional and retail investor open interest in FLEX equity options
for one year from the commencement of its FLEX equity option trading
program. In particular, the Commission requests that the Exchange
provide a report to the Commission's Division of Market Regulation
describing the nature of investor participation (i.e., retail vs.
institutional) in FLEX equity options no later than two months
following the one-year anniversary of FLEX equity options trading on
the Exchange. If the Exchange determines in the interim that the
proposed rule change has resulted in a pattern of retail investor
participation in FLEX equity options, it should notify the Commission's
Division of Market Regulation to determine if (1) the minimum contract
requirements for opening transactions should be increased from 250
contracts, and/or (2) the minimum contract requirements for closing
truncations should be restored to the originally proposed level.
The Commission also notes that effective surveillance guidelines
are essential to ensure that the Exchange has the capacity to
adequately monitor trading in FLEX options for potential trading
abuses. The Commission's staff has reviewed Phlx's surveillance program
and believes it provides a reasonable framework in which to monitor the
trading of FLEX options on its trading floor and detect as well as
deter manipulation activity and other trading abuses.
In order to ensure adequate systems processing capacity to
accommodate the additional options listed in accordance with the FLEX
options program, OPRA has concluded that the additional traffic
generated by FLEX index and equity options traded on the Phlx is within
OPRA's capacity.\74\
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\74\ See Letter from Joseph P. Corrigan, Executive Director,
OPRA, to Sharon Lawson, Senior Special Counsel, OMS, Market
Regulation, Commission, dated October 20, 1997. (``OPRA Capacity
Letter'').
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The Commission finds good cause for approving Amendment No. 2 prior
to the thirtieth day after the date of publication of notice of filing
thereof in the Federal Register. Specifically, this amendment proposes
that (1) the RFQ include the size and intention to cross, consistent
with the existing procedures of other exchanges; and (2) a specific
position limit of 22,000 contracts for the Super Cap Index option be
adopted. The Commission believes that the proposed amendment further
clarifies the proposal and does not raise any new or unique regulatory
issues.
Accordingly, the Commission believes, consistent with Section
6(b)(5) of the Act, that good cause exists, to approve Amendment No. 2
to the proposal on an accelerated basis.
The Commission finds good cause for approving Amendment No. 4 prior
to the thirtieth day after the date of publication of notice of filing
thereof in the Federal Register \75\ Specifically, as noted above, the
Exchange's proposal to (1) eliminate the application of position and
exercise limits to FLEX equity options for a two-year pilot period; and
(2) reduce the minimum size applicable to a Request-for-Quote for a
closing transaction in already-opened FLEX equity options from 100 to
25 contracts, are identical to proposals by other options exchanges
that were recently approved by the Commission. Therefore, the
Commission believes that the proposal raises no new regulatory issues.
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\75\ As noted supra in note 8, Amendment No. 4 supersedes
Amendment No. 3, in its entirety.
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Further, the Commission believes that other changes incorporated
into Amendment No. 4, including, proposals to: (1) amend the proposal
rule change to refer consistently to ``FLEX index and equity options''
(as opposed to index FLEX options); (2) correct the text of proposed
Rule 1079(b)(6) regarding the crossing procedure to reflect that the
crossing intention has already been announced as part of the RFQ, as
amended by Amendment No. 2; and (3) amend proposed Rule 1079(a)(1) to
clearly state that any options-eligible security pursuant to Rule 1009
to eligible to underlie FLEX equity options trading. The Commission
also believes that these amendments do not raise any new regulatory
issues.
Accordingly, the Commission believes, consistent with Section
6(b)(5) of the Act, that good cause exists, to approve Amendment No. 4
to the proposal on an accelerated basis.
The Commission finds good cause for approving Amendment No. 5 prior
to the thirtieth day after the date of publication of notice of filing
thereof in the Federal Register. Specifically, as noted above, the
Exchange's proposed amendment clarifies: (1) the parity and priority
principles for FLEX options transactions; and (2) that each assigned
ROT or assigned Specialist is not required to respond with a quote in
every instance, unless requested by a Floor Official. These provisions
are substantially similar to those of other options exchanges that were
recently approved by the Commission. Therefore, the Commission believes
that the proposal raises no new regulatory issues.
Accordingly, the Commission believes, consistent with Section
6(b)(5) of the Act, that good cause exists, to approve Amendment No. 5
to the proposal on an accelerated basis.
Interested persons are invited to submit written date, views and
arguments concerning Amendment Nos. 2, 4 and 5 to the proposed rule
change. Persons making written submissions should file six copies
thereof with the Secretary, Securities and Exchange Commission, 450
Fifth Street, N.W., Washington, D.C. 20549. Copies of this 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
[[Page 3611]]
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 at the Commission's Public Reference Section, 450 Fifth Street,
N.W., Washington, D.C. 20549. Copies of such filing will also be
available for inspection and copying at the principal office of the
Exchange. All submissions should refer to SR-Phlx-96-38 and should be
submitted by February 13, 1998.
V. Conclusion
For the reasons discussed above; the Commission finds that the
proposal is consistent with the Act and Sections 6 and 11A of the Act,
in particular. In addition, the Commission has previously concluded
pursuant to Rule 9b-1 under the Act, that FLEX options, including FLEX
equity options and FLEX index options, and FLEX index options traded
and settled in certain designated foreign currencies, are standardized
options for purposes of the options disclosure framework established
under Rule 9b-1 of the Act.\76\ Apart from the flexibility with respect
to strike prices, expiration dates, exercise styles, and settlement
(for FLEX index options), all of the other terms of FLEX options are
standardized pursuant to OCC and Phlx rules.
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\76\ 17 CFR 240.9b-1 See supra note 9.
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Standardized terms include matters such as exercise procedures,
contract adjustments, time of issuance, effect of closing transactions,
restrictions on exercise under OCC rules, margin requirements, and
other matters pertaining to the rights and obligations of holders and
writers.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\77\ that the proposal (File No. SR-Phlx-96-38), as amended,
including Amendment Nos. 2, 4 and 5 on an accelerated basis, is
approved. In addition, the portion of the proposal eliminating FLEX
equity options position and exercise limits is approved on a pilot
basis until January 14, 2000.
\77\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\78\
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\78\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-1552 Filed 1-22-98; 8:45 am]
BILLING CODE 8010-01-M
