[Federal Register Volume 59, Number 215 (Tuesday, November 8, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-27632]
[[Page Unknown]]
[Federal Register: November 8, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34925; International Series No. 738; File No. SR-Phlx-
94-18]
Self-Regulatory Organizations; Order Granting Approval of a
Proposed Rule Change and Notice of Filing and Order Granting
Accelerated Approval of Amendment No. 3 to the Proposed Rule Change by
the Philadelphia Stock Exchange, Inc., Relating to Customized Foreign
Currency Options
November 1, 1994.
I. Introduction
On April 12, 1994, the Philadelphia Stock Exchange, Inc. (``Phlx''
or ``Exchange'') filed with the Securities and Exchange Commission
(``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to provide for the listing and trading of
customized foreign currency options (``FCOs''), specifically,
customized inverse FCOs (``Customized Inverses'')\3\ and customized
cross-rate FCOs (``Customized Cross-Rates''). (Customized Inverses,
Customized Cross-Rates, and Customized Strikes (as defined herein) are
collectively referred to as ``Customized FCOs''.) Notice of the
proposed rule change appeared in the Federal Register on July 12,
1994.\4\ No comment letters were received on the proposed rule change.
The Exchange subsequently filed Amendment No. 1 to the proposal on
August 15, 1994,\5\ Amendment No. 2 on September 20, 1994,\6\ and
Amendment No. 3 on November 1, 1994.\7\ This order approves the
Exchange's proposal, as amended.
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\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1992).
\3\See infra Section II.A (Characteristics of Customized FCOs).
\4\See Securities Exchange Act Release No. 34308 (July 5, 1994),
59 FR 35551 (July 12, 1994).
\5\In Amendment No. 1 the Exchange proposed several substantive
and clarifying amendments to the proposed rule change. See Letter
from Michele Weisbaum, Associate General Counsel, Phlx, to Michael
Walinskas, Branch Chief, Office of Market Supervision (``OMS''),
Division of Market Regulation (``Division''), Commission, dated
August 12, 1994.
\6\The Exchange previously submitted a proposed rule change to
list and trade FCOs with customized strike prices (``Customized
Strikes''). Customized Strikes will provide FCO traders and their
customers with the ability, within certain limits, to trade an FCO
with any exercise price it chooses on a specific Approved Currency
(as defined herein) even if that price does not correspond to an
exercise price of a listed non-Customized FCO. See Securities
Exchange Act Release No. 33959 (April 25, 1994), 59 FR 22698 (May 2,
1994) (``File No. SR-Phlx-94-11''). Because of the overlap between
that proposal and the current proposal, the Exchange withdrew File
No. SR-Phlx-94-11 and, in Amendment No. 2, the Exchange incorporated
the substance of File No. SR-Phlx-94-11, as amended and
supplemented, into the current proposed rule change. In Amendment
No. 2, the Exchange also established how bids and offers for
Customized FCOs will be expressed pursuant to Phlx Rule 1033, and
the minimum fractional changes that will be applicable to Customized
FCOs pursuant to Phlx Rule 1034. See Letter from Michele Weisbaum,
Associate General Counsel, Phlx, to Michael Walinskas, Branch Chief,
OMS, Division, Commission, dated September 20, 1994.
\7\Amendment No. 3 incorporates the substance of and withdraws
Amendment Nos. 1 and 2. In Amendment No. 3, the Exchange also
proposes several additional substantive and clarifying amendments to
the proposed rule change, as discussed herein, that were not
contained in Amendment Nos. 1 and 2. See Letter from Michele
Weisbaum, Associate General Counsel, Phlx, to Michael Walinskas,
Branch Chief, OMS, Division, Commission, dated November 1, 1994
(``Amendment No. 3'').
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II. Description of the Proposal
Pursuant to the proposed rule change, the Exchange will be able to
offer the ability for its participants to trade: (1) Customized Strikes
on any of the existing eight currencies on which the Exchange presently
lists FCOs, i.e., the British pound, Swiss frank, French franc,
Deutsche mark, Japanese yen, Australian dollar, Canadian dollar, and
European Currency Unit (``ECU'') (collectively, ``Approved
Currencies''); (2) Customized Inverses on any Approved Currency; and
(3) Customized Cross-Rates on any two Approved Currencies.
Additionally, the proposed rule change will allow FCO participants\8\
to express quotes for Customized FCOs as a percentage of the underlying
currency,\9\ in addition to the current method of quoting ``regular''
FCOs\10\ in terms of the base currency\11\ per unit of the relevant
underlying currency.
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\8\FCO participants include Exchange members, and non-members
who have been admitted to the Exchange as FCO participants. See Phlx
Rule 13.
\9\The underlying currency is the currency in which an FCO
settles. All non-Customized FCOs currently traded on the Exchange
settle in one of the Approved Currencies.
\10\The terms regular FCOs and non-Customized FCOs, as used
herein, refer to the standardized FCOs currently approved for
listing and trading by the Exchange.
\11\Presently, the base currency is the currency in which
premiums are quoted and paid. For the Exchange's existing non-
Customized FCOs (other than regular cross-rate FCOs) the base
currency is the U.S. dollar.
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A. Characteristics of Customized FCOs
The characteristics of and procedures for trading Customized FCOs
are contained in new Phlx Rule 1069 (Customized Foreign Currency
Options). Rule 1069(a) sets forth the parameters applicable to
Customized FCOs. Specifically, Customized Strikes may be traded on any
Approved Currency,\12\ and Customized Cross-Rates may be traded on any
two Approved Currencies, exclusive of the U.S. dollar. The contract
size for Customized Strikes and Cross-Rates will be the same as those
for non-Customized FCOs on the same underlying Approved Currency.
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\12\The proposal also adds the U.S. dollar to list of Approved
Currencies.
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Additionally, Rule 1069(a) provides for the trading of Customized
Inverses on any Approved Currency.\13\ A Customized Inverse is a
Customized FCO where the underlying currency is the U.S. dollar. When
trading a Customized Inverse, bids and offers will be quoted in, and
premium will be paid in, the base currency (i.e., an Approved Currency
other than the U.S. dollar), and the contract will be settled in the
underlying currency (i.e., U.S. dollars).\14\ The contract size for a
Customized Inverse will be US$50,000.
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\13\The Exchange also sometimes refers to Customized Inverses as
``European-Term'' Customized FCOs.
\14\As the name suggests, a Customized Inverse merely inverts
the terms of the Exchange's non-Customized FCOs (other than the
regular cross-rate FCOs). For example, the existing non-Customized
U.S. dollar/German mark contract is quoted in the base currency
(cents) per unit of the underlying currency (marks), the premium is
paid in U.S. dollars, and the contract is settled in German marks.
In a Customized Inverse (e.g., German mark/U.S. dollar), the U.S.
dollar becomes the underlying currency and the German mark becomes
the base currency. As a result, when trading this Customized
Inverse, the premium would be quoted in German marks per U.S.
dollar, the premium would be paid in German marks, and the contract
would be settled in U.S. dollars.
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Rule 1069(a) further provides an alternative quote format for
Customized FCOs. Presently, the Exchange's non-Customized FCOs are
quoted in terms of the base currency per unit of underlying currency,
in which case premium is quoted and paid in the base currency. The
proposal provides an alternative quoting format whereby quotes for
Customized FCOs may be quoted as a percentage of the underlying
currency (``Percentage Quoting''). In Percentage Quoting, the contract
will be quoted in, the premium will be paid in, and the contract will
settle in, the underlying currency.
Finally, Rule 1069(a) provides that Customized FCOs (1) may be
either put or call contracts, (2) must be European-style,\15\ (3) must
have a standardized expiration date as provided in Phlx Rule
1000(b)(21), and (4) may have any listed or non-listed exercise price
determined by the requesting FCO participant.\16\
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\15\European-style options may only be exercised during a
specified time period immediately prior to expiration of the option.
\16\See Amendment No. 3, supra note 7.
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B. Procedures for Trading Customized FCOs
The procedures for requesting and obtaining quotes for Customized
FCOs are provided in Phlx Rule 1069 (a) and (b). First, Rule 1069(a)
provides minimum sizes for trades in Customized FCOs. Specifically, (1)
the minimum size for an opening transaction in any series in which
there is no open interest at the time a request for quote (``RFQ'') is
submitted will be 300 contracts, (2) the minimum size for an opening
transaction in any series with open interest will be 100 contracts, and
(3) the minimum size for a closing transaction will be the lesser of
100 contracts or the remaining number of contracts. The minimum size
for quotes responsive to a RFQ will be the lesser of 100 contracts or
the remaining number of contracts on a closing transaction, provided,
however, that assigned registered options traders (``ROT'') must
provide responsive quotes for at least 300 contracts or the number of
contracts requested, whichever is less.\17\
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\17\Assigned ROTs are not specifically required to provide a
responsive quote for each RFQ. The Phlx maintains, however, that an
assigned ROT can be required by a Floor Broker or Floor Official
(each as defined in the Phlx's rules), pursuant to Phlx Rule
1014(c), to provide a responsive quote to a party submitting a RFQ.
See Amendment No. 3, supra note 7, and Phlx Floor Procedure Advice
B-1.
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Rule 1069(b) provides that any FCO participant may request a quote
for a Customized FCO from the trading crowd, with the characteristics
as specified in Rule 1069(a). The FRQ may include the number of
contracts for which the quote is being requested.\18\ If neither the
RFQ nor any responsive quote specifies the number of contracts for
which it applies, responsive quotes will be firm only for the minimum
transaction sizes discussed above.\19\
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\18\All RFQs, in addition to all responsive quotes and completed
trades, will be promptly reported to the Options Price Reporting
Authority (``OPRA'') and disseminated as administrative text
messages. See Phlx Rule 1069(h). The Exchange has represented that
the OPRA has the capacity to, and will, disseminate this information
to vendors in a manner clearly indicating the type of Customized FCO
involved (i.e., Customized Strike, Cross-Rate, or Inverse), the
quoting format (i.e., either base currency per unit of underlying
currency or Percentage Quoting), and the Approved Currency in which
premiums are quoted and paid. Telephone conversation between Michele
Weisbaum, Associate General Counsel, Phlx, and Brad Ritter, Senior
Counsel, OMS, Division, Commission, on October 31, 1994.
\19\Id.
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Once a RFQ has been submitted and disseminated, all FCO
participants will be given a reasonable opportunity to request a
response time period during which time any participant may provide a
responsive quote.\20\ If a response time period is requested, no trades
may be executed until the response time period has elapsed, provided,
however, that if two or more assigned ROTs provide responsive quotes
prior to the end of the response time period, at the option of the
party who submitted the RFQ or any other FCO participant, the order may
trade at that time either in whole or in part.\21\
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\20\The length of the response time period will be fixed and set
by the Exchange's Foreign Currency Options Committee and will be
within a range between one and ten minutes. Neither the party
submitting the RFQ nor any other FCO participant will have any
ability to adjust the length of the response period. See Amendment
No. 3, supra note 7.
\21\Responsive quotes cannot be made specific for acceptance by
particular participants. Id.
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Rule 1069(b) further provides that responsive quotes which become
the best bid (offer) are entitled to participate in resulting trades on
a parity/priority basis in accordance with Rule 1014(h),\22\ provided,
however, that any assigned ROT who previously responded with a
responsive quote which was thereafter improved upon during the response
time period by another participant is entitled to participate on a
parity basis with that other participant by announcing immediately
thereafter, and prior to the execution of the order, that he or she is
matching that best bid (offer). This ability to match on parity is
available to assigned ROTs until the execution of the trade or the end
of the response time period, whichever occurs first.\23\ When a
response time period is requested, the party submitting the RFQ may not
cross any portion of the order until after the earlier of the end of
the response time period, if any, or the receipt of responsive quotes
from two or more assigned ROTs. An order may be executed after the
response time period has elapsed regardless of how many assigned ROTs
have previously responded. After the response time period has elapsed,
Phlx Rule 1014(h) governs priority/parity except that priority and
parity obtained during the response time period, as discussed above,
are retained unless or until the best bid (offer) established during
the response time period is improved.\24\
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\22\Phlx Rule 1014(h) generally sets forth the priority and
parity rules applicable to FCOs traded on the Phlx.
\23\See Amendment No. 3, supra note 7.
\24\Id.
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C. Additional Rules Contained in Phlx Rule 1069
Rule 1069 also contains additional rules applicable to the trading
of Customized FCOs. Rule 1069(d) provides that ROTs must apply to the
Exchange in order to obtain an assignment in Customized FCOs in one or
more Approved Currencies. Further, all ROTs assigned to trade
Customized FCOs are subject to the general obligations and restrictions
applicable to ROTs as specified in Phlx Rule 1014(c).\25\
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\25\ROTs will be subject to Exchange disciplinary actions for
failing to meet their responsibility of making two-sided markets
when requested to do so. See Phlx Rule 1014(c) and Phlx Floor
Procedure Advice B-1. Additionally, Phlx ROTs are required to trade
in person, and not through the use of orders, the greater of 1,000
contracts or 50% of their contract volume on the Exchange in each
quarter. Also, at least 50% of a ROT's trading activity in each
quarter must be in assigned options. See Phlx Floor Procedure Advice
B-3. For purposes of determining whether these trading requirements
have been satisfied, trading in Customized FCOs will be treated the
same as non-Customized FCOs. Telephone conversation with Michele
Weisbaum, Associate General Counsel, Phlx, and Brad Ritter, Senior
Counsel, OMS, Division, Commission, on October 20, 1994.
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Rule 1069(d) sets forth the financial requirements for ROTs trading
Customized FCOs. Specifically, assigned ROTs will be required to
maintain a minimum of $1 million in net liquid assets. Further, non-
assigned ROTs may not execute transactions in Customized FCOs unless
the non-assigned ROT has a minimum of $250,000 in net liquid assets.
All ROTs trading Customized FCOs, both assigned and non-assigned ROTs,
will be required to immediately inform the Exchange's Examination
Department whenever the ROT fails to be in compliance with these
requirements.\26\
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\26\See Amendment No. 3, supra note 7. The Exchange represents
that this affirmative obligation is being added to supplement the
Exchange's current surveillance and monitoring procedures pursuant
to which the Exchange monitors compliance with, among other things,
the Exchange's financial requirements. Telephone conversation
between Michele Weisbaum, Associate General Counsel, Phlx, and Brad
Ritter, OSM, Division, Commission, on October 17, 1994.
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Phlx Rule 1069(e) specifies that ROTs may not effect a transaction
in Customized FCOs unless a letter of guarantee has been issued by a
Phlx clearing member organization and filed with the Exchange pursuant
to Phlx Rule 703 specifically accepting financial responsibility for
all Customized FCO transactions entered into by the ROT. Additionally,
a ROT cannot engage in Customized FCO transactions if the letter of
guarantee is revoked.
Phlx Rule 1069(f) provides that transactions in Customized FCOs may
be effected during normal Exchange FCO trading hours on any business
day. Rule 1069(f) further provides that there will be no trading
rotations in Customized FCOs, either at the opening or at the close of
trading.
Finally, Rule 1069(j) provides that for Customized Strikes, the
quote spread parameters will be twice those specified in Phlx Rule
1014(c) for the relevant underlying Approved Currency. The rule further
provides that Customized Inverses and Customized Cross-Rates will be
exempt from quote spread parameters.\27\
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\27\The Exchange will conduct a study of the markets for
Customized Inverses and Cross-Rates to build an historical pricing
reference database on which to analyze whether quotation parameter
rules should be imposed in the future for these Customized FCOs. See
Amendment No. 3, supra note 7.
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D. Position and Exercise Limits
Phlx Rule 1001 (Position Limits) is being amended to provide
position limits for Customized FCOs. Rule 1001 presently provides that
the position limit for non-Customized FCOs on a particular Approved
Currency, other than the U.S. dollar, is 150,000 contracts on the same
side-of-the-market, provided that annual trading volume in FCOs on that
Approved Currency is at least 3,500,000 contracts. In all other cases,
the position limit for non-Customized FCOs is 100,000 contracts on the
same side-of-the-market.\28\
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\28\See Phlx Rule 1001, Commentary .05(b).
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Customized FCOs will be subject to these same position limits;
however, positions in Customized FCOs will be aggregated with positions
in non-Customized FCOs and, in some cases, with other Customized FCOs.
Specifically, Customized Strikes will be aggregated with positions in
regular FCO contracts having the same underlying currency.\29\ For
Customized Inverses, the position limit applicable to the base currency
of the Customized Inverse will apply.\30\ Except as provided below,
position limits applicable to Customized Cross-Rates will be the same
as position limits applicable to regular cross-rate FCOs pursuant to
Phlx Rule 1001, Commentary 05. For aggregation purposes, positions in
Customized Cross-Rates will be aggregated with positions in regular
cross-rate FCOs and other Customized Cross-Rates (1) with the same base
and underlying currencies and (2) where the base and underlying
currencies are reversed.\31\
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\29\See Amendment No. 3, supra note 7.
\30\For example, if the position limit for the U.S. dollar/
German mark non-Customized FCO is 150,000 contracts, the position
limit for German mark/U.S. dollar Customized Inverses will also be
150,000 contracts. Further, positions in U.S. dollar/German mark
non-Customized FCO contracts will be aggregated with positions in
German mark/U.S. dollar Customized Inverse contracts on the same
side of the market. In the case of the German mark, positions in the
Exchange's cash/spot German mark FCOs must also be aggregated with
the above positions and with positions in Customized Strikes where
the German mark is the underlying currency. See infra note 32.
\31\For example, positions in the German mark/Japanese yen
Customized Cross-Rate will be aggregated with positions in the non-
Customized German mark/Japanese yen contracts and with positions in
the Japanese yen/German mark Customized Cross-Rate.
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Additionally, Phlx Rule 1001, Commentary .05(c)(4), provides that
for purposes of aggregating positions, long positions in Customized
Inverse calls, short positions in Customized Inverse puts, short
positions in non-Customized FCO calls, short positions in Customized
Strike calls, long positions in non-Customized FCO puts, and long
positions in Customized Strike puts will be aggrgated. Similarly long
positions in Customized Inverse puts, short positions in Customized
Inverse calls, short positions in non-Customized FCO puts, short
positions in Customized Strike puts, long positions in non-Customized
FCO calls, and long positions in Customized Strike calls will be
aggregated.\32\ This is consistent with the aggregation procedures
currently provided in Phlx Rule 1001, Commentary .02, for positions on
the same side of the market.
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\32\For example, the following positions related to the German
mark would be aggregated for purposes of Rule 1001: (1) Long Inverse
German mark/U.S. dollar calls; (2) short Inverse German mark/U.S.
dollar puts; (3) short standardized U.S. dollar/German mark calls;
(4) short Customized Strike U.S. dollar/German mark calls; (5) long
standardized U.S. dollar/German market puts; and (6) long Customized
Strike U.S. dollar/German market puts. In addition, positions in the
Exchange's cash/spot U.S. dollar/German mark contract on the same
side of the market as the foregoing positions must also be
aggregated.
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Furthermore, for purposes of determining whether the 3,500,000
contract annual trading volume level has been satisfied for purposes of
applying the 150,000 contract position limit pursuant to Rule 1001,
Commentary .05(b), trading volume in Customized FCOs will not be
considered.\33\ Customized FCOs will be eligible for the 150,000
position limit level if: (1) In the case of Customized Strikes, non-
Customized FCOs on the same underlying currency, when considered alone,
would be so eligible; (2) in the case of Customized Inverses, if non-
Customized FCOs on the same base currency, when considered alone, would
be so eligible; and (3) in the case of Customized Cross-Rates, if
regular cross-rate FCOs on the same base and underlying currencies,
when considered alone, would be so eligible. The higher position limit
will not be available for Customized Cross-Rates where there are no
regular cross-rate FCOs trading on the same or the reverse base and
underlying currencies.
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\33\See Amendment No. 3, supra note 7.
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Finally, Rule 1069(i) provides that the exercise limits set forth
in Rule 1002 applicable to non-Customized FCOs also apply to Customized
FCOs.\34\ Moreover, when Customized FCOs are exercised, the lesser of
100 contracts or the remaining number of open contracts must be
exercised.
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\34\Id.
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E. Margin Requirements Applicable to Customized FCOs
Customized Inverses and Customized Strikes will be margined at the
same levels as the Exchange's non-Customized FCOs.\35\ Customized
Cross-Rates, however, will be margined using a two tier system. Tier I
will consist of all pairings of Approved Currencies (not involving the
U.S. dollar) whose daily price changes have a correlation greater than
or equal to .25, and Tier II will consist of all remaining pairings of
Approved Currencies. The initial and/or maintenance margin requirements
for Customized Cross-Rates will be 100% of the value of the underlying
position plus: (1) 4% for Tier I Approved Currency pairings; and (2) 6%
for Tier II Approved Currency Pairings.\36\
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\35\See Phlx Rule 722.
\36\The minimum margin for Tiers I and II will be reduced by the
amount by which the position is out-of-the-money, subject to a floor
of 100% of the value of the underlying position plus \3/4\% Id.
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The Exchange will conduct a regular two-step review of the margin
levels for Customized Cross-Rates. The first review, to be conducted at
least monthly,\37\ will determine the correlations between all of the
possible combinations of Approved Currencies for the most recent 24
month period. If a monthly or any special review reveals that a
combination of Approved Currencies should be in another tier based on
the correlation of those Approved Currencies, the change will
immediately be implemented and the membership, the public, and the
Commission will be promptly notified.
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\37\The Exchange also has the ability to conduct more frequent
reviews in the event of major price movements in any of the
underlying currencies.
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The second review will determine whether the actual margin levels
are adequate to cover seven day price changes for all possible cross-
rate combinations within a tier. Frequency distributions of seven day
price movements for all currency combinations will be reviewed on a
monthly basis to determine whether the percentage of margin ``add-on''
is sufficient to cover 95% of all instances over the preceding two year
period within the tier group for those combinations. If the percentage
falls to less than 95%, the Exchange will take steps to increase the
margin level for those pairings to one which will cover at least 97.5%
of all instances. If the margin adequacy level is greater than 99%, the
Exchange will take steps to lower the margin requirements for those
pairings to one which will cover 99%. In no event, however, will the
initial and/or maintenance margin levels for any pairing of Approved
Currencies be reduced below the 4% and 6% levels discussed above.\38\
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\38\See Amendment No. 3, supra note 7.
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The OCC will clear and settle all trades in Customized FCOs.
Because quotes in these options will not be continuously updated or
otherwise priced by the Exchange, the OCC will generate a theoretical
price based on the prices and quotes of the Customized FCOs, prices of
non-Customized FCO series, and the closing value of the relevant
underlying Approved Currency. The OCC will use this price to mark the
Customized FCO contracts daily and calculate margin requirements.\39\
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\39\See infra note 55.
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F. Other Applicable Exchange Rules
The Phlx is also amending certain other Exchange rules to
accommodate the trading of Customized FCOs. Several of these amendments
are necessary because of the fact that for purposes of trading
Customized FCOs, the U.S. dollar is now included as an Approved
Currency.\40\
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\40\See Phlx Rules 1000 (Applicability, Definitions and
References), 1001 (Position Limits), 1009 (Criteria for Underlying
Stocks), and 1034 (Minimum Fractional Changes).
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Other rule amendments are also necessary in order to incorporate
Customized FCOs into the Exchange's rules. First, Rule 1002 (Exercise
Limits) is being amended to add a cross-reference to Rule 1069 to
specify that when exercised, there is both a maximum and a minimum
number of Customized FCOs that can be exercised pursuant to the
Rule.\41\ Second, Rule 1014 (Obligations and Restrictions Applicable to
Specialists and Registered Options Traders) is being amended to add a
cross-reference to Rule 1069(j) to indicate that separate bid/ask
differentials are applicable to Customized FCOs. Third, Rule 1033 (Bids
and Offers--Premium) and Rule 1034 (Minimum Fractional Changes) are
being amended in order to provide rules for quoting Customized Inverses
and Cross-Rates and for the minimum fractional changes applicable to
Customized Inverses and Cross-Rates, respectively. Fourth, Rule 1047
(Trading Rotations, Halts and Suspensions) is being amended to specify
that there will be no trading rotations for Customized FCOs.
Additionally, because the proposed rule change will alter language in
Rules 1009 (Criteria for Underlying Stocks) and 1033 (Bids and Offers--
Premium), the Exchange is proposing to correct some inaccurate or
redundant information presently contained in those rules.
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\41\See supra Section II.C (Additional Rules Contained in Phlx
Rule 1069).
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Furthermore, except as modified or amended herein, Customized FCOs
will be subject to all Exchange rules applicable to non-Customized FCOs
and will be subject to all Exchange rules regarding surveillance and
sale practices. Finally, unless specifically exempted, all floor
trading procedures will also apply to the trading of Customized FCOs.
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, the requirements of Sections 6(b)(5)\42\ and 11A\43\ of the
Act. In particular, the Commission believes that the proposed rule
change is designed to provide institutional investors with exchange-
traded customized FCOs that may be more suitable to their investment
needs.\44\
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\42\ 15 U.S.C. 78f(b)(5) (1988).
\43\ 15 U.S.C. 78k-1 (1982).
\44\ The Commission notes that in many respects, the Phlx
proposal to trade Customized FCOs raises many of the same issues
that were raised and addressed in connection with proposals by
certain of the options exchanges to trade flexible exchange options
on broad-based indexes (``FLEX Options''). See Securities Exchange
Act Release Nos. 31920 (February 24, 1993), 58 FR 12280 (March 3,
1993) (order approving the trading of FLEX Options on the S&P 100
and 500 stock indexes), 32694 (July 29, 1993) 58 FR 41814 (August 5,
1993) (order approving the trading of FLEX Options on the Russell
2000 stock index), 32781 (August 20, 1993), 58 FR 45360 (August 27,
1993) (order approving the trading of FLEX Options on the Major
Market, Institutional, and S&P MidCap 400 stock indexes), and 34364
(July 13, 1994), 59 FR 36813 (July 19, 1994) (order approving the
trading of FLEX Options on the Wilshire Small Cap and PSE Technology
stock indexes) (collectively, ``FLEX Options Approval Orders'').
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Moreover, consistent with Section 11A of the Act, the proposal
should encourage fair competition among brokers and dealers and
exchange markets by allowing the Phlx to compete more effectively with
the over-the-counter (``OTC'') derivatives market in FCOs. For
instance, as noted by the Phlx, FCO market participants traditionally
have been able to customize FCOs in the OTC derivatives market,
designating many if not all of the terms of the FCOs. By trading in the
OTC derivatives market, however, these users, who are almost
exclusively institutional investors, do not benefit from the advantages
of an organized exchange. These benefits include, but are not limited
to, a centralized market center, an auction market with posted
transparent market quotations and transaction reporting, standardized
contract specifications, parameters and procedures for clearance and
settlement, and the guarantee of the OCC that will apply for all
Customized FCOs traded on the Exchange. The Commission believes that
the Phlx proposal will provide these benefits to investors.
Accordingly, the Commission believes that Phlx proposal is a reasonable
response by the Exchange to meet the demands of sophisticated portfolio
managers and other institutional investors who currently rely
predominantly on the OTC derivatives market to satisfy their foreign
currency hedging needs.
A. Proposed Framework for Trading Customized FCOs
In general, transactions in Customized FCOs will be subject to many
of the same rules that apply to non-Customized FCOs traded on the Phlx.
In order to provide investors with the flexibility to designate terms
of the Customized FCOs and to accommodate the special trading of
Customized FCOs, however, several new rules will apply solely to
Customized FCOs.
Due to the customized nature of these options, Customized FCOs will
not have trading rotations at either the opening or closing of trading.
In addition, the auction process outlined above in proposed Rule 1069
sets forth a procedure of customized negotiation for those investors
seeking particular flexibility in setting certain FCO terms.
Accordingly, the Phlx proposed rules specific to Customized FCOs vary
from the traditional procedures for trading non-Customized FCOs. The
Commission believes that the Customized FCO auction process, as
outlined above, appears reasonably designed to provide investors with
the benefits of an exchange auction environment for FCOs with features
of a negotiated transaction between investors. The Commission believes
that this is particularly true in view of the fact that most
participants in the FCO market are institutional investors and that the
proposed rule change is geared specifically to these investors.
Further, the auction process proposed for Customized FCOs is similar to
that previously approved by the Commission for exchange-trading of FLEX
Options.\45\
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\45\ Id. In addition, based on representations from the Phlx and
the OPRA, the Commission believes that the Exchange and the OPRA
will have adequate systems processing capacity to accommodate the
additional options listed in connection with customized strike
options. See Letter from Steven Watson, Data Processing, Phlx, to
Richard Cangelosi, Director of New Products, Phlx, dated July 27,
1994, and letter from Joseph Corrigan, Executive Director, OPRA, to
Richard Cangelosi, Director of New Products, Phlx, dated July 21,
1994. See also, supra note 18.
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Moreover, the proposal offers flexibility to institutional
investors in the FCO market without raising significant market
manipulation concerns. First, as noted above, transactions in
Customized FCOs will be subject to many of the same rules that apply to
non-Customized FCOs traded on the Exchange, including all Exchange
rules regarding surveillance and sales practices. Additionally,
position limits for Customized FCOs, as described above, are the same
as those for non-Customized FCOs with the additional protection that
positions in Customized FCOs will be aggregated with positions in non-
Customized FCOs.\46\ The Commission believes that these provisions will
help to ensure that the Exchange has the ability to adequately surveil
the market for Customized FCOs and to take prompt actions (including
timely communications with the Commission) should any unanticipated
adverse market effects develop.
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\46\The Commission notes that in contrast to FLEX Options which
have position limits substantially higher than those applicable to
non-FLEX Options on the same underlying indexes, positions in
Customized FCOs will be aggregated with positions in non-Customized
FCOs for position limit purposes. As a result, the Commission is not
requiring that the trading of Customized FCOs be implemented as a
pilot program nor will the Exchange be required to submit reports to
the Commission similar to those required from the exchanges that are
trading FLEX Options. See FLEX Options Approved Orders, supra note
44.
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B. Customized Strikes and Inverses
The Commission believes that the listing and trading of Customized
Strikes and Inverses does not raise any significant regulatory issues
that were not addressed by the Phlx when the Commission originally
approved the trading of non-Customized FCOs.\47\ Specifically, while
Customized Strikes and Inverses are new FCO products, they are very
similar to non-Customized FCOs in that investors will still be taking
positions based on their expectations of the future relationship
between an Approved Currency (other than the U.S. dollar) and the U.S.
dollar. The proposal, as with FLEX Options that currently trade on
several of the other options exchanges,\48\ merely allows investors to
more closely tailor the current Exchange-traded FCOs to their
particular investment needs. As a result, the Commission believes that
the listing and trading of Customized Strikes and Customized Inverses,
in the context of the framework described above, is appropriate and
consistent with the Act.
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\47\See Securities Exchange Act Release No. 19133 (October 14,
1982), 47 FR 46946 (October 21, 1982).
\48\See FLEX Options Approved Orders, supra note 44.
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C. Customized Cross-Rates
The discussion above regarding Customized Strikes and Inverses also
applies to the listing of Customized Cross-Rates. Customized Cross-
Rates, however, raise additional issues in that with Customized Cross-
Rates, investors will be able to trade options on combinations of
Approved Currencies that currently cannot be traded on the Exchange.
The Exchange believes, however, that the concerns raised by this
portion of the proposal are not any different from those that were
raised and addressed by the Exchange when the Commission approved the
listing and trading of regular cross-rate FCOs.\49\ In the Cross-Rate
Approval Order, the Commission stated that regular cross-rate FCOs are
riskier and more complex than non-Customized FCOs where the U.S. dollar
is the base currency. The Commission, however, found that those risks
were adequately disclosed in the Options Disclosure Document (``ODD'')
which is required to be delivered to all options investors.\50\
Similarly, the Commission notes here that the ODD was recently amended
so that the discussion of FCOs now also discloses the risks of
Customized Cross-Rates, in particular, and Customized FCOs, in
general.\51\
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\49\See Securities Exchange Act Release No. 29919 (November 7,
1991), 56 FR 58109 (November 15, 1991) (``Cross-Rate Approval
Order'').
\50\Id.
\51\See Securities Exchange Act Release No. 33582 (February 4,
1994), 59 FR 661 (February 11, 1994).
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Further, the Commission notes that the proposed margin levels for
Customized Cross-Rates are more stringent than those approved for
regular cross-rate FCOs. Specifically, for regular cross-rate FCOs, the
Exchange requires a margin of 100% of the option premium plus 4% of the
value of the underlying foreign currency, with an adjustment for out-
of-the-money options of not less than 100% of the options premiums plus
\3/4\% of the value of the underlying foreign currency. As described
above, the proposed rule change provides two tiers for purposes of
determining the applicable margin for Customized Cross-Rates based on
historical correlation rates between particular combinations of
Approved Currencies (other than the U.S. dollar). The lower tier
requires margin of not less than 100% of the options premium plus 4% of
the value of the underlying currency, and the higher tier requires
margin of not less than 100% of the options premium plus 6% of the
value of the underlying currency. The Commission notes that the Phlx
must raise these levels, if during a review of margin levels and tier
classifications,\52\ the Phlx determines that the 4% and 6% margin
levels for Tiers I and II, respectively, fail to meet certain specified
criteria designed to ensure coverage of most expected market moves in
the relevant currencies.\53\ The Commission, therefore, believes that
the proposed margin levels for Customized Cross-Rates will result in
adequate coverage of contract obligations, and are designed to preclude
systemic risks arising from excessively low margin levels.\54\
Accordingly, the Commission believes that the listing and trading of
Customized Cross-Rates, within the framework described above, is
appropriate and consistent with the Act.
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\52\See supra Section II.E (Margin Requirements Applicable to
Customized FCOs).
\53\While the proposed margin levels cannot account for every
unexpected market movement in each particular Approved Currency
pairing, it is important that the margin levels contain some ``add-
on'' provision to cover a short-term sharp movement beyond a two
standard deviation coverage of expected movements. The Phlx has
attempted to provide this ``add-on'' through the 4% and 6% margin
floors. Id.
\54\See Cross-Rate Approval Order, supra note 49.
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D. Percentage Quoting
The Commission also believes that allowing Customized FCOs to be
quoted as a percentage of the particular underlying currency does not
raise any significant regulatory issues. As in the discussion above
with regard to Customized Strikes and Inverses, Percentage Quoting does
not change the basic structure of non-Customized FCOs now trading on
the Exchange. Investors currently can mathematically convert a premium
expressed in terms of U.S. dollars per unit of underlying currency into
a percentage of the underlying currency by applying a particular
exchange rate. The real significance of percentage quoting is that it
allows investors to quote, pay premium, and settle, Customized FCOS
solely in the underlying currency instead of having to quote and pay
premiums in the base currency, and settle the options in the underlying
currency. Because the OCC has the ability to settle FCOs in any of the
Approved Currencies, allowing investors to also pay the premiums in an
Approved Currency does not raise any new market or investor protection
concerns.\55\
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\55\The Commission notes that simultaneously with this approval
order, the Commission is also approving rule changes proposed by the
OCC by which the OCC is adopting the framework necessary to clear
and settle Customized FCOs. See Securities Exchange Act Release No.
34926 (November 1, 1994) (order approving File Nos. SR-OCC-94-04,
SR-OCC-94-05, and SR-OCC-94-07).
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E. Procedures for Trading Customized FCOs
As stated above, the Commission believes that the procedures
outlined above for the trading of Customized FCOs are reasonably
designed to provide the benefits of an exchange auction market with
features of a negotiated transaction between investors. The Commission
recognizes that the Phlx's proposal will permit the trading of FCO
contracts of substantial value for which continuous quotation may be
difficult to sustain. Accordingly, the Phlx has established procedures
for quotes upon request which will be publicly disseminated through the
OPRA.\56\
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\56\See supra note 18. The Commission notes that the proposed
procedures for disseminating RFQs, responsive quotes, and completed
transactions, through OPRA as administrative text messages are the
same procedures used by the options exchanges that trade FLEX
Options (see supra note 44). By making these administrative text
messages available to vendors, transparency in the market for
Customized FCOs will be significantly greater than the transparency
that exists in the OTC FCO derivatives market.
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Additionally, the Commission believes that allowing assigned ROTs
who have previously provided responsive quotes to be able to achieve
parity during a response period is a reasonable means by the Phlx of
attempting to add liquidity to the market. By making this benefit
available to assigned ROTs, the Phlx may be able to encourage ROTs to
become assigned to trade Customized FCOs and, once assigned, to act in
a manner to create liquid Customized FCO markets. Specifically,
assigned ROTs will only be able to benefit from this feature if they
act quickly to provide responsive quotes during the response time
period which, in turn, may facilitate trading in the Customized FCOs.
In addition, the Commission believes that the requirement that
assigned ROTs must respond to a RFQ and must honor their quoted markets
for a certain minimum number of a contracts is appropriate. The
Commission recognizes that although assigned ROTs are not required to
respond to RFQs, the market making obligations under the Phlx's rules,
as discussed above, in addition to the ability of Floor Officials and
Floor Brokers to require a ROT to respond to RFQs, should help to
ensure that assigned ROTs provide adequate liquidity in the market for
Customized FCOs. In this regard, the Commission will expect the Phlx to
take action against assigned ROTs that fail, on an on-going basis, to
provide responsive quotes.\57\
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\57\In addition, the Commission notes that even if a ROT
provides responsive quotes, the Exchange can take disciplinary
action against the ROT pursuant to Phlx Rule 960 if the ROT quotes
markets that the Exchange deems inconsistent with the maintenance of
fair and orderly markets.
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In summary, the Commission believes that based on the unique nature
of the FCO market (i.e., that participants are largely institutional
investors) that the Phlx has set forth a reasonable proposal that
blends the customized nature of the OTC FCO derivatives market with
exchange auction market principles. In approving the proposed rule
change, the Commission recognizes that some of the procedures, such as
the ability of assigned ROTs to establish parity, in some instances,
during a request response time, and the minimum contract requirements,
deviate from existing rules that apply to Phlx's non-Customized FCO
market. Nevertheless, the Commission believes the proposal adequately
balances the Exchange's need to attract liquidity to its trading floor
with the specialized institutional characteristics of the FCO market.
Moreover, to the extent that the Phlx proposal attracts transactions to
the Exchange floor that would otherwise be completed in the OTC
derivatives market, the investors participating in those transactions
will receive the benefits of an exchange auction market, such as full
transaction reporting and the clearance and settlement features
provided by the OCC. Based on the above, the Commission finds that the
proposed rule change is appropriate.
F. Amendment No. 3
The Commission finds good cause for approving Amendment No. 3 to
the proposed rule change prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register in
order to allow the Exchange to begin trading Customized FCOs, which
have been under review by the Commission for several months, without
further delay.\58\ The Commission believes that the majority of the
changes contained in Amendment No. 3 strengthen the Exchange's original
proposal to trade Customized FCOs and serve to minimize the potential
for confusion as to the application of the Exchange's rules regarding
Customized FCOs. Additionally, each of these changes clarifies the
Exchange's original proposal which, the Commission notes, was published
for the full comment period without any comments being received.
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\58\As noted previously, Amendment No. 3 incorporates the
substance of, and withdrew, Amendment Nos. 1 and 2. See supra note
7.
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The Commission also believes that the changes to Rule 1069 proposed
in Amendment No. 3 do not raise any significant new issues that require
notice prior to approval. Most of the changes to Rule 1069 contained in
amendment No. 3 are nonsubstantive and are designed to reflect more
clearly the intent of the Exchange's original proposal in order to
minimize any potential for confusion among participants in the market
for Customized FCOs. The amendment to subsection (d) requiring all ROTs
to notify the Exchange's Examination Department immediately if they are
not in compliance with the financial requirements of the rule should
serve to strengthen the proposal and promote the creation of a fair and
orderly market for Customized FCOs. The amendment withdrawing the
request for spread margin treatment simply removes a potential
reduction in margin for spread transactions.
Similarly, the amendment to Rule 1001 provides certainty as to the
exclusion of trading volume in Customized FCOs when determining whether
the 150,000 contract position limit is available. The remaining
amendment to Rule 1001, Commentary .05, merely clarifies which
positions are considered to be on the same side of the market for
aggregation purposes.
The changes to Rule 722 contained in Amendment No. 3 are also more
restrictive than the proposal as originally noticed. The original
proposal provided for three margin tiers applicable to Customized
Inverses with the margin for the lowest tier being only 2%. In
Amendment No. 3 the Exchange provides that only two tiers will exist
and that the lowest applicable margin level will be 4%. As discussed
above, the Commission believes that this two-tiered structure and the
margin levels proposed are appropriate.\59\ The amendments to Rule 722
also merely codify this two-tier approach and clarify the manner by
which applicable margin will be determined for each specific Approved
Currency combination for Customized Cross-Rates.
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\59\See supra Section III.C (Customized Cross-Rates).
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The other substantive changes proposed in Amendment No. 3 are
merely for the purpose of conforming existing Exchange rules to the
procedures provided in new Rule 1069, thus eliminating inconsistencies
in the Phlx's rules. The remaining changes contained in Amendment No.
3, as discussed above, correct inaccurate or redundant information
presently contained in Phlx Rules 1009 and 1033 and thus raise no new
issues.
Accordingly, the Commission believes it is consistent with Section
6(b)(5) of the Act to approve Amendment No. 3 to the proposed rule
change on an accelerated basis.
Interested persons are invited to submit written data, views and
arguments concerning Amendment No. 3. 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 the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the proposed rule change between the Commission and any person, other
than those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for inspection and
copying in the Commission's Public Reference Section, 450 Fifth Street,
N.W., Washington, D.C. Copies of such filing will also be available for
inspection and copying at the principal office of the Phlx. All
submissions should refer to the File No. SR-Phlx-94-18 and should be
submitted by November 29, 1994.
IV. Conclusion
For the reasons discussed above, the Commission finds that the
proposal, as amended, is consistent with the Act and Sections 6 and 11A
of the Act in particular. In addition, the Commission also finds
pursuant to Rule 9b-1 under the Act that Customized FCOs are
standardized options for purposes of the options disclosure framework
established under Rule 9b-1 of the Act.\60\
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\60\As part of the original approval process of the FLEX Options
framework (see, e.g., supra note 44), the Commission delegated to
the Director of the Division of Market Regulation the authority to
authorize the issuance of orders designating securities as
standardized options pursuant to Rule 9b-1(a)(4) under the Act. See
Securities Exchange Act Release No. 31911 (February 23, 1993), 58 FR
11792 (March 1, 1993). On May 4, 1993, Chairman Breeden, pursuant to
Public Law 87-592, 76 Stat. 394 [15 U.S.C. 78d-1, 78d-2], and
Article 30-3 of the Commission's Statement of Organization; Conduct
and Ethics; and Information and Requests [17 CFR 200.30-3],
designated that persons serving in the position of Deputy Director,
Associate Director, and Assistant Director, in the Division of
Market Regulation, be authorized to issue orders designating
securities as ``standardized options'' pursuant to Rule 9b-1(a)(4).
Accordingly, this subdelegation provides the necessary authority for
Customized FCOs to be designated as ``standardized options'' by the
Division of Market Regulation. See Designation of Personnel to
Perform Delegated Functions in the Division of Market Regulation,
dated May 4, 1993.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\61\ that the proposed rule change (SR-Phlx-94-18), as amended, is
hereby approved.
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\61\15 U.S.C. 78s(b)(2) (1988).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\62\
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\62\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-27632 Filed 11-7-94; 8:45 am]
BILLING CODE 8010-01-M
