[Federal Register Volume 62, Number 29 (Wednesday, February 12, 1997)]
[Rules and Regulations]
[Pages 6474-6484]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-3479]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-38248; File No. S7-7-94]
RIN 3235-AG14
Net Capital Rule
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
amending Rule 15c3-1 under the Securities Exchange Act of 1934
(``Exchange Act''), the net capital rule, to permit broker-dealers to
employ theoretical option pricing models in determining net capital
requirements for listed options and related positions. Alternatively,
broker-dealers may elect a strategy-based methodology. The amendments
are intended to simplify the net capital rule's treatment of options
for capital purposes and more accurately reflect the risk inherent in
broker-dealer options positions.
EFFECTIVE DATE: The amendments become effective September 1, 1997.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director (202) 942-0131, Peter R. Geraghty, Assistant Director (202)
942-0177, or Louis A. Randazzo, Special Counsel (202) 942-0191,
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, N.W., Mail Stop 5-1, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
I. Introduction
The Commission is adopting amendments to Rule 15c3-1 under the
Exchange Act to permit broker-dealers to employ theoretical option
pricing models to calculate required net capital for listed options and
the related positions that hedge those options. In adopting these
amendments, the Commission is continuing its process of revising the
net capital rule that was contemplated when the Commission solicited
comments on a range of capital related issues in 1993.1 The
amendments being adopted today were proposed in initial form in March
of 1994 and would allow broker-dealers to use an options pricing model
to determine capital charges for listed options and related
positions.2 Simultaneously with the Commission's proposal, the
Division of Market Regulation (``Division'') issued a no-action letter
allowing broker-dealers to utilize the options pricing approach
immediately.3 Based on the experience gained by the Commission
under the no-action letter, and the nature of the comments received
during the public comment period, the Commission is
[[Page 6475]]
adopting the proposed amendments with certain changes discussed herein.
The rules will become effective on September 1, 1997; however, broker-
dealers that desire to apply the rule before the effective date may do
so.
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\1\ Securities Exchange Act Release No. 32256 (May 4, 1993), 58
FR 27486 (May 10, 1993) (``Concept Release'').
\2\ Securities Exchange Act Release No. 33761 (March 15, 1994),
59 FR 13275 (March 21, 1994) (``Proposing Release'').
\3\ Letter from Brandon Becker, Division of Market Regulation,
SEC to Mary L. Bender, First Vice President, CBOE and Timothy
Hinkas, Vice President, The Options Clearing Corporation (``OCC'')
(March 15, 1994) (``1994 No-Action Letter'').
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A. The Net Capital Rule Generally
The Commission adopted its first net capital rule in 1942.4
The rule requires that every registered broker-dealer maintain certain
specified minimum levels of net capital. The primary purpose of the
rule is to protect the customers of a broker-dealer from losses that
can be incurred upon the broker-dealer's failure. Rule 15c3-1 requires
registered broker-dealers to maintain sufficient liquid assets to
enable those firms that fall below the minimum net capital requirements
to liquidate in an orderly fashion without the need for a formal legal
proceeding. The rule prescribes different required minimum levels based
upon both the method a firm adopts in computing its net capital and the
type of securities business it conducts. A firm engaging in a general
securities business (which would allow the firm to clear and carry
customer accounts) must maintain a minimum net capital level of the
greater of $250,000 or 6\2/3\ percent of its liabilities (with certain
exclusions), or if the firm chooses the alternative method, the greater
of $250,000 or 2 percent of its customer-related receivables. The
different minimum levels of net capital for firms based on categories
of business activity are designed to address the perceived risk in the
broker-dealers' business. For example, if a broker-dealer carries no
customer accounts and does not engage in certain specified activities,
it can maintain as little as $5,000 in net capital.
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\4\ The section 8(b) of the Securities Exchange Act that was
adopted in 1934 contained a rudimentary net capital ratio
requirement for members of national securities exchanges and broker-
dealers conducting business through members. In 1942, the Commission
adopted its first net capital rule. Section 8(b) was repealed by
section 5(2) of the Securities Act Amendments of 1975, which also
required the adoption of the uniform net capital rule applicable to
all broker-dealers.
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Under the net capital rule, a broker-dealer takes its net worth,
computed in accordance with generally accepted accounting principles,
deducts certain illiquid assets (such as goodwill), certain percentages
from its proprietary securities or commodities inventory, and adds back
certain liabilities to arrive at net capital. This number is then
compared to its requirement to determine compliance. Much of the rule
itself is comprised of the haircut deductions which account for the
market and other risks inherent in a trading business. The Commission
believes the net capital rule has performed its customer protection
function well over the years, has enabled the Commission and the self-
regulatory organizations (``SROs'') to identify financial problems at
early stages, and has allowed the Commission and the SROs to perform
self-liquidations of failing securities firms without both customer
loss and the need for proceedings under the Securities Investor
Protection Act of 1970.5
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\5\ 15 U.S.C. 78aaa et seq.
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Currently, the net capital rule provides two basic capital
treatments for option positions held by broker-dealers. The first
approach, which is set forth in Appendix A to Rule 15c3-1, was designed
for firms clearing their proprietary listed option and related
positions, and assumes that the option will be exercised or held to
expiration. The second approach, which is set forth in Rule 15c3-
1(c)(2)(x), is a premium-based approach. Both methodologies of
computing charges provide for lower haircuts for certain risk
offsetting positions held by broker-dealers, although the premium-based
approach recognizes more types of offsetting positions and gives value
for the portion of the premium which is related to time.
B. The Development of the Options Pricing Approach to Capital
In 1973, Fischer Black and Myron Scholes introduced a formula to
calculate the value of European style options. The Black-Scholes
formula assumes that the primary factors affecting the price of an
option are: the value of the underlying asset, the exercise price of
the option, the volatility of the underlying asset, the risk-free rate
of interest, and the remaining time to expiration. Subsequent to the
development of the Black-Scholes formula, the Cox-Ross-Rubinstein
binomial pricing formula was developed. By calculating different
probable option values at various intervals, the formula is able to
more easily incorporate dividends, the term structure of the yield
curve, and the early exercise feature of American style options. Other
models which are based on the Cox-Ross-Rubinstein formula have since
been developed, including OCC's Theoretical Intermarket Margining
System (``TIMS''), which is used to measure the market risk associated
with participants' positions and to establish clearing house margin
requirements.
The sharp market breaks in 1987 and 1989 made it imperative for the
Commission to review the adequacy of the current options haircut
methodology. The Chicago Board Options Exchange (``CBOE'') and OCC
formed a task force to determine whether a more rigorous and predictive
approach to haircuts could be developed. As noted, the current
methodology requires that positions be allocated to specific recognized
strategies which are then haircut at the prescribed levels. The
aggregate haircut for a class, or product group in the case of indexes,
is the sum of the haircuts calculated for each individually identified
strategy. CBOE and OCC believed that the current strategy-based
approach did not effectively recognize the risk reduction of offsetting
positions within a class or product group, and therefore such approach
required excessive amounts of capital to maintain such offsetting
positions. In addition, CBOE and OCC maintained that the haircuts
associated with short, unhedged, out-of-the-money options were an
insufficient measure of capital adequacy with respect to rapid,
material changes in market prices. At that time, OCC had been utilizing
an options pricing model to establish clearing house margin
requirements. In addition, traders and risk managers had been using
options pricing models in the development of trading strategies and the
management of market risk. Thus, the task force determined to explore
the impact of haircuts calculated through the use of an options pricing
model.
CBOE and OCC conducted a preliminary study which compared haircut
and account equity data obtained from three options market-maker
clearing firms with position risk calculated using a derivation of TIMS
for a three month time frame in late 1990. Current haircuts and equity
were compared to the maximum loss under TIMS per class or product group
for each market-maker account. The preliminary study disclosed that
haircuts would be reduced for well-hedged, strategy-diverse positions,
and increased for unhedged positions. The study further disclosed that
the subject clearing firms maintained sufficient capital to continue in
capital compliance under the new approach. Based upon the results of
this study, the Division invited CBOE and OCC to propose a formal pilot
program specifically designed for calculating haircuts for listed
options on currencies, equities, and securities and futures indexes.
The Division, CBOE, and OCC agreed upon the criteria to be used in
the pilot program, and OCC staff developed the software and performed
the operations
[[Page 6476]]
to calculate the risk-based haircuts. TIMS was used to project prices.
Projected price moves were calculated based upon the closing underlying
asset price for each day plus and minus moves at ten equidistant data
points over a range of market movements. The greatest loss at any one
of these points would become the haircut. The volatility implied from
the closing price of the options series was used for the calculation of
each projected price for that series. To account for liquidation risk,
a minimum charge of \1/8\ point per option contract was applied when
the haircut for the class or product group reflected little or no
market exposure.
The results of the pilot program were consistent with earlier
findings in that accounts having primarily hedged positions reflected
significant haircut reductions; unhedged portfolios received higher
capital charges. Based in part on this experience, the Commission
issued the Proposing Release for comment.
C. The Commission's Proposal
The proposed amendments provided that, with respect to each option
series 6 it clears, OCC would collect certain information on a
daily basis.7 Using this information and TIMS, OCC would measure
the implied volatility for each option series. After measuring the
implied volatility for each option series, OCC would input to the model
the resulting implied volatility for each option series. For each
option series, the model would calculate theoretical prices at 10
equidistant valuation points within a range consisting of an increase
or a decrease of the following percentages of the daily market price of
the underlying instrument:
\6\ An option series includes option contracts of the same type
(either a call or a put) and exercise style covering the same
underlying instrument with the same exercise price, expiration date,
and number of underlying units. The Commission notes that for the
purposes of the final amendments, the term listed option includes
listed warrants.
\7\ Under the proposed rule, OCC would collect the following
information: (1) the dividend streams for the underlying securities,
(2) interest rates (either the current call rate or the Eurodollar
rate for the maturity date which approximates the expiration date of
the option), (3) days to expiration, and (4) closing underlying
security and option prices from various vendors.
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(i) +(-) 15% for equity securities with a ready market, narrow-based
indexes, and non-high-capitalization diversified indexes,8
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\8\ In order to avoid confusion with the designation of indexes
for margin or futures eligibility, the final amendments and the
remainder of this release refer to ``broad-based'' indexes as
``diversified'' indexes.
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(ii) +(-) 6% for major market currencies,9
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\9\ The major market currencies are: Deutsche Mark, British
Pound, Swiss Franc, French Franc, Canadian Dollar, Japanese Yen and
European Currency Unit.
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(iii) +(-) 10% for high-capitalization diversified indexes,10 and
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\10\ The Commission indicated in the Proposing Release that
underlying price movement assumptions for the proposed theoretical
pricing model should be consistent with the volatility assumptions
currently incorporated in the net capital rule.
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(iv) +(-) 20% for currencies other than major market currencies.
After the model calculated the theoretical gain/loss valuations,
OCC would provide the valuations to broker-dealers. Broker-dealers
would download this information into a spreadsheet from which the
broker-dealer would calculate the profit/loss for each of its
proprietary and market-maker options positions.11 The greatest
loss at any one valuation point would be the haircut.12
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\11\ For those broker-dealers which choose to use TIMS but do
not obtain a computer interface with OCC, OCC has developed a dial-
up service by which such broker-dealers may obtain, on a daily
basis, theoretical gains and losses. Other third-party vendors would
presumably offer a similar service. Any such dial-up service may be
a more practical option for those broker-dealers that do not find it
economically feasible to maintain a computerized interface with a
third-party source, but that do not wish to apply the alternative
strategy-based methodology, as discussed below.
\12\ The spreadsheet would be programmed to compute a minimum
haircut charge and identify the greater of the computed or minimum
charge as the haircut. For example, assume a portfolio consisting of
IBM common stock and various puts and calls on IBM common stock with
different strikes and expiration dates. OCC would re-price each
option position assuming that the price of the IBM common stock had
moved up or down by a maximum of 15%, at 10 valuation points (i.e.,
-15%, -12%, -9%, -6%, -3%, +3%, +6%, +9%, +12%, +15%). The single,
maximum net loss amount at any one of the 10 valuation points would
become the haircut for the portfolio.
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Depending upon the type of positions a broker-dealer sought to
offset, a percentage of a position's gain at any one valuation point
would offset another position's loss at the same valuation point. The
proposed amendments allowed the following offsets: (1) within any
portfolio type involving the same underlying stock, index, or currency,
100% of a position's gain at any one valuation point would offset
another position's loss at the same valuation point; (2) between
qualified stock baskets (provided the stock basket represented no less
than 90% of a high-capitalization diversified index's capitalization or
100% of the capitalization of a narrow diversified index) offset by
index options, or futures, or futures options on the same underlying
index, 95% of gains would offset losses at the same valuation point;
(3) among high-capitalization diversified index options, futures, and
futures options, 90% of the gain on one high-capitalization index
position in the same product group would offset the loss on a position
on a different high-capitalization diversified index at the same
valuation point; and (4) among non-high-capitalization diversified
index options, futures, and futures options, 75% of the gain on one
non-high-capitalization diversified index position would offset the
loss on a different non-high-capitalization diversified index at the
same valuation point.
Under the proposed amendments, required deductions were: (1) the
amount of losses at any of the 10 equidistant valuation points
representing the largest theoretical loss after applying the
permissible offsets; or (2) a minimum charge equal to \1/4\ of a point
13 times the multiplier for each options contract (or $25.00 per
option contract assuming that option contract covers 100 shares) and
each related instrument within the option's class or product group, or
$25 for each option on a major market foreign currency; plus (3) in the
case of portfolio types involving index options and related instruments
offset by a qualified stock basket, a minimum charge of 5% of the
market value of the qualified stock basket for high-capitalization
indexes, whether diversified or narrow-based; or (4) in the case of
portfolio types involving index options and related instruments offset
by a qualified stock basket, a minimum charge of 10% of the market
value of the qualified stock basket for diversified non-high-
capitalization indexes.
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\13\ As noted earlier, the pilot program applied a minimum
haircut of \1/8\ of a point. Pursuant to a recommendation by CBOE
and OCC, the Proposing Release increased the minimum charge to \1/4\
of a point per option contract. The Commission believed this
increase was appropriate to account for liquidation and decay risk
in options prices in situations where application of the proposed
amendments resulted in little or no charge.
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In proposing the amendments, the Commission recognized that certain
broker-dealers may not want to, or may not find it cost effective to
use an options pricing methodology because of their limited dealings in
options. Accordingly, the proposed amendments also included an
alternative strategy-based haircut methodology that generally followed,
but was more limited than, the haircut approach embodied in the current
rule.
Under the current rule, a broker-dealer that carries accounts of
listed options specialists must take a charge against capital as of the
close of business each day even though the broker-dealer does not know
the level of the charges until the following day. The proposed
amendments provided broker-
[[Page 6477]]
dealers with additional time by which to take the capital charge.
Specifically, the proposed amendments provided that broker-dealers
could adjust their net worth by deducting as of noon of the next
business day the charges computed as of the prior business day. In
addition, the proposed amendments provided that the required deductions
could be reduced by the deposit of funds or securities by noon of the
next business day.
D. Summary of Comments
The Commission received ten comment letters in response to the
Proposing Release.14 The comments, in general, were supportive of
the Commission's proposal. Most commenters, however, suggested that, in
addition to TIMS, the Commission permit the use of other pricing
models.15 In addition, some commenters suggested that the
Commission allow the use of theoretical pricing models in connection
with over-the-counter (``OTC'') options and positions in U.S. Treasury
securities.
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\14\ The comment letters are available for public inspection and
copying in the Commission's public reference room located at 450
Fifth Street, N.W., Washington, D.C. 20549 (File No. S7-7-94).
\15\ Some commenters suggested the use of broker-dealer
proprietary models or the Chicago Mercantile Exchange's Standard
Portfolio Analysis System (``SPAN'') which is used by many futures
exchanges to calculate margin requirements. Letter from Jeffrey
Bernstein, Chairman, Capital Committee of the Securities Industry
Association (``SIA'') to Jonathan G. Katz, Secretary, SEC (September
16, 1994), and Letter from Thomas R. Donovan, President and Chief
Executive Officer, Chicago Board of Trade to Jonathan G. Katz,
Secretary, SEC (May 13, 1994).
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The commenters also suggested that the underlying price assumption
for high-capitalization diversified indexes be reduced and that the
rule permit implied volatility inputs to fluctuate within certain
parameters. In addition, a few commenters suggested that the minimum
charge of \1/4\ of a point per option contract be reduced. These
issues, as well as others, are discussed below.
II. Description of Rule Amendments
A. Use of TIMS Versus Other Pricing Models
In the Proposing Release and under the 1994 No-Action Letter,
broker-dealers were required to use the OCC TIMS system as the
exclusive means of determining theoretical options prices. While TIMS
is a theoretically sound options pricing methodology, it is not the
only recognized methodology in the marketplace. Other models, using
different formulae, are also capable of arriving at legitimate results.
In response to the comments and based on additional experience with
models, the Commission is removing the requirement that TIMS be used.
The final rule permits the use of a model (other than a proprietary
model) maintained and operated by any third-party source and approved
by an examining authority designated pursuant to Section 17(d) of the
Exchange Act (``DEA''). The DEA shall submit to the Commission for
consideration a description of its methods for approving models.16
The model must consider at a minimum the following factors in pricing
the option: (1) the current spot price of the underlying asset; (2) the
exercise price of the option; (3) the remaining time until the option's
expiration; (4) the volatility of the underlying asset; (5) any cash
flows associated with ownership of the underlying asset that can
reasonably be expected to occur during the remaining life of the
option; and (6) current information about interest rates. Any such
approval of a model by a DEA must include appropriate provisions
relating to the obligations of the third-party vendor to supply timely
and accurate information to the broker-dealers. Once a model has been
approved by a DEA, broker-dealers may use the model in order to
calculate haircuts. For purposes of this rule, the TIMS system as
operated by OCC will be deemed to be an approved model for a period of
two years from the effective date of these amendments. OCC, however,
should clarify its vendor status by appropriate DEA approval.
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\16\ The Commission notes that any such third-party source,
including OCC, may charge broker-dealers a fee for the services they
provide in connection with these amendments.
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In addition to the commenters' suggestions that the final
amendments permit broker-dealers to utilize theoretical pricing systems
other than TIMS, certain commenters argued that the Commission should
permit the use of internal proprietary models for both listed products
and OTC options. The staff of the Division is preparing a separate
release which will propose for comment further amendments to the net
capital rule to permit the use of proprietary models to value listed
options.
B. Implied Volatilities
The TIMS model uses implied options volatilities to calculate
theoretical prices of options. It was suggested that because TIMS does
not alter implied volatilities as the theoretical price of the option
changes, the model overlooks an important element that could have a
major effect on capital requirements. In fact, requiring alteration of
the implied volatilities would cause numerous additional computations
without substantial benefits given the wide range in assumed underlying
price movements. The Commission notes, however, that the amendments
have been liberalized and permit the use of differing options pricing
models. The properties of each model can then be evaluated during the
model approval process established in the amendments.
C. Underlying Price Movement Assumptions
The proposed amendments included underlying price movement
assumptions for the theoretical pricing model that are consistent with
the volatility assumptions currently incorporated in the net capital
rule. The Commission believes that requiring the model to ``shock'' the
portfolio in the amounts currently incorporated into the net capital
rule is necessary to ensure consistent treatment of options and the
underlying positions. Since the amendments permit broker-dealers to
take haircuts on equities after taking into consideration options on
those equities, broker-dealers with limited options positions might
seek to apply the assumptions to all of their positions (both equities
and options) if the options pricing amendments utilized assumptions
that were less robust than those currently in the net capital rule for
the underlying positions. If this were the case, broker-dealers could
potentially obtain more favorable treatment on their equity positions
than currently contemplated by the net capital rule.
The Commission notes that the 1994 No-Action Letter contained a
reduction in the underlying price movements for non-clearing
specialists and market-makers to +(-)4\1/2\% for major market foreign
currency positions, +(-)10% for non-high-capitalization diversified
indexes, and +6(-8)% for high-capitalization diversified indexes. In
that letter, the Division expressly declined to extend this position to
other broker-dealers.17 The concession for market-makers and non-
clearing specialists was based upon the important role that non-
clearing specialists and market-makers perform in maintaining fair and
orderly markets. The Commission is incorporating the reduced
requirements for market-makers into the final rule in light of these
considerations, however, this concession expires two years from the
effective date of the amendments unless
[[Page 6478]]
it can be demonstrated by the non-clearing specialists and market-
makers that retention of reduced capital requirements is in the public
interest. Therefore, the Commission is adopting the minimum price
movements substantially as proposed.
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\17\ See 1994 No-Action Letter, supra note 3, at note 5.
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Similarly, some commenters suggested that the +(-)10% price move
assumption for high-capitalization diversified indexes (such as the S&P
500) was too high and should be reduced. During the time the 1994 No-
Action Letter has been in effect using a +(-)10% assumption, there does
not appear to have been any evidence of liquidity or execution problems
in the option markets from application of this assumption. The
Commission notes that this assumption is intended to cover the risks of
uncovered, out-of-the-money option positions. Accordingly, the
amendment retains the +(-)10% underlying assumption for high-
capitalization diversified indexes.
D. Permissible Offsets
The proposed amendments permitted specified offsets between
differing categories of instruments. The rule being adopted today
maintains the concept of specifying offsets, but with a few significant
changes. With respect to the offset between qualified stock baskets,
the Commission received one comment which contended that rather than
requiring that a basket contain a certain minimum amount of stock to be
considered a qualified stock basket, the rule should permit a broker-
dealer to convert every basket into a qualified stock basket by taking
a haircut on the missing or excess stocks, depending on whether too
little or too much of a stock was in the basket.
The Commission believes that the better approach is to maintain the
stock basket capitalization requirement. The purpose of the minimum
capitalization requirement is to ensure that a broker-dealer has a
sufficient number of stocks that match those in the index so that the
stocks correlate with the index. The Commission, however, believes that
a decrease in the capitalization requirement is appropriate.
Accordingly, under the rule amendment, to be a qualified stock basket,
the basket must represent no less than 50% of a diversified index's
capitalization and, for a narrow-based index, the basket must represent
no less than 95% capitalization. The proposed amendments allowed
offsets only between the same type of indexes and related positions.
Commenters suggested that offsets be allowed between different
diversified index product groups, and the Commission agrees it is
appropriate to permit offsets for positions among different diversified
index product groups. The groupings and netting allowances are set
forth below.
In addition, questions have arisen regarding the methodology that
should be used to designate indexes as high-capitalization diversified
or non-high capitalization diversified for purposes of the rule. Set
forth below is a list of those indexes which are to be treated as high
capitalization diversified or non-high capitalization diversified, and
the appropriate offsets. The offsets designated in the groupings are
based on historical correlations. The Commission recognizes that this
approach does not provide for the treatment of new indexes, however,
the Commission intends to issue a release which will set forth generic
guidelines for adding and deleting indexes (and designating appropriate
offsets) for purposes of the net capital rule.
U.S. Market Group A (i) Institutional Index (``XII''),
(ii) Major Market Index (``XMI''), (iii) S&P 100 Index (``OEX''), (iv)
S&P 500 Index (``SPX''), (v) New York Stock Exchange Composite Index
(``NYA''), (vi) Big-Cap Sector Index (``MKT''), and (vii) PHLX US Top
100 Index (``TPX''). A 90% offset is permitted between classes within
this product group, an 85% offset with U.S. Market Group B, and a 50%
offset with the non-high capitalization diversified U.S. Market Product
Group and the U.S. NASD Market Group.
U.S. Market Group B (i) S&P Barra Growth Index, and (ii)
S&P Barra Value Index. An 80% offset is permitted within this product
group, an 85% offset with U.S. Market Group A, and a 50% offset with
the non-high capitalization diversified U.S. Market Product Group and
the U.S. NASD Market Group.
Japan Market Group A (i) Japan Index (``JPN''), (ii) CBOE
Nikkei 300 Index (``NIK''), and (iii) the Nikkei 225 Index (``NK''). A
90% offset is permitted within this product group.
Japan Market Group B consists of the CBOE Japanese Export
Warrant Index.
European Market Product Group consists of the EuroTop 100
Index (``TOP'').
United Kingdom Market Product Group consists of the
Financial Times Exchange Index (``FT-SE'').
The following indexes are designated non high-capitalization
diversified market indexes:
U.S. Market Product Group (i) MidCap Index (``MID''), (ii)
Russell 2000 Index (``RUT''), (iii) Value Line Index (``VLE''), (iv)
Wilshire 250 Index (``WSX''), and (v) the S&P 600 Smallcap Index
(``SML''). A 75% offset is permitted within this product group, and a
50% offset with the U.S. NASD Market Group and with high-capitalization
diversified U.S. Market Groups A and B.
U.S. NASD Market Group (i) NASDAQ 100 Index (``NDX''), and
(ii) National OTC Index (``XOC''). A 75% offset is permitted within
this product group and a 50% offset with the U.S. Market Product Group
and with high-capitalization diversified U.S. Market Groups A and B.
Mexican Market Product Group consists of the Index of
Prices and Quotations (``IPC'').
The following indexes are designated narrow-based index options
within the following sector product groups.
Bank Sector Product Group (i) S&P Banking Index (``BIX''),
and (ii) PHLX KBW Bank Index (``BKX''). A 90% offset is permitted
within this product group.
Technology Sector Product Group (i) Morgan Stanley High
Tech 35 Index (``MSH''), (ii) PSE Technology Index (``PSE''), (iii)
CBOE Technology Index (``TXX''), (iv) AMEX Computer Technology Index
(``XCI''), (v) Goldman Sachs Technology Index (``GSTI'') Composit Index
(``GTC''), (vi) GSTI Hardware Index (``GHA''), (vii) GSTI Multimedia
Network Index (``GIP''), and (viii) GSTI Software Index (``GSO''). A
75% offset is permitted within this group. In addition, the PSE may be
offset 75% with the U.S. NASD Market Group.
Internet Product Group (i) CBOE Internet Index, (ii) AMEX
Internet Index, and (iii) GSTI Internet Index (``GIN''). A 75% offset
is permitted within this group.
Oil Product Group (i) CBOE Oil Index (``OIX''), and (ii)
AMEX Oil and Gas Index (``XOI''). A 90% offset is permitted within this
product group.
Gold Product Group (i) CBOE Gold Index (``GOX''), and (ii)
PHLX Gold/Silver Index (``XAU''). A 90% offset is permitted within this
product group.
Semiconductor Product Group (i) PHLX Semiconductor Index
(``SOX''), and (ii) GSTI Semiconductor Index (``GSM''). A 90% offset is
permitted within this product group.
Semiconductor Product Group (General) All remaining
narrow-based indexes. No offset is permitted within this product group.
E. Minimum Charges
The minimum charge specified in the rule is designed to account for
liquidation and decay risk in the prices of long and short options in
those
[[Page 6479]]
instances in which applications of the theoretical pricing methodology
results in little or no capital requirement. One commenter noted that
the use of a minimum charge of a \1/4\ of a point was a fair method of
estimating the liquidation risk of out-of-the-money options. Another
commenter indicated that the impact of the minimum charge was to cause
spreads for out-of-the-money calls and puts to expand because market-
makers are reluctant to sell these options.
Thus far, there is no evidence that these concerns have been borne
out, however, the Commission intends to monitor the impact of the
amendments and whether these concerns arise in fact. In the meantime,
the Commission believes that the minimum charge should be retained as
proposed. The rule as adopted, therefore, requires a minimum charge of
\1/4\ of a point or $25.00 per option contract assuming that the basic
equity option contract covers 100 shares. To the extent that an option
or futures contract exceeds the size of a basic option contract, the
minimum charge will be increased by the additional percentage amount of
underlying units. For example, an option or a futures contract on the
S&P 500 Index covers 500 shares (rather than 100 shares for a basic
equity option contract) and therefore the minimum charge would be
$125.00 (5 x $25.00).
In addition to the \1/4\ of a point minimum charge, the proposed
amendments required an additional deduction of 10% for each qualified
stock basket of non-high-capitalization diversified indexes, and 5% for
each qualified stock basket of high-capitalization diversified and
narrow-based indexes for those positions hedging an options or futures
contract subject to the minimum charge. In response to concerns that,
in the case of non-high-capitalization indexes, the 10% charge was
excessive, the Commission believes it is appropriate to decrease this
charge to 7.5%. For high-capitalization indexes, the proposed 5% charge
will be adopted.
F. Alternative Strategy-Based Methodology
The proposed amendments provided that broker-dealers could elect to
use the alternative strategy-based method for calculating haircuts. One
commenter contended that the alternative strategy-based methodology
contained in the proposal, because it contained very few simple
strategies, would impose haircuts on a trading book which are larger
than the haircuts in the current rule. The commenter recommended that
the Commission explore the possibility of adopting a strategy-based
calculation that would include common strategies currently used by
firms.
The Commission notes that the new rule is designed in part to
eliminate the complicated overlay of strategies and interpretations
that developed out of the necessity to accommodate all dealer options
strategies. To attempt to recognize many classes of strategies in the
alternative section would result in a return to the system the
Commission is revising today. Hence, the Commission believes that a
simple strategy-based alternative should be retained in the rule.
Limiting the alternative to simple strategies will tend to encourage
firms with any options positions of substance to utilize the pricing
model methodology. Because the recognized strategies in the alternative
section are minimal, limited hedges will be recognized with the result
that a book of any significance will incur larger charges under the
strategy-based method than the options pricing methodology. This will
provide an economic incentive for firms active in options to develop
the capability to use up-to-date modelling techniques.
G. Clearing Firm Capital Deposits
The net capital rule requires broker-dealers carrying the accounts
of listed options specialists to take capital charges reflecting
haircuts required due to specialists' trading activity. The capital
rule historically has required the clearing firm to take the required
charge as of the close of business each day to ensure it has sufficient
capital to open the next morning. However, the carrying firm generally
will not know the full extent of its requirements as to its specialists
until that next morning. Generally, clearing firms will seek to bring
in money, either from the specialist or from elsewhere during the
morning. This is a conservative charge considering the rule's usual
acceptance of allowing time for margin calls. To remedy this, the
proposal allowed the clearing firm until noon to obtain funds or
arrange financing. All of the commenters who addressed the issue
supported it; accordingly, the Commission is adopting the provision
with the clarification that ``noon'' is determined according to the
local time where the carrying firm has its headquarters. In any event,
this provision will not be available for a market-maker account in
deficit.
III. Technical Amendments to the Rule
As noted in the Proposing Release, in connection with the adoption
of the amendments, the Commission is making the following technical
amendments to the net capital rule necessitated by the new amendments
and to codify a long-standing staff interpretation:
A. Deletion of Paragraph (a)(7) of the Net Capital Rule
As previously stated, the net capital rule, as it currently is
written, contains two haircut methodologies, the premium-based approach
set forth in Rule 15c3-1(c)(2)(x) and the approach embodied in Appendix
A to Rule 15c3-1. Currently, pursuant to the provisions of paragraph
(a)(7) of the net capital rule, the premium-based approach is available
to a clearing firm if its business is limited almost exclusively to
effecting (either directly or as agent) and clearing market-making
transactions in listed options.
The final rule deletes paragraph (a)(7) of the net capital rule.
The Commission believes that this provision is no longer necessary
because the final rule eliminates the distinction between the premium-
based approach set forth in 15c3-1(c)(2)(x) and the approach set forth
in Appendix A to 17 CFR 240.15c3-1.
B. Steps To Be Taken by a Broker-Dealer Carrying the Account of an
Option Market-Maker When Equity in That Account is Insufficient to
Cover Haircuts
Pursuant to an interpretation letter,18 carrying broker-
dealers may extend credit in a market-maker account even when haircuts
for that account exceed the equity in the account.19 This
interpretation is conditioned upon the carrying broker-dealer taking a
charge against its capital to the extent that the equity in the market-
maker's account is insufficient to cover the haircuts. The amendments
incorporate this interpretation into the net capital rule.
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\18\ Letter from Lee A. Pickard, Director, Division of Market
Regulation, SEC, to Joseph W. Sullivan, President, CBOE (April 8,
1977).
\19\ Currently, paragraph (c)(2)(x)(F) of Rule 15c3-1 provides
that, if the haircuts for a particular market-maker's account exceed
the equity in the account, the carrying broker-dealer may not extend
further credit to the market-maker unless the carrying broker-dealer
requires the additional deposit of sufficient equity to eliminate
the net capital charge.
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IV. Summary of the Final Regulatory Flexibility Analysis
The Regulatory Flexibility Act, which became effective on January
1, 1981, imposes procedural steps applicable to agency rule making
which has a ``significant economic impact on a substantial number of
small entities.'' 20
[[Page 6480]]
The Commission has prepared a Final Regulatory Flexibility Analysis
(``Analysis'') in accordance with 5 U.S.C. Sec. 604 regarding the
amendments. The Analysis states that the Commission did not receive any
comments concerning the Initial Regulatory Flexibility Analysis.
---------------------------------------------------------------------------
\20\ Although Section 601(b) of the Regulatory Flexibility Act
defines the term ``small entity,'' the statute permits agencies to
formulate their own definitions. The Commission has adopted
definitions of the term ``small entity'' for purposes of Commission
rulemaking in accordance with the Regulatory Flexibility Act. Those
definitions are set forth in Rule 0-10, 17 CFR 240.0-10. See
Securities Exchange Act Release No. 18452 (January 28, 1982), 47 FR
5215 (February 4, 1982). A broker-dealer is a ``small business'' or
``small organization'' under Rule 0-10, if the broker-dealer (i) had
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its
audited financial statements were prepared pursuant to 17 CFR
240.17-5(d) or, if not required to file such statements, a broker-
dealer that had total net capital (net worth plus subordinated
liabilities) of less than $500,000 on the last business day of the
preceding fiscal year (or in the time that it has been in business,
if shorter); and (ii) is not affiliated with any person (other than
a natural person) that is not a small business or small organization
as defined in 17 CFR 240.0-10.
---------------------------------------------------------------------------
The Analysis notes that the amendments implement a haircut
methodology which employs a mathematical formula to determine the
theoretical value of options. The purpose of the amendments is to make
haircuts more accurately reflect the risks associated with dealer
option positions than is possible under the current rule and to
simplify the net capital rule's treatment of options for capital
purposes. The amendments permit the use of a model (other than a
proprietary model) maintained and operated by a third-party source,
including OCC, and approved according to the terms of the amendments.
The amendments will impact approximately 247 ``small entities'' which
are subject to the provisions of Rule 15c3-1 and have listed options
positions insofar as they would be required to implement a computer
interface with a third-party vendor in order to receive reliable data
to calculate haircuts. The Commission recognizes, however, that some
broker-dealers with very limited options positions might find it cost
prohibitive to install such computerized interface with a model
provider. In order to reduce the economic impact on these broker-
dealers, the amendments include an alternative haircut methodology that
is based on the basic options strategies used by broker-dealers, and is
similar to the approach used in the current rule.
The Analysis also states that no federal securities laws duplicate,
overlap, or conflict with the amendments, and adds that the Commission
does not believe any less burdensome alternatives are available to
accomplish the objectives of the amendments. In addition, the Analysis
notes that the staff carefully considered the possibility that smaller
broker-dealers who elect the strategy-based approach may receive more
severe haircut treatment than under the current rule because the
strategy-based approach under the amendments is limited to a few very
simple strategies. Because the Commission intended to eliminate the
complicated overlay of strategies and interpretations that developed
under the former rule to accommodate all dealer options strategies, and
because smaller broker-dealers which elect the alternate approach will
not be required to incur the costs associated with adopting a new
system to employ models, the Commission believes the amendments should
have a minimal adverse impact on small businesses or small
organizations. As such, the amendments contain no additional reporting,
recordkeeping, or other compliance requirements. For additional
information, a copy of the Analysis may be obtained by contacting Peter
Geraghty (202/942-0177) or Louis A. Randazzo (202/942-0191), Division
of Market Regulation, Securities and Exchange Commission, Washington,
D.C. 20549.
V. Paperwork Reduction Act
The text of the amendments contain ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(``PRA'').21 Broker-dealers subject to the rule are required to
notify the Commission and the appropriate designated examining
authority whenever their level of net capital falls below a prescribed
level for any period exceeding three business days, and whenever there
is a liquidating deficit in a specialist's market-maker account. These
same notification obligations exist under the present rule before
adoption of the amendments.22 Consequently, the amendment does not
change the PRA collection of information requirements or burden under
Rule 15c3-1. The Commission recently received an extension from the
Office of Management and Budget (``OMB'') for the collection of
information requirements contained in Rule 15c3-1. The title of the
collection of information is ``Net Capital Requirements for Brokers and
Dealers, Rule 15c3-1.'' The OMB control number is 3235-0200. The
Commission also reminds brokers and dealers subject to the amendments
about their related recordkeeping obligations under Rule 17a-4.
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\21\ 44 U.S.C. Sec. 3501 et seq.
\22\ See Rule 15c3-1(c)(2)(x).
---------------------------------------------------------------------------
VI. Statutory Analysis
Pursuant to the Securities Exchange Act of 1934 and particularly
Section 15(c)(3), (15 U.S.C. 78o(c)(3)) thereof, the Commission is
adopting amendments to Sec. 240.15c3-1 of Title 17 of the Code of
Federal Regulations in the manner set forth below.
List of Subjects in 17 CFR Part 240
Brokers, Reporting and recordkeeping requirements, Securities.
Text of Final Rule
In accordance with the foregoing, Title 17, chapter II, part 240 of
the Code of Federal Regulations is amended as follows:
Part 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for Part 240 continues to read in part as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l, 78m,
78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-
23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
2. Section 240.15c3-1 is amended by removing and reserving
paragraph (a)(7).
3. Section 240.15c3-1 is amended by adding an undesignated center
heading before paragraph (c)(2)(x) and revising paragraph (c)(2)(x) to
read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
* * * * *
(c) * * *
(2) * * *
Brokers or Dealers Carrying Accounts of Listed Options Specialists
(x)(A) With respect to any transaction of a specialist in listed
options, who is either not otherwise subject to the provisions of this
section or is described in paragraph (c)(2)(vi)(N) of this section, for
whose specialist account a broker or dealer acts as a guarantor,
endorser, or carrying broker or dealer, such broker or dealer shall
adjust its net worth by deducting as of noon of each business day the
amounts computed as of the prior business day pursuant to
Sec. 240.15c3-1a. The required deductions may be reduced by any
liquidating equity that exists in such specialist's market-maker
account as of that time and shall be increased to the extent of any
liquidating deficit in such account. Noon shall be determined according
to
[[Page 6481]]
the local time where the broker or dealer is headquartered. In no event
shall excess equity in the specialist's market-maker account result in
an increase of the net capital of any such guarantor, endorser, or
carrying broker or dealer.
(B) Definitions. (1) The term listed option shall mean any option
traded on a registered national securities exchange or automated
facility of a registered national securities association.
(2) For purposes of this section, the equity in an individual
specialist's market-maker account shall be computed by:
(i) Marking all securities positions long or short in the account
to their respective current market values;
(ii) Adding (deducting in the case of a debit balance) the credit
balance carried in such specialist's market-maker account; and
(iii) Adding (deducting in the case of short positions) the market
value of positions long in such account.
(C) No guarantor, endorser, or carrying broker or dealer shall
permit the sum of the deductions required pursuant to Sec. 240.15c3-1a
in respect of all transactions in specialists' market-maker accounts
guaranteed, endorsed, or carried by such broker or dealer to exceed
1,000 percent of such broker's or dealer's net capital as defined in
Sec. 240.15c3-1(c)(2) for any period exceeding three business days. If
at any time such sum exceeds 1,000 percent of such broker's or dealer's
net capital, then the broker or dealer shall:
(1) Immediately transmit telegraphic or facsimile notice of such
event to the Division of Market Regulation in the headquarters office
of the Commission in Washington, D.C., to the district or regional
office of the Commission for the district or region in which the broker
or dealer maintains its principal place of business, and to its
examining authority designated pursuant to section 17(d) of the Act (15
U.S.C. 78q(d)) (``Designated Examining Authority''); and
(2) Be subject to the prohibitions against withdrawal of equity
capital set forth in Sec. 240.15c3-1(e) and to the prohibitions against
reduction, prepayment, and repayment of subordination agreements set
forth in paragraph (b)(11) of Sec. 240.15c3-1d, as if such broker or
dealer's net capital were below the minimum standards specified by each
of those paragraphs.
(D) If at any time there is a liquidating deficit in a specialist's
market-maker account, then the broker or dealer guaranteeing,
endorsing, or carrying listed options transactions in such specialist's
market-maker account may not extend any further credit in that account,
and shall take steps to liquidate promptly existing positions in the
account. This paragraph shall not prevent the broker or dealer from,
upon approval by the broker's or dealer's Designated Examining
Authority, entering into hedging positions in the specialist's market-
maker account. The broker or dealer also shall transmit telegraphic or
facsimile notice of the deficit and its amount by the close of business
of the following business day to its Designated Examining Authority and
the Designated Examining Authority of the specialist, if different from
its own.
(E) Upon written application to the Commission by the specialist
and the broker or dealer guaranteeing, endorsing, or carrying options
transactions in such specialist's market-maker account, the Commission
may approve upon specified terms and conditions lesser adjustments to
net worth than those specified in Sec. 240.15c3-1a.
* * * * *
4. Section 240.15c3-1a is revised to read as follows:
Sec. 240.15c3-1a Options (Appendix A to 17 CFR 240.15c3-1).
(a) Definitions. (1) The term unlisted option shall mean any option
not included in the definition of listed option provided in paragraph
(c)(2)(x) of Sec. 240.15c3-1.
(2) The term option series refers to listed option contracts of the
same type (either a call or a put) and exercise style, covering the
same underlying security with the same exercise price, expiration date,
and number of underlying units.
(3) The term related instrument within an option class or product
group refers to futures contracts and options on futures contracts
covering the same underlying instrument. In relation to options on
foreign currencies a related instrument within an option class also
shall include forward contracts on the same underlying currency.
(4) The term underlying instrument refers to long and short
positions, as appropriate, covering the same foreign currency, the same
security, or a security which is exchangeable for or convertible into
the underlying security within a period of 90 days. If the exchange or
conversion requires the payment of money or results in a loss upon
conversion at the time when the security is deemed an underlying
instrument for purposes of this Appendix A, the broker or dealer will
deduct from net worth the full amount of the conversion loss. The term
underlying instrument shall not be deemed to include securities
options, futures contracts, options on futures contracts, qualified
stock baskets, or unlisted instruments.
(5) The term options class refers to all options contracts covering
the same underlying instrument.
(6) The term product group refers to two or more option classes,
related instruments, underlying instruments, and qualified stock
baskets in the same portfolio type (see paragraph (b)(1)(ii) of this
section) for which it has been determined that a percentage of
offsetting profits may be applied to losses at the same valuation
point.
(b) The deduction under this Appendix A to Sec. 240.15c3-1 shall
equal the sum of the deductions specified in paragraphs (b)(1)(v)(C) or
(b)(2) of this section.
Theoretical Pricing Charges
(1)(i) Definitions.
(A) The terms theoretical gains and losses shall mean the gain and
loss in the value of individual option series, the value of underlying
instruments, related instruments, and qualified stock baskets within
that option's class, at 10 equidistant intervals (valuation points)
ranging from an assumed movement (both up and down) in the current
market value of the underlying instrument equal to the percentage
corresponding to the deductions otherwise required under Sec. 240.15c3-
1 for the underlying instrument (See paragraph (a)(1)(iii) of this
section). Theoretical gains and losses shall be calculated using a
theoretical options pricing model that satisfies the criteria set forth
in paragraph (a)(1)(i)(B) of this section.
(B) The term theoretical options pricing model shall mean any
mathematical model, other than a broker-dealer proprietary model,
approved by a Designated Examining Authority. Such Designated Examining
Authority shall submit the model to the Commission, together with a
description of its methods for approving models. Any such model shall
calculate theoretical gains and losses as described in paragraph
(a)(1)(i)(A) of this section for all series and issues of equity, index
and foreign currency options and related instruments, and shall be made
available equally and on the same terms to all registered brokers or
dealers. Its procedures shall include the arrangement of the vendor to
supply accurate and timely data to each broker-dealer with respect to
its services, and the fees for distribution of the services. The data
provided to brokers or dealers shall also contain the minimum
requirements set forth in paragraphs (b)(1)(v)(C) of this section and
the
[[Page 6482]]
product group offsets set forth in paragraphs (b)(1)(v)(B) of this
section. At a minimum, the model shall consider the following factors
in pricing the option:
(1) The current spot price of the underlying asset;
(2) The exercise price of the option;
(3) The remaining time until the option's expiration;
(4) The volatility of the underlying asset;
(5) Any cash flows associated with ownership of the underlying asset
that can reasonably be expected to occur during the remaining life of
the option; and
(6) The current term structure of interest rates.
(C) The term major market foreign currency shall mean the currency
of a sovereign nation whose short-term debt is rated in one of the two
highest categories by at least two nationally recognized statistical
rating organizations and for which there is a substantial inter-bank
forward currency market. For purposes of this section, the European
Currency Unit (ECU) shall be deemed a major market foreign currency.
(D) The term qualified stock basket shall mean a set or basket of
stock positions which represents no less than 50% of the capitalization
for a high-capitalization or non-high-capitalization diversified market
index, or, in the case of a narrow-based index, no less than 95% of the
capitalization for such narrow-based index.
(ii) With respect to positions involving listed options in a single
specialist's market-maker account, and, separately, with respect to
positions involving listed option positions in its proprietary or other
account, the broker or dealer shall group long and short positions into
the following portfolio types:
(A) Equity options on the same underlying instrument and positions
in that underlying instrument;
(B) Options on the same major market foreign currency, positions in
that major market foreign currency, and related instruments within
those options' classes;
(C) High-capitalization diversified market index options, related
instruments within the option's class, and qualified stock baskets in
the same index;
(D) Non-high-capitalization diversified index options, related
instruments within the index option's class, and qualified stock
baskets in the same index; and
(E) Narrow-based index options, related instruments within the
index option's class, and qualified stock baskets in the same index.
(iii) Before making the computation, each broker or dealer shall
obtain the theoretical gains and losses for each options series and for
the related and underlying instruments within those options' class in
each specialist's market-maker account guaranteed, endorsed, or carried
by a broker or dealer, or in the proprietary or other accounts of that
broker or dealer. For each option series, the theoretical options
pricing model shall calculate theoretical prices at 10 equidistant
valuation points within a range consisting of an increase or a decrease
of the following percentages of the daily market price of the
underlying instrument:
(A) +(-)15% for equity securities with a ready market, narrow-based
indexes, and non-high-capitalization diversified indexes;
(B) +(-)6% for major market foreign currencies;
(C) +(-) 20% for all other currencies; and
(D) +(-)10% for high-capitalization diversified indexes.
(iv)(A) As to non-clearing option specialists and market-makers,
the percentages of the daily market price of the underlying instrument
shall be:
(1) +(-) 4\1/2\% for major market foreign currencies; and
(2) +6(-)8% for high-capitalization diversified indexes.
(3) +(-) 10% for a non-clearing market-maker, or specialist in non-high
capitalization diversified index product group.
(B) The provisions of this paragraph (b)(1)(iv) shall expire two
years from September 1, 1997, unless otherwise extended by the
Commission.
(v)(A) The broker or dealer shall multiply the corresponding
theoretical gains and losses at each of the 10 equidistant valuation
points by the number of positions held in a particular options series,
the related instruments and qualified stock baskets within the option's
class, and the positions in the same underlying instrument.
(B) In determining the aggregate profit or loss for each portfolio
type, the broker or dealer will be allowed the following offsets in the
following order, provided, that in the case of qualified stock baskets,
the broker or dealer may elect to net individual stocks between
qualified stock baskets and take the appropriate deduction on the
remaining, if any, securities:
(1) First, a broker or dealer is allowed the following offsets
within an option's class:
(i) Between options on the same underlying instrument, positions
covering the same underlying instrument, and related instruments within
the option's class, 100% of a position's gain shall offset another
position's loss at the same valuation point;
(ii) Between index options, related instruments within the option's
class, and qualified stock baskets on the same index, 95%, or such
other amount as designated by the Commission, of gains shall offset
losses at the same valuation point;
(2) Second, a broker-dealer is allowed the following offsets within
an index product group:
(i) Among positions involving different high-capitalization
diversified index option classes within the same product group, 90% of
the gain in a high-capitalization diversified market index option,
related instruments, and qualified stock baskets within that index
option's class shall offset the loss at the same valuation point in a
different high-capitalization diversified market index option, related
instruments, and qualified stock baskets within that index option's
class;
(ii) Among positions involving different non-high-capitalization
diversified index option classes within the same product group, 75% of
the gain in a non-high-capitalization diversified market index option,
related instruments, and qualified stock baskets within that index
option's class shall offset the loss at the same valuation point in
another non-high-capitalization diversified market index option,
related instruments, and qualified stock baskets within that index
option's class or product group;
(iii) Among positions involving different narrow-based index option
classes within the same product group, 90% of the gain in a narrow-
based market index option, related instruments, and qualified stock
baskets within that index option's class shall offset the loss at the
same valuation point in another narrow-based market index option,
related instruments, and qualified stock baskets within that index
option's class or product group;
(iv) No qualified stock basket should offset another qualified
stock basket; and
(3) Third, a broker-dealer is allowed the following offsets between
product groups: Among positions involving different diversified index
product groups within the same market group, 50% of the gain in a
diversified market index option, a related instrument, or a qualified
stock basket within that index option's product group shall offset the
[[Page 6483]]
loss at the same valuation point in another product group;
(C) For each portfolio type, the total deduction shall be the
larger of:
(1) The amount for any of the 10 equidistant valuation points
representing the largest theoretical loss after applying the offsets
provided in paragraph (b)(1)(v)(B) if this section; or
(2) A minimum charge equal to 25% times the multiplier for each
equity and index option contract and each related instrument within the
option's class or product group, or $25 for each option on a major
market foreign currency with the minimum charge for futures contracts
and options on futures contracts adjusted for contract size
differentials, not to exceed market value in the case of long positions
in options and options on futures contracts; plus
(3) In the case of portfolio types involving index options and
related instruments offset by a qualified stock basket, there will be a
minimum charge of 5% of the market value of the qualified stock basket
for high-capitalization diversified and narrow-based indexes; and
(4) In the case of portfolio types involving index options and
related instruments offset by a qualified stock basket, there will be a
minimum charge of 7\1/2\% of the market value of the qualified stock
basket for non-high-capitalization diversified indexes.
Alternative Strategy Based Method
(2) A broker or dealer may elect to apply the alternative strategy
based method in accordance with the provisions of this paragraph
(b)(2).
(i) Definitions. (A) The term intrinsic value or in-the-money
amount shall mean the amount by which the exercise value, in the case
of a call, is less than the current market value of the underlying
instrument, and, in the case of a put, is greater than the current
market value of the underlying instrument.
(B) The term out-of-the-money amount shall mean the amount by which
the exercise value, in the case of a call, is greater than the current
market value of the underlying instrument, and, in the case of a put,
is less than the current market value of the underlying instrument.
(C) The term time value shall mean the current market value of an
option contract that is in excess of its intrinsic value.
(ii) Every broker or dealer electing to calculate adjustments to
net worth in accordance with the provisions of this paragraph (b)(2)
must make the following adjustments to net worth:
(A) Add the time value of a short position in a listed option; and
(B) Deduct the time value of a long position in a listed option,
which relates to a position in the same underlying instrument or in a
related instrument within the option class or product group as
recognized in the strategies enumerated in paragraph (b)(2)(iii)(D) of
this section; and
(C) Add the net short market value or deduct the long market value
of listed options as recognized in the strategies enumerated in
paragraphs (b)(2)(iii)(E)(1) and (2) of this section.
(iii) In computing net capital after the adjustments provided for
in paragraph (b)(2)(ii) of this section, every broker or dealer shall
deduct the percentages specified in this paragraph (b)(2)(iii) for all
listed option positions, positions covering the same underlying
instrument and related instruments within the options' class or product
group.
Uncovered Calls
(A) Where a broker or dealer is short a call, deducting the
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1 of the current market value of the underlying
instrument for such option reduced by its out-of-the-money amount, to
the extent that such reduction does not operate to increase net
capital. In no event shall this deduction be less than the greater of
$250 for each short call option contract for 100 shares or 50% of the
aforementioned percentage.
Uncovered Puts
(B) Where a broker or dealer is short a put, deducting the
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1 of the current market value of the underlying
instrument for such option reduced by its out-of-the-money amount, to
the extent that such reduction does not operate to increase net
capital. In no event shall the deduction provided by this paragraph be
less than the greater of $250 for each short put option contract for
100 shares or 50% of the aforementioned percentage.
Long Positions
(C) Where a broker or dealer is long puts or calls, deducting 50
percent of the market value of the net long put and call positions in
the same options series.
Certain Security Positions With Offsetting Options
(D)(1) Where a broker or dealer is long a put for which it has an
offsetting long position in the same number of units of the same
underlying instrument, deducting the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the long offsetting position,
not to exceed the out-of-the-money amount of the option. In no event
shall the deduction provided by this paragraph be less than $25 for
each option contract for 100 shares, provided that the minimum charge
need not exceed the intrinsic value of the option.
(2) Where a broker or dealer is long a call for which it has an
offsetting short position in the same number of units of the same
underlying instrument, deducting the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the short offsetting position,
not to exceed the out-of-the-money amount of the option. In no event
shall the deduction provided by this paragraph be less than $25 for
each option contract for 100 shares, provided that the minimum charge
need not exceed the intrinsic value of the option.
(3) Where a broker or dealer is short a call for which it has an
offsetting long position in the same number of units of the same
underlying instrument, deducting the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the offsetting long position
reduced by the short call's intrinsic value. In no event shall the
deduction provided by this paragraph be less than $25 for each option
contract for 100 shares.
Certain Spread Positions
(E)(1) Where a broker or dealer is short a listed call and is also
long a listed call in the same class of options contracts and the long
option expires on the same date as or subsequent to the short option,
the deduction, after adjustments required in paragraph (b) of this
section, shall be the amount by which the exercise value of the long
call exceeds the exercise value of the short call. If the exercise
value of the long call is less than or equal to the exercise value of
the short call, no deduction is required.
(2) Where a broker or dealer is short a listed put and is also long
a listed put in the same class of options contracts and the long option
expires on the same date as or subsequent to the short option, the
deduction, after the adjustments required in paragraph (b) of this
section, shall be the amount by which the exercise value of the short
put exceeds the exercise value of the long put. If the exercise value
of the long put is equal to or greater than the
[[Page 6484]]
exercise value of the short put, no deduction is required.
(c) With respect to transactions involving unlisted options, every
broker or dealer shall determine the value of unlisted option positions
in accordance with the provision of paragraph (c)(2)(i) of
Sec. 240.15c3-1, and shall deduct the percentages of all securities
positions or unlisted options in the proprietary or other accounts of
the broker or dealer specified in this paragraph (c). However, where
computing the deduction required for a security position as if the
security position had no related unlisted option position and positions
in unlisted options as if uncovered would result in a lesser deduction
from net worth, the broker or dealer may compute such deductions
separately.
Uncovered Calls
(1) Where a broker or dealer is short a call, deducting 15 percent
(or such other percentage required by paragraphs (c)(2)(vi) (A) through
(K) of Sec. 240.15c3-1) of the current market value of the security
underlying such option reduced by any excess of the exercise value of
the call over the current market value of the underlying security. In
no event shall the deduction provided by this paragraph be less than
$250 for each option contract for 100 shares.
Uncovered Puts
(2) Where a broker or dealer is short a put, deducting 15 percent
(or such other percentage required by paragraphs (c)(2)(vi) (A) through
(K) of Sec. 240.15c3-1) of the current market value of the security
underlying the option reduced by any excess of the market value of the
underlying security over the exercise value of the put. In no event
shall the deduction provided by this paragraph be less than $250 for
each option contract for 100 shares.
Covered Calls
(3) Where a broker or dealer is short a call and long equivalent
units of the underlying security, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the current market value of the underlying security
reduced by any excess of the current market value of the underlying
security over the exercise value of the call. No reduction under this
paragraph shall have the effect of increasing net capital.
Covered Puts
(4) Where a broker or dealer is short a put and short equivalent
units of the underlying security, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the current market value of the underlying security
reduced by any excess of the exercise value of the put over the market
value of the underlying security. No such reduction shall have the
effect of increasing net capital.
Conversion Accounts
(5) Where a broker or dealer is long equivalent units of the
underlying security, long a put written or endorsed by a broker or
dealer and short a call in its proprietary or other accounts, deducting
5 percent (or 50 percent of such other percentage required by
paragraphs (c)(2)(vi) (A) through (K) of Sec. 240.15c3-1) of the
current market value of the underlying security.
(6) Where a broker or dealer is short equivalent units of the
underlying security, long a call written or endorsed by a broker or
dealer and short a put in his proprietary or other accounts, deducting
5 percent (or 50 percent of such other percentage required by
paragraphs (c)(2)(vi) (A) through (K) of Sec. 240.15c3-1) of the market
value of the underlying security.
Long Options
(7) Where a broker or dealer is long a put or call endorsed or
written by a broker or dealer, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the market value of the underlying security, not to
exceed any value attributed to such option in paragraph (c)(2)(i) of
Sec. 240.15c3-1.
By the Commission.
Dated: February 6, 1997.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-3479 Filed 2-11-97; 8:45 am]
BILLING CODE 8010-01-P
