[Federal Register Volume 61, Number 39 (Tuesday, February 27, 1996)]
[Notices]
[Pages 7295-7297]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-4313]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36858; File No. SR-PHLX-95-45]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval of
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the
Philadelphia Stock Exchange, Inc., Relating to the Industry Index
Option Hedge Exemption
February 16, 1996.
On September 18, 1995, the Philadelphia Stock Exchange, Inc.
(``PHLX'' or ``Exchange'') submitted to the Securities and Exchange
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to amend PHLX Rule 1001A,
``Position Limits,'' to establish a hedge exemption from industry
(narrow-based) index option position and exercise limits.\3\
\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1995).
\3\ Position limits impose a ceiling on the number of option
contracts which an investor or group of investors acting in concert
may hold or write in each class of options on the same side of the
market (i.e., aggregating long calls and short puts or long puts and
short calls). Exercise limits prohibit an investor or group of
investors acting in concert from exercising more than a specified
number of puts or calls in a particular class within five
consecutive business days.
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The proposed rule change was published for comment in the Federal
Register on October 23, 1995.\4\ No comments were received on the
proposed rule change. On December 20, 1995, on February 14, 1996, and
on February 16, 1996, the PHLX amended its proposal.\5\
\4\ See Securities Exchange Act Release No. 36380 (October 17,
1995), 60 FR 54403.
\5\ On December 20, 1995, the PHLX amended its proposal to
specify certain requirements and monitoring procedures which the
Exchange will use in connection with the hedge exemption. See Letter
from Gerald D. O'Connell, First Vice President, Market Regulation
and Trading Operations, PHLX, to Michael Walinskas, Branch Chief,
Office of Market Supervision (``OMS''), Division of Market
Regulation (``Division''), Commission, dated December 20, 1995
(``Amendment No. 1''). Among other things, Amendment No. 1 indicates
that the PHLX will monitor accounts utilizing the hedge exemption on
a daily basis; that the hedging portfolio must be previously
established and that options must be carried in an account with an
Exchange member; that initiating or liquidating positions should not
be conducted in a manner calculated to cause unreasonable price
fluctuations or unwarranted price changes; and that the PHLX's
Market Surveillance Department must be notified of any material
change in the portfolio or futures positions which materially
affects the unhedged value of the portfolio. Amendment No. 2
modifies the proposal by providing that the industry index hedge
exemption will be two times the existing position and exercise limit
rather than three times the limit because the hedged option position
is held in addition to the contracts currently permitted under the
Exchange's rules. In addition, Amendment No. 2 indicates that
offsetting positions in stock index futures options must be deducted
from the total market value of the net stock position to determine
the value of the hedging portfolio. See Letter from Gerald D.
O'Connell, First Vice President, Market Regulation and Trading
Operations, PHLX, to Michael Walinskas, Branch Chief, OMS, Division,
Commission, dated February 14, 1996 (``Amendment No. 2''). On
February 16, 1996, the PHLX amended its proposal by adding
subparagraph (C) to paragraph (b)(2) of Commentary .01 in order to
make clear that economically equivalent positions must be deducted
from the market value of the net stock position to determine the
value of the underlying portfolio. See Letter from Gerald D.
O'Connell, First Vice President, Market Regulation and Trading
Operations, PHLX, to Michael Walinskas, Branch Chief, OMS, Division,
Commission, dated February 16, 1996 (``Amendment No. 3'').
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The PHLX proposes to exempt from position and exercise limits any
position in an industry index option that is hedged by share positions
in at least 75% of the number of component stocks of that index or
securities convertible into such stock.\6\ Under the proposal, no
position in an industry index option may exceed two times the narrow-
based index option position specified in PHLX Rule 1001A(b)(i) \7\ and
the value of the index option position may not exceed the value of the
underlying hedging portfolio. The value of the underlying hedging
portfolio is determined as follows: (1) the total market value of the
net stock position, less (2) the value of: (a) the notional value \8\
of any offsetting calls and puts in the respective index option class;
(b) the notional value of any offsetting positions in stock index
futures or options; and (c) any economically equivalent positions.\9\
\6\ The PHLX permits the use of convertible securities in its
equity option hedge exemption. See Securities Exchange Act Release
No. 32174 (April 20, 1993), 58 FR 25687 (April 27, 1993) (order
approving File No. SR-PHLX-92-22). Similarly, other options exchange
permit the use of convertible securities in broad-based index hedge
exemptions. See Securities Exchange Act Release No. 35738 (May 18,
1995), 60 FR 27573 (May 24, 1995) (File Nos. SR-Amex-95-13, SR-CBOE-
95-13, SR-NYSE-95-04, SR-PSE-95-05, and SR-PHLX-95-10) (permanently
approving hedge exemption pilot programs).
\7\ PHLX Rule 1001A(b)(i) provides the following position limits
for industry index options: 6,000 contracts if any single stock
accounted, on average, for 30% or more of the index value during the
30-day period preceding the review; 9,000 contracts if any single
stock accounted, on average, for 20% or more of the index value or
any five stocks together accounted, on average, for more than 50% of
the index value, but no single stock in the group accounted on
average, for 30% or more of the index value during the 30-day period
preceding the review; or 12,000 contracts if none of the above
conditions apply. See Securities Exchange Act Release No. 36194
(September 6, 1995), 60 FR 47637 (order approving File No. SR-PHLX-
95-16) (increasing position limits for industry index options to
6,000, 9,000 or 12,000 contracts).
\8\ Notional values are determined by adding the number of
contracts and multiplying the total by the multiplier, expressing
that number in dollar terms.
\9\ See Amendment Nos. 2 and 3, supra note 5.
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Under the proposal, exercise limits will continue to correspond to
position limits, so that investors may exercise the number of contracts
set forth as the position limit, as well as those contracts exempted by
the proposal, during five consecutive business days.
The proposed exemption requires that both the options and stock
positions be initiated and liquidated in an orderly manner.
Specifically, a reduction of the options position must occur at or
before the corresponding reduction in the stock portfolio position.
The proposed exemption will be available to firm and proprietary
traders, as well as public customers. According to the PHLX, because
customers rely, for the most part, on a limited number of proprietary
traders to facilitate large-sized orders, failure to include such
traders in the exemption could effectively reduce the benefit of the
exemption to customers.
The PHLX believes that the hedge exemption provision is necessary
to better meet the needs of investors who would use PHLX industry index
options for investment and hedging purposes. The PHLX states that many
institutional traders and portfolio managers deal in dollar amounts
much greater than permissible under current position limit levels and
have expressed that Exchange position limits hamper their ability to
fully utilize Exchange index options. As a result, the PHLX believes
that many index options are ineffective for such traders, who may as a
result choose to
[[Page 7296]]
use futures instruments.\10\ Thus, the PHLX believes that the proposed
hedge exemption should alleviate the situation where investors with
substantial hedging needs are discouraged from participation in the
options markets by existing position limits.
\10\ Under rules promulgated by the Commodity Futures Trading
Commission, futures positions that are deemed to be bona fide
hedging transactions (as defined) are exempted from position limit
rules. See Securities Exchange Act Release No. 25739 (May 24, 1988),
53 FR 20204, (June 2, 1988) (order approving File No. SR-CBOE-87-
25).
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The PHLX believes that the proposed narrow-based index option hedge
exemption should not increase the potential for disruption or
manipulation in the markets for the stocks underlying each index. In
this regard, the proposal incorporates several surveillance safeguards,
which the PHLX will employ to monitor the use of this exemption.
Specifically, the Exchange will require that an application for
exemption be filed by member firms and their customers who seek hedge
exemptions. The Exchange will review the application and approve only
those applications that satisfy the hedge exemption requirements. The
Exchange's Market Surveillance Department will monitor trading activity
in PHLX-traded index options and the stocks underlying those indexes to
detect potential frontrunning and manipulation abuses, as well as
review such trading to ensure that the closing of positions subject to
an exemption is conducted in a fair and orderly manner.\11\
\11\ See also Amendment No. 1, supra note 5.
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The PHLX also notes that the provision itself contains several
built-in safeguards. First, the hedge must consist of a position in at
least 75% of the stocks underlying the index. Thus, the ``basket'' of
stocks constituting the hedge resembles the underlying index.\12\
Second, the proposal provides a ceiling on the maximum size of the
option position by providing that positions established under the
proposal may not exceed two times the limits established under PHLX
Rule 1001A(b)(i). Third, both the options and stock positions must be
initiated and liquidated in an orderly manner, meaning that a reduction
of the options position must occur at or before the corresponding
reduction in the stock portfolio position. Lastly, the value of the
industry index option position cannot exceed the dollar value of the
underlying hedging portfolio. The purpose of this requirement is to
further ensure that stock transactions are not used to manipulate the
market in a manner benefiting the option position. In addition, these
safeguards prevent the increased positions from being used in a
leveraged manner by ensuring that the options position subject to the
increased position limit is properly ``covered'' by the hedge.
\12\ To determine the share amount of each component required to
hedge an index option position: index value x index multiplier x
component's weighing = dollar amount of component. That amount
divided by price = number of shares of component. Conversely, to
determine how many options can be purchased based on a certain
portfolio, divide the dollar amount of the basket by the index value
x index multiplier.
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For the above reasons, the PHLX believes that the proposed industry
index hedge exemption should increase the depth and liquidity of the
markets for narrow-based index options and allow more effective hedging
with underlying stock portfolios without increasing the potential for
market manipulation or disruption, consistent with the purposes of
position and exercise limits.
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 Section 6(b)(5) thereunder.\13\ The
Commission concludes that providing for increased position and exercise
limits for narrow-based index options in circumstances where those
excess positions are fully hedged with offsetting stock positions will
provide greater depth and liquidity to the market and will allow
investors to hedge their stock portfolios more effectively, without
significantly increasing concerns regarding intermarket manipulations
or disruptions of either the options market or the underlying stock
market.
\13\ 15 U.S.C. 78f(b)(5) (1988 & Supp. V 1993).
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Specifically, the PHLX proposal contains safeguards that should
make it difficult to use the exempted positions to disrupt or
manipulate the market. First, requests for the exemption must be
approved by the PHLX, which should ensure that the hedges are
appropriate for the position being taken and are in compliance with
PHLX rules. Second, the stock portfolio must consist of at least 75% of
the number of component securities underlying the index, and must
correspond in value to the value of the options position hedged, so
that the increased positions are less likely to be used in a leveraged
manner in any manipulative scheme. As noted above the value of the
hedging portfolio is equal to (1) The total market value of the net
stock position; less (2) the value of (a) any offsetting calls and puts
in the index option; (b) any offsetting positions in related stock
index futures or options; and (c) any economically equivalent
positions.\14\ Third, both the options and the stock positions must be
initiated and liquidated in an orderly manner. Moreover, a reduction of
the options position must occur at or before the corresponding
reduction in the stock portfolio position, thereby helping to ensure
that the stock transactions are not used to impact the market so as to
benefit the options positions. Fourth, the PHLX's Market Surveillance
Department must be notified in writing for approval prior to
liquidating or initiating any such position and the PHLX's Market
Surveillance Department must also be notified of any material change in
the portfolio or futures positions which materially affects the value
of the qualified portfolio. Fifth, the maximum hedge exemption position
is two times the existing limit. The ``two times the limit'' is not
automatic and the PHLX has the authority to approve a hedge limit for
less than that amount.
\14\ See Amendment Nos. 2 and 3, supra note 5. According to the
PHLX, ``economically equivalent'' positions are instruments whose
prices fluctuate in tandem. The PHLX believes, for example, that
National Over-the-Counter Index options and Nasdaq 100 Index options
are economic equivalents, and that stock and bonds issued by the
same company may be economic equivalents. Telephone conversation
between Edith Hallahan, Special Counsel, Regulatory Services, PHLX,
and Yvonne Fraticelli, Attorney, OMS, on February 14, 1996.
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The Commission notes that the PHLX's surveillance procedures are
designed to detect as well as deter manipulation and market
disruptions. In particular, the PHLX will monitor the options position
of a person utilizing the hedge exemption on a daily basis to ensure
that each option contract is hedged by the equivalent dollar amount of
component securities.\15\ In addition, the PHLX's Market Surveillance
Department will monitor trading activity in PHLX-traded index options
and their underlying component stocks to detect potential frontrunning
and manipulation, and to ensure that the closing of positions subject
to the exemption is conducted in a fair and orderly manner. Violation
of any of the provisions of the industry index hedge exemption, absent
reasonable justification or excuse, will result in the withdrawal of
the hedge exemption and
[[Page 7297]]
subsequent denial of an application for a hedge exemption thereunder.
\15\ Market participants granted a hedge exemption are also
required to keep their application forms for the hedge exemption
current and promptly provide the PHLX with any information
concerning the dollar value and composition of the stock portfolio,
the current hedged and aggregate option positions, and any stock
index futures positions, or economically equivalent positions.
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Finally, the Commission believes that it is reasonable for the PHLX
to allow firm and proprietary traders, as well as public customers, to
utilize the proposed hedge exemption. The Commission believes that
extending the narrow-based index option hedge exemption to firm and
proprietary traders may help to increase the depth and liquidity of the
market for industry index options and may help to ensure that public
customers receive the full benefit of the exemption. Moreover, the
PHLX's monitoring procedures, as described above, should be able to
detect abuses and ensure that the options position, whether firm,
proprietary trader, or customer, is properly hedged.
The Commission finds good cause for approving Amendment Nos. 1, 2,
and 3 to the proposed rule change prior to the thirtieth day after the
date of publication of the notice thereof in the Federal Register.
Specifically, Amendment No. 1, is designed to protect investors and the
public interest by providing additional requirements and surveillance
procedures which the Exchange will use in monitoring the narrow-based
index option hedge exemption. Amendment No. 2 clarifies the Exchange's
proposal by indicating that the hedge exemption allows a market
participant to hold up to two times, rather than three times, the
current position limit because the hedged position is held in addition
to the contracts permitted under PHLX Rule 1001A. In addition,
Amendment No. 2 strengthens the PHLX's proposal by providing that
options on stock index futures must be deducted when calculating the
value of the hedging portfolio. Amendment No. 3 strengthens the PHLX's
proposal by making technical revisions that clarify, among other
things, that economically equivalent positions must be deducted when
calculating the value of the hedging portfolio. Accordingly, the
Commission believes that there is good cause, consistent with Sections
6(b)(5) and 19(b)(2) of the Act, to approve Amendment Nos. 1, 2, and 3
to the proposal on an accelerated basis.
Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning Amendment Nos. 1, 2, and 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 at 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 above-mentioned
self-regulatory organization. All submissions should refer to the file
number in the caption above and should be submitted by March 19, 1996.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\16\ that the proposed rule change (SR-PHLX-95-45), as amended, is
approved.
\16\ 15 U.S.C. 78s(b)(2) (1982).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\17\
\17\ 17 CFR 200.30-3(a)(12) (1995).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-4313 Filed 2-26-96; 8:45 a.m.]
BILLING CODE 8010-01-M
