[Federal Register Volume 62, Number 63 (Wednesday, April 2, 1997)]
[Notices]
[Pages 15659-15666]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-8365]
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COMMODITY FUTURES TRADING COMMISSION
Petition of the Philadelphia Stock Exchange, Inc. for Exemptive
Relief To Permit United States Customers To Establish or Offset
Positions in Certain Foreign Currency Options on the Hong Kong Futures
Exchange Ltd. Through Registered Broker-Dealers
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of final order.
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SUMMARY: In response to a petition by the Philadelphia Stock Exchange,
Inc. (``PHLX''), the Commodity Futures Trading Commission
(``Commission'' or ``CFTC'') has issued an Order (the ``Order'')
exempting from regulation under the Commodity Exchange Act (``Act'' or
``CEA'') \1\ transactions in which United States (``U.S.'') customers
establish or offset positions in Philadelphia Stock Exchange, Inc.
(``PHLX'') foreign currency options on the Hong Kong Futures Exchange
Ltd. (``HKFE'') through registered broker-dealers pursuant to
regulation by the Securities and Exchange Commission (``SEC'') under
the federal securities laws and subject to specified conditions as set
forth herein. The Order grants the requested relief pursuant to section
4c(b) of the Act.
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\1\ 7 U.S.C. 1 et seq.
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EFFECTIVE DATE: March 28, 1997.
FOR FURTHER INFORMATION CONTACT: Susan C. Ervin, Deputy Director/Chief
Counsel or Christopher W. Cummings, Attorney/Advisor, Division of
Trading and Markets, Commodity Futures Trading Commission, 1155 21st
Street, NW., Washington, DC. 20581. Telephone number: (202) 418-5450.
Facsimile number: (202) 418-5536. Electronic mail: tm@cftc.gov.
[[Page 15660]]
SUPPLEMENTARY INFORMATION: On October 9, 1996, the Commission published
a Notice of Proposed Order and Request for Comment (the ``Proposing
Release'') \2\ in connection with the petition of PHLX (the ``PHLX
Petition'') for exemptive relief under sections 4(c) and 4c(b) of the
Act.\3\ In its Petition, PHLX requested that, to the extent pertinent,
the Commission exempt from its regulatory framework certain
transactions by U.S. customers in PHLX foreign currency options
(``FCOs'') effected on HKFE pursuant to a cross-listing and clearing
linkage arrangement between PHLX and HKFE.
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\2\ 61 FR 52921 (October 9, 1996).
\3\ 7 U.S.C. 6(c) and 6c(b) (1994), respectively. The intial
thirty-day period specified in the Proposing Release for public
comment on the PHLX Petition would have expired on November 8, 1996
but was extended to December 11, 1996. 61 FR 59089 (November 20,
1996). The PHLX Petition (dated August 15, 1996) is described in
detail in the Proposing Release.
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I. Background
PHLX and HKFE have entered into a licensing agreement pursuant to
which FCOs traded on PHLX may also be traded and offset on HKFE (the
``Linkage''). The Linkage is intended to permit U.S. customers, acting
through U.S.-registered broker-dealers, to establish FCO positions on
PHLX and offset such positions on HKFE or to establish FCO positions on
HKFE and offset the positions on PHLX.\4\ PHLX petitioned the
Commission for exemptive relief in order to assure that: (1) PHLX FCOs
may be cross-listed on HKFE, treated as fungible with PHLX-traded FCOs
and cleared through a securities-regulated clearing organization
pursuant to the federal securities laws and SEC oversight; and (2) the
PHLX and HKFE cross-listed FCOs would not be dually regulated under the
securities laws and the CEA, taking cognizance of the policies inherent
in Section 4c(f) of the Act, which provides that within the U.S.
options on foreign currencies may be traded on both futures and
securities exchanges.\5\
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\4\ Non-U.S. customers will also be able to use the Linkage to
trade PHLX FCOs. Although a non-U.S. customer will be able to
establish a position on HKFE through an HKFE broker that need not be
a clearing member of PHLX, if that customer wishes to offset or add
to that position on PHLX, the customer (or his HKFE broker) must
ultimately do so through a broker that is a PHLX member clearing
through The Options Clearing Corporation (``OCC'').
\5\ 7 U.S.C. 6c(f) (1994) provides that nothing in the CEA
``shall be deemed to govern or in any way be applicable to any
transaction in an option on foreign currency traded on a national
securities exchange.'' The parallel securities law provision is
Section 9(g) of the Securities Exchange Act of 1934 (the ``Exchange
Act''), 15 U.S.C. 78i(g) (1994), which provides, in relevant part,
that:
Notwithstanding any other provision of law, the [Securities and
Exchange] Commission shall have the authority to regulate the
trading of * * * any put, call, straddle, option, or privilege
entered into on a national securities exchange relating to foreign
currency * * *.
An option on foreign currency is within the securities law
definition of a ``security'' when it is ``entered into on a national
securities exchange.'' Exchange Act section 2(a)(1), 15 U.S.C.
77b(a)(1) (1994).
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A. PHLX Foreign Currency Options Trading
PHLX is a national securities exchange which has been registered
with the SEC since 1934. Equity securities, equity and index options,
and FCOs are listed for trading on the PHLX. PHLX commenced trading
FCOs on December 10, 1982. FCOs currently listed on PHLX include
dollar-denominated options on foreign currencies, cross-rate currency
options, cash/spot FCOs (which permit the holder to receive the
difference between the current foreign exchange spot price and the
exercise price of the particular contract) and customized currency
options.\6\
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\6\ The Proposing Release more fully describes the FCOs listed
for trading on PHLX and cross-references the relevant SEC releases
approving PHLX's proposed listing and trading of such FCOs. See 61
FR 52921 at 52922 (October 9, 1996).
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As discussed in the PHLX Petition,\7\ trading of options on PHLX is
governed by PHLX rules that require, inter alia, that a customer's
account be specifically approved for options trading before any option
transactions may be effected by a PHLX member for that customer. Such
approval must be in writing, may be made only by a person registered
with (and approved by) PHLX as a ``Registered Options Principal,'' \8\
and may occur only after the PHLX member ``exercise[s] due diligence to
learn the essential facts as to the customer and his investment
objectives and financial situation.'' \9\ PHLX rules additionally
require that a customer's account be specifically approved, in writing,
for transactions in foreign currency options by a ``Foreign Currency
Options Principal,'' \10\ before transactions in foreign currency
options are effected.
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\7\ PHLX Petition at 7-11.
\8\ A ``Registered Options Principal'' must pass a proficiency
examination demonstrating knowledge of the self-regulatory
organization requirements applicable to options transactions,
including the rules of PHLX and OCC, and also must demonstrate an
understanding of options trading. PHLX Rule 1024(a). Both the
National Association of Securities Dealers (``NASD'') and PHLX
require that persons selling FCOs pass a proficiency examination.
\9\ PHLX Petition at 7, quoting from PHLX Rule 1024(b)(ii). As
used herein, ``PHLX member'' means a broker-dealer that is either a
full member of PHLX or a non-member that has been admitted to PHLX
as a ``Foreign Currency Options Participant.'' A Foreign Currency
Options Participant must meet the same financial and fitness
requirements as a full member of PHLX (including registration with
the SEC and compliance with SEC net capital requirements), but
avoids paying the full price of a PHLX seat.
\10\ A ``Foreign Currency Options Principal'' of a PHLX member
must be a general partner, officer or person or appropriate
supervisory or managerial rank who has successfully completed a
registered options principal examination, allied member's
examination or other principal's examination (or equivalent
demonstration of knowledge) and who has also successfully completed
an examination prescribed by PHLX to demonstrate adequate knowledge
of foreign currency options and foreign currency markets. PHLX Rule
1025(c).
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PHLX also has a customer suitability rule, which prohibits a member
firm from recommending any option transaction to a customer unless the
firm ``has reasonable grounds to believe that the entire recommended
transaction is not unsuitable'' for the customer.\11\ Before a broker
may permit a customer to begin trading options, SEC and PHLX rules
require the broker to provide to the customer an SEC-mandated
disclosure document specific to the particular type of option order the
customer seeks to enter.\12\ PHLX and NASD rules also regulate the
content and presentation of advertisements, sales literature, and other
options-related communications in connection with sales of PHLX-offered
options to the public. Each foreign currency option contract on PHLX is
issued and marketed by prospectus pursuant to a registration statement
filed with the SEC under the Securities Act of 1933 (the ``Securities
Act'').\13\
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\11\ PHLX Petition at 8, quoting from PHLX Rule 1026(a).
\12\ Exchange Act Rule 9b-1 provides that an options disclosure
document must include information delineating the mechanics of
options trading, options trading risks, the uses of options,
transaction costs, margin requirements, and relevant tax issues. 17
CFR 240.9b-1(1996). PHLX Rule 1029 also requires delivery of the
Rule 9b-1 options disclosure document.
\13\ The prospectus prepared and delivered pursuant to the
Securities Act is a separate document from the options disclosure
document required to be furnished to customers under Exchange Act
Rule 9b-1.
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PHLX rules require member firms to establish written procedures
concerning supervision of customer option accounts and of all option
orders in such accounts and to maintain a special supervisory structure
for foreign currency options.\14\ Consistent with SEC regulations, PHLX
requires that all order tickets be time-stamped immediately upon
execution, and floor brokers and traders are required to report
relevant information regarding each option transaction. With the
exception of specialists, PHLX floor traders are prohibited from dual
trading, that is, trading a particular options class for their own
account on the day of
[[Page 15661]]
execution of a customer order in the same options class.\15\
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\14\ PHLX Petition at 9.
\15\ PHLX Petition at 11.
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PHLX has represented that HKFE has agreed to adopt rules similar to
certain of PHLX's rules and requirements applicable to cross-listed
PHLX FCOs in order assure fungibility.\16\ HKFE has further agreed not
to adopt any rules that conflict with PHLX's options rules.\17\
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\16\ Such rules include those regarding margin levels and
changes thereof, position and exercise limits, reporting and
liquidation of positions, quote spread parameters, minimum
fractional changes, allocation of exercise notices, series of
options open for trading, customized FCOs and settlement of dollar-
denominated FCOs.
\17\ PHLX Petition at 11.
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B. Proposed PHLX-HKFE Linkage
Incorporated in 1976, HKFE is licensed as an exchange company by
the Governor in Council of Hong Kong and is governed by a board of
directors consisting of both HKFE members and non-members from the Hong
Kong financial and business community. In addition, the operations of
the HKFE and the HKFE Clearing Corporation Limited (``HCC''), HKFE's
subsidiary, are under the jurisdiction of and are regulated by Hong
Kong's independent financial regulatory body, the Securities and
Futures Commission (``SFC'') pursuant to the Commodities Trading
Ordinance, which treats options on foreign currencies similarly to
securities options for such purposes, and which regulates fitness and
qualifications of persons involved in customer order solicitation and
acceptance, imposes minimum financial requirements upon persons
accepting customer funds, and establishes requirements for the
protection of customer funds from misapplication, recordkeeping and
reporting, sales practices and risk disclosure, and procedures to
ensure compliance with such regulatory requirements. It currently is
expected that the existing regulatory structure will continue beyond
July 1997, notwithstanding the changeover to mainland Chinese rule.
Currently, no FCOs are listed for trading on HKFE. The Linkage
provides for cross-listing of PHLX FCOs, permitting U.S. customers and
non-U.S. customers to establish positions in PHLX FCOs on HKFE and
offset them on PHLX or to establish PHLX FCO positions on PHLX and
offset them on HKFE. Only registered broker-dealers would be permitted
to carry the account of FCOs traded through the Linkage on behalf of
U.S. persons (and to clear FCOs on the PHLX side of the Linkage for
non-U.S. customers). The Linkage will be applicable to all foreign
currency option contracts for which PHLX has received SEC approval.
Pursuant to the Linkage, trading in PHLX FCOs will be permitted on HKFE
during Asian business hours in the same manner as such FCOs are
currently traded on PHLX.\18\ In general, auction trading of PHLX's
FCOs occurs between 2:30 a.m. and 2:30 p.m. Eastern Time each business
day. The Linkage thus effectively extends the trading hours for PHLX
foreign currency option contracts. FCOs, regardless of where
originated, will be marketed by means of the same prospectus and
subject to the same securities margin requirements.
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\18\ The licensing agreement between PHLX and HKFE provides that
PHLX FCOs may not be traded on HKFE between the hours of 2:00 a.m.
and 3:00 p.m. Eastern Time, Monday through Friday.
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The Commission has permitted appropriately designed linkages
between exchanges in different time zones as a means of lengthening
trading hours, broadening distribution of products, enhancing trading
volume and open interest, and increasing the capacity to offset risk or
adjust portfolios in a timely manner without incurring excessive
transaction costs.\19\ In its Petition, PHLX states that it expects
that the proposed Linkage will stimulate trading interest in PHLX's
FCOs in the Far East. The PHLX agreement with HKFE does not preclude
similar agreements between HKFE and U.S. futures exchanges with respect
to foreign currency options. Consequently, a similar linkage agreement
between HKFE and a futures exchange potentially could permit such an
exchange to extend its hours and allow registered futures commission
merchants (``FCMs'') to offset currency options undertaken there on
HKFE.
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\19\ The Commission has approved linkage arrangements between
the Singapore International Monetary Exchange, Ltd. (``SIMEX'') and
CME (approved August 28, 1984); between the Commodity Exchange, Inc.
(``COMEX'') and the Sydney Futures Exchange, Ltd. (``SFE'')
(approved August 1, 1986); between Marche a Terme International de
France (``MATIF'') and the CME (approved September 24, 1992); and
between the New York Merchantile Exchange and SFE (approved
September 1, 1995).
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OCC, owned equally by the five national securities exchanges that
list options, functions as the issuer and clearing organization for all
options traded on national securities exchanges, including the FCOs
traded on PHLX. OCC is regulated as a clearing agency by the SEC under
section 17A of the Exchange Act \20\ and the Standards for the
Registration of Clearing Agencies issued thereunder.\21\ OCC will
issue, clear and settle PHLX FCOs that are cross-listed on HKFE.\22\
Subject to SEC approval, PHLX, HKFE, and OCC expect to enter into an
International Market Agreement (the ``IMA''), which will govern the
trading and clearance of transactions in FCOs cross-listed on HKFE. The
IMA will address issues relevant to the trading and clearance of the
PHLX contracts, including issuance, disclosure, expiration months,
exercise prices, units of trading, margin, trade information
comparison, clearing and settlement of PHLX FCOs traded on HKFE, and
the respective rights and obligations of the parties with respect to
such options.
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\20\ 15 U.S.C. 78q-1 (1994).
\21\ Exchange Act Release No. 34-16900 (June 17, 1980) 45 FR
41920.
\22\ PHLX Petition at 5. However, as noted below, OCC expects
that FCO transactions for HKFE members that are not clearing members
of OCC will be cleared through HKFE or an affiliate of HKFE.
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Subject to SEC approval, OCC expects to execute an ``Associate
Clearinghouse Agreement'' with HCC (or another affiliate of HKFE)
organized for the purpose of acting as a clearing organization for the
PHLX foreign currency option contracts traded on HKFE, under which HCC
(or such affiliate) will act as an ``associate clearinghouse'' of OCC.
The Associate Clearinghouse Agreement will provide that HCC (or other
HKFE affiliate) will be treated in all material respects as an OCC
clearing member for purposes of clearing trades in PHLX foreign
currency options for HKFE members that are not clearing members of OCC,
whether such trades are effected on HKFE or (through PHLX members) on
PHLX.\23\ As such, HCC (or other HKFE affiliate) will be subject to SEC
oversight, albeit indirectly through the SEC's oversight of OCC.
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\23\ Provision will be made, however, for matters such as
reconciling non-U.S. accounting principles.
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C. Request for Comments
In the Proposing Release, the Commission sought comments on any
aspect of the Petition that commenters believed might raise issues
under the CEA or Commission regulations. In particular, the Commission
invited comments regarding: (1) The appropriateness of addressing the
transactions specified in the Proposing Release pursuant to the
Commission's exemptive authority under section 4(c) and/or pursuant to
the Commission's plenary authority under section 4c(b); (2) whether the
proposed exemption is consistent with the standards set forth in
section 4(c) of the CEA; (3) whether there is sufficient authority
under existing law for the SEC to exercise its regulatory and
supervisory authority over transactions effected pursuant to the
Linkage; (4) any material adverse
[[Page 15662]]
effects that granting the PHLX petition would have upon other
securities exchanges, futures exchanges, or Commission registrants,
such as FCMs, from a competitive or other perspective; (5) the type of
risk assessment information that should be available to the Commission
regarding FCO transactions by FCM affiliates; (6) whether the
Commission should attach any conditions to any exemptive relief that
may be granted; and (7) any other issues relevant to the PHLX Petition.
Five comment letters were received: one from OCC, one each from the
Chicago Board of Trade (``CBOT'') and the Chicago Mercantile Exchange
(``CME''), both designated contract markets, one from the SEC, and one
from the Futures Industry Association Inc. (``FIA''), a futures
industry trade organization. The comments of the SEC, FIA and OCC
generally supported granting the relief sought by the PHLX Petition;
the CBOT and CME comment letters offered conditional or qualified
support and identified various concerns for future consideration by the
Commission.
II. The Order
Based upon its consideration of the PHLX Petition and the comments
received, and subject to SEC approval of the relevant rules and
agreements establishing and governing operation of the Linkage, the
Commission has determined to issue an order, pursuant to its authority
under Section 4c(b) of the Act, granting an exemption from Commission
regulation consistent with certain conditions more particularly set
forth herein, for Linkage transactions. As discussed below, the
Commission has considered the public comments received in response to
the Proposing Release in connection with issuing this Order.
A. Statutory and Regulatory Basis of the Order
1. The Commission's Authority To Grant the Requested Relief
Section 4c(b) of the Act prohibits persons from entering into any
transaction involving any commodity regulated under the CEA which is of
the character of or is commonly known ``as an option * * * contrary to
any rule, regulation or order of the Commission * * *.'' Section 4c(b)
vests the Commission with the authority to adopt orders, rules or
regulations to prohibit or allow commodity option transactions, upon
notice and opportunity for hearing. Section 4c(b) of the Act,
therefore, affords the Commission plenary authority to permit the
trading of commodity options outside of designated futures
exchanges.\24\
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\24\ Section 4c(b) provides, in relevant part:
No person shall offer to enter into, enter into or confirm the
execution of, any transaction involving any commodity regulated
under this Act which is of the character of, or is commonly known to
the trade as, an ``option'' [or] ``privilege'', * * * contrary to
any rule, regulation, or order of the commission prohibiting any
such transaction or allowing any such transaction under such terms
and conditions as the Commission shall prescribe. Any such order,
rule, or regulation may be made only after notice and opportunity
for hearing, and the Commission may set different terms and
conditions for different markets.
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CME and OCC commented that in order to permit the Linkage the
Commission would be required to grant particularized relief and that a
new rule, order or regulation must be adopted under section 4c(b) for
this purpose. The commenters generally concurred that the appropriate
basis for granting the relief requested would be pursuant to an order
issued under section 4c(b). Several commenters nonetheless urged the
Commission to apply the standards required for exercising its exemptive
authority under section 4(c) of the Act in determining whether to grant
relief under section 4c(b). The SEC stated that the CFTC could
appropriately address Linkage transactions under either section 4(c) or
section 4c(b), as both sections provide the CFTC with broad flexibility
to address the transactions encompassed by the PHLX Petition. FIA and
the CBOT, however, commented that basing an exemptive order solely on
section 4c(b) would be more consistent with the CEA than an order based
upon sections 4c(b) and 4(c).
2. Consistency with Section 4c(f)
The Commission believes that while section 4c(f) may not itself
confer authority to grant the requested relief to the Linkage, such
relief would be consistent with the policy of section 4c(f) of the CEA,
which provides that nothing in the CEA ``shall be deemed to govern or
in any way be applicable to any transaction in an option on foreign
currency traded on a national securities exchange.'' \25\ In its
petition, PHLX contended that a PHLX FCO would remain ``an option on
foreign currency traded on a national securities exchange,'' despite
being cross-listed on HKFE, which is not so registered.\26\ PHLX urged
that ``[f]or this purpose, cross-listing of PHLX foreign currency
options on the HKFE may be viewed as adding another PHLX trading floor,
or as lengthening the trading day for PHLX foreign currency options.''
\27\ Thus, PHLX contended that section 4c(f) should remove the Linkage
from CFTC jurisdiction, while requesting exemptive relief under
sections 4(c) and 4c(b) ``to eliminate any potential uncertainty as to
the status of these transactions.'' \28\
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\25\ Section 4c(f) is part of the jurisdictional accord between
the SEC and the CFTC that was codified in the Futures Trading Act of
1982. Public Law 97-444, Act of January 11, 1983, effective January
11, 1983, sec. 102, 96 Stat. 2294, 2296. The effect of the provision
was that the SEC would have jurisdiction over FCOs that trade on
national securities exchanges, while the CFTC continued to have
jurisdiction to regulate other trading of FCOs. H.R. Rep. No. 97-
565, 97th Cong., 2d Sess. 82 (1982).
\26\ The SEC and OCC comments agreed with this characterization.
The SEC stated that it would treat the Linkage as an operating
extension of the trading of FCOs on PHLX and therefore as being
subject to the full scope of the federal securities laws (noting
that the FCOs traded on PHLX and HKFE would be identical, would be
cleared and settled through OCC, and would be traded pursuant to an
agreement between PHLX and HKFE, as are other linked securities
contracts). The CBOT and the CME, however, disputed that the Linkage
should be treated as an extension of the PHLX trading floor and
questioned the validity of any assertion of SEC jurisdiction over
the establishment or offsetting of FCO positions on HKFE.
\27\ PHLX Petition at 2.
\28\ Id. In its comment letter, OCC supported PHLX's request
that the CFTC issue an exemption to eliminate potential uncertainty.
CME and CBOT disputed PHLX's assertion that transactions in the
cross-listed FCOs are excluded from the CFTC's jurisdiction,
contending that HKFE is not a national securities exchange and
should not be characterized as an additional PHLX trading floor.
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3. Consistency with Section 4(c)
Section 4(c) provides, in relevant part, that the Commission may
exempt, ``by rule, regulation, or order, after notice and opportunity
for hearing, * * * any agreement, contract, or transaction * * * that
is otherwise subject to'' the exchange-trading requirement of section
4(a) from all provisions of the CEA except section 2(a)(1)(B).\29\ Such
exemption may be granted upon a determination by the Commission that:
(1) The exemption is in the public interest;\30\ (2) the requirements
from
[[Page 15663]]
which exemption is sought should not be applied to the agreement,
contract, or transaction at issue and the exemption would be consistent
with the purposes of the CEA; (3) the agreement, contract or
transaction will be entered into solely between ``appropriate
persons;'' \31\ and (4) the agreement, contract or transaction will not
have a material adverse effect upon the ability of the Commission or
any contract market to discharge its regulatory or self-regulatory
duties under the CEA.
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\29\ 7 U.S.C. 6(c)(1) (1994). In particular, section 4(c)(1)
provides:
In order to promote responsible economic or financial innovation
and fair competition, the Commission by rule, regulation, or order,
after notice and opportunity for hearing, may (on its own initiative
or on application of any person, including any board of trade
designated as a contract market for transactions for future delivery
in any commodity under section 5 of this Act) exempt any agreement,
contract or transaction (or class thereof) that is otherwise subject
to subsection (a) (the exchange-trading requirement) (including any
person or class of persons offering, entering into, rendering advice
or rendering other services with respect to, the agreement,
contract, or transaction), either unconditionally or on stated terms
or conditions or for stated periods and either retroactively or
prospectively, or both, from any of the requirements of subsection
(a), or from any other provision of this Act (except section
2(a)(1)(B)), if the Commission determines that the exemption would
be consistent with the public interest.
\30\ As the Commission noted in the Proposing Release, the
Conference Committee Report on the legislation enacting section 4(c)
indicated that the ``public interest'' includes ``the national
public interests noted in the (CEA), the prevention of fraud and the
preservation of the financial integrity of markets, as well as the
promotion of responsible economic or financial innovation and fair
competition,'' and that the Commission should ``assess the impact of
a proposed exemption on the maintenance of the integrity and
soundness of markets and market participants'' and that an exemption
should not be denied ``solely on grounds that it may compete with or
draw market share away from the existing market.'' H.R. Rep. No.
978, 102d Cong., 2d Sess. 78-79 (1992).
\31\ ``Appropriate person'' is defined in section 4(c)(3) (A)-
(K) of the Act to include, generally, a bank or trust company, a
savings association, an insurance company, a registered investment
company, a commodity pool operated by a Commission registrant,
certain business entities and employee benefit plans, governmental
entities, registered broker-dealers, registered futures commission
merchants, floor brokers and floor traders and ``[s]uch other
persons that the Commission determines to be appropriate in light of
their financial or other qualifications or the applicability of
appropriate regulatory protections.'' 7 U.S.C. 6(c)(3) (A)-
(K)(1994).
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Several commenters expressed the view that, because section 4(c)
provides the Commission with authority to exempt from CEA regulation
transactions in futures contracts on or subject to the rules of a U.S.
exchange, it is not the appropriate basis for an exemptive order with
respect to the PHLX/HKFE Linkage. However, although CBOT, CME and OCC
argued against reliance by the Commission upon section 4(c) as the
basis for granting an exemption for Linkage transactions, CBOT and FIA
urged the Commission to consider the merits of the PHLX Petition in
light of the standards set forth in section 4(c).\32\ The Commission
concurs that the standards for exemption established by section 4(c)
are relevant in determining whether an order of relief should be issued
under section 4c(b). Accordingly, the Commission has considered the
PHLX Petition in light of the criteria of section 4(c) and believes,
for the reasons discussed below, that granting the Petition is
consistent with such criteria.
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\32\ OCC stated that ``the Commission may of course choose as a
policy matter to consider the standards of section 4(c).'' CME
stated that even if the Commission had authority under section 4(c)
to grant the requested relief, the proposed exemption is not
consistent with (and does not meet the standards set forth in)
section 4(c).
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a. Consistency with the Public Interest and Purposes of the Act.
With respect to the public interest standard of section 4(c), the CBOT
commented that ``(w)hen the retail public is involved, it would seem
that the only way an exemption from CEA regulation could be consistent
with the public interest is if another comparable regulatory scheme
also applies.'' The CBOT expressed the view that before deciding to
grant exemptive relief, the Commission should carefully examine ``the
nature and reach'' of the SEC's regulation of broker-dealers, including
the scope of the SEC's authority to regulate ``broker-dealers'
activities with respect to foreign currency options traded on the HKFE,
given that such instruments are technically not securities.''
The Commission believes that based upon the SEC's analysis of its
regulatory authority with respect to Linkage transactions and the other
materials of record, the concerns voiced by the CBOT are adequately
addressed. Under the linkage, FCOs may be traded for U.S. customers on
a foreign futures exchange. The Commission does not and, indeed, cannot
directly regulate foreign boards of trade, under section 4(b) of the
Act.\33\ Under that section, however, the Commission has authority to
adopt regulations prohibiting fraud, setting financial standards, and
imposing registration, recordkeeping, reporting and other obligations
on persons trading futures contracts for U.S. customers on non-U.S.
exchanges. Pursuant to part 30 of its regulations, the Commission
regulates the offer and sale to U.S. persons of commodity option
contracts made on or subject to the rules of foreign boards of trade.
However, the Commission's rules no longer require prior authorization
by the Commission before a foreign commodity option may be offered or
sold to U.S. customers, and therefore, U.S. customers could trade
foreign currency options on HKFE without further action by the
Commission.
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\33\ 7 U.S.C. 6(b) (1994). Section 4(b) provides that the
Commission may not adopt any rule that requires Commission approval
of a foreign board of trade's contracts or rules, or that governs in
any way any rule or contract term or action of a foreign board of
trade.
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Moreover, irrespective of the characterization of HKFE FCOs cross-
listed with PHLX FCOs, the Commission believes that the SEC has
authority to exercise regulatory functions comparable to those that the
CFTC would be able to exercise with respect to transactions to be
established or offset on HKFE through the Linkage. The CFTC itself
could not directly regulate the HKFE market and would be limited to
regulating sales to U.S. persons from locations outside the U.S. in
accordance with section 4(b) of the Act. The SEC regulates broker-
dealer fitness, capital requirements, sales practices and protection of
customer funds. In the limited circumstances of the PHLX-HKFE Linkage,
therefore, based upon the SEC's regulatory authority and program
applicable to registered broker-dealers, and subject to the conditions
discussed below, the Commission believes that its deference to SEC
regulation over the Linkage as a whole to facilitate the Linkage
arrangement is warranted, especially as such deference is without
prejudice to a similar arrangement for linking a U.S. futures market to
HKFE or the regulatory characterization of foreign currency options in
that context.
Although it acknowledged that it does not have express authority
over activities occurring on HKFE, the SEC cited its authority under
the Exchange Act to condition approval of the PHLX rules necessary to
implement the Linkage upon establishment of adequate safeguards
addressing surveillance-sharing between PHLX and HKFE, as well as
between the SEC and Hong Kong regulators; provisions for trading and
clearing the FCOs (on PHLX and on HKFE); and the requirement that the
FCOs be registered under the Securities Act. The SEC has authority over
OCC (and indirectly over HCC or other HKFE affiliate) and the broker-
dealers who will effect Linkage transactions for U.S. customers and
offset on PHLX linked transactions undertaken for U.S. customers. It
therefore can require meaningful safeguards as a condition for approval
of the implementing PHLX and OCC rule changes for the Linkage.\34\
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\34\ CBOT urged the Commission to consider carefully the nature
and scope of SEC and NASD regulation (including whether SEC and NASD
are willing or prepared to accept this jurisdiction, whether
safeguards exist equivalent to the Commission's segregation
requirements, and whether the requested relief amounts to a transfer
to the SEC of Commission jurisdiction over foreign currency
options). The SEC has indicated in its comment letter that it is
prepared to exercise regulatory oversight with respect to
transactions over the Linkage. Moreover, PHLX FCOs are already
subject to SEC and PHLX regulation, and broker-dealer practices are
subject to NASD regulation.
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The FIA, OCC and SEC urged that the Commission find that the
requested exemption would be consistent with the public interest and
the purposes of the Act. To this end, FIA commented that the requested
exemption would not be contrary to the essential purposes of the Act
(customer protection, financial integrity and market integrity)
because: (1) FCOs executed on HKFE may be offered and sold in the U.S.
only
[[Page 15664]]
through registered broker-dealers in accordance with sales practice and
related customer protection rules of PHLX and the NASD;
(2) the financial integrity of the transactions will be assured
because they will be settled and cleared by OCC (and trades on HKFE for
non-OCC clearing members will be carried out pursuant to an agreement
with OCC); and (3) market integrity is assured by the Intermarket
Surveillance Group Surveillance Sharing Agreement between PHLX and
HKFE. The SEC stated that FCOs cross-listed on HKFE ``would be subject
to full SEC regulation'' and that ``subjecting such trading to a single
regulatory regime is appropriate and might additionally facilitate
efficiencies in the trading, clearance and settlement of such
transactions.''
OCC expressed the view that the proposed relief would be consistent
with the public interest because it is an essential precondition to the
Linkage, and the Linkage itself is in the public interest because it
would ``contribute to greater depth and liquidity in the market for
PHLX FX Options'' and ``foster global market efficiency and reduce
systemic risk by standardizing the currency options traded on PHLX and
HKFE and centralizing the clearance and settlement process for trades
in such options.'' The currency cash market is a 24-hour market.
Establishing an Asia time zone link extends the liquidity and the
hedging usefulness of the PHLX foreign currency options market and
renders it more competitive with the larger over-the-counter market,
subject to significant regulatory safeguards for participants. Pursuant
to part 30 of its regulations, the Commission routinely evaluates the
comparability of other regulatory regimes. In this case, without ceding
authority or characterizing the jurisdictional status of the HKFE FCOs,
the Commission concludes that sufficient grounds exist for deference to
the SEC regulatory regime, especially in light of the policies
underlying section 4c(f), which supports trading in foreign currency
options in both domestic securities and futures exchanges, subject to
either securities or futures laws and the attendant regulatory
frameworks, respectively.
b. The ``Appropriate Person'' Criterion. Section 4(c) of the Act
defines the term ``appropriate person'' to include various categories
of business and corporate entities, including banks and trust
companies, savings associations; insurance companies, registered
investment companies, CEA-regulated commodity pools, corporations or
other business entities with net worth of $1 million or total assets of
$5 million, and ``[s]uch other persons that the Commission determines
to be appropriate in light of their financial or other qualifications
or the applicability of appropriate regulatory protections.'' \35\ In
its Petition, PHLX urges that because PHLX FCOs ``are subject to the
full panoply of SEC regulation under the securities laws,'' appropriate
regulatory protections apply to the Linkage, and the Commission
therefore should be able to determine that any person eligible to
purchase or sell such options under the SEC regulatory scheme is an
``appropriate person'' within the meaning of section 4(c)(3)(K).\36\ In
its comment letter, the SEC agreed that the class of permissible FCO
participants proposed by PHLX may not be identical to those designated
in the enumerated categories of section 4(c)(3) (A)-(J) but concluded
that ``it is appropriate for the CFTC to determine, pursuant to
4(c)(3)(K), that such persons are appropriate persons because they meet
the requirements set forth by PHLX and approved by the SEC for persons
engaged in exchange-traded options transactions.''
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\35\ 7 U.S.C. 6(c)(3) (1994).
\36\ PHLX Petition at 16.
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Section 4(c)(3)(K) permits the Commission to determine that persons
engaging in transactions that are otherwise regulated by another
governmental agency qualify as ``appropriate persons.'' In adopting
rules exempting from CFTC regulation certain hybrid instruments, the
Commission stated that ``appropriate persons'' eligible for that
exemption would include ``person[s] permitted by applicable securities
or banking requirements to purchase or enter into the security
(component) of the hybrid instrument * * *.'' 58 FR 5580 (January 22,
1993) (release adopting final rules regarding the regulation of hybrid
instruments). As discussed above, the SEC, PHLX and NASD requirements
applicable to U.S. customers in FCO transactions conducted on PHLX will
apply equally to cross-linked FCO transactions on HKFE. Based upon the
restrictions imposed by these requirements upon participation in FCOs
cross-linked on HKFE and the other regulatory safeguards applicable to
such transactions, the Commission believes that the ``appropriate
persons'' criterion is satisfied with respect to U.S. persons engaging
in FCO transactions pursuant to the Linkage.\37\
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\37\ However, an ``appropriate person'' for purposes of Linkage
transactions in accordance with this Order may not be an
``appropriate person'' in other contexts.
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c. No Material Adverse Effect on Regulatory or Self-Regulatory
Responsibilities. Commenters differed in their assessment as to whether
granting the PHLX Petition would have a material adverse effect on the
ability of the Commission or any contract market to discharge its
regulatory or self-regulatory duties under the CEA. The Commission
believes that with appropriate risk assessment information sharing, and
retention of its own ability to terminate relief, granting the
requested relief will not interfere with the Commission's regulatory
program or adversely affect the ability of any U.S. contract market to
discharge its regulatory duties.
B. Risk Assessment
The Commission requested comments regarding the type of risk
assessment information that should be available to it concerning FCO
transactions effected by FCM affiliates. The two commenters who
addressed this issue. The SEC noted that all PHLX/HKFE cross-listed FCO
transactions involving U.S. customers must be effected through U.S.-
registered broker-dealers and that the SEC's risk assessment rules
would thus be applicable and would result in the provision of important
risk assessment data to the SEC. The SEC has confirmed that it would
coordinate information-sharing with the CFTC in the event that problems
developed warranting CFTC review. Similarly, the OCC stated that there
was no need for risk assessment information in addition to that which
the Commission currently obtains regarding FCM affiliate transactions
on PHLX, since PHLX and HKFE FCO transactions pose the same risks. The
Commission nonetheless has conditioned this relief on its access to
information on transactions through the Linkage relevant to exercise of
its and its markets' supervisory duties with respect to FCMs or other
relevant futures market participants engaged in Linkage transactions.
C. Conditions
The Commission also invited comment concerning whether conditions
should be attached to any exemptive relief granted in response to the
PHLX Petition. Several commenters addressed this subject. The SEC
recommended that the Commission condition exemptive relief on assured
availability to the Commission of information exchanged pursuant to the
terms of the Intermarket Surveillance Group Surveillance Sharing
Agreement
[[Page 15665]]
between PHLX and HKFE and suggested that the Commission consider
conditioning relief upon the SEC's approval of a PHLX implementing rule
submission under section 19(b) of the Exchange Act. The CME urged the
Commission to ensure that adequate regulatory protections exist with
respect to any trading activities that take place in Hong Kong,
suggesting, by way of example, that the Commission consider whether the
policies underlying Rule 30.7 \38\ require that the foreign futures and
options secured amount for HKFE positions be separately accounted for
and segregated from customer funds used to margin PHLX positions. OCC
commented that it saw no need for any conditions other than that the
Linkage be operated substantially as described in the PHLX Petition.
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\38\ Rule 30.7 sets forth an FCM's duty to maintain in a
segregated account at an appropriate depository sufficient money or
other property to cover all of its current obligations to foreign
futures and options customers and to keep records and make daily
computations with respect to such obligations.
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D. Other Issues Raised by Commenters
The FIA urged the Commission to consider granting relief for
registered broker-dealers that are also registered as FCMs from the
restrictions on options transactions applicable to FCMs set forth in
Commission Rule 1.19 and to consider whether any relief with respect to
the provisions of subchapter IV of Chapter 7 of the Bankruptcy Code
\39\ and part 190 of the Commission's rules may be necessary. CME
commented that granting the requested relief would amount to
sanctioning the cross-margining of securities options and futures
positions at the customer level and that if the Commission grants the
PHLX Petition, CME expects to be permitted to expand its cross-
margining program with OCC to include retail customer accounts. Because
the PHLX FCOs are functionally identical, whether traded on PHLX or
HKFE, and because offsetting positions will cancel, rather than hedge
each other, the Commission believes that cross-margining arrangements
raise different issues from the cross-listing of FCOs. In any event,
the Commission will address any such request on its individual merits
and believes that a response to CME is outside the scope of this
proceeding.
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\39\ 11 U.S.C. 761-766 (1994).
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E. Conclusion
Regulatory authority over trading activity in FCOs is divided
between the SEC and the CFTC, and absent a grant of exemptive relief by
the CFTC, participation by U.S. customers in the HKFE side of the
proposed Linkage would be subject to regulation under the CEA.
Nonetheless, upon consideration of the PHLX Petition and the comments
received and for the reasons stated above, the Commission has
determined to exercise its authority under Section 4c(b) of the Act by
issuing the attached Order granting the Petition, provided that certain
conditions are met. The Commission believes that under the specific
circumstances of the Linkage, and subject to certain conditions,
deference to the SEC to provide regulatory oversight for the Linkage is
appropriate.
The Commission believes that the SEC's existing regulation of
registered broker-dealers and clearing organizations, combined with its
ability to condition approval of the PHLX and OCC rule changes
necessary to implement the Linkage upon incorporation of appropriate
safeguards will enable the SEC to exercise regulatory authority over
the HKFE side of the Linkage comparable to that which the Commission
would be able to exercise. Neither agency is empowered directly to
regulate HKFE, but each has statutory authority to regulate assigned
classes of market participants, and thereby, activities on HKFE of such
persons. The Commission believes that the existing regulatory framework
applicable to HKFE in Hong Kong, combined with the SEC's regulation of
U.S. broker-dealers effecting transactions over the Linkage and
regulation of OCC, will be adequate in the absence of direct regulation
of trading on HKFE by U.S. regulatory agencies. Additionally, the SEC
has authority over the design of relevant clearing arrangements and the
rules of PHLX establishing the operating agreement between the markets
for the Linkage. The Commission further believes that the risk
assessment information provided to the SEC will be adequate but that it
should likewise be provided to the Commission upon request or as
otherwise appropriate in light of market conditions.
The Commission also believes that the standards set forth in
section 4(c) will be met by the Linkage, in that: (1) Granting the
requested relief is in the public interest, because due to the
applicability of a regulatory scheme comparable to the Commission's,
the Linkage can operate to expand the availability and usefulness of
PHLX FCOs, while maintaining regulatory protections for customers and
markets; (2) granting the requested relief will neither interfere with
the Commission's ability to carry out its regulatory program nor
adversely affect the ability of any contract market to carry out its
self-regulatory duties; and (3) in view of the regulatory and self-
regulatory requirements regarding eligibility of customers to effect
transactions over the Linkage, it is appropriate to determine pursuant
to section 4(c)(3)(K) that participation in the Linkage will be limited
to appropriate persons.
Several commenters raised related issues which the Commission does
not believe affect the appropriateness of granting the PHLX Petition.
In response to concerns that broker-dealers that are also registered as
FCMs may be considered to be in violation of Rule 1.19 as a result of
transactions in FCOs on the HKFE, the Commission hereby confirms that
PHLX FCOs traded on the Linkage may be considered exchange-traded
``commodity options'' for purposes of Rule 1.19(a) such that an FCM
would not be precluded from taking a position in such FCOs. With
respect to FIA's concern as to the applicability of Subchapter IV of
Chapter 7 of the Bankruptcy Code, the Commission has conditioned its
exemptive order upon the applicability of the SEC's segregation
requirements for securities,\40\ and Subchapter III of Chapter 7 of the
Bankruptcy Code \41\ to securities broker-dealers. Consequently, PHLX
represents that it will take whatever contractual or regulatory actions
may be necessary to cause the cross-listed FCOs to be treated as
securities for purposes of the Bankruptcy Code and for purposes of the
segregation requirements under Exchange Act Rule 15c3-3.
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\40\ Exchange Act Rule 15c3-3, 17 CFR 240.15c3-3 (1996).
\41\ 11 U.S.C. 741-752 (1994).
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The Commission thus has determined that an exemption with respect
to the Linkage should be conditioned upon implementation of the Linkage
pursuant to PHLX and OCC rules approved by the SEC, operation of the
Linkage (including restrictions on participation by U.S. customers)
substantially as described in the PHLX Petition, availability to the
Commission of adequate risk assessment information, availability to the
Commission of surveillance information required to be exchanged
pursuant to the Surveillance Sharing Agreement between PHLX and HKFE
and the completion of any necessary contractual or other measures to
cause FCOs traded over the Linkage to be treated as securities for
purposes of securities segregation requirements and under the
Bankruptcy Code.
[[Page 15666]]
Order of the Commodity Futures Trading Commission Exempting From
Regulation Certain Foreign Currency Option Transactions
Whereas, it is the Commission's understanding, based upon
representations made by the Philadelphia Stock Exchange, Inc.
(``PHLX'') as set forth in a Request for Exemptive Relief from
regulation under the Commodity Exchange Act (7 U.S.C. 1 et seq.), dated
August 15, 1996, that PHLX and the Hong Kong Futures Exchange Ltd.
(``HKFE'') have entered into a licensing agreement (the ``Linkage'')
pursuant to which foreign currency options (``FCOs'') listed and traded
on PHLX will be cross-listed and traded on HKFE. The Linkage will
permit PHLX FCOs to be traded on HKFE during Asian business hours.
Transactions for U.S. customers will be effected only through brokers
or dealers registered as such with the Securities and Exchange
Commission (``SEC'') on behalf of persons meeting the PHLX customer
options account approval and suitability standards (approved by the
SEC) for persons engaging in options transactions. Transactions on PHLX
for non-U.S. customers, whether or not initiated through a non-PHLX
member, must ultimately be effected through a member of PHLX that is a
clearing member of The Options Clearing Corporation (``OCC'').
Whereas, transactions effected through the Linkage will be issued,
cleared and settled by OCC pursuant to the terms of an International
Market Agreement (``IMA'') among PHLX, HKFE and OCC. Clearing of trades
in PHLX FCOs for HKFE members that are not clearing members of OCC
(whether such trades are effected on PHLX or on HKFE) will be made by
an OCC clearing member or an affiliate of HKFE (as an ``associate
clearinghouse'' of OCC) pursuant to an Associate Clearinghouse
Agreement between OCC and such affiliate of HKFE, and such associate
clearinghouse will be treated in all material respects as a clearing
member of OCC for purposes of Linkage transactions.
Whereas, PHLX and HKFE have entered into an Intermarket
Surveillance Group Surveillance Sharing Agreement obligating each to
use its best efforts to obtain and provide information required by the
other to fulfill its self-regulatory responsibilities.
Whereas, PHLX will submit for SEC approval an amendment to PHLX's
rules, permitting the establishment and operation of the Linkage, and
that OCC will likewise submit a rule amendment to accommodate clearing
and settlement functions with respect to the Linkage.
And Whereas, PHLX represents that the licensing agreement and other
relevant documentation, including the Surveillance Sharing Agreement,
the IMA and the Associate Clearinghouse Agreement, are consistent with
the aforesaid understanding of the Linkage arrangement and will be
submitted to the SEC for its review in conjunction with the SEC's
review of PHLX and OCC rule changes to implement the Linkage.
It is therefore ordered, pursuant to section 4c(b) of the Commodity
Exchange Act (the ``Act'') and based upon the Commission's
consideration of the representations set forth in the PHLX Petition and
the comments received pursuant to the Notice of Proposed Order and
Request for Comments, that transactions in FCOs listed for trading on
HKFE as described in the PHLX Petition are exempt from all provisions
of the Act and the Commission's rules promulgated thereunder subject to
the following conditions:
1. That the Linkage is operated substantially as described in the
PHLX Petition;
2. That FCO transactions effected pursuant to the Linkage on behalf
of U.S. customers are undertaken through broker-dealers registered as
such with the SEC, cleared through clearing facilities subject to SEC
oversight, and restricted to customers who satisfy the customer options
account approval and suitability standards set forth in PHLX rules
approved by the SEC;
3. That the Linkage is implemented pursuant to rules of PHLX and
OCC approved by the SEC pursuant to section 19(b) of the Securities
Exchange Act of 1934 (the ``Exchange Act''), 15 U.S.C. 78s;
4. That HKFE and PHLX will make available to the Commission upon
request all information required to be exchanged under the terms of the
Intermarket Surveillance Group Surveillance Sharing Agreement between
PHLX and HKFE;
5. That HKFE is subject to rules which establish fitness and
qualifications of persons through whom customer orders are solicited or
accepted, minimum financial requirements for persons that accept
customer funds, measures for protection of customer funds from
misapplication, recordkeeping and reporting requirements, minimum sales
practice and risk disclosure standards, and procedures to ensure and to
audit for compliance with regulatory requirements;
6. That all risk assessment information pertinent to the Linkage
provided to the SEC by broker-dealers participating in the Linkage (and
that is not otherwise available to the CFTC pursuant to its risk
assessment rules) is made available to the Commission by the SEC and/or
PHLX upon request and as otherwise appropriate; and
7. That the FCO positions, regardless of where established, will be
treated as securities for purposes of required segregation pursuant to
Exchange Act Rule 15c3-3 and for application of the relevant insolvency
laws, including the Bankruptcy Code and rules, and Securities Investor
Protection Act of 1970.
By issuing this Order, the Commission does not intend to prohibit
or restrict the ability of any futures exchange to establish a similar
linkage arrangement with HKFE.
By issuing this Order, the Commission takes notice of its
surveillance and enforcement information sharing arrangements with the
appropriate Hong Kong regulatory authorities.
The Commission retains the authority to terminate or otherwise to
modify this relief at such time as it determines that exemption of
transactions through the Linkage is no longer in the public interest.
Issued in Washington, DC on March 28, 1997, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-8365 Filed 4-1-97; 8:45 am]
BILLING CODE 6351-01-P
