[Federal Register Volume 61, Number 123 (Tuesday, June 25, 1996)]
[Notices]
[Pages 32878-32880]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-16064]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37320; File No. SR-Phlx-96-07]
Self-Regulatory Organizations; Order Granting Approval to
Proposed Rule Change by the Philadelphia Stock Exchange, Inc., to Adopt
a Market Index Option Hedge Exemption
June 18, 1996.
I. Introduction
On February 13, 1996, the Philadelphia Stock Exchange, Inc.
(``Phlox'' or ``Exchange'') submitted to the Securities and Exchange
Commission (``Commission''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to amend Commentary .01 to Phlx
Rule 1001A to establish a hedge exemption from broad-based (Market)
index option position and exercise limits.\3\
---------------------------------------------------------------------------
\1\ 15 .S.C. Sec. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1994).
\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 concern from exercising more than a specified
number of puts or calls in a particular class of options within five
consecutive business days.
---------------------------------------------------------------------------
The proposed rule change appeared in the Federal Register on March
21, 1996.\4\ No comments were received on the proposed rule change.
This order approves the Phlx's proposal.
---------------------------------------------------------------------------
\4\ See Securities Exchange Act Release No. 36976 (March 14,
1996), 61 FR 11668 (March 21, 1996).
---------------------------------------------------------------------------
II. Background and Description
The Phlx proposes to adopt a market index option hedge exemption
under which broad-based index option positions hedged in accordance
with the proposal would be entitled to exceed existing position and
exercise limits by up to two-times about the limit.\5\ According to the
Phlx, the purpose of the proposal is to establish a provision parallel
to the hedge exemption of equity options \6\ as well as the broad-based
index option hedge exemptions that are in place at other option
exchanges.\7\
---------------------------------------------------------------------------
\5\ The Exchange notes that is adopting the language ``two times
above the limit'' to signify ``in addition to'' the current position
limit. For instance, if the position limit for a market index option
is 25,000 contracts, an additional 50,000 contracts under this
proposal would be permitted, for a total of 75,000 contracts. This
language parallels a recent change by another exchange. See
Securities Exchange Act Release No. 36609 (December 20, 1995), 60 FR
67002 (December 27, 1995) (notice of File No. SR-CBOE-95-68).
\6\ See Phlx Rule 1001, Commentary .07. See also Securities
Exchange Act Release No. 35738 (May 18, 1995), 60 FR 27573 (May 24,
1995) (order approving permanent hedge exemption pilot programs)
(File Nos. SR-Phlx-95-10, SR-Amex-95-13, SR-CBOE-95-13, SR-NYSE-95-
04, and SR-PSE-95-05).
\7\ See, e.g., CBOE Rule 24.4 and the Interpretations and
Policies thereunder, and Commentary .01 to Amex Rule 904C.
---------------------------------------------------------------------------
In order to qualify for the exemption, the market index option
position must be hedged by share positions in at lease 20 stocks, or
securities immediately or readily convertible into such stock,\8\ in
four industry groups comprising the index, of which no one component
security accounts for more than 15% for the value of the portfolio
hedging the index option position. Under the proposal, no position in a
market index option may exceed two-times the broad-based index option
position specified in Phlx Rule 1001A(a).\9\ In addition, the
underlying value of the option position may not exceed the value of the
[[Page 32879]]
underlying portfolio employed as the hedge.\10\
---------------------------------------------------------------------------
\8\ The Exchange permits the use of convertible securities in
its equity option hedge exemption as long as such securities are
immediately or readily convertible into the underlying stock. 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 with respect to broad-based index option hedge
exemptions.
\9\ Under Phlx Rule 1001A(a), the Value Line Composite Index
(``VLE'') the U.S. Top 100 Index (``TPX''), and the National Over-
the-Counter Index (``XOC'') each have a position limit of 25,000
contracts, of which no more than 15,000 contracts can be in the
nearest expiration month. The Phlx notes that the Big Cap Index
(``MKT'') is no longer listed on the Exchange.
\10\ The value of the underlying portfolio is determined as
follows: (1) the total market value of the net stock position; less
(2) the value of: (a) any offsetting calls and puts in the
respective index option; (b) any offsetting positions in related
stock index futures or options; and (c) any economically equivalent
positions.
The values of offsetting positions are determined by the
multiplying the number of opposite-side-of-the-market (offsetting)
calls, puts, or futures contracts by the index value and by the
index multiplier. Then, the value if subtracted from the market
value of the portfolio. This number must be compared with the
underlying value of the option position, in excess of the standard
or base position limit being hedge/exempted, which is calculated by
multiplying the number of option contracts for which the exemption
is sought by the index value and the multiplier; this value cannot
exceed the value of the underlying portfolio.
---------------------------------------------------------------------------
In addition, 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 this proposal, during five consecutive business
days.\11\
---------------------------------------------------------------------------
\11\ See Phlx Rule 1002A.
---------------------------------------------------------------------------
The Phlx notes that broad-based index option hedge exemptions are
in place at other options exchanges. Generally, these index option
hedge exemptions allow public customers to apply for position limit
exemptions in broad-based index options that are hedged with exchange-
approved qualified stock portfolios.
In light of the Exchange's experience with the equity option hedge
exemption, as well as its review of the rules of the other options
exchanges, the Phlx believes that a similar hedge exemption for its
market index options is appropriate. The Phlx also believes that the
proposed conditions for granting such an exemption are reasonable and
in line with prior Commission-approved provisions.
According to the Phlx, trading volume for index options has
markedly increased. In 1994, volume increased two-fold over 1993, from
1,119,147 contracts to 2,456,685. In 1995, volume remained steady with
over 2,783,043 contracts traded. The Phlx attributes the recent growth
in trading and open interest to institutional trading, which, according
to the Phlx, is typically hedged by baskets of the underlying stocks.
The Phlx proposes to exempt positions in broad-based index options
in a manner which balances the hedging needs of index options traders
with the Exchange's obligation to maintain a fair and orderly market.
The Phlx believes that a hedge exemption up to two-times above the
limit for broad-based index options would considerably enhance the
attractiveness of these products for institutional traders, who would,
in turn, trade more of the product in a hedged manner and thereby
provide stabilizing liquidity in both the index options and the
underlying securities.
The Phlx also believes that it is appropriate and necessary to
expand the availability of the exemption beyond public customers. The
Phlx states that significant increases in the depth and liquidity of
the market for these index options could result from permitting firm
and proprietary traders to be eligible for the exemption. According to
the Phlx, because customers rely, for the most part, on a limited
number of proprietary traders to facilitate large-sized orders, not
including such traders in the exemption effectively reduces the benefit
of the exemption to customers. While large-sized positions in market
index options are most commonly initiated by institutional trades
hedging stock portfolios on behalf of public customers, the Phlx
believes that proprietary traders should be afforded the same exemption
so that they may fulfill their role as facilitators.
The Phlx also believes that the hedge exemption is necessary to
better meet the needs of investors who use Phlx market index options
for investment and hedging purposes. According to the Phlx, many
institutional traders and portfolio managers deal in dollar amounts
much greater than that permissible under current position limit levels
and have expressed that Exchange position limits hamper their ability
to fully utilize such index options.
The Phlx believes that the proposed broad-based index option hedge
exemption should not increase the potential for disruption or
manipulation in the markets for the stocks underlying each index. The
Phlx notes that this is because the proposal incorporates several
surveillance safeguards, which the Phlx will employ to monitor the use
of this exemption. Specifically, the Exchange will require that a form
be filed by members firms and their customers who seek exemptions, in
lieu of granting an automatic exemption. The Exchange will review the
request and approve only those applications that satisfy the hedge
exemption requirements. Moreover, the hedge exemption form must be kept
current, with information updated as warranted. Any information
concerning the dollar value and composition of the stock portfolio,\12\
or its equivalent, the current hedged and aggregate options positions,
and any stock index futures positions must be promptly provided to the
Exchange. In addition, 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, as well as review such trading to ensure that the closing
of positions subject to the exemption are conducted in a fair and
orderly manner. On a daily basis, the Exchange's Market Surveillance
Department will also monitor each option contract to ensure that it is
hedged by the equivalent dollar amount of component securities.
---------------------------------------------------------------------------
\12\ The Phlx notes that as the dollar value of the hedging
portfolio fluctuates, the number of exempt contracts may need to be
adjusted.
---------------------------------------------------------------------------
III. Discussion
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular, the requirements of Section 6(b)(5) thereunder,\13\ The
Commission believes that providing for increased position and exercise
limits for broad-based index options in circumstances where those
excess positions are fully hedged with offsetting 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. Sec. 78f(b)(5) (1988).
---------------------------------------------------------------------------
Specifically, the Phlx proposal contains safeguard that should make
it difficult to use the exempted positions to disrupt or manipulate the
market. First, request 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 20 stocks, or securities convertible
into such stock, in four industry groups comprising the index, of which
no one component security accounts for more than 15% of the value of
the portfolio hedging the index option position, 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 underlying
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 respective index options; (b) any offsetting positions in
related stock index futures or options; and (c) any economically
equivalent
[[Page 32880]]
positions. Third, both the options and stock positions must be
initiated and liquidated in an orderly manner. This means that 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 as well as of any
change in the portfolio or futures positions which materially affects
the value of the qualified portfolio. Fifth, the proposal provides a
ceiling on the maximum size of the options position by providing that
positions established under the proposal may not exceed two-times the
limits set forth in Exchange Rule 1001A(a). In addition, the Exchange
may determine to grant a position limit exemption for less than the
maximum of two-times above the limit.
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 persons utilizing the hedge exemption on a daily basis to ensure
that each option contract is hedged by the equivalent dollar amount of
component securities.\14\ In addition, the Phlx'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, as well as to review such trading to
ensure that the closing of positions subject to the exemption are
conducted in a fair and orderly manner. Violation of any of the
provisions of the market index hedge exemption, absent reasonable
justification or excuse, will result in the withdrawal of the hedge
exemption and subsequent denial of an application for hedge exemption
thereunder.
---------------------------------------------------------------------------
\14\ 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 options positions, and any stock
index futures positions, or economically equivalent positions.
---------------------------------------------------------------------------
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 broad-based index option hedge exemption to firm and
proprietary traders may help to increase the depth and liquidity of the
market for market 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, are properly hedged.
IV. Conclusion
For the foregoing reasons, the Commission finds that the Phlx's
proposal to establish a hedge exemption from broad-based index option
position and exercise limits is consistent with the requirements of the
Act and the rules and regulations thereunder.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\15\ that the proposed rule change (SR-Phlx-96-07) is approved.
\15\ 15 U.S.C. Sec. 78s(b)(2) (1988).
---------------------------------------------------------------------------
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\16\
---------------------------------------------------------------------------
\16\ 17 CFR 200.30-3(a)(12) (1994).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-16064 Filed 6-24-96; 8:45 am]
BILLING CODE 8010-01-M
