[Federal Register Volume 64, Number 150 (Thursday, August 5, 1999)]
[Notices]
[Pages 42736-42745]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-20174]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-41658; File No. SR-CBOE-97-67]
Self-Regulatory Organizations; Chicago Board Options Exchange,
Incorporated; Order Approving Proposed Rule Change and Notice of Filing
and Order Granting Accelerated Approval of Amendment Nos. 1 and 2 to
Proposed Rule Change Revising the Exchange's Margin Rules
July 27, 1999.
I. Introduction
On December 29, 1997, the Chicago Board Options Exchange,
Incorporated (``Exchange'' or ``CBOE'') 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 revise and restructure the
Exchange's margin requirements for stock options, stock index options,
and other securities, as currently set forth in CBOE Rule 12.3,
``Margin Requirements.'' The proposed rule change was published for
comment in the Federal Register on May 4, 1998.\3\ The Commission
received 4 comment letters with respect to the proposal.\4\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 39925 (April 27,
1998), 63 FR 24580.
\4\ See Letter from Robert C. Sheehan, President, Robert C.
Sheehan and Associates, to Jonathan Katz, Secretary, Commission,
dated March 26, 1999 (``Sheehan Letter''); Letter from Alvin
Wilkinson to Jonathan Katz, Secretary, Commission, dated March 25,
1999 (``Wilkinson Letter''); Letter from William C. Floersch,
President and CEO, O'Connor & Company, to Jonathan G. Katz,
Secretary, Commission, dated April 5, 1999 (``O'Connor Letter'');
and Letter from Lon Gorman, Executive Vice President, Charles Schwab
& Co., to Jonathan G. Katz, Secretary, Commission, dated April 13,
1999 (``Schwab Letter'').
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The Exchange submitted Amendment No. 1 to the proposal on January
7, 1999,\5\ and Amendment No. 2 on May 26, 1999.\6\ This order approves
the proposed rule change and accelerates approval of Amendment Nos. 1
and 2.
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\5\ With respect to options that are not proposed to be
marginable, Amendment No. 1 specifies that margin must be deposited
and maintained equal to at least 100% of the current market value,
rather than 100% of the purchase price. Amendment No. 1 also
incorporates into the proposed rule text a definition of ``OTC
margin bond,'' which has been eliminated from Regulation T by the
Board of Governors of the Federal Reserve System as of April 1,
1998. Finally, Amendment No. 1 deletes from the proposal the
provision that would have allowed the use of unit investment trusts
(``UITs'') or open-end mutual funds (``mutual funds'') as offsets,
or cover, for short index option positions held in customer margin
or cash accounts, provided that the UIT or mutual fund replicated
the index underlying the option, and the Exchange had specifically
approved such UIT or mutual fund. As a replacement, the Exchange
proposes to allow customers to use underlying open-end index mutual
funds of sufficient aggregate market value as cover for short S&P
500 call options held in customer margin or cash accounts, provided
the mutual funds have been specifically designated by the Exchange.
See Letter from Mary L. Bender, Senior Vice President, Division of
Regulatory Services, Exchange, to Michael A. Walinskas, Associate
Director, Division of Market Regulation (``Division''), Commission,
dated December 23, 1998 (``Amendment No. 1'').
\6\ Amendment No. 2 revises the proposal by limiting loan value
to long term stock options, stock index options, and stock index
warrants. The Exchange had originally proposed to allow loan value
on any long term option, regardless of the underlying instrument
(e.g., foreign currency options and options on interest rate
composites would be marginable). Amendment No. 2 also corrects an
error in the Exchange's purpose statement regarding the net credit
received for selling a box spread. See Letter from Mary L. Bender,
Senior Vice President, Division of Regulatory Services, Exchange, to
Michael A. Walinskas, Associate Director, Division, Commission,
dated May 14, 1999 (``Amendment No. 2'').
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II. Description of the Proposal
A. Background
Until several years ago, the margin requirements governing listed
options were set forth in Regulation T, ``Credit by Brokers and
Dealers.'' \7\ However, Federal Reserve Board amendments to Regulation
T that became effective June 1, 1997, modified or deleted certain
margin requirements regarding options transactions in favor of rules to
be adopted by the options exchanges, subject to approval by the
Commission.\8\ In a CBOE rule filing approved by the Commission in
1997, the Exchange adopted certain options-related margin requirements
that were dropped from Regulation T by the Federal Reserve Board.\9\
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\7\ 12 CFR 220 et seq. The Board of Governors of the Federal
Reserve System (``Federal Reserve Board'') issued Regulation T
pursuant to the Act.
\8\ See Board of Governors of the Federal Reserve System Docket
No. R-0772 (Apr. 24, 1996), 61 FR 20386 (May 6, 1996) (permitting
the adoption of margin requirements ``deemed appropriate by the
exchange that trades the option, subject to the approval of the
Securities and Exchange Commission'').
\9\ See Securities Exchange Act Release No. 38709 (June 2,
1997), 62 FR 31643 (June 10, 1997).
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At the present time, the Exchange seeks to further revise its
margin rules to implement enhancements long desired by Exchange members
and member firms, public investors, and the Exchange staff. The
Exchange believes that certain multiple options position strategies and
other strategies that combine stock with option positions warrant more
equitable margin requirements. The Exchange further believes that the
offset in risk that results if the stock and options position are
viewed collectively is not reflected in the current maintenance margin
requirements. In addition, the Exchange believes it is appropriate for
member firms to extend credit on certain types of long term options.
In sum, the proposed revisions to the Exchange's margin rules
would: (i) Permit the extension of credit on certain long term options
and certain long box spread; (ii) recognize butterfly and box spreads
as strategies for purposes of margin treatment and establish
appropriate margin requirements; (iii) recognize various strategies
involving stocks (or other underlying instruments) paired with long
options, and provide for lower maintenance margin requirements on such
hedged stock positions; (iv) expand the types of short positions that
would be considered ``covered'' in a cash account, specifically,
certain short positions that are components of limited-risk spread
strategies (e.g., butterfly and box spreads); (v) allow a bank-issued
escrow agreement to serve as cover in lieu of cash for certain spread
positions held in a cash account; (vi) consolidate in one chapter, the
various margin requirements that presently are dispersed throughout the
Exchange's rules; and (vii) revise and update, as necessary, other
Exchange rules impacted by the proposal.
[[Page 42737]]
B. Definitions
Presently, the Exchange's definition of ``current market value'' is
equivalent to the definition found in Regulation T.\10\ Instead of
repeating the Regulation T definition, the proposal would revise the
definition found in the Exchange's rules to note that the meaning of
the term ``current market value'' is as defined in Regulation T.
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\10\ Regulation T defines ``current market value'' of a security
to be:
(i) Throughout the day of the purchase or sale of a security,
the security's total cost of purchase or the net proceeds of its
sale including any commissions charged; or (ii) At any other time,
the closing sale price of the security on the preceding business
day, as shown by any regularly published reporting or quotation
service. If there is no closing sale price, the creditor may use any
reasonable estimate of the market value of the security as of the
close of business on the preceding business day.
See 12 CFR 220.2.
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The Exchange also seeks to establish definitions for ``butterfly
spread'' \11\ and ``box spread'' \12\ options strategies. The
definitions are important elements of the Exchange's proposal to
recognize and specify cash and margin account requirements for
butterfly and box spread. The definitions will specify what multiple
option positions, if held together, qualify for classification as
butterfly or box spreads, and consequently are eligible for the
proposed cash and margin treatment.
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\11\ The proposal defines ``butterfly spread'' as:
[A]n aggregation of positions in three series of either put or
call options all having the same underlying component or index and
time of expiration, and based on the same aggregate current
underlying value, where the interval between the exercise price of
each series is equal, which positions are structured as either (A) a
``long butterfly spread'' in which two short options in the same
series are offset by one long option with a higher exercise price
and one long option with a lower exercise price, or (B) a ``short
butterfly spread'' in which two long options in the same series
offset one short option with a higher exercise price and one short
option with a lower exercise price.
\12\ The proposal defines ``box spread'' as:
[A]n aggregation of positions in a long call option and short
put option with the same exercise price (``buy side'') coupled with
a long put option and short call option with the same exercise price
(``sell side'') all of which have the same underlying component or
index and time of expiration, and are based on the same aggregate
current underlying value, and are structured as either: (A) A ``long
box spread'' in which the sell side exercise price exceeds the buy
side exercise price, or (B) a ``short box spread'' in which the buy
side exercise price exceeds the sell side exercise price.
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The proposal also would define the term ``OTC martin bond.'' \13\
The definition is necessary because the Exchange's margin rules
currently cross-reference the Regulation T definition of ``OTC margin
bond,'' which was eliminated by the Federal Reserve Board as of April
1, 1998.\14\
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\13\ The proposal defines ``OTC margin bond'' as:
(1) Any debt securities not traded on a national securities
exchange that meet all of the following requirements (a) at the time
of the original issued, a principal amount of not less than
$25,000,000 of the issue was outstanding; (b) the issue was
registered under Section 5 of the Securities Act of 1933 and the
issuer either files periodic reports pursuant to the Act or is an
insurance company under Section 12(g)(2)(G) of the Act; or (c) at
the time of the extension of credit the creditor has a reasonable
basis for believing that the issuer is not in default on interest or
principal payments; or (2) any private pass-through securities (not
guaranteed by a U.S. Government agency) that meet all of the
following requirements: (a) An aggregate principal amount of not
less than $25,000,000 was issued pursuant to a registration
statement filed with the Commission; and (b) current reports
relating to the issue have been filed with the Commission; and (c)
at the time of the credit extension, the creditor has a reasonable
basis for believing that mortgage interest, principal payments and
other distributions are being passed through as required and that
the servicing agent is meeting its material obligations under the
terms of the offering.
\14\ See Board of Governors of the Federal Reserve System Docket
Nos. R-0905, R-0923, and R-0944 (Jan. 8, 1998), 63 FR 2806 (Jan. 16,
1998).
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Finally, the proposal would define the term ``listed,'' \15\
Because ``listed'' is frequently used in the Exchange's margin rules,
the Exchange believes it would be more efficient to define the term
once rather than specifying the meaning each time the term is utilized.
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Under the proposal, the term ``listed'' means ``a security
traded on a registered national securities exchange or automated
facility of a registered national securities association.
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C. Extensions of Credit on Long Term Options and Warrants
The proposal would allow extensions of credit on certain listed,
long options (i.e., listed put or call options on a stock or stock
index) and warrant products (i.e., listed stock index warrants, but not
traditional stock warrants issued by a corporation on its own
stock.\16\ Only those options or warrants that are more than 9 months
from expiration (``long term'') would be eligible for credit
extension.\17\ The proposal requires initial and maintenance margin of
not less than 75% of the current market value of a long term listed
option or warrant. Therefore, an Exchange member firm would be able to
loan up to 25% of the current market value of a long term listed option
or warrant.\18\
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\16\ Throughout the remainder of this approval order, the term
``warrant'' means this type of warrant.
\17\ In the case of any stock option, stock index option, or
stock index warrant, which expires in 9 months or less, initial
margin must be deposited and maintained equal to at least 100% of
the current market value of the option or warrant.
\18\ For example, if an investor purchased an Exchange-listed
call option on stock XYZ that expired in January 2001 for
approximately $100 (excluding commissions), the investor would be
required to deposit and maintain at least $75. The investor could
borrow the remaining $25 from its broker. Under the Exchange's
current margin rules, the investor would be required to pay the
entire $100.
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The proposal also would permit the extension of credit on certain
long term options and warrants not listed or traded on a registered
national securities exchange or a registered securities association
(``OTC options and warrants''). Specifically, a member firm could
extend credit on an OTC put or call option on a stock or stock index,
and an OTC stock index warrant. In addition to being more than 9 months
from expiration, a marginable OTC option or warrant must: (i) Be in-
the-money; \19\ (ii) be guaranteed by the carrying broker-dealer; and
(iii) have an American-style exercise provision.\20\ The proposal
requires initial and maintenance margin of not less than 75% of the
long term OTC option's or warrant's in-the-money amount (i.e.,
intrinsic value), plus 100% of the amount, if any, by which the current
market value of the OTC option or warrant exceeds the in-the-money
amount.
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\19\ The Exchange stated that it proposes to restrict loan value
to long term OTC options and warrants that are in-the-money because
``a liquid secondary market for an over-the-counter option or
warrant does not generally exist. Therefore, a current bid or offer
price, or last sale price, is not readily available.'' In addition,
the Exchange noted that because OTC options are not obligations of
the AAA-rated Options Clearing Corporation, their value may vary
depending upon the creditworthiness of the issuer. The Exchange
concluded that ``loaning on over-the-counter options without
intrinsic value posed too much uncertainty to the creditor as to the
value of the collateral'' As a result, the only OTC options that
would be deemed eligible for credit are in-the-money options,
because ``their value can reasonably be expected to be at least
equal to their intrinsic value.'' See Letter to Michael Walinskas,
Associate Director, Division, Commission, from Mary L. Bender,
Senior Vice President, Division of Regulatory Services, Exchange,
dated May 21, 1998.
\20\ Exchange Rule 1.1(vv), ``American-style Option,'' states
that an American-style option is an option contract that ``can be
exercised on any business day prior to its expiration date and on
its expiration date.''
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When the time remaining until expiration for an option or warrant
(listed and OTC) on which credit has been extended reaches nine months,
the maintenance margin requirement would become 100% of the current
market value. Thus, options or warrants expiring in less than 9 months
would have no loan value under the proposal.
D. Extensions of Credit on Long Box Spread in European-Style Options
The proposal would allow the extension of credit on a long box
spread comprised entirely of European-style options \21\ that are
listed or guaranteed by the carrying broker-dealer. A long box spread
is a strategy composed of four option positions that is designed to
lock in the ability to buy and sell the
[[Page 42738]]
underlying component or index for a profit, even after netting the cost
of establishing the long box spread. The two exercise prices embedded
in the strategy determine the buy and the sell price.\22\
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\21\ Exchange Rule 1.1(uu), ``European-style Option,'' states
that a European-style option is an option contract that ``can be
exercised only on its expiration date.''
\22\ For example, an investor might be long 1 XYZ Jan 50 Call @
7 and short 1 XYZ Jan 50 Put @ 1 (``buy side''), and short 1 XYZ Jan
60 Call @ 2 and long 1 XYZ Jan 60 Put @ 5\1/2\ (``sell side''). As
required by the Exchange's proposed definition of ``long box
spread'' (supra note 12), the sell side exercise price exceeds the
buy side exercise price. In this example, the long box spread is a
riskless position because the net debit ((2+1)-(7+5\1/2\)= net debit
of 9\1/2\) is less than the exercise price differential (60-50=10).
Thus, the investor has locked in a profit of $50 (\1/2\ x 100).
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For long box spreads made up of European-style options, the
proposed margin requirement would equal 50% of the aggregate difference
in the two exercise prices (buy and sell), which results in a
requirement slightly higher than 50% of the debit typically
incurred.\23\ The 50% margin requirement is both an initial and
maintenance margin requirement. The proposal would afford a long box
spread a market value for margin equity purposes of not more than 100%
of the aggregate difference in exercise prices.
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\23\ In the example appearing in the preceding footnote, the
margin required (50% x (60-50) = 5) would be slightly higher than
50% of the net debit (50% x 9\1/2\ = 4\3/4\).
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E. Cash Account Treatment of Butterfly and Box Spreads, Other Spreads,
and Short Options
The proposal would make butterfly spreads and box spreads in cash-
settled, European-style options eligible for the cash account. A
butterfly spread is a pairing of two standard spreads, one bullish and
one bearish. To qualify for carrying in the cash account, the butterfly
spreads and box spreads must meet the specifications contained in the
proposed definition section,\24\ and must be comprised of options that
are listed or guaranteed by the carrying broker-dealer. In addition,
the long options must be held in, or purchased for, the account on the
same day.
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\24\ See supra notes 11 and 12.
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For long butterfly spreads and long box spreads, the proposal would
require full payment of the net debit that is incurred when the spread
strategy is established.\25\
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\25\ To create a long butterfly spread, which is comprised of
call options, an investor may be long 1 XYZ Jan 45 Call @ 6, short 2
XYZ Jan 50 Calls @ 3 each, and long 1 XYZ Jan 55 Call @ 1. The
maximum risk for this long butterfly spread is the net debit
incurred to establish the strategy ((3+3)-(6+1)= net debit of 1).
Under the proposal, therefore, the investor would be required to pay
the net debit, or $100 (1 x 100).
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Short butterfly spreads generate a credit balance when established
(i.e., the proceeds from the sale of short option components exceed the
cost of purchasing long option components). However, in the worst case
scenario where all options are exercised, a debit (loss) greater than
the initial credit balance received would accrue to the account. To
eliminate the risk to the broker-dealer carrying the short butterfly
spread, the proposal would require that an amount equal to the maximum
risk be held or deposited in the account in the form of cash or cash
equivalents.\26\ The maximum risk potential in a short butterfly spread
comprised of call options is the aggregate difference between the two
lowest exercise prices.\27\ With respect to short butterfly spreads
comprised of put options, the maximum risk potential is the aggregate
difference between the two highest exercise prices. The net credit
received from the sale of the short option components could be applied
towards the requirement.
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\26\ An escrow agreement could be used as a substitute for cash
or cash equivalents if the agreement satisfies certain criteria. For
short butterfly spreads, the escrow agreement must certify that the
bank holds for the account of the customer as security for the
agreement (1) cash, (2) cash equivalents, or (3) a combination
thereof having an aggregate market value at the time the positions
are established of not less than the amount of the aggregate
difference between the two lowest exercise prices with respect to
short butterfly spreads comprised of call options or the aggregate
difference between the two highest exercise prices with respect to
short butterfly spreads comprised of put options and that the bank
will promptly pay the member organization such amount in the event
the account is assigned an exercise notice on the call (put) with
the lowest (highest) exercise price.
\27\ For example, an investor may be short 1 XYZ Jan 45 Call @
6, long 2 XYZ Jan 50 Calls @ 3 each, and short 1 XYZ Jan 55 Call @
1. Under the proposal, the maximum risk for this short butterfly
spread, which is comprised of call options, is equal to the
difference between the two lowest exercise prices (50-45=5). If the
net credit received from the sale of short option components
((6+1)-(3+3)= net credit of 1) is applied, the investor is required
to deposit an additional $400 (4 x 100). Otherwise, the investor
would be required to deposit $500 (5 x 100).
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Short box spreads also generate a credit balance when established.
This credit is nearly equal to the total debit (loss) that, in the case
of a short box spread, will accrue to the account if held to
expiration. The proposal would require that cash or cash equivalents
covering the maximum risk, which is equal to the aggregate difference
in the two exercise prices involved, be held or deposited.\28\ The net
credit received from the sale of the short option components may be
applied towards the requirement; if applied, only a small fraction of
the total requirement need be held or deposited.\29\
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\28\ As a substitute for cash or cash equivalents, an escrow
agreement could be used if it satisfies certain criteria. For short
box spreads, the escrow agreement must certify that the bank holds
for the account of the customer as security for the agreement (1)
cash, (2) cash equivalents, or (3) a combination thereof having an
aggregate market value at the time the positions are established of
not less than the amount of the aggregate difference between the
exercise prices and that the bank will promptly pay the member
organization such amount in the event the account is assigned an
exercise notice on either short option.
\29\ To create a short box spread, an investor may be short 1
XYZ Jan 60 Put @ 5\1/2\ and long 1 XYZ Jan 60 Call @ 2 (``buy
side''), and short 1 XYZ Jan 50 Call @ 7 and long 1 XYZ Jan 50 Put @
1 (``sell side''). As required by the Exchange's proposed definition
of ``short box spread'' (supra note 12), the buy side exercise price
exceeds the sell side exercise price. In this example, the maximum
risk for the short box spread is equal to the difference between the
two exercise prices (60-50=10). If the net credit received from the
sale of short option components ((5\1/2\+7)-(2+1)=net credit of 9\1/
2\) is applied, the investor is required to deposit an additional
$50 (\1/2\ x 100). Otherwise, the investor would be required to
deposit $1,000 (10 x 100).
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In addition to butterfly spreads and box spreads, the proposal
would permit investors to hold in their cash accounts other spreads
made up of European-style, cash-settled index options, stock index
warrants, or currency index warrants. A short position would be
considered covered, and thus eligible for the cash account, if a long
position in the same European-style, cash-settled index option, stock
index warrant, or currency index warrant was held in, or purchased for,
the account on the same day.\30\ The long and short positions making up
the spread must expire concurrently, and the long position must be paid
in full. Lastly, the cash account must contain cash, cash equivalents,
or an escrow agreement equal to at least the aggregate exercise price
differential.
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\30\ Under the proposal, a long warrant may offset a short
option contract and a long option contract may offset a short
warrant provided they have the same underlying component or index
and equivalent aggregate current underlying value.
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The proposal also would establish requirements for the following
types of options and warrants carried short in the cash account: equity
options, index options, capped-style index options, packaged vertical
spread options, packaged butterfly spread options, stock index
warrants, and currency index warrants. For each of these securities,
the proposal specifies certain criteria that must be satisfied for the
short position to be deemed a covered position, and thus considered
eligible for the cash account. For example, a short put warrant on a
market index would be deemed covered if, at the time the put warrant is
sold or promptly thereafter, the cash account holds cash, cash
equivalents, or an escrow agreement equal to the aggregate exercise
price.
[[Page 42739]]
F. Margin Account Treatment of Butterfly Spreads and Box Spreads
The Exchange's margin rules presently do not recognize butterfly
spreads for margin purposes. Under the Exchange's current margin rules,
the two spreads (bullish and bearish) that make up a butterfly spread
each must be margined separately. The Exchange believes that the two
spreads should be viewed in combination, and that commensurate with the
lower combined risk, investors should receive the benefit of lower
margin requirements.
The Exchange's proposal would recognize as a distinct strategy
butterfly spreads held in margin accounts, and specify requirements
that are the same as the cash account requirements for butterfly
spreads.\31\ Specifically, in the case of a long butterfly spread, the
net debit must be paid in full. For short butterfly spreads comprised
of call options, the initial and maintenance margin must equal at least
the aggregate difference between the two lowest exercise prices. For
short butterfly spreads comprised of put options, the initial and
maintenance margin must equal at least the aggregate difference between
the two highest exercise prices. The net credit received from the sale
of the short option components may be applied towards the margin
requirement for short butterfly spreads.
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\31\ See supra, Section II(E), ``Cash Account Treatment of
Butterfly and Box Spreads, Other Spreads, and Short Options.'' The
margin requirements would apply to butterfly spreads where all
option positions are listed or guaranteed by the carrying broker-
dealer.
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The proposed requirements for box spreads held in a margin account,
where all option positions making up the box spread are listed or
guaranteed by the carrying broker-dealer, also are the same as those
applied to the cash account. With respect to long box spreads, where
the component options are not European-style, the proposal would
require full payment of the net debit that is incurred when the spread
strategy is established.\32\ For short box spreads held in the margin
account, the proposal would require that cash or cash equivalents
covering the maximum risk, which is equal to the aggregate difference
in the two exercise prices involved, be deposited and maintained. The
net credit received from the sale of the short option components may be
applied towards the requirement. Generally, long and short box spreads
would not be recognized for margin equity purposes; however, the
proposal would allow loan value for one type of long box spread where
all component options have a European-style exercise provision and are
listed or guaranteed by the carrying broker-dealer.
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\32\ As discussed above in Section II(D), ``Extension of Credit
on Long Box Spread in European-style Options,'' the margin
requirement for a long box spread made up of European-style options
is 50% of the aggregate difference in the two exercise prices.
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G. Maintenance Margin Requirements for Stock Positions Held With
Options Positions
The Exchange proposes to recognize, and establish reduced
maintenance margin requirements for, five options strategies designed
to limit the risk of a position in the underlying component. The
strategies are: (1) Long Put/Long Stock: (2) Long Call/Short Stock; (3)
Conversion; (4) Reverse Conversion; and (5) Collar. Although the five
strategies are summarized below in terms of a stock position held in
conjunction with an overlying option (or options), the proposal is
structured to also apply to components that underlie index options and
warrants. For example, these same maintenance margin requirements will
apply when these strategies are utilized with a stock basket underlying
index options or warrants. Proposed Exchange Rule 12.3(c)(5)(C)(3),
``Exceptions,'' would define the five strategies and set forth the
respective maintenance margin requirements for the stock component for
each strategy.\33\
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\33\ The Exchange's proposal provides maintenance margin relief
for the stock component (or other underlying instrument) of the five
identified strategies. The Exchange believes that a reduction in the
initial margin for the stock component of these strategies is not
currently possible because the 50% initial margin requirement under
Regulation T continues to apply, and the Exchange does not possess
the independent authority to lower the initial margin requirement
for stock. However, the Exchange noted that the Federal Reserve
Board is considering recognizing the reduced risk afforded stock by
these option strategies for the purpose of lowering initial stock
margin requirements and is also considering other changes that would
facilitate risk-based margins.
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1. Long Put/Long Stock
The Long Put/Long Stock strategy requires an investor to carry in
an account a long position in the component underlying the put option,
and a long put option specifying equivalent units of the underlying
component. The maintenance margin requirement for the Long Put/Long
Stock combination would be the lesser of: (i) 10% of the put option
exercise price, plus 100% of any amount by which the put option is out-
of-the-money; or (ii) 25% of the current market value of the long stock
position.\34\
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\34\ Suppose an investor is long 100 shares of XYZ @ 52 and long
1 XYZ Jan 50 Put @ 2. The margin would be the lesser of ((10% x
50) + (100% x 2) = 7) or (25% x 52 = 13). Therefore, the
investor would be required to maintain margin equal to at least $700
(7 x 100).
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2. Long Call/Short Stock
The Long Call/Short Stock strategy requires an investor to carry in
an account a short position in the component underlying the call
option, and a long call option specifying equivalent units of the
underlying components. For a Long Call/Short Stock combination, the
maintenance margin requirement would be the lesser of: (i) 10% of the
call option exercise price, plus 100% of any amount by which the call
option is out-of-the-money; or (ii) the maintenance margin requirement
on the short stock position as specified in CBOE rule 12.3(b).\35\
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\35\ For each stock carried short that has a current market
value of less than $5 per share, the maintenance margin is $2.50 per
share or 100% of the current market value, whichever is greater. For
each stock carried short that has a current market value of $5 per
share or more, the maintenance margin is $5 per share or 30% of the
current market value, whichever is greater. See Exchange Rule
12.3(b)(2), ``Short Positions.''
Suppose an investor is short 100 shares of XYZ @ 48 and long 1
XYZ Jan 50 Call @ 1. The margin would be the lesser of ((10% of 50)
=7) or 30% x 48 = 14.4). Therefore, the investor would be required
to maintain margin equal to at least $700 (7 x 100).
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3. Conversion
A ``Conversion'' is a long stock position held in conjunction with
a long put and a short call. The long put and short call must have the
same expiration date and exercise price. The short call is covered by
the long stock and the long put is a right to sell the stock at a
predetermined price--the exercise price of the long put. Regardless of
any decline in market value, the stock, in effect, is worth no less
than the long put exercise price.
The Exchange's current margin regulations specify that no
maintenance margin would be required on the short call option because
it is covered, but the underlying long stock position would be margined
according to the present maintenance margin requirement (i.e., 25% of
current market value).\36\ Under the proposal, the maintenance for a
[[Page 42740]]
Conversion would be 10% of the exercise price.\37\
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\36\ Suppose an investor is long 100 shares of XYZ @ 48, long 1
XYZ Jan 50 Put at 2, and short 1 XYZ Jan 50 Call @ 1. The present
maintenance margin on the long stock position would be $1,200 ((25%
x 48) x 100). However, if the price of the stock increased to 60,
current Exchange Rule 12.3(c)(5)(B)(2) specifies that the stock may
not be valued at more than the short call exercise price. Thus, the
maintenance margin on the long stock position would be $1,250 ((25%
x 50) x 100). The writer of the call option cannot receive the
benefit (i.e., greater loan value) of a market value that is above
the call exercise price because, if assigned an exercise, the
underlying component would be sold at the exercise price, not the
market price of the long position.
\37\ For example in the preceding footnote, where the investor
was long 100 shares of XYZ @ 48, long 1 XYZ Jan 50 Put @ 2, and
short 1 XYZ Jan 50 Call @ 1, the proposed maintenance margin
requirement for the Conversion strategy would be $500 ((10% x 50)
x 100).
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4. Reverse Conversion
A ``Reverse Conversion'' is a short stock position held in
conjunction with a short put and a long call. As with the Conversion,
the short put and long call must have the same expiration date and
exercise price. The short put is covered by the short stock and the
long call is a right to buy the right stock at a predetermined price--
the call exercise price. Regardless of any rise in market value, the
stock can be acquired for the call exercise price, in effect, the short
position is valued at no more than the call exercise price. The
maintenance margin requirement for a Reverse Conversion would be 10% of
the exercise price, plus any in-the-money amount (i.e., the amount by
which the exercise price of the short put exceeds the current market
value of the underlying stock position).\38\
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\38\ The seller of a put option has an obligation to buy the
underlying component at the put exercise price. If assigned an
exercise, the underlying component would be purchased (the short
position in the Reverse Conversion effectively closed) at the
exercise price, even if the current market price is lower. To
recognize the lower market value of a component, the short put in-
the-money amount is added to the requirement. For example, an
investor holding a Reverse Conversion may be short 100 shares of XYZ
@ 52, long 1 XYZ Jan 50 Call @ 2\1/2\, and short 1 XYZ Jan 50 Put @
1\1/2\. If the current market value of XYZ stock drops to 30, the
maintenance margin would be $2,500 ((10% x 50) + (50-30)) x 100.
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5. Collar
A ``Collar'' is a long stock position held in conjunction with a
long put and a short call. A Collar differs from a Conversion in that
the exercise price of the long put is lower than the exercise price of
the short call. Therefore, the options positions in a Collar do not
constitute a pure synthetic short stock position. The maintenance
margin for a Collar would be the lesser of: (i) 10% of the long put
exercise price, plus 100% of any amount by which the long put is out-
of-the-money; or (ii) 25% of the short call exercise price.\39\ Under
the Exchange's current margin regulations, the stock may not be valued
at more than the call exercise price.
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\39\ To create a Collar, an investor may be long 100 shares of
XYZ @ 48, long 1 XYZ Jan 45 Put @ 4, and short 1 XYZ Jan 50 Call @
3. The maintenance margin requirement would be the lesser of ((10%
x 45) + 3 = 7\1/2\) or (25% x 50 = 12\1/2\). Therefore, the
investor would need to maintain at least $750 (7\1/2\ x 100) in
margin.
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H. Restructuring
The proposal would replace the present margin requirement for
uncovered short listed options, which appears as CBOE Rule
12.3(c)(5)(A), ``Short Listed Equity Options: General Rule,'' with
current Interpretation and Policy .01 to Exchange Rule 12.3
(``Interpretation''). The Interpretation contains a table that
includes: (i) Different types of listed option and warrant products;
(ii) the underlying component value; (iii) the percentage used in the
basic formula for calculating the margin requirement for positions
carried short; and (iv) the percentage used in the alternative formula
for calculating the minimum margin requirement, which becomes operative
whenever the basic formula results in a lower requirement.\40\ The
Interpretation has been modified slightly to incorporate the margin
requirements for narrow-based stock index warrants, which are currently
located in Chapter 30 of the Exchange's rules.
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\40\ For example, if an investor writes an uncovered equity
option, such as 1 XYZ Jan 25 Put @ 1, the investor's position would
be subject to the Exchange's short option margin requirements. If
the current market value of XYZ stock is $30, under the basic
formula the investor would be required to deposit and maintain
margin equal to at least $200 (i.e., $100 (100% of the current
market value of the option) + $600 (20% x $3,000 the
current market value of the XYZ stock underlying the short option) -
$500 (the out-of-the-money amount)). However, the alternative
formula becomes operative because it requires a minimum margin that
exceeds the amount required under the basic formula. Under the
alternative formula, the investor would be required to deposit and
maintain margin equal to at least $350 (i.e., $100 (100% of the
current market value of the option) + $250 (10% x $2,500
the aggregate exercise price amount of the short put option)).
Therefore, the investor would be required to comply with the higher
margin requirement of $350.
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Under the proposal, the margin requirements for uncovered short
positions in OTC options would be relocated from Exchange Rule
12.3(c)(5)(B)(5) to Exchange Rule 12.3(c)(5)(B). The current text of
the Exchange rule that sets forth the margin requirements for short OTC
options differs from the proposed text of the rule that contains the
margin requirements for short listed options (i.e., the
Interpretation). To establish greater consistency, the proposal would
revise the rule text of the margin requirements for both listed and OTC
short options to make them more similar. The methodology of calculating
margin requirements for short listed and OTC options is essentially the
same, only different percentages are applies.\41\
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\41\ For example, the percentage used in the basic formula for
calculating the margin requirement for short listed stock options is
20%. In contrast, the percentage used with respect to short OTC
stock options is 30%.
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The proposal also would combine the margin requirements pertaining
to long position offsets for short OTC options with those pertaining to
long position offsets for short listed options. The combined margin
requirements would appear in proposed Exchange Rule 12.3(c)(5)(C),
``Related Securities Position'' and would apply to listed and OTC
option positions where: (i) a short call is covered by a convertible
security; (ii) a short call is covered by a warrant; and (iii) a short
call or short put is covered.\42\ As a result, two sets of relatively
identical requirements that now exist separately would be consolidated
into one section.
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\42\ In the case of short call, the position must be covered by
a long position in equivalent units of the underlying security, and
in the case of a short put, the position must be covered by a short
position in equivalent units of the underlying security. With
respect to short calls options on the S&P 500 stock index, the
Exchange proposes to allow the use of long positions in underlying
open-end index mutual funds as cover for short S&P 500 call options
held in customer margin or cash accounts, provided the mutual funds
have sufficient aggregate market value and have been specifically
designated by the Exchange.
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The proposed restructuring would ensure that the margin
requirements for short options and warrants are organized in one
section. The restructuring also would allow the deletion of the margin
requirements applicable to short options and warrants that are now
dispersed among several other chapters: Chapter 23 (interest rate
options), Chapter 24 (index options), and Chapter 30 (warrants). In
addition, the proposal would restructure Exchange Rule 12.3 to
generically cover the margin requirements for spread positions in
options/warrants of the types currently addressed in other
chapters.\43\ Margin requirements located elsewhere that are not
amenable to such generic treatment, have been incorporated into
Exchange Rule 12.3 as necessary.
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\43\ For example, the margin requirements for capped-style (CAPS
and Q-CAPS) index option spreads, packaged vertical spreads, and
packaged butterfly spreads were moved from Chapter 24 and updated to
reflect the proposed margin requirements for spreads.
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I. Time Margin Must Be Obtained
The proposal would clarify the time in which initial margin is due.
Exchange Rule 12.2, ``Time Margin Must Be Obtained,'' was adopted at a
time when the Exchange had authority only to set maintenance margin
levels, and currently requires that margin be obtained as promptly as
possible. Because the Exchange now has additional rulemaking
responsibility for the initial margin requirements for options, the
proposal specifies that
[[Page 42741]]
initial margin requirements would be due in one ``payment period'' as
defined in Regulation T.\44\ The proposal also would revise Exchange
Rule 12.2 to specify that maintenance margin must be obtained as
promptly as possible, but in any event within 15 days. The current
standard is ``within a reasonable time.''
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\44\ Regulation T defines payment period as ``the number of
business days in the standard securities settlement cycle in the
United States, as defined in paragraph (a) of SEC Rule 15c6-1, plus
two business days.'' See 12 CFR 220.2.
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J. Effect of Mergers and Acquisitions on the Margin Required for Short
Options
The proposal would implement, as Interpretation and Policy .13 of
Exchange Rule 12.3, an exception to the margin requirement for short
options if trading in the underlying security ceases due to a merger or
acquisition. The exception currently exists as part of an Exchange
Regulatory Bulletin.\45\ Under the proposed exception, if an underlying
security ceases to trade due to a merger or acquisition, and a cash
settlement price has been announced by the issuer of the option, margin
would be required only for in-the-money options and would be set at
100% of the in-the-money amount.
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\45\ Exchange Regulatory Bulletin No. 91-29, ``Customer Margin
Requirements,'' specifies the margin requirements for uncovered,
short equity options that have been delisted by the Exchange due to
a merger or acquisition. For out-of-the-money options, no margin is
required. For in-the-money options, margin must equal the difference
between the underlying stock value set by the registered clearing
corporation and the strike price of the option. See Exchange
Regulatory Bulletin Number 91-29 (April 10, 1991).
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K. Determination of Value for Margin Purposes
The proposal would revise Exchange rules 12.5, ``Determination of
Value for Margin Purposes,'' to make it consistent with that portion of
the Exchange's proposal that allows the extension of credit on certain
long-term options and warrants (i.e, stock options, stock index
options, and stock index warrants that are more than 9 months from
expiration). Currently, Exchange Rule 12.5 does not allow the market
value of long term options to be considered for margin equity purposes.
The revision would allow options and warrants eligible for loan value
under proposed Rule 12.3 to be valued at current market prices for
margin purposes. This change is designed to ensure that the value of
the marginable option or warrant (the collateral) is sufficient to
cover the debit carried in conjunction with the purchase.
L. Exempted Securities
Currently, the Exchange's maintenance margin requirement for non-
convertible debt securities is found in Exchange Rule 12.3(c)(1),
``Exempted Securities.'' However, the term ``non-convertible debt
security'' refers to corporate bonds, which are not considered exempt
securities under the Act. The Exchange seeks to rectify this misnomer
by removing the margin requirement for non-convertible debt securities
from the ``Exempted Securities'' section and redesignating it as a
separate provision, Exchange Rule 12.3(c)(2).
III. Summary of Comments
The Commission received 4 comment letters regarding the proposed
rule change, all of which supported the proposal.\46\ One commenter, a
registered broker-dealer, stated that its clients complained that the
margin requirements on certain index options positions are ``much
higher than the overall risk of the position[s] would indicate.'' \47\
Another commenter, who acts as a market maker in S&P 500 index options
at the CBOE and also serves as a member of the CBOE's Board of
Directors, reported that some market participants believe that the
margin requirements for offsetting spread positions are onerous, and
that present margin requirements are a ``major barrier to more customer
business.'' \48\ This commenter stated that in some instances customers
have shifted their options trades to the OTC and futures markets
because the margin requirements at the CBOE are higher.\49\
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\46\ See Sheehan Letter, Wilkinson Letter, O'Connor Letter, and
Schwab Letter supra note 4.
\47\ See Sheehan Letter supra note 4.
\48\ See Wilkinson Letter supra note 4.
\49\ The commenter alleged that margin requirements for certain
S&P 500 index options traded on the CBOE can be as much as 2 to 16
times greater than options on S&P 500 index futures traded on the
Chicago Mercantile Exchange. Id.
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One commenter believed that the proposed margin requirements will
benefit investors by recognizing the limited risk of many hedged
positions.\50\ Another commenter believed that the current margin
requirements for listed options positions, particularly hedged
strategies using multiple positions, do not ``adequately recognize the
defined risk of these positions.'' \51\ This commenter believed that
reducing the margin requirements for options strategies with defined
risk will benefit customers by providing increased flexibility and
lowering costs, and will better align the level of margin with the risk
of the positions. This commenter also believed that the proposal would
serve to ``increase the viability of listed options and the
competitiveness of the options markets generally.'' \52\
---------------------------------------------------------------------------
\50\ See O'Conner Letter supra note 4.
\51\ See Schwab Letter supra note 4.
\52\ Id.
---------------------------------------------------------------------------
In addition, all four commenters advocated the adoption of a risk-
based methodology for margining options positions. One commenter
believed that in terms of margin treatment, listed options are often at
a disadvantage compared to similar derivative products traded on the
futures exchanges (i.e., the futures exchanges employ risk-based
margin).\53\ Another commenter believed that the availability of risk-
based margin for listed options could help the options exchanges to
serve more customers.\54\
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\53\ Id.
\54\ See Wilkinson Letter supra note 4.
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IV. Discussion
For the reasons discussed below, the Commission finds that the
proposed rule changes is consistent with the Act and the rules and
regulations under the Act applicable to a national securities exchange.
In particular, the Commission finds that the proposed rule change is
consistent with the Section 6(b)(5) \55\ requirements that the rules of
an exchange be designed to promote just the equitable principles of
trade, prevent fraudulent and manipulative acts and practices, and
protect investors and the public interest. The Commission also finds
that the proposal may serve to remove impediments to and perfect the
mechanism of a free and open market by revising the Exchange's margin
requirements to better reflect the risk of certain hedged options
strategies.
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\55\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
The Commission believes that it is appropriate for the Exchange to
allow member firms to extend credit on certain long term options and
warrants, and that such practice is consistent with Regulation T. In
1996, the Federal Reserve Board amended Regulation T to enable the
self-regulatory organizations (``SROs'') to adopt rules permitting the
margining of options.\56\ The CBOE rules approved in this order are the
first SRO rules that will permit the margining of options under the
grant of authority from the Federal Reserve Board.
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\56\ See Board of Governors of the Federal Reserve System Docket
No. R-0772 (Apr. 24, 1996), 61 FR 20386 (May 6, 1996), and 12 CFR
220.12(f).
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The Commission believes that it is reasonable for the Exchange to
restrict the extension of credit to long term options and warrants. The
Commission believes that by limiting loan value to long term options
and warrants, the proposal will help to ensure that the extension of
credit is backed by
[[Page 42742]]
collateral (i.e., the long term option or warrant) that has sufficient
value.\57\ Because the expiration dates attached to options and
warrants make such securities wasting assets by nature, it is important
that the Exchange restrict the extension of credit to only those
options and warrants that have adequate value at the time of the
purchase, and during the term of the margin loan.\58\
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\57\ The value of an option contract is made up of two
components: Intrinsic value and time value. Intrinsic value, or the
in-the-money-accounts, is an option contract's arithmetically
determinable value based on the strike price of the option contract
and the market value of the underlying security. Time value is the
portion of the option contract's value that is attributable to the
amount of time remaining until the expiration of the option
contract. The more time remaining until the expiration of the option
contract, the greater the time value component.
\58\ For similar reasons, the Commission believes that it is
appropriate for the Exchange to permit the extension of credit on
long box spread comprised entirely of European-style options that
are listed or guaranteed by the carrying broker-dealer. Because the
European-style long box spread locks in the ability to buy and sell
the underlying component or index for a profit, and all of the
component options must be exercised on the same expiration day, the
Commission believes that the combined positions have adequate value
to support an extension of credit.
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The Commission believes that the proposed margin requirements for
eligible long term options and warrants are reasonable. For long term
listed options and warrants, the proposal requires that an investor
deposit and maintain margin of not less than 75% of the current market
value of the option or warrant. For long term OTC options and warrants,
an investor must deposit and maintain margin of not less than 75% of
the long term OTC option's or warrant's-in-the-money amount (i.e.,
intrinsic value), plus 100% of the amount, if any, by which the current
market value of the OTC option or warrant exceeds the in-the-money
amount. The Commission observes that the proposed margin requirements
are more stringent than the current Regulation T margin requirements
for equity securities (i.e., 50% initial margin and 25% maintenance
margin).
The Commission recognizes that because current Exchange rules
prohibit loan value for options, increases in the value of long term
options cannot contribute to margin equity (i.e., appreciated long term
options cannot be used to offset losses in other positions held in a
margin account). Consequently, some customers may face a margin call or
liquidation for a particular position even though they concurrently
hold a long term option that has appreciated sufficiently in value to
obviate the need for additional margin equity. The Exchange's proposal
would address this situation by allowing loan value for long term
options and warrants.
The Commission believes that it is reasonable for the Exchange to
afford long term options and warrants loan value because mathematical
models for pricing options and evaluating their worth as loan
collateral are widely recognized and understood.\59\ Moreover, some
creditors, such as the Options Clearing Corporation, extend credit on
options as part of their current business.\60\ The Commission believes
that because options market participants possess significant experience
in assessing the value of options, including the use of sophisticated
models, it is appropriate for them to extend credit on long term
options and warrants.
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\59\ For example, the Black-Scholes model and the Cox Ross
Rubinstein model are often used to price options. See F. Black and
M. Scholes, The Pricing of Options and Corporate Liabilities, 81
Journal of Political Economy 637 (1973), and J.C. Cox, S. A. Ross,
and M. Rubinstein, Option Pricing: A Simplified Approach, 7 Journal
of Financial Economics 229 (1979).
\60\ The Exchange stated, ``[t]he fact that market-maker
clearing firms and the Options Clearing Corporation extend credit on
long options demonstrates that long options are acceptable
collateral to lenders. In addition, banks have for some time loaned
funds to market-maker clearing firms through the Options Clearing
Corporation's Market Maker Pledge Program.'' See Letter to Michael
Walinskas, Associate Director, Division, Commission, from Mary L.
Bender, Senior Vice President, Division of Regulatory Services,
Exchange, dated May 21, 1998.
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Furthermore, since 1998, lenders other than broker-dealers have
been permitted to extend 50% loan value against long, listed options
under Regulation U.\61\ The Commission understands that the current bar
preventing broker-dealers from extending credit on options may place
some CBOE member firms at a competitive disadvantage relative to other
financial service firms. By permitting Exchange members to extend
credit on long term options and warrants, the proposal should enable
Exchange members to better serve customers and offer additional
financing alternatives.
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\61\ See Board of Governors of the Federal Reserve System Docket
Nos. R-0905, R-0923, and R-0944 (Jan. 8, 1998), 63 FR 2806 (Jan. 16,
1998). In adopting the final rules that permitted non-broker-dealer
lenders to extend credit on listed options, the Federal Reserve
Board states that it was:
[A]mending the Supplement to Regulation U to allow lenders other
than broker-dealers to extend 50 percent loan value against listed
options. Unlisted options continue to have no loan value when used
as part of a mixed-collateral loan. However, banks and other lenders
can extend credit against unlisted options if the loan is not
subject to Regulation U [12 CFR 221 et seq.].
The Board first proposed margining listed options in 1995. See
Board of Governors of the Federal Reserve System Docket No. R-0772
(June 21, 1995), 60 FR 33763 (June 29, 1995) (``[T]he Board is
proposing to treat long positions in exchange-traded options the
same as other registered equity securities for margin purposes.'').
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The Commission believes that it is appropriate for the Exchange to
recognize the hedged nature of certain combined options strategies and
prescribe margin and cash account requirements that better reflect the
true risk of the strategy. Under current Exchange rules, the multiple
positions comprising an option strategy such as a butterfly spread must
be margined separately. In the case of a butterfly spread, the two
component spreads (bull spread and bear spread) are margined without
regard to the risk profile of the entire strategy. The net debit
incurred on the bullish spread must be paid in full, and margin equal
to the exercise price differential must be deposited for the bearish
spread.
The Commission believes that the revised margin and cash account
requirements for butterfly spread and box spread strategies are
reasonable measures that will better reflect the risk of the combined
positions. Rather than view the butterfly and box spread strategies in
terms of their individual option components, the Exchange's proposal
would take a broader approach and require margin that is commensurate
with the risk of the entire, hedged position. For long butterfly
spreads and long box spreads, the proposal would require full payment
of the net debit that is incurred when the spread strategy is
established.\62\ For short butterfly spreads and short box spreads, the
initial and maintenance margin required would be equal to the maximum
risk potential. Thus, for short butterfly spreads comprised of call
options, the margin must equal the aggregate difference between the two
lowest exercise prices. For short butterfly spreads comprised of put
options, the margin must equal the aggregate difference between the two
highest exercise prices. For short box spreads, the margin must equal
the aggregate difference in the two exercise prices involved. In each
of these instances, the net credit received from the sale of the short
option components may be applied towards the requirement.
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\62\ However, the long box spreads made up of European-style
options, the margin requirements is 50% of the aggregate difference
in the two exercise prices.
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The Commission believes that the proposed margin and cash account
requirements for butterfly spreads and box spreads are appropriate
because the component option positions serve to offset each other with
respect to risk.
[[Page 42743]]
The proposal takes into account the defined risk of these strategies
and sets margin requirements that better reflect the economic reality
of each strategy. As a result, the margin requirements are tailored to
the overall risk of the combined positions.
For similar reasons, the Commission approves of the proposed cash
account requirements for spreads made up of European-style cash-Settled
index options, stock index warrants, or currency index warrants. Under
the proposal, a short position would be considered covered, and thus
eligible for the cash account, if a long position in the same European-
style cash-settled index option, stock index warrant, or currency index
warrant was held in, or purchased for, the account on the same day. In
addition, the long and short positions must expire concurrently, and
the cash account must contain cash, cash equivalents, or an escrow
agreement equal to at least the aggregate exercise price differential.
The Commission believes that it is reasonable for the Exchange to
specify cash account requirements for certain options and warrants
carried short. The proposed requirements clearly identify the criteria
that must be satisfied before a short position will be deemed covered.
By codifying the criteria in its margin rules, the Exchange will assist
CBOE members in determining whether a short position is eligible for
the cash account.
The Commission believes that is appropriate for the Exchange to
revise the maintenance margin requirements for several hedging
strategies that combine stock positions with options positions. The
Commission recognizes that hedging strategies such as the Long Put/Long
Stock, Long Call/Short Stock, Conversion, Reverse Conversion and
Reverse Conversion, and Collar are designed to limit the exposure of
the investor holding the combined stock and option positions. The
proposal would modify the maintenance margin required for the stock
component of a hedging strategy. For example, the stock component of a
Long Put/Long Stock combination currently is margined without regard to
the hedge provided by the long put position (i.e., the 25% maintenance
margin requirement for the stock component is applied in full). Under
the proposal, the maintenance margin requirement for the stock
component of a Long Put/Long Stock strategy would be the lesser of: (i)
10% of the put option exercise price, plus 100% of any amount by which
the put option is out-of-the-money; or (ii) 25% of the current market
value of the long stock position. Although for some market values the
proposed margin requirement would be the same as the current
requirement, in many other cases it would be lower.\63\ The Commission
believes that reduced maintenance margin requirements for the stock
components of hedging strategies are reasonable given the limited risk
profile of the strategies.
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\63\ Suppose an investor is long 100 shares of XYZ @ 52 and long
1 XYZ Jan 50 Put @ 2. Under the proposal, the required margin would
be $700--the lesser of ((10% x 50) + (100% x 2) = 7) or (25% x
52 = 13). In contrast, the current margin requirement would be
$1,300, a difference of $600.
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The Commission believes that the Exchange's proposal is a carefully
crafted measure that draws on the Exchange's experience in monitoring
the credit exposures of options strategies. In particular, the Exchange
regularly examines the coverage of options margin as it relates to
price movements in the underlying securities and index components.
Furthermore, many of the proposed margin requirements were thoroughly
reviewed by the New York Stock Exchange (``NYSE'') Rule 431 Review
Committee,\64\ which is made up of industry participants who have
extensive experience in margin and credit matters. Therefore, the
Commission is confident that the proposed margin requirements are
consistent with investor protection and properly reflect the risks of
the underlying options positions.
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\64\ NYSE Rule 431 contains the margin requirements that NYSE
members must observe. See NYSE Rule 431, ``Margin Requirements.''
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The Commission notes that the margin requirements approved in this
order are mandatory minimums. Therefore, an Exchange member may freely
implement margin requirements that exceed the margin requirements
adopted by the Exchange.\65\ The Commission recognizes that the
Exchange's margin requirements serve as non-binding benchmarks, and
that Exchange members often establish different margin requirements for
their customers based on a number of factors, including market
volatility. The Commission encourages Exchange numbers to continue to
perform independent and rigorous analyses when determining prudent
levels of margin for customers.
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\65\ Exchange Rule 12.3(c), ``Customer Margin Account--
Exception,'' states that nothing in the provision addressing
customer margin accounts ``shall prevent a broker-dealer from
requiring margin from any account in excess of the amounts specified
in these provisions.
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The Commission believes that it is appropriate for the Exchange to
revise Exchange Rule 12.5, ``Determination of Value for Margin
Purposes.'' to allow the market value of certain long term stock
options, stock index options, and stock index warrants to be considered
for margin equity purposes. Under the current terms of Exchange Rule
12.5, options contracts are not deemed to have market value. Because
the Exchange's proposal will allow extensions of credit on certain long
term options and warrants, Exchange Rule 12.5 must be revised to permit
such marginable options and warrants to be valued at current market
prices for margin purposes. The Commission notes that unless Rule 12.5
is revised to recognize the market value of the marginable options and
warrants, the Exchange's loan value proposal will be ineffective (i.e.,
the market value of an appreciated marginable security would not be
recognized or allowed to offset any loss in value of other securities
held in the margin account).
The Commission believes that is reasonable for the Exchange to
codify as part of its rules the current margin requirements for short
options on securities that have been delisted due to a merger or
acquisition. Under the provision, if any underlying security ceases to
trade due to a merger or acquisition. Under the provision, if an
underlying security ceases to trade due to a merger or acquisition, and
a cash settlement price has been announced by the issuer of the option,
margin would be required only for in-the-money options and would be set
at 100% of the in-the-money amount. The Commission believes that it is
appropriate for the Exchange to not require margin for out-of-the-money
short options. Given that a fixed settlement price will have been
announced by the issuer of the option (e.g., Options Clearing
Corporation) and trading in the delisted security will have stopped,
the Commission believes that margin for the out-of-the-money short
option contract is unnecessary because the intrinsic value of the
option contract will not appreciate or vary such that the seller risks
assignment (i.e., the intrinsic value will remain nil). The Commission
believes that because the intrinsic value of short-in-the-money options
will similarly remain fixed, it is reasonable to require margin that
corresponds to 100% of the aggregate in-the-money amount.
The Commission believes that is appropriate for the Exchange to
clarify the time in which initial and maintenance margin requirements
are due. This revision should help avoid confusion as to when margin
payments must be made. By specifying that initial margin requirements
are due in one payment period--five business days as currently defined
in Regulation T--the
[[Page 42744]]
Exchange will help to facilitate the prompt collection of initial
margin. In addition, the proposal revises the time-frame for the
collection of maintenance margin by replacing the phrase ``within a
reasonable time'' with ``as promptly as possible,'' and establishing an
objective cut-off date of 15 days. The Commission believes that these
changes will provide clear and definite guidelines concerning the
collection of margin.
The Commission believes that it is appropriate for the Exchange to
revise the definition of ``current market value'' by making it
correspond to the same definition found in Regulation T. A linkage to
the Regulation T definition should keep the Exchange's definition
equivalent without requiring a rule filing if there are future changes
to the Regulation T definition. The Commission also believes that it is
reasonable for the Exchange to define ``butterfly spread'' and ``box
spread.'' These definitions will specify which multiple option
positions, if held together, qualify for classification as buttlerfly
or box spreads, and consequently are eligible for the proposed cash and
margin treatment. The Commission believes that it is important for the
Exchange to clearly define which options strategies are eligible for
the proposed margin treatment.
The Commission believes that it is reasonable for the Exchange to
reorganize its margin provisions and consolidate them into a single
section--Chapter 12 of the Exchange's Rules. As currently structured,
the Exchange's margin rules are widely dispersed, appearing in Chapters
12, 23, 24, and 30. The Commission believes that Exchange members and
other market participants will find the consolidated margin provisions
easier to locate and use.
The Commission also believes that it is reasonable for the Exchange
to rephrase and update some of the margin provisions that have been
relocated and consolidated. The revisions are designed to ensure
consistency among the Exchange's margin provisions. In some instances,
changes proposed to one particular margin requirement impacted the
requirements for other positions and products. In other instances, the
Exchange simply revised language to clarify the meaning of the
provision.\66\ In addition, the Commission believes that it is
appropriate for the Exchange to correct the misnomer in Exchange Rule
12.3(c)(1) that erroneously characterizes nonconvertible debt
securities as exempted securities.
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\66\ For example, the Exchange revised the rule language
regarding straddles comprised of OTC options, but left intact the
specific margin requirements. See Proposed Exchange Rule
12.3(c)(5)(C)(5)(B).
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The revisions to the Exchange's margin rules will significantly
impact the way Exchange members calculate margin for options customers.
The Commission believes that it is important for the Exchange to be
adequately prepared to implement and monitor the revised margin
requirements. To best accommodate the transition, the Commission
believes that a phase-in period is appropriate. Therefore, the approved
margin requirements shall not become effective until the earlier of
November 3, 1999 or such date the Exchange represents in writing to the
Commission that the Exchange is prepared to fully implement and monitor
the approved margin requirements.
The Commission expects the Exchange to issue a regulatory circular
to members that discusses the revised margin provisions and provides
guidance to members regarding their regulatory responsibilities. The
Commission also believes that it would be helpful for the Exchange to
publicly disseminate (i.e., via web site posting) a summary of the most
significant aspects of the new margin rules and provide clear examples
of how various options positions will be margined under the new
provisions.
The Commission finds good cause for approving proposed Amendment
Nos. 1 and 2 prior to the thirtieth day after the date of publication
of notice of filing thereof in the Federal Register. Amendment No. 1
clarified that the margin requirement for non-marginable options and
warrants is 100% of current market value, rather than 100% of purchase
price. Unless this revision was made, the margin required for some long
term options that had wound down to 9 months would have been
inappropriate.\67\ By linking the margin requirement to current market
value, rather than purchase price, Amendment No. 1 ensures that
appropriate margin will be required.
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\67\ For example, suppose that a long term option, which had
significantly appreciated in value, reached nine months until
expiration. A margin requirement of 100% of the purchase price would
be insufficient given the increase in value. A requirement of 100%
of the current market value, in contrast, is more appropriate.
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Amendment No. 1 also revised the provision concerning the use of
UITs and open-end mutual funds as cover for short index options. The
revision conformed the Exchange's proposal to the narrower change that
was recommended by the NYSE Rule 431 Committee. As a result, the
Exchange's proposal limits the use of mutual funds as cover to short
S&P 500 call options held in a margin or cash account.\68\ Amendment
No. 1 also incorporated into the proposal the definition of ``OTC
margin bond,'' which had been eliminated from Regulation T by the
Federal Reserve Board as of April 1, 1998. These changes will
strengthen the proposal by making it consistent with the margin
requirements supported by the NYSE Rule 431 Committee, and by defining
an important term that was dropped from Regulation T.
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\68\ In accordance with an interpretation that the Federal
Reserve Board provided to the American Stock Exchange, the Exchange
will continue to permit members to use certain UITs as cover for
short index option positions in a margin account. For example, the
Exchange allows members to use S&P 500 Depository Receipts
(``SPDRs'') as cover for short S&P 500 index options. The Federal
Reserve Board deemed such practice consistent with Regulation T in
1993. See Letter from Michael J. Shoenfeld, Federal Reserve Board,
to James McNeil, American Stock Exchange, dated February 1, 1993.
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Amendment No. 2 revised the proposal by limiting loan value to long
term stock options, stock index options, and stock index warrants. The
Exchange had originally proposed to allow loan value on any long term
option, regardless of the underlying instrument (e.g., foreign currency
options and options on interest rate composites would be marginable):
This change conforms the Exchange's proposal to the measures supported
by the NYSE Rule 431 Committee and the companion margin filing
submitted by the NYSE.\69\ Amendment No. 2 will ensure consistency
among the national securities exchanges regarding the types of
securities on which credit may be extended.
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\69\ See Securities and Exchange Act Release (No. 41168 Mar. 12,
1999), 64 FR 13620 (Mar. 19, 1999) (notice of filing of SR-NYSE-99-
03).
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Based on the above, the Commission finds that good cause exists,
consistent with Section 19(b) of the Act,\70\ to accelerate approval of
Amendment Nos. 1 and 2 to the proposed rule change.
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\70\ 15 U.S.C. 78s(b).
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V. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning Amendment Nos. 1 and 2 to the proposed rule
change, including whether the proposed rule change, as amended, is
consistent with the Act. Persons making written submissions should file
six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Copies of
the submissions, all subsequent amendments, all written statements with
respect to the proposed
[[Page 42745]]
rule change that are filed with the Commission, and all written
communications relating to the proposed rule change between the
Commission and any persons, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. 552, will be
available for inspection and copying in the Commission's Public
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 25049.
Copies of such filing will also be available for inspection and copying
at the principal office of the Exchange. All submissions should refer
to File No. SR-CBOE-97-67 and should be submitted by August 26, 1999.
VI. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\71\ that the proposed rule change (SR-CBOE-97-67), as amended, is
approved. The approved margin requirements shall become effective the
earlier of November 3, 1999 or such date the Exchange represents in
writing to the Commission that the Exchange is prepared to fully
implement and monitor the approved margin requirements.
\71\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\72\
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\72\ 17 CFR 200.30-3(a)(12)
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-20174 Filed 8-4-99; 8:45 am]
BILLING CODE 8010-01-M
