[Federal Register Volume 61, Number 184 (Friday, September 20, 1996)]
[Notices]
[Pages 49508-49515]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-24167]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37676; File No. SR-CBOE-96-01]
Self-Regulatory Organizations; Order Granting Approval to
Proposed Rule Change and Amendment No. 2 Thereto and Notice of Filing
and Order Granting Accelerated Approval to Amendment No. 1 to Proposed
Rule Change by the Chicago Board Options Exchange, Inc., to, Among
Other Things, Increase SPX Position and Exercise Limits, Increase SPX
Firm Facilitation, Index Hedge, and Money Manager Exemptions, and
Extend Broad-Based Index Hedge Exemption to Broker-Dealers
September 13, 1996.
I. Introduction
On January 8, 1996, the Chicago Board Options Exchange, Inc.
(``CBOE'' 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, among other things, increase
the Standard & Poor's 500 index (``SPX'') option position and exercise
limits, increase the SPX firm facilitation, index hedge, and money
manager exemptions, extend the broad-based index hedge exemption to
broker-dealers, and
[[Page 49509]]
expand the types of qualified portfolios for the broad-based index
hedge exemption.
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\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4.
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Notice of the proposed rule change appeared in the Federal Register
on January 25, 1996.\3\ One comment letter, representing the views of
ten broker-dealers, was received in response to the proposed rule
change.\4\ The Exchange subsequently filed Amendment No. 1 to the
proposed rule change on May 9, 1996,\5\ and Amendment No. 2 to the
proposed rule change on July 25, 1996.\6\ This order approves the
CBOE's proposal, as amended.
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\3\ See Securities Exchange Act Release No. 36738 (January 19,
1996), 61 FR 2324 (January 25, 1996).
\4\ See Letter from Bear Sterns & Co., CS First Boston, Goldman,
Sachs & Co., J.P. Morgan Securities, Lehman Brothers Inc., Merrill
Lynch & Co. Inc., Morgan Stanley & Co. Incorporated, Smith Barney
Inc., Salomon Brothers Inc., and Swiss Bank Corporation to Jonathan
G. Katz, Secretary, Commission, dated April 12, 1995 (``Working
Group Letter'').
\5\ In Amendment No. 1, the CBOE proposed the following
revisions to its rule filing: (1) Amend the SPX index hedge
exemption limits to 250,000 contracts (from the previously proposed
400,000 contracts); (2) amend the money manager SPX index hedge
exemption limits to 350,000 SPX option contracts in the money
manager's aggregated accounts and 235,000 SPX option contracts in
any single account (from the previously proposed 600,000/325,000
contract levels); and (3) amend the broad-based index hedge
exemption so that the Exchange's Department of Market Regulation may
grant prospective broad-based index hedge exemptions to broker-
dealers who may not yet have established qualified portfolios under
Interpretation .01(c) to Exchange Rule 24.4. See letter from
Margaret G. Abrams, Senior Attorney, CBOE, to Holly Smith, Associate
Director, Division of Market Regulation, Commission, dated May 9,
1996 (``Amendment No. 1'').
\6\ See Securities Exchange Act Release No. 37504 (July 31,
1996), 61 FR 40868 (August 6, 1996) (notice of Amendment No. 2 to
File No. SR-CBOE-96-01) (``Amendment No. 2'').
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II. Background
A. Increase SPX Position and Exercise Limits
The CBOE is proposing to increase the basic SPX position and
exercise limits from 45,000 contracts to 100,000 contracts on the same-
side of the market.\7\ According to the CBOE, member firms have
expressed their need for relief from the current SPX position and
exercise limits,\8\ which have not been increased since 1992.\9\ Since
1992, however, volume in the SPX index option class has more than
doubled, and open interest has remained consistently high.\10\ The CBOE
believes that by increasing the existing SPX position and exercise
limits of 45,000 contracts to 100,000 contracts the investing public as
well as CBOE members and member firms will be afforded greater
opportunity and flexibility to use SPX options for their hedging needs.
The CBOE does not believe that the higher limits will increase the
potential for market disruption.
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\7\ These positions do not have to be hedged under CBOE rules.
\8\ Position limits impose a ceiling on the aggregate number of
option contracts on the same-side of the market that an investor, or
group of investors acting in concert, may hold or write. Exercise
limits impose a ceiling on the aggregate long positions in option
contracts that an investor, or group of investors acting in concert,
can or will have exercised within five consecutive business days.
\9\ See Securities Exchange Act Release No. 30944 (July 21,
1992), 57 FR 33376 (July 28, 1992) (increase of SPX position and
exercise limits from 25,000 contracts to 45,000 contracts) (approval
order for File No. SR-CBOE-92-09).
\10\ The CBOE notes that in September 1992, the average daily
SPX index option volume during expiration week was 86,682 contracts
and open interest was 1.3 million contracts. In comparison, in March
1995, the average daily SPX index option volume during expiration
week was 208,678 contracts and open interest was 1.2 million
contracts. In each of the years 1992 through 1994, approximately 300
market-maker exemptions from SPX position limits were granted in
accordance with Interpretation .05 to Exchange Rule 4.11. In
contrast, from January through November 20, 1995, 455 market-maker
exemptions from SPX position limits were granted.
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To enhance its ability to monitor unhedged positions as well as to
create a database of non-standard hedge practices, the CBOE will add a
reporting requirement (new Interpretation .03 to Exchange Rule 24.4)
for accounts having a position in excess of 45,000 a.m.-settled,
European-style S&P 500 option contracts on the same-side of the market.
According to the CBOE, this reporting requirement will allow the
Exchange to gather data on hedging practices that do not fit into the
CBOE's definition of a qualified portfolio.\11\ Specifically, new
Interpretation .03 to Exchange Rule 24.4 states that if a member or
member organization, other than an Exchange market-maker,\12\ maintains
a position in excess of 45,000 a.m.-settled, European-style S&P 500
option contracts on the same-side of the market on behalf of its own
account or for the account of a customer, it must report information as
to whether those positions are hedged and provide documentation as to
how such contracts are hedged, in the manner and form required by the
Exchange's Department of Market Regulation. In addition, to address the
Commission's concerns with respect to the ability of the Exchange to
monitor customer accounts that maintain large unhedged positions, the
CBOE will add a margin and clearing firm requirement. Pursuant to new
Interpretation .04 to Exchange Rule 24.4, whenever the Exchange
determines that additional margin is warranted in light of the risks
associated with an under-hedged option position in excess of 45,000
contracts, the Exchange may impose additional margin upon the account
maintaining such under-hedged position, or assess capital charges upon
the clearing firm carrying the account to the extent of any margin
deficiency resulting from the higher margin requirement.
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\11\ See Interpretation .01 to Exchange Rule 24.4.
\12\ According to the Exchange, the SPX reporting requirement of
Interpretation .03 to Exchange Rule 24.4 will not apply to market-
maker accounts because the Exchange's Department of Financial
Compliance routinely monitors market-maker risk. As such, the
Exchange believes that it is not necessary for a market-maker to
report hedging information to the Exchange as this information is
available through other means.
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B. Increase SPX Firm Facilitation, SPX Index Hedge, and SPX Money
Manager Exemptions
In light of the increased SPX index option contract volume and the
interest expressed by the member firm community, the Exchange proposes
to increase the SPX firm facilitation exemption \13\ from 100,000
contracts to 400,000 contracts, and to increase the SPX index hedge
exemption \14\ from 150,000 contracts to 250,000 contracts. The
Exchange also proposes to increase the SPX money manager exemption to
350,000 exempted same-side of the market contracts, with no more than
235,000 contracts in any single account (from the existing 250,000 and
135,000 contracts permitted, respectively).
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\13\ The CBOE defines a facilitation trade as a transaction that
involves crossing an order of a member firm's public customer with
an order from the member firm's proprietary account.
\14\ Under existing rules, public customers are allowed to apply
for a hedge exemption from established position limits of SPX
options if those customers hold certain pre-approved stock
portfolios. The maximum size of the exempted position, however,
cannot exceed the unhedged value of the qualified stock portfolio,
and no exempted positions can exceed 150,000 contracts, regardless
of the size of the stock portfolio.
As discussed below, the CBOE is also proposing to expand the
existing definition of a qualified portfolio as well as to extend
the customer index hedge exemption to broker-dealers. See Section
II.C. and its discussion infra.
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C. Expansion of Definition of Qualified Portfolio and extension of
Broad-Based Index Hedge Exemption to Broker-Dealers
The CBOE proposes to expand the types of qualified portfolios
described in Interpretation .01 to Exchange Rule 24.4, as well as the
types of option strategies that qualify for higher position limits. As
the investing public and broker-dealers use a broader and more
sophisticated range of hedging strategies, the CBOE believes that there
is a need to include in a qualified portfolio products that overlay
various broad-based indexes, including index futures, options on index
futures, index options, and index warrants, where the
[[Page 49510]]
indexes are included in the same margin or cross-margin product groups
at the Options Clearing Corporation (``OCC'').
In addition, the CBOE proposes to extend the broad-based index
hedge exemption to broker-dealers. The existing broad-based index hedge
exemption is currently available only to public customers, including
money managers. The CBOE notes that the corresponding equity hedge
exemption \15\ is available to both public customers and broker-
dealers. The Exchange believes that it can better meet the needs of
securities professionals by making the broad-based index hedge
exemption available to them to the same extent that the index hedge
exemption is available to public customers.
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\15\ See Interpretation .04 to Exchange Rule 4.11.
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D. Prospective Broad-Based Index Hedge Exemption for Broker-Dealers
The CBOE also proposes to amend the broad-based index hedge
exemption so that the Exchange's Department of Market Regulation may
grant prospective broad-based index hedge exemptions to broker-dealers
who may not yet have established qualified portfolios under
Interpretation .01(c) to Exchange Rule 24.4. The Exchange's Department
of Market Regulation anticipates the need for granting prospective
hedge exemptions in a situation where an Exchange market-maker or
member organization is close to exceeding position limits in a
particular broad-based index option class. According to the Exchange, a
market-maker or member organization often will trade the option first
and then hedge with either a stock basket or futures contract. Thus, a
broker-dealer may not have established the qualified portfolio at the
exact time it is putting on its options position. Accordingly, the
Exchange's Department of Market Regulation may grant the index hedge
exemption to a broker-dealer without a qualified portfolio, so long as
the broker-dealer establishes the portfolio ``concurrent with or at or
about the same time as the execution of the exempt options positions''
and provides to the Exchange's Department of Market Regulation
appropriate documentation within two business days. The Exchange
expects that the hedge will be established immediately following the
execution of the options transaction.
E. Treatment of Collar and Debit Put Spread Transaction as One Contract
for Hedging and Position Limit Purposes and Neither Side of Collar
Transaction Can Be In-the-Money When Established for Broad-Based Index
Hedge Exemption Purposes
The CBOE proposes to treat a ``collar'' \16\ position as one
contract rather than as two contracts in Interpretation .01(f)(5) to
Exchange Rule 24.4. \17\ According to the Exchange, within a limited
range, the collar has less opportunity to benefit from upward and
downward price changes than either of the collar's components. If the
market climbs, the collar is equivalent to a covered write position. If
the market declines, the collar is equivalent to a long put position.
Because the strategy requires both the purchase of puts and the sale of
calls, the CBOE believes that the position is more appropriately
treated as one contract for hedging purposes rather than two separate
put and call components. For the same reasons, because a strategy
involving a covered write accompanied by a debit put spread requires a
collar component, the CBOE similarly believes that the short call and
long put should be treated as one contract in Interpretation .01(f)(7)
to Exchange Rule 24.4.
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\16\ In existing Interpretation .02(a)(5) to Exchange Rule 24.4,
a collar position is referred to as a ``hedgewrap.''
\17\ A collar is a short call/long put option combination that
is designed to protect the value of a related stock position.
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The CBOE also proposes that new language in Interpretations
.01(f)(5) and .01(f)(7) to Exchange Rule 24.4 will be added to require
that neither side of the collar transaction can be in-the-money at the
time the position is established. According to the Exchange, this is
consistent with the Commission's approval of the National Association
of Securities Dealer's (``NASD'') definition of a collar transaction
pursuant to its hedge exemption rule,\18\ as well as with the
Exchange's original intention.\19\
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\18\ See Securities Exchange Act Release No. 35874 (June 21,
1995), 60 FR 33440 (June 28, 1995) (approval order for File No. SR-
NASD-94-60).
\19\ The Exchange is also proposing to replace the references to
``a.m. settled'' contracts in Interpretations .01(f)(5), .01(f)(6),
and .01(f)(7) to Exchange Rule 24.4 with ``non-p.m. settled''
contracts.
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F. Miscellaneous Changes
The CBOE also proposes to make other editorial changes to Exchange
Rule 24.4 that are designed to streamline the rule and to eliminate
confusing provisions. The CBOE notes that some of the changes include
the following: (1) Allowing a hedge exemption account to be carried by
any member of a self-regulatory organization (``SRO'') participating in
the Intermarket Surveillance Group (``ISG''); \20\ confirming Exchange
Rule 24.11A concerning debit put spread cash account transactions to
Exchange Rule 24.4; and (3) consolidating the treatment of Quarterly
Index Expiration (``QIXs'') and Quarterly Index Expiration, Capped-
Style (``Q-CAPS'') options from three paragraphs to one.
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\20\ See new Interpretation .01(b) to Exchange Rule 24.4.
Previously, such an account was restricted to being carried by a
CBOE clearing member.
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III. Summary of Comments
The Commission received one comment letter on the proposed rule
changes.\21\ The commenters, in general, expressed support for the
proposed changes, noting that there is a demonstrated need for the
higher position limits and that the increased and expanded facilitation
and hedge exemptions will not increase market disruptions. In support
of this, the commenters believe that the size of the market for index
options has lessened the possibility that market participants could
successfully engage in manipulation and that the SROs' surveillance
systems have developed into highly sophisticated mechanisms that would
make any effort to manipulate securities underlying indices easily
transparent. Although believing that the proposals are a ``good first
step'' in reducing the constraints imposed by position limits, the
commenters state that further expansion of position limits is required.
For example, the commenters argue that because hedged positions are
market neutral, there should be no position or exercise limits on these
positions. In addition, the commenters state that any limitation on the
ability of market participants to use options to hedge their positions
exposes participants to unnecessary risk on the unhedged portion of
their portfolios. In this regard, the commenters believe that the
adoption of an uncapped hedge exemption (i.e., the ability to
accumulate an unlimited number of options contracts provided that such
contracts are properly hedged) is appropriate.
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\21\ See supra note 4.
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Similarly, the commenters support the CBOE's proposal to expand the
types of hedges that qualify under the rule. By opening the discussion
of how to take into account more sophisticated hedging techniques, the
commenters believe that the CBOE is taking the ``first step'' toward
recognizing delta hedging
[[Page 49511]]
as a valid hedging mechanism for position limit purposes.
In addition, by increasing SPX limits, the commenters believe that
the proposal provides much needed relief for market participants who
have increasingly found their ability to enter into legitimate market
transactions unnecessarily constrained or who have turned to the
futures market for the liquidity they require. Similarly, as the number
of institutional clients who have the capacity and the need to hedge
multi-billion dollar portfolios has grown, the increased customer
facilitation limits will provide market participants with the ability
to address both their current and potential clients' liquidity needs.
IV. Discussion
The Commission finds that the proposed rule changes are consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange, and, in
particular, with the requirements of Section 6(b)(5).\22\ Specifically,
the Commission believes that the proposed increase in the SPX position
limits and the SPX exemptions, together with the expansion of the index
hedge exemption and the qualified portfolio provisions, will enhance
the depth and liquidity of the market for both members and investors.
Accordingly, the Commission believes that these rule changes are
consistent with, and further the objectives of, Section 6(b)(5) of the
Act in that they would remove impediments to and perfect the mechanism
of a free and open market in a manner consistent with the protection of
investors and the public interest.
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\22\ 15 U.S.C. 78f(b)(5) (1988).
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A. Increase SPX Position and Exercise Limits
Since the inception of standardized options trading, the options
exchanges have had rules imposing limits on the aggregate number of
options contracts that a member or customer could hold or exercise.
These rules are intended to prevent the establishment of options
positions that can be used or might create incentives to manipulate or
disrupt the underlying market so as to benefit the options position. In
particular, position and exercise limits are designed to minimize the
potential for mini-manipulations \23\ and for corners or squeezes of
the underlying market. In addition, they serve to reduce the
possibility for disruption of the options market itself, especially in
illiquid options classes.
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\23\ Mini-manipulation is an attempt to influence, over a
relatively small range, the price movement in a stock to benefit a
previously established derivatives position.
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The Commission has been careful to balance two competing concerns
when considering an SRO's position and exercise limits. First, the
Commission has recognized that the limits must be sufficient to prevent
investors from disrupting the market for the underlying security by
acquiring and exercising a number of options contracts disproportionate
to the deliverable supply and average trading volume of the underlying
security. At the same time, the Commission has realized that limits
must not be established at levels that are so low as to discourage
participation in the options market by institutions and other investors
with substantial hedging needs or to prevent specialists and market-
makers from adequately meeting their obligations to maintain a fair and
orderly market.\24\
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\24\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. at 189-91
(Comm. Print 1978) (``Options Study'').
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The Commission believes that the proposed increase in SPX position
and exercise limits to 100,000 contracts will expand the depth and
liquidity of the SPX market without significantly increasing concerns
regarding intermarket manipulations or disruptions of the options or
the underlying securities.\25\ As previously noted by the Commission,
markets with active and deep trading interest, as well as with broad
public ownership, are more difficult to manipulate or disrupt than less
active and deep markets with smaller public floats. In this regard, the
SPX is a broad-based, capitalization-weighted index consisting of 500
of the most actively-traded and liquid stocks in the U.S.
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\25\ See Exchange Rule 24.4(a).
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Moreover, the CBOE has adopted important safeguards that will allow
it to monitor large unhedged positions (those in excess of 45,000
contracts) in order to identify instances of potential risk \26\ and to
assess additional margin or capital charges against the clearing firm,
if necessary.\27\ In this regard, the CBOE states that in the event of
a large unhedged, potentially risky position, the Exchange will notify
the clearing firm and assess the circumstances of the transactions,
along with the firm's view of the exposure of the account, whether the
account is approved and suitable for the strategies used, and whether
additional margin has been collected.\28\ The monitoring of unhedged
accounts in excess of 45,000 contracts in this manner should provide
the CBOE with the information necessary to determine whether additional
margin or capital charges should be imposed in light of the risks
associated with the under-hedged SPX option position in accordance with
Interpretation .04 to Exchange Rule 24.4.
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\26\ Under new Interpretation .03 to Exchange Rule 24.4, each
member or member organization, other than an Exchange marketmaker,
that maintains a position in excess of 45,000 a.m.--settled,
European-style S&P 500 option contracts on the sameside of the
market on behalf of its own account or for the account of a customer
will report information as to whether those positions are hedged and
provide documentation as to how such contracts are hedged, in the
manner and form required by the Exchange's Department of Market
Regulation.
\27\ Under new Interpretation .04 to Exchange Rule 24.4,
whenever the Exchange determines that additional margin is warranted
in light of the risks associated with an under-hedged SPX option
position in excess of 45,000 contracts, the Exchange may impose
additional margin upon the account maintaining such under-hedged
position, or assess capital charges upon the clearing firm carrying
the account to the extent of any margin deficiency resulting from
the higher margin requirement.
\28\ See Amendment No. 2, supra note 6.
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Accordingly, given the size and breadth of the SPX, along with the
new SPX reporting requirement set forth in Interpretation .03 to
Exchange 24.4 and the new margin and clearing firm requirements set
forth in Interpretation .04 to Exchange Rule 24.4, the Commission
believes that increasing the SPX position and exercise limits to
100,000 contracts should not increase any manipulative concerns.
Finally, the Exchange's surveillance program will continue to be
applicable to the trading of SPX options and should detect and deter
trading abuses arising from the increased position and exercise
limits.\29\
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\29\ The Exchange has represented that it intends to implement
increased surveillance and reporting procedures to ensure a thorough
understanding of the uses and risks of the underlying strategies
supported by the increased position limits. The Exchange has also
represented that it intends to provide reports regarding position
limits to the Commission's Division of Market Regulation on a
periodic basis and at appropriate thresholds of activity. See
Amendment No. 1, supra note 5.
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B. Increase SPX Firm Facilitation Exemption
The Commission believes that the proposed increase of the SPX firm
facilitation exemption from 100,000 contracts to 400,000 contracts will
accommodate the needs of investors as well as market participants
without substantially increasing concerns regarding the potential for
manipulation and other trading abuses.\30\ The Commission also believes
that the proposed rule change will further enhance the potential depth
and liquidity of the options market as well
[[Page 49512]]
as the underlying markets by providing Exchange members greater
flexibility in executing large customer orders.\31\
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\30\ The Commission notes that the SPX firm facilitation
exemption is in addition to the standard limit and other exemptions
available under Exchange rules, interpretations, and policies.
\31\ When initially approving the firm facilitation exemption
for SPX options, the Commission expressed its opinion that providing
member organizations with an exemption for the purpose of
facilitating large customer orders would better serve the needs of
the investing public. At that time, the Commission also noted that
safeguards were built into the exemption to minimize any potential
disruption or manipulation concerns. The Commission currently
believes that these same benefits and assurances are also applicable
with respect to the increased firm facilitation exemption. See
Securities Exchange Act Release No. 20944 (July 21, 1992), 57 FR
33376 (July 28, 1992) (approval order for File No. SR-CBOE-92-09).
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The CBOE's existing safeguards that apply to the current
facilitation exemption will continue to serve to minimize any potential
disruption or manipulation concerns. First, the facilitation firm must
receive approval from the Exchange's Exemption Committee prior to
executing facilitation trades.\32\ Second, a facilitation firm must,
within five business days after the execution of a facilitation
exemption order, hedge all exempt options positions that have not
previously been liquidated, and furnish to the Exchange's Department of
Market Regulation documentation reflecting the resulting hedging
positions.\33\ In meeting this requirement, the facilitation firm must
liquidate and establish its customer's and its own options and stock
positions or their equivalent in an orderly fashion, and not in a
manner calculated to cause unreasonable price fluctuations or
unwarranted price changes.\34\ In addition, a facilitation firm is not
permitted to use the facilitation exemption for the purpose of engaging
in index arbitrage.\35\ The Commission believes that these requirements
will help to ensure that the facilitation exemption will not have an
undue market impact on the options or on any underlying stock
positions.
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\32\ See Interpretation .06(a) to Exchange Rule 4.11.
\33\ See Interpretation .06(d) to Exchange Rule 4.11.
\34\ See Interpretation .06(e)(1) to Exchange Rule 4.11.
\35\ Id.
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Third, the facilitation firm is required to promptly provide to the
Exchange any information or documents requested concerning the exempted
options positions and the positions hedging them, as well as to
promptly notify the Exchange of any material change in the exempted
options position or the hedge.\36\
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\36\ See Interpretations .06(b) and .06(e)(2) to Exchange Rule
4.11.
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Fourth, neither the member's nor the customer's order may be
contingent on ``all or none'' or ``fill or kill'' instructions, and the
orders may not be executed until Exchange Rule 6.74(b) (crossing order)
procedures have been satisfied and crowd members have been given a
reasonable time to participate in the trade.\37\
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\37\ See Interpretations .06(c)(1) and .06(c)(2) to Exchange
Rule 4.11.
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Fifth, the facilitation firm may not increase the exempted option
position once it is closed, unless approve from the CBOE is again
received pursuant to a reapplication.\38\
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\38\ See Interpretation .06(e)(3) to Exchange Rule 4.11.
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Lastly, violation of any of these provisions, absent reasonable
justification or excuse, will result in the withdrawal of the
facilitation exemption and may form the basis for subsequent denial of
an application for a facilitation exemption.\39\
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\39\ See Interpretation.06(f) to Exchange Rule 4.11.
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In summary, the Commission continues to believe that the safeguards
built into the facilitation exemptive process will serve to minimize
the potential for disruption and manipulation concerns, while at the
same time benefitting market participants by allowing member firms
greater flexibility to facilitate large customer orders. The Commission
also believes that the CBOE has adequate surveillance procedures to
surveil for compliance with the rule's requirements. Based on these
reasons, the Commission believes that it is appropriate to increase the
SPX firm facilitation exemption to 400,000 contracts.
C. Increase SPX Index Hedge Exemption
The Commission believes that the proposed increase of the SPX index
hedge exemption from 150,000 contracts to 250,000 contracts is
consistent with the Commission's approach to position and exercise
limits and adequately balances the benefits derived from increased
limits against concerns regarding the potential for market disruptions
and manipulations.\40\ Specifically, because any SPX options position
in excess of the outstanding SPX position limit must be fully hedged in
conformity with one of the enumerated hedge positions,\41\ market
disruption concerns are reduced. Moreover, to the extent that an SPX
options position is hedged with a qualified stock portfolio,\42\ it
should be more difficult to profit from any intermarket manipulation.
The Commission also notes that the rule will continue to require that
the underlying options positions cannot exceed the unhedged value of
the qualified portfolio. Accordingly, the Commission does not believe
that the proposed increase of the index hedge exemption for SPX options
will disrupt the options or equity markets or materially increase the
possibility of manipulation in the underlying securities or options.
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\40\ See Interpretation .01 to Exchange Rule 24.4.
\41\ See Interpretation .01(f) to Exchange Rule 24.4.
\42\ As discussed below, the CBOE is also proposing to expand
the definition of a qualified portfolio as well as to extend the
customer index hedge exemption to broker-dealers. See Section IV.D.
and its discussion infra.
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The CBOE's existing safeguards that apply to the current SPX index
hedge exemption will continue to serve to minimize any potential
disruption or manipulation concerns. The Commission notes that these
safeguards and procedures will apply to the SPX index hedge exemption
as well as to all other broad-based index hedge exemptions permitted
under CBOE rules. First, the account in which exempted option positions
are held must receive prior Exchange approval for the hedge exemption
as well as specify the maximum number of contracts which may be
exempt.\43\ In addition, the hedge exemption account must promptly
provide to the CBOE any information requested concerning the qualified
portfolio, as well as promptly notify the Exchange of any material
change in the qualified portfolio which materially affects the unhedged
value of the qualified portfolio.\44\
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\43\ See new Interpretation .01(a) to Exchange Rule 24.4.
\44\ See new Interpretation .02(a) and .01(g)(3) to Exchange
Rule 24.4.
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Second, positions included in a qualified portfolio which serve to
secure an index hedge exemption may not also be used to secure any
other position limit exemption granted by the Exchange, any other SRO,
or any futures contract market.\45\
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\45\ See new Interpretation .02(b) to Exchange Rule 24.4.
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Third, any member or member organization that maintains a broad-
based index option position in such member's or member organization's
own account or in a customer account, and has reason to believe that
such position is in excess of the applicable limit, must promptly take
the action necessary to bring the position into compliance.\46\ Failure
to abide by this provision will be deemed to be a violation of Exchange
Rules 4.11 and 24.4.\47\
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\46\ See new Interpretation .02(c) to Exchange Rule 24.4.
\47\ Id.
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Lastly, violation of any of the provisions of Exchange Rule 24.4
and the interpretations and policies thereunder, absent reasonable
justification or excuse, will result in the
[[Page 49513]]
withdrawal of the index hedge exemption and may form the basis for
subsequent denial of an application for an index hedge exemption.\48\
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\48\ See new Interpretation .02(d) to Exchange Rule 24.4. The
hedge exemption account also must: (i) Liquidate and establish
options, stock positions or their equivalent, or other qualified
portfolio products in an orderly fashion; (ii) not initiate or
liquidate positions in a manner calculated to cause unreasonable
price fluctuations or unwarranted price changes; (iii) not initiate
or liquidate a stock position or its equivalent with an equivalent
index option position with a view toward taking advantage of any
differential in price between a group of securities and an overlying
stock index; and (iv) liquidate any options prior to, or
contemporaneously with, a decrease in the hedged value of the
qualified portfolio, which options would thereby be rendered
excessive. See new Interpretations .01(g)(1) and .01(g)(2) to
Exchange Rule 24.4.
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Accordingly, the Commission continues to believe that the
safeguards built into the index hedge exemptive process will serve to
minimize the potential for disruption and manipulation, while at the
same time benefitting market participants. The Commission also believes
that the CBOE's surveillance procedures are sufficient to detect and
deter trading abuses arising from the increased position and exercise
limits associated with the increased index hedge exemption. Based on
these reasons, the Commission believes that it is appropriate to
increase the SPX index hedge exemption to 250,000 contracts.\49\
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\49\ The Commission notes that the SPX index hedge exemption is
in addition to the standard limit and other exemptions available
under Exchange rules, interpretations, and policies.
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D. Expansion of Definition of Qualified Portfolio and Extension of
Broad-Based Index Hedge Exemption to Broker-Dealers
As noted above, the CBOE's broad-based index hedge exemption may be
granted for positions in broad-based index options that are hedged with
Exchange-approved qualified portfolios. The CBOE is proposing to expand
current definition of a qualified portfolio to take into account the
broader range of hedging strategies currently used by market
participants. Specifically, the CBOE has proposed to include within the
definition of a qualified portfolio products that overlay various
broad-based indexes, including index futures, options on index futures,
index options, and index warrants, where the indexes are represented in
margin or cross-margin product groups at the OCC. Specifically, under
the new index hedge exemption's requirements, a qualified portfolio may
consist of: (i) Net long or short positions in common stocks, or
securities readily convertible into common stocks, in at least four
industry groups, where the portfolio contains at least twenty stocks,
none of which accounts for more than fifteen percent of the value of
the portfolio; and/or (ii) net long or short positions in index futures
contracts or in options on index futures contracts, or long or short
positions in index options or index warrants, for which the underlying
index is included in the same margin or cross-margin product group
cleared at the OCC as the index option class to which the hedge
exemption applies.\50\ To remain qualified, a portfolio must at all
times meet these standards, notwithstanding trading activity.\51\ In
addition, the index hedge exemption applies to positions in broad-based
index options and is applicable to the unhedged value of the qualified
portfolio.\52\ the Exchange also proposes to extend the broad-based
index hedge exemption to broker-dealers.
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\50\ See new Interpretations .01(c)(i) and .01(c)(ii) to
Exchange Rule 24.4.
\51\ Id.
\52\ See new Interpretation .01(d) to Exchange Rule 24.4. Under
this provision, the unhedged value is determined as follows: (1) The
values of the net long or short positions of all qualifying products
in the portfolio are totalled; (2) for positions in excess of the
standard limit, the underlying market value of (a) any economically
equivalent opposite side of the market calls and puts in broad-based
index options, and (b) any opposite side of the market positions in
stock index futures, options on stock index futures, and any
economically equivalent opposite side of the market positions,
assuming no other hedges for these contracts exist, is subtracted
from the qualified portfolio; and (3) the market value of the
resulting unhedged portfolio is equated to the appropriate number of
exempt contracts as follows: the unhedged qualified portfolio is
divided by the correspondent closing index value and the quotient is
then divided by the index multiplier or 100.
In order to show how the CBOE would determine the number of
contracts that qualify for an index hedge exemption, the CBOE has
included in its rules both a definition of the unhedged value of a
qualified portfolio as well as an example. See Interpretation .01(d)
to Exchange Rule 24.4.
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The Commission believes, as it did when originally approving the
CBOE`s index hedge exemption, that providing for increased position and
exercise limits for broad-based index options in circumstances where
those excess positions are effectively hedged with offsetting positions
will provide greater depth and liquidity to the market and will allow
investors to hedge their portfolios more effectively, without
significantly increasing concerns regarding intermarket manipulations
or disruptions of either the options market or the underlying stock
market. The Commission believes that through the expanded definition of
a qualified portfolio, an increased number of public customers and
broker-dealers with long or short portfolios will be able to utilize
the broad-based index hedge exemption, thereby making an alternative
hedging technique more available.
In addition, the Commission believes that it is reasonable for the
CBOE to allow broker-dealers as well as public customers to utilize the
broad-based index hedge exemption. The Commission believes that
extending the exemption to broker-dealers may help to increase the
depth and liquidity of the market for broad-based index options and may
help to ensure that public customers receive the full benefit of the
exemption. Moreover, the Commission is relying on the absence of
discernible manipulation problems under the corresponding equity hedge
exemption,\53\ which is available to both public customers and broker-
dealers, as an indicator that the proposed extension of the broad-based
index hedge exemption is appropriate. Lastly, the Commission notes that
the broad-based index hedge exemption will continue to include
safeguards designed to lessen the possibility that the exempted
positions could be used to disrupt or manipulate the market.\54\
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\53\ See Interpretation .04 to Exchange Rule 4.11.
\54\ See supra notes 43-48 and accompanying text.
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E. Increase SPX Money Manager Exemption
The Commission believes that the proposed increase of the SPX
position limit exemption for money managers is both reasonable and
consistent with the Act because it provides further flexibility to
money managers in managing their accounts, without raising the
potential for market disruption or manipulation.\55\ First, the
Commission notes that no single account can hold more than 235,000
exempted same-side of the market SPX option contracts.\56\ Second, the
exempted options position must be associated with one of the enumerated
hedged positions.\57\ Thus, all of the safeguards to minimize any
potential disruption or manipulation that were discussed above in
relation to the SPX index hedge exemption, are also applicable to the
money manager SPX exemption.\58\
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\55\ See Interpretation .01(e) to Exchange Rule 24.4.
\56\ Id.
\57\ See Interpretation .01(f) to Exchange Rule 24.4.
\58\ See supra notes 43-48 and accompanying text.
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F. Prospective Broad-Based Index Hedge Exemption for Broker-Dealers
The CBOE proposes to amend the broad-based index hedge exemption so
that the Exchange's Department of Market Regulation may grant
prospective broad-based index hedge exemptions to broker-dealers who
may
[[Page 49514]]
not yet have established qualified portfolios under Interpretation
.01(c) to Exchange Rule 24.4. The Exchange's Department of Market
Regulation anticipates the need for granting prospective hedge
exemptions in a situation where an Exchange market-maker or member
organization is close to exceeding position limits in a particular
broad-based index option class. According to the Exchange, a market-
maker or member organization often will trade the option first and then
hedge with either a stock basket or futures contract. Thus, a broker-
dealer may not have established the qualified portfolio at the time it
is hedging with the options. Accordingly, the Exchange's Department of
Market Regulation may grant the index hedge exemption to a broker-
dealer without a qualified portfolio.
The Commission does not believe that trading abuses are likely to
result from the prospective hedge exemption for the following reasons.
First, the exemption is limited to registered broker-dealers, and
second these broker-dealers must effect the transaction(s) necessary to
obtain a qualified portfolio ``concurrent with or at or about the same
time as the execution of the exempt options positions.'' The CBOE has
stated to the Commission that it expects the hedge to be established
immediately following the execution of the options transaction.
Moreover, broker-dealers must provide to the Exchange's Department of
Market Regulation appropriate documentation related to the portfolio
within two business days. The Commission believes that the CBOE's
surveillance procedures are sufficient to detect and deter trading
abuses arising from the prospective hedge exemption and, in the event a
broker-dealer is found to have violated the exemption, the CBOE is
authorized to take all necessary and appropriate disciplinary actions.
Accordingly, the Commission believes that it is appropriate for the
Exchange to adopt a limited prospective broad-based index hedge
exemption for broker-dealers.
G. Treatment of Collar and Debit Put Spread Transaction as One Contract
for Hedging and Position Limit Purposes and Neither Side of Collar
Transaction Can Be In-the-Money When Established for Broad-Based Index
Hedge Exemption Purposes
The CBOE proposes to treat a collar position as one contract rather
than as two contracts in Interpretation .01(f)(5) to Exchange Rule
24.4. Under the CBOE's rules, a collar is defined as a short call
position accompanied by long put(s), where the short call(s) expires
with the long put(s), and the strike price of the short call(s) equals
or exceeds the strike price of the long put(s). According to the
Exchange, within a limited range, the collar has less opportunity to
benefit from upward and downward price changes than either of the
collar's components. If the market climbs, the collar is equivalent to
a covered write position. If the market declines, the collar is
equivalent to a long put position. Because the strategy requires both
the purchase of puts and the sale of calls, the CBOE believes that the
position is more appropriately treated as one contract for hedging
purposes rather than two separate put and call components. In adopting
this interpretation of a collar, the CBOE is also proposing that new
language in Interpretations .01(f)(5) and .01(f)(7) to Exchange Rule
24.4 will be added to require that neither side of the collar
transaction (or the short call, long put transaction) can be in-the-
money at the time the position is established. According to the
Exchange, this is consistent with the Commission's approval of the
NASD's definition of a collar transaction pursuant to its hedge
exemption rule, as well as with the Exchange's original intention. For
the same reasons, because a strategy involving a covered write
accompanied by a debit put spread requires a collar component, the CBOE
similarly believes that the short call and long put should be treated
as one contract in Interpretation .01(f)(7) to Exchange Rule 24.4.\59\
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\59\ The CBOE defines a debit put spread position as a long put
position coupled with a short put position overlying the same broad-
based index and having an equivalent underlying aggregate index
value, where the short put(s) expires with the long put(s), and the
strike price of the long put(s) exceeds the strike price of the
short put(s).
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The Commission believes that the increased number of options
positions available by virtue of the Exchange's proposal will not
result in disruptions to either the options or underlying stock market
due to the conditions and limitations that must be met to be eligible
for the exemption.\60\ For example, the broad-based index hedge
exemption collar strategy can only be effected in conjunction with a
qualified stock portfolio; the exemption is available only for non-p.m.
settled, European-style index options; the short call(s) must expire
with the long put(s); the strike price of the short call(s) must equal
or exceed the strike price of the long put(s); and neither side of the
collar transaction can be in-the-money at the time the position is
established. The Commission also believes that the Exchange's
surveillance program is adequately equipped to ensure that Exchange
members comply with the exemption's requirements.
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\60\ See interpretations .01(f)(5) and .01(f)(7) to Exchange
Rule 24.4.
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In addition, by approving the Exchange's proposal that neither side
of the collar transaction can be in-the-money at the time the position
is established, the Commission believes that the desired uniformity
between the CBOE's and the NASD's definition of a collar transaction
pursuant to their hedge exemption rules will be achieved.
H. Miscellaneous Changes
The CBOE is also proposing several other changes to its rules,
including a requirement in new Interpretation .01(b) to Exchange Rule
24.4 that a hedge exemption account can be carried by a member of a SRO
participating in the ISG.\61\ The Commission believes that through the
Exchange's ISG information sharing arrangements,\62\ the hedge
exemption account will continue to be adequately monitored. Other
changes to the Exchange's rules include: (1) conforming Exchange Rule
24.11A concerning debit put spread cash account transactions to
Exchange Rule 24.4; (2) consolidating the treatment of QIXs and Q-CAPS
options from three paragraphs to one; \63\ and (3) replacing the
references to ``a.m. settled'' contracts in Interpretations .01(f)(5),
.01(f)(6), and .01(f)(7) to Exchange Rule 24.4 with ``non-p.m.
settled'' contracts. Because these changes are non-substantive or
technical in nature or raise no additional regulatory issues, the
Commission believes that they are consistent with Section 6(b)(5) of
the Act.
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\61\ Previously, such an account was restricted to being carried
by a CBOE clearing member.
\62\ See Exchange Rule 15.9.
\63\ See Exchange Rule 24.4(b).
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The Commission finds good cause to approve Amendment No. 1 to the
proposed rule change prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Specifically, the increased position limits for the SPX index hedge
exemption and the SPX money manager exemption that are contained in
Amendment No. 1 to the proposed rule change are more restrictive than
the CBOE's original proposal, which was published for the entire
twenty-one day comment period and generated no negative responses. In
addition, with regard to the prospective broad-based index hedge
exemption for broker-dealers, the Commission believes that the Exchange
has established sufficient safeguards to address concerns regarding
manipulation or
[[Page 49515]]
other market disruptions. Accordingly, the Commission believes that it
is consistent with Sections 6(b)(5) and 19(b)(2) of the Act to approve
Amendment No. 1 to the proposed rule change on an accelerated basis.
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 1 to the rule proposal. Persons
making written submissions should file six copies thereof with the
Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W.,
Washington, D.C. 20549. Copies of the submission, all subsequent
amendments, all written statements with respect to the proposed rule
change that are filed with the Commission, and all written
communications relating to the proposed rule change between the
Commission and any person, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. 552, will be
available for inspection and copying at the Commission's Public
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549.
Copies of such filing also will be available for inspection and copying
at the principal office of the CBOE. All submissions should refer to
File No. SR-CBOE-96-01 and should be submitted by October 11, 1996.
V. Conclusion
Based on the above, the Commission believes that the proposed rule
changes will serve to provide market participants with greater
flexibility without significantly increasing concerns regarding
intermarket manipulations or disruptions of either the options market
or the underlying stock market.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\64\ that the proposed rule change (SR-CBOE-96-01), as amended, is
approved.
\64\ 15 U.S.C. 78s(b)(2) (1988).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\65\
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\65\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 96-24167 Filed 9-19-96; 8:45 am]
BILLING CODE 8010-01-M
