[Federal Register Volume 59, Number 9 (Thursday, January 13, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-877]


[[Page Unknown]]

[Federal Register: January 13, 1994]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33442; File No. SR-CBOE-93-49]

 

Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the Chicago Board Options Exchange, Inc., Relating to the 
Listing of Options and Long-Term Options on the CBOE Gaming Index and 
Long-Term Options on a Reduced-Value Gaming Index

January 6, 1994.

I. Introduction

    On October 27, 1993, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to provide for the listing and 
trading of index options on the CBOE Gaming Index (``Gaming Index'' or 
``Index''). Notice of the proposal appeared in the Federal Register on 
November 18, 1993.\3\ No comment letters were received on the proposed 
rule change. This order approves the Exchange's proposal.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1992).
    \3\See Securities Exchange Act Release No. 33173 (November 9, 
1993), 58 FR 60889 (November 18, 1993).
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II. Description of Proposal

A. General

    The CBOE proposes to list and trade options on the CBOE Gaming 
Index, an index developed by the CBOE. The CBOE also proposes to list 
either long-term options on the full-value Index or long-term options 
on a reduced-value Index that will be computed at one-tenth of the 
value of the Gaming Index (``Gaming LEAPS'' or ``Index LEAPS'').\4\ 
Gaming LEAPS will trade independent of and in addition to regular 
Gaming Index options traded on the Exchange.\5\
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    \4\LEAPS is an acronym for Long-Term Equity Anticipation 
Securities. LEAPS are long-term index option series that expire from 
twelve to thirty-six months from their date of issuance. See CBOE 
Rule 24.9(b)(1).
    \5\According to the CBOE, the S&P Gaming Index represents a 
segment of the U.S. equity market that is not currently represented 
in the derivative markets and, as such, the CBOE concludes, should 
offer investors a low-cost means to achieve diversification of their 
portfolios toward or away from the gaming industry. The CBOE 
believes the Index will provide retail and institutional investors 
with a means to benefit from their forecasts of that industry's 
market performance. Options on the Index also can be utilized by 
portfolio managers and investors to provide a performance measure 
and evaluation guide for passively or actively managed gaming 
industry funds, as well as a means of hedging the risks of investing 
in the gaming industry.
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B. Composition of the Index

    The Index is based on fifteen gaming industry stocks. Eight of 
those stocks currently trade on the New York Stock Exchange, Inc. 
(``NYSE''), and seven currently trade through the facilities of the 
National Association of Securities Dealers Automated Quotation System 
(``NASDAQ'').\6\ The Index is price-weighted and will be calculated on 
a real-time basis using last sale prices.
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    \6\All seven NASDAQ component stocks are currently qualified for 
and traded on the NASDAQ National Market.
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    As of December 31, 1993, the Index was at 244.52. As of October 20, 
1993, the market capitalizations of the individual stocks in the Index 
ranged from a high of $5.08 billion to a low of $137.123 million, with 
the mean and median being $1.305 billion and $447.6 million, 
respectively. The market capitalization of all the stocks in the Index 
was $19.581 billion. The total number of shares outstanding for the 
stocks in the Index ranged from a high of 122.571 million shares to a 
low of 9.066 million shares. The average price per share of the stocks 
in the Index, for a six-month period between April 1 and September 30, 
1993, ranged from a high of $56.15 to a low of $7.92. In addition, the 
average daily trading volume of the stocks in the Index, for the same 
six-month period, ranged from a high of 1,099,278 shares per day to a 
low of 93,627 shares per day, with the mean and median being 384,389 
and 351,635 shares, respectively. Lastly, no one stock comprised more 
than 16.19% of the Index's total value and the percentage weighting of 
the five largest issues in the Index accounted for 55.51% of the 
Index's value. The percentage weighting of the lowest weighted stock 
was 1.57% of the Index and the percentage weighting of the five 
smallest issues in the Index accounted for 16.28% of the Index's value.

C. Maintenance

    The Index will be maintained by the CBOE. The CBOE may change the 
composition of the Index at any time to reflect the conditions in the 
gaming industry. If it becomes necessary to replace a stock in the 
Index, the Exchange represents that it will make every effort to add 
new stocks that are representative of the gaming industry and will take 
into account a stock's capitalization, liquidity, volatility, and name 
recognition. Further, stocks may be replaced in the event of certain 
corporate events, such as takeovers or mergers, that change the nature 
of the security. If, however, the Exchange determines to increase the 
number of Index component stocks to greater than twenty or reduce the 
number of Index component stocks to fewer than ten, the proposal 
provides that the CBOE will submit a rule filing with the Commission 
pursuant to Section 19(b) of the Act. In addition, in choosing 
replacement stocks for the Index, the CBOE will be required to ensure 
that at least 90% of the weight of the Index continues to be made up of 
stocks that are eligible for standardized options trading.\7\
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    \7\See note 22, infra.
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D. Applicability of CBOE Rules Regarding Index Options

    Except as modified by this order, the rules in Chapter XXIV of the 
CBOE Rules will be applicable to Gaming Index options. Those rules 
address, among other things, the applicable position and exercise 
limits, policies regarding trading halts and suspensions, and margin 
treatment for both broad and narrow-based index options.

E. Calculation of the Index

    The CBOE Gaming Index is a price-weighted index and reflects 
changes in the prices of the Index component stocks relative to the 
Index's base date. Specifically, the Index value is calculated by 
adding the prices of the component stocks and them dividing this 
summation by a divisor that is equal to the number of stocks in the 
Index to get the average price. To maintain the continuity of the 
Index, the divisor will be adjusted to reflect non-market changes in 
the prices of the component securities as well as changes in the 
composition of the Index. Changes which may result in divisor 
adjustments include, but are not limited to, stock splits and 
dividends, spin-offs, certain rights issuances, and mergers and 
acquisitions.
    The Index will be calculated continuously and will be disseminated 
to the Options Price Reporting Authority (``OPRA'') every fifteen 
seconds by the CBOE, based on the last-sale prices of the component 
stocks.\8\ OPRA, in turn, will disseminate the Index value to other 
financial vendors such as Reuters, Telerate, and Quotron.
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    \8\For purposes of the daily dissemination of the Index value, 
if a stock included in the Index has not opened for trading, the 
CBOE will use the closing value of that stock on the prior trading 
day when calculating the value of the Index, until the stock opens 
for trading.
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    The Index value for purposes of settling outstanding Index options 
contracts upon expiration will be calculated based upon the regular way 
opening sale prices for each of the Index's component stocks in their 
primary market on the last trading day prior to expiration. In the case 
of securities traded on and trough the NASDAQ National Market, the 
first reported sale price will be used. Once all of the component 
stocks have opened, the value of the Index will be determined and that 
value will be used as the final settlement value for expiring Index 
options contracts. If any of the component stocks do not open for 
trading on the last trading day before expiration, then the prior 
trading day's (i.e., Thursday's) last sale price will be used in the 
Index calculation. In this regard, before deciding to use Thursday's 
closing value of a component stock for purposes of determining the 
settlement value of the Index, the CBOE will wait until the end of the 
trading day on expiration Friday.\9\
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    \9\Id.
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F. Contract Specifications

    The proposed options on the Index will be cash-settled, European-
style options.\10\ Standard options trading hours (8:30 a.m. to 3:10 
p.m.) Central Standard time) will apply to the contracts. The Index 
multiplier will be 100. The strike price interval will be $5.00 for 
full-value Index options with a duration of one year or less to 
expiration.\11\ In addition, pursuant to CBOE Rule 24.9, there will be 
six expiration months outstanding at any given time. Specifically, 
there will be three expiration months from the March, June, September, 
and December cycle plus three additional near-term months so that the 
two nearest term months will always be available. As described in more 
detail below, the Exchange also intends to list several Index LEAP 
series that expire from twelve to thirty-six months from the date of 
issuance.
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    \10\A European-style option can be exercised only during a 
specified period before the option expires.
    \11\For a description of the strike price intervals for reduced-
value Index options and long-term Index options, See Section G, 
infra.
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    Lastly, the options on the Index will expire on the Saturday 
following the third Friday of the expiration month (``Expiration 
Friday''). Accordingly, since options on the Index will settle based 
upon opening prices of the component stocks on the last trading day 
before expiration (normally a Friday), the last trading day for an 
expiring Index option series will normally be the second to the last 
business day before expiration (normally a Thursday).

G. Listing of Long-Term Options on the Full-Value or Reduced-Value 
Gaming Index

    The proposal provides that the Exchange may list long-term Index 
options that expire from 12 to 36 months from listing on the full-value 
Gaming Index or a reduced-value Gaming Index that will be computed at 
one-tenth the value of the full-value Index. Existing Exchange 
requirements applicable to full-value and reduced-value LEAPS will 
apply to full-value and reduced-value Index LEAPS.\12\ Also, the 
current and closing Index value for reduced-value Gaming LEAPS will be 
computed by dividing the value of the full-value Index by 10 and 
rounding the resulting figure to the nearest one-hundredth. For 
example, a Index value of 185 185.46 would be 18.55 for the Index LEAPS 
and 185.43 would become 18.54. The reduced-value Index LEAPS will have 
a European-style exercise and will be subject to the same rules that 
govern the trading of all the Exchange's index options, including sales 
practice rules, margin requirements and floor trading procedures. The 
strike price interval for the reduced-value Index LEAPS will be no less 
than $2.50 instead of $5.00.
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    \12\See CBOE Rule 24.9(b).
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H. Position and Exercise Limits, Margin Requirements, and Trading Halts

    Because the Index is classified as an Industry Index under CBOE 
rules, Exchange rules that are applicable to the trading of options on 
narrow-based indexes will apply to the trading of Gaming Index options 
and Gaming Index LEAPS. Specifically, Exchange rules governing margin 
requirements,\13\ position and exercise limits,\14\ and trading halt 
procedures\15\ that are applicable to the trading of narrow-based index 
options will apply to options traded on the Index. The proposal further 
provides that, for purposes of determining whether a given position in 
reduced-value Index options complies with applicable position and 
exercise limits, positions in reduced-value Index options will be 
aggregated with positions in the full-value Index options. For these 
purposes, tend reduced-value contracts will equal one full-value 
contract for purposes of aggregating these positions.
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    \13\Pursuant to CBOE Rule 24.11, the margin requirements for the 
Index options will be: (1) For short options positions, 100% of the 
current market value of the options contract plus 20% of the 
underlying aggregate Index value, less any out-of-the-money amount, 
with a minimum requirement of the options premium plus 10% of the 
underlying Index value; and (2) for long term options positions, 
100% of the options premium paid.
    \14\Pursuant to CBOE Rules 24.4A and 24.5, respectively, the 
position and exercise limits for the Index options will be 6,000 
contracts, unless the Exchange determines, pursuant to Rules 24.4A 
and 24.5 that a lower limit is warranted.
    \15\Pursuant to CBOE Rule 24.7, the trading on the CBOE of Index 
options may be halted or suspended whenever trading in underlying 
securities whose weighted value represents more than 20% of the 
Index value are halted or suspended.
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I. Surveillance

    Surveillance procedures currently used to monitor trading in each 
of the Exchange's other index options will also be used to monitor 
trading in full-value and reduced-value Index options. These procedures 
include complete access to trading activity in the underlying 
securities. Further, the Intermarket Surveillance Group Agreement, 
dated July 14, 1983, as amended on January 29, 1990, will be applicable 
to the trading of options on the Index.\16\
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    \16\ISG was formed on July 14, 1983 to, among other things, 
coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets. 
See Intermarket Surveillance Group Agreement, July 14, 1983. The 
most recent amendment to the ISG Agreement, which incorporates the 
original agreement and all amendments made thereafter, was signed by 
ISG members on January 29, 1990. See Second Amendment to the 
Intermarket Surveillance Group Agreement, January 29, 1990.
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III. Findings and Conclusions

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 6(b)(5).\17\ Specifically, the 
Commission finds that the trading of Gaming Index options, including 
full-value and reduced-value Index LEAPS, will serve to promote the 
public interest and help to remove impediments to a free and open 
securities market by providing investors with a means to hedge exposure 
to market risk associated with securities in the gaming industry.\18\ 
The trading of options on the Gaming Index, including full-value and 
reduced-value LEAPS on the Index, however, raises several concerns, 
namely issues related to index design, customer protection, 
surveillance, and market impact. The Commission believes, for the 
reasons discussed below, that the CBOE adequately has addressed these 
concerns.
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    \17\15 U.S.C. 78f(b)(5) (1988).
    \18\Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new option proposal upon a finding that 
the introduction of such new derivative instrument is in the pubic 
interest. Such a finding would be difficult for a derivative 
instrument that served no hedging or other economic function, 
because any benefits that might be derived by market participants 
likely would be outweighed by the potential for manipulation, 
diminished public confidence in the integrity of the markets, and 
other valid regulatory concerns. In this regard, the trading of 
listed options on the Gaming Index will provide investors with a 
hedging vehicle that should reflect the overall movement of the 
stocks comprising the gaming industry in the U.S. stock markets. The 
Commission also believes that these Index options will provide 
investors with a means by which to make investment decisions in the 
gaming industry sector of the U.S. stock markets, allowing them to 
establish positions or increase existing positions in such markets 
in a cost effective manner. Moreover, the Commission believes that 
the reduced-value Index LEAPS, that will be traded on an index 
computed at one-tenth the value of the Gaming Index, will serve the 
needs of retail investors by providing them with the opportunity to 
use a long-term option to hedge their portfolios from long-term 
market moves at a reduced cost.
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A. Index Design and Structure

    The Commission finds that the Gaming Index and reduced-value Gaming 
Index are narrow-based indices. The Gaming Index is comprised of only 
fifteen stocks, all of which are within one industry--the gaming 
industry. In addition, the basic character of the reduced-value Gaming 
Index, which is comprised of the same component securities as the 
Gaming Index and calculated by dividing the Gaming Index value by ten, 
is essentially identical to the Gaming Index.\19\ Accordingly, the 
Commission believes it is appropriate for the CBOE to apply its rules 
governing narrow-based index options to trading in the Index 
options.\20\
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    \19\See generally Securities Exchange Act Release No. 29994 
(November 26, 1991), 56 FR 63536 (December 4, 1991) (order 
designating the PSE Technology Index as a broad-based index rather 
than a narrow-based index).
    \20\See supra notes 13 through 15, and a accompanying text.
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    The Commission also finds that the large capitalizations, liquid 
markets, and relative weightings of the Index's component stocks 
significantly minimize the potential for manipulation of the Index. 
First, the overwhelming majority of the stocks that comprise the Index 
are actively traded, with a mean and median average daily trading 
volume of 384,389 and 351,635 shares, respectively.\21\ Second, the 
market capitalizations of the stocks in the Index are very large, 
ranging from a high of $5.08 billion to a low of $37.123 million as of 
October 20, 1993, with the mean and median being $1.305 billion and 
$447.566 million, respectively. Third, although the Index is only 
comprised of fifteen component stocks, no one particular stock or group 
of stocks dominates the Index. Specifically, no one stock comprises 
more than 16.19% of the Index's total value and the percentage 
weighting of the three largest issues in the Index accounting for 
37.75% of the Index's value. Fourth, all fifteen stocks in the Index 
currently are eligible for options trading.\22\ The proposed CBOE 
maintenance requirement that 90% of the weighting of the Index be 
comprised of stocks that are eligible for options trading will ensure 
that the Index is almost completely comprised of options eligible 
stocks. Fifth, if the CBOE increases the number of component stocks to 
more than twenty or decreases that number to less than ten, the CBOE 
will be required to seek Commission approval pursuant to Section 
19(b)(2) of the Act before listing new strike price or expiration month 
series of Gaming Index options. This will help protect against material 
changes in the composition and design of the Index that might adversely 
affect the CBOE's obligations to protect investors and to maintain fair 
and orderly markets in Gaming Index options. Finally, the Commission 
believes that the expense of attempting to manipulate the value of the 
Gaming Index in any significant way through trading in component stocks 
(or options on those stocks) coupled with, as discussed below, existing 
mechanisms to monitor trading activity in those securities, will help 
deter such illegal activity.
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    \21\In addition, for the six-month period between April 1 and 
September 30, 1993, all of the companies comprising the Index had an 
average daily trading volume greater than 93,627 shares per day.
    \22\The CBOE's options listing standards, which are uniform 
among the options exchanges, provide that a security underlying an 
option must, among other things, meet the following requirements: 
(1) The public float must be at least 7,000,000; (2) there must be a 
minimum of 2,000 stockholders; (3) trading volume must have been at 
least 2.4 million over the preceding twelve months; and (4) the 
market price must have been at least $7.50 for a majority of the 
business days during the preceding three calendar months. See CBOE 
Rule 5.3.
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B. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as Gaming Index options 
(including full-value and reduced-value Gaming LEAPS), can commence on 
a national securities exchange. The Commission notes that the trading 
of standardized exchange-traded options occurs in an environment that 
is designed to ensure, among other things, that: (1) The special risks 
of options are disclosed to public customers; (2) only investors 
capable of evaluating and bearing the risks of options trading are 
engaged in such trading; and (3) special compliance procedures are 
applicable to options accounts. Accordingly, because the Index options 
and Index LEAPS will be subject to the same regulatory regime as the 
other standardized options currently traded on the CBOE, the Commission 
believes that adequate safeguards are in place to ensure the protection 
of investors in Gaming Index options and Gaming Index LEAPS.

C. Surveillance

    The Commission believes that a surveillance sharing agreement 
between an exchange proposing to list a stock index derivative product 
and the exchange(s) trading the stocks underlying the derivative 
product is an important measure for surveillance of the derivative and 
underlying securities markets. Such agreements ensure the availability 
of information necessary to detect and deter potential manipulations 
and other trading abuses, thereby making the stock index product less 
readily susceptible to manipulation.\23\ In this regard, the CBOE, 
NYSE, and NASD are all members of the Intermarket Surveillance Group 
(``ISG''), which provides for the exchange of all necessary 
surveillance information.\24\
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    \23\Securities Exchange Act Release No. 31243 (September 28, 
1992), 57 FR 45849 (October 5, 1992).
    \24\See note 16, supra. Although the Index currently does not 
contain ADRs, the proposal provides that the Index could contain 
ADRs representing gaming industry stocks. If the composition of the 
Index would change so that greater than 20% of the Index was 
represented by ADRs whose underlying securities were not subject to 
a comprehensive surveillance sharing arrangement, then it would be 
difficult for the Commission to reach the conclusions reached in 
this order and the Commission would have to determine whether it 
would be suitable to continue to trade options on the Index. The 
CBOE should, accordingly, notify the Commission immediately if more 
than twenty percent of the numerical value of the Index is 
represented by ADRs whose underlying securities are not subject to a 
comprehensive surveillance sharing agreement. Such a change in the 
composition of the Index may warrant the submission of a rule filing 
pursuant to Section 19 under the Act.
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D. Market Impact

    The Commission believes that the listing and trading of Gaming 
Index options, including full-value and reduced-value Index LEAPS on 
the CBOE will not adversely impact the underlying securities 
markets.\25\ First, as described above, for the most part, no one stock 
or group of stocks dominates the Index. Second, because 90% of the 
numerical value of the Index must be accounted for by stocks that meet 
the options listing standards, the component securities generally will 
be actively-traded, highly-capitalized stocks.\26\ Third, the position 
and exercise limits applicable to Index options and Index LEAPS will 
serve to minimize potential manipulation and market impact concerns. 
Fourth, the risk to investors of contra-party non-performance will be 
minimized because the Index options and Index LEAPS will be issued and 
guaranteed by the Options Clearing Corporation just like any other 
standardized option traded in the United States.
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    \25\In addition, the CBOE has represented that the CBOE and the 
Options Price Reporting Authority (``OPRA'') have the necessary 
systems capacity to support those new series of index options that 
would result from the introduction of Index options and Index LEAPS. 
See letter from Nancy L. Nielsen, Assistant Corporate Secretary, 
CBOE, to Sharon Lawson, Assistant Director, Division of Market 
Regulation, SEC, dated October 26, 1993, and memorandum from Joe 
Corrigan, Executive Director, OPRA, to Eileen Smith, CBOE, dated 
October 22, 1993.
    \26\See note 22, supra.
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    Lastly, the Commission believes that settling expiring Gaming Index 
options (including full-value and reduced-value Index LEAPS) based on 
the opening prices of component securities is consistent with the Act. 
As noted in other contexts, valuing options for exercise settlement on 
expiration based on opening prices rather than closing prices may help 
reduce adverse effects on markets for securities underlying options on 
the Index.\27\
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    \27\See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\28\ that the proposed rule change (SR-CBOE-93-49) is approved.


    \28\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.\29\
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    \29\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-877 Filed 1-12-94; 8:45 am]
BILLING CODE 8010-01-M