[Federal Register Volume 59, Number 95 (Wednesday, May 18, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-12045]


[[Page Unknown]]

[Federal Register: May 18, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34052; File No. SR-CBOE-93-46]

 

Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Chicago Board Options Exchange, Inc. Relating to the 
Listing and Trading of Flexible Exchange Options Based on the Nasdaq 
100 Index

May 12, 1994.

I. Introduction

    On October 20, 1993, 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 proposal to list and trade large-size, customized 
index options, referred to as Flexible Exchange Options (``FLEX 
Options''), based on the Nasdaq 100 Index (``Nasdaq 100'').\3\
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1993).
    \3\The Nasdaq 100 is a capitalization-weighted index composed of 
the stocks of 100 of the largest, non-financial U.S. issuers whose 
securities are traded on the Nasdaq National Market. The Nasdaq 100 
is maintained by the Nasdaq Stock Market, Inc., a subsidiary of the 
National Association of Securities Dealers, Inc. (``NASD''). On 
January 5, 1994, the Commission approved a proposed rule change by 
the CBOE that provided for the listing and trading on the CBOE of 
standardized options, including both full-value and reduced-value 
long-term options series, based on the Nasdaq 100. See Securities 
Exchange Act Release No. 33428 (January 5, 1994), 59 FR 1576 
(January 11, 1994) (``Nasdaq 100 Approval Order''). In approving 
Nasdaq 100 options, the Commission believed that the Index would 
provide investors with an important trading and hedging mechanism 
that accurately reflected the overall movement of 100 of the 
largest, non-financial stocks listed on Nasdaq. In addition, the 
Commission determined that the Nasdaq 100 was a broad-based index 
not readily susceptible to manipulation. For information regarding 
the makeup, weighting, and formula used to calculate the value of 
the Nasdaq 100, see Nasdaq 100 Approval Order.
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    Notice of the proposed rule change was published for comment and 
appeared in the Federal Register on November 23, 1993.\4\ No comments 
were received on the proposal. This order approves the proposal.
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    \4\See Securities Exchange Act Release No. 33199 (November 15, 
1993), 58 FR 61934 (November 23, 1993) (``Notice'').
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II. Description of the Proposal

    In this proposal, the CBOE is seeking to expand its FLEX Options 
program to include FLEX Options on the Nasdaq 100.\5\ The purpose of 
the CBOE's FLEX Options program is to provide a framework for the 
Exchange to list and trade index options that give investors the 
ability, within specified limits, to designate certain of the terms of 
the options. Consistent with the original FLEX Options Approval Order, 
the present proposal to trade FLEX Options based on the Nasdaq 100 
similarly will permit market participants to designate certain terms of 
the options contract, such as the strike price, exercise type, 
expiration date, and form of settlement.\6\ However, a market 
participant's designation of the expiration date is not without 
limitation. Specifically, in order to protect against possible market 
disruptions that may otherwise result from the concurrent expiration of 
listed options and FLEX Options, the expiration dates for FLEX Options 
must be at least three business days away from the expiration dates for 
existing listed options.\7\
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    \5\The Commission approved the CBOE's Flex Options framework on 
February 24, 1993, permitting the Exchange to list and trade FLEX 
Options based on the Standard & Poor's Corporation (``S&P'') 100 
(``OEX'') and 500 (``SPX'') Indexes. See Securities Exchange Act 
Release No. 31920 (February 24, 1993), 58 FR 12280 (March 3, 1993) 
(``FLEX Options Approval Order''). Subsequently, on July 29, 1993, 
the Commission approved the listing and trading on the CBOE of FLEX 
Options on the Russell 2000 Index (``Russell 2000''), consistent 
with the FLEX Options Approval Order. See Securities Exchange Act 
Release No. 32694 (July 29, 1993), 58 FR 41814 (August 5, 1993) 
(``Russell 2000 Approval Order'').
    \6\In the FLEX Options Approval Order, the Commission designated 
FLEX Options as ``standardized options'' for purposes of the option 
disclosure framework established under Rule 9b-1 under the Act. See 
Securities Exchange Act Release No. 31919 (February 24, 1993), 58 FR 
12286 (March 3, 1993) (``9b-1 Order''). As described in note 24 
infra, and for the same reasons stated in the 9b-1 Order, Nasdaq 100 
FLEX Options are deemed ``standardized options'' for purposes of the 
Rule 9b-1 options disclosure framework.
    \7\See FLEX Options Approval Order, supra note 5.
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    Currently, the CBOE lists and trades FLEX Options based on the OEX 
and SPX Indexes, which consist of 100 and 500 highly capitalized 
stocks, respectively, and on the Russell 2000, which consists of the 
bottom 2,000 of the 3,000 largest U.S. equity securities in terms of 
domestic market capitalization. The components of the Nasdaq 100 are 
the stocks of 100 of the largest, non-financial U.S. issuers quoted on 
the Nasdaq National Market.
    CBOE Rule 24A.7 provides that FLEX Options are subject to maximum 
position and exercise limits of 200,000 contracts on the same side of 
the market on a given index, without aggregation for other contracts on 
the same index, with one exception.\8\ This exception requires that at 
the close of business two days prior to the last day of trading of the 
Calendar quarter, members must aggregate positions in P.M.-Settled\9\ 
FLEX Options and comparable quarterly expiration index options 
(``QIXs''), with such positions not exceeding the QIX limits specified 
in CBOE Rule 24.4. However, the applicable hedge exemptions under Rule 
24.4 may be applied to aggregate positions.
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    \8\The applicable position limits with respect to the CBOE's 
FLEX Options program were established as a three year pilot, 
commencing as of February 24, 1993, during or following which 
adjustments may be required. See FLEX Options Approval Order, supra 
note 5.
    \9\The settlement value of a P.M.-settled stock index options 
contract is based on the closing prices of the component securities.
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    The CBOE proposes that FLEX Options on the Nasdaq 100 be subject to 
position limits of 200,000 contracts on the same side of the market 
(which is identical to the existing limits for OEX, SPX, and Russell 
2000 FLEX Options), without aggregation for other contracts on the same 
index.\10\ Because the CBOE does not anticipate listing and trading 
QIXs on the Nasdaq 100, the CBOE's proposal to add the Nasdaq 100 to 
the CBOE FLEX Options program does not provide for the exception to the 
prohibition against aggregation. The CBOE represents that it would 
amend Rule 24A.7, pursuant to a filing with the Commission made in 
accordance with Section 19(b) of the Act, in the event that it decided 
to list such QIXs in the future.\11\
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    \10\The position limits pilot for Nasdaq 100 FLEX Options will 
expire on February 24, 1996, unless specifically extended by the 
Commission. See supra note 8.
    \11\See Notice, supra note 4.
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III. Discussion

    The Commission believes 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 Sections 6(b)(5) and 11A.\12\ In 
particular, the Commission believes that the proposed rule change is 
designed to provide investors with a tailored or customized product for 
a broad-based index consisting of Nasdaq National Market-listed, high-
capitalization stocks that may be more suitable to their investment 
needs than the other outstanding FLEX index options. Moreover, 
consistent with Section 11A, the proposal should encourage fair 
competition among brokers and dealers and exchange markets by allowing 
the CBOE to compete in the growing over-the-counter (``OTC'') market 
for customized index options.
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    \12\15 U.S.C. 78f(b)(5) and 78k-1 (1982). See FLEX Options 
Approval Order and Russell 2000 Approval Order, supra note 5, for 
the Commission's findings and discussions relating to the FLEX 
Options program. These findings are incorporated by reference 
herein.
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    In addition, the Commission believes that the CBOE proposal will 
help to promote the maintenance of a fair and orderly market, 
consistent with Sections 6(b)(5) and 11A, because the purpose of the 
proposal is to extend the benefits of a listed exchange market in 
Nasdaq 100 options that have certain terms varied by the particular 
investor. The attributes of the Exchange's options market versus an OTC 
market include, but are not limited to, a centralized market center, an 
auction market with posted transparent market quotations and 
transaction reporting, standardized contract specifications, parameters 
and procedures for clearance and settlement, and the guarantee of The 
Options Clearing Corporation for all contracts traded on the Exchange.
    In general, transactions in FLEX Options based on the Nasdaq 100 
will be subject to many of the same rules that apply to index options 
traded on the CBOE. However, in order to provide investors with the 
flexibility to designate certain terms of the options and accommodate 
the special trading of FLEX Options, several rules of the CBOE apply 
solely to FLEX Options.\13\
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    \13\See FLEX Options Approval Order, supra note 5.
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    The Commission believes that the FLEX auction process appears 
reasonably designed to provide the benefits of a competitive Exchange 
auction environment for Nasdaq 100 options while allowing market 
participants the flexibility to negotiate certain terms. For example, 
because certain terms of these options can be negotiated between the 
parties to the transaction, Nasdaq 100 FLEX Options, unlike regular 
Nasdaq 100 options, will not have trading rotations at either the 
opening or closing of trading. In addition, the individually-tailored 
auction process outlined in the FLEX Options Approval Order sets forth 
in detail the procedure of negotiation for those investors seeking 
particular flexibility in options terms.\14\ Accordingly, the CBOE's 
FLEX Options framework for trading stock index options, such as Nasdaq 
100 FLEX Options, differs from the traditional exchange procedure for 
trading non-FLEX stock index options, due to the special FLEX 
procedures allowing for limited individual negotiation of certain of 
the terms of the contract between the parties.
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    \14\Among other things, there are specific procedures governing 
the entering of quotes for FLEX Options, including that such quotes 
must be firm for a designated period and be disseminated through the 
Options Price Reporting Authority (``OPRA''). Id.
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    The Commission further notes that FLEX Options based on the Nasdaq 
100 can be constructed with expiration exercise settlement based on the 
closing values of the component securities, which potentially could 
result in adverse effects on the markets for those securities.\15\ 
Although the Commission continues to believe that basing the settlement 
of index products on opening as opposed to closing prices on expiration 
Fridays helps alleviate stock market volatility,\16\ these concerns 
will be allayed in the case of FLEX Options based on the Nasdaq 100, 
since expiration of these stock index options will not correspond to 
the normal expiration of stock index options, stock index futures, and 
options on stock index futures. In particular, Nasdaq 100 FLEX Options 
will never expire on an expiration Friday or any other expiration 
Fridays in March, June, September, and December, thereby diminishing 
the impact that these FLEX Options could have on the underlying cash 
market.\17\
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    \15\See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992) (order approving A.M. settlement 
of options on the SPX).
    \16\Id.
    \17\See supra note 7 and accompanying text.
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    Pursuant to the existing FLEX Options position limits framework, 
the CBOE has proposed to establish position limits of 200,000 contacts 
on the same side of the market for the Nasdaq 100 FLEX Options. The 
Commission finds that these proposed position limits are consistent 
with the FLEX Options position limit framework as set forth in the FLEX 
Options Approval Order.\18\
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    \18\See FLEX Options Approval Order, supra note 5.
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    Nevertheless, because the position limits for Nasdaq 100 FLEX 
Options are much higher than those currently existing for outstanding 
exchange-traded Nasdaq 100 options, and open interest in one or more 
FLEX series could grow to significant exposure levels, the Commission 
cannot rule out the potential for adverse effects on the securities 
markets for the component securities underlying the Nasdaq 100 FLEX 
Options. The CBOE has taken several steps to address this concern, 
including establishing the FLEX Options position limits framework as a 
three year pilot program\19\ and undertaking to monitor carefully open 
interest, position limit compliance, and potential adverse market 
effects, and to report to the Commission after one year's experience 
trading Nasdaq 100 FLEX Options.\20\ The reporting of the CBOE's 
experience in connection with the trading of Nasdaq 100 FLEX Options 
will be consistent with the original FLEX Options Approval Order and 
the Russell 2000 Approval Order, and will include, among other things:
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    \19\See supra note 8.
    \20\See Letter from Michael L. Meyer, Schiff Hardin & Waite, to 
Thomas N. McManus, Options Branch, Division of Market Regulation 
(``Division''), SEC, dated April 22, 1994.
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     The type of strategies used by Nasdaq 100 FLEX Options 
market participants, and whether Nasdaq 100 FLEX Options are being used 
in lieu of existing standardized stock index options on the Nasdaq 100.
     The type of market participants using Nasdaq 100 FLEX 
Options.
     The terms which are predominantly being ``flexed'' by 
market participants, i.e., strike prices, form of settlement (A.M.- 
versus F.M.-settlement), expiration date, exercise type (European 
versus American style).
     The size of the Nasdaq 100 FLEX position on average, the 
size of the largest Nasdaq 100 FLEX positions on any given day, and the 
size of the largest Nasdaq 100 FLEX position held by any single 
customer/member.
     The relationship between strike prices and current index 
value.
     Whether there is significant interest in long-term 
expirations greater than nine months.
     Any effect that Nasdaq 100 FLEX positions have had on the 
underlying cash market, including an analysis of Nasdaq 100 FLEX 
positions and their market impact on days when the NYSE's Rule 80A\21\ 
is triggered.
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    \21\NYSE Rule 80A is designed to ensure that index arbitrage 
will be exercised only in a market-stabilizing manner during 
volatile market conditions. Thus, Rule 80A places conditions on 
index arbitrage orders to buy or sell NYSE component stocks of the 
SPX when the Dow Jones Industrial Average advances or declines by 50 
points or more from its previous day's closing value. See Securities 
Exchange Act Release No. 29854 (October 24, 1991), 56 FR 55963 
(October 30, 1991).
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    In addition, the Commission expects, and the CBOE has agreed, to 
monitor the actual effect of Nasdaq 100 FLEX Options once trading 
commences and take prompt action (including timely communication with 
marketplace self-regulatory organizations responsible for oversight of 
trading in component stocks) should any unanticipated adverse market 
effects develop.
    Finally, based on representations from the CBOE, the Commission 
believes that the CBOE and OPRA will have adequate systems processing 
capacity to accommodate the additional options listed in accordance 
with Nasdaq 100 FLEX Options. Specifically, the Exchange represents 
that it ``has the necessary systems capacity to support the new series 
that could result from introduction of Nasdaq 100 FLEX Options.''\22\ 
In addition, OPRA represents that, ``regarding FLEX options on the 
Nasdaq-100 index, additional traffic generated by this product is 
within OPRA's capacity.''\23\
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    \22\See Letter from Charles J. Henry, CBOE, to Thomas McManus, 
Division of Market Regulation, Commission, dated May 11, 1994.
    \23\See Letter from Eileen Smith, Director of Product 
Development, CBOE, to Thomas McManus, Division, SEC, dated April 22, 
1994, incorporating a memorandum from Joseph P. Corrigan, Executive 
Director, OPRA, to Eileen Smith, Director of Product Development, 
CBOE, dated April 22, 1994.
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IV. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act, and, in particular, sections 6 and 
11A of the Act. In addition, the Commission also finds, pursuant to 
Rule 9b-1 under the Act, the Flex Options based on the Nasdaq 100 are 
standardized options for purposes of the options disclosure framework 
established under Rule 9b-1.\24\
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    \24\As part of the original approval process of the FLEX Options 
framework, the Commission delegated to the Director of the Division 
the authority to authorize the issuance of orders designating 
securities as standardized options pursuant to Rule 9b-1(a)(4) under 
the Act. See Securities Exchange Act Release No. 31911 (February 23, 
1993), 58 FR 11792 (March 1, 1993). On May 4, 1993, then-Chairman 
Richard Breeden, pursuant to Public Law 87-592, 76 Stat. 394 [15 
U.S.C. Secs. 78d-1, 78d-2], and Article 30-3 of the Commission's 
Statement of Organization; Conduct and Ethics; and Information and 
Requests [17 CFR 200.30-3), designated that persons serving in the 
position of Deputy Director, Associate Director, and Assistant 
Director in the Division be authorized to issue orders designating 
securities as ``standardized options'' pursuant to Rule 9b-1(a)(4). 
Accordingly, this subdelegation provides the Division with the 
necessary authority for designating Nasdaq 100 FLEX Options as 
``standardized options.'' See Designation of Personnel to Perform 
Delegated Functions in the Division of Market Regulation, dated May 
4, 1993.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-CBOE-93-46) is approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\
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    \25\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-12045 Filed 5-17-94; 8:45 am]
BILLING CODE 8010-01-M