[Federal Register Volume 59, Number 137 (Tuesday, July 19, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-17426]


[[Page Unknown]]

[Federal Register: July 19, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34364; File No. SR-PSE-93-13]

Self-Regulatory Organizations; Order Approving and Notice of Filing 
and Order Granting Accelerated Approval of Amendment Nos. 2 and 3 
to a Proposed Rule Change by the Pacific Stock Exchange, Inc., 
Relating to Flexible Exchange Options (``FLEX Options'') on the 
Wilshire Small Cap Index and the PSE Technology Index

July 13, 1994.

I. Introduction

    On June 21, 1993, the Pacific Stock Exchange, Inc. (``PSE'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b) 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 Wilshire 
Small Cap Index (``Wilshire Index'') and the PSE Technology Index 
(``Technology Index''). On October 1, 1993, the PSE filed Amendment No. 
1 to the proposed rule change.3 Notice of the proposed rule change 
and Amendment No. 1 were published for comment in the Federal Register 
on November 1, 1993.4 On February 7, 1994, the PSE filed Amendment 
No. 2 to the proposed rule change.5 On May 26, 1994, the PSE filed 
Amendment No. 3 to the proposed rule change.6 This order approves 
the proposal, as amended.
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    \1\15 U.S.C. 78s(b)(1) (1982).
    \2\17 CFR 240.19b-4 (1991).
    \3\In Amendment No. 1, the PSE proposes: (1) to reduce the 
proposed position limits for FLEX Options to 200,000 contracts on 
the same side of the market; (2) that the proposal be approved as a 
three-year pilot program; (3) to submit a monitoring report to the 
Commission after the first year of trading FLEX Options on the 
Exchange; (4) provide that the Exchange will use its best efforts to 
assure that bids and offers will be in compliance with Section 11(a) 
of the Act; (5) establish the trading hours for FLEX Options; (6) 
specify the permissible averaging methods for calculating exercise 
settlement values; and (7) establish the range for Request Response 
Times between 10 and 30 minutes. See Letter from Michael Pierson, 
Senior Attorney, PSE, to Jeffrey Burns, Attorney, Office of Market 
Supervision (``OMS''), Division of Market Regulation (``Division''), 
Commission, dated September 28, 1993 (``Amendment No. 1'').
    \4\See Securities Exchange Act Release No. 33100 (October 25, 
1993), 58 FR 56368 (November 1, 1993).
    \5\Amendment No. 2 adds Rule 7.50(a)(1), which specifies the 
indexes on which FLEX Options have been approved for trading by the 
Exchange. See Letter from Michael Pierson, Senior Attorney, PSE, to 
Sharon Lawson, Assistant Director, OMS, Division, Commission, dated 
February 7, 1994.
    \6\In Amendment No. 3, the PSE proposes to: (1) define the term 
``Market Maker'' to include lead market makers; (2) provide that the 
automatic executive system shall not be available for transactions 
in FLEX Options; (3) provide that PSE Rules 6.76 (Priority on Split 
Price Transactions) and 6.80 (Accommodation Transactions) shall not 
apply to transactions in FLEX Options; (4) state in the language of 
the rule that all transactions must be in compliance with Section 
11(a) of the Act; (5) provide, in certain circumstances, for 
aggregation of p.m.-settled FLEX Options with positions in quarterly 
index expiration options on the same index; (6) clarify that the 
position limits for FLEX Options are limited to 200,000 contracts on 
the same side of the market; (7) provide minimum financial 
requirements for floor brokers of at least $100,000 in net 
liquidating equity in order to effect transactions in FLEX Options; 
and (8) provide that floor brokers effecting transactions in FLEX 
Options must be issued one or more Letters of Authorization by a 
clearing member accepting responsibility for the clearance of FLEX 
Options transactions of the floor broker. See Letter from Michael 
Pierson, Senior Attorney, PSE, to Brad Ritter, Attorney, OMS, 
Division, Commission, dated May 26, 1994 (``Amendment No. 3'').
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II. Background

    The purpose of the PSE's FLEX Option proposal 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. The PSE is currently proposing to trade FLEX 
Options only on the Wilshire and Technology Indexes. In recent years, 
an over-the-counter (``OTC'') market in customized index options has 
developed which permits participants to designate the basic terms of 
the options, including size, term to expiration, exercise style, 
exercise price, and exercise settlement value, in order to meet their 
individual investment needs. Participants in this OTC market are 
typically institutional investors, who buy and sell options in large-
size transactions7 through a relatively small number of securities 
dealers. The Exchange believes FLEX Options will help it compete with 
this growing OTC market in customized index options. In particular, the 
PSE's proposal will allow FLEX Option market participants to designate 
the following FLEX Option contract terms: (1) exercise price; (2) 
exercise style (i.e., American,8 European,9 or capped);\10\ 
(3) expiration date;11 (4) option type (i.e., put, call, or 
spread); and (5) form of settlement (i.e., a.m.-settlement v. p.m.-
settlement).
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    \7\Large size in this context is intended to mean options having 
an underlying contract value equal to or greater than $1 million.
    \8\An American-style index option is one that may be exercised 
at any time on or before the expiration date.
    \9\A European-style index option is one that may be exercised 
only during a limited period of time prior to expiration of the 
option.
    \1\0A capped-style index option is one of that is exercised 
automatically prior to expiration when the cap price is less than or 
equal to the closing index value for calls or when the cap price is 
greater than or equal to the closing index value for puts.
    \1\1The FLEX Options proposal, however, requires that the 
expiration dates for FLEX Options be at least three business days 
away from the expiration dates for existing listed options in order 
to protect against possible market disruptions that may otherwise 
result from the concurrent expiration of existing listed non-FLEX 
index options and FLEX Options.
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    The PSE believes that market participants will benefit from the 
trading of FLEX Options in several ways, including, but not limited to: 
(1) enhanced efficiency in initiating and closing out positions; (2) 
increased market transparency; and (3) heightened contra-party 
creditworthiness due to the role of the Options Clearing Corporation 
(``OCC'') as issuer and guarantor of FLEX Options.12
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    \1\2The Commission has designated FLEX Options as standardized 
options for purposes of the options disclosure framework established 
under Rule 9b-1 of 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 33 infra, and for the same reasons 
stated in the 9b-1 Order, Wilshire and Technology Index FLEX Options 
are deemed ``standardized options'' for purposes of the Rule 9b-1 
options disclosure framework.
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III. Description of the Proposal

    Transactions in FLEX Options traded on the PSE generally will be 
subject to the same rules that presently apply to the trading of PSE 
index options.\13\ In order, however, to provide investors with the 
flexibility to designate certain of the terms of the options and to 
accommodate other special features of FLEX Options and the way in which 
they are traded, the PSE has proposed several new rules.
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    \13\See PSE Rule 7.
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    The princpal rules proposed by the PSE that are uniquely applicable 
to the FLEX Option market include a rule containing new definitions 
(Rule 7.50(b)), a rule regarding hours of trading FLEX Options (Rule 
7.51(a)), a special rule regarding trading rotations (Rule 7.51(b)), 
rules setting forth the special terms of FLEX Option contracts and 
certain special pieces of information that must be included in FLEX 
Option Requests for Quotes and Responsive Quotes (Rule 7.52), rules 
prescribing the mechanics of initiating a FLEX Option Request for 
Quotes and bidding and offering in response thereto, rules setting 
forth the principles applicable to the formation of binding FLEX Option 
contracts, rules defining the applicable priority principles (Rules 
7.53(e)), special position limit and exercise limit rules (Rues 7.55 
and 7.56), special FLEX Option market maker appointment rules (Rule 
7.57), and special market maker and floor broker capital and letter of 
guarantee rules (Rules 7.59(a), (b), and (c)). Discussion of each of 
these rules follows.
    Proposed Rule 7.50(b) adopts nomenclature uniquely tailored to fit 
the special characteristics of FLEX Options and the FLEX Option market. 
For example, the term ``Request Response Time'' refers to the time 
interval, set by the submitting member in its Request for Quotes, 
during which responsive bidding and offering is to take place.\14\ 
Similarly, the term ``FLEX Quote`` has both its usual connotation--
market maker bids and offers--and a new connotation--floor brokers' 
orders to purchase and orders to sell--that is necessary in view of the 
unique mechanics of the FLEX Option exchange auction.
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    \14\The ``Request Response Time'' is intended by the Exchange to 
initially be set at a minimum of 10 minutes and a maximum of 30 
minutes. See Amendment No. 1, supra note 3.
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    Proposed Rule 7.51(a) provides that FLEX Option trading will 
commence at 7 a.m. Pacific Time, one-half hour later than the opening 
time currently set for the trading of regular index options, and, will 
conclude at 1:15 p.m. Pacific Time, the existing close of trading at 
the Exchange for regular index options. The Exchange may, from time to 
time, determine to amend the trading hours set for FLEX Options.\15\ As 
a complementary rule uniquely applicable to FLEX Options, Proposed Rule 
7.51(b) specifies that there will be no trading rotations in FLEX 
Options, either at the opening or at the close of trading.
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    \15\Specifically, the PSE proposes to implement the hours of 
trading for FLEX Options as follows: (1) initial hours of FLEX 
trading will be 7 a.m.--1:15 p.m. (Pacific Time); (2) FLEX trading 
hours may be altered at the discretion of the Exchange by 15 minutes 
or less so long as the change does not extend trading beyond the 
normal PSE business hours of 6:30 a.m.--1:15 p.m. (Pacific Time); 
(3) FLEX trading hours that are altered by more than 15 minutes but 
remain within normal business hours must be submitted by the 
Exchange to the Commission in a Section 19(b)(3)(A) filing; (4) FLEX 
trading hours extended beyond the PSE's normal business hours must 
be submitted to the Commission for approval pursuant to Section 
19(b)(2); and (5) the Exchange will provide adequate advance 
notification to its members and member organizations of such changes 
in FLEX trading hours. id.
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    Proposed Rule 7.52 specifies the term elements and other 
informational ingredients that must be included in Requests for Quotes, 
FLEX Quotes submitted in response to such requests, and, ultimately, 
FLEX Option contracts that are the product of FLEX Option trading. As 
paragraph (b) of this proposed rule indicates, the content of certain 
terms of each FLEX Option contract is to be determined by the parties 
of the contract. Other terms, such as the level of the index multiplier 
and the nature of the rights and obligations of FLEX Option purchasers 
and sellers, are the same for FLEX Options as for regular index 
options.
    More specifically, Paragraph (b) of Proposed Rule 7.52 specifies 
the term elements that a submitting member must include in its Request 
for Quotes and indicates the alternatives available for each term. 
Under this paragraph, a submitting member must designate, among other 
terms, the day, month, and year of the FLEX Option's expiration, 
subject to certain limitations designed to avoid the overlap of FLEX 
Option expirations with expirations of regular index options.\16\ To 
further ensure against any adverse market impact, expirations for FLEX 
Options may not fall within 3 business days (before or after) of 
conventional options expirations (generally, the third Friday of the 
month). Similarly, a submitting member must identify the exercise 
price\17\ and the exercise settlement value\18\ of the FLEX Option, and 
those variable FLEX Option terms must fit within stated parameters.
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    \16\See Securities Exchange Act Release No. 33700 (March 2, 
1994), 59 FR 11342 (March 10, 1994) (order approving quarterly index 
expiration options on Wilshire Index).
    \17\Specifically, exercise prices can be determined in reference 
to (a) a specific index value number, (b) a method for fixing such a 
number at the time a FLEX Quote is accepted, (c) a percentage of 
index value calculated as of the open or close of trading on the 
Exchange on the trade date, or (d) the cap interval in the case of 
capped-style options.
    \18\The Exchange proposes that the averaging parameters will be 
limited to three alternatives: the average of the opening and 
closing index values; the average of the intra-day high and low 
index values; values; and the average of the opening, closing, and 
intra-day high and low index values. See Amendment No. 1, supra note 
3.
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    Paragraph (c) of this proposed rule lists certain additional 
categories of information that must be addressed by the submitting 
member in its Request for Quotes. In particular, under this paragraph a 
submitting member must indicate the type and form of quote sought, the 
length of the Request Response Time (i.e., the time interval during 
which FLEX Option-participating members may enter quotes responsive to 
the request), and the submitting member's intention, if any, to cross a 
customer order or act as principal with respect to any part of the FLEX 
Option trade.
    Finally, paragraph (d) of this proposed rule specifies the maximum 
term and the minimum value size of any FLEX Option contract and 
provides that the term and size may be set, within the stated limits, 
at the discretion of the submitting member or the quoting party, as 
applicable. Under this paragraph, the maximum FLEX Option term is five 
years; the minimum value size (i.e., the aggregate underlying dollar 
value that is the subject of the option) for a FLEX Request for Quotes 
is $10 million in an opening transaction in a new FLEX Option series 
and $1 million in an opening or closing transaction in any currently-
opened FLEX Option series (or less in a closing transaction where the 
remaining underlying value is less than $1 million); and the minimum 
value size for quotes of market makers in response to a Request for 
Quotes is $1 million or any lesser amount reflected in a Request for 
Quotes (except that market makers appointed to FLEX Options on the 
underlying index that is the subject of the Request for Quotes must be 
prepared to respond to a Request for Quotes in a size of at least $10 
million underlying value or the dollar amount indicated in the Request 
for Quote, whichever is less).
    These provisions, collectively, provide investors and FLEX Option-
participating members with significant latitude in structuring the 
terms of FLEX Options contracts. The Exchange believes that such 
latitude is both important and necessary to the Exchange's effort to 
create a product and a market that provides members and investors 
interested in FLEX Options with an improved but comparable alternative 
to the OTC options market. To enable the efficient, centralized 
clearance and active secondary trading of opened FLEX Options, however, 
the extent of variability in structuring FLEX Options is necessarily 
limited. Only certain terms are subject to flexible structuring by the 
parties to FLEX Option transactions, and most of such terms have a 
specified number of alternative configurations. In addition to the 
specified term alternatives indicated above, FLEX Options will be 
limited to transactions on the Wilshire and Technology Indexes (Rule 
750(a)(1)) and shall be denominated for settlement in cash in U.S. 
dollars only (Rule 7.52(e)).
    Proposed Rule 7.53 prescribes in some detail the mechanics of 
submitting Requests for Quotes and entering responsive bids and offers. 
These mechanics, described below, are designed to create a modified 
auction that takes into account the relatively small number of 
transactions that are lively to occur in this institutional, large-size 
market, while at the same time providing the FLEX Option market with 
the price improvement and transparency benefits of competitive Exchange 
floor bidding and offering, as compared with the OTC market.\19\ 
Proposed Rule 7.53 establishes time and price priority principles and 
contains special rules respecting the bidding and offering process and 
the method of allocating trades in instances in which the submitting 
member expresses an intention to cross or act as principal on a Request 
for Quotes. These proposed rules are designed to promote active bidding 
and offering that will generate the best price available, while also 
providing incentives to market makers appointed to FLEX Options, floor 
brokers, other floor participants, and upstairs firms alike to 
participate in the FLEX Option market.
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    \19\All FLEX Option transactions must be in compliance with 
Section 11(a) of the At and the rules thereunder. See Amendment No. 
3, supra note 6.
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    In particular, paragraphs (a) and (b) of proposed Rule 7.53 
indicate that the FLEX Option bidding and offering process is initiated 
once a submitting member has supplied a Request for Quotes in proper 
form and the terms and specifications of the Request for Quotes are 
disseminated at the post and over FLEX Option communications 
facilities. Thereafter, FLEX Quotes in proper form may be entered, 
modified, or withdrawn (subject to special limitations imposed on 
appointed market makers) by public outcry at any time during the 
Request Response Time. The length of the Request Response Time, which 
must fall within time parameters to be set by the Exchange, is to be 
specified in the Request for Quotes. At the expiration of the Request 
Response Time, the FLEX Post Official will determine the best bid and/
or offer (``BBO'').
    Proposed paragraph (c) of Rule 7.53 provides that the BBO will be 
displayed at the post and over communication facilities and, at that 
point, or after further bidding and offering that occurs in certain 
specified circumstances the submitting member will have the opportunity 
to accept or reject the BBO. The submitting member, however, has no 
obligation to accept the BBO. Thus, whenever the BBO is rejected the 
Request for Quotes expires, although FLEX Option-participating members 
other than the submitting member may accept the unfilled balance of the 
BBO. Similarly, whenever the BBO is accepted, the transaction (or 
transactions) will be executed in accordance with the crossing 
principles and priority principles set forth in paragraph (e) of 
proposed Rule 7.53, although, again, FLEX Option-participating members 
may accept any unfilled balance of the BBO.
    Proposed Rule 7.55 states position limits that will be unique to 
FLEX Options.\20\ Specifically, the PSE is proposing that FLEX Options 
will be subject to a maximum limit of 200,000 contracts on the same 
side of the market on a given underlying index, without aggregation for 
other contracts on the same index with one exception. Under the 
proposal members must, at the close of business two days prior to the 
last day of trading of the calendar quarter, aggregate positions in 
p.m.-settled FLEX Options on the Wilshire Index with quarterly 
expiration index options (``QIXs'') with the same expiration date and 
those positions may not exceed the QIX limits specified in Rule 
7.6(d)(2) (i.e., 37,500 contracts on the same side of the market in the 
case of QIX options on the Wilshire Index).\21\ In this case, the 
applicable hedge exemptions under Rule 7.6 may be applied to the 
aggregate positions.\22\
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    \20\Proposed Rule 7.56 establishes exercise limit provisions 
that correspond to the position limits prescribed in proposed Rule 
7.55.
    \21\QIX options have not been approved for trading on the 
Technology Index.
    \22\Under the proposal, FLEX Options would be listed for trading 
by the Exchange on a three-year pilot, during or following which 
adjustments may be required. In addition, among other things,the PSE 
has stated that it will monitor the effect of the position limits at 
the end of the first year of trading and provide the Commission with 
a report concerning the adequacy of the limits and its effects on 
the underlying cash market. See, Amendment No. 1, supra note 3.
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    Proposed Rule 7.57 provides for separate appointments of market 
makers to FLEX Options, although the appointment process will be 
essentially the same as appointments to other options. This rule 
further provides that appointed market makers will have an affirmative 
obligation to quote in a size of at least $10 million in response to 
every Request for Quotes on a FLEX Option on an index to which the 
market maker is appointed. Such quotes must be firm, unless modified or 
withdrawn prior to the end of the Request Response Time, for the 
duration of the Request Response Time and, if applicable, the BBO 
Improvement Interval. As noted earlier, market makers have no 
obligation to maintain continuous quotes or to quote a minimum spread, 
and quotes expire at the end of each FLEX Option bidding and offering 
period.
    Proposed Rules 7.59(a)-(c) set minimum financial requirements for 
market makers trading or appointed to FLEX Options. The financial 
minimums stated in proposed Rules 7.59(a) and (b) are unique to FLEX 
Options.
    Specifically, proposed Rule 7.59(a) requires every market maker 
approved to effect transactions in FLEX Options to maintain at least 
$100,000 in net liquidating equity in any FLEX Option trading account 
with each given clearing member. Similarly, proposed Rule 7.59(b)(2) 
requires every floor broker eligible to effect FLEX Option transactions 
to maintain at least $100,000 in net liquidating equity in any FLEX 
Option trading account with each given clearing member. The Exchange 
believes that these stated minimums provide an adequate and suitable 
financial floor for FLEX Options trading activity without unduly 
restricting access to these markets.
    Proposed Rule 7.59(b) requires FLEX Option-appointed market makers 
to maintain at least $1 million in net liquidating equity or net 
capital, as applicable. Again, although this minimum requirement is 
unique to FLEX Options, the Exchange believes that it represents a 
suitable and adequate financial floor for FLEX Option-appointed market 
makers undertaking the substantial FLEX Quote responsibility.
    Proposed Rule 7.59(c) extends the general letter of guarantee 
requirement under existing Exchange Rule 6.36(a) to FLEX Option market 
makers and FLEX Options floor brokers, thereby subjecting them to a 
focused credit worthiness review by their clearing members. The review 
and issuance requirement imposed under proposed Rule 7.59(c) 
substantially supplements the independent financial requirements of 
proposed Rules 7.59(a) and (b).\23\
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    \23\The proposed rule changes include the following changes as 
well as the changes discussed in the text. Proposed Rule 7.54 
enables a Floor Broker to exercise discretion with respect to the 
number of FLEX Option contracts to be purchased or sold 
(notwithstanding contrary limitations in Rule 6.48) in view of the 
special features that will be associated with FLEX Option bidding 
and offering. Finally, proposed Rule 7.58 establishes a new class of 
Exchange employee (a FLEX Post Official) and sets forth the FLEX 
Post Official's special duties.
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IV. 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)\24\ and 11A.\25\ In 
particular, the Commission believes that the proposed rule change is 
designed to provide investors with a tailored or customized product for 
broad-based indexes currently traded on the Exchange that may be more 
suitable to their investment needs than other outstanding FLEX 
Options.\26\ Moreover, consistent with Section 11A, the proposal should 
encourage fair competition among brokers and dealers and exchange 
markets, by allowing the PSE to compete with the growing OTC market in 
customized index options.
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    \24\15 U.S.C. 78f(b)(5) (1982).
    \25\15 U.S.C. 78k-1 (1982).
    \26\The Chicago Board Options Exchange, Inc. (``CBOE'') trades 
FLEX Options based on the S&P 100, S&P 500, and Russell 2000 stock 
indexes. See Securities Exchange Act Release Nos. 31920 (February 
24, 1993), 58 FR 12280 (March 3, 1993); and 32694 (July 29, 1993), 
58 FR 41814 (August 5, 1993). The American Stock Exchange, Inc. 
(``AMEX'') trades FLEX Options based on the Major Market, 
Institutional, and S&P MidCap 400 indexes. See Securities Exchange 
Act Release No. 32781 (August 20, 1993), 58 FR 45360 (August 27, 
1993).
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    For instance, as noted by the PSE, the OTC market in customized 
index options has developed, in part, to meet the needs of 
institutional investors who require increased flexibility for the 
purpose of satisfying particular investment objectives that could not 
be met by existing standardized exchange markets in options. 
Accordingly, the Commission believes the PSE proposal is a reasonable 
response by the Exchange to meet the demands of sophisticated portfolio 
managers and other institutional investors who are increasingly using 
the OTC market in order to satisfy their hedging needs, and will 
thereby promote competition among these markets.
    In addition, the Commission believes that the PSE proposal will 
help to promote the maintenance of a fair a orderly market, consistent 
with Sections 6(b)(5) and 11A of the Act, because the purpose of the 
proposal is to extend the benefits of a listed, exchange market in 
Wilshire Index and Technology Index 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 OCC for all contracts traded on the Exchange.
    In general, transactions in FLEX Options will be subject to many of 
the same rules that apply to index options traded on the PSE. In order 
to provide investors with the flexibility to designate terms of the 
options and accommodate the special trading of FLEX Options, however, 
several new rules will apply solely to FLEX Options.
    Due to the customized nature of these options, FLEX Options will 
not have trading rotations at either the opening or closing of trading. 
In addition, the auction process outlined above in proposed Rule 7.53 
sets forth a procedure of customized negotiation for those investors 
seeking particular flexibility in setting certain options terms.\27\ 
Accordingly, the PSE proposed rules specific to FLEX Options vary from 
the traditional procedure for trading regular index options.
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    \27\A submitting member (the Exchange member that initiates the 
FLEX Option auction process by submitting a request for quotes) is 
under no obligation to accept any FLEX Option bid or offer, even if 
it is the BBO. See, Proposed PSE Rule 7.53.
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    The Commission believes that the FLEX Option auction process, as 
outlined in PSE's proposal, appears reasonably designed to provide the 
benefits of an Exchange auction environment for Wilshire and Technology 
Index options with features of a negotiated transaction between 
investors. The Commission recognizes that PSE's proposal marks, in many 
respects, an experiment in trading option contracts of substantial 
value, for which continuous quotation may be difficult to sustain. 
Accordingly, PSE has established procedures for quotes upon request, 
which must then be firm for a designated period and which will be 
disseminated through the Options Price Reporting Authority (``OPRA'').
    The Commission notes that FLEX Options based on the Wilshire and 
Technology Indexes can be constructed with expiration exercise 
settlement based on the closing values of the component securities, 
which could potentially result in adverse effects for the markets in 
these securities.\28\ Although the Commission continues to believe that 
basing the settlement of index products on opening as opposed to 
closing prices on Expiration Friday helps alleviate stock market 
volatility,\29\ these concerns are reduced in the case of FLEX Options 
because 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, 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 FLEX Options could have on the market.
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    \28\See, e.g., Securities Exchange Act Release No. 30944 (July 
21, 1992), 57 FR 33376 (July 28, 1992).
    \29\Id.
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    Also, as noted above, the proposal would limit the effect on 
securities markets by addressing the relationship between FLEX Options 
and QIXs. As proposed, PSE Rule 7.55(c) requires P.M.-settled FLEX 
Options to be aggregated with QIXs that are based on the same index and 
have the same expiration date. In such a case, the FLEX Options would 
be aggregated two days prior to expiration subject to the lower 
position limits of 37,500 contracts for QIX options on the Wilshire 
Index. The Commission believes that these rules should help prevent an 
investor for using FLEX Options for the purpose of avoiding the 
position limits applicable to QIXs.
    Nevertheless, because the position limits for FLEX Options are much 
higher than those currently existing for outstanding exchange-traded 
index options and open interest in one or more FLEX Option 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 FLEX Option stock indices. The PSE has 
taken several steps to address this concern, including establishing the 
proposed FLEX Options as a three-year pilot and undertaking to monitor 
open interest, position limit compliance and potential adverse market 
effects carefully and to report to the Commission after one year's 
experience trading FLEX Options.\30\ That report will include, among 
other things:
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    \30\See Amendment No. 1, supra note 3.
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     The type of strategies used by FLEX Options market 
participants and whether FLEX Options are being used, in lieu of 
existing standardized stock index options.
     The type of market participants using FLEX Options.
     The terms which are predominantly being ``flexed'' by 
market participants, i.e., strike prices, settlement value (A.M. v. 
P.M.), term of duration, European v. American style.
     The size of the FLEX Option position on average, the size 
of the largest FLEX Option positions on any given day and size of the 
largest FLEX Option 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 FLEX Option positions have had on the 
underlying cash market, including an analysis of FLEX Option positions 
and their market impact on days Rule 80A of the New York Stock Exchange 
is invoked.
    In addition, the Commission expects the PSE to monitor the actual 
effect of 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 anticipated adverse market effects develop.
    Lastly, based on representations from the PSE, the Commission 
believes that the PSE and OPRA will have adequate systems processing 
capacity to accommodate the additional options listed in connection 
with FLEX Options. Specifically, the Exchange represents that PSE and 
OPRA have the necessary systems capacity to support the new series 
which could result from introduction of FLEX Options.\31\
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    \31\See Letter from Michael Pierson, Senior Attorney, Market 
Regulation, PSE, to Brad Ritter, Attorney, OMS, Division, 
Commission, dated May 27, 1994; and Letter from Joe Corrigan, 
Executive Director, OPRA, to Kim Koppien, PSE, dated May 26, 1994.
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    The Commission finds good cause for approving Amendment Nos. 2 and 
3 prior to the thirtieth day after the date of publication of notice 
thereof in the Federal Register. Amendment No. 2 merely proposes to 
include in the PSE's rules applicable to FLEX Options those particular 
broad-based indexes on which FLEX Options have been approved for 
trading. The Commission believes this will serve to minimize investor 
confusion. Amendment No. 3 to the proposed rule change makes several 
clarifying amendments and other changes designed to conform the PSE's 
rules regarding FLEX Options to those rules approved for the listing 
and trading of FLEX Options by the CBOE and the Amex,\32\ which to the 
Commission's knowledge, have not resulted in any problems. Accordingly, 
for the reasons discussed herein, the Commission believes that the 
changes contained in Amendment No. 3 strengthen the PSE's proposal and 
thus will help to promote the maintenance of a fair and orderly market.
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    \32\See supra note 26.
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 2 and 3. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street NW., Washington, 
DC 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 changes 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 in the Commission's Public Reference Section, 450 Fifth Street, 
NW., Washington, DC 20549. Copies of such filing will also be available 
for inspection and copying at the principal office of the PSE. All 
submissions should refer to File No. SR-PSE-93-13 and should be 
submitted by August 9, 1994.

VI. Conclusion

    For the reasons discussed above, the Commission finds that the 
proposal is consistent with the Act and sections 6 and 11A of the Act 
in particular. In addition, the Commission finds pursuant to Rule 9b-1 
under the Act, that FLEX Options based on the Wilshire and Technology 
Indexes are standardized options for purposes of the options disclosure 
framework established under Rule 9b-1 of the Act.\33\
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    \33\As part of the original approval process of the FLEX Options 
framework, the Commission delegated to the Director of the Division 
of Market Regulation 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, Chairman Breeden, pursuant to Public Law 87-592, 76 Stat. 
394 [15 U.S.C. 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 of Market Regulation, be authorized to 
issue orders designating securities as ``standardized options'' 
pursuant to Rule 9b-1(A)(4). Accordingly, this subdelegation 
provides the necessary authority for Wilshire and Technology FLEX 
Options to be designated as ``standardized options'' by the Division 
of Market Regulation. 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,\34\ that the proposed rule change (SR-PSE-93-13) is approved, as 
amended, on a pilot basis until July 13, 1997.

    \34\15 U.S.C. 78s(b)(2) (1982).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\35\
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    \35\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-17522 Filed 7-18-94; 8:45 am]
-----------------------------------------------------------------------B
ILLING CODE 80-01-M
[Release No. 34-34357; International Series Release No. 682; File No. 
SR-PHLX-94-05]

 
Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the Philadelphia Stock Exchange, Inc., Relating to Quote 
Spread Parameters for Long-Term Foreign Currency Options

July 12, 1994.
    On February 7, 1994, the Philadelphia Stock Exchange, Inc. 
(``PHLX'' 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 amend Exchange Rule 1014, ``Obligations 
and Restrictions Applicable to Specialists and Registered Options 
Traders,'' and Floor Procedure Advice (``Advice'') F-6, ``Option Quote 
Spread Parameters'' to: (1) establish quote spread parameters for long-
term foreign currency options (``FCOs''); (2) revise the quote spread 
parameters for options on the French franc; and (3) revise the quote 
spread parameters for cross-rate FCOs.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1993).
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    The proposal was published for comment in Securities Exchange Act 
Release No. 33693 (February 28, 1994), 59 FR 10659 (March 7, 1994). No 
comments were received on the proposal.\3\
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    \3\On June 27, 1994, the PHLX submitted a letter explaining the 
rationale for the proposed quote spread parameters for long-term 
FCOs. The PHLX notes that foreign currency swaps and forward 
contracts are used frequently to hedge long-term FCOs and that 
foreign currency swaps are the basis for pricing long-term FCOs 
because the swap market takes into account the interest rate 
differential among the relevant countries, which becomes less 
certain over time. In light of the hedging process for long-term 
FCOs, and based on its experience in trading long-term FCOs, the 
PHLX believes that the foreign currency swap market provides a 
reasonable basis for measuring quote spread parameters for long-term 
FCOs. See Letter from Edith Hallahan, Special Counsel, PHLX, to 
Michael Walinskas, Branch Chief, Options Regulation, Division of 
Market Regulation, Commission, dated June 23, 1994 (``June 23 
Letter'').
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    The PHLX has traded long-term FCOs since 1992, when PHLX Rule 1012 
was amended to permit the listing of options with an expiration of up 
to 36 months in the future.\4\ The Long-Term FCO Approval Order stated 
specifically that long-term FCOs would not be subject to existing quote 
spread parameters because, at that time, there was no basis for 
establishing reasonable prices for long-term FCOs due to the lack of 
historical pricing. Under the Long-Term FCO Approval Order, long-term 
FCOs are subject to Advice F-6 once there is less than twelve months 
remaining until expiration.
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    \4\See Securities Exchange Act Release No. 30672 (May 6, 1992), 
57 FR 20546 (order approving File No. SR-PHLX-91-30) (``Long-Term 
FCO Approval Order'').
---------------------------------------------------------------------------

    Currently, the PHLX trades four long-term FCOs: British pound, 
German mark, French franc, and Japanese yen.\5\ The PHLX proposes to 
codify specific parameters for long-term FCOs in order to demonstrate 
consistency in quote width to FCO customers and to prevent overly wide 
quotes.
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    \5\Although the PHLX has not yet listed a long-term option on 
the Swiss franc, the PHLX may do so in the future. Its proposed 
Swiss franc spread parameter would be identical to the proposed 
quote spread parameter applicable to the long-term German mark 
option.
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    Specifically, the PHLX proposes to establish the following quote 
spread parameters for long-term FCOs: for options on the British pound, 
a maximum quote spread of $.0100 where the bid is $.1500 or less and 
$.0150 where the bid is more than $.1500; for options on the French 
franc, a maximum quote spread of $.00100 where the bid is $.01500 or 
less and $.00150 where the bid is more than $.1500; for options on the 
German mark and Swiss franc, a maximum quote spread of $.0030 where the 
bid is $.0500 or less and $.0050 where the bid is more than $.0500; and 
for options on the Japanese yen, a maximum quote spread of $.000040 
where the bid is $.000500 or less and $.000070 where the bid is over 
$.000500.
    In addition, the PHLX proposes to correct the parameters for cross-
rate FCOs, which appear in the incorrect base currency, and for French 
franc options, which cannot be quoted in odd numbers due to system 
limitations. Specifically, for options on the French Franc, the PHLX 
proposes to establish a maximum quote spread of $.00014 where the bid 
is $.00250 or less; $.00024 where the bid is between $.00252 and 
.00750; and $.00034 where the bid is over $.00750.
    With respect to cross-rate options, the PHLX states that the 
original quote spread parameters were incorrect because the bids, which 
determine the quote spread, should be based on bids relating to the 
first currency. Under the current rule, for British pound/German mark 
cross-rate options, if the bid is .0100 German marks or less, the 
maximum quote spread is .0015 German marks. The PHLX states that this 
has proved incompatible with the parameters commonly employed by 
traders to quote the British pound/German mark cross-rate option for 
two reasons: (1) the range of bids did not correspond to the ranges 
previously used for British pound quotes;\6\ and (2) the actual 
parameters (.0015, .0025 and .0035 German marks) proved to be too 
narrow in view of the unique pricing and settlement of cross-rate 
options. Thus, for British pound/German mark cross-rate options, the 
PHLX proposes the following parameters: a maximum quote spread of .0030 
German marks where the bid is .0250 German marks or less; .0050 German 
marks where the bid is more than .0250 but does not exceed .0750 German 
marks; and .0070 German marks where the bid is more than .0750 German 
marks.
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    \6\The range of bids that determine the quote spread parameters 
applicable to British pound options is: $.0250 or less, $.0251 to 
$.0750, and over $.0750.
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    For German mark/Japanese yen cross-rate options, the PHLX proposes 
the following parameters: a maximum quote spread of .12 Japanese yen 
where the bid is .40 Japanese yen or less; .16 Japanese yen where the 
bid is more than .40 but does not exceed 1.60 Japanese yen; and .20 
Japanese yen where the bid is more than 1.60 Japanese yen.
    For British pound/Japanese yen options, the PHLX proposes to 
establish the following parameters:\7\ a maximum quote spread of .0030 
Japanese yen where the bid is .0250 Japanese yen or less; .0050 
Japanese yen where the bid is more than .0250 but does not exceed .0750 
Japanese yen; and .0070 Japanese yen where the bid is more than .0750 
Japanese yen. The exchange proposes to correct the cross-rate 
parameters both in the text of exchange Rule 1014 as well as in Advice 
F-6 in order to facilitate the efficient trading and quoting of the 
relevant cross-rate options, as well as to inform members and customers 
of the maximum quote spread parameters.
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    \7\Although the PHLX has not yet listed the British pound/
Japanese yen option, the same inconsistency with British pound bid 
ranges requires correction and the quote spread parameters were also 
proposed too narrowly.
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    The PHLX believes that the proposed rule change is consistent with 
Section 6 of the Act, in general, and, in particular, with Section 
6(b)(5), in that it is designed to promote just and equitable 
principles of trade, prevent fraudulent and manipulative acts and 
practices, and to protect investors and the public interest. 
Specifically, the PHLX believes that established quote spread 
parameters for long-term FCOs should prevent overly wide quotes and 
foster uniformity in quote width, consistent with Section 6(b)(5). In 
addition, the PHLX believes that the correction to cross-trade quote 
spread parameters should promote just and equitable principles of trade 
by providing a more feasible bid/ask differential, which, in turn, 
should facilitate trading in those options.
    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, with the requirements of Section 6(b)(5) in that proposal 
is designed to promote just and equitable principles of trade and to 
protect investors and the public interest.\8\ Specially, the Commission 
believes that the PHLX's proposal to establish quote spread parameters 
for long-term FCO's should result in improved price continuity and 
tighter, more liquid markets. In light of the hedging process for long-
term FCOs and the PHLX's experience in trading long-term FCOS, the 
Commission believes that it is reasonable for the Exchange to base the 
quote spread parameters for long-term FCOs on the foreign currency swap 
and forward markets.\9\ The Commission believes that the quote spread 
parameters for long-term FCOs should prevent overly wide quotes and are 
designed to be consistent with the obligations of PHLX specialists and 
Registered Options Treaders (``ROTs'') under the Act to provide fair 
and orderly markets.
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    \8\15 U.S.C. 78f(b)(5) (1982).
    \9\The PHLX states that swaps and forward contracts are often 
used to hedge FCOs and that swaps provide the basis for pricing 
long-term FCOs because the swap market takes into account the 
interest rate differential among the relevant countries. Because of 
the interest rate differential and the corresponding less-liquid 
nature of the market for long-term FCO forward contracts, the 
forward markets for long-term FCOs are wider than the FCO spot 
market, which provides the basis for pricing shorter-term FCOs. 
Accordingly, the quote spread parameters for long-term FCOs are 
wider than the quote spread parameters for shorter-term FCOs. See 
June 23 Letter, supra note 3.
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    In addition, the Commission believes that it is reasonable for the 
PHLX to establish new even-numbered quote spread parameters for options 
on the French franc, which cannot be quoted in odd numbers, and to 
establish new quote spread parameters for cross-rate FCOs, which the 
PHLX believes should be based on bids relating to the first currency. 
The Commission believes that these amendments should benefit investors 
by helping the PHLX to maintain a fair and orderly market for FCOs.
    In additional, the Commission believes that the proposed quote 
spread parameters for cross-fire FCOs are based on the PHLX's 
experience in trading cross-rate FCOs and more accurately reflect the 
market for those options. The Commission believes that the proposed 
parameters for cross-rate FCOs are intended to facilities tightly 
quoted markets without impairing specialist's and ROT's ability to 
provide market depth and liquidity. Accordingly, the Commission 
believes that the cross-rate FCO parameters are consistent with the 
obligations of PHLX specialists and ROTs to provide fair and orderly 
markets.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\10\ that the proposed rule change (SR-PHLX-94-05) is approved.

    \10\15 U.S.C. Sec. 78s(b)(2) (1982).
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\17 CFR 200.30-3(a)(12) (1993).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-17426 Filed 7-18-94; 8:45 am]
BILLING CODE 8010-01-M