[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: 94-17524]


[[Page Unknown]]

[Federal Register: July 19, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34359; File No. SR-Amex-91-35]

 

Self-Regulatory Organizations; Order Approving and Notice of 
Filing and Order Granting Accelerated Approval of Amendment No. 1 to a 
Proposed Rule Change by the American Stock Exchange, Inc., Relating to 
the Development of Stock Indexes for Index Option Trading.

July 12, 1994.
    On December 26, 1991, the American Stock Exchange, Inc. (``Amex'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act''),1 and Rule 19b-4 thereunder,2 
a proposed rule change to provide the Exchange with greater flexibility 
in developing stock indexes for index option trading. Notice of the 
proposal appeared in the Federal Register on February 14, 1992.3 
No comment letters were received on the proposed rule change.4 The 
Amex subsequently filed Amendment No. 1 to the proposed rule change on 
May 20, 1994.5 This order approves the Exchange's proposal, as 
amended.
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    \1\15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\17 CFR 240.19b-4 (1992).
    \3\See Securities Exchange Act Release No. 30356 (February 10, 
1992), 57 FR 30356 (February 14, 1992).
    \4\The Commission, however, did receive a letter from 
Congressman Edward Markey requesting additional information 
regarding the subject matter of the proposed rule change and seeking 
assurances that the proposal would not result in any enhanced 
opportunities for market manipulation or other improper trading 
activities. See Letter from Rep. Edward Markey, Chairman, Committee 
on Energy and Commerce, U.S. House of Representatives, to Richard 
Breeden, Chairman, Commission, dated March 5, 1992. For the reasons 
discussed below, the Commission believes that the proposal is 
structured to minimize any potential for market manipulation and 
other improper trading activity.
    \5\In Amendment No. 1, the Amex represents that: (1) members 
will be prohibited from using hand signals for purposes of 
communicating between the Exchange's main equity trading floor 
(``Equity Floor'') and the mezzanine trading level (``Mezzanine'') 
when index options on indexes where Amex-listed stocks comprise more 
than 10% of the index value, by weight, are being traded in the 
Mezzanine; (2) members will be notified by the Exchange of the 
prohibition on the use of hand signal communications; and (3) no 
trading of index options on indexes containing Amex-listed stocks 
will be allowed on the Mezzanine in areas visible from the Equity 
Floor. See Letter from Claire McGrath, Managing Director and Special 
Counsel, Derivative Securities, Amex, to Michael Walinskas, Branch 
Chief, Office of Market Supervision, Division of Market Regulation, 
Commission, dated May 20, 1994 (``Amendment No. 1'').
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    When exchange-traded stock index options were developed, there was 
a concern with allowing options to trade on indexes composed of a 
relatively small number of stocks where a substantial portion of those 
stocks were traded on the same exchange. As a result, the Exchange has 
rules restricting the number of Amex-traded stocks that can be included 
in a stock index upon which options are also traded on the Amex. 
Specifically, no components of an index may be traded on the Amex if 
the index is composed of less than 25 stocks; less than 10% of the 
market value of the index may be accounted for by stocks traded on the 
Amex if the index is composed of 25 or more stocks but less than 50 
stocks; and 10% or more of the market value of the index may be 
accounted for by stocks traded on the Amex if the index is composed of 
50 or more components.6
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    \6\See Amex Rule 901C(a).
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    Further, the first indexes on which options were traded were valued 
either on the price of the components of the index (price-weighted) or 
on the market capitalizations of the components of the index 
(capitalization-weighted). Accordingly, Exchange Rule 900C defines the 
term ``stock index group'' as a group of stocks each of whose inclusion 
and relative representation in the group is determined by the inclusion 
and relative representation of their current market values or market 
prices in a widely disseminated stock index.
    As a result of significant changes in the options industry, the 
Exchange believes that the restrictions on the inclusion of Amex-traded 
stocks in indexes on which options are traded on the Exchange are no 
longer appropriate. Similarly, the Exchange believes that the 
definition of stock index group is now too restrictive because of the 
creation of new and different methods of calculating and determining 
the relative representation of the stocks underlying an index (e.g. 
equal dollar-weighting).\7\ The Exchange is, therefore, proposing to 
revise Exchange Rule 901C to provide for greater flexibility in the 
design and development of new stock index option products which can be 
listed and traded on the Exchange, and to revise Rule 900C to reflect 
the changes in the methods of valuing indexes. With regard to Rule 
900C, the Exchange proposes to eliminate references to market value and 
market price as the methods of determining the relative representation 
of a stock within an index. This will clarify that an index need not be 
based on a strictly proportional representation of the prices or market 
values of its component stocks. The Exchange believes this is necessary 
because the Exchange either currently trades or has had approved for 
trading, index options on several indexes which are neither 
capitalization-weighted or price-weighted (e.g., the Morgan Stanley 
Consumer and Cyclical Indexes, the Biotechnology Index, and the Natural 
Gas Index).
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    \7\An equal dollar-weighted index is based on the number of 
shares of each component that could be purchased spending the same 
dollar amount on each. The value of the index equals the sum of the 
current market value of the assigned number of shares of each of the 
stocks in the index portfolio divided by the current index divisor. 
See, e.g., Securities Exchange Act Release No. 33720 (March 7, 
1994), 59 FR 11630 (March 11, 1994).
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    The Exchange also proposes to revise Rule 901C to remove the 
limitation on the number of Amex-listed stocks that can be included in 
an index on which stock index options trade on the Exchange. The 
proposed revision would allow indexes composed of less than 50 
securities to have Amex-listed stocks account for more than 10% of the 
index's value, by weight, and it would allow Amex-listed stocks to be 
included in indexes that are composed of less than 25 stocks. The 
Exchange believes that concerns that certain market participants would 
have an informational advantage when trading an option on an index that 
is composed of stocks that also trade on the same exchange have 
lessened considerably since index options were first developed, due in 
large part to the real-time electronic quotation and transaction 
information dissemination systems that now link today's securities 
markets. The Exchange also believes that there is less concern that an 
index value can be influenced by any one stock, given the preference 
for insuring that no one security represents a large portion of the 
value of an index.
    In order to further minimize these concerns, however, the Exchange 
is proposing certain restrictions on the trading of such index options. 
First, index option trading areas shall not be located on the 
Exchange's Equity Floor.8 Secondly, for index options traded on 
the Mezzanine where Amex-listed stocks comprise more than 10% of the 
value of the index, by weight, (1) those options shall not be traded in 
the portion of the Mezzanine that is visible from the Equity Floor, and 
(2) members will be prohibited from using hand signals to communicate 
between the Mezzanine and the Equity Floor.9
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    \8\Currently, all index options traded on the Exchange are 
physically traded on the Mezzanine, which abuts and overlooks the 
Exchange's equity trading floor. See Amendment No. 1, supra note 5.
    \9\Id.
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    Finally, if greater than 10% of the value of a narrow-based index 
is represented by Amex-traded stocks, the index options and each Amex-
listed component of the index must be treated as a ``paired 
security.''10 Treating the stocks and the narrow-based index 
options as paired securities invokes several additional safeguards 
designed to prevent the misuse of market information and market 
manipulation by Amex members. First, as discussed earlier, trading of 
the index option and the underlying securities must take place in 
physically separated trading rooms. Secondly, a registered options 
trader (``ROT'') who is also a registered equity trader or a registered 
equity market maker would be prohibited from executing a proprietary 
transaction in the index option if, during the preceding 60 minutes, he 
or she had been on the Equity Floor. Third, an Amex equity specialist 
in any of the stocks contained in the narrow-based index would be 
prohibited from acting as a specialist or ROT in the index options. 
Finally, odd-lot dealers in the Amex-traded stocks would be prohibited 
from being ROTs in the index option. These restrictions are an 
extension of the restrictions currently in place regarding paired 
securities of Amex-listed options on Amex-listed stocks.11
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    \1\0Telephone conversation between Claire McGrath, Managing 
Director and Special Counsel, Derivative Securities, Amex, and Brad 
Ritter, Attorney, Office of Market Supervision, Division of Market 
Regulation, Commission, on May 31, 1994. A paired security is 
defined as a security which is the subject of securities trading on 
the Amex as well as options trading. See Amex Rule 900(b) (38).
    \1\1See Securities Exchange Act Release No. 26147 (October 3, 
1988), 53 FR 39556 (October 7, 1988).
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    The Commission believes that the Amex proposal is consistent with 
the requirements of Section 6 of the Act, in general, and Section 
6(b)(5)12 in particular, in that it should help to remove 
impediments to and perfect the mechanism of a free and open market, 
promote just and equitable principles of trade and protect investors 
and the public interest. Specifically, the proposal will provide the 
Exchange with greater flexibility to construct new indexes which may 
offer additional means to investors of hedging exposure to market risk. 
The Commission believes that the proposal will allow this flexibility 
while at the same time minimizing the potential for abuse by ensuring 
that Amex traders will not be able to obtain unfair informational 
advantages as a result of increasing the representation of Amex-listed 
stocks as components of indexes on which index options trade on the 
Exchange. The Commission agrees with the Exchange that the real-time 
electronic dissemination of quotation and transaction information 
dissemination has improved in recent years in both stock and options 
markets. The Commission, however, still believes that floor traders and 
market makers, by virtue of their close proximity to the trading crowds 
and access to market information, may have a time and place advantage 
over other market participants.13 For the reasons stated below, 
however, the Commission believes that the restrictions contained in the 
Amex proposal adequately minimize any potential for misuse of 
information or market manipulation.
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    \1\215 U.S.C. Sec. 78f(b)(5) (1988).
    \1\3Specifically, floor traders in the crowd may be able to gain 
an insight into the future direction of a market on the basis of, 
among other things, the other traders in the crowd and their 
bidding/offering patterns. Likewise, market makers have an 
informational advantage about order flow and quote changes.
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    First, regardless of how an index is weighted or constructed, the 
Exchange is still required to submit all index option proposals to the 
Commission for approval.14 During this review process, the 
Commission will examine, among other things, whether the proposal is 
consistent with the protection of investors and the maintenance of fair 
and orderly markets. In reviewing Amex narrow-based index option 
proposals, the Commission will examine the number of Amex-listed stocks 
comprising each particular index. The Commission will only approve 
those indexes found not to be readily susceptible to manipulation.
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    \1\4Pursuant to the recently-approved generic standards for 
options on narrow-based indexes, the Exchange may submit proposals 
to list and trade options on indexes, which become effective upon 
filing. The Exchange, however, cannot begin trading options on the 
index until 30 days after the filing date. During this time period, 
the Commission will be able to review the index and consider any 
comments received on the proposal. If the Commission determines that 
an Amex proposal submitted pursuant to the generic standards is 
susceptible to manipulation because, for example, of the number of 
Amex-listed components in the Index, the Commission will have 60 
days from the filing date in which to abrogate the rule change. See 
Securities Exchange Act Release No. 34157 (June 3, 1994), 59 FR 
30062 (June 10, 1994).
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    Secondly, where Amex-listed stocks comprise more than 10% of the 
value of a particular index,15 (1) options on that index must be 
traded in a room physically separated from the Equity Floor, (2) if 
index options are traded on the Mezzanine, the trading area must be 
located so as to avoid direct sight lines with the Equity Floor, and 
(3) communication by means of hand signals between the mezzanine and 
the Equity Floor will be prohibited.16 The Commission believes 
that each of these restrictions will further serve to minimize the 
informational advantages that can be gained by Amex equity and options 
floor traders as a result of permitting the Amex to trade index options 
with Amex-listed stock components.
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    \1\5For indexes where Amex-listed stocks comprise less than 10% 
of the value of the index, changes in the prices of the Amex-listed 
stocks should not have a significant impact on the value of the 
index. As a result, the Commission believes that any informational 
advantage that might exist in these circumstances as a result of an 
Amex member being present on the Exchange floor will be deminimis. 
Nevertheless, the Amex will apply its existing surveillance 
procedures to all index options, which should deter as well as 
detect any potential manipulation.
    \1\6The Amex shall deliver written notice to its membership 
informing them of the prohibition against the use of hand signal 
communications.
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    Finally, the Commission believes that treating a narrow-based index 
and each Amex-listed component in the index as paired securities in 
those cases where the Amex-listed components comprise more than 10% of 
the index value, further minimizes any potential for manipulation. This 
requirement would establish the same restrictions that are currently in 
place regarding the trading of equity options on Amex-listed 
securities, to narrow-based index options with Amex-listed components 
representing over 10% of the value of the index. For example, a ROT who 
is also a registered equity trader would be prohibited from executing a 
proprietary trade in such an index option for 60 minutes after he or 
she had been on the Equity Floor.17 The Commission believes that 
these restrictions severely restrict the potential for the abuse of 
informational advantages by Amex traders thereby ensuring that any 
narrow-based index option constructed pursuant to the proposed rule 
change will, as with narrow-based index options currently traded on the 
Exchange, not be readily susceptible to manipulation. Accordingly, the 
Commission believes it is appropriate to extend these restrictions to 
Amex-listed stocks and options on narrow-based indexes containing those 
stocks in cases where the Amex-listed stocks account for more than 10% 
of the index.
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    \1\7See supra notes 10 and 11, and accompanying text.
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    The Commission also believes that the proposed change to the 
definition of ``stock index group'' is appropriate in light of changes 
in the securities market since that definition was adopted. 
Specifically, the Amex currently is trading, or has had approved for 
trading, options on equal dollar-weighted indexes, which do not fit 
within the current definition. The Commission believes the proposed 
change more accurately reflects the current index option products 
approved for trading and is sufficiently broad enough to allow further 
innovations in the methods for calculating and determining index 
values.\18\ Accordingly, the Commission believes the proposed rule 
change to Rule 900C is consistent with the Act.
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    \18\The Commission, however, will continue to examine any new 
weighting methods when reviewing new index option proposals pursuant 
to Section 19(b) of the Act.
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    Based on the foregoing, the Commission believes that the proposal 
will provide the Exchange with flexibility to construct new hedging 
vehicles for use by investors while sufficiently protecting investors 
by minimizing the susceptibility of these securities to manipulation. 
Accordingly, the Commission believes the proposed rule change, as 
amended, is consistent with the Act.
    The Commission finds good cause for approving Amendment No. 1 to 
the proposed rule change prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Specifically, Amendment No. 1 proposes certain restrictions on the 
trading of index options on narrow-based indexes comprised of Amex-
listed stocks accounting for more than 10% of the value of the index, 
by weight. For the reasons discussed above, the Commission believes 
these restrictions adequately minimize any potential for misuse of 
information or market manipulation. Accordingly, the Commission 
believes it is consistent with Section 6(b)(5) of the Act to approve 
Amendment No. 1 to the Amex's proposal on an accelerated basis.
    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 1 to the proposed rule change. 
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 change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Section, 450 Fifth Street, NW., Washington, DC. Copies of 
such filing will also be available for inspection and copying at the 
principal office of the above-mentioned self-regulatory organization. 
All submissions should refer to File No. SR-Amex-91-35 and should be 
submitted by August 9, 1994.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\19\ that the proposed rule change (SR-Amex-91-35), as amended, is 
approved.

    \19\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.\20\
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    \20\17 CFR 200.30-3(a)(12) (1993).
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[FR Doc. 94-17524 Filed 7-18-94; 8:45 am]
BILLING CODE 8010-01-M