[Federal Register Volume 59, Number 141 (Monday, July 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-18030]


[[Page Unknown]]

[Federal Register: July 25, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34405; File Nos. SR-CBOE-87-03; SR-PSE-87-21; SR-Phlx-
87-05]

 

Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Pacific Stock Exchange, Inc.; Philadelphia Stock Exchange, Inc.; 
Order Approving Proposed Rule Changes and Notice of Filing and Order 
Granting Accelerated Approval to Amendments to Proposed Rule Changes 
Relating to Market Index Option Escrow Receipts

July 19, 1994.

I. Introduction

    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'')\1\ and Rule 19b-4 thereunder,\2\ the Chicago Board Options 
Exchange, Inc. (``CBOE''), the Pacific Stock Exchange, Inc. (``PSE'') 
and the Philadelphia Stock Exchange, Inc. (``Phlx'')\3\ submitted to 
the Securities and Exchange Commission (``SEC'' or ``Commission'') 
proposed rule changes to permit, on a permanent basis, the use of cash, 
cash equivalents, one or more qualified equity securities, or a 
combination thereof, as collateral for market index option escrow 
receipts (``MIOERs'') issued to cover short call positions in broad-
based stock index options.\4\ On May 12, 1994, May 25, 1994 and July 5, 
1994, respectively, the CBOE, PSE and Phlx submitted to the Commission 
Amendment Nos. 1, 7 and 5 to the proposed rule changes in order to 
conform their proposals with recently approved amendments to the rules 
of the Options Clearing Corporation (``OCC'').\5\
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    \1\15 U.S.C. Sec. 78s(b)(1) (1982).
    \2\17 CFR 240.19b-4 (1990).
    \3\Hereinafter, the terms ``exchanges'' and ``self-regulatory 
organizations'' (``SROs'') refer to the CBOE, PSE and Phlx.
    \4\The Phlx also has proposed to allow the use of cash and cash 
equivalents as collateral for escrow receipts issued to cover short 
put positions in both broad-based stock index options and individual 
stock options.
    \5\See Securities Exchange Act Release No. 33549 (January 31, 
1994), 59 FR 5629 (February 7, 1994) (File No. SR-OCC-89-04) (``OCC 
approval order''). Amendments Nos. 1-6 to the PSE filing and 
Amendments Nos. 1-4 to the Phlx filing requested extensions of the 
pilot program and previously were approved by the Commission. See 
infra, note 12.
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    The proposed rule changes were noticed in Securities Exchange Act 
Release Nos. 24253 (March 24, 1987), 52 FR 10433 (April 1, 1987) (File 
No. SR-CBOE-87-03); 24708 (July 15, 1987), 52 FR 27604 (File No. SR-
PSE-87-21); and 24383 (April 23, 1987), 52 FR 15796 (April 30, 1987) 
(File No. SR-Phlx-87-05). No comments were received on the proposals. 
This order approves the proposed rule changes, including the most 
recent amendments on an accelerated basis.

II. Background

    For various reasons, such as state and federal regulations, many 
institutions may write call options only on a covered basis in a cash 
account.\6\ Many of these institutions, however, are legally restrained 
from having deposits of cash or securities at a brokerage firm. 
Accordingly, in lieu of such a deposit, a bank may issue to the broker 
an escrow receipt on behalf of their mutual customer, in order to meet 
the margin requirements for any short options the customer may have 
written.\7\
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    \6\In the context of a short call position, an options writer is 
covered if he owns the securities underlying the options he has 
written.
    \7\Pursuant to Regulation T of the Board of Governors of the 
Federal Reserve System (``Federal Reserve Board''), in a cash 
account, an escrow agreement may be used in lieu of margin for a 
short call option position if a bank hold the underlying security 
for the customer writing the option. See 12 CFR 220.8(a)(4)(i) 
(1990).
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    Because it is difficult to apply the traditional concept of 
``cover'' to broad-based, cash-settled index options,\8\ in 1984, the 
Commission approved SRO proposals to allow index options writers to 
enter into escrow agreements without requiring them to collateralize 
the agreements with all the securities underlying the index.\9\ The 
original MIOER program permitted the use of escrow receipts for short 
call positions if, among other things, a bank or trust company held for 
the customer a ``basket'' of at least ten qualified equity securities. 
Due to inadequate recordkeeping procedures, settlement delay and 
financial disincentives, many market participants found this program to 
be impracticable and uneconomic, particularly in comparison to similar 
products traded on commodities exchanges.\10\
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    \8\Existing options on broad-based stock indexes overlie from 20 
to over 2,000 securities. As a result, it can be impracticable for 
an index options writer to be ``covered'' by having appropriate 
positions in each component security. In addition, because index 
options are cash-settled, the securities underlying an index option 
are never delivered upon assignment.
    \9\See, e.g., Securities Exchange Act Release Nos. 20619 
(February 6, 1984), 49 FR 5221 (February 10, 1984) (File No. SR-
CBOE-83-31); and 21032 (June 8, 1984), 49 FR 24964 (June 18, 1984) 
(File No. SR-PSE-84-07). At that time, the staff of the Federal 
Reserve Board indicated that it believed a MIOER could be used as 
cover in a cash account. See letter from Laura Homer, Securities 
Credit Officer, Federal Reserve Board, to Richard G. Ketchum, 
Associate Director, SEC, Division of Market Regulation, dated 
January 27, 1984.
    \10\In addition, OCC, at that time, did not accept escrow 
receipts for index options margin. For further discussion of the 
original MIOER program and the problems encountered thereunder, see 
Securities Exchange Act Release No. 22323 (August 13, 1985), 50 FR 
33439 (August 19, 1985) (File Nos. SR-Amex-84-33; SR-CBOE-84-28; SR-
NYSE-84-35; SR-PSE-85-19; SR-Phlx-85-18-- (``pilot approval 
order'').
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    Accordingly, in 1985, the Commission approved, on a pilot basis, 
SRO proposals to change the type of property acceptable as an escrow 
deposit.\11\ These pilot programs subsequently have been extended eight 
times,\12\ in order to provide the exchanges and OCC with the 
opportunity to resolve certain matters concerning the format of the 
receipt and administration of the program.
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    \11\See pilot approval order, supra note 10. The Commission 
simultaneously approved the use by the clearing member of an escrow 
receipt form, in lieu of margin payments to OCC. See Securities 
Exchange Act Release No. 22324 (August 13, 1985), 50 FR 33443 
(August 18, 1985) (File No. SR-OCC-85-07)
    \12\See, e.g., Securities Exchange Act Release Nos. 23552 
(August 25, 1986), 51 FR 31183 (September 2, 1986) (File No. SR-
CBOE-86-26); 24246 (March 23, 1987), 52 FR 10432 (April 1, 1987) 
(File No. SR-CBOE-87-04); 24383 (April 23, 1987), 52 FR 15796 (April 
30, 1987) (File No. SR-Phlx-87-05); 24405 (April 29, 1987), 52 FR 
16969 (May 6, 1987) (File No. SR-PSE-87-10); 24708 (July 15, 1987), 
52 FR 27604 (July 22, 1987) (File No. SR-CBOE-87-29; SR-PSE-87-21; 
and SR-Phlx-87-22); 25242 (January 4, 1987), 53 FR 648 (January 11, 
1988) (File No. SR-CBOE-87-55); 25486 (March 18, 1988), 53 FR 9722 
(March 24, 1988) (File No. SR-Phlx-88-01 and SR-PSE-87-21); 25888 
(July 6, 1988), 53 FR 26457 (July 13, 1988) (File No. SR-CBOE-88-11; 
SR-PSE-87-21; and SR-Phlx-87-05); 26274 (November 10, 1988), 53 FR 
46522 (November 17, 1988) (File No. SR-CBOE-88-21; SR-PSE-87-21; and 
SR-Phlx-87-05); 27189 (August 28, 1989), 54 FR 37064 (September 6, 
1989) (File No. SR-CBOE-89-16; SR-PSE-87-21; and SR-Phlx-89-46); 
27657 (January 30, 1990), 55 FR 4295 (February 7, 1990) (File No. 
SR-CBOE-90-01; SR-PSE-87-21; and SR-Phlx-90-02).
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    Currently, a MIOER may be collateralized by cash, cash equivalents, 
one or more qualified equity securities, or a combination thereof. 
Pursuant to Regulation T, the term ``cash equivalents'' is defined to 
mean the market value of any of the following instruments with one year 
or less to maturity: (1) Securities issued or guaranteed by the United 
States or its agencies; (2) negotiable bank certificates of deposit; or 
(3) bankers acceptances issued by banking institutions in the United 
States and payable in the United States.\13\ An equity security (other 
than warrants, rights or options) is qualified to be used as collateral 
for MIOERs issued to cover short call positions if it is traded on a 
national securities exchange and substantially meets the listing 
requirements of the New York Stock Exchange (``NYSE'') or American 
Stock Exchange (``Amex'') or if it is enumerated on the current list of 
over-the-counter margin stocks published by the Federal Reserve Board.
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    \13\See 12 CFR 220.8(a)(3)(ii) (1990).
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    The current escrow receipt program requires that, at the time the 
option is written, the total value of the collateral underlying the 
MIOER must be at least equal to the aggregate initial position value 
(i.e., the index value at trade date times the applicable index 
multiplier times the number of options contracts covered by the 
collateral). Although the escrow deposit may include only one or even 
no securities, the customer must affirm that he is writing index 
options against a diversified portfolio. In addition, the issuing bank 
or trust company must be approved by OCC if the receipt is to be 
forwarded to OCC to meet the clearing member's margin obligations.\14\
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    \14\There are also certain financial, regulatory and depository 
standards for MIOER issuers. For further discussion of OCC's 
monitoring obligations, see OCC approval order, supra, note 5.
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    Thereafter, the terms of the MIOER\15\ specify that, if the value 
of the collateral falls below 55% of the current position value, the 
issuing bank or trust company promptly must notify the customer and 
request that the escrow deposit be supplemented. If the value of the 
collateral falls below 50% of the current position value, the bank or 
trust company promptly must notify OCC and the broker who, in turn, 
will disregard the MIOER and request that margin be deposited for the 
previously covered short position.
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    \15\Under the SROs' rules, escrow receipts must be in a form 
satisfactory to the exchange. Because the Commission has only 
reviewed the escrow receipt submitted by OCC, the Commission 
previously has indicated that approval of these proposals is limited 
to the use of escrow receipts containing terms and conditions 
substantively identical to those in the OCC escrow receipt.
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III. Description of the Proposals

    The exchanges' most recent amendments (Amendment Nos. 1, 7 and 5 to 
the CBOE, PSE and Phlx filings, respectively) propose to convert their 
MIOER programs\16\ from pilot to permanent status and to conform their 
rules with recently approved amendments to OCC's rules.\17\ Despite 
certain refinements, as discussed in more detail below, the current 
rules will, for the most part, continue to apply.
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    \16\See CBOE Rule 24.11(d); PSE Rule 7.16(d); and Phlx Rule 
722(c).
    \17\See OCC approval order, supra, note 5.
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    First, the SROs proposals will limit acceptable ``cash 
equivalents'' to securities issued or guaranteed by the United States 
and having one year or less to maturity (``short-term United States 
government securities''). As a result, securities issued or guaranteed 
by agencies of the United States, certificates of deposit and bankers 
acceptances will no longer be eligible as collateral for MIOERs issued 
to cover short call position.
    In addition, the definition of ``qualified equity securities'' will 
be amended to incorporate all exchange-traded securities, whether or 
not they meet NYSE or Amex listing standards. The proposals also will 
make certain editorial changes to the exchanges' rules regarding the 
use of over-the-counter securities to collateralize an escrow receipt, 
in order to conform that language with the phrasing used in OCC's 
rules.
    The exchanges believe that the proposed rule changes are consistent 
with Section 6 of the Act in general and, in particular, with Section 
6(b)(5), in that they are designed to prevent fraudulent and 
manipulative acts and practices, to foster cooperation and coordination 
with persons engaged in regulating, clearing, settling, processing 
information with respect to, and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, as well as to 
protect investors and the public interest by establishing a MIOER 
consistent with OCC rules and procedures.

IV. Discussion

    The Commission finds that the proposed rule changes are consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Section 6(b).\18\ In particular, 
the Commission believes the proposals are consistent with the Section 
6(b)(5) requirements that the rules of an exchange be designed to 
promote just and equitable principles of trade, prevent fraudulent and 
manipulative acts, and, in general, protect investors and the public 
interest.
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    \18\15 U.S.C. Sec. 78f(b) (1988).
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    After careful review of the operation of the pilot programs, the 
Commission has concluded that the revised MIOER should help provide a 
safe and efficient mechanism by which index call options can be written 
in a cash account. As set forth in more detail in its order approving 
the pilot procedures,\19\ the commission believes that the range of 
collateral permitted thereunder should provide market participants with 
greater flexibility, prevent settlement delays and eliminate many of 
the problems encountered under the original MIOER program. To the 
extent that the revised escrow receipt is a cost-effective means for 
institutions restricted to cash account transactions to manage 
portfolio risk, its implementation on a permanent basis should 
encourage broader participation in the index options market, thereby 
adding depth and liquidity to that market.
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    \19\See pilot approval order, supra, note 10.
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    Based on their experience with the pilot program, however, the 
SROs, along with OCC, have proposed certain minor refinements to the 
types of property acceptable as collateral for MIOERs issued to cover 
short call positions. As the Commission noted in regard to the recently 
approved OCC proposal,\20\ these new standards will ensure that only 
liquid assets are eligible to underlie escrow receipts. Specifically, 
the Commission believes that the proposed rule changes are a reasonable 
response to OCC's finding that certificates of deposit and bankers 
acceptances present an undue risk to OCC because it has no means of 
ensuring that issuers of such instruments are financially sound.\21\ 
Thus, the Commission agrees with the SROs that limiting ``cash 
equivalents'' to short-term United States government securities will 
enhance the integrity of escrowed collateral. Moreover, the changes to 
the definition of ``qualified equity security'' are consistent with the 
Federal Reserve Board's definition of ``margin security'' or existing 
OCC rules.
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    \20\See OCC approval order, supra, note 5.
    \21\In contrast to its monitoring of MIOER issuers, OCC receives 
no financial information on banks issuing certificates of deposit or 
bankers' acceptances. Because of the potential exposure if the 
issuer fails and the instruments become worthless, OCC proposed 
eliminating them as eligible types of collateral. See Securities 
Exchange Act Release No. 26951 (June 21, 1989), 54 FR 26870 (June 
26, 1989) (File No. SR-OCC-89-04). OCC also found that few customers 
utilize such instruments. Id.
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    Finally, the Commission has determined that the escrow receipt 
contains safeguards (e.g., minimum collateral levels; the requirement 
that issuing banks or trust companies notify customers and OCC of 
reductions in collateral\22\ that should help ensure the adequacy of 
the collateral posted and diminish the risks associated with MIOERs. To 
date, the SROs' experience with the pilot program supports the 
Commission's earlier conclusion that, absent extremely unusual 
circumstances, the value of the collateral should be greater than the 
cash difference between the current index value and the exercise price 
of the option (i.e., the amount that must be delivered upon 
assignment).\23\ The Commission therefore believes that implementation 
on a permanent basis is now appropriate.
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    \22\For further discussion of value requirements and incentives 
for the industry to police itself, see supra, notes 14-15 and 
accompanying text.
    \23\See pilot approval order, supra, note 10.
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    The Phlx proposal regarding the types of property acceptable as 
collateral for escrow receipts issued to cover short put positions\24\ 
is identical to existing rules in other options markets.\25\ The 
Commission finds that the Phlx proposal will provide sufficient 
investor protection while facilitating hedging transactions in both 
broad-based stock index options and individual stock options.
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    \24\See supra, note 4.
    \25\See, e.g., NYSE Rule 431(f)(2)(H)(iv).
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    The commission finds good cause for approving Amendment Nos. 1, 7 
and 5 to the CBOE, PSE and Phlx proposals, respectively, prior to the 
thirtieth day after the date of publication of notice of filing 
thereof. These amendments merely conform the exchanges proposals with 
recently approved amendments to OCC rules.\26\ Finally, the Commission 
did not receive any comments on either original CBOE, PSE and Phlx 
proposals or the comparable OCC proposal, both of which were noticed 
for he full statutory period.
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    \26\For further discussion of the substance of these amendments, 
see supra, notes 16-17 and accompanying text. See also OCC approval 
order, supra note 5.
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    Interested persons are invited to submit written data, views and 
arguments concerning the most recent amendments to the proposed rule 
changes. 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 rules changes that are filed with the Commission, and all 
written communications relating to these amendments between the 
Commission and any persons, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. Sec. 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 filings will also be available at the principal offices of the 
CBOE, PSE and Phlx. All submissions should refer to File Nos. SR-CBOE-
87-03; SR-PSE-87-21; and SR-Phlx-87-05 and should be submitted by 
August 15, 1994.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\27\ that the proposed rule changes permitting, on a permanent 
basis, the use of cash, cash equivalents, one or more qualified 
securities, or a combination of the foregoing, as collateral for escrow 
receipts issued to cover short call positions in broad-based stock 
index options, in lieu of margin (SR-CBOE-87-03; SR-PSE-87-21; and SR-
Phlx-87-05) hereby are approved.

    \27\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.\28\
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    \28\17 CFR 200.30-3(a)(12) (1990).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-18030 Filed 7-22-94; 8:45 am]
BILLING CODE 8010-01-M