[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Notices]
[Pages 46644-46651]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-22108]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36169; File No. SR-CBOE-94-34]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving Proposed Rule and Notice of Filing and Order 
Granting Accelerated Approval of Amendments No. 1, 2, 3, 4 and 5 to 
Proposed Rule Change Relating to the Establishment of Uniform Listing 
and Trading Guidelines for Stock Index, Currency and Currency Index 
Warrants

August 29, 1995.

I. Introduction

    On September 29, 1994, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to establish uniform rules for 
the listing and trading of broad-based stock index (``stock index'' or 
``index''), currency (``currency'') and currency index (``currency 
index'') warrants (collectively ``warrants''). Notice of the proposed 
rule change appeared in the Federal Register on January 9, 1995.\3\ One 
comment letter was received in response to the proposal.\4\

    \1\ 15 U.S.C. 78s(b)(1) (1988 & Supp. V 1993).
    \2\ 17 CFR 240.19b-4 (1994).
    \3\ Securities Exchange Act Release No. 35178 (Dec. 29, 1994), 
60 FR 2409.
    \4\ See Letter from Paul M. Gottlieb, Seward & Kissel, to 
Jonathan G. Katz, Secretary, Commission, dated January 10, 1995 
(``Comment Letter'' or ``Seward & Kissel Letter'').
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    The Exchange subsequently filed five Amendments to the proposal. 
Amendment No. 1 (``Amendment No. 1'') brought several of CBOE's 
proposed rules and policies into conformity with those previously filed 
by other markets.\5\ Amendment No. 2 (``Amendment No. 2'') imposes a 
reporting requirement for positions in currency and currency index 
warrants.\6\ Amendment No. 3 (``Amendment No. 3'') addresses issues 
relating to settlement methodology, surveillance of issuer hedge 
transactions, early exercise notification and reporting requirements 
for index warrants.\7\ Amendment No. 4 (``Amendment No. 4'') addresses 
surveillance issues related to the trading of index warrants.\8\ 
Amendment No. 5 clarifies the settlement procedures for index warrant 
which are exercised at or prior to expiration.\9\ This order approves 
the proposal, as amended.

    \5\ Letter from Janet Angstadt, Schiff Hardin & Waite, to 
Michael Walinskas, SEC, dated March 2, 1995.
    \6\ Letter from Timothy Thompson, CBOE, to Michael Walinskas, 
SEC, dated May 8, 1995.
    \7\ Letter from James R. McDaniel, Schiff Hardin & Waite, to 
Michael Walinskas, SEC, dated June 23, 1995.
    \8\ Letter from Janet Angstadt, Schiff Hardin & Waite, to 
Michael Walinskas, SEC, dated August 4, 1995.
    \9\ Letter from Janet Angstadt, Schiff Hardin & Waite, to 
Michael Walinskas, SEC, dated August 18, 1995.
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II. Description of the Proposal

    The CBOE proposes to establish uniform rules for the listing and 
trading of stock index, currency and currency index warrants.\10\ This 
filing incorporates the results of numerous communications with the 
Commission staff and other exchanges, including comments contained in a 
letter from Sharon Lawson to Joanne Moffic-Silver dated January 28, 
1993 (``Lawson letter''). This filing also makes certain changes in the 
listing criteria for stock index and currency warrants and makes clear 
that certain rules applicable to currency warrants would apply equally 
to currency index warrants.

    \10\ The proposed rules would apply to both American-style 
warrants (which may be exercised at any time prior to expiration) 
and European-style warrants (which may be exercised only during a 
specified period before expiration).
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Exercise and Position Limits

    The Exchange is proposing position limits for stock index warrants 
that, in general, are approximately 75%, in terms of underlying dollar 
value, of the current position limits for index options. Accordingly, 
proposed Rule 30.35(a) provides that position limits for stock index 
warrants on the same index with original issue prices of ten dollars or 
less will be fifteen million warrants covering all such issues.\11\ In 
addition, with respect to warrants on the Russell 2000 Index, the 
position limit will be twelve and one half million warrants covering 
all such issues, provided the original issue prices of the warrants are 
not greater than ten dollars. The rule provides that warrants with an 
original issue price of greater than ten dollars will be weighted more 
heavily than warrants with an original issue price of ten dollars or 
less in calculating position limits.\12\

    \11\ See infra note 47.
    \12\ For example, if an investor held 100,000 warrants based 
upon the Standard & Poor's 500 Index offered originally at $20 per 
warrant, the size of this position for the purpose of calculating 
position limits would be 200,000.
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    Proposed Rule 30.35(d) also gives the Exchange the authority to 
require the liquidation of a position in stock index warrants that is 
in excess of the position limits set forth in the rule.\13\

    \13\ Proposed Rule 30.35(d) makes Rule 4.14 (Liquidation of 
Positions) applicable to index warrants.
    Proposed Rule 30.35(b) also establishes exercise limits on stock 
index warrants which are analogous to those found in stock index 
options. The rule prohibits holders from exercising, within any five 
consecutive business days, long positions in warrants in excess of the 
base position limit established in Rule 30.35(a).
    In order to facilitate its review of compliance with position and 
exercise limits, proposed rule 30.35(d) establishes reporting 
requirements for large warrant positions. Under the terms of the Rule, 
members will be required to file a report with the Exchange whenever 
any account in which the member has an interest has established an 
aggregate position of 100,000 warrants overlying the same index, 
currency or currency index.\14\ For 

[[Page 46645]]
purposes of this rule, the Exchange proposes that positions on the same 
side of the market be aggregated together (e.g., long positions in puts 
be combined with short positions in call warrants, and short positions 
in puts be combined with long positions in call warrants).\15\

    \14\ See Amendment No. 2. In the original filing, the CBOE 
proposed establishing a reportable limit for stock index warrants at 
20,000 warrants. Amendment No. 2 extended the reporting requirement 
to currency and currency index warrants at a level of 100,000 
warrants (on the same side of the market). Finally, Amendment No. 3 
proposed raising the reporting requirement for stock index warrants 
from 20,000 to 100,000 warrants (on the same side of the market).
    \15\ See Amendment Nos. 2 and 3.
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Margin

    The Exchange's proposed margin requirements for customers having 
positions in index warrants, currency index warrants and currency 
warrants are included in proposed new Rule 30.52. In general, the 
proposed margin requirements for long and short positions in stock 
index warrants are the same as margin requirements for positions in 
stock index options and the margin requirements for long and short 
positions in currency warrants are the same as those for corresponding 
currency options. Thus, all purchases of warrants will require payment 
in full, and short sales of stock index warrants will require initial 
margin of: (i) 100 percent of the current value of the warrant plus 
(ii) 15 percent of the current value of the underlying broad stock 
index less the amount by which the warrant is out of the money, but 
with a minimum of ten percent of the index value. Short sales of 
currency warrants will follow the margin requirements currently 
applicable to listed currency options. Specifically, the Exchange 
proposes that short sales of warrants on the German Mark, French Franc, 
Swiss Franc, Japanese Yen, British Pound, Australian Dollar and 
European Currency Unit shall each be subject to margin level of 100% of 
the current market value of each such warrant plus a four percent 
``add-on.'' \16\ The margin required on currency index warrants would 
be an amount as determined by the Exchange and approved by the 
Commission.\17\ The Exchange also proposes that its stock index, 
currency and currency index warrant margin requirements be permitted 
offset treatment for spread and straddle positions. In this regard, the 
Exchange proposes that index, currency and currency index warrants may 
be offset with either warrants or Options Clearing Corporation 
(``OCC'') issued options on the same index, currency or currency index, 
respectively. Furthermore, the Exchange has proposed that Rules 
30.35(d)(i), (ii) and (iii), to the extent that such rules concern 
spread and straddle positions in warrants, be subject to a one year 
pilot basis.\18\ Finally, proposed Rule 30.53(d)(iv) will permit the 
use of escrow receipts to cover a short position in a broad-based stock 
index warrant.\19\

    \16\ See Amendment No. 3. Consistent with the treatment of 
options on foreign currencies, warrants on the Canadian Dollar will 
be subject to a one percent ``add-on.'' The margin required on any 
other foreign currency would be subject to approval by the 
Commission. See infra note 34.
    \17\ See infra note 17.
    \18\ Three months prior to the expiration of the pilot program, 
the Exchange will submit a report to SEC staff analyzing the price 
relationship between listed warrants and options on similar stock 
indexes. See Amendment No. 1. The Exchange has also requested no-
action relief from the Commission in order to permit certain short 
positions in stock index call and put warrants to be treated as 
covered for margin purposes.
    \19\ See Amendment No. 1. The Exchange notes that this treatment 
is consistent with the rules that allow for the use of escrow 
receipts to cover a short call position in broad-based stock index 
options.
    CBOE believes that a broker-dealer carrying positions in warrants 
must bear in mind that special characteristics of warrants--such as 
pricing differences, the necessity of borrowing to make delivery on 
short sales, and the issuer credit risk associated with long warrants--
may cause these margin requirements to be insufficient to fully cover 
the risk of such positions in certain circumstances, and broker-dealers 
must therefore be prepared to call for additional margin when 
appropriate. CBOE further believes that each exchange listing stock 
index, currency index or currency warrants should draw the attention of 
its member firms to this issue in connection with the adoption of these 
margin rules.
    In accordance with the Lawson letter, the proposed rules would be 
applicable only to warrants issued after the effective date of this 
filing. Warrants issued prior to that date would remain subject to the 
rules in effect at the time of their listing.

Customer Protection

    Modifications are proposed to Exchange Rule 30.50, Doing Business 
With the Public, to incorporate references to proposed new Rule 30.52. 
Proposed Rule 30.52(c) states that no member or member organization 
shall accept an order from a customer for the purchase or sale of 
warrants unless the customer's account has been approved for options 
trading pursuant to Exchange Rule 9.7. Accordingly, the Exchange will 
rescind Interpretation .02 to Rule 30.52, its current suitability 
standard applicable to warrants, which currently provides that the 
Exchange ``recommends'' that index and currency warrants only be sold 
to investors whose accounts have been approved for options trading. 
Appendix A to Chapter XXX, which is a cross-reference table to other 
rules of the Exchange that are applicable to securities otherwise 
covered in Chapter XXX, is being updated to reflect the applicability 
of certain options rules (i.e., customer protection rules including, 
but not limited to, account supervision, suitability, etc.) to 
warrants:

Rule 4.13  Reports Related to Position Limits
Rule 4.14  Liquidation of Positions
Rule 9.2  Registration of Options Principals
Rule 9.6  Registration of Branch Offices
Rule 9.7  Account Approval Requirements
Rule 9.8  Supervision Requirements
Rule 9.9  Suitability Requirements
Rule 9.10  Discretionary Account Requirements
Rule 9.21  Requirements for Customer Communications
Rule 9.23  Record-keeping Requirements for Customer Complaints

Listing Criteria

    The listing criteria for stock index warrants and currency warrants 
are being amended to reflect the comments contained in the Lawson 
letter and to make clear that they apply to currency index warrants. In 
particular, proposed Rule 31.5(E) (1) and (4) provide that issuers are 
required to have a minimum tangible net worth in excess of $250 million 
or, in the alternative, have a minimum tangible net worth in excess of 
$150 million, provided that the issuer does not have (including as a 
result of the proposed issuance) issued outstanding warrants where the 
aggregate original issue price of all such warrant offerings (combined 
with offerings by its affiliates) listed on a national securities 
exchange or that are National Market securities traded through NASDAQ 
exceeds 25% of the issuer's net worth.\20\

    \20\ See Amendments No. 1 and 3. The Exchange amended this 
provision in response to the Seward & Kissell Letter.
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    Second, proposed Rule 31.5(E)(6) requires that unexercised in-the-
money warrants be automatically exercised on either the delisting date 
(if the issue is not listed upon another organized securities market) 
or upon expiration. Third, proposed Rule 31.5(E)(5) provides that for 
warrant offerings where U.S. stocks constitute 25% or more of the index 
value (``domestic index''), issuers shall use opening prices (``a.m. 
settlement'') for U.S. stocks to determine index warrant settlement 
values on the final determination of settlement value date (``valuation 
date'') as well as during the two business days 

[[Page 46646]]
prior to valuation date.\21\ Fourth, Rule 31.5(E)(7) has been amended 
to provide that foreign country securities or American Depositary 
Receipts (``ADRs'') thereon that are not subject to a comprehensive 
surveillance sharing agreement with the Exchange and that have less 
than 50% of their global trading volume (in dollar value) within the 
U.S., shall not represent more than 20% of the weight of the index.\22\ 
Finally, the Exchange proposes to add Rule 31.5(E)(8) in order to 
assist in the surveillance of index warrant trading. Specifically, the 
Exchange will require issuers of stock index warrants to notify the 
Exchange of any early exercises by no later than 3:30 p.m. (Chicago 
time) on the day that the settlement value for the warrants is 
determined.\23\

    \21\ See Amendment No. 5. The Exchange amended its proposal in 
response to the Seward & Kissell Letter and notes that a warrant 
based upon a domestic U.S. stock index may be settled using closing 
prices (``p.m. settlement'') for the underlying stocks at all times 
except for the warrants valuation day and the two business days 
immediately preceding valuation date.
    \22\ See Amendment No. 1.
    \23\ See Amendment No. 3.
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Trading Halts or Suspensions

    Proposed new Rule 30.36 makes the provisions in Rule 24.7 
concerning trading halts or suspensions in stock index options 
applicable to stock index warrants.

Specific Warrant Issues

    Upon Commission approval of the foregoing rule amendments, the 
Exchange proposes that it will only file rule changes for specific 
stock index warrant issuances where there is no corresponding option or 
warrant on the same underlying stock index already listed on a national 
securities exchange or included for quotation on NASDAQ. Accordingly, 
when a listed option overlies a particular broad based index, the 
Exchange proposes it be allowed to list warrants on that index without 
further Commission review and approval pursuant to Section 19(b) of the 
Act as long as the listing complies with the warrant listing standards 
as approved in this Order.\24\ Finally, prior to trading stock index or 
currency warrants, the Exchange will distribute circulars to its 
membership providing guidance regarding member firm compliance 
responsibilities (including suitability recommendations) when handling 
transactions in warrants.

    \24\ See infra note 34.
III. Comments Received

    The Commission received one letter in response to its request for 
comments on the CBOE proposal.\25\ The Comment Letter was generally 
supportive of the CBOE's proposal, however, it recommended several 
changes in the proposed regulatory structure applicable to stock index, 
currency and currency index warrants. The Comment Letter was submitted 
on behalf of the Firms, all of whom are represented to be major 
participants in the issuance, underwriting and trading of warrants. 
Because the proposed regulatory regime applicable to warrants will, to 
some extent, be based upon the rules governing standardized options, 
the Comment Letter states that the Firms' comments are driven, in part, 
by the fact that fundamental differences exist between warrants and 
standardized options which necessitate disparate regulatory treatment 
in certain situations.\26\

    \25\ See supra note 4. The Seward & Kissel Letter was submitted 
on behalf of PainWebber Inc., Bear, Stearns & Co. Inc., Lehman 
Brothers Inc., Smith Barney Inc., Salomon Brothers Inc., Morgan 
Stanley & Co. Inc., and Hambrecht & Quist Inc. (collectively the 
``Firms'').
    \26\ The Comment Letter lists several differences which it 
perceives exist between warrants and standardized options. Chief 
among these are: (1) warrants are separately registered, unsecured 
obligations of their issuer while options are issued and guaranteed 
by the Options Clearing Corp. (``OCC''); (2) during the prospectus 
delivery period, warrant purchasers receive a product-specific 
prospectus while options customers receive an options disclosure 
document (``ODD'') at the time the account is opened; (3) each 
warrant creates a fixed number of outstanding warrants while there 
is theoretically no limit to the number of options that may be 
issued by OCC; and (4) warrants are traded on an exchange in a 
manner similar to stocks which, therefore, translates into superior 
price transparency than for listed options.
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    First, the Comment Letter suggested amending the issuer Listing 
Standards to eliminate the 25% test or, in the alternative, to adopt 
hedging and/or netting standards designed to more accurately reflect 
issuer-specific risk.\27\ Because warrants are sold by means of a 
registration statement, the Firms believe that adequate disclosure of 
the amount of an issuer's outstanding securities could be included in 
the prospectus. Furthermore, the Comment Letter points out that issuers 
of warrants are traditionally subject to outside evaluation by certain 
credit rating agencies, which should assist investors in determining 
undue issuer credit risk. Finally, the Firms do not believe the 25% 
test bears any resemblance to an issuer's risk exposure since exposure 
fluctuates with market changes at any given time and also because the 
proposal provides no recognition for offsetting hedges or for warrants 
subject to netting.

    \27\ As originally proposed, an issuer would have been required 
to have a tangible net worth of at least $150 million and the 
aggregate original issue price of all of a particular issuer's 
warrant offerings (combined with such offerings by its affiliates) 
that are listed on a national securities exchange or that are 
national market securities traded through NASDAQ was not to exceed 
25% of the issuer's net worth (``25% test).
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    In response to the Seward & Kissel Letters's comments respecting 
issuer listings standards, the CBOE amended the filing to add an 
alternative issuer qualification criteria.\28\ Under the new criteria, 
an issuer will be required to either: (a) have a minimum tangible net 
worth of $250 million; or (b) meet the existing criteria (i.e., 
tangible net worth of $150 million and meet the 25% test).

    \28\ See Amendment No. 1.
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    The Comment Letter also recommended allowing the use of p.m. 
settlement for all American-style warrants exercised anytime except 48 
hours prior to expiration, at which time a.m. settlement would be 
required. According to the Comment Letter, unlike with listed options 
(where OCC is the issuer and runs a balanced book), a warrant issuer 
must hedge its exposure to maintain offsetting positions. Upon early 
exercise of the warrants, the issuer that has hedged its exposure will 
have to take action to ``unwind'' the portion of its hedge relating to 
the exercised warrants. The Firms believe that requiring a.m. 
settlement on the first day after an investor exercises the warrant 
will place additional market risk upon them due to the difficulty in 
managing the hedge. This increased hedging cost, the Firm's argue, 
could result in a higher issuance price for the warrant or could 
require that the warrant settlement value date be postponed an 
additional day, with warrant holders bearing additional market risk 
during this period.
    In response to the Comment Letter, the CBOE amended its filing to 
include a provision permitting p.m. settlement for stock index warrants 
except for a short period before expiration.\29\ Under the terms of the 
amendment, stock index warrants for which 25% or more of the value of 
the underlying index is represented by securities that are traded 
primarily in the U.S. shall, by their terms, provide that, on valuation 
date, as well as for the two business days prior to valuation date, the 
value of the stocks traded primarily in the U.S. which underlie such 
warrants shall be determined by reference to the opening prices of such 
underlying U.S. securities. For example, if the valuation date for an 
issuance of index warrants occurs on a Friday, a.m. settlement must be 
utilized for warrants that are valued on the preceding Wednesday or 

[[Page 46647]]
Thursday, as well as on the valuation date.

    \29\ See Amendments No. 3 and 5.
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    Third, the Comment Letter recommended creating a special category 
of ``warrant eligible'' customers (separate and distinct from options 
eligibility criteria), who are authorized to trade warrants even if not 
approved to trade options. The Firms believe it is inappropriate to 
apply an options regulatory regime to warrants and that doing so may 
prevent institutional customers who are not permitted to purchase 
options products, yet who nevertheless meet all of the options 
eligibility criteria, from purchasing warrants. In this regard, the 
Firms propose to create a ``warrant eligible'' category with standards 
mimicking those currently required for options approved accounts. As 
such, ``warrant-approved'' accounts could purchase warrants, however, 
they could not purchase options or other products requiring options 
account approval. The CBOE did not amend its filing in response to this 
comment.
    Fourth, the Comment Letter urges the adoption of a rule permitting 
firms to approve for warrant trading those accounts managed by an 
investment adviser (``IA'') based upon the IA's representation 
concerning the eligibility status of its customers to engage in warrant 
trading, even if the underlying documentation relating to the managed 
accounts is not provided to the brokerage firms. The CBOE has amended 
its proposal to allow member firms to accept the representation of an 
investment adviser registered under the Investment Advisers Act of 1940 
concerning the eligibility status of its customers to engage in warrant 
trading, even if the underlying documentation relating to the managed 
account is not provided to the member firm, where the managed account 
is for an institutional customer or the investment advisor account 
represents the collective investment of a number of persons. The CBOE 
states that this will conform the handling of warrant accounts to the 
current practice with respect to listed options accounts.\30\

    \30\ See Amendment No. 1.
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    Finally, the Comment Letter addressed the proposed position limits 
applicable to warrants. Specifically, the Comment Letter noted that 
position limits for warrants would be set at levels that are 
approximately 75% of that allowed for similar broad-based indexes. The 
Comment Letter recommended establishing position limits for warrants 
that were equivalent to those established for listed options, allowing 
a hedge exemption similar to listed option procedures and providing a 
mechanism for specific waivers or exemptions of warrant position limits 
for hedgers, market-makers and broker-dealers comparable to the 
procedures in place for listed options. The CBOE did not amend its 
filing in response to this comment.

IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of Section 6(b)(5).\31\ Specifically, the 
Commission finds that the Exchange's proposal to establish uniform 
listing standards for broad-based stock index, currency and currency 
index warrants strikes a reasonable balance between the Commission's 
mandates under Section 6(b)(5) to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, while 
protecting investors and the public interest. In addition, the CBOE's 
proposed listing standards for warrants are consistent with the Section 
6(b)(5) requirements that rules of an exchange be designed to prevent 
fraudulent and manipulative acts, to promote just and equitable 
principles of trade, and are not designed to permit unfair 
discrimination among issuers.

    \31\ 15 U.S.C. 78f(b)(5) (1982).
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    The CBOE's proposed generic listing standards for broad-based stock 
index warrants, currency and currency indexes set forth a regulatory 
framework for the listing of such products.\32\ Generally, listing 
standards serve as a means for an exchange to screen issuers and to 
provide listed status only to bona fide issuances that will have 
sufficient public float, investor base, and trading interest to ensure 
that the market has the depth and liquidity necessary to maintain fair 
and orderly markets. Adequate standards are especially important for 
warrant issuances given the leverage and contingent liability they 
represent. Once a security has been approved for initial listing, 
maintenance criteria allow an exchange to monitor the status and 
trading characteristics of that issue to ensure that it continues to 
meet the exchange's standards for market depth and liquidity so that 
fair and orderly markets can be maintained.

    \32\ The Commission notes that warrants issued prior to this 
approval order will continue to be governed by the rules applicable 
to them at the time of their listing.
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    In reviewing listing standards for derivative-based products, the 
Commission also must ensure that the regulatory requirements provide 
for adequate trading rules, sales practice requirements, margin 
requirements, position and exercise limits and surveillance procedures. 
These rules minimize the potential for manipulation and help to ensure 
that derivatively-priced products will not have a negative market 
impact. In addition, these standards should address the special risks 
to consumers arising from the derivative products.\33\ For the reasons 
discussed below, the Commission believes the CBOE's proposal will 
provide it with significant flexibility to list index, currency and 
currency index warrants, without compromising the effectiveness of the 
Exchange's listing standards or regulatory program for such 
products.\34\

    \33\ Pursuant to Section 6(b)(5) of the Act, the Commission is 
required to find, among other things, that trading in warrants will 
serve to protect investors and contribute to the maintenance of fair 
and orderly markets. In this regard, the Commission must predicate 
approval of any new derivative product upon a finding that the 
introduction of such derivative instrument is in the public 
interest. Such a finding would be difficult for a derivative 
instrument that served no hedging or other economic function, 
because any benefits that might be derived by market participants 
likely would be outweighed by the potential for manipulation, 
diminished public confidence in the integrity of the markets, and 
other valid regulatory concerns. As discussed below, the Commission 
believes warrants will serve an economic purpose by providing an 
alternative product that will allow investors to participate in the 
price movements of the underlying securities in addition to allowing 
investors holding positions in some or all of such securities to 
hedge the risk associated with their portfolios.
    \34\ Issuances of warrants overlying a single currency may 
currently be listed for trading without a rule filing provided that 
the underlying currency is one of the original seven foreign 
currencies approved for options trading: the Australian Dollar, 
British Pound, Canadian Dollar, French Franc, German Mark, Japanese 
Yen, Swiss Franc and the European Currency Unit. Issuances of 
currency warrants overlying any other foreign currency would require 
a rule filing pursuant to Section 19(b) of the Act. The Commission 
notes that currency index warrants may only be established without a 
further rule filing upon an index that has been previously approved 
by the Commission pursuant to a Section 19(b) filing. To date, the 
only currency index approved pursuant to Section 19(b) is an equal-
weighted index comprised of the British Pound, Japanese Yen and 
German Deutsche Mark. See Securities Exchange Act Release No. 31627 
(Dec. 21, 1992), 57 FR 62399 (Dec. 30, 1992). Accordingly, any other 
currency index (as well as a broad-based stock index) not previously 
approved by the Commission would require approval pursuant to 
Section 19(b).
A. Issuer Listing Standards and Product Design

    As a general matter, the Commission believes that the trading of 
warrants on a stock index, currency or currency index permits investors 
to participate in the price movements of the underlying assets, and 
allows investors holding positions in some or all of such assets 

[[Page 46648]]
to hedge the risks associated with their portfolios. The commission 
further believes that trading warrants on a stock index, currency or 
currency index provides investors with an important trading and hedging 
mechanism that is designed to reflect accurately the overall movement 
of the component securities.
    Warrants, unlike standardized options, however, do not have a 
clearinghouse guarantee but are instead dependent upon the individual 
credit of the issuer. This heightens the possibility that an exerciser 
of warrants may not be able to receive full cash settlement upon 
exercise. This additional credit risk, to some extent, is reduced by 
the Exchange's issuer listing standards that require an issuer to have 
either; (a) a minimum tangible net worth of $250 million; or (b) a 
minimum tangible net worth of $150 million, provided that the issuer 
does not have (including as a result of the proposed issuance) issued 
outstanding warrants where the aggregate original issue price of all 
such stock index, currency or currency index warrant offerings (or 
affiliates) that are listed on a national securities exchange or traded 
through the facilities of NASDAQ is in excess of 25% of the warrant 
issuer's net worth. Furthermore, financial information regarding the 
issuers of warrants will be disclosed or incorporated in the prospectus 
accompanying the offering of the warrants. Moreover, the alternative 
test addresses the Comment Letter's concerns on the 25% standard.
    The CBOE's proposal will provide issuers flexibility by allowing 
them to utilize either a.m. or p.m. settlement, provided, however, 
domestic index warrants (i.e., warrants based on indexes for which 25% 
or more of the index value is represented by securities traded 
primarily in the U.S.) (``domestic index warrants'') are required to 
utilize a.m. settlement for warrants on valuation date as well as 
during the last two business days prior to valuation date.\35\ The 
Commission continues to believe that a.m. settlement significantly 
improves the ability of the market to alleviate and accommodate large 
and potentially destabilizing order imbalances associated with the 
unwinding of index-related positions. Nevertheless, in accordance with 
the Comment Letter's suggestions, the use of p.m. settlement except 
during the last two business days prior to a domestic index warrant's 
valuation date, as well as the valuation date, strikes a reasonable 
balance between ameliorating the price effects associated with 
expirations of derivative index products and providing issuers with 
flexibility in designing their products.\36\ In this context, the 
Commission notes that unlike standardized index options whose 
settlement times are relatively uniform, index warrants are issuer-
based products, whose terms are individually set by the issuer. In 
addition, while options may have unlimited open interest, the number of 
warrants on a given index is fixed at the time of issuance. 
Accordingly, it is not certain that there will be a significant number 
of warrants in indexes with similar components expiring on the same 
day. This may reduce the pressure from liquidation of warrant hedges at 
settlement. Nevertheless, the Commission expects the Exchange to 
monitor this issue and, should significant market effects occur as a 
result of early exercises from p.m. settled index warrants, would 
expect it to make appropriate changes including potentially limiting 
the number of index warrants with p.m. settlement.

    \35\ Currency and currency index warrants are not limited to 
a.m. or p.m. settlement.
    \36\ Foreign stock market based index warrants may utilize p.m. 
settlement throughout their duration.
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B. Customer Protection

    Due to their derivative and leveraged nature, and the fact that 
they are a wasting asset, many of the risks of trading in warrants are 
similar to the risks of trading standardized options. Accordingly, the 
CBOE has proposed to apply its options customer protection rules to 
warrants. In particular, the Commission notes that warrants may only be 
sold to options approved accounts capable of evaluating and bearing the 
risks associated with trading in these instruments, in accordance with 
CBOE Rule 9.7, and that adequate disclosure of the risks of these 
products must be made to investors.\37\ In addition, the CBOE will 
apply the options rules for suitability, discretionary accounts, 
supervision of accounts and customer complaints to transactions in 
warrants. By imposing the special suitability and disclosure 
requirements noted above, the Commission believes the CBOE has 
addressed adequately several of the potential customer protection 
concerns that could arise from the options-like nature of warrants.

    \37\ Pursuant to CBOE Rule 9.7, all options approved accounts 
must receive an ODD, which discusses the characteristic and risks of 
standardized options.
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    The ODD, which all options approved accounts must receive, 
generally explains the characteristics and risks of standardized 
options products. Although many of the risks to the holder of an index 
warrant and option are substantially similar, however, because warrants 
are issuer-based products, some of the risks, such as the lack of a 
clearinghouse guarantee and certain terms for index warrants, are 
different. The CBOE has adequately addressed this issue by proposing to 
distribute a circular to its members that will call attention to the 
specific risks associated with stock index, currency and currency index 
warrants that should be highlighted to potential investors. In 
addition, the issuer listing guidelines described above will ensure 
that only substantial companies capable of meeting their warrant 
obligations will be eligible to issue warrants. These requirements will 
help to address, to a certain extent, the lack of a clearinghouse 
guarantee for index warrants. Finally, warrant purchasers will receive 
a prospectus during the prospectus delivery period. The Commission 
believes that this will ensure that certain information about the 
particular issuance and issuer is publicly available.
    As noted above, the Comment Letter indicates that applying the 
options disclosure framework to warrants is inappropriate. However, the 
Commission believes that the combined approach of making available 
general derivative product information (the ODD), product specific 
information (the Exchange circular), and issuer specific information 
(the prospectus) should provide an effective disclosure mechanism for 
these products.
    At this time, the Commission does not agree with the proposal 
contained in the Comment Letter to create a special ``warrant 
eligible'' classification of purchasers. As noted above, index, 
currency and currency index warrants are very similar to standardized 
options. They are so similar that a customer precluded from trading 
options should not avoid the restriction indirectly by being designated 
by Exchange rules as eligible for stock index, currency or currency 
index warrants. Nevertheless, as the range of exchange-traded 
derivative products increases, the SROs might consider in the future as 
to whether a new derivatives eligibility classification is appropriate.

C. Surveillance

    In evaluating proposed rule changes to list derivative instruments, 
the Commission considers the degree to which the market listing the 
derivative product has the ability to conduct adequate surveillance. In 
this regard the Commission notes that the Exchange has developed 
adequate surveillance procedures for the trading of index and currency 
warrants. First, new issues of 

[[Page 46649]]
currency warrants will be subject to the CBOE's existing surveillance 
procedures applicable to foreign currency warrants, which the 
Commission previously has found to be adequate to surveil for 
manipulation and other abuses involving the warrant market and the 
underlying foreign currencies.\38\

    \38\ See Securities Exchange Act Release No. 24555 (June 5, 
1987), 52 FR 22570 (June 12, 1987), and Securities Exchange Act 
Release No. 26152 (Oct. 3, 1988), 53 FR 39832 (Oct. 12, 1988). The 
Commission notes that these surveillance procedures only apply to 
the issuance of warrants overlying one of the approved foreign 
currencies. See supra note 34. The issuance of warrants upon any 
other foreign currency would necessitate a Section 19(b) rule filing 
which, among other things, details applicable surveillance 
procedures.
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    Second, the Exchange has developed enhanced surveillance procedures 
to apply to domestic stock index warrants which the Commission believes 
are adequate to surveil for manipulation and other abuses involving the 
warrant market and component securities.\39\ Among these enhanced 
surveillance procedures, the Commission notes that issuers will be 
required to report to the Exchange on settlement date the number and 
value of domestic index warrants subject to early exercise the previous 
day. The Commission believes that this information will aid the CBOE in 
its surveillance capacity and help it to detect and deter market 
manipulation and other trading abuses.

    \39\ In addition, the Commission notes that issuers will be 
required to report to the Exchange all trades to unwind a warrant 
hedge that are effected as a result of the early exercise of 
domestic index warrants. This will enable the Exchange to monitor 
the unwinding activity to determine if it was effected in a manner 
that violates Exchange or Commission rules.
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    Third, the Exchange had developed adequate surveillance procedures 
to apply to foreign stock index warrants (i.e., less than 25% of the 
index value is derived from stocks traded primarily in the U.S.).\40\ 
The Commission believes that the ability to obtain information 
regarding trading in the stocks underlying an index warrant is 
important to detect and deter market manipulation and other trading 
abuses. Accordingly, the Commission generally requires that there be a 
surveillance sharing agreement \41\ in place between an exchange 
listing or trading a derivative product and the exchange(s) trading the 
stocks underlying the derivative contract that specifically enables the 
relevant markets to surveil trading in the derivative product and its 
underlying stocks.\42\ Such agreements provide a necessary deterrent to 
manipulation because they facilitate the availability of information 
needed to fully investigate a potential manipulation if it were to 
occur.\43\ In this regard, the CBOE will require that no more than 20% 
of an Index's weight may be comprised (upon issuance and thereafter) of 
foreign securities (or ADRs thereon) that do not satisfy one of the 
following tests: (1) The Exchange has in place an effective 
surveillance agreement \44\ with the primary exchange in the home 
country in which the security underlying the ADR is traded; or (2) 
meets an existing alternative standard available for standardized 
options trading (e.g., satisfy the 50% U.S. trading volume test).\45\ 
The Commission believes that this standard will ensure that index 
warrants are not listed upon foreign indexes whose underlying 
securities trade on exchanges with whom the CBOE has no surveillance 
sharing agreement.

    \40\ Each prior issuance of a foreign stock market-based index 
warrant is subject to specific surveillance procedures. These 
procedures are generally tailored to the individual warrant issuance 
and are based upon several factors involving the primary foreign 
market, including the existence of surveillance or information 
sharing agreements.
    \41\ The Commission believes that a surveillance sharing 
agreement should provide the parties with the ability to obtain 
information necessary to detect and deter market manipulation and 
other trading abuses. Consequently, the Commission generally 
requires that a surveillance sharing agreement require that the 
parties to the agreement provide each other, upon request, 
information about market trading activity, clearing activity, and 
the identity of the ultimate purchasers for securities. See e.g., 
Securities Exchange Act Release No. 31529 (Nov. 27, 1992).
    \42\ The ability to obtain relevant surveillance information, 
including, among other things, the identity of the ultimate 
purchasers and sellers of securities, is an essential and necessary 
component of a comprehensive surveillance sharing agreement.
    \43\ In the context of domestic index warrants, the Commission 
notes that the U.S. exchanges are members of the Intermarket 
Surveillance Group (``ISG''), which was formed to, among other 
things, coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets. 
See Intermarket Surveillance Group Agreement, July 14, 1983. The 
most recent amendment to the ISG Agreement, which incorporates the 
original agreement and all the amendments made thereafter, was 
signed by ISG members on January 29, 1990. See Second Amendment to 
the ISG Agreement.
    \44\ See supra note 41.
    \45\ See Securities Exchange Act Release Nos. 31529, 57 FR 57248 
(Dec. 3, 1992) and 33555, 59 FR 5619 (Feb. 7, 1994).
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D. Market Impact

    The Commission believes that the listing and trading of index 
warrants, currency warrants and currency index warrants will not 
adversely affect the U.S. securities markets or foreign currency 
markets. First, with respect to currency and currency index warrants, 
the Commission notes that the interbank foreign currency spot market is 
an extremely large, diverse market comprised of banks and other 
financial institutions worldwide. That market is supplemented by 
equally deep and liquid markets for standardized options and futures on 
foreign currencies and options on those futures. An active over-the-
counter market also exists in options, forwards and swaps for foreign 
currencies. This minimizes the possibility that Exchange listed 
warrants would be used to manipulate the spot currency markets. In 
addition, the surveillance procedures for these products should allow 
the Exchange to detect and deter potential manipulation involving 
currency warrants and currency index warrants.
    Second, with respect to index warrants, the Commission notes that 
warrants may only be established upon indexes the Commission has 
previously determined to be broad-based in the context of index options 
or warrant trading. As part of its review of a proposal to list an 
index derivative product, the Commission must find that the trading of 
index options or warrants will serve to protect investors, promote the 
public interest, and contribute to the maintenance of fair and orderly 
markets. Accordingly, the Commission does not believe that the issuance 
of index warrants upon previously approved broad based stock index 
options or warrants will adversely impact the underlying component 
securities. In addition, because index warrants are issued by various 
individual issuers who set their own terms, it is likely that 
expirations among similar index products will be varied, thereby 
reducing the likelihood that unwinding hedge activities would adversely 
affect the underlying cash market. Finally, as discussed above, the 
Commission believes the CBOE's enhanced surveillance procedures 
applicable to stock index warrants are adequate to surveil for 
manipulation and other abuses involving the warrant market, component 
securities and issuer hedge unwinding transactions.
    Third, the Exchange has proposed margin levels for stock index and 
currency warrants equivalent to those in place for stock index and 
currency options. The Commission believes these requirements will 
provide adequate customer margin levels sufficient to account for the 
potential volatility of these products. In addition, options margin 
treatment is appropriate given the options-like market risk posed by 
warrants. The Commission notes that the customer spread margin 
treatment applicable to warrants is subject to a one year pilot 
program. This will allow the Exchange to analyze the pricing 
relationships between listed options and warrants on the same index in 
order to determine whether to revise or approve 

[[Page 46650]]
on a permanent basis the proposed spread margin rules.\46\

    \46\ The Commission notes that the margin levels for currency 
index warrants will be set at a level determined by the Exchange and 
approved by the SEC. See Amendment No. 4. Issuances of warrants 
listed prior to the approval of this order will continue to apply 
the margin level applicable to them at the time of their listing.
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    Fourth, the CBOE has established reasonable position and exercise 
limits for stock index warrants, which will serve to minimize potential 
manipulation and other market impact concerns.\47\ Contrary to the 
views expressed in the Comment Letter, the Commission believes that in 
the absence of trading experience with domestic index warrants, it 
would be imprudent to establish position limits for positions greater 
than those currently applicable to domestic stock index options on the 
same index.\48\

    \47\ The Commission notes that there are no position or exercise 
limits applicable to currency or currency index warrants, although 
reporting requirements do apply. Nevertheless, the Commission may 
review the need to establish foreign currency position limits if the 
size of the currency or currency index warrant market increases 
significantly.
    \48\ With respect to the Comment Letter's suggestion that a 
hedge exemption rule be established in order to allow participants 
to readily acquire exemptions from the Exchange as needed, the 
Commission does not believe that such an approach is appropriate at 
this time. The hedge exemption for index options was adopted after 
several years experience with index options trading. Until the SROs 
gain some experience with domestic index warrant trading, it is 
difficult to determine the need for a hedge exemption (i.e., that 
speculative limits are insufficient to meet hedging needs).
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V. Conclusion

    The Commission believes that the adoption of these uniform listing 
and trading standards covering index, currency and currency index 
warrants will provide an appropriate regulatory framework for these 
products. These standards will also benefit the Exchange by providing 
them with greater flexibility in structuring warrant issuances and a 
more expedient process for listing warrants without further Commission 
review pursuant to Section 19(b) of the Act. As noted above, additional 
Commission review of specific warrant issuances will generally only be 
required for warrants overlying any non-approved broad-based index or a 
non-approved currency or currency index. If Commission review of a 
particular warrant issuance is required, the Commission expects that, 
to the extent that the warrant issuance complies with the uniform 
criteria adopted herein, its review should generally be limited to 
issues concerning the newly proposed index. This should help ensure 
that such additional Commission review could be completed in a prompt 
manner without causing any unnecessary delay in listing new warrant 
products.
    The Commission finds good cause for approving Amendments No. 1, 2, 
3, 4 and 5 to the proposed rule change prior to the thirtieth day after 
the date of publication of notice of filing thereof in the Federal 
Register for the following reasons. As discussed below, the changes are 
either (1) minor and technical in nature; (2) responsive to the Comment 
Letter; (3) designed to conform to warrant proposals from other 
markets; or (4) modifications to Exchange surveillance procedures. 
Accordingly, the amendments do not raise new significant regulatory 
issues or are responsive to prior comments. In order to enable the 
Exchange to list new index, currency or currency index warrants as soon 
as possible, the Commission believes it is necessary and appropriate to 
approve the amendments on an accelerated basis.
    Amendment No. 1 makes several changes to the filing which are 
designed to bring it into conformity with the other options exchanges. 
First, it revises Rule 31.5(E) in several respects to provide uniform 
issuer listing standards. The first two changes provide an alternative 
issuer listing qualification criteria (as discussed above under Issuer 
Listing Standards and Product Design) and limit the number of foreign 
securities that may comprise an underlying stock index. The Commission 
notes that the first change was made in response to comments received 
from the Seward & Kissell Letter and further believes it will provide 
added flexibility to issuers without compromising investor protection 
concerns. The Commission believes the second change strengthens the 
issuer listing standards to the benefit of warrant investors.
    Amendment No. 1 also revises Rule 462 to provide that the proposed 
spread and straddle margin treatment for stock index warrants will be 
effected as part of a one year pilot program, and to provide that 
escrow receipts will be accepted to cover short positions in stock 
index warrants. The Commission notes that these changes conform the 
margin treatment afforded options and warrants and provide a basis for 
evaluating pricing correlations between warrants and options overlying 
the same index, currency or currency index.
    Finally, Amendment No. 1 provides that the Exchange will permit 
member firms to accept an IA's representation concerning the options 
eligibility status of its customers, as described above. The Commission 
notes this practice is consistent with the treatment of options and, 
therefore, raises no new or unique regulatory issues. Accordingly, for 
the reasons discussed above relating to each proposed revision of the 
Amendment, the Commission believes it is appropriate to approve 
Amendment No. 1, to the Exchange's proposal on an accelerated basis.
    Amendment No. 2 establishes that currency and currency index 
warrants will be subject to reporting levels in the same manner as 
stock index warrants. The Commission notes that this revision helps to 
provide uniformity in the regulatory treatment of warrants. 
Furthermore, because currency and currency index warrants are not 
subject to position and exercise limits, the Commission believes that 
requiring investors to report to the Exchange when their holdings 
exceed specified levels should aid the Exchange in its monitoring for 
potential trading abuses involving currency and currency index 
warrants.\49\ Accordingly, the Commission believes it is appropriate to 
approve Amendment No. 2 on an accelerated basis.

    \49\ Amendment No. 3 proposes to raise the reporting requirement 
for stock index warrants from 20,000 to 100,000 warrants.
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    Amendment No. 3 to the proposal clarifies several issues relating 
to a.m. settlement, position reporting for index warrants, and other 
surveillance related matters. In particular, it provides that issuers 
must report all hedge unwinding transactions related to the early 
exercise of domestic index warrants to the listing exchange by the 
business day following trade date (``T+1'').\50\ Also, the Amendment 
requires issuers to notify the listing exchange of any early exercises 
of index warrants by 3:30 p.m. (Chicago time) on settlement date for 
the warrants. The Commission believes these changes to the CBOE's 
surveillance procedures strengthen the Exchange's monitoring of index 
warrants. Also, the Amendment clarifies that a.m. settlement will be 
used during the 48 hour period prior to expiration of index warrants. 
The Commission notes that this change simply codifies a provision the 
CBOE previously agreed to in Amendment No. 2.\51\ Finally, the 
Amendment raises the reporting level requirement for index warrants 
from 20,000 warrants to 100,000 warrants on the same side of the 
market. The Commission notes that this change 

[[Page 46651]]
provides uniform treatment to index, currency and currency index 
warrants and should aid the Exchange's surveillance procedures. 
Accordingly, the Commission believes it is appropriate to approve 
Amendment No. 3 on an accelerated basis.

    \50\ The Commission notes that Amendment No. 4 removes this 
transaction reporting requirement which will be incorporated into 
the Exchange's surveillance procedures.
    \51\ Amendment No. 5 subsequently changes the language of this 
provision to require a.m. settlement be used during the two business 
days prior to valuation date.
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    Amendment No. 4 deletes a transaction reporting requirement which 
will be revised and incorporated into the Exchange's surveillance 
procedures and also makes other minor changes. As such, the Commission 
does not believe the Amendment raises any new or unique regulatory 
issues. Second, the Amendment clarifies that the applicable margin 
level for currency index warrants will be a percentage as specified by 
the exchange and approved by the Commission. The Commission notes that 
this revision is consistent with the treatment afforded currency index 
options, where margin levels are established on a case by case basis. 
Accordingly, the Commission believes it is appropriate to approve 
Amendment No. 4 on an accelerated basis.
    Amendment No. 5 clarifies the settlement procedures for index 
warrants which are exercised prior to expiration. Specifically, the 
Amendment clarifies that a.m. settlement will be required on valuation 
date as well as during the last two business days prior to an index 
warrant's valuation date. As discussed above, the Commission believes 
that the use of a.m. settlement during this period will help to 
ameliorate any potential price effects associated with expirations of 
derivative index products. Accordingly, the Commission believes it is 
appropriate to approve Amendment No. 5 on an accelerated basis.
    Therefore, the Commission believes it is consistent with Sections 
6(b)(5) and 19(b)(2) of the Act to approve Amendments No. 1, 2, 3, 4 
and 5 to the CBOE's proposal on an accelerated basis.

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendments No. 1, 2, 3, 4 and 5. Persons making 
written submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., 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, 
N.W., 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 the file 
number in the caption above and should be submitted by September 28, 
1995.
    It therefore is ordered, pursuant to Section 19(b)(2) of the 
Act,\52\ that the proposed rule change (SR-CBOE-94-34) is approved, as 
amended, with the portion of the rule change relating to spread margin 
treatment being approved on a one year pilot program basis, ending 
August 29, 1996.

    \52\ 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.\53\

    \53\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-22108 Filed 9-6-95; 8:45 am]
BILLING CODE 8010-01-M