[Federal Register Volume 61, Number 52 (Friday, March 15, 1996)]
[Notices]
[Pages 10832-10835]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-6232]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36948; File No. SR-NYSE-95-10]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment No. 1 to the Proposed Rule Change by the New York Stock 
Exchange, Inc., Relating to Margin Requirements for Over-the-Counter 
Options and Interest Rate Composites

March 11, 1996.

I. Introduction

    On March 9, 1995, the New York Stock Exchange, Inc. (``NYSE'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``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 amend Exchange Rule 431, 
``Margins,'' to revise the initial and/or maintenance margin 
requirements for short positions in a variety of over-the-counter 
(``OTC'') options \3\ held in customer accounts and to adopt margin 
requirements for options on interest rate composites.

    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1994).
    \3\ OTC options are not issued by the Options Clearing 
Corporation (``OCC'') or listed on any national securities exchange. 
They are individually negotiated options contracts between a 
customer and a broker-dealer designed to reflect the customer's 
specific needs as to the options characteristics. According to the 
Exchange, these contracts are generally entered into by domestic and 
foreign institutions, mutual funds and insurance companies and are 
usually written for periods of less than one year.
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    Notice of the proposal appeared in the Federal Register on April 7, 
1995.\4\ No comments were received on the proposed rule change. The 
proposal was amended on September 15, 1995.\5\ This order approves the 
Exchange's proposal, as amended.

    \4\ See Securities Exchange Act Release No. 35555 (March 31, 
1995), 60 FR 17831.
    \5\ On September 15, 1995, the NYSE amended its proposal to 
increase the margin requirement for non-mortgage backed U.S. 
government agency debt securities that qualify for exemption under 
Rule 3a12-7 under the Act and are held in exempt accounts from 2% to 
3% in order to meet the 97.5% confidence level for seven-day price 
movements. The amendment also indicates that only OTC options on 
corporate debt securities that qualify as OTC margin bonds under 
Section 220.2(t)(1) of Regulation T under the Act are accorded 15% 
margin treatment for OTC options. All other options that qualify as 
OTC margin bonds as defined in Section 220.2(t) (including foreign 
sovereign debt and foreign corporate debt) are not eligible for the 
15% margin requirement and are subject to the current 45% margin 
requirement for OTC options. See Letter from James E. Buck, Senior 
Vice President and Secretary, NYSE, to Sharon Lawson, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated September 13, 1995 (``Amendment No. 1'').

[[Page 10833]]

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II. Description of the Proposal

A. Margin Requirements for OTC Options

    Currently, NYSE Rule 431 requires customer margin for short OTC 
stock and stock index options to be 100% of the option premium plus 45% 
of the current market value of the underlying security or the product 
of the current index group value of the underlying index and the 
applicable index multiplier.\6\ The NYSE proposes to amend Exchange 
Rule 431 to revise the initial and/or maintenance customer margin 
requirements for short positions in OTC overlying certain instruments. 
Specifically, the NYSE proposes to establish customer margin for OTC 
options equal to a specified percentage of the current value of the 
underlying component and the applicable multiplier, if any, plus any 
in-the-money amount. The required OTC option customer margin may be 
reduced by any out-of-the-money amount, but may not be less than the 
minimum amount specified for each option category.

    \6\ In contrast, margin for exchange-traded equity options, for 
example, is premium plus 20% of the value of the equivalent number 
of shares at current market prices.
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    The proposed percentages of the current value of the underlying 
components\7\ are as follows: (1) For stock and convertible corporate 
debt securities, 30%, with minimum margin of 10%; (2) for industry 
index stock groups, 30%, with minimum margin of 10%; (3) for broad 
index stock groups, 20%, with minimum margin of 10%; (4) for U.S. 
government or U.S. government agency debt securities other than those 
exempted by Rule 3a12-7 under the Act, 5%, with minimum margin of 
3%;\8\ (5) for corporate debt securities registered on a national 
securities exchange and OTC margin bonds as defined in Section 
220.2(t)(1) of Regulation T under the Act, 15% with minimum margin of 
5%;\9\ and (6) for all other OTC options (except as discussed below), 
45%, with minimum margin of 20%.

    \7\ Under the proposal, the ``underlying component'' is: for 
stocks, the equivalent number of shares; for industry and broad 
index stock groups, the current index group value and the applicable 
index multiplier; for U.S. Treasury bills, notes and bonds, the 
underlying principal amount; for foreign currencies, the units per 
foreign currency contract; and for interest rate contracts, the 
interest rate measure based on the yield of U.S. Treasury bills, 
notes, or bonds and the applicable multiplier. The ``interest rate 
measure'' for short term U.S. Treasury bills represents the 
annualized discount yield of a specific issue multiplied by 10 or, 
for long term U.S. Treasury notes and bonds, the average of the 
yield to maturity of the specific issues multiplied by 10.
    \8\ Rule 3a12-7 under the Act provides that options that are not 
traded on a national securities exchange and which relate to 
securities that are direct obligations of the U.S. or are issued or 
guaranteed by a corporation in which the U.S. has a direct or 
indirect interest (and designated for exemption pursuant to Section 
3(a)(12) of the Act) are exempt from all provisions of the Act which 
by their terms do not apply to ``exempted security'' or ``exempted 
securities,'' provided that the securities underlying the option 
represent an obligation equal to or exceeding $250,000 in principal 
amount. Under the proposal, option contracts in this category must 
be for a principal amount of not less than $500,000.
    \9\ See Amendment No. 1, supra note 5. Section 220.2(t)(1) of 
Regulation T under the Act defines an OTC margin bond to include 
certain debt securities not traded on a national securities 
exchange. Options transactions on private mortgage pass-through 
securities and mortgage related debt securities qualified under 
Section 3(a)(41) under the Act are not eligible for the margin 
requirements contained in this provision. Margin requirements for 
such securities must be computed pursuant to the proposed 
requirements for all other OTC options, i.e., 45% of the current 
market value of the underlying instrument, with minimum margin of 
20%.
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    Under the proposal, OTC options on U.S. government and U.S. 
government agency debt securities that qualify for exemption pursuant 
to Rule 3a12-7 under the Act must be for a principal amount of not less 
than $500,000. For exempt accounts,\10\ the required margin for U.S. 
government debt securities will be 3% of the current value of the 
underlying principal amount on 30-year U.S. Treasury bonds and 2% of 
the current value of the underlying principal amount on all other U.S. 
government debt securities, plus any in-the-money amount or minus any 
out-of-the-money amount. For non-mortgage backed U.S. agency debt 
securities in exempt accounts, the required margin will be 3% plus any 
in-the-money amount or minus any out-of-the-money amount.\11\

    \10\ Under the proposal, an ``exempt account'' is a member 
organization, non-member broker/dealer, ``designated account,'' as 
defined in NYSE Rule 431(a)(3), any person having net tangible 
assets of at least $16 million, or in the case of mortgage-related 
debt securities transactions, an independently audited mortgage 
banker with both more than $1.5 million of net current assets (which 
may include \3/4\ of 1% maximum allowance on loan servicing 
portfolios) and with more than $1.5 million of net worth.
    \11\ See Amendment No. 1, supra note 5.
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    For exempt accounts holding OTC options on U.S. government and U.S. 
government agency debt securities that qualify for exemption pursuant 
to Rule 3a12-7 under the Act, the amount of any deficiency between the 
equity in the account and the margin required\12\ will be deducted in 
computing the net capital of the member organization under the NYSE's 
capital requirements on the following basis: (a) On any account or 
group of commonly controlled accounts to the extent the deficiency 
exceeds 5% of the member organization's tentative net capital (net 
capital before deductions on securities), 100% of such excess amount; 
and (b) on all accounts combined to the extent such deficiency exceeds 
25% of a member organization's tentative net capital, 100% of such 
excess amount, reduced by any amount already deducted pursuant to 
paragraph (a).

    \12\ Under the proposal, a member may collect margin from the 
exempt account, or take a capital charge in lieu of collecting 
margin.
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    For non-exempt accounts, the required margin will be 5% of the 
current value of the underlying principal amount on 30-year U.S. 
Treasury bonds and 3% of the current value of the underlying principal 
amount on all other U.S. government and U.S. government agency debt 
securities, plus any in-the-money amount or minus any amount.
    The Exchange has agreed to a system of periodic reviews to ensure 
the adequacy of the proposed margin requirements and for increasing the 
requirements on an expedited basis if necessary. The NYSE's monitoring 
plan will consist of the following:
     Semi-annual reviews of the seven-day price movements of 
the underlying instruments will be conducted. These volatility reviews 
will cover both the last six months and the last three years.\13\

    \13\ Under SEC Rule 15c6-1, which became effective on June 1, 
1995, the securities transaction settlement period is three days. 
The Board of Governors of the Federal Reserve System amended 
Regulation T under the Act to make Regulation T consistent with SEC 
Rule 15c6-1. Specifically, Regulation T, as amended, states that a 
margin call must be satisfied within one payment period after the 
margin deficiency was created or increased. Regulation T defines a 
``payment period'' as the number of business days in the standard 
securities settlement cycle in the U.S. as defined in SEC Rule 15c6-
1 under the Act, plus two business days. Accordingly, under 
Regulation T, as amended, margin calls must be satisfied within five 
business days. In light of these changes, the NYSE may wish, in the 
future, to adopt procedures that would review volatility over five-
day periods. Any such change would be submitted as a proposed rule 
change pursuant to Section 19(b) of the Act.
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     The semi-annual review must indicate a 97.5% confidence 
level (e.g., the required margin level is adequate for seven-day price 
movements 97.5% of the time).
     For each option category, two member organizations using 
their own data or one member organization using an independent pricing 
source acceptable to the Exchange must provide semi-annual reports on 
price movements.
     if one semi-annual review indicates the margin level is 
inadequate for an option category, the Exchange will increase the 
margin requirements by filing a proposal pursuant to Section

[[Page 10834]]
19(b)(3)(A) under the Act for immediate effectiveness.
     In order to lower the margin requirements, two consecutive 
six-month reviews must demonstrate that the immediate effectiveness.
     In order to lower the margin requirements, two consecutive 
six-month reviews must demonstrate that the lower requirement meets the 
97.5% confidence level. The Exchange will submit proposals to lower the 
margin requirements by filing a proposed rule change pursuant to 
Section 19(b)(2) under the Act.
     Before lowering the margin requirements, the Exchange will 
take into consideration other relevant factors, such as current market 
conditions, member organization views, and margin levels from other 
options products (where similar OCC-issued options exist).

B. Margin Requirements for Interest Rate Options

    The NYSE proposes to incorporate into NYSE Rule 431 the margin 
requirements for short positions in exchange-traded interest rate 
options previously approved by the Commission for the Chicago Board 
Options Exchange, Inc. (``CBOE'').\14\ Specifically, for short 
positions in interest rate option contracts issued by a registered 
clearing agency, the initial and/or maintenance margin will be premium 
plus 10% of the underlying component value (i.e., the product of the 
current interest rate measure and the applicable multiplier), minus any 
out-of-the-money amount, and the minimum required margin will be 5% of 
the underlying component value.

    \14\ See Securities Exchange Act Release No. 26938 (June 15, 
1989), 54 FR 26285 (June 22, 1989) (order approving File No. SR-
CBOE-87-30).
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C. Statutory Basis

    The NYSE believes that the proposed rule change is consistent with 
the requirements of the Act and, in particular, furthers the objectives 
of Section 6(b)(5), which provides that the rules of the Exchange be 
designed to promote just and equitable principles of trade and to 
protect the investing public. In addition, the NYSE believes that the 
proposed rule change is also consistent with the rules and regulations 
of the Board of Governors of the Federal Reserve System for the purpose 
of preventing the excessive use of credit for the purchase or carrying 
of securities, pursuant to Section 7(a) under the Act.

III. Findings and Conclusions

    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), in that the proposal 
is designed to remove impediments to and perfect the mechanism of a 
free and open market and to protect investors and the public 
interest.\15\ Specifically, the Commission believes that the proposed 
rule change will establish margin levels for OTC options that are 
adequate to ensure investor protection and maintain fair and orderly 
markets, as well as address prudential concerns regarding the margin 
levels for OTC options. In approving the proposal, the Commission and 
the NYSE have worked closely with NYSE member firms to reduce the 
current high margin levels for OTC options while ensuring that the 
proposed margin levels provide adequate coverage of potential future 
price movements.

    \15\ 15 U.S.C. 78f(b)(5) (1988 & Supp. V 1993).
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    Historically, margin in OTC options has been set at levels 
substantially higher than that for similar exchange-traded products 
issued and guaranteed by the OCC, a registered clearing corporation. 
This difference in treatment is due, in part, to the nature of an OTC 
option where performance is not guaranteed by a registered 
clearinghouse but rather is dependent on the creditworthiness of the 
parties to the contract and their ability to perform. In addition to 
credit risk, higher margin was used due to the lack of a trading market 
to close out a position, which theoretically increased the risk of 
assuming a position in the option.
    As a result of these factors, the self-regulatory organizations in 
1985 set OTC options margins at the premium paid plus 45% of the value 
of the underlying instrument. Since then, the market for OTC options 
has grown and changed significantly. Consequently, the NYSE and the 
Commission staff have been working closely with industry 
representatives to determine how to reduce current margin levels on 
certain OTC options and still maintain adequate coverage. In this 
regard, NYSE member firms have submitted historical price volatility 
data for the options' underlying instruments indicating the percentage 
movements that would capture 97.5% of the seven-day price moves within 
the review period. The NYSE used the data to help it determine the 
minimum margin levels for options overlying the instruments. Based on a 
review of the historical price volatility data provided by the firms, 
the Commission believes that the proposed OTC option margin 
requirements should provide adequate coverage of contract obligations 
and address the systemic risks arising from a substantial reduction in 
margin levels.
    The Commission notes that the methodology utilized in the proposal 
for determining the adequacy of the OTC option margin levels are 
similar to the methodology used currently by the options exchanges to 
establish margin levels for exchange-traded options.\16\ Specifically, 
in 1985, the Commission approved proposals that established initial 
margin sufficient to cover each underlying product's historical 
volatility over a seven-day period with a 95% confidence level.\17\ The 
current proposal provides for margin levels that cover each underlying 
product's seven-day price movements with a 97.5% confidence level. The 
extra 2.5% coverage (97.5% versus 95%) used by the NYSE will help to 
capture better any episodic, short-term volatility in the underlying 
instruments. In addition, the use of two review periods by the NYSE 
(six months and three years) will capture both recent and medium term 
volatility, which is prudent given the difficulty in closing out a 
position in OTC options. Moreover, the NYSE has attempted to account 
for the lack of a clearinghouse guarantee through several additions to 
the numbers obtained by the confidence level reviews.

    \16\ See Securities Exchange Act Release No. 22469 (September 
26, 1985), 50 FR 40633 (order approving File Nos. SR-Amex-84-29, SR-
CBOE-84-27, SR-NASD-85-15, SR-NYSE-84-88, SR-PSE-84-20, SR-PHLX-84-
32, and SR-PHLX-85-18) (``1985 Approval Order''). In light of the 
increased market volatility during the last quarter of 1987, the 
Commission in 1988 approved proposals to increase the margin levels 
for equity options and broad-based and narrow-based index options. 
See Securities Exchange Act Release No. 25701 (May 17, 1988), 53 FR 
20706 (June 6, 1988) (order approving File Nos. SR-Amex-88-12, SR-
CBOE-88-6, SR-CBOE-88-8, SR-NYSE-88-12, SR-PSE-88-4, and SR-PHLX-88-
19).
    \17\ The Commission notes, however, that for exchange-traded 
options, margin is calculated based on the option premium plus a 
specified percentage of the value of the underlying instrument. The 
proposed levels for OTC options will be calculated based on a 
specified percentage of the current value of the underlying 
instrument plus any in-the-money amount and less any out-of-the-
money amount.
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    In connection with exempt accounts holding OTC options on U.S. 
government or U.S. government agency debt securities that qualify for 
exemption pursuant to rule 3a12-7 under the Act, the Commission 
believes that it is reasonable for the Exchange to allow a deduction 
from a member's net capital rather than require collection of

[[Page 10835]]
margin. In this regard, the Commission notes that the proposal is 
similar to the Exchange provisions applicable to exempt Government 
National Mortgage Association (``GNMA'') transactions, which provide 
that exempt accounts are not required to post margin or marks-to-market 
for their exempt GNMA transactions, although members must charge their 
capital for any mark-to-market deficits that are not collected.\18\ The 
Commission notes, in addition, that the proposal allows members to take 
a capital charge only in connection with exempt accounts trading 
options on securities that are exempted under Rule 3a12-7.

    \18\ See NYSE Interpretation Handbook, NYSE Rule 431(c)(2)(C)/
033.
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    The Commission also believes that the NYSE has proposed adequate 
procedures to review periodically the margin levels for the OTC options 
included in this rule proposal. Specifically, the NYSE will conduct 
semi-annual reviews of price volatility over both the previous six 
months and the previous three years. The semi-annual reviews must 
indicate that the required margin covers a product's historical price 
volatility over a seven-day period with a 97.5% confidence level. For 
each option category, the price volatility reports must be prepared 
either by two NYSE member organizations or by one member organization 
using an independent pricing source acceptable to the Exchange. If a 
semi-annual review indicates that the margin level for an OTC option 
category is inadequate, the Exchange will increase the margin 
requirements for that category by filing a proposal pursuant to Section 
19(b)(3)(A) under the Act for immediate effectiveness.
    In order to lower the margin requirements, two consecutive six-
month reviews must demonstrate that the proposed lower requirement 
meets the 97.5% confidence level and the Exchange must consider other 
relevant factors, including current market conditions, member 
organization views, and margin levels for similar OCC-issued options. 
In addition, a proposal to decrease the margin requirement for an 
option category must be filed pursuant to Section 19(b)(2) under the 
Act.
    The Commission believes that these procedures should provide the 
Exchange with the flexibility to lower margin levels when price 
volatility and other relevant factors indicate that a lower margin 
level may be warranted and, at the same time, require the Exchange to 
increase margin promptly when a semi-annual review indicates that the 
current margin fails to cover a product's historical price volatility 
with a 97.5% confidence level.
    As noted above, the Commission has worked closely with NYSE member 
firms to establish adequate OTC option margin levels. The NYSE's 
proposal should enhance the competitiveness of U.S. securities firms by 
substantially reducing options margin levels while ensuring that OTC 
options margin levels are adequate to protect investors and avoid the 
risks associated with excessively low margin levels.
    Finally, the Commission believes that it is reasonable for the NYSE 
to adopt a margin requirement for exchange-traded interest rate option 
contracts equal to premium plus 10% of the product of the current 
interest rate measure and the applicable multiplier, with minimum 
margin equal to 5% of the current interest rate measure and the 
applicable multiplier. The NYSE's proposed margin for interest rate 
options is identical to the margin level for interest rate options 
adopted previously by the CBOE \19\ and thus does not raise new 
regulatory concerns.

    \19\ See CBOE Rule 23.13, ``Margin Requirements.''
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    The Commission finds good cause for approving Amendment No. 1 to 
the proposal prior to the thirtieth day after the date of publication 
of notice of filing thereof in the Federal Register. Amendment No. 1 
increases the margin requirement for non-mortgage backed agency 
securities, thereby helping to ensure that the required margin covers 
seven-day price movements in non-mortgage backed U.S. government agency 
debt securities with a 97.5% confidence level. The Commission believes 
that Amendment No. 1 strengthens the Exchange's proposal by 
establishing adequate margin for non-mortgage backed agency securities 
and by clarifying the definition of marginable OTC corporate debt 
securities for purposes of the proposal. Therefore, the Commission 
believes that it is consistent with Section 6(b)(5) of the Act to 
approve Amendment No. 1 to the proposal on an accelerated basis.
    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 1 to the proposal. Persons making 
written submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 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 at the Commission's Public Reference Section, 450 Fifth Street, 
N.W., Washington, D.C. 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 April 5, 1996.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\20\ that the amended proposed rule change (SR-NYSE-95-10) is 
approved.

    \20\ 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.\21\

    \20\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-6232 Filed 3-14-96; 8:45 am]
BILLING CODE 8010-01-M