[Federal Register Volume 61, Number 57 (Friday, March 22, 1996)]
[Notices]
[Pages 11929-11931]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-6967]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36981; File No. SR-PSE-95-28]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the Pacific 
Stock Exchange, Inc., Relating to Establishing a Hedge Exemption for 
Narrow-Based Index Options

March 15, 1996.
    On November 1, 1995, the Pacific Stock Exchange, Inc. (``PSE'' 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 PSE Rule 7.6, ``Position 
Limits for Index Options,'' to establish a hedge exemption from 
industry (narrow-based) index option position and exercise limits.\3\

    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1995).
    \3\ Position limits impose a ceiling on the number of option 
contracts which an investor or group of investors acting in concert 
may hold or write in each class of options on the same side of the 
market (i.e., aggregating long calls and short puts or long puts and 
short calls). Exercise limits prohibit an investor or group of 
investors acting in concert from exercising more than a specified 
number of puts or calls in a particular class within five 
consecutive business days.
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    The proposed rule change was published for comment in the Federal 
Register on December 6, 1995.\4\ On January 31, 1996, on February 29, 
1996, and on March 15, 1996, the PSE amended its proposal.\5\ No 
comments were received on the proposed rule change.

    \4\ See Securities Exchange Act Release No. 36526 (November 29, 
1995), 60 FR 62517.
    \5\ On January 31, 1996, the PSE amended its proposal to 
indicate that the requirements of subsections (a), (b), (c), (f), 
(g), (h), and (i) of Commentary .02, ``Broad-Based Index Hedge 
Exemption,'' will apply to narrow-based index option hedge 
exemptions. In addition, the PSE clarified its rules by indicating 
that exercise limits will correspond to position limits under both 
the narrow-based and broad-based index hedge exemptions. Finally, 
the PSE stated that whenever the Exchange grants a narrow-based 
index option hedge exemption, it will monitor the equity position 
used as a hedge on a daily basis. See Letter from Michael D. 
Pierson, Senior Attorney, Market Regulation, PSE, to Yvonne 
Fraticelli, Attorney, Office of Market Supervision (``OMS''), 
Division of Market Regulation (``Division''), Commission, dated 
January 30, 1996 (``Amendment No. 1''). On February 29, 1996, the 
PSE amended its proposal to indicate that economically equivalent 
positions must be deducted from the market value of the net stock 
position in order to determine the value of the underlying 
portfolio. The amendment also provides examples of the number of 
contracts that a market participant may hold and exercise pursuant 
to the exemption. See Letter from Michael Pierson, Senior Attorney, 
Market Regulation, PSE, to Yvonne Fraticelli, Attorney, OMS, 
Division, Commission, dated February 29, 1996 (``Amendment No. 2''). 
On March 15, 1996, the PSE clarified the test of its rule by 
indicating that the position in a narrow-based index option may not 
exceed the total of: (a) the limit established under PSE Rule 7.6, 
plus (b) two times that limit (for hedged positions). See Letter 
from Michael D. Pierson, Senior Attorney, Market Regulation, PSE, to 
Yvonne Fraticelli, Attorney, OMS, Division, Commission, dated March 
14, 1996 (``Amendment No. 3'').
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    The PSE proposes to amend its rules to provide that industry index 
option positions may be exempt from established position and exercise 
limits for each contract ``hedged'' by an equivalent dollar amount of 
the underlying component securities or securities convertible into such 
components, provided that each option position to be exempted is hedged 
by a position in at least 75% of the number of component securities 
underlying the index, and that the underlying value of the option 
position does not exceed the value of the underlying portfolio. The 
value of the portfolio is: (a) The total market value of the net stock 
position, less (b) the value of (1) any offsetting calls and puts in 
the respective index option; (2) any offsetting positions in related 
stock index futures or options; and (3) any economically equivalent 
positions.\6\ The values of any such index option position or related 
futures position are determined by aggregating the notional value\7\ of 
each option contract comprising the position. Under the proposed 
exemption, position and exercise limits for any hedged industry

[[Page 11930]]
index option may not exceed two times the limits established under PSE 
Rule 7.6(a).\8\

    \6\ See Amendment No. 2, supra note 5.
    \7\ Notional values are determined by adding the number of 
contracts and multiplying the total by the multiplier, expressing 
that number in dollar terms.
    \8\ PSE Rule 7.6(a) provides that option contracts on an 
industry index are subject to the following position limits: 6,000 
contracts if the Exchange determines, during its semi-annual review, 
that any single stock in the group accounted, on average, for 30% or 
more of the index value during the 30-day period immediately 
preceding the review; 9,000 contracts if the Exchange determines, at 
the time of its semi-annual review, that any single stock in the 
group accounted, on average, for 20% or more of the index value or 
that any five stocks in the group together accounted, on average, 
for more than 50% of the index value, but that no single stock in 
the group accounted, on average, for 30% or more of the index value 
during the 30-day period immediately preceding the review; or 12,000 
contracts, if the Exchange determines that the conditions specified 
above have not occurred. See Securities Exchange Act Release No. 
36537 (November 30, 1995), 60 FR 62916 (December 7, 1995) (order 
approving File Nos. SR-Amex-95-45 and SR-PSE-95-30) (increasing 
position and exercise limits for industry index options to 6,000, 
9,000, or 12,000 contracts). Narrow-based index hedge exemption will 
allow a member organization to maintain an option position in that 
issue of up to 18,000 contracts on the same side of the market, 
provided that 12,000 of the contracts are ``hedged,'' as provided in 
the proposal. See Amendment Nos. 2 and 3, supra note 5.
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    Members, member organizations, and public customers seeking to use 
the proposed exemption must obtain prior Exchange approval. In 
addition, the exemption requires that both the option and stock 
positions be initiated and liquidated in an orderly manner. 
Specifically, a reduction of the option position must occur at or 
before the corresponding reduction in the stock portfolio position.
    Under the proposal, exercise limits will correspond to position 
limits, so that investors may exercise the number of contracts set 
forth as the position limit, as well as those contracts exempted by the 
proposal, during five consecutive business days.\9\

    \9\ See Amendment No. 1, supra note 5.
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    The Exchange believes it is appropriate to expand the availability 
of the proposed narrow-based index option position limit exemption 
beyond public customers.\10\ According to the PSE, because customers 
rely, for the most part, on a limited number of proprietary traders to 
facilitate large-sized orders, not including such traders in the 
exemption effectively reduces the benefit of the exemption to 
customers.

    \10\ The Exchange proposes to apply only the proposed narrow-
based industry index option hedge exemption, and not the existing 
broad-based index option hedge exemption, to firms and proprietary 
traders as well as public customers. Telephone conversation between 
Michael Pierson, Senior Attorney, Market Regulation, PSE, and Yvonne 
Fraticelli, Attorney, OMS, Division, Commission, on November 14, 
1995.
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    The Exchange believes that its proposed narrow-based index option 
hedge exemption should not increase the potential for disruption or 
manipulation in the markets for the stocks underlying each index. The 
PSE notes that the proposal incorporates several surveillance 
safeguards, which the Exchange will employ to monitor the use of the 
exemption. Specifically, the Exchange will require that member firms 
and their customers who seek exemptions file a form with the PSE, in 
lieu of granting an automatic exemption similar to that for equity 
options. The PSE's Options Surveillance Department will monitor trading 
activity in PSE-traded index options and the stocks underlying those 
indexes to detect potential frontrunning and manipulation abuses, as 
well as review to ensure that the closing of positions subject to an 
exemption is conducted in a fair and orderly manner. In addition, the 
PSE will monitor the equity position used as a hedge on a daily 
basis.\11\

    \11\ See Amendment No. 1, supra note 5.
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    And lastly, the PSE notes that the provision itself contains 
several built-in safeguards. First, the hedge must consist of a 
position in at least 75% of the stocks underlying the index, so that 
the ``basket'' of stocks constituting the hedge will resemble the 
underlying index.\12\  Second, hedged positions may not exceed two 
times the limit established under PSE Rule 7.6(a).\13\ This places a 
ceiling on the maximum size of the option position. Third, both the 
options and stock positions must be initiated and liquidated in an 
orderly manner, such that a reduction of the options position must 
occur at or before the corresponding reduction in the stock portfolio 
position. Lastly, the value of the industry index option position may 
not exceed the dollar value of the underlying portfolio. The purpose of 
this requirement is to ensure that stock transactions are not used to 
manipulate the market in a manner benefitting the option position. In 
addition, these safeguards prevent the increased positions from being 
used in a leveraged manner by ensuring that the options position 
subject to the increased hedge position limit is properly ``covered'' 
by the hedge.

    \12\ To determine the share amount of each component required to 
hedge an index option position: index value x index multiplier x 
component's weighting = dollar amount of component. That amount 
divided by price = number of shares of component. Conversely, to 
determine how many options can be purchased based on a certain 
portfolio, divide the dollar amount of the basket by the index value 
x the index multiplier.
    \13\ See Amendment No. 3, supra note 5.
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    For the above reasons, the Exchange believes that the proposed 
narrow-based index option hedge exemption should increase the depth and 
liquidity of narrow-based index option markets and allow more effective 
hedging with underlying stock portfolios, without increasing the 
potential for market manipulation or disruption, consistent with the 
purposes of position limits. For the same reasons, the Exchange 
believes that exercise limits should correspond to the position limit 
exemption granted by this proposal.
    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) thereunder.\14\ The 
Commission concludes that providing for increased position and exercise 
limits for narrow-based index options in circumstances where those 
excess positions are fully hedged with offsetting stock positions will 
provide greater depth and liquidity to the market and will allow 
investors to hedge their stock portfolios more effectively, without 
significantly increasing concerns regarding intermarket manipulations 
or disruptions of either the options market or the underlying stock 
market.

    \14\ 15 U.S.C. Sec. 78f(b)(5) (1988 & Supp. V. 1993).
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    Specifically, the PSE proposal contains safeguards that should make 
it difficult to use the exempted positions to disrupt or manipulate the 
market. First, requests for the exemption must be approved by the PSE, 
which should ensure that the hedges are appropriate for the position 
being taken and are in compliance with PSE rules. Second, the stock 
portfolio must consist of at least 75% of the number of component 
securities underlying the index, and must correspond in value to the 
value of the options position hedged, so that the increased positions 
are less likely to be used in a leveraged manner in any manipulative 
scheme. As noted above, the value of the hedging portfolio is equal to 
(a) the total market value of the net stock position, less (b) the 
value of (1) any offsetting calls and puts in the respective index 
option; (2) any offsetting positions in related stock index futures or 
options; and (3) any economically equivalent positions. Third, both the 
options and the stock positions must be initiated and liquidated in an 
orderly manner. Moreover, a reduction of the options position must 
occur at or before the corresponding reduction in the stock portfolio 
position, thereby helping to ensure that the stock transactions are not 
used to impact the market so as to benefit the options positions. 
Fourth, the PSE must be notified of any material

[[Page 11931]]
change in the portfolio or futures positions which materially affects 
the unhedged value of the qualified portfolio. Fifth, the maximum hedge 
exemption position is two times the existing limit.\15\ The ``two times 
the limit'' is not automatic and the PSE has the authority to approve a 
hedge limit for less than that amount.

    \15\ See Amendment No. 3, supra note 5.
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    The Commission notes that the PSE's surveillance procedures are 
designed to detect as well as deter manipulation and market 
disruptions. In particular, the PSE will monitor the equity position of 
a person utilizing the hedge exemption on a daily basis to ensure that 
each option contract is hedged by the equivalent dollar amount of 
component securities.\16\ In addition, the PSE's Options Surveillance 
Department will monitor trading activity in PSE-traded index options 
and their underlying component stocks to detect potential frontrunning 
and manipulation, and to ensure that the closing of positions subject 
to the exemption is conducted in a fair and orderly manner. Violation 
of any of the provisions of the industry index hedge exemption, absent 
reasonable justification or excuse, will result in the withdrawal of 
the hedge exemption and subsequent denial of an application for a hedge 
exemption thereunder.

    \16\See Amendment No. 1, supra note 5. Market participants 
granted a hedge exemption are also required to keep their 
application forms for the hedge exemption current and promptly 
provide the PSE with any information requested concerning the dollar 
value and composition of their stock portfolio or its equivalent, 
the current hedged and aggregate options positions, and any stock 
index futures positions.
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    The Commission believes that it is reasonable for the PSE to allow 
firm and proprietary traders, as well as public customers, to utilize 
the proposed hedge exemption. The Commission believes that extending 
the narrow-based index option hedge exemption to firm and proprietary 
traders may help to increase the depth and liquidity of the market for 
industry index options and may help to ensure that public customers 
receive the full benefit of the exemption. Moreover, the PSE's 
monitoring procedures, as described above, should be able to detect any 
abuses and ensure that the options position, whether firm, proprietary 
trader, or customer, is properly hedged.
    Finally, the commission believes that it is reasonable for the PSE 
to amend the text of its broad-based index hedge exemption, and to 
clarify its narrow-based hedged index hedge exemption, by indicating 
that exercise limits under the hedge exemptions will correspond to 
position limits. In this regard, the Commission notes that it has 
approved previously an identical amendment to the Chicago Board Options 
Exchange, Inc.'s (``CBOE'') broad-based index Chicago Board Options 
Exchange, Inc.'s (``CBOE'') broad-based index hedge exemption.\17\ In 
addition, the equity and index hedge exemptions of other options 
exchanges provide for corresponding position and exercise limits.\18\

    \17\ See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992) (order approving File No. SR-
CBOE-92-09) (``CBOE'' Approval Order'').
    \18\ See Securities Exchange Act Release No. 35738 (May 18, 
1995), 60 FR 27573 (May 24, 1995) (order approving File Nos. SR-
Amex-95-13, SR-CBOE-95-13, SR-NYSE-95-04, SR-PSE-95-05, and SR-PHLX-
95-10) (order granting permanent approval to hedge exemption pilot 
programs) (``Hedge Exemption Order'').
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    The Commission finds good cause for approving Amendment Nos. 1, 2, 
and 3 to the proposed rule change prior to the thirtieth day after the 
date of publication of the notice thereof in the Federal Register. 
Specifically, Amendment No. 1 is designed to protect investors and the 
public interest by providing additional requirements and surveillance 
procedures which the Exchange will use in monitoring the narrow-based 
index option hedge exemption. In addition, Amendment No. 1 indicates 
that, under the PSE's broad-based and narrow-based hedge exemptions, 
position limits will correspond to exercise limits. As noted above, 
position limits correspond to exercise limits under the hedge exemption 
rules of the other options exchanges.\19\ Accordingly, the Commission 
does not believe that the PSE's proposal to provide corresponding 
position and exercise limits under its hedge exemptions raises new 
regulatory issues. Amendment No. 2 strengthens the Exchange's proposal 
providing that economically equivalent positions must be deducted when 
calculating the value of the hedging portfolio. Amendment No. 3 
clarifies the text of the Exchange's proposal by indicating that the 
hedged position may not exceed two times the limit established under 
PSE Rule 7.6. Accordingly, the Commission believes that there is good 
cause, consistent with Sections 6(b)(5) and 19(b)(2) of the Act, to 
approve Amendment Nos. 1, 2, and 3 to the proposal on an accelerated 
basis.

    \19\ See CBOE Approval Order, supra note 17 and Hedge Exemption 
Order, supra note 18.
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Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1, 2, and 3. 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 12, 1996.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\20\ that the proposed rule change (SR-PSE-95-28), as amended is 
approved.

    \20\ 15 U.S.C. Sec. 78s(b)(2) (1982).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\21\

    \21\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-6967 Filed 3-21-96; 8:45 am]
BILLING CODE 8010-01-M