[Federal Register Volume 62, Number 1 (Thursday, January 2, 1997)]
[Notices]
[Pages 138-141]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-33314]
[[Page 138]]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38081; File No. SR-PSE-96-40]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval to
Amendment No. 1 to Proposed Rule Change by the Pacific Stock Exchange,
Inc., Relating to the Listing and Trading of Index Options on the Dow
Jones & Co. Taiwan Index
December 23, 1996.
I. Introduction
On October 17, 1996, the Pacific Stock Exchange, Inc. (``PSE'' or
``Exchange'') submitted to the Securities and Exchange Commission
(``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 thereunder,\2\ a
proposed rule change to list and trade index options based on the Dow
Jones & Co. (``Dow Jones & Co.'') Taiwan Index (``Index'').
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\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4.
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The proposed rule change appeared in the Federal Register on
October 25, 1996.\3\ No comments were received on the proposed rule
change. The Exchange subsequently filed Amendment No. 1 to the proposed
rule change on December 17, 1996.\4\ This order approves the PSE's
proposal, as amended.
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\3\ See Securities Exchange Act Release No. 37842 (October 18,
1996), 61 FR 55345 (October 25, 1996).
\4\ See letter from Michael D. Pierson, Senior Attorney,
Regulatory Policy, PSE, to Matthew Morris, Office of Market
Supervision, Division of Market Regulation, Commission, dated
December 17, 1996 (``Amendment No. 1''). In No. 1, the PSE amended
its rule filing regarding its maintenance criteria and Index value
dissemination procedures. See infra notes 10 and 12, and
accompanying text.
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II. Description
The Exchange is proposing to list and trade cash-settled, European-
style \5\ stock index options on the Dow Jones & Co. Taiwan Index. The
Index is comprised of 113 representative stocks traded on the Taiwan
Stock Exchange (``TSE'').\6\ According to the Exchange, the Index is
representative of the Taiwan stock market as a whole, and therefore, is
deemed a broad-based index.
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\5\ European-style options may only be exercised during a
specified period before expiration.
\6\ A list of Index components is available at the Commission
and at the PSE.
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A. Index Design
The Index was designed, and is maintained, by Dow Jones & Co. The
113 stocks comprising the Index were selected for their market weight,
trading liquidity, and their representation of the business industries
reflected on the TSE. The Exchange believes that these stocks reflect
the industrial composition of the broader Taiwanese equity market.
Specifically, stocks from nineteen different economic sectors of the
Taiwan stock market were ranked by their market value and the largest
stocks were selected from the sectors until approximately 80% of the
market was represented by Index stocks.\7\
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\7\ Due to foreign investment restrictions of Taiwanese stocks,
Dow Jones & Co. only includes 20% of a component stocks' total
shares outstanding in calculating the market capitalization.
Accordingly, only 20% of the actual market value of the component
stocks is represented by the Index.
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Only publicly traded and liquid common stocks are considered for
inclusion in the Index. Stocks which are not traded frequently, do not
have sufficiently high share turnover, or a sufficiently large dollar
volume are excluded from the Index. Companies whose stocks are 75%
owned by another company or state entity will be excluded, and
companies controlled by a family or an individual are carefully
reviewed before inclusion.
The Index is weighted by the market capitalization of the component
stocks. As of August 30, 1996, the market capitalization of the Index
was US$181 billion \8\ (at the exchange rate of NT $27.5 per dollar),
which represents approximately 80% of the capitalization of the TSE.
The average market capitalization of these stocks was US$1.6 billion on
the same date (at the same rate of exchange). The individual market
capitalization of these stocks ranged from US$18.6 billion (Cathay Life
Insurance) to US$150 million (Hong Ho Precision Textile Co.) on the
same date. The largest stock accounted for 10.26% of the Index, while
the smallest accounted for .08%. The top five stocks in the Index, by
weight, accounted for approximately 31% of the Index.\9\ The average
daily trading volume of the component securities for the period April 1
through August 30, 1996, ranged from a high of 49,879,418 shares (China
Steel) to a low of 457,091 shares (Hsing Ta Cement Co.), with an
average daily trading volume for all components of the Index of
approximately 7,698,763 shares. For the quarter ended September 30,
1996, the Index components, in the aggregate, had an average daily
trading volume of US$1.1 billion.
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\8\ This figure includes all outstanding shares for each
component stock. The Index itself is comprised of approximately 20%
of this figure, of US$36.2 billion. See supra note 7.
\9\ The five most heavily weighted stocks in the Index as of
August 30, 1996 were: Cathay Life Insurance (10.26%); First
Commercial Bank (5.98%); Hua Nan Bank (5.75%); Chang Hwa Bank
(5.22%); and China Steel (3.88%).
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B. Calculation and Maintenance of Index
The value of the Index is determined by multiplying the price of
each stock by its number of shares included in the Index, adding those
sums, and then dividing by a divisor which gives the Index value of 100
on its base date of December 31, 1991. The Index had a closing value of
160.33 on August 30, 1996. The Index will be maintained by Dow Jones &
Co. and, in order to maintain continuity of the Index, the divisor of
the Index will be adjusted to reflect certain events relating to the
component stocks. These events include, but are not limited to, changes
in the number of shares outstanding, spin-offs, certain rights
insurances, and mergers and acquisitions.
The composition of the Index is reviewed every quarter using size,
liquidity, and investibility screens. Dow Jones & Co. may make
component changes at any time to ensure that the Index continues to
represent the overall character of the Taiwanese equity market. To
restrict turnover at quarterly revisions, however, an Index stock can
be replaced by a new stock from the same economic sector only if the
market value of the new stock exceeds its market value by a threshold
amount. Index stocks may also be replaced when necessary between
quarterly reviews following special corporate events such as
delistings, mergers, or acquisitions. Adjustments may also become
necessary following changes in government restrictions on the foreign
ownership of stocks.
In addition, in the event that the Index does not comply with any
of the following maintenance criteria, the Exchange will notify the
Commission to determine the appropriate regulatory response: (a) the
number of component stocks in the Index changes and there are more than
150 stocks or less than 75 stocks comprising the Index; (b) at the time
of a quarterly review, a component's market capitalization is below $75
million; (c) the top weighted component stock accounts for more than
25% of the weight of the Index; or (d) the top three weighted stocks
account for more than 45% of the weight of the Index.\10\ The
Commission's and the PSE's regulatory responses for failure to meet the
above criteria could include, but are not limited to, the removal of
the securities from the Index, prohibiting opening transactions, or
discontinuing
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the listing of new series of Index options.
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\10\ See Amendment No. 1.
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C. Index Option Trading
The Exchange proposes to base trading in options on the Index on
the full value of the Index as expressed in U.S. dollars. The Exchange
also may provide for the listing of long-term index option series
(``LEAPS'') on the Index. The Exchange will list expiration months for
Index options and Index LEAPS in accordance with PSE Rule 7.8.
The trading hours for options on the Index will be from 6:30 a.m.
Pacific time to 1:15 p.m. Pacific time.\11\ With no overlap in trading
hours between the PSE and the TSE, the Exchange is proposing to
disseminate the Index value only at the beginning of each trading
day.\12\ Specifically, the PSE plans to disseminate the Index value via
the Consolidated Tape Authority (``CTA'') Network B once a day at the
opening of trading. The Index value will be subsequently re-
disseminated throughout the trading day through data venders as well as
through the Dow Jones Global Index web site.
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\11\ Regular trading hours in Taiwan are Monday to Friday 0900-
1200, and Saturday from 0900-1100.
\12\ According to the PSE, the Consolidated Tape Authority
(``CTA'') has asked the options exchanges to evaluate the need to
disseminate index values based on foreign indices every fifteen
seconds when the index value does not change during U.S. trading
hours. The CTA is concerned that disseminating the same index value
every fifteen seconds results in unnecessary data traffic. By
disseminating the Index value only once a day, the Exchange believes
that it is complying with the CTA's request. See Amendment No. 1.
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In addition, the Exchange will be trading options on an Index value
that is calculated in the ``local currency'' (i.e., Taiwan dollars) and
not converted into U.S. dollars. Although premiums will be in U.S.
dollars, the strike prices will be based on the local currency Index
level. It also should be noted that the futures and futures options
that will be traded at the Chicago Mercantile Exchange (``CME'') will
be based on the same underlying Index and the same Index value.
The Exchange is proposing to establish position limits for Index
options equal to 50,000 contracts on the same side of the market, with
no more than 30,000 contracts in the series with the nearest expiration
date. According to the Exchange, these limits are roughly equivalent,
in dollar terms, to the limits applicable to options on other indices.
Furthermore, the hedge exemption rule applicable to broad-based index
options will apply to Index options.\13\
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\13\ See Commentary .02 to PSE Rule 7.6.
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The PSE also represents that it has the necessary systems capacity
to support new series that would result from the introduction of the
Index options.
D. Exercise and Settlement
The proposed options on the Index will expire on the Saturday
following the third Friday of the expiration month, and trading in the
expiring contract month on the PSE will normally cease on Friday at
1:15 p.m. Pacific time unless a holiday occurs. The exercise settlement
value of Index options at expiration will be determined from closing
prices established at the close of the regular Friday trading session
in Taiwan. If a stock does not trade during this interval or if it
fails to open for trading, the last available price of the stock will
be used in the calculation of the Index. When expirations are removed
in accordance with Exchange holidays, such as when the PSE is closed on
the Friday before expiration, the last trading day for expiring options
will be Thursday and the exercise settlement value of Index options at
expiration will be determined at the close of the regular Thursday
trading sessions in Taiwan even if the Taiwanese markets are open on
Friday. If the Taiwanese markets are closed on the Friday before
expiration but the PSE is open for trading, the last trading day for
expiring options will similarly be Thursday, with the exercise
settlement value being determined from Thursday closing prices on the
TSE.
E. Surveillance
The Exchange will apply its existing index option surveillance
procedures to Index options. In addition, the Exchange has entered into
a surveillance sharing agreement with the TSE, which should, as
discussed below, enable the Exchange to obtain information concerning
the trading of the component stocks of the Index.
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, with the requirements of Section 6(b).\14\ Specifically,
the Commission finds that the trading of index options based on the Dow
Jones & Co. Taiwan Index, including long-term index options, will serve
to protect investors, promote the public interest, and will help to
remove impediments to a free and open market by providing investors
with a means to hedge exposure to the market risk associated with the
Taiwanese equity market and to provide a risk management instrument for
positions in the Taiwanese securities market.\15\
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\14\ 15 U.S.C. 78f(b) (1988).
\15\ Pursuant to Section 6(b)(5) of the Act, the Commission must
predicate approval of any new securities product upon a finding that
the introduction of such product is in the public interest. Such a
finding would be difficult with respect to a product 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.
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Nevertheless, the trading of options on the Index raises several
issues related to the design and structure of the Index, customer
protection, and surveillance. The Commission believes, however, for the
reasons discussed below, that the PSE has adequately addressed these
issues.
A. Index Design and Structure
The Commission finds that it is appropriate and consistent with the
Act to apply the Exchange rules applicable to broad-based index options
to the Index options. First, the Index consists of 113 of the most
actively traded stocks on the TSE. Second, stocks in the Index are
among the most highly capitalized stocks on the TSE. For example, on
August 30, 1996, the market capitalization of the Index was US$181
billion (at the exchange rate of NT $27.5 per dollar), which represents
approximately 80% of the capitalization of the TSE. In addition, the
market capitalization of the individual stocks in the Index ranged from
a high of US$18.6 billion (Cathay Life Insurance) to a low of US$150
million (Hong Ho Precision Textile Co.), with an average market
capitalization of US$1.6 billion. Third, the Index includes stocks of
companies from nineteen separate industries. Fourth, PSE maintenance
criteria require that no single Index component shall comprise more
than 25% of the Index's total value, and that the percentage weighting
of the three largest issues in the Index shall not exceed 45% of the
Index's value. This will help to ensure that a single stock or small
group of stocks does not dominate the Index.\16\ Fifth, Dow Jones & Co.
has adopted listing and maintenance criteria to ensure that the Index
maintains its broad representative sample of stocks as well as a
variety of industries and economic sectors.\17\ In addition, the
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maintenance criteria will ensure that the Index continues to be
comprised of component stocks that are among the most highly
capitalized and actively traded stocks on the TSE. Accordingly, the
Commission believes it is appropriate to classify the Index as broad-
based.
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\16\ As noted above, as of August 30, 1996, the top five stocks
in the Index, by weight, accounted for approximately 31% of the
Index, and no single stock accounted for more than 10.26% of the
Index. See supra note 9 and accompanying text.
\17\ For example, the Exchange's maintenance criteria require
that at the time of a quarterly review, a component's market
capitalization be above $75 million, and that the number of
component stocks in the Index not be more than 150 or less than 75
stocks. In the event that the Index does not comply with any of the
Exchange's maintenance criteria, the PSE will notify the Commission
to determine that appropriate regulatory responses. Such responses
could include, but are not limited to, the removal of the securities
from the Index, prohibiting opening transaction, or discontinuing
the listing of new series of Index options.
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For many of the same reasons, the Commission believes that the
general broad diversification of the Index component stocks, as well as
their high capitalizations and trading activity, lessen the potential
for manipulation of the index. First, as noted above, the Index
represents a broad cross-section of highly-capitalized Taiwanese
stocks, with no single industry group or stock dominating the Index.
Second, the stocks that comprise the Index are relatively actively
traded. Third, the Commission believes that the Index selection and
maintenance criteria will serve to ensure that the Index continues to
represent stocks with the highest capitalizations and trading volumes
on the TSE. In addition, the Exchange has proposed position and
exercise limits for the Index options that are consistent with other
broad-based index options. Finally, as discussed in more detail below,
the Commission believes that adequate surveillance mechanisms exist
between the PSE and the underlying security market to detect and deter
potential market manipulation and other trading abuses.
B. Customer Protection
The Commission believes that a regulatory system designed to
protect public customers must be in place before the trading of
sophisticated financial instruments, such as the Dow Jones & Co. Taiwan
Index options and Index LEAPS, can commence on a national securities
exchange. The Commission notes that the trading of standardized
exchange-traded options occurs in an environment that is designed to
ensure, among other things, that: (1) the special risks of options are
disclosed to public customers; (2) only investors capable of evaluating
and bearing the risks of options trading are engaged in such trading;
and (3) special compliance procedures are applicable to options
accounts. Accordingly, because the Index options and Index LEAPS will
be subject to the same regulatory regime as the other standardized
options currently traded on the PSE, the Commission believes that
adequate safeguards are in place to ensure the protection of investors
in Dow Jones & Co. Taiwan Index options and Index LEAPS.
C. Surveillance
In evaluating a proposal to trade a new derivative instrument, the
Commission, consistent with the protection of investors, considers the
degree to which the derivative market can conduct adequate surveillance
of trading in the instrument. The ability of the options market to
obtain information necessary to detect and deter market manipulation
and other trading abuses is a critical factor in this evaluation. It is
for this reason that it is important that the Commission determine that
there is an adequate mechanism in place to provide for the exchange of
information between the market trading the derivative product and the
market on which the securities underlying the derivative product are
traded. Such mechanisms enable officials to surveil trading in both the
derivative product and the underlying securities. \18\ For foreign
stock index derivative products, such mechanisms are especially
important for the relevant foreign and domestic exchanges to facilitate
the collection of necessary regulatory, surveillance, and other
information.
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\18\ The Commission believes that a comprehensive 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
insists that such agreements require that the parties provide each
other, upon request, with information about market trading activity,
clearing activity, and the identity of the purchasers and sellers of
securities underlying the derivative product. See, e.q., Securities
Exchange Act Release No. 31529 (November 27, 1992), 57 FR 574248
(December 3, 1992) (File No. Amex-91-26) (order approving proposed
rule changes relating to the listing and trading of options on
American Depositary Receipts and preferred stock).
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The Commission notes that the PSE and the TSE have entered into a
Memorandum of Understanding (``MOU'') which appears to enable the
Exchange to obtain necessary surveillance information concerning the
trading of the component stocks of the Index, including the identity of
persons who execute transactions on either the TSE or the PSE.\19\ The
Commission recognizes, however, that there are conditions that affect
the flow of information under the MOU between the two exchanges. While
the TSE has represented that there are no TSE rules or Taiwanese laws
that might act to restrict the flow of market surveillance information,
any request that involves information on an investor's identity or any
information that is confidential or classified must be approved by the
Taiwan Securities and Exchange Commission (``TSEC''). The TSEC will
review the request on a case-by-case basis in deciding whether to
permit the TSE to provide the information to the PSE. As such,
pertinent transaction, clearing, or customer identity information that
may be necessary for the PSE to review during an investigation might
need approval by the TSEC before it could be relayed to the PSE.
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\19\ See Memorandum of Understanding Concerning the Provision of
Information for the Purpose of Regulation and Enforcement between
the Pacific Stock Exchange and the Taiwan Stock Exchange, dated
October 22, 1993.
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In most situations, in the absence of a fully effective
surveillance sharing agreement between exchanges, the Commission finds
it difficult to conclude that a derivative product, such as the Dow
Jones & Co. Taiwan Index options, is not susceptible to manipulation.
Other factors, however, mitigate such a conclusion in this instance and
support approval of the PSE's proposal. First, while the size of the
underlying market is not necessarily determinative of whether a
particular derivative product is readily susceptible to manipulation,
the size of the market underlying the Dow Jones & Co. Taiwan Index
makes it less likely that the proposed Index options are readily
susceptible to manipulation.
Second, the PSE and the TSE, as discussed above, have signalled
their intentions to prevent cross-border fraud and manipulation by
entering into a MOU.
Third, although it appears that the TSEC has the ability to limit
or condition the information to be provided by the TSE to the PSE, the
TSEC has stated to the Commission that it would share surveillance
information with the Commission on a case-by-case basis.\20\ Moreover,
in connection with the Commission's review of a proposal by the CME to
trade futures on the Dow Jones & Co. Taiwan Index, the CME provided an
opinion of counsel that indicates that the TSEC has the authority to
obtain market oversight information that the Commission might
request.\21\ Consequently, it appears as though the TSEC can obtain the
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necessary information and is willing to provide it to the Commission.
The Commission believes that this, along with the PSE's agreement with
the TSE, should help to detect as well as to deter potential
manipulation.
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\20\ Such information would include transaction, clearing, and
customer identity information necessary to conduct an investigation.
\21\ See letter from Carl A. Royal, Senior Vice President,
Chicago Mercantile Exchange, to Jane C. Kang, Special Counsel, CFTC,
and Howard Kramer, Associate Director, Division of Market
Regulation, Commission, dated September 12, 1996.
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While the situation described above is not ideal, the Commission
believes that it is adequate in light of the circumstances and
considering the large capitalizations, substantial trading volume, wide
diversity of the component stocks in the Dow Jones & Co. Taiwan Index,
and the size of the market underlying the Index.\22\
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\22\ The Commission has similarly explored alternatives in other
instances when the relevant foreign exchange was unwilling or unable
to enter into a comprehensive surveillance sharing agreement. See,
e.q., Securities Exchange Act Release No. 36070 (August 9, 1995), 60
FR 42205 (August 15, 1995) (order approving proposed rule change
relating to the listing and trading of warrants on the Deutscher
Aktienindex).
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The Commission finds good cause to approve Amendment No. 1 to the
proposed rule filing prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Amendment No. 1 to the PSE's proposal describes details of certain
Index maintenance procedures. In this regard, the Commission believes
that the Exchange's review of the Index's component securities for
liquidity, capitalization, and concentration levels will help to ensure
that the Index maintains its intended market character as well as
remains an appropriate trading vehicle for public customers. In
addition, Amendment No. 1 changes the Exchange's dissemination
procedures. Rather than calculating and disseminating the Index value
every fifteen seconds throughout the trading day, the Exchange will
disseminate the Index value only at the beginning of each trading day.
The Commission believes that in light of the PSE's assurances that the
Index value will be widely available to investors throughout the
trading day through data vendors as well as through the Dow Jones
Global Index web site, and because stock exchange trading in Taiwan and
U.S. markets do not overlap, approval of the amendment is appropriate.
The changes proposed by Amendment No. 1 are minor, technical, or
clarify and, for the reasons noted above, do not raise any new
regulatory issues. The Commission also notes that no comments were
received on the original PSE proposal, which was subject to the full
21-day notice and comment period. Accordingly, the Commission believes
that it is consistent with Section 6(b)(5) of the Act to approve
Amendment No. 1 to the proposed rule change on an accelerated basis.
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 1 to the rule 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. 20549.
Copies of such filing also will be available for inspection and copying
at the principal office of the PSE. All submissions should refer to
File No. SR-PSE-96-40 and should be submitted by January 23, 1997.
IV. Conclusion
For the foregoing reasons, the Commission finds that the PSE's
proposal to list and trade index options based on the Dow Jones & Co.
Taiwan Index is consistent with the requirements of the Act and the
rules and regulations thereunder.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\23\ that the proposed rule change (SR-PSE-96-40), as amended, is
approved.
\23\ 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.\24\
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\24\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 96-33314 Filed 12-31-96; 8:45 am]
BILLING CODE 8010-01-M