[Federal Register Volume 63, Number 85 (Monday, May 4, 1998)]
[Notices]
[Pages 24580-24584]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-11747]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39925; File No. SR-CBOE-97-67]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Chicago Board Options Exchange, Incorporated, Relating to 
Substantive Revisions of the Exchange's Rules Governing Margin 
Regulation

April 27, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on December 29, 1997, the 
Chicago Board Options Exchange, Incorporated (``Exchange'' or ``CBOE'') 
filed with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by the Exchange. The Commission is publishing 
this notice to solicit comments on the proposed rule change from 
interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Exchange proposes substantive changes to its rules concerning 
margin requirements. The revisions would: (i) Expand the types of short 
positions that would be considered ``covered'' in a cash account, 
specifically, certain short positions that are components of limited-
risk spread strategies (e.g., butterfly and box spreads); (ii) allow a 
bank-issued escrow agreement to serve as cover in lieu of cash for 
certain spread positions held in a cash account; (iii) recognize 
butterfly and box spreads as strategies for purposes of margin 
treatment and establish appropriate margin requirements; (iv) recognize 
various strategies involving stocks (or other underlying instruments) 
paired with long options, and provide for lower maintenance margin 
requirements on such hedged stock positions; (v) permit the extension 
of credit on certain long term options and certain long box spreads; 
(vi) consolidate in one chapter, the various margin requirements that 
presently are dispersed throughout the Exchange's rules; (vii) revise 
other Exchange rules impacted by the proposal; and (viii) update and 
improve, as necessary, current margin rules.
    The text of the proposed rule change is available at the Office of 
the Secretary, the Exchange, and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Exchange included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
sections A, B, and C below, of the most significant aspects of such 
statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The Exchange proposes to make revisions to its rules governing 
margin regulation that would: (i) Expand the types of short positions 
that would be considered ``covered'' in a cash account, specifically, 
certain short positions that are components of limited-risk spread 
strategies (e.g., butterfly and box spreads); (ii) allow a bank-issued 
escrow agreement to serve as cover in lieu of cash for certain spread 
positions held in a cash account; (iii) recognize butterfly and box 
spreads as strategies for purposes of margin treatment and establish 
appropriate margin requirements; (iv) recognize various strategies 
involving stocks (or other underlying instruments) paired with long 
options, and provide for lower maintenance margin requirements on such 
hedged stock positions; (v) permit the extension of credit on certain 
long term options and certain long box spreads; (vi) consolidate in one 
chapter, the various margin requirements that presently are dispersed 
throughout the Exchange's rules; (vii) revise other Exchange rules 
impacted by the proposal; and (viii) update and improve, as necessary, 
current margin rules.
    Previously, the margin requirements governing options were set 
forth in Regulation T, ``Credit by Brokers and Dealers.'' \2\ However, 
recent amendments to Regulation T that became effective June 1, 1997, 
modified or deleted certain margin requirements regarding options 
transactions in favor of rules to be adopted by the option self-
regulatory organizations (``OSROs''),

[[Page 24581]]

subject to approval by the Commission.\3\ In a rule filing approved 
last year, the Exchange adopted certain options-related margin 
requirements that were dropped from Regulation T.\4\ The rule filing 
also made changes to clarify several margin rules and to establish 
consistency with certain margin rules maintained by the New York Stock 
Exchange (``NYSE'').
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    \2\ 12 CFR 220 et seq. The Board of Governors of the Federal 
Reserve System issued Regulation T pursuant to the Act.
    \3\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (Apr. 26, 1996), 61 FR 20386 (May 6, 1996).
    \4\ See Securities Exchange Act Release No. 38709 (June 2, 
1997), 62 FR 31643 (June 10, 1997).
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    At the present time, the Exchange seeks to revise its margin rules 
to implement enhancements long desired by Exchange members and member 
firms, public investors, and the Exchange staff. The Exchange believes 
that certain multiple options position strategies and other strategies 
that combine stock with option positions warrant identification and 
recognition for purposes of establishing more equitable margin 
requirements. Currently, the two components of a strategy that combines 
stock with an options position must be margined separately. The 
Exchange believes the risk limitation that results if the stock and 
options position are viewed collectively is not reflected in the 
current maintenance margin requirements.\5\ Lastly, the proposal would 
permit credit to be extended on certain types of options.
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    \5\ Telephone conversation between Richard Lewandowski, 
Assistant Vice President, Exchange, and Michael Loftus, Attorney, 
Division of Market Regulation, Commission, April 27, 1998.
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    During the development of the proposed rule change, the Exchange 
reviewed its margin rules with a view towards updating and improving 
the rules. In some instances, the Exchange found it necessary to make 
minor changes to certain rules because they would be impacted by the 
more substantive proposals.
    a. Definition Section. Presently, the Exchange's definition 
``current market value'' is equivalent to the definition found in 
Regulation T. Instead of repeating the Regulation T definition, the 
proposal would revise the definition found in the Exchange's rules to 
note that the meaning of the term ``current market value'' is as 
defined in Regulation T. Because the Exchange and other OSROs intend to 
seek a change in the Regulation T definition, a linkage to the 
Regulation T definition would keep the Exchange's definition equivalent 
without requiring a future rule filing.
    The Exchange also seeks to establish definitions for the 
``butterfly spread'' and ``box spread'' options strategies. The 
definitions relate to the Exchange's proposed rules that would 
recognize and specify cash and margin account requirements for 
butterfly and box spreads.\6\ The Exchange believes the definitions are 
necessary to specifically establish what multiple option positions, if 
held together, qualify for classification as butterfly or box spreads, 
and consequently are eligible for the proposed cash and margin 
treatment.
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    \6\ The proposed rules are outlined below under the ``Cash 
Account'' and ``Margin Account'' sections.
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    Finally, the proposal would define the term ``listed.'' Because 
``listed'' is frequently used in the Exchange's margin rules, the 
Exchange believes it would be more efficient to define the term once 
rather than specifying the meaning each time the term is utilized.
    b. Extension of Credit on Long Options, Stock Index Warrants, 
Foreign Currency Warrants, and Currency Index Warrants. The proposal 
would allow extensions of credit on certain listed long options and 
warrant productions (including currency and index warrants, but 
excluding traditional stock warrants issued by a corporation on its own 
stock).\7\ Only those options or warrants that are more than 9 months 
from expiration would be eligible for credit extension. The proposal 
requires initial and maintenance margin of not less than 75% of the 
current market value of a listed option or warrant. Therefore, a 
broker-dealer would be able to loan up to 25% of the current market 
value of a listed option or warrant.
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    \7\ Throughout the remainder of this notice, the term 
``warrant(s)'' means this type of warrant.
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    The proposal also would permit the extension of credit on options 
and warrants not listed or traded on a registered national securities 
exchange or a registered securities association (``OTC options''). 
However, in addition to being more than 9 months from expiration, an 
OTC option or warrant must be in-the-money and guaranteed by the 
carrying broker-dealer. The proposal requires initial and maintenance 
margin of not less than 75% of the OTC option's (warrant's) in-the-
money amount (or intrinsic value), plus 100% of the amount, if any, by 
which the current market value of the OTC option or warrant exceeds the 
in-the-money amount.
    When the time remaining until expiration for a warrant or option 
(listed and OTC) on which credit has been extended reaches nine months, 
the maintenance margin requirement would become 100% of the purchase 
price.
    The proposal also would provide for the extension of credit on a 
long box spread composed entirely of European-style option. A long box 
spread is a strategy composed of four option positions which 
essentially lock-in the ability to buy and sell the underlying 
component or index for a profit, even after netting the cost of 
establishing the long box. The two exercise prices embedded in the 
strategy determine the buy and the sell price. The Exchange believes 
that because the cost of establishing the long box is covered by the 
profit realizable at expiration, there is no risk in carrying the debit 
incurred to establish the box spread. Although the Exchange believes 
that 100% of the debit could be loaned, the Exchange proposes to 
implement a margin requirement and approximates 50% of the debit. The 
Exchange's proposal would require 50% of the aggregate difference in 
the two exercise prices (buy and sell) which results in a margin 
requirement slightly higher than 50% of the debit typically incurred. 
This is both an initial and maintenance margin requirement. The 
proposal would afford a long box position a market value for margin 
equity purposes of not more than 100% of the aggregate exercise price 
differential.
    c. Cash Account. The proposal would make butterfly and box spreads 
in cash-settled, European-style options eligible for the cash account. 
To quality for carrying in the cash account, the butterfly and box 
spreads would be required to meet the specifications, contained in the 
proposed definition section. The proposal would require full cash 
payment of the debit that is incurred when a long butterfly or box 
spread strategy is established. The Exchange believes that if the debit 
is fully paid, there is no risk to the carrying broker-dealer.
    Short butterfly spread generate a credit balance when established. 
However, in the worst case scenario where all options are exercised, a 
debit (loss) greater than the initial credit balance received would 
accrue to the account. This debit or loss is limited. To eliminate the 
risk to the carrying broker-dealer, the proposal would require that the 
initial credit balance, plus an amount equal to the difference between 
the initial credit and the total risk, be held in the account in the 
form of cash or cash equivalents. The total risk potential in a short 
butterfly spread comprised of call options is the aggregate difference 
between the two lowest exercise prices. When respect to short butterfly 
spreads comprised of put options, the total potential is the aggregate 
difference between the two highest exercise prices. Therefore, to carry 
short butterfly spreads in the cash

[[Page 24582]]

account, the proposal would require that cash or cash equivalents equal 
to the maximum risk be held or deposited.
    Short box spreads also generate a credit balance when established, 
but unlike the butterfly spread, this credit is sufficient to cover the 
total debit (loss) that, in the case of a box spread, will accrue to 
the account if held to expiration. The Exchange believes the credit 
should be retained in the account. Therefore, the proposal would 
require that cash or cash equivalent coverings the maximum risk, which 
is equal to the aggregate difference in the two exercise prices 
involved, be held or deposited.
    In addition, the proposal would allow an escrow agreement to be 
utilized in lieu of the cash or cash equivalents that are a 
prerequisite to carrying short butterfly and box spreads in the cash 
account.
    d. Margin Account. Currently, the Exchange's margin rules do not 
recognize butterfly and box spreads for margin purposes. Therefore, 
margin requirements tailored to the risks of these respective 
strategies, which the Exchange believes have limited risk, are not 
currently provided. A butterfly spread is a pairing of two standard 
spreads, one bullish and one bearish. Under current Exchange margin 
rules, the two spreads (bullish and bearish) must be margined 
separately. The Exchange believes this practice requires more margin 
than necessary because the two spreads serve to offset each other with 
respect to risk. The Exchange believes that the two individual spreads 
should be viewed in combination to form a butterfly spread, and that 
commensurate with the lower combined risk, investors should receive the 
benefit of lower margin requirements. The proposal would recognize 
butterfly spreads as distinct strategies and specify requirements that 
are the same as the cash account requirements described above.
    As noted earlier, under the proposal the margin required for a long 
box spread would be 50% of the aggregate difference in the two exercise 
prices framing the strategy. This is both an initial and maintenance 
margin requirement. For margin equity purposes, a long box spread could 
not be valued at more than 100% of the aggregate exercise price 
differential. The requirement for a short box spread in the margin 
account would be the same as the cash account requirement described 
earlier. Short box spreads would not be recognized for margin equity 
purposes.
    In addition to butterfly and box spreads, the Exchange proposes to 
recognize five options strategies that are designed to limit the risk 
of a position in the underlying component. The strategies are: (i) Long 
Put/Long Stock; (ii) Long Call/Short Call; (iii) Conversion; (iv) 
Reverse Conversion; and (v) Collar. Proposed Exchange Rule 
12.3(c)(5)(C)(3), ``Exceptions,'' would identify and set forth the 
requirements for these hedge strategies.
    The five strategies are summarized below in terms of a stock 
position held in conjunction with an overlying option (or options). 
However, the proposal is structured to also apply to components that 
underlie index options and warrants. The Exchange's proposal only 
addresses maintenance margin relief for the stock component (or other 
underlying instrument) of the five proposed strategies. The Exchange 
believes that a reduction in the initial margin for the stock component 
of these strategies is not currently possible because the 50% initial 
margin requirement under Regulation T continues to apply, and the 
Exchange does not possess the independent authority to lower the 
initial margin requirement for stock. However, the Exchange notes that 
the Federal Reserve Board is considering recognizing the reduced risk 
afforded stock by these option strategies for the purpose of lowering 
initial stock margin requirements and is also considering other changes 
that would facilitate risk-based margins.
    The ``Long Put/Long Stock'' and the ``Long Call/Short Stock'' 
strategies are very similar to the ``Collar'' and ``Reverse 
Conversion'' strategies that are addressed below.
    A ``Conversion'' is a long stock position held in conjunction with 
a long put and a short call. The put and call must have the same 
expiration and exercise price. The long put/short call is essentially a 
synthetic short stock position which offsets the long stock, and the 
exercise price of the options acts like a predetermined sale price. The 
short call is covered by the long stock and the long put is a right to 
sell the stock at a predetermined price--the put exercise price. 
Regardless of any decline in market value, the stock, in effect, is 
worth no less than the put exercise price.
    A ``Reverse Conversion'' is a short stock, short put, and long call 
trio. Again, the put and call must have the same expiration and 
exercise price. The long call/short put is essentially a synthetic long 
stock position which offsets the short stock and the exercise price of 
the options acts like a predetermined purchase (buy-in) price. The 
short put is covered by the short stock and the long call is a right to 
buy the stock (in this case closing the short position) at a 
predetermined price--the call exercise price. Regardless of any rise in 
market value, the stock can be acquired for the call exercise price, in 
effect, the short position is valued at no more than the call exercise 
price. The ``Long Call/Short Stock'' hedge described above is a Reverse 
Conversion without the short put, or simply short stock offset by a 
long call.
    A ``Collar'' is a long stock position held in conjunction with a 
long put and a short call. A Collar differs from a Conversion in that 
the exercise price of the put is lower than the exercise price of the 
call in the Collar strategy, therefore, the options do not constitute a 
pure synthetic short stock position. The ``Long Put/Long Stock'' hedge 
mentioned above is similar to a Collar without the short call, or 
simply long stock hedged by a long put.
    The proposal would establish reduced maintenance margin 
requirements for the stock component of these five strategies as 
described below:
1. Long Put/Long Stock
    The lesser of:
     10% of the put exercise price, plus 100% of any amount by 
which the put is out-of-the-money; or
     25% of the long stock market value.
2. Long Call/Short Stock
    The lesser of:
     10% of the call exercise price, plus 100% of any amount by 
which the call is out-of-the-money; or
     The maintenance margin requirement on the short stock.
3. Conversion
     10% of the exercise price.
    The stock may not be valued at more than the exercise price.\8\
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    \8\ The writer of a call option has an obligation to sell the 
underlying component at the call exercise price. The writer cannot 
receive the benefit of a market value that is above the call 
exercise price because, if assigned an exercise, the underlying 
component would be sold at the exercise price, not the market price.
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4. Reverse Conversion
     10% of the exercise price, plus any in-the-money 
amount.\9\
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    \9\ The writer of a put option has an obligation to buy the 
underlying component at the put exercise price. If assigned an 
exercise, the underlying component would be purchased (the short 
position effectively closed) at the exercise price, even in the 
event the market price is lower. To offset the benefit to the 
account of a lower market value, the put in-the-money amount is 
added to the requirement.
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5. Collar
    The lesser of:
     10% of the put exercise price, plus 100% of any amount by 
which the put is out-the-money; or

[[Page 24583]]

     25% of the call exercise price.
    The stock may not be valued at more than the call exercise price.
    These same maintenance margin requirements will apply, for example, 
when these strategies are utilized with a mutual fund or a stock basket 
underlying index options or warrants.
    e. Restructuring. The proposal would replace the present margin 
requirement for short (uncovered) listed options with current 
Interpretation and Policy .01 to Exchange Rule 12.3 
(``Interpretation''). The Interpretation contains a table listing all 
existing options and warrant products, their underlying component or 
index, the percentage used in a basic formula for calculating the 
margin requirement, and the percentage used in the calculation of a 
minimum requirement that becomes operative whenever the basic formula 
results in a lower requirement.\10\ The revision will ensure that the 
margin requirements for all types of options and warrants will be set 
forth in one section in an efficient and organized manner. The 
restructuring also allows the deletion of the short, uncovered option 
margin requirements for option/warrant products that now appear in the 
other chapters (Chapter 23 (interest rate options), Chapter 24 (index 
options), and Chapter 30 (warrants)) because the methodology for 
calculating the margin is identical--only the percentages and 
underlying components or indexes differ.
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    \10\ A row also has been added to the table to incorporate the 
margin requirement for a narrow-based stock index warrant. This 
requirement is being moved from Chapter 30.
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    The margin requirements for short (uncovered) positions in OTC 
options would be relocated under Exchange Rule 12.3(c)(5)(B). The text 
of the Interpretation (margin requirements for short listed options) 
currently differs from the text of the Exchange rule that sets forth 
the margin requirements for short OTC options. The difference stems 
from the fact that the current Exchange rule relating to OTC options 
was modeled after the NYSE margin rule. To establish consistency and 
better organization, the proposal would revise the text of the margin 
requirements for both listed and OTC short options to make them 
similar. The Exchange has noted that the methodology of both margin 
requirements is essentially the same, only different percentages are 
applied.
    In addition, to the extent possible, the proposal has combined the 
margin requirements pertaining to long position offsets for short OTC 
options with those for short listed options. The revision will combine 
two sets of relatively identical requirements that currently exist.
    f. Consolidation. For the most part, the proposal would delete the 
margin requirements applicable to short options/warrants and spreads 
that currently appear in Chapters 23, 24, and 30. Exchange Rule 12.3 
would be restructured to generically cover the margin requirements for 
short and spread positions in options/warrants of the types currently 
in the other chapters. Other complex requirements located elsewhere 
that are not amenable to such generic treatment, have been incorporated 
into Exchange Rule 12.3 as necessary.
    g. Miscellaneous. 1. Time Margin Must Be Obtained. The proposal 
would clarify the time in which initial margin, or payment in respect 
of cash account transactions, is due. Exchange Rule 12.2, which was 
adopted at a time when the Exchange had authority only to set 
maintenance margin levels, currently requires that margin be obtained 
as promptly as possible. Because the Exchange now has additional 
rulemaking responsibility for initial margin requirements, the proposal 
specifies that initial margin requirements are due in one ``payment 
period'' as defined in Regulation T.\11\ The proposal also revises 
Exchange Rule 12.2 to specify that maintenance margin must be obtained 
as promptly as possible, but in any event within 15 days (rather than 
the former standard--``within a reasonable time''). The Exchange 
believes this revision is consistent with the current NYSE requirement.
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    \11\ 12 CFR 220.2.
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    2. Effect of Mergers and Acquisitions on the Margin Required for 
Short Equity Options. The proposal would implement as Interpretation 
and Policy .13 of Exchange Rule 12.3, an exception to the margin 
requirement for short options in the event trading in the underlying 
security ceases due to a merger or acquisition. The exception currently 
exists pursuant to an Exchange Regulatory Circular. Under the 
exception, if an underlying security ceases to trade due to a merger or 
acquisition, and a cash settlement price has been anounced by the 
issuer of the option, margin would be required only for in-the-money 
options and would be set at 100% of the in-the-money amount. The 
Exchange has noted that the NYSE currently maintains a similar written 
interpretation.
    3. Determination of Value for Margin Purposes. The proposal would 
revise Exchange Rule 12.5 to make it consistent with the other portion 
of the Exchange's proposal that allows the extension of credit on 
certain long-term options. Currently, Exchange Rule 12.5 does not allow 
the market value of long-term options to be considered for margin 
equity purposes. The revision would allow options and warrants eligible 
for loan value pursuant to proposed Rule 12.3 to be valued at current 
market prices for margin purposes. The Exchange believes the change in 
necessary to ensure that the value of the option or warrant (the 
collateral) is sufficient to cover the debit carried in conjunction 
with the purchase.
    4. OTC Options. Some minor corrections have been made to the table 
in Exchange Rule 12.3(c)(5)(B) that displays the margin requirements 
for short OTC options.
    5. Exempted Securities. Currently, the Exchange's maintenance 
margin requirement for a non-convertible debt security is found in 
Exchange Rule 12.3(c)(1), ``Exempted Securities.'' However, the term 
``non-convertible debt security'' refers to corporate bonds which are 
not considered exempt securities under the Act. Therefore, the Exchange 
seeks to remove the paragraph regarding non-convertible debt securities 
from the ``Exempted Securities'' category, and redesignate it as a 
separate section of Exchange Rule 12.3(c)(2).
2. Statutory Basis
    The Exchange believes the proposed rule change is consistent with 
and furthers the objectives of Section 6(b)(5) of the Act,\12\ in that 
it is designed to perfect the mechanisms of a free and open market, and 
to protect investors and the public interest.
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    \12\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any inappropriate burden on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange did not solicit or receive written comments with 
respect to the proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal

[[Page 24584]]

Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which the Exchange consents, the Commission will:
    (A) By order approve the proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. 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 submissions, 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 persons, 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, D.C. 20549. Copies of such filing will also be available 
for inspection and copying at the principal office of the Exchange. All 
submission should refer to File No. SR-CBOE-97-67 and should be 
submitted May 26, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12)
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-11747 Filed 5-1-98; 8:45 am]
BILLING CODE 8010-01-M