[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