[Federal Register Volume 63, Number 131 (Thursday, July 9, 1998)]
[Notices]
[Pages 37153-37155]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-18146]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40158; File No. SR-CBOE-98-23]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Chicago Board Options Exchange, Inc., Relating to the 
Elimination of Position and Exercise Limits for Options on Broad-Based 
Indexes

July 1, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act'' or ``Act'')\1\ and Rule 19b-4 thereunder,\2\ notice 
is hereby given that on June 11, 1998, the Chicago Board Options 
Exchange, Inc. (``CBOE'' or ``Exchange'') filed with the Securities and 
Exchange Commission (``Commission'' or ``SEC'') the proposed rule 
change as described in Items I, II and III below, which Items have been 
prepared by the self-regulatory organization. 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).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The CBOE proposes to eliminate position and exercise limits for 
broad-based index options. The current reporting procedures, with 
slight modifications, which serve to identify large option holdings and 
hedging information, will remain in place.
    The text of the proposed rule change is available at the Office of 
the Secretary, CBOE 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 self-regulatory organization 
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 self-regulatory organization 
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 CBOE is proposing the elimination of position and exercise 
limits for broadbased index options for the reasons detailed below. The 
Exchange will, however, still require that member organizations file 
reports with the Exchange in the event that they maintain proprietary 
or customer positions in excess of Exchange established reporting 
thresholds in the different broad-based index option products.
    Manipulation. The CBOE believes that position and exercise limits 
in broad-based index options no longer serve their stated purpose. The 
Commission has stated that:

    Since the inception of standardized options trading, the options 
exchanges have had rules imposing limits on the aggregate number of 
options contracts that a member or customer could hold or exercise. 
These rules are intended to prevent the establishment of options 
positions that can be used or might create incentives to manipulate 
or disrupt the underlying market so as to benefit the options 
position. In particular, position and exercise limits are designed 
to minimize the potential for mini-manipulations and for corners or 
squeezes of the underlying market. In addition such limits serve to 
reduce the possibility for disruption of the options market itself, 
especially in illiquid options classes.\3\

    \3\ Exchange Act Release No. 39489 (December 24, 1997), 63 FR 
276 (January 5, 1998) (SR-CBOE-97-11) (order approving an increase 
in OEX position and exercise limits).
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On the fifteenth anniversary of listed index options trading, the 
Exchange believes that the size of the market underlying broad-based 
index options is so large as to dispel any concerns regarding market 
manipulation. To date, there has not been a single disciplinary action 
involving manipulation in any broad-based index product listed on the 
Exchange. The Exchange believes that its fifteen years of experience 
conducting surveillance of index options and program trading activity 
is sufficient to identify improper activity. The CBOE believes that 
routine oversight inspections of CBOE's regulatory programs by the 
Commission have not uncovered any inconsistencies or shortcomings in 
the manner in which index option surveillance is conducted. These 
procedures entail a daily monitoring of market movements via automated 
surveillance techniques to identify unusual activity in both the 
options and underlying stock basket components. Moreover, the CBOE 
believes that current NYSE Market on Open and Market on Close 
procedures facilitate the orderly unwinding of large index program 
trades.\4\ Further, the significant increases in unhedged options 
capital charges resulting from the September 1997 adoption of risk-
based haircuts and the high margin requirements applicable to these 
products under Exchange rules serves as a more effective protection 
than position limits ever have or ever could.\5\
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    \4\ See NYSE Informational Memo Number 96-34 (November 8, 1996).
    \5\ See Exchange Act Release No. 34-38248 (February 6, 1997), 62 
FR 6474 (February 12, 1997) (adopting Risk-Based Haircuts); and CBOE 
Rule 24.11 Margins.
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    Competition. The Commission has stated that ``limits must not be 
established at levels that are so low as to discourage participation in 
the options market by institutions and other investors with substantial 
hedging needs or to prevent specialists and market-makers from 
adequately meeting their obligations to maintain a fair and orderly 
market.'' \6\ However, in today's market, the Exchange believes that 
position and exercise limits severely hamper CBOE's ability to compete 
with the OTC and futures markets. Investors who trade listed options on 
the CBOE are placed at a serious disadvantage in comparison to the OTC 
market where index options and other types of index based derivaties 
(e.g., forwards and swaps) are not subject to position and exercise 
limits. Member firms continue to express concern to the Exchange that 
position limits on CBOE products are an impediment to their business 
and that they have no choice but to move their

[[Page 37154]]

business to the OTC market where position limits are not an issue.
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    \6\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. At 189-91 
(Comm. Print 1978).
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    Position and exercise limits restrict legitimate options use. The 
Exchange believes that the current base limit for broad-based index 
options \7\ is not adequate for the hedging needs of institutions which 
engage in trading strategies differing from those covered under the 
index hedge exemption policy (e.g., delta hedges, OTC vs. listed 
hedges). Moreover, the current index hedge exemption, which requires a 
daily monitoring of positions and reports to the exchange is too 
cumbersome. CBOE and member firm compliance staff devote an inordinate 
amount of time monitoring a firm's position, when in fact, the firm is 
more than adequately capitalized to carry such sizeable option 
positions. The CBOE believes that, with the elimination of position 
limits for these products, staff resources could be better utilized 
elsewhere.
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    \7\ The base limits for broad-based index options are set forth 
in paragraph (a) of Rule 24.4. The limits range from 25,000 
contracts in OEX to 1,000,000 contracts on options based on the Dow 
Jones Industrial Average (``DJIA''), which is a contract that is 
based on one-one hundredth of the value of the DJIA.
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    Financial requirements. The Exchange believes that financial 
requirements imposed by the Exchange and by the Commission adequately 
address concerns that a member or its customer may try to maintain an 
inordinately large unhedged position in a broad-based index option. 
Current margin, and risk-based haircut methodologies serve to limit the 
size of positions maintained by any one account by increasing the 
margin and/or capital that a member must maintain for a large position 
held by itself or by its customer.\8\ It should also be noted that the 
Exchange has the authority under paragraph (h) of Rules 12.3 and 12.10 
to impose a higher margin requirement upon the member of member 
organization when the Exchange determines a higher requirement is 
warranted. In addition, the Commission's net capital rule, Rule 15c3-1 
under the Exchange Act, imposes a capital charge on members to the 
extent of any margin deficiency resulting from the higher margin 
requirement.
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    \8\ Exchange Act Rule 15c3-1 requires a capital charge equal to 
the maximum potential loss on a broker-dealer's aggregate index 
position over a +(-) 10% market move. Exchange margin rules require 
margin on naked index options which are in or at-the-money equal to 
a 15% move in the underlying index; and a minimum 10% charge for 
naked out-of-the money contracts. At an index value of 9,000 this 
approximates to a $135,000 to $90,000 requirement per each unhedged 
contract. This compares to an approximate $36,000 requirement for an 
equivalent index futures contract position.
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    FLEX Equity options. In 1997, the SEC approved the elimination of 
position and exercise limits in FLEX Equity options under a two-year 
pilot program.\9\ To date, there have been no adverse effects on the 
market as a result of the elimination of position and exercise limits. 
Member firms have commented favorably on this change and believe that 
it is the first step towards eliminating position and exercise limits 
in all option products. In its release approving the elimination of 
FLEX equity option limits for a two-year pilot, period, the Commission 
stated that the elimination of position limits will allow the listed 
options markets to better compete with the OTC market.\10\

    \9\ Exchange Act Release No. 39032 (September 9, 1997), 62 FR 
48683 (September 16, 1997) (order approving SR-CBOE-96-79).
    \10\ Id.

    [T]he elimination of position and exercise limits for FLEX 
equity options allows the Exchanges to better compete with the 
growing OTC market in customized equity options, thereby encouraging 
fair competition among brokers and exchange markets. The attributes 
of the Exchanges' options markets versus an OTC market include, but 
are not limited to, a centralized market center, an auction market 
with posted transparent market quotations and transaction reporting, 
parameters and procedures for clearance and settlement, and the 
guarantee of the OCC for all contracts traded on the Exchanges.\11\
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    \11\ Id. at 48685. The Commission notes that approval of the 
elimination of position and exercise limits for FLEX equity options 
for a two-year pilot period and was based on several other factors 
including, in large part, additional safeguards adopted by the 
exchanges to allow them to monitor large options positions.
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    Reporting requirements. The Exchange will require that each member 
or member organization that maintains a position on the same side of 
the market in excess of 100,000 contracts in any broad based index 
option class, for its own account or for the account of a customer 
report certain information. This data would include, but would not be 
limited to, the option position, whether such position is hedged, and, 
if so, a description of the hedge and if applicable, the collateral 
used to carry the position. Exchange market-makers would continue to be 
exempt from this reporting requirement as market-maker information can 
be accessed through the Exchange's market surveillance systems. The 
Exchange proposes to increase the reporting level to 100,000 contracts 
\12\ from the current levels (i.e., 45,000 for SPX and 65,000 for OEX) 
for the following reasons. To date, information collected shows that 
member firms and customer accounts are hedged with either futures, 
options on futures or index options. This information can be obtained 
either through in-house surveillance systems, from the Chicago 
Mercantile Exchange or by contacting the member firm. Considering that 
the CBOE currently lists sixteen (16) different broad-based index 
option products, imposing a uniform reporting number will eliminate 
confusion. The CBOE believes that an increase in the reporting level to 
100,000 contracts for all broad based index products will result in the 
collection of more meaningful information, and will lessen the 
administrative burden for member firms and for the Exchange staff. In 
addition, the general reporting requirement for customer accounts that 
maintain a position in excess of 200 contracts will remain at this 
level for broad based index options.\13\ Last, it is important to note 
that the proposed 100,000 contract reporting requirement is above and 
beyond what is currently required in the OTC market. NASD member firms 
are only required to report index option positions in excess of 200 
contracts and are not required to report any related hedging 
information.
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    \12\ Currently only OEX and SPX are subject to reporting 
requirements beyond those required by Exchange Rule 4.13. The 
Exchange would expand this revised reporting requirement to all 
broad-based index options.
    \13\ See Exchange Rule 4.13 Reports Related to Position Limits.
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2. Basis
    The Exchange believes that the proposal is consistent with Section 
6(b)\14\ of the Act, in general, and Section 6(b)(5)\15\ of the Act, in 
particular, in that it is designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in facilitating transactions in securities, and to 
remove impediments to and perfect the mechanism of a free and open 
market and a national market system.
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    \14\ 15 U.S.C. 78f(b).
    \15\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange believes that the proposed rule changes are consistent 
with Section 6(b) of the Act in general, and further the objectives of 
Section 6(b)(5), in particular, in that they are designed to promote 
just and equitable principles of trade and to protect investors and the 
public interest.

[[Page 37155]]

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

    Written comments on the proposed rule change were neither solicited 
nor received.

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 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 self-regulatory organization consents, the Commission will:
    (A) by order approve such 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 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 in the 
Commission's Public Reference Room, located at the above address. 
Copies of such filing will also be available for inspection and copying 
at the principal office of the self-regulatory organization. All 
submissions should refer to File No. SR-CBOE-98-23 and should be 
submitted by July 30, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-18146 Filed 7-8-98; 8:45 am]
BILLING CODE 8010-01-M