[Federal Register Volume 63, Number 132 (Friday, July 10, 1998)]
[Notices]
[Pages 37430-37433]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-18413]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40166; File No. SR-CBOE-97-03]
Self-Regulatory Organizations; Order Granting Approval of a
Proposed Rule Change and Notice of Filing and Order Granting
Accelerated Approval of Amendment Nos. 2 and 3 to the Proposed Rule
Change by the Chicago Board Options Exchange, Inc. Relating to Options
on Interests in Listed, Open-End, Indexed Investment Companies
July 2, 1998.
I. Introduction
On January 22, 1997, the Chicago Board Options Exchange, Inc.
(``CBOE'' or ``Exchange''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ filed with the Securities and Exchange Commission
(``SEC'' or ``Commission'') a proposed rule change to adopt rules to
permit the trading of options on securities representing interest in
open-end, exchange-listed investment companies that hold a portfolio of
securities comprising or based on a broad-based stock index
(``Exchange-Traded Fund Shares'' or ``Fund Shares''). Notice of the
proposal appeared in the Federal Register on March 5, 1997.\3\ No
comment letters were received on the proposed rule change.\4\ On
January 12, 1998, the Exchange filed Amendment No. 2 to the
proposal.\5\ On May 18, 1998, the CBOE
[[Page 37431]]
filed Amendment No. 3 to the proposed rule change.\6\ Finally, on June
24, 1998, the Exchange filed a technical amendment to the filing.\7\
This order approves the Exchange's proposal, and Amendment Nos. 2 and 3
on an accelerated basis.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 38342 (February 26,
1997), 62 FR 10098.
\4\ On May 2, 1997, the CBOE filed an amendment to the proposed
rule change. See Letter from Michael L. Meyer, Esq., Schiff Hardin &
Waite, to Howard L. Kramer, Senior Associate Director, Office of
Market Supervision (``OMS''), Division of Market Regulation
(``Division''), Commission, dated May 2, 1997 (``Amendment No. 1'').
Amendment No. 1 made no changes to the proposal, but merely
clarified the Exchange's original filing. Amendment No. 1 is no
longer relevant, and has been replaced and superseded by Amendment
Nos. 2 and 3.
\5\ See Letter from Michael L. Meyer, Esq., Schiff Hardin &
Waite to Howard L. Kramer, Senior Associate Director, OMS, Division,
Commission, dated January 9, 1998 (``Amendment No. 2''). In
Amendment No. 2 the Exchange proposes to revise the listing
standards for Fund Shares set forth in Interpretation and Policy .06
under Rule 5.3 to require, in addition to other criteria, either:
(1) that the underlying Fund Shares or units must satisfy the same
criteria and guidelines under CBOE rules that apply to determine the
eligibility for listing options on underlying equity securities; or
(2) that the issuer is obligated to issue Fund Shares in a specified
aggregate number in return for a cash deposit in an amount equal to
the value of the securities that comprise the index or portfolio
represented by the Fund Shares. In addition, Amendment No. 2
provides that the same tiered position and exercise limits that
apply to options on individual equity securities will apply to
options on Fund Shares. Finally, Amendment No. 2 removed certain
continued listing standards that were in the original filing.
\6\ See Letter form Joseph Levin, Vice President, Research,
CBOE, to Howard L. Kramer, Senior Associate Director, OMS, Division,
Commission, dated May 14, 1998 (``Amendment No. 3''). In Amendment
No. 3 the Exchange proposes a new surveillance sharing standard for
options on Fund Shares that include non-U.S. stocks in the index or
portfolio upon which Fund Shares are based. In addition, Amendment
No. 3 includes continued listing standards for options on Fund
Shares, which are discussed herein.
\7\ See Letter from Michael L. Meyer, Esq., Schiff Hardin &
Waite, to James T. McHale, Special Counsel, OMS, Division,
Commission, dated June 23, 1998 (``Amendment No. 4''). Amendment No.
4 merely corrects an erroneous cross-reference in Interpretation and
Policy .08 to Rule 5.4.
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II. Description of the Proposal
The purpose of the proposed rule change is to provide for the
trading of options on Fund Shares. As noted above, Fund Shares are
exchange-listed securities representing interests in open-end unit
investment trusts or open-end management investment companies
(``Funds'') that hold securities based on an index or a portfolio of
securities. Fund Shares are issued in exchange for an ``in kind''
deposit of a specified portfolio of securities, together with a cash
payment, in minimum size aggregations or multiples thereof (``Creation
Units''). The size of the applicable Creation Unit size aggregation is
set forth in the Fund's prospectus, and varies from one series of Fund
Shares to another, but generally is of a substantial size (e.g., value
in excess of $450,000 per creation unit). A fund, generally, will issue
and sell Fund Shares in Creation Unit size through a principal
underwriter on a continuous basis at the net asset value per share next
determined after an order to purchase Fund Shares and the appropriate
securities are received. Following issuance, Fund Shares are traded on
an exchange like other equity securities, and equity trading rules
apply. Likewise, redemption of Fund Shares is made in Creation Unit
size and ``in kind,'' with a portfolio of securities and cash exchanged
for Fund Shares that have been tendered for redemption.
The CBOE proposes to trade options on Fund Shares pursuant to the
same rules and procedures that apply generally to trading in options on
equity securities, except that some special listing criteria are
proposed to apply to this category of options. Options on Fund Shares
will be physically-settled and will have either the European-style or
American-style exercise feature, as specified.\8\
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\8\ Telephone conversation between Michael L. Meyer, Esq.,
Schiff Hardin & Waite, and James T. McHale, Special Counsel, OMS,
Division, Commission, on June 30, 1998.
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The listing and maintenance standards proposed for options on Fund
Shares are set forth in proposed Interpretation and Policy .06 under
CBOE Rule 5.3 and in Interpretation .10 under CBOE Rule 5.4,
respectively. Pursuant to the proposed initial listing standards, CBOE
only will list options on Fund Shares that are principally traded on a
national securities exchange or through the facilities of a national
securities association and reported as national market securities. In
addition, the initial listing standards require that either: (1) the
Fund Shares meet the uniform options listing standards in CBOE Rule 5.3
and Interpretation and Policy .01 thereunder, which include minimum
public float, trading volume, and share price of the underlying
security in order to list the option;\9\ or (2) the Exchange-Traded
Fund Shares must be available for creation or redemption each business
day in cash or in kind from the Fund at a price related to the net
asset value, and the Exchange will require that the Fund is obligated
to issue Fund Shares in a specified aggregate number even though some
or all of the securities needed to be deposited have not been received
by the Fund.\10\
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\9\ Specifically, Interpretation and Policy .01 to Rule 5.3
requires the underlying security to have a public float of 7,000,000
shares, 2000 holders, trading volume of 2,400,000 shares in the
preceding 12 months, a share price of $7.50 for the majority of the
business days during the three calendar months preceding the date of
the selection, and that the issuer of the underlying security is in
compliance with the Act.
\10\ Provided the person obligated to deposit the securities has
undertaken to deliver the securities as soon as possible and such
undertaking has been secured by the delivery and maintenance of
collateral consisting of cash or cash equivalents satisfactory to
the Fund which underlies the option, as described in the Fund
prospectus. See Amendment No. 3, supra note 6.
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In addition, the initial listing standards require that: (1) any
Fund Share with non-US stocks in the underlying index or portfolio that
are not subject to comprehensive surveillance agreements do not in the
aggregate represent more than 50% of the weight of the index or
portfolio; (2) stocks for which the primary market is in any one
country that is not subject to a comprehensive surveillance agreement
do not represent 20% of more of the weight of the index; and (3) stocks
for which the primary market is in any two countries that are not
subject to comprehensive surveillance agreements do not represent 33%
of more of the weight of the index.\11\
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\11\ See Amendment No. 3, supra note 6.
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The Exchange's proposed maintenance standards provide that if a
particular series of Exchange-Traded Fund Shares should cease to trade
on an exchange or as national market securities in the over-the-counter
market, there will be no opening transactions in the options on the
Fund Shares, and all such options will trade on a liquidation-only
basis. In addition, the CBOE will consider the suspension of opening
transactions in any series of options of the class covering Fund Shares
if: (1) the options fail to meet the uniform equity option maintenance
standards in paragraphs (a), (b), (c), and (d) of Interpretation and
Policy .01 to Rule 5.4,\12\ when the options were listed pursuant to
the equity option listing standards of Rule 5.3 and Interpretation and
Policy .01 thereunder; \13\ (2) following the initial twelve-month
period beginning upon the commencement of trading of the Fund Shares on
a national securities exchange or as national market securities through
the facilities of a national securities association there are fewer
than 50 record and/or beneficial holders of Fund Shares for 30 or more
consecutive trading days, when options on Fund Shares were listed
pursuant to clause (D)(y) under Interpretation and Policy .06 of Rule
5.3; \14\ or (3) the value of the index or portfolio of securities on
which the Fund Shares are based is no longer calculated or available.
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\12\ Specifically, paragraphs (a), (b), (c) and (d) of
Interpretation and Policy .01 to Rule 5.4 provide that an underlying
security will not meet the Exchange's requirements for continued
listing when, among other things: (1) there are fewer than 6,300,000
publicly-held shares; (2) there are fewer than 1600 holders; (3)
trading volume was less than 1,800,000 shares in the preceding
twelve months; and (4) the share price of the underlying security
closed below $5 on a majority of the business days during the
preceding 6 months.
\13\ See Amendment No. 2, supra note 5. The Commission notes
that even if options on Fund Shares were not listed under the
uniform equity option listing standards, initial listing standards
for the underlying Fund Shares typically require a minimum number of
Fund Shares to be outstanding before trading in a series of Fund
Shares may commence. In addition, the CBOE has represented that
although there is no comparable public float maintenance standard
for the underlying Fund Shares, as a practical matter there can
never be trading in a series of Fund Shares in which there is less
than one Creation Unit outstanding, since Fund Shares only may be
created and redeemed in Creation Unit size, and if the last
outstanding Creation Unit should ever be redeemed, the series (and
the options on that series) will cease to trade.
\14\ See Amendment No. 4, supra note 7.
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Reflecting the indexed nature of the underlying portfolios of the
Fund
[[Page 37432]]
Shares on which options are proposed to be traded, the Exchange
proposes to amend Interpretation and Policy .01 under Exchange Rule 5.5
to provide that the minimum strike price intervals for these options
will be $2.50 where the strike price is $200 or less, and $5.00 where
the strike price is over $200. These are comparable to the strike price
intervals provided in Interpretation and Policy .01 under Exchange Rule
24.9, as applicable to broad-based index options having strike prices
at about the level expected for options on Fund Shares.
Margin requirements are proposed for options on Fund Shares at the
same levels that apply to options generally under Exchange Rule 12.3,
except that, reflecting the broad-based nature of the index or
portfolio underlying Fund Shares, minimum margin must be deposited and
maintained equal to 100% of the current market value of the option plus
15% (instead of 20%) of the market value of equivalent units of the
underlying security value. In this respect, the margin requirements
proposed for options on Fund Shares are comparable to margin
requirements that currently apply to broad-based index options under
Exchange Rule 24.11(b)(i).\15\
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\15\ The Commission notes that the CBOE's proposal is limited to
trading options on Fund Shares comprising or based on a broad-based
index or portfolio.
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CBOE believes it has the necessary systems capacity to support the
additional series of options that would result from the introduction of
options on Fund Shares, and it has been advised that the Option Price
Reporting Authority (``OPRA'') also has the capacity to support these
additional series.\16\
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\16\ See memorandum from Joseph Corrigan, Executive Director,
OPRA, to Eileen Smith, CBOE, dated January 21, 1997.
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III. Commission 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, the requirements of Section 6(b)(15).\17\ Specifically, the
Commission believes that providing for the listing and trading of
standardized options on Exchange-Traded Fund Shares should give
investors a better means to hedge their positions in the underlying
Fund Shares. Further, the Commission believes that pricing of the
underlying Fund Shares may become more efficient and market makers in
these shares, by virtue of enhanced hedging opportunities, may be able
to provide deeper and more liquid markets. In sum, the Commission
believes that options on Fund Shares likely will engender the same
benefits to investors and the market place that exist with respect to
options on common stock,\18\ thereby serving to promote the public
interest, remove impediments to a free and open securities market, and
promote efficiency, competition, and capital formation.\19\
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\17\ 15 U.S.C. 78f(b)(5).
\18\ 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 new product is in the public interest. Such
a finding would be difficult for a derivative instrument that served
no hedging or 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.
\19\ 15 U.S.C. 78c(f).
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As a general matter, 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 options on Fund
Shares, can commence trading 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 costumers; (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. With
regard to position and exercise limits, the Commission finds that it is
appropriate to adopt the tiered approach used in setting position and
exercise limits for standardized stock options. This approach should
serve to minimize potential manipulation and market impact concerns.
Accordingly, because options on Fund Shares will be subject to the same
regulatory regime as the other standardized options currently traded on
the CBOE, the Commission believes that adequate safeguards are in place
to ensure the protection of investors in options on Fund Shares.
The Commission also believes that it is appropriate to permit the
CBOE to list and trade options on Exchange-Traded Fund Shares given
that these options must meet specific requirements related to the
protection of investors.\20\ First, the Exchange's listing and
delisting criteria for options on Fund Shares are adequate. With regard
to initial listing, the proposal requires that either: (1) The
underlying Fund Shares meet the CBOE's uniform options listing
standards; or (2) the Exchange-Traded Fund Shares must be available for
creation or redemption each business day in cash or in kind from the
Fund at a price related to the net asset value, and the Exchange will
require that the Fund is obligated to issue Fund Shares in a specified
aggregate number even though some or all of the securities needed to be
deposited have not been received by the Fund.\21\ This listing
requirement should ensure that there exists sufficient supply of the
underlying Fund Shares so that a short call writer, for example, will
have the ability to secure delivery of the Fund Shares upon exercise of
the option.
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\20\ The Commission notes, and CBOE has verified, that holders
of options on Fund Shares who exercise and receive the underlying
Fund Shares must receive, like any purchaser of Fund Shares, a
product description or prospectus, as appropriate. Telephone
Conservation between Michael L. Meyer, Esq., Schiff Hardin & Waite,
and James T. McHale, Special Counsel, OMS, Division, Commission, on
June 30, 1998.
\21\ Provided the person obligated to deposit the securities has
undertaken to deliver the securities as soon as possible and such
undertaking has been secured by the delivery and maintenance of
collateral consisting of cash or cash equivalents satisfactory to
the Fund which underlies the option, as described in the Fund
prospectus.
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In reviewing the CBOE's proposal, as originally submitted, the
Commission had been concerned with the ability to produce Fund Shares
upon exercise of the option. The Commission believes the CBOE has
adequately addressed these concerns through the adoption of the listing
standards set forth above. In particular, options listed pursuant to
the uniform options listing standards will have to meet the options
maintenance listing standards which require, among other things, that a
minimum number of Fund Shares be outstanding to continue trading the
options.\22\ The alternative listing criteria, noted above, should also
help to ensure that the underlying Fund Shares will be available upon
exercise by requiring the Fund to allow market participants to create
Fund Shares even though some or all of the necessary securities needed
to be deposited are not available.\23\ Although there is no absolute
assurance that market participants will go ahead and create Fund Shares
in the event a short call writer needs to purchase Fund Shares to meet
an exercise notice, it is likely that arbitrage opportunities will
create an incentive to do so. Further, in the event there are not
enough Fund Shares to meet exercise requirements, as with other
physically-settled equity options, the Options Clearing Corporation
[[Page 37433]]
(``OCC'') has rules that would apply to such situations.
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\22\ See supra note 12.
\23\ See supra note 21.
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Second, the Commission believes that the surveillance standard
developed by the CBOE for options on Fund Shares is adequate to address
the concerns associated with the listing and trading of such
securities. Specifically, the CBOE has proposed that: (1) Any Fund
Share with non-US stocks in the underlying index or portfolio that are
not subject to comprehensive surveillance agreements do not in the
aggregate represent more than 50% of the weight of the index or
portfolio; (2) stocks for which the primary market is in any one
country that is not subject to a comprehensive surveillance agreement
do not represent 20% or more of the weight of the index; and (3) stocks
for which the primary market is in any two countries that are not
subject to comprehensive surveillance agreements do not represent 33%
or more of the weight of the index.\24\
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\24\ The Exchange uses the term ``comprehensive surveillance
agreement'' to mean an agreement which requires that the parties
provide each other, upon request, information about market trading,
clearing activity and the identity of the ultimate purchasers and
sellers of securities. Telephone conversation between Michael L.
Meyer, Esq., Schiff Hardin & Waite, and James T. McHale, Special
Counsel, OMS, Division, Commission, on June 30, 1998.
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As a general matter, the Commission believes that comprehensive
surveillance agreements provide an important deterrent to manipulation
because they facilitate the availability of information needed to fully
investigate a potential manipulation if it were to occur. These
agreements are especially important in the context of derivative
products based on foreign securities because they facilitate the
collection of necessary regulatory, surveillance and other information
from foreign jurisdictions. In evaluating the current proposal, the
Commission believes that requiring comprehensive surveillance
agreements to be in place between the CBOE and the primary markets for
foreign securities that represent 50% or more of the weight of the
underlying index or portfolio upon which Fund Shares are based, as well
as the other conditions discussed above, provides an adequate mechanism
for the exchange of surveillance sharing information necessary to
detect and deter possible market manipulations. Although the Commission
recognizes that up to 50% of the portfolio's value may not be covered
by comprehensive surveillance agreements, the other requirement will
ensure that a significant percentage of the portfolio is not made up of
securities from uncovered countries.
Further, as to the domestically-traded Fund Shares themselves and
the domestic stocks in an underlying index or portfolio upon which Fund
Shares are based, the Intermarket Surveillance Group (``ISG'') \25\
Agreement will be applicable to the trading of options on Fund Shares.
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\25\ ISG was formed on July 14, 1983 to, among other things,
coordinate more effectively surveillance and investigative
information sharing arrangements in the stock and options markets.
See Intermarket Surveillance Group Agreement, July 14, 1983. The
members of ISG include all of the registered National Securities
Exchanges and the National Association of Securities Dealers, Inc.
(``NASD''). In addition, the major stock index futures exchanges
(e.g., the Chicago Mercantile Exchange and the Chicago Board of
Trade) are affiliate members of ISG.
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Finally, the Commission believes that requiring minimum margin of
100% of the current market value of the option plus 15% of the market
value of the underlying security value (``broad-based margin'') for
options on Fund Shares is appropriate. The Commission notes that this
margin requirement is comparable to margin requirements that currently
apply to broad-based index options, and that the CBOE's proposal is
limited to trading options on Fund Shares comprising or based on a
broad-based index or portfolio. Accordingly, the Commission believes
that broad-based margin is appropriate for options on Fund Shares.
The Commission finds good cause for approving Amendment Nos. 2, and
3 to the proposed rule change prior to the thirtieth day after the date
of publication of notice thereof in the Federal Register. Amendment No.
2 strengthens the proposal by: (1) providing that either the Fund
Shares underlying the options satisfy the listing standards for options
on underlying equity securities or the Fund has agreed to issue Fund
Shares even though some or all of the securities needed to be deposited
have not been received, thus ensuring a minimum level of liquidity; and
(2) adopting standardized equity option position and exercise limits.
Amendment No. 2 also removed certain continued maintenance standards,
but these requirements were added back to CBOE's rules with Amendment
No. 3.
The Commission also believes that Amendment No. 3, concerning
surveillance requirements, strengthens the CBOE's proposal. Amendment
No. 3 provides a clear, objective standard for determining the
comprehensive surveillance requirements for trading options on Fund
Shares where the underlying index or portfolio contains non-U.S.
stocks. In addition, Amendment No. 3 strengthens the Exchange's
proposal by including contained listing standards for options on Fund
Shares.
Finally, the Commission notes that no comments were received on the
original CBOE proposal, which was subject to the full 21-day comment
period. Accordingly, the Commission believes that there is good cause,
consistent with Section 6(b)(5) of the Act, to approve Amendment Nos. 2
and 3 to the proposed rule change on an accelerated basis.
Amendment No. 4 merely corrects an erroneous cross-reference in
Interpretation and Policy .08 to Rule 5.4.\26\
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\26\ Because Amendment No. 4 is technical in nature, it is not
subject to a notice and comment requirement.
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Interested persons are invited to submit written data, views and
arguments concerning Amendment Nos. 2 and 3 to the proposed rule
change, including whether such Amendments are consistent with the Act.
Persons making written submissions should file six copies thereof with
the Secretary, Securities and Exchange Commission, 450 Fifth Street,
NE., Washington, DC 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 Section, 450 Fifth Street, NW., Washington, DC. Copies of
such filing will also be available for inspection and copying at the
principal office of the CBOE. All submissions should refer to File No.
SR-CBOE-97-03 and should be submitted by July 31, 1998.
For the foregoing reasons, the Commission finds that the CBOE's
proposal to list and trade options on Fund Shares 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,\27\ that the proposed rule change (File No. SR-CBOE-97-03), as
amended, is approved.
\27\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\28\
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\28\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-18413 Filed 7-9-98; 8:45 am]
BILLING CODE 8010-01-M