[Federal Register Volume 63, Number 140 (Wednesday, July 22, 1998)]
[Notices]
[Pages 39338-39341]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-19439]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40208; File No. SR-Phlx-97-63]


Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; 
Order Granting Approval of Proposed Rule Change and Amendment No. 1 
Thereto and Notice of Filing and Order Granting Accelerated Approval of 
Amendment No. 2 to Proposed Rule Change To Adopt a New Method of 
Calculating Initial and Maintenance Margin Requirements for Foreign 
Currency Options

July 15, 1998.

I. Introduction

    On December 22, 1997, the Philadelphia Stock Exchange, Inc. 
(``Phlx'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change that would adopt a new method of

[[Page 39339]]

calculating initial and maintenance customer margin requirements for 
foreign currency options under Phlx Rule 722. Under proposed new 
Commentary .16 to Rule 722, the Exchange would calculate the margin 
requirements for each foreign currency separately, rather than 
determining one margin level for all foreign currencies based upon the 
historical pricing information for all foreign currencies together. The 
Phlx filed Amendment No. 1 to the proposed rule change on April 6, 
1998.\3\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Amendment No. 1 to Phlx 97-63 and cover letter from 
Nandita Yagnik, Counsel, Phlx, to Sharon Lawson, Senior Special 
Counsel, Division of Market Regulation (``Division''), Commission, 
dated April 3, 1998 (``Amendment No. 1''). Amendment No. 1 
incorporates the original proposed rule change and amendments to the 
original proposal into a Rule 19b-4 notice. In Amendment No. 1, the 
Phlx proposes to amend its original proposal to: (1) conduct margin 
reviews quarterly rather then semi-annually; (2) monitor currencies 
monthly when the confidence level falls to between 97% and 97.5% 
until the confidence level exceeds 97.5% for two consecutive months; 
and (3) revise Rule 722 to exclude the actual margin level for each 
currency and instead, to distribute membership circulars announcing 
the margin levels that are derived pursuant to proposed Commentary 
.16 of Rule 722. Amendment No. 1 also incorporates changes 
originally proposed in a letter from Michele R. Weisbaum, Vice 
President and Associate General Counsel, Phlx, to Sharon Lawson, 
Senior Special Counsel, Division, Commission, dated February 19, 
1998.
---------------------------------------------------------------------------

    On April 20, 1998, the proposed rule change and Amendment No. 1 
were published for comment in the Federal Register.\4\ No comments were 
received on the proposal. On June 1, 1998, the Phlx filed Amendment No. 
2 to the proposed rule change.\5\ This order approves the amended 
proposed rule change including Amendment No. 2 to the proposed rule 
change on an accelerated basis.
---------------------------------------------------------------------------

    \4\ See Securities Exchange Act Release No. 39856 (April 13, 
1998) 63 FR 19554.
    \5\ See Letter from Nandita Yagnik, Counsel, Phlx, to Sharon 
Lawson, Senior Special Counsel, Division, Commission, dated May 29, 
1998 (``Amendment No. 2''), In Amendment No. 2, the Phlx represents 
that it will inform its membership and the public via memoranda and 
circulars of the margin levels for each currency option immediately 
following the quarterly reviews described in proposed Commentary .16 
to Rule 722.
---------------------------------------------------------------------------

III. Description of the Proposal

    Currently, the Exchange calculates the margin requirement for 
customers that assume short foreign currency option positions by adding 
4% of the current market value of the underlying foreign currency 
contract to the option premium price less an adjustment for the out-of-
the-money amount of the option contract.\6\ The 4% add-on percentage 
was adopted in 1986 and provided for initial margin which would cover 
the aggregate underlying foreign currencies' historical volatility over 
a seven day period with a 95% confidence level over the latest nine 
month period.\7\ Thus, the margin level for foreign currency options 
has been set based on the historical pricing information for all 
foreign currencies considered together. This add-on percentage is now 
reviewed by the Exchange every quarter to assure that it provides for a 
97.5% confidence level over a five day period.
---------------------------------------------------------------------------

    \6\ This 4% ``add-on'' percentage is applicable to the following 
foreign currencies: Australian dollar, British pound, Canadian 
dollar, German mark, European Currency Unit, French franc, Japanese 
yen and Swiss franc. The Spanish peseta and the Italian lira 
currently have a 7% add-on percentage and the Mexican peso has an 
add-on percentage of 17%.
    \7\ See Securities Exchange Act Release No. 22469 (September 26, 
1985) 50 FR 40663 (October 4, 1985) (order approving File Nos. SR-
Amex-84-29, SR-CBOE-84-27, SR-NASD-85-15, SR-PSE-84-20, SR-Phlx-84-
32 and SR-Phlx-85-18 and establishing a uniform margin system for 
options products).
---------------------------------------------------------------------------

    In response to the Commission's recommendation that the Exchange 
should set margin levels for each foreign currency option independently 
and specify its procedure for setting these levels in its rules, the 
Phlx is proposing to determine the applicable add-on percentage by 
reviewing, on a quarterly calendar basis,\8\ five-day price changes 
over the preceding three-year period for each underlying currency and 
set the add-on percentage at a level which would have covered those 
price changes at least 97.5% of the time (``confidence level''). 
Pursuant to the proposal, if the results of subsequent reviews show 
that the current margin level provides a confidence level below 97%, 
the Exchange will increase the margin requirement for that individual 
currency up to a 98% confidence level. If the confidence level is 
between 97% and 97.5%, the margin level will remain the same but will 
be subject to monthly follow-up reviews until the confidence level 
exceeds 97.5% for two consecutive months.\9\ If during the course of 
the monthly follow-up reviews, the confidence level drops below 97%, 
the margin level will be increased to a 98% level and if it exceeds 
97.5% for two consecutive months, the currency will be taken off 
monthly reviews and will be put back on the quarterly review cycle. If 
the currency exceeds 98.5%, the margin level will be reduced to a 98% 
confidence level during the most recent 3 year period. Finally, in 
order to account for large price movements outside the established 
margin level, if the quarterly review shows that the currency had a 
price movement, either positive or negative, greater than two times the 
margin level during the most recent 3 year period, the margin 
requirement would be set at a level to meet a 99% confidence level 
(``Extreme Outlier Test'').
---------------------------------------------------------------------------

    \8\ Although the Phlx initially proposed semi-annual margin 
reviews, in Amendment No. 1, the Phlx proposes to amend Commentary 
.16(b) of Rule 722 to require martin reviews to be conducted 
quarterly, promptly following the 15th of January, April, July and 
October of each year. See Amendment No. 1, supra note 4.
    \9\ As initially proposed, it was unclear whether monthly margin 
reviews would be required once the confidence level equaled 97.5%. 
Amendment No. 1 makes clear that the confidence level must exceed 
97.5% for two consecutive months before the currency will no longer 
be reviewed monthly. See Amendment No. 1, supra note 4.
---------------------------------------------------------------------------

    The quarterly reviews will be conducted promptly following the 15th 
of January, April, July and October of each year. In addition to the 
routine reviews described above, the Exchange continues to have 
authority to impose a higher margin level at any time in between 
reviews if market conditions so warrant.\10\ At this time, the margin 
levels for Tier, I, II, and III customized cross rate options will 
remain the same.
---------------------------------------------------------------------------

    \10\ See Phlx Rule 722(i)(8).
---------------------------------------------------------------------------

    Finally, the Phlx proposes to revise Rule 722 so that while the 
calculation methodology will be outlined in Commentary .16, the actual 
margin level for each currency will not be stated. Instead, the 
Exchange will distribute circulars to the membership announcing the 
margin levels that are derived pursuant to the methodology in 
Commentary .16 to Rule 722. The Exchange also will inform its 
membership and the pubic via memoranda and circulars of the margin 
levels for each foreign currency option immediately following the 
quarterly reviews described in proposed Commentary .16 of Rule 722.\11\ 
In addition, any time that a particular margin level changes based on a 
review or otherwise pursuant to Rule 722, the new margin requirement 
will be announced via circular to the membership.\12\
---------------------------------------------------------------------------

    \11\ See Amendment No. 2, supra note 6.
    \12\ As initially proposed, all changes to the add-on percentage 
for individual currencies set forth in Phlx Rule 722 would have 
required a proposed rule change to be filed with the Commission 
pursuant to Section 19(b)(3)(A) of the Act. Because the actual 
margin levels will not be set forth in Phlx Rule 722 pursuant to 
Amendment No. 1 such changes will not trigger a requirement to 
submit a Section 19(b)(3)(A) filing to the Commission. Instead, 
changes to the margin levels as a result of the new calculation 
methodology will be announced to the Phlx membership via circular, 
as discussed above. Telephone conversation between Nandita Yagnik, 
Counsel, Phlx, and Deborah Flynn, Division, Commission, on April 13, 
1998.
---------------------------------------------------------------------------

III. Discussion

    The Commission finds that the proposed rule change, as amended,

[[Page 39340]]

relating to the calculation of customer margin requirements for foreign 
currency options is consistent with the requirements of Section 6 of 
the Act \13\ and the rules and regulations thereunder applicable to a 
national securities exchange.\14\ Specifically, the Commission believes 
that the proposed rule change is consistent with and furthers the 
objectives of Section 6(b)(5) of the Act \15\ in that the amendment and 
codification of the methodology used to calculate initial and 
maintenance customer margin requirements for foreign currency options 
should remove impediments to and perfect the mechanism of a free and 
open market in a manner consistent with the protection of investors and 
the public interest.
---------------------------------------------------------------------------

    \13\ 15 U.S.C. 78f.
    \14\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \15\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    The Commission believes that the Exchange's proposed methodology 
for determining customer margin requirements for each foreign currency 
independently, rather than determining one margin level from the 
combined historical volatilities of all underlying foreign currencies 
together, is reasonable and should adequately account for the 
historical and potential volatility of each of the traded foreign 
currencies. By setting margin levels for each foreign currency option 
separately, the Commission believes that the margin requirements 
established pursuant to this approach will better reflect the specific 
risks associated with each individual foreign currency option.
    As discussed above, the Exchange will calculate the applicable add-
on percentage by reviewing, on a quarterly basis, five-day price 
changes over the preceding three-year period for each underlying 
currency and will set the add-on percentage at a level sufficient to 
cover those price changes at least 97.5% of the time. The Commission 
believes that this methodology should allow the Phlx to reasonably 
determine an appropriate add-on percentage for each individual 
currency. In addition, the Exchange must conduct reviews at least 
quarterly of the volatility of each foreign currency and must take 
immediate steps to increase the existing customer margin requirements 
if the existing margin levels are deemed to be inadequate. The Extreme 
Outlier Test will also ensure adequate margin by monitoring for large 
currency price movements that are outside the normal range. As 
discussed above, the Extreme Outlier Test would require margin 
confidence levels to be increased to 99% if the underlying currency has 
had a price movement of greater than two times the margin level over 
the last 3 years. Moreover, the Commission notes that the Exchange 
continues to have authority to conduct reviews of foreign currency 
margin levels at any time that market conditions warrant. The 
Commission fully expects the Exchange to exercise this authority to 
review the adequacy of existing foreign currency margin levels during 
times of significant volatility in the foreign currency markets, in 
addition to the routine quarterly reviews. The new margin methodology, 
coupled with the Extreme Outlier Test, routine quarterly and as-needed 
reviews, has been designed to reduce risks arising from inadequate 
margin levels for foreign currency options and should help to ensure 
adequate margin is required to cover contract obligations. Accordingly, 
the Commission believes that consistent with Section 6(b)(5) of the 
Act,\16\ the Phlx's proposal will serve to protect investors and the 
public interest by reducing the risks that can arise from inadequate 
margin levels.
---------------------------------------------------------------------------

    \16\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    The Commission notes that the calculation methodology, rather than 
the actual margin level for each currency, will be set forth in 
Commentary .16 to Rule 722. Instead, the Phlx proposes to distribute 
circulars to its membership periodically to announce the margin levels 
derived pursuant to the proposed methodology. As discussed above, the 
Phlx proposes to distribute circulars to its membership announcing the 
margin levels derived pursuant to Commentary .16 of Rule 722, 
immediately following is quarterly reviews of the applicable add-on 
percentages, and at any time that a particular margin level changes. 
The Commission believes that providing information about margin 
requirements initially, on a quarterly basis, and whenever there is a 
change in a margin level should ensure that Exchange members and others 
with a interest in trading foreign currency options listed on the Phlx 
are provided with adequate notice of the applicable margin 
requirements.
    The Commission finds good cause for approving Amendment No. 2 to 
the proposed rule change prior to the thirtieth day after publication 
in the Federal Register. The Commission notes that Amendment No. 2 
merely increases the frequency of distribution of circulars informing 
the Exchange's membership of the margin levels for each foreign 
currency option. As discussed above, the Commission believes that 
issuing circulars immediately following the proposed quarterly reviews 
of margin levels strengthens the Phlx's proposal by ensuring interested 
Exchange members and other market participants receive adequate notice 
of the applicable add-on percentages. For these reasons, the Commission 
believes that the proposed Amendment No. 2 raises no issues of 
regulatory concern. Accordingly, the Commission finds that good cause 
exists, consistent with Sections 19(b) and 6(b)(5) of the Act,\17\ to 
accelerate approval of Amendment No. 2 to the proposed rule change.
---------------------------------------------------------------------------

    \17\ 15 U.S.C. 78s(b) and 78f(b)(5).
---------------------------------------------------------------------------

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 2, including whether Amendment No. 2 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 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 person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying at the Commission's 
Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. 
Copies of such filing will also be available for inspection and copying 
at the principal office of the Phlx. All submissions should refer to 
File No. SR-Phlx-97-63 and should be submitted by August 12, 1998.

Conclusion

    For the foregoing reasons, the Commission finds that the Phlx's 
proposal, as amended, to change Phlx's method of calculating initial 
and maintenance margin requirements for foreign currency options under 
Rule 722 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,\18\ that the proposed rule change (SR-Phlx-97-63), as amended, is 
approved.

    \18\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

    For the Commission, by the Division of Market Regulations, 
pursuant to delegated authority.\19\
---------------------------------------------------------------------------

    \19\ 17 CFR 200.30-3(a)(12).

---------------------------------------------------------------------------

[[Page 39341]]

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-19439 Filed 7-21-98; 8:45 am]
BILLING CODE 8010-01-M