[Federal Register Volume 64, Number 20 (Monday, February 1, 1999)]
[Notices]
[Pages 4911-4915]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-2251]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40969; File No. SR-CBOE-98-23]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Granting Approval to Proposed Rule Change and Notice of 
Filing and Order Granting Accelerated Approval to Amendment Nos. 1, 2 
and 3 Relating to an Elimination of Position and Exercise Limits for 
Certain Broad-Based Index Options

January 22, 1999.

I. Introduction

    On June 11, 1998, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section

[[Page 4912]]

19(b)(1) of the Securities Exchange Act of 1934 (``Exchange Act'' or 
``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change to 
establish a two year pilot program eliminating position and exercise 
limits for certain broad-based index options.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on July 9, 1998.\3\ CBOE filed amendments to the proposed rule 
change on August 19, 1998, November 13, 1998, and January 21, 1999, 
respectively.\4\ One comment letter was received on the proposal.\5\ 
This order approves the proposal, as amended.
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    \3\ See Exchange Act Release No. 40158 (July 1, 1998), 63 FR 
37153.
    \4\ See Letter to Christine Richardson, Attorney, Division of 
Market Regulation, Commission, from Timothy Thompson, CBOE, dated 
August 18, 1998 (``Amendment No. 1''). CBOE's original submission 
proposed to eliminate position and exercise limits for all broad-
based index options on a permanent basis. Amendment No. 1 limited 
the proposal to a two year pilot program. Amendment No. 1 also 
limited the proposal to those broad-based indexes meeting the 
following criteria: (1) a total capitalization of at least $2 
trillion or (2) an average capitalization of at least $15 billion. 
Amendment No. 1 also stated that, near the end of the program, CBOE 
would provide a report detailing the size and different types of 
strategies employed with respect to positions established in those 
classes not subject to position limits. The report would also 
indicate whether any problems resulted from the no limit approach 
and provide any other information that may be useful in evaluating 
the effectiveness of the pilot program.
    See Letter to Michael Walinskas, Deputy Associate Director, 
Division of Market Regulation, Commission, from Mary Bender, CBOE, 
dated October 28, 1998 (``Amendment No. 2''). Superseding the index 
criteria set forth in Amendment No. 1, Amendment No. 2 limited the 
proposal to three specific broad-based indexes. Specifically, the 
proposal was limited to options on the S&P 500 (``SPX''), options on 
the S&P 100 (``OEX''), and options on the Dow Jones Industrial 
Average (``DJX''). Amendment No. 2 also clarified that OEX and SPX 
options would be subject to a 100,000 contract reporting threshold 
requirement and DJX options, 1/10th the size of a full value index 
contract, would be subject to a 1 million contract reporting 
threshold requirement. Amendment No. 2 also stated that the contract 
thresholds, which would trigger an inquiry into whether additional 
margin should be imposed, were being changed to 100,000 contracts 
for OEX and SPX options and 1 million contracts for DJX options.
    See Letter to Michael Walinskas, Deputy Associate Director, 
Division of Market Regulation, Commission, from Mary Bender, CBOE, 
dated January 20, 1999 (``Amendment No. 3''). Amendment No. 3 
deleted the margin review thresholds proposed in Amendment No. 2. 
Amendment No. 3 also clarified that the elimination of position 
limits for FLEX broad-based index options will apply only to FLEX 
options on the SPX, OEX and DJX, and not to all broad-based index 
options as originally proposed. Furthermore, SPX, OEX and DJX FLEX 
options contracts will be subject to a 100,000 reporting 
requirement, and DJX will be subject to a 1 million contract 
reporting thresholds. Language was also added to reflect that the 
Exchange has the authority, pursuant to CBOE Rule 12.10, to impose 
additional margin upon and account maintaining an underhedged FLEX 
SPX, OEX or DJX option position. Finally, Amendment No. 3 specified 
that that CBOE would provide a report to the Commission detailing 
the impact of the pilot program no later than three months prior to 
the expiration of the two year pilot program, containing certain 
data from the first eighteen month period of the pilot.
    \5\ See Letter to Jonathan G. Katz, Secretary, Commission, from 
Kathryn N. Natale, Deputy General Counsel/Director of Compliance-
Americas, Credit Suisse First Boston, dated September 23, 1998 
(``CSFB Letter''). CSFB general supported the proposal.
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II. Description

    CBOE proposes to eliminate position and exercise limits for certain 
broad-based index options on a two year pilot basis. Specifically, CBOE 
proposes to eliminate position and exercise limits for SPX, OEX, and 
DJX options.\6\ The proposal would also apply to FLEX broad-based index 
options on SPX, OEX, and DJX. These indexes will be subject to new 
reporting thresholds.\7\ OEX, SPX and all FLEX broad-based index 
options will be subject to a 100,000 contract reporting requirement and 
DJX options, which are 1/10th the size of a full value index contract, 
will be subject to a 1 million contract reporting threshold. These 
reporting thresholds reflect an increase from the current levels (i.e., 
45,000 for SPX and 65,000 for OEX).\8\ The proposal also reiterates 
that the Exchange has the authority, pursuant to CBOE Rule 12.10, to 
impose additional margin as it deems necessary upon an account 
maintaining an under-hedged option position in SPX, OEX, DJX or FLEX 
options on these indexes. Finally, three months prior to completion of 
the pilot program, CBOE will provide a report to the Commission, 
including data for the first eighteen months of the pilot. The report 
will detail the size and different types of strategies employed with 
respect to positions established in those classes not subject to 
position limits. The report will also discuss whether any problems 
resulted from the no limit approach and any other information that may 
be useful in evaluating the effectiveness of the pilot program.
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    \6\ The current position limits for SPX, OEX and DJX are 100,000 
contracts, 150,000 contracts, and 1,000,000 contracts, respectively. 
See CBOE Rule 24.4.
    \7\ Reporting thresholds are the contract levels at which 
members are required to report certain information regarding 
customer positions to the Exchange.
    \8\ Currently, DJX is not subject to an index reporting 
requirement. Because DJX is part of the proposal, CBOE is imposing 
new reporting requirement for DJX options.
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III. Discussion

    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, with the requirements of Section 6 of the Act.\9\ 
Specifically, the Commission believes the proposed rule change 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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    \9\ See 15 U.S.C. 78f(b). In approving this rule change, the 
commission notes that it has considered the proposal's impact on 
efficiency, competition, and capital formation, consistent with 
Section 3 of the Act. Id. at 78c(f).
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    Position limits serve as a regulatory tool designed to address 
potential manipulative schemes and adverse market impact surrounding 
the use of options. In the past, 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.\10\

    \10\ Exchange Act Release Nos. 39489 (December 24, 1997), 63 FR 
276 (January 5, 1998) (SR-CBOE-97-11) (order approving an increase 
in OEX position and exercise limits); 31330 (October 16, 1992), 57 
FR 48408 (October 23, 1992) (SR-Amex-91-13) (order approving an 
increase in Institutional Index Options position and exercise 
limits).
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    In general, the Commission has taken a gradual, evolutionary 
approach toward expansion of position and exercise limits.\11\ The 
Commission has been careful to balance two competing concerns when 
considering the appropriate level at which to set option position and 
exercise limits. The Commission has recognized that the limits must be 
sufficient to prevent investors from disrupting the market in the 
component securities comprising

[[Page 4913]]

the indexes. At the same time, the Commission has determined 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.\12\
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    \11\ This gradual approach to increasing position limits is 
evident with both the SPX and OEX. See Exchange Act Release Nos. 
37676 (September 13, 1996), 61 FR 49508 (September 20, 1996) (order 
approving SR-CBOE-96-01; increasing position limits for the SPX from 
45,000 to 100,000 contracts); 39789 (December 24, 1997), 63 FR 276 
(January 5, 1998) (order approving SR-CBOE-97-11; increasing 
position limits for the OEX from 75,000 to 150,000 contracts).
    \12\ See H.R. No. IFC-3, 96th Cong., 1st Sess. at 189-91 (Comm. 
Print 1978).
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    The Commission has carefully considered the CBOE's proposal. At the 
outset, the Commission notes that it still believes the fundamental 
purposes of position and exercise limits are being served by their 
existence. Nevertheless, the Commission believes that the current 
experience with the trading of index options as well as the 
surveillance capabilities of the CBOE have made it permissible to 
consider other, less prophylactic alternatives to regulating the index 
options market while still ensuring that large positions in such index 
options will not unduly disrupt the options or underlying cash markets. 
At this time, the Commission believes that it is appropriate to allow 
for an elimination of position and exercise limits for certain broad-
based index options on a two-year pilot basis.
    The Commission believes that an elimination of position and 
exercise limits for certain broad-based index options on a pilot basis 
is appropriate for several reasons. Overall, the Commission believes 
that the pilot will allow the CBOE to allocate certain of its 
surveillance resources differently, focusing on enhanced reporting and 
surveillance of trading to detect potential manipulation and risky 
positions that may unduly affect the cash market, rather than focusing 
on the strict enforcement of position limits. Although this regulatory 
approach deviates from the current structure that has been in place 
since the beginning of index options trading, the Commission believes 
that the enhanced reporting and surveillance CBOE is providing, as well 
as the fact that the pilot is limited to the CBOE's three most highly 
capitalized and actively traded index options, provides a sound basis 
for approving a two year pilot program eliminating position and 
exercise limits.
    The Commission notes first that the proposal is limited to options 
on three broad-based indexes, the SPX, OEX, DJX, and FLEX options on 
those indexes. The Commission believes that the enormous capitalization 
of and deep, liquid markets for the underlying securities contained in 
these indexes significantly reduces concerns regarding market 
manipulation or disruption in the underlying market.\13\ Removing 
position and exercise limits for these index options may also bring 
additional depth and liquidity, in terms of both volume and open 
interest, to the affected index options classes without significantly 
increasing concerns regarding intermarket manipulations or disruptions 
of the options or the underlying securities.
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    \13\ SPX is a capitalization-weighted index composed of 500 
stocks from a broad range of industries. As of August 1998, the 
total market capitalization value for SPX was $8.5 trillion. See 
Amendment No. 1. OEX is a capitalization-weighted index composed of 
100 stocks from a broad range of industries. As of August 1998, the 
total market capitalization value for OEX was $3.8 trillion. Id. DJX 
is a price-weighted index composed of 30 of the largest, most liquid 
New York Stock Exchange-listed stocks. As of August 1998, the total 
market capitalization value for DJX was $2.2 trillion. Id.
    In addition, the average trading volume for the underlying 
components of these indexes for the six months preceding January 20, 
1999, demonstrates the substantial liquidity of the index components 
as a group. The average trading share volume underlying the SPX is 
757.5 million shares. The average trading share volume underlying 
the OEX is 244.3 million shares. Finally, the average trading share 
volume underlying the DJX is 94.77 million shares. Telephone call 
between Patricia Cerny, CBOE, and Christine Richardson, Commission, 
on January 21, 1999.
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    Second, eliminating position and exercise limits for these 
specified indexes should better serve the hedging needs of institutions 
that engage in trading strategies different from those covered under 
the index hedge exemption policy (e.g., delta hedges, OTC vs. listed 
hedges).\4\ Furthermore, eliminating position and exercise limits for 
the SPEX, OEX and DJX options will alleviate the regulatory burdens 
related to the current index hedge exemption, which involves a daily 
monitoring of positions and reports to the Exchange at the current 
levels.
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    \14\ CSFB notes that many institutional traders conduct 
substantial hedging activity similar to that of the listed options 
market in other markets that are not restricted by position and 
exercise limits, e.g., by trading off-shore or in the U.S. treasury 
bond futures and Eurodollar futures market. See CSFB Letter.
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    Third, the Commission believes that financial requirements imposed 
by CBOE and by the Commission adequately address concerns that a CBOE 
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.\15\ CBOE also has the authority under its rules to impose 
a higher margin requirement upon the member or member organization when 
it determines a higher requirement is warranted. Monitoring accounts 
maintaining large positions should provide the Exchange with the 
information necessary to determine whether to impose additional margin 
and/or whether to assess capital charges upon a member organization 
carrying the account. 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. The significant increases in unhedged options capital 
charges resulting from the September 1997 adoption of risk-based 
haircuts and CBOE's margin requirements applicable to these products 
under Exchange rules serves as an additional form of protection.\16\ 
The Commission also notes that the OCC will serve as the counter-party 
guarantor in every exchange-traded transaction.
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    \15\ 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.
    \16\ See Exchange Act Release No. 38248 (February 6, 1997), 62 
FR 6474 (February 12, 1997)(adopting Risk Based Haircuts), and CBOE 
Rule 24.11 Margins.
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    Fourth, the Commission notes that the index options and other types 
of index-based derivatives (e.g., forwards and swaps) are not subject 
to position and exercise limits in the OTC market. The Commission 
believes that eliminating position and exercise limits for the SPX, 
OEX, and DJX options on a two-year pilot basis will better allow CBOE 
to compete with the OTC market.
    Fifth, the Commission believes that CBOE has adopted important 
enhanced surveillance and reporting safeguards that will allow it to 
detect and deter trading abuses arising from the elimination of 
position and exercise limits for SPX, OEX, DJX, and FLEX options on 
those indexes. These safeguards will also allow CBOE to monitor large 
positions in order to identify instances of potential risk and to 
assess additional margin and/or capital charges, if deemed necessary. 
Specifically, CBOE will subject SPX, OEX and FLEX options on those 
indexes to a 100,000 contract hedge reporting requirement, and DJX, 
which is one-tenth the size of a full value index contract, and FLEX 
options on the DJX will be subject to a 1 million contract

[[Page 4914]]

hedge reporting threshold.\17\ Each member or member organization that 
maintains a position on the same side of the market in excess of these 
contract thresholds for its own account of for the account of a 
customer must file a report that includes, but is not limited to, data 
related to the option position, whether such position is hedged and if 
so, a description of the hedge. If applicable, the report must contain 
information concerning collateral used to carry the position. Exchange 
market makers would continue to be exempt from this reporting 
requirement. Although the new reporting thresholds are higher for SPX 
and OEX, the new levels will enable CBOE to allocate its surveillance 
resources on those accounts maintaining larger, potentially riskier, 
positions. CBOE has submitted to the Commission a detailed description 
of enhanced surveillance procedures the Exchange will implement in 
order to monitor accounts maintaining large positions. The Commission 
also believes that CBOE's new surveillance procedures should enable the 
Exchange to assess and respond to market concerns at an early stage. 
Although it is inappropriate to discuss the details of CBOE's enhanced 
surveillance program, the Commission notes that these enhanced 
procedures were critical in its determination to approve the proposed 
rule change.\18\
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    \17\ The current hedge reporting thresholds for SPX and OEX are 
45,000 contracts and 65,000 contracts, respectively. DJX is not 
currently subject to a reporting requirement.
    \18\ Disclosure of specific surveillance procedures could 
provide market participants with information that could aid 
potential attempts at avoiding regulatory detection of inappropriate 
trading activity.
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    Finally, the Commission notes the lack of any discernible problems 
at existing levels. Although it is difficult to compare a market with 
position limits and one without, the Commission notes that the lack of 
any significant problems at existing levels, which are relatively high 
for these three index options compared to other similar products does 
provide some basis for going forward with the CBOE's proposal. The 
Commission further believes that, if problems were to occur during the 
pilot period, the enhanced market surveillance of large positions 
should help CBOE to take the appropriate action in order to avoid any 
manipulation or market risk concerns.
    With regard to the elimination of position and exercise limits for 
FLEX options on the SPX, OEX and DJX, the Commission believes that, 
given the size and sophisticated nature of the FLEX options market for 
these indexes, along with the reporting requirements, eliminating 
position and exercise limits for FLEX options on the SPX, OEX and DJX 
for a two-year pilot period should not substantially increase 
manipulative concerns.
    Notwithstanding the protections that have been built into CBOE's 
proposal, the Commission believes a prudent approach is warranted with 
respect to the elimination of position limits for these indexes. In 
this regard, the Commission cannot rule out the potential for adverse 
effects on the securities markets for the component securities 
underlying the effected broad-based indexes. To address this concern, 
the Commission is approving the proposal for a two-year pilot period 
and limiting the proposal to SPX, OEX, DJX options, and FLEX options on 
those indexes.19 Furthermore, three months prior to the end 
of the pilot program, CBOE will provide the Commission with a report 
detailing the size and different types of strategies employed with 
respect to positions established in those classes not subject to 
position limits. In addition, the report will note whether any problems 
resulted due to the no limit approach and any other information that 
may be useful in evaluating the effectiveness of the pilot 
program.20 The Commission expects that CBOE will take prompt 
action, including timely communication with the Commission and other 
marketplace self-regulatory organizations responsible for oversight of 
trading in component stocks, should any unanticipated adverse market 
effects develop.
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    \19 \Cf. Exchange Act Release No. 30932 (September 9, 1997), 62 
FR 48683 (September 16, 1997) (order approving the elimination of 
position and exercise limits for FLEX equity options on a two year 
pilot basis).
    \20 \See Amendment No. 1.
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    The Commission finds good cause to approve Amendment No. 1 to the 
proposed rule filing prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Specifically, by restricting the elimination of position and exercise 
limits for certain broadbased index options to a two-year pilot period, 
the proposed rule change is more restrictive than the original 
proposal, which was published for the entire twenty-one day comment 
period and generated only one response.21 Amendment No. 1 
also stated that CBOE will provide a report to the Commission three 
months prior to the end of the pilot period,22 detailing any 
resulting problems, as well as the size and different types of 
strategies employed with respect to positions established in those 
classes of options not subject to position limits. This report will 
help CBOE and the Commission to assess the effects of eliminating 
position and exercise limits on the effected index options. 
Accordingly, the Commission believes that good cause exists, consistent 
with Sections 6(b)(5) and 19(b) of the Act to approve Amendment No. 1 
to the proposed rule change on an accelerated basis.23
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    \21 \See CSFB Letter.
    \22 \See Amendment No. 3.
    \23 \The Commission notes that Amendment No. 1 also limited the 
proposal to all broad-based indexes meeting the following criteria: 
(1) a total capitalization of at least $2 trillion or (2) an average 
capitalization of at least $15 billion. Although this provision 
narrowed the application of the proposed rule change, at the request 
of the Commission, CBOE filed Amendment No. 2 which replaced this 
provision and further narrowed application of the proposed rule 
change to SPX, OEX, and DJX options.
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    The Commission finds good cause to approve Amendment No. 2 to the 
proposed rule filing prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Specifically, Amendment No. 2 limited the proposal to three specific 
broad-based indexes--SPX, OEX, and DJX options. By restricting the 
elimination of position and exercise limits to SPX, OEX, and DJX 
options, the proposed rule change is more restrictive than the original 
proposal, which was published for the entire twenty-one day comment 
period and generated only one response.24 Amendment No. 2 
also imposed new reporting thresholds on members holding large 
positions in the effected options. These reporting requirements will 
better enable CBOE to detect and deter trading abuses arising from the 
elimination of position and exercise limits. In addition, the 
Commission notes that CBOE's proposal reiterates the Exchange's ability 
to impose margin and/or assess capital charges an important safeguard 
to address concerns regarding potential manipulation or other market 
disruptions. Accordingly, the Commission believes that good cause 
exists, consistent with Sections 6(b)(5) and 19(b) of the Act to 
approve Amendment No. 2 to the proposed rule change on an accelerated 
basis.
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    \24 \See CSFB Letter.
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    The Commission finds good cause to approve Amendment No. 3 to the 
proposed rule filing prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. 
Specifically, the Commission believes that deleting the proposed margin 
review thresholds of 100,000 contracts for SPX and OEX and 1 million 
for DJX is appropriate to avoid possible a misinterpretation that the

[[Page 4915]]

Exchange may only impose additional margin under CBOE Rule 12.10 when 
these thresholds are reached. Amendment No. 3 clarifies that the 
Exchange may impose additional margin as it deems necessary. The 
Commission also believes that narrowing the elimination of position and 
exercise limits to FLEX options on the SPX, OEX, and DJX, rather than 
all FLEX broad-based index options is appropriate because it is more 
restrictive than the original proposal and it will allow the Exchange 
to focus initially on a smaller number of accounts maintaining 
positions in FLEX SPX, OEX and DJX options. Amendment No. 3 also 
appropriately clarifies when the CBOE will provide the Commission with 
a report concerning the impact of the pilot program. Accordingly, the 
Commission believes that good cause exists, consistent with Sections 
6(b)(5) and 19(b) of the Act to approve Amendment No. 3 to the proposed 
rule change on an accelerated basis.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendments No. 1, 2 and 3, including whether the 
proposal 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 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 inspecting and copying at the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
Exchange. All submissions should refer to File No. SR-CBOE-98-23 and 
should be submitted by February 22, 1999.

V. Conclusion

    It is therefore Ordered, pursuant to section 19(b)(2) of the 
Act,\25\ that the proposed rule change (SR-CBOE-98-23) is approved, as 
amended, on a two-year pilot basis until January 22, 2001.

    \25\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\26\
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    \26\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-2251 Filed 1-29-99; 8:45 am]
BILLING CODE 8010-01-M