[Federal Register Volume 64, Number 150 (Thursday, August 5, 1999)]
[Notices]
[Pages 42736-42745]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-20174]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41658; File No. SR-CBOE-97-67]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Approving Proposed Rule Change and Notice of Filing 
and Order Granting Accelerated Approval of Amendment Nos. 1 and 2 to 
Proposed Rule Change Revising the Exchange's Margin Rules

July 27, 1999.

I. Introduction

    On December 29, 1997, the Chicago Board Options Exchange, 
Incorporated (``Exchange'' or ``CBOE'') 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 to revise and restructure the 
Exchange's margin requirements for stock options, stock index options, 
and other securities, as currently set forth in CBOE Rule 12.3, 
``Margin Requirements.'' The proposed rule change was published for 
comment in the Federal Register on May 4, 1998.\3\ The Commission 
received 4 comment letters with respect to the proposal.\4\
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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. 39925 (April 27, 
1998), 63 FR 24580.
    \4\ See Letter from Robert C. Sheehan, President, Robert C. 
Sheehan and Associates, to Jonathan Katz, Secretary, Commission, 
dated March 26, 1999 (``Sheehan Letter''); Letter from Alvin 
Wilkinson to Jonathan Katz, Secretary, Commission, dated March 25, 
1999 (``Wilkinson Letter''); Letter from William C. Floersch, 
President and CEO, O'Connor & Company, to Jonathan G. Katz, 
Secretary, Commission, dated April 5, 1999 (``O'Connor Letter''); 
and Letter from Lon Gorman, Executive Vice President, Charles Schwab 
& Co., to Jonathan G. Katz, Secretary, Commission, dated April 13, 
1999 (``Schwab Letter'').
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    The Exchange submitted Amendment No. 1 to the proposal on January 
7, 1999,\5\ and Amendment No. 2 on May 26, 1999.\6\ This order approves 
the proposed rule change and accelerates approval of Amendment Nos. 1 
and 2.
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    \5\ With respect to options that are not proposed to be 
marginable, Amendment No. 1 specifies that margin must be deposited 
and maintained equal to at least 100% of the current market value, 
rather than 100% of the purchase price. Amendment No. 1 also 
incorporates into the proposed rule text a definition of ``OTC 
margin bond,'' which has been eliminated from Regulation T by the 
Board of Governors of the Federal Reserve System as of April 1, 
1998. Finally, Amendment No. 1 deletes from the proposal the 
provision that would have allowed the use of unit investment trusts 
(``UITs'') or open-end mutual funds (``mutual funds'') as offsets, 
or cover, for short index option positions held in customer margin 
or cash accounts, provided that the UIT or mutual fund replicated 
the index underlying the option, and the Exchange had specifically 
approved such UIT or mutual fund. As a replacement, the Exchange 
proposes to allow customers to use underlying open-end index mutual 
funds of sufficient aggregate market value as cover for short S&P 
500 call options held in customer margin or cash accounts, provided 
the mutual funds have been specifically designated by the Exchange. 
See Letter from Mary L. Bender, Senior Vice President, Division of 
Regulatory Services, Exchange, to Michael A. Walinskas, Associate 
Director, Division of Market Regulation (``Division''), Commission, 
dated December 23, 1998 (``Amendment No. 1'').
    \6\ Amendment No. 2 revises the proposal by limiting loan value 
to long term stock options, stock index options, and stock index 
warrants. The Exchange had originally proposed to allow loan value 
on any long term option, regardless of the underlying instrument 
(e.g., foreign currency options and options on interest rate 
composites would be marginable). Amendment No. 2 also corrects an 
error in the Exchange's purpose statement regarding the net credit 
received for selling a box spread. See Letter from Mary L. Bender, 
Senior Vice President, Division of Regulatory Services, Exchange, to 
Michael A. Walinskas, Associate Director, Division, Commission, 
dated May 14, 1999 (``Amendment No. 2'').
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II. Description of the Proposal

A. Background

    Until several years ago, the margin requirements governing listed 
options were set forth in Regulation T, ``Credit by Brokers and 
Dealers.'' \7\ However, Federal Reserve Board amendments to Regulation 
T that became effective June 1, 1997, modified or deleted certain 
margin requirements regarding options transactions in favor of rules to 
be adopted by the options exchanges, subject to approval by the 
Commission.\8\ In a CBOE rule filing approved by the Commission in 
1997, the Exchange adopted certain options-related margin requirements 
that were dropped from Regulation T by the Federal Reserve Board.\9\
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    \7\ 12 CFR 220 et seq. The Board of Governors of the Federal 
Reserve System (``Federal Reserve Board'') issued Regulation T 
pursuant to the Act.
    \8\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (Apr. 24, 1996), 61 FR 20386 (May 6, 1996) (permitting 
the adoption of margin requirements ``deemed appropriate by the 
exchange that trades the option, subject to the approval of the 
Securities and Exchange Commission'').
    \9\ See Securities Exchange Act Release No. 38709 (June 2, 
1997), 62 FR 31643 (June 10, 1997).
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    At the present time, the Exchange seeks to further revise its 
margin rules to implement enhancements long desired by Exchange members 
and member firms, public investors, and the Exchange staff. The 
Exchange believes that certain multiple options position strategies and 
other strategies that combine stock with option positions warrant more 
equitable margin requirements. The Exchange further believes that the 
offset in risk that results if the stock and options position are 
viewed collectively is not reflected in the current maintenance margin 
requirements. In addition, the Exchange believes it is appropriate for 
member firms to extend credit on certain types of long term options.
    In sum, the proposed revisions to the Exchange's margin rules 
would: (i) Permit the extension of credit on certain long term options 
and certain long box spread; (ii) recognize butterfly and box spreads 
as strategies for purposes of margin treatment and establish 
appropriate margin requirements; (iii) recognize various strategies 
involving stocks (or other underlying instruments) paired with long 
options, and provide for lower maintenance margin requirements on such 
hedged stock positions; (iv) expand the types of short positions that 
would be considered ``covered'' in a cash account, specifically, 
certain short positions that are components of limited-risk spread 
strategies (e.g., butterfly and box spreads); (v) allow a bank-issued 
escrow agreement to serve as cover in lieu of cash for certain spread 
positions held in a cash account; (vi) consolidate in one chapter, the 
various margin requirements that presently are dispersed throughout the 
Exchange's rules; and (vii) revise and update, as necessary, other 
Exchange rules impacted by the proposal.

[[Page 42737]]

B. Definitions

    Presently, the Exchange's definition of ``current market value'' is 
equivalent to the definition found in Regulation T.\10\ Instead of 
repeating the Regulation T definition, the proposal would revise the 
definition found in the Exchange's rules to note that the meaning of 
the term ``current market value'' is as defined in Regulation T.
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    \10\ Regulation T defines ``current market value'' of a security 
to be:
    (i) Throughout the day of the purchase or sale of a security, 
the security's total cost of purchase or the net proceeds of its 
sale including any commissions charged; or (ii) At any other time, 
the closing sale price of the security on the preceding business 
day, as shown by any regularly published reporting or quotation 
service. If there is no closing sale price, the creditor may use any 
reasonable estimate of the market value of the security as of the 
close of business on the preceding business day.
    See 12 CFR 220.2.
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    The Exchange also seeks to establish definitions for ``butterfly 
spread'' \11\ and ``box spread'' \12\ options strategies. The 
definitions are important elements of the Exchange's proposal to 
recognize and specify cash and margin account requirements for 
butterfly and box spread. The definitions will specify what multiple 
option positions, if held together, qualify for classification as 
butterfly or box spreads, and consequently are eligible for the 
proposed cash and margin treatment.
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    \11\ The proposal defines ``butterfly spread'' as:
    [A]n aggregation of positions in three series of either put or 
call options all having the same underlying component or index and 
time of expiration, and based on the same aggregate current 
underlying value, where the interval between the exercise price of 
each series is equal, which positions are structured as either (A) a 
``long butterfly spread'' in which two short options in the same 
series are offset by one long option with a higher exercise price 
and one long option with a lower exercise price, or (B) a ``short 
butterfly spread'' in which two long options in the same series 
offset one short option with a higher exercise price and one short 
option with a lower exercise price.
    \12\ The proposal defines ``box spread'' as:
    [A]n aggregation of positions in a long call option and short 
put option with the same exercise price (``buy side'') coupled with 
a long put option and short call option with the same exercise price 
(``sell side'') all of which have the same underlying component or 
index and time of expiration, and are based on the same aggregate 
current underlying value, and are structured as either: (A) A ``long 
box spread'' in which the sell side exercise price exceeds the buy 
side exercise price, or (B) a ``short box spread'' in which the buy 
side exercise price exceeds the sell side exercise price.
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    The proposal also would define the term ``OTC martin bond.'' \13\ 
The definition is necessary because the Exchange's margin rules 
currently cross-reference the Regulation T definition of ``OTC margin 
bond,'' which was eliminated by the Federal Reserve Board as of April 
1, 1998.\14\
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    \13\ The proposal defines ``OTC margin bond'' as:
    (1) Any debt securities not traded on a national securities 
exchange that meet all of the following requirements (a) at the time 
of the original issued, a principal amount of not less than 
$25,000,000 of the issue was outstanding; (b) the issue was 
registered under Section 5 of the Securities Act of 1933 and the 
issuer either files periodic reports pursuant to the Act or is an 
insurance company under Section 12(g)(2)(G) of the Act; or (c) at 
the time of the extension of credit the creditor has a reasonable 
basis for believing that the issuer is not in default on interest or 
principal payments; or (2) any private pass-through securities (not 
guaranteed by a U.S. Government agency) that meet all of the 
following requirements: (a) An aggregate principal amount of not 
less than $25,000,000 was issued pursuant to a registration 
statement filed with the Commission; and (b) current reports 
relating to the issue have been filed with the Commission; and (c) 
at the time of the credit extension, the creditor has a reasonable 
basis for believing that mortgage interest, principal payments and 
other distributions are being passed through as required and that 
the servicing agent is meeting its material obligations under the 
terms of the offering.
    \14\ See Board of Governors of the Federal Reserve System Docket 
Nos. R-0905, R-0923, and R-0944 (Jan. 8, 1998), 63 FR 2806 (Jan. 16, 
1998).
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    Finally, the proposal would define the term ``listed,'' \15\ 
Because ``listed'' is frequently used in the Exchange's margin rules, 
the Exchange believes it would be more efficient to define the term 
once rather than specifying the meaning each time the term is utilized.
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    Under the proposal, the term ``listed'' means ``a security 
traded on a registered national securities exchange or automated 
facility of a registered national securities association.
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C. Extensions of Credit on Long Term Options and Warrants

    The proposal would allow extensions of credit on certain listed, 
long options (i.e., listed put or call options on a stock or stock 
index) and warrant products (i.e., listed stock index warrants, but not 
traditional stock warrants issued by a corporation on its own 
stock.\16\ Only those options or warrants that are more than 9 months 
from expiration (``long term'') would be eligible for credit 
extension.\17\ The proposal requires initial and maintenance margin of 
not less than 75% of the current market value of a long term listed 
option or warrant. Therefore, an Exchange member firm would be able to 
loan up to 25% of the current market value of a long term listed option 
or warrant.\18\
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    \16\ Throughout the remainder of this approval order, the term 
``warrant'' means this type of warrant.
    \17\ In the case of any stock option, stock index option, or 
stock index warrant, which expires in 9 months or less, initial 
margin must be deposited and maintained equal to at least 100% of 
the current market value of the option or warrant.
    \18\ For example, if an investor purchased an Exchange-listed 
call option on stock XYZ that expired in January 2001 for 
approximately $100 (excluding commissions), the investor would be 
required to deposit and maintain at least $75. The investor could 
borrow the remaining $25 from its broker. Under the Exchange's 
current margin rules, the investor would be required to pay the 
entire $100.
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    The proposal also would permit the extension of credit on certain 
long term options and warrants not listed or traded on a registered 
national securities exchange or a registered securities association 
(``OTC options and warrants''). Specifically, a member firm could 
extend credit on an OTC put or call option on a stock or stock index, 
and an OTC stock index warrant. In addition to being more than 9 months 
from expiration, a marginable OTC option or warrant must: (i) Be in-
the-money; \19\ (ii) be guaranteed by the carrying broker-dealer; and 
(iii) have an American-style exercise provision.\20\ The proposal 
requires initial and maintenance margin of not less than 75% of the 
long term OTC option's or warrant's in-the-money amount (i.e., 
intrinsic value), plus 100% of the amount, if any, by which the current 
market value of the OTC option or warrant exceeds the in-the-money 
amount.
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    \19\ The Exchange stated that it proposes to restrict loan value 
to long term OTC options and warrants that are in-the-money because 
``a liquid secondary market for an over-the-counter option or 
warrant does not generally exist. Therefore, a current bid or offer 
price, or last sale price, is not readily available.'' In addition, 
the Exchange noted that because OTC options are not obligations of 
the AAA-rated Options Clearing Corporation, their value may vary 
depending upon the creditworthiness of the issuer. The Exchange 
concluded that ``loaning on over-the-counter options without 
intrinsic value posed too much uncertainty to the creditor as to the 
value of the collateral'' As a result, the only OTC options that 
would be deemed eligible for credit are in-the-money options, 
because ``their value can reasonably be expected to be at least 
equal to their intrinsic value.'' See Letter to Michael Walinskas, 
Associate Director, Division, Commission, from Mary L. Bender, 
Senior Vice President, Division of Regulatory Services, Exchange, 
dated May 21, 1998.
    \20\ Exchange Rule 1.1(vv), ``American-style Option,'' states 
that an American-style option is an option contract that ``can be 
exercised on any business day prior to its expiration date and on 
its expiration date.''
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    When the time remaining until expiration for an option or warrant 
(listed and OTC) on which credit has been extended reaches nine months, 
the maintenance margin requirement would become 100% of the current 
market value. Thus, options or warrants expiring in less than 9 months 
would have no loan value under the proposal.

D. Extensions of Credit on Long Box Spread in European-Style Options

    The proposal would allow the extension of credit on a long box 
spread comprised entirely of European-style options \21\ that are 
listed or guaranteed by the carrying broker-dealer. A long box spread 
is a strategy composed of four option positions that is designed to 
lock in the ability to buy and sell the

[[Page 42738]]

underlying component or index for a profit, even after netting the cost 
of establishing the long box spread. The two exercise prices embedded 
in the strategy determine the buy and the sell price.\22\
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    \21\ Exchange Rule 1.1(uu), ``European-style Option,'' states 
that a European-style option is an option contract that ``can be 
exercised only on its expiration date.''
    \22\ For example, an investor might be long 1 XYZ Jan 50 Call @ 
7 and short 1 XYZ Jan 50 Put @ 1 (``buy side''), and short 1 XYZ Jan 
60 Call @ 2 and long 1 XYZ Jan 60 Put @ 5\1/2\ (``sell side''). As 
required by the Exchange's proposed definition of ``long box 
spread'' (supra note 12), the sell side exercise price exceeds the 
buy side exercise price. In this example, the long box spread is a 
riskless position because the net debit ((2+1)-(7+5\1/2\)= net debit 
of 9\1/2\) is less than the exercise price differential (60-50=10). 
Thus, the investor has locked in a profit of $50 (\1/2\ x  100).
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    For long box spreads made up of European-style options, the 
proposed margin requirement would equal 50% of the aggregate difference 
in the two exercise prices (buy and sell), which results in a 
requirement slightly higher than 50% of the debit typically 
incurred.\23\ The 50% margin requirement is both an initial and 
maintenance margin requirement. The proposal would afford a long box 
spread a market value for margin equity purposes of not more than 100% 
of the aggregate difference in exercise prices.
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    \23\ In the example appearing in the preceding footnote, the 
margin required (50%  x  (60-50) = 5) would be slightly higher than 
50% of the net debit (50%  x  9\1/2\ = 4\3/4\).
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E. Cash Account Treatment of Butterfly and Box Spreads, Other Spreads, 
and Short Options

    The proposal would make butterfly spreads and box spreads in cash-
settled, European-style options eligible for the cash account. A 
butterfly spread is a pairing of two standard spreads, one bullish and 
one bearish. To qualify for carrying in the cash account, the butterfly 
spreads and box spreads must meet the specifications contained in the 
proposed definition section,\24\ and must be comprised of options that 
are listed or guaranteed by the carrying broker-dealer. In addition, 
the long options must be held in, or purchased for, the account on the 
same day.
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    \24\ See supra notes 11 and 12.
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    For long butterfly spreads and long box spreads, the proposal would 
require full payment of the net debit that is incurred when the spread 
strategy is established.\25\
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    \25\ To create a long butterfly spread, which is comprised of 
call options, an investor may be long 1 XYZ Jan 45 Call @ 6, short 2 
XYZ Jan 50 Calls @ 3 each, and long 1 XYZ Jan 55 Call @ 1. The 
maximum risk for this long butterfly spread is the net debit 
incurred to establish the strategy ((3+3)-(6+1)= net debit of 1). 
Under the proposal, therefore, the investor would be required to pay 
the net debit, or $100 (1  x  100).
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    Short butterfly spreads generate a credit balance when established 
(i.e., the proceeds from the sale of short option components exceed the 
cost of purchasing long option components). However, in the worst case 
scenario where all options are exercised, a debit (loss) greater than 
the initial credit balance received would accrue to the account. To 
eliminate the risk to the broker-dealer carrying the short butterfly 
spread, the proposal would require that an amount equal to the maximum 
risk be held or deposited in the account in the form of cash or cash 
equivalents.\26\ The maximum risk potential in a short butterfly spread 
comprised of call options is the aggregate difference between the two 
lowest exercise prices.\27\ With respect to short butterfly spreads 
comprised of put options, the maximum risk potential is the aggregate 
difference between the two highest exercise prices. The net credit 
received from the sale of the short option components could be applied 
towards the requirement.
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    \26\ An escrow agreement could be used as a substitute for cash 
or cash equivalents if the agreement satisfies certain criteria. For 
short butterfly spreads, the escrow agreement must certify that the 
bank holds for the account of the customer as security for the 
agreement (1) cash, (2) cash equivalents, or (3) a combination 
thereof having an aggregate market value at the time the positions 
are established of not less than the amount of the aggregate 
difference between the two lowest exercise prices with respect to 
short butterfly spreads comprised of call options or the aggregate 
difference between the two highest exercise prices with respect to 
short butterfly spreads comprised of put options and that the bank 
will promptly pay the member organization such amount in the event 
the account is assigned an exercise notice on the call (put) with 
the lowest (highest) exercise price.
    \27\ For example, an investor may be short 1 XYZ Jan 45 Call @ 
6, long 2 XYZ Jan 50 Calls @ 3 each, and short 1 XYZ Jan 55 Call @ 
1. Under the proposal, the maximum risk for this short butterfly 
spread, which is comprised of call options, is equal to the 
difference between the two lowest exercise prices (50-45=5). If the 
net credit received from the sale of short option components 
((6+1)-(3+3)= net credit of 1) is applied, the investor is required 
to deposit an additional $400 (4  x  100). Otherwise, the investor 
would be required to deposit $500 (5  x  100).
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    Short box spreads also generate a credit balance when established. 
This credit is nearly equal to the total debit (loss) that, in the case 
of a short box spread, will accrue to the account if held to 
expiration. The proposal would require that cash or cash equivalents 
covering the maximum risk, which is equal to the aggregate difference 
in the two exercise prices involved, be held or deposited.\28\ The net 
credit received from the sale of the short option components may be 
applied towards the requirement; if applied, only a small fraction of 
the total requirement need be held or deposited.\29\
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    \28\ As a substitute for cash or cash equivalents, an escrow 
agreement could be used if it satisfies certain criteria. For short 
box spreads, the escrow agreement must certify that the bank holds 
for the account of the customer as security for the agreement (1) 
cash, (2) cash equivalents, or (3) a combination thereof having an 
aggregate market value at the time the positions are established of 
not less than the amount of the aggregate difference between the 
exercise prices and that the bank will promptly pay the member 
organization such amount in the event the account is assigned an 
exercise notice on either short option.
    \29\ To create a short box spread, an investor may be short 1 
XYZ Jan 60 Put @ 5\1/2\ and long 1 XYZ Jan 60 Call @ 2 (``buy 
side''), and short 1 XYZ Jan 50 Call @ 7 and long 1 XYZ Jan 50 Put @ 
1 (``sell side''). As required by the Exchange's proposed definition 
of ``short box spread'' (supra note 12), the buy side exercise price 
exceeds the sell side exercise price. In this example, the maximum 
risk for the short box spread is equal to the difference between the 
two exercise prices (60-50=10). If the net credit received from the 
sale of short option components ((5\1/2\+7)-(2+1)=net credit of 9\1/
2\) is applied, the investor is required to deposit an additional 
$50 (\1/2\  x  100). Otherwise, the investor would be required to 
deposit $1,000 (10  x  100).
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    In addition to butterfly spreads and box spreads, the proposal 
would permit investors to hold in their cash accounts other spreads 
made up of European-style, cash-settled index options, stock index 
warrants, or currency index warrants. A short position would be 
considered covered, and thus eligible for the cash account, if a long 
position in the same European-style, cash-settled index option, stock 
index warrant, or currency index warrant was held in, or purchased for, 
the account on the same day.\30\ The long and short positions making up 
the spread must expire concurrently, and the long position must be paid 
in full. Lastly, the cash account must contain cash, cash equivalents, 
or an escrow agreement equal to at least the aggregate exercise price 
differential.
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    \30\ Under the proposal, a long warrant may offset a short 
option contract and a long option contract may offset a short 
warrant provided they have the same underlying component or index 
and equivalent aggregate current underlying value.
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    The proposal also would establish requirements for the following 
types of options and warrants carried short in the cash account: equity 
options, index options, capped-style index options, packaged vertical 
spread options, packaged butterfly spread options, stock index 
warrants, and currency index warrants. For each of these securities, 
the proposal specifies certain criteria that must be satisfied for the 
short position to be deemed a covered position, and thus considered 
eligible for the cash account. For example, a short put warrant on a 
market index would be deemed covered if, at the time the put warrant is 
sold or promptly thereafter, the cash account holds cash, cash 
equivalents, or an escrow agreement equal to the aggregate exercise 
price.

[[Page 42739]]

F. Margin Account Treatment of Butterfly Spreads and Box Spreads

    The Exchange's margin rules presently do not recognize butterfly 
spreads for margin purposes. Under the Exchange's current margin rules, 
the two spreads (bullish and bearish) that make up a butterfly spread 
each must be margined separately. The Exchange believes that the two 
spreads should be viewed in combination, and that commensurate with the 
lower combined risk, investors should receive the benefit of lower 
margin requirements.
    The Exchange's proposal would recognize as a distinct strategy 
butterfly spreads held in margin accounts, and specify requirements 
that are the same as the cash account requirements for butterfly 
spreads.\31\ Specifically, in the case of a long butterfly spread, the 
net debit must be paid in full. For short butterfly spreads comprised 
of call options, the initial and maintenance margin must equal at least 
the aggregate difference between the two lowest exercise prices. For 
short butterfly spreads comprised of put options, the initial and 
maintenance margin must equal at least the aggregate difference between 
the two highest exercise prices. The net credit received from the sale 
of the short option components may be applied towards the margin 
requirement for short butterfly spreads.
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    \31\ See supra, Section II(E), ``Cash Account Treatment of 
Butterfly and Box Spreads, Other Spreads, and Short Options.'' The 
margin requirements would apply to butterfly spreads where all 
option positions are listed or guaranteed by the carrying broker-
dealer.
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    The proposed requirements for box spreads held in a margin account, 
where all option positions making up the box spread are listed or 
guaranteed by the carrying broker-dealer, also are the same as those 
applied to the cash account. With respect to long box spreads, where 
the component options are not European-style, the proposal would 
require full payment of the net debit that is incurred when the spread 
strategy is established.\32\ For short box spreads held in the margin 
account, the proposal would require that cash or cash equivalents 
covering the maximum risk, which is equal to the aggregate difference 
in the two exercise prices involved, be deposited and maintained. The 
net credit received from the sale of the short option components may be 
applied towards the requirement. Generally, long and short box spreads 
would not be recognized for margin equity purposes; however, the 
proposal would allow loan value for one type of long box spread where 
all component options have a European-style exercise provision and are 
listed or guaranteed by the carrying broker-dealer.
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    \32\ As discussed above in Section II(D), ``Extension of Credit 
on Long Box Spread in European-style Options,'' the margin 
requirement for a long box spread made up of European-style options 
is 50% of the aggregate difference in the two exercise prices.
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G. Maintenance Margin Requirements for Stock Positions Held With 
Options Positions

    The Exchange proposes to recognize, and establish reduced 
maintenance margin requirements for, five options strategies designed 
to limit the risk of a position in the underlying component. The 
strategies are: (1) Long Put/Long Stock: (2) Long Call/Short Stock; (3) 
Conversion; (4) Reverse Conversion; and (5) Collar. Although the five 
strategies are summarized below in terms of a stock position held in 
conjunction with an overlying option (or options), the proposal is 
structured to also apply to components that underlie index options and 
warrants. For example, these same maintenance margin requirements will 
apply when these strategies are utilized with a stock basket underlying 
index options or warrants. Proposed Exchange Rule 12.3(c)(5)(C)(3), 
``Exceptions,'' would define the five strategies and set forth the 
respective maintenance margin requirements for the stock component for 
each strategy.\33\
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    \33\ The Exchange's proposal provides maintenance margin relief 
for the stock component (or other underlying instrument) of the five 
identified strategies. The Exchange believes that a reduction in the 
initial margin for the stock component of these strategies is not 
currently possible because the 50% initial margin requirement under 
Regulation T continues to apply, and the Exchange does not possess 
the independent authority to lower the initial margin requirement 
for stock. However, the Exchange noted that the Federal Reserve 
Board is considering recognizing the reduced risk afforded stock by 
these option strategies for the purpose of lowering initial stock 
margin requirements and is also considering other changes that would 
facilitate risk-based margins.
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1. Long Put/Long Stock
    The Long Put/Long Stock strategy requires an investor to carry in 
an account a long position in the component underlying the put option, 
and a long put option specifying equivalent units of the underlying 
component. The maintenance margin requirement for the Long Put/Long 
Stock combination would be the lesser of: (i) 10% of the put option 
exercise price, plus 100% of any amount by which the put option is out-
of-the-money; or (ii) 25% of the current market value of the long stock 
position.\34\
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    \34\ Suppose an investor is long 100 shares of XYZ @ 52 and long 
1 XYZ Jan 50 Put @ 2. The margin would be the lesser of ((10%  x  
50) + (100%  x  2) = 7) or (25%  x  52 = 13). Therefore, the 
investor would be required to maintain margin equal to at least $700 
(7  x  100).
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2. Long Call/Short Stock
    The Long Call/Short Stock strategy requires an investor to carry in 
an account a short position in the component underlying the call 
option, and a long call option specifying equivalent units of the 
underlying components. For a Long Call/Short Stock combination, the 
maintenance margin requirement would be the lesser of: (i) 10% of the 
call option exercise price, plus 100% of any amount by which the call 
option is out-of-the-money; or (ii) the maintenance margin requirement 
on the short stock position as specified in CBOE rule 12.3(b).\35\
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    \35\ For each stock carried short that has a current market 
value of less than $5 per share, the maintenance margin is $2.50 per 
share or 100% of the current market value, whichever is greater. For 
each stock carried short that has a current market value of $5 per 
share or more, the maintenance margin is $5 per share or 30% of the 
current market value, whichever is greater. See Exchange Rule 
12.3(b)(2), ``Short Positions.''
    Suppose an investor is short 100 shares of XYZ @ 48 and long 1 
XYZ Jan 50 Call @ 1. The margin would be the lesser of ((10% of 50) 
=7) or 30%  x  48 = 14.4). Therefore, the investor would be required 
to maintain margin equal to at least $700 (7  x  100).
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3. Conversion
    A ``Conversion'' is a long stock position held in conjunction with 
a long put and a short call. The long put and short call must have the 
same expiration date and exercise price. The short call is covered by 
the long stock and the long put is a right to sell the stock at a 
predetermined price--the exercise price of the long put. Regardless of 
any decline in market value, the stock, in effect, is worth no less 
than the long put exercise price.
    The Exchange's current margin regulations specify that no 
maintenance margin would be required on the short call option because 
it is covered, but the underlying long stock position would be margined 
according to the present maintenance margin requirement (i.e., 25% of 
current market value).\36\ Under the proposal, the maintenance for a

[[Page 42740]]

Conversion would be 10% of the exercise price.\37\
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    \36\ Suppose an investor is long 100 shares of XYZ @ 48, long 1 
XYZ Jan 50 Put at 2, and short 1 XYZ Jan 50 Call @ 1. The present 
maintenance margin on the long stock position would be $1,200 ((25% 
x  48)  x  100). However, if the price of the stock increased to 60, 
current Exchange Rule 12.3(c)(5)(B)(2) specifies that the stock may 
not be valued at more than the short call exercise price. Thus, the 
maintenance margin on the long stock position would be $1,250 ((25% 
x  50)  x  100). The writer of the call option cannot receive the 
benefit (i.e., greater loan value) of a market value that is above 
the call exercise price because, if assigned an exercise, the 
underlying component would be sold at the exercise price, not the 
market price of the long position.
    \37\ For example in the preceding footnote, where the investor 
was long 100 shares of XYZ @ 48, long 1 XYZ Jan 50 Put @ 2, and 
short 1 XYZ Jan 50 Call @ 1, the proposed maintenance margin 
requirement for the Conversion strategy would be $500 ((10%  x  50) 
x  100).
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4. Reverse Conversion
    A ``Reverse Conversion'' is a short stock position held in 
conjunction with a short put and a long call. As with the Conversion, 
the short put and long call must have the same expiration date and 
exercise price. The short put is covered by the short stock and the 
long call is a right to buy the right stock at a predetermined price--
the call exercise price. Regardless of any rise in market value, the 
stock can be acquired for the call exercise price, in effect, the short 
position is valued at no more than the call exercise price. The 
maintenance margin requirement for a Reverse Conversion would be 10% of 
the exercise price, plus any in-the-money amount (i.e., the amount by 
which the exercise price of the short put exceeds the current market 
value of the underlying stock position).\38\
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    \38\ The seller of a put option has an obligation to buy the 
underlying component at the put exercise price. If assigned an 
exercise, the underlying component would be purchased (the short 
position in the Reverse Conversion effectively closed) at the 
exercise price, even if the current market price is lower. To 
recognize the lower market value of a component, the short put in-
the-money amount is added to the requirement. For example, an 
investor holding a Reverse Conversion may be short 100 shares of XYZ 
@ 52, long 1 XYZ Jan 50 Call @ 2\1/2\, and short 1 XYZ Jan 50 Put @ 
1\1/2\. If the current market value of XYZ stock drops to 30, the 
maintenance margin would be $2,500 ((10%  x  50) + (50-30))  x  100.
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5. Collar
    A ``Collar'' is a long stock position held in conjunction with a 
long put and a short call. A Collar differs from a Conversion in that 
the exercise price of the long put is lower than the exercise price of 
the short call. Therefore, the options positions in a Collar do not 
constitute a pure synthetic short stock position. The maintenance 
margin for a Collar would be the lesser of: (i) 10% of the long put 
exercise price, plus 100% of any amount by which the long put is out-
of-the-money; or (ii) 25% of the short call exercise price.\39\ Under 
the Exchange's current margin regulations, the stock may not be valued 
at more than the call exercise price.
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    \39\ To create a Collar, an investor may be long 100 shares of 
XYZ @ 48, long 1 XYZ Jan 45 Put @ 4, and short 1 XYZ Jan 50 Call @ 
3. The maintenance margin requirement would be the lesser of ((10% 
x  45) + 3 = 7\1/2\) or (25%  x  50 = 12\1/2\). Therefore, the 
investor would need to maintain at least $750 (7\1/2\  x  100) in 
margin.
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H. Restructuring

    The proposal would replace the present margin requirement for 
uncovered short listed options, which appears as CBOE Rule 
12.3(c)(5)(A), ``Short Listed Equity Options: General Rule,'' with 
current Interpretation and Policy .01 to Exchange Rule 12.3 
(``Interpretation''). The Interpretation contains a table that 
includes: (i) Different types of listed option and warrant products; 
(ii) the underlying component value; (iii) the percentage used in the 
basic formula for calculating the margin requirement for positions 
carried short; and (iv) the percentage used in the alternative formula 
for calculating the minimum margin requirement, which becomes operative 
whenever the basic formula results in a lower requirement.\40\ The 
Interpretation has been modified slightly to incorporate the margin 
requirements for narrow-based stock index warrants, which are currently 
located in Chapter 30 of the Exchange's rules.
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    \40\ For example, if an investor writes an uncovered equity 
option, such as 1 XYZ Jan 25 Put @ 1, the investor's position would 
be subject to the Exchange's short option margin requirements. If 
the current market value of XYZ stock is $30, under the basic 
formula the investor would be required to deposit and maintain 
margin equal to at least $200 (i.e., $100 (100% of the current 
market value of the option) + $600 (20%  x  $3,000  the 
current market value of the XYZ stock underlying the short option) - 
$500 (the out-of-the-money amount)). However, the alternative 
formula becomes operative because it requires a minimum margin that 
exceeds the amount required under the basic formula. Under the 
alternative formula, the investor would be required to deposit and 
maintain margin equal to at least $350 (i.e., $100 (100% of the 
current market value of the option) + $250 (10%  x  $2,500  
the aggregate exercise price amount of the short put option)). 
Therefore, the investor would be required to comply with the higher 
margin requirement of $350.
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    Under the proposal, the margin requirements for uncovered short 
positions in OTC options would be relocated from Exchange Rule 
12.3(c)(5)(B)(5) to Exchange Rule 12.3(c)(5)(B). The current text of 
the Exchange rule that sets forth the margin requirements for short OTC 
options differs from the proposed text of the rule that contains the 
margin requirements for short listed options (i.e., the 
Interpretation). To establish greater consistency, the proposal would 
revise the rule text of the margin requirements for both listed and OTC 
short options to make them more similar. The methodology of calculating 
margin requirements for short listed and OTC options is essentially the 
same, only different percentages are applies.\41\
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    \41\ For example, the percentage used in the basic formula for 
calculating the margin requirement for short listed stock options is 
20%. In contrast, the percentage used with respect to short OTC 
stock options is 30%.
---------------------------------------------------------------------------

    The proposal also would combine the margin requirements pertaining 
to long position offsets for short OTC options with those pertaining to 
long position offsets for short listed options. The combined margin 
requirements would appear in proposed Exchange Rule 12.3(c)(5)(C), 
``Related Securities Position'' and would apply to listed and OTC 
option positions where: (i) a short call is covered by a convertible 
security; (ii) a short call is covered by a warrant; and (iii) a short 
call or short put is covered.\42\ As a result, two sets of relatively 
identical requirements that now exist separately would be consolidated 
into one section.
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    \42\ In the case of short call, the position must be covered by 
a long position in equivalent units of the underlying security, and 
in the case of a short put, the position must be covered by a short 
position in equivalent units of the underlying security. With 
respect to short calls options on the S&P 500 stock index, the 
Exchange proposes to allow the use of long positions in underlying 
open-end index mutual funds as cover for short S&P 500 call options 
held in customer margin or cash accounts, provided the mutual funds 
have sufficient aggregate market value and have been specifically 
designated by the Exchange.
---------------------------------------------------------------------------

    The proposed restructuring would ensure that the margin 
requirements for short options and warrants are organized in one 
section. The restructuring also would allow the deletion of the margin 
requirements applicable to short options and warrants that are now 
dispersed among several other chapters: Chapter 23 (interest rate 
options), Chapter 24 (index options), and Chapter 30 (warrants). In 
addition, the proposal would restructure Exchange Rule 12.3 to 
generically cover the margin requirements for spread positions in 
options/warrants of the types currently addressed in other 
chapters.\43\ Margin requirements located elsewhere that are not 
amenable to such generic treatment, have been incorporated into 
Exchange Rule 12.3 as necessary.
---------------------------------------------------------------------------

    \43\ For example, the margin requirements for capped-style (CAPS 
and Q-CAPS) index option spreads, packaged vertical spreads, and 
packaged butterfly spreads were moved from Chapter 24 and updated to 
reflect the proposed margin requirements for spreads.
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I. Time Margin Must Be Obtained

    The proposal would clarify the time in which initial margin is due. 
Exchange Rule 12.2, ``Time Margin Must Be Obtained,'' was adopted at a 
time when the Exchange had authority only to set maintenance margin 
levels, and currently requires that margin be obtained as promptly as 
possible. Because the Exchange now has additional rulemaking 
responsibility for the initial margin requirements for options, the 
proposal specifies that

[[Page 42741]]

initial margin requirements would be due in one ``payment period'' as 
defined in Regulation T.\44\ The proposal also would revise Exchange 
Rule 12.2 to specify that maintenance margin must be obtained as 
promptly as possible, but in any event within 15 days. The current 
standard is ``within a reasonable time.''
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    \44\ Regulation T defines payment period as ``the number of 
business days in the standard securities settlement cycle in the 
United States, as defined in paragraph (a) of SEC Rule 15c6-1, plus 
two business days.'' See 12 CFR 220.2.
---------------------------------------------------------------------------

J. Effect of Mergers and Acquisitions on the Margin Required for Short 
Options

    The proposal would implement, as Interpretation and Policy .13 of 
Exchange Rule 12.3, an exception to the margin requirement for short 
options if trading in the underlying security ceases due to a merger or 
acquisition. The exception currently exists as part of an Exchange 
Regulatory Bulletin.\45\ Under the proposed exception, if an underlying 
security ceases to trade due to a merger or acquisition, and a cash 
settlement price has been announced by the issuer of the option, margin 
would be required only for in-the-money options and would be set at 
100% of the in-the-money amount.
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    \45\ Exchange Regulatory Bulletin No. 91-29, ``Customer Margin 
Requirements,'' specifies the margin requirements for uncovered, 
short equity options that have been delisted by the Exchange due to 
a merger or acquisition. For out-of-the-money options, no margin is 
required. For in-the-money options, margin must equal the difference 
between the underlying stock value set by the registered clearing 
corporation and the strike price of the option. See Exchange 
Regulatory Bulletin Number 91-29 (April 10, 1991).
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K. Determination of Value for Margin Purposes

    The proposal would revise Exchange rules 12.5, ``Determination of 
Value for Margin Purposes,'' to make it consistent with that portion of 
the Exchange's proposal that allows the extension of credit on certain 
long-term options and warrants (i.e, stock options, stock index 
options, and stock index warrants that are more than 9 months from 
expiration). Currently, Exchange Rule 12.5 does not allow the market 
value of long term options to be considered for margin equity purposes. 
The revision would allow options and warrants eligible for loan value 
under proposed Rule 12.3 to be valued at current market prices for 
margin purposes. This change is designed to ensure that the value of 
the marginable option or warrant (the collateral) is sufficient to 
cover the debit carried in conjunction with the purchase.

L. Exempted Securities

    Currently, the Exchange's maintenance margin requirement for non-
convertible debt securities is found in Exchange Rule 12.3(c)(1), 
``Exempted Securities.'' However, the term ``non-convertible debt 
security'' refers to corporate bonds, which are not considered exempt 
securities under the Act. The Exchange seeks to rectify this misnomer 
by removing the margin requirement for non-convertible debt securities 
from the ``Exempted Securities'' section and redesignating it as a 
separate provision, Exchange Rule 12.3(c)(2).

III. Summary of Comments

    The Commission received 4 comment letters regarding the proposed 
rule change, all of which supported the proposal.\46\ One commenter, a 
registered broker-dealer, stated that its clients complained that the 
margin requirements on certain index options positions are ``much 
higher than the overall risk of the position[s] would indicate.'' \47\ 
Another commenter, who acts as a market maker in S&P 500 index options 
at the CBOE and also serves as a member of the CBOE's Board of 
Directors, reported that some market participants believe that the 
margin requirements for offsetting spread positions are onerous, and 
that present margin requirements are a ``major barrier to more customer 
business.'' \48\ This commenter stated that in some instances customers 
have shifted their options trades to the OTC and futures markets 
because the margin requirements at the CBOE are higher.\49\
---------------------------------------------------------------------------

    \46\ See Sheehan Letter, Wilkinson Letter, O'Connor Letter, and 
Schwab Letter supra note 4.
    \47\ See Sheehan Letter supra note 4.
    \48\ See Wilkinson Letter supra note 4.
    \49\ The commenter alleged that margin requirements for certain 
S&P 500 index options traded on the CBOE can be as much as 2 to 16 
times greater than options on S&P 500 index futures traded on the 
Chicago Mercantile Exchange. Id.
---------------------------------------------------------------------------

    One commenter believed that the proposed margin requirements will 
benefit investors by recognizing the limited risk of many hedged 
positions.\50\ Another commenter believed that the current margin 
requirements for listed options positions, particularly hedged 
strategies using multiple positions, do not ``adequately recognize the 
defined risk of these positions.'' \51\ This commenter believed that 
reducing the margin requirements for options strategies with defined 
risk will benefit customers by providing increased flexibility and 
lowering costs, and will better align the level of margin with the risk 
of the positions. This commenter also believed that the proposal would 
serve to ``increase the viability of listed options and the 
competitiveness of the options markets generally.'' \52\
---------------------------------------------------------------------------

    \50\ See O'Conner Letter supra note 4.
    \51\ See Schwab Letter supra note 4.
    \52\ Id.
---------------------------------------------------------------------------

    In addition, all four commenters advocated the adoption of a risk-
based methodology for margining options positions. One commenter 
believed that in terms of margin treatment, listed options are often at 
a disadvantage compared to similar derivative products traded on the 
futures exchanges (i.e., the futures exchanges employ risk-based 
margin).\53\ Another commenter believed that the availability of risk-
based margin for listed options could help the options exchanges to 
serve more customers.\54\
---------------------------------------------------------------------------

    \53\ Id.
    \54\ See Wilkinson Letter supra note 4.
---------------------------------------------------------------------------

IV. Discussion

    For the reasons discussed below, the Commission finds that the 
proposed rule changes is consistent with the Act and the rules and 
regulations under the Act applicable to a national securities exchange. 
In particular, the Commission finds that the proposed rule change is 
consistent with the Section 6(b)(5) \55\ requirements that the rules of 
an exchange be designed to promote just the equitable principles of 
trade, prevent fraudulent and manipulative acts and practices, and 
protect investors and the public interest. The Commission also finds 
that the proposal may serve to remove impediments to and perfect the 
mechanism of a free and open market by revising the Exchange's margin 
requirements to better reflect the risk of certain hedged options 
strategies.
---------------------------------------------------------------------------

    \55\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    The Commission believes that it is appropriate for the Exchange to 
allow member firms to extend credit on certain long term options and 
warrants, and that such practice is consistent with Regulation T. In 
1996, the Federal Reserve Board amended Regulation T to enable the 
self-regulatory organizations (``SROs'') to adopt rules permitting the 
margining of options.\56\ The CBOE rules approved in this order are the 
first SRO rules that will permit the margining of options under the 
grant of authority from the Federal Reserve Board.
---------------------------------------------------------------------------

    \56\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (Apr. 24, 1996), 61 FR 20386 (May 6, 1996), and 12 CFR 
220.12(f).
---------------------------------------------------------------------------

    The Commission believes that it is reasonable for the Exchange to 
restrict the extension of credit to long term options and warrants. The 
Commission believes that by limiting loan value to long term options 
and warrants, the proposal will help to ensure that the extension of 
credit is backed by

[[Page 42742]]

collateral (i.e., the long term option or warrant) that has sufficient 
value.\57\ Because the expiration dates attached to options and 
warrants make such securities wasting assets by nature, it is important 
that the Exchange restrict the extension of credit to only those 
options and warrants that have adequate value at the time of the 
purchase, and during the term of the margin loan.\58\
---------------------------------------------------------------------------

    \57\ The value of an option contract is made up of two 
components: Intrinsic value and time value. Intrinsic value, or the 
in-the-money-accounts, is an option contract's arithmetically 
determinable value based on the strike price of the option contract 
and the market value of the underlying security. Time value is the 
portion of the option contract's value that is attributable to the 
amount of time remaining until the expiration of the option 
contract. The more time remaining until the expiration of the option 
contract, the greater the time value component.
    \58\ For similar reasons, the Commission believes that it is 
appropriate for the Exchange to permit the extension of credit on 
long box spread comprised entirely of European-style options that 
are listed or guaranteed by the carrying broker-dealer. Because the 
European-style long box spread locks in the ability to buy and sell 
the underlying component or index for a profit, and all of the 
component options must be exercised on the same expiration day, the 
Commission believes that the combined positions have adequate value 
to support an extension of credit.
---------------------------------------------------------------------------

    The Commission believes that the proposed margin requirements for 
eligible long term options and warrants are reasonable. For long term 
listed options and warrants, the proposal requires that an investor 
deposit and maintain margin of not less than 75% of the current market 
value of the option or warrant. For long term OTC options and warrants, 
an investor must deposit and maintain margin of not less than 75% of 
the long term OTC option's or warrant's-in-the-money amount (i.e., 
intrinsic value), plus 100% of the amount, if any, by which the current 
market value of the OTC option or warrant exceeds the in-the-money 
amount. The Commission observes that the proposed margin requirements 
are more stringent than the current Regulation T margin requirements 
for equity securities (i.e., 50% initial margin and 25% maintenance 
margin).
    The Commission recognizes that because current Exchange rules 
prohibit loan value for options, increases in the value of long term 
options cannot contribute to margin equity (i.e., appreciated long term 
options cannot be used to offset losses in other positions held in a 
margin account). Consequently, some customers may face a margin call or 
liquidation for a particular position even though they concurrently 
hold a long term option that has appreciated sufficiently in value to 
obviate the need for additional margin equity. The Exchange's proposal 
would address this situation by allowing loan value for long term 
options and warrants.
    The Commission believes that it is reasonable for the Exchange to 
afford long term options and warrants loan value because mathematical 
models for pricing options and evaluating their worth as loan 
collateral are widely recognized and understood.\59\ Moreover, some 
creditors, such as the Options Clearing Corporation, extend credit on 
options as part of their current business.\60\ The Commission believes 
that because options market participants possess significant experience 
in assessing the value of options, including the use of sophisticated 
models, it is appropriate for them to extend credit on long term 
options and warrants.
---------------------------------------------------------------------------

    \59\ For example, the Black-Scholes model and the Cox Ross 
Rubinstein model are often used to price options. See F. Black and 
M. Scholes, The Pricing of Options and Corporate Liabilities, 81 
Journal of Political Economy 637 (1973), and J.C. Cox, S. A. Ross, 
and M. Rubinstein, Option Pricing: A Simplified Approach, 7 Journal 
of Financial Economics 229 (1979).
    \60\ The Exchange stated, ``[t]he fact that market-maker 
clearing firms and the Options Clearing Corporation extend credit on 
long options demonstrates that long options are acceptable 
collateral to lenders. In addition, banks have for some time loaned 
funds to market-maker clearing firms through the Options Clearing 
Corporation's Market Maker Pledge Program.'' See Letter to Michael 
Walinskas, Associate Director, Division, Commission, from Mary L. 
Bender, Senior Vice President, Division of Regulatory Services, 
Exchange, dated May 21, 1998.
---------------------------------------------------------------------------

    Furthermore, since 1998, lenders other than broker-dealers have 
been permitted to extend 50% loan value against long, listed options 
under Regulation U.\61\ The Commission understands that the current bar 
preventing broker-dealers from extending credit on options may place 
some CBOE member firms at a competitive disadvantage relative to other 
financial service firms. By permitting Exchange members to extend 
credit on long term options and warrants, the proposal should enable 
Exchange members to better serve customers and offer additional 
financing alternatives.
---------------------------------------------------------------------------

    \61\ See Board of Governors of the Federal Reserve System Docket 
Nos. R-0905, R-0923, and R-0944 (Jan. 8, 1998), 63 FR 2806 (Jan. 16, 
1998). In adopting the final rules that permitted non-broker-dealer 
lenders to extend credit on listed options, the Federal Reserve 
Board states that it was:
    [A]mending the Supplement to Regulation U to allow lenders other 
than broker-dealers to extend 50 percent loan value against listed 
options. Unlisted options continue to have no loan value when used 
as part of a mixed-collateral loan. However, banks and other lenders 
can extend credit against unlisted options if the loan is not 
subject to Regulation U [12 CFR 221 et seq.].
    The Board first proposed margining listed options in 1995. See 
Board of Governors of the Federal Reserve System Docket No. R-0772 
(June 21, 1995), 60 FR 33763 (June 29, 1995) (``[T]he Board is 
proposing to treat long positions in exchange-traded options the 
same as other registered equity securities for margin purposes.'').
---------------------------------------------------------------------------

    The Commission believes that it is appropriate for the Exchange to 
recognize the hedged nature of certain combined options strategies and 
prescribe margin and cash account requirements that better reflect the 
true risk of the strategy. Under current Exchange rules, the multiple 
positions comprising an option strategy such as a butterfly spread must 
be margined separately. In the case of a butterfly spread, the two 
component spreads (bull spread and bear spread) are margined without 
regard to the risk profile of the entire strategy. The net debit 
incurred on the bullish spread must be paid in full, and margin equal 
to the exercise price differential must be deposited for the bearish 
spread.
    The Commission believes that the revised margin and cash account 
requirements for butterfly spread and box spread strategies are 
reasonable measures that will better reflect the risk of the combined 
positions. Rather than view the butterfly and box spread strategies in 
terms of their individual option components, the Exchange's proposal 
would take a broader approach and require margin that is commensurate 
with the risk of the entire, hedged position. For long butterfly 
spreads and long box spreads, the proposal would require full payment 
of the net debit that is incurred when the spread strategy is 
established.\62\ For short butterfly spreads and short box spreads, the 
initial and maintenance margin required would be equal to the maximum 
risk potential. Thus, for short butterfly spreads comprised of call 
options, the margin must equal the aggregate difference between the two 
lowest exercise prices. For short butterfly spreads comprised of put 
options, the margin must equal the aggregate difference between the two 
highest exercise prices. For short box spreads, the margin must equal 
the aggregate difference in the two exercise prices involved. In each 
of these instances, the net credit received from the sale of the short 
option components may be applied towards the requirement.
---------------------------------------------------------------------------

    \62\ However, the long box spreads made up of European-style 
options, the margin requirements is 50% of the aggregate difference 
in the two exercise prices.
---------------------------------------------------------------------------

    The Commission believes that the proposed margin and cash account 
requirements for butterfly spreads and box spreads are appropriate 
because the component option positions serve to offset each other with 
respect to risk.

[[Page 42743]]

The proposal takes into account the defined risk of these strategies 
and sets margin requirements that better reflect the economic reality 
of each strategy. As a result, the margin requirements are tailored to 
the overall risk of the combined positions.
    For similar reasons, the Commission approves of the proposed cash 
account requirements for spreads made up of European-style cash-Settled 
index options, stock index warrants, or currency index warrants. Under 
the proposal, a short position would be considered covered, and thus 
eligible for the cash account, if a long position in the same European-
style cash-settled index option, stock index warrant, or currency index 
warrant was held in, or purchased for, the account on the same day. In 
addition, the long and short positions must expire concurrently, and 
the cash account must contain cash, cash equivalents, or an escrow 
agreement equal to at least the aggregate exercise price differential.
    The Commission believes that it is reasonable for the Exchange to 
specify cash account requirements for certain options and warrants 
carried short. The proposed requirements clearly identify the criteria 
that must be satisfied before a short position will be deemed covered. 
By codifying the criteria in its margin rules, the Exchange will assist 
CBOE members in determining whether a short position is eligible for 
the cash account.
    The Commission believes that is appropriate for the Exchange to 
revise the maintenance margin requirements for several hedging 
strategies that combine stock positions with options positions. The 
Commission recognizes that hedging strategies such as the Long Put/Long 
Stock, Long Call/Short Stock, Conversion, Reverse Conversion and 
Reverse Conversion, and Collar are designed to limit the exposure of 
the investor holding the combined stock and option positions. The 
proposal would modify the maintenance margin required for the stock 
component of a hedging strategy. For example, the stock component of a 
Long Put/Long Stock combination currently is margined without regard to 
the hedge provided by the long put position (i.e., the 25% maintenance 
margin requirement for the stock component is applied in full). Under 
the proposal, the maintenance margin requirement for the stock 
component of a Long Put/Long Stock strategy would be the lesser of: (i) 
10% of the put option exercise price, plus 100% of any amount by which 
the put option is out-of-the-money; or (ii) 25% of the current market 
value of the long stock position. Although for some market values the 
proposed margin requirement would be the same as the current 
requirement, in many other cases it would be lower.\63\ The Commission 
believes that reduced maintenance margin requirements for the stock 
components of hedging strategies are reasonable given the limited risk 
profile of the strategies.
---------------------------------------------------------------------------

    \63\ Suppose an investor is long 100 shares of XYZ @ 52 and long 
1 XYZ Jan 50 Put @ 2. Under the proposal, the required margin would 
be $700--the lesser of ((10%  x  50) + (100%  x  2) = 7) or (25%  x  
52 = 13). In contrast, the current margin requirement would be 
$1,300, a difference of $600.
---------------------------------------------------------------------------

    The Commission believes that the Exchange's proposal is a carefully 
crafted measure that draws on the Exchange's experience in monitoring 
the credit exposures of options strategies. In particular, the Exchange 
regularly examines the coverage of options margin as it relates to 
price movements in the underlying securities and index components. 
Furthermore, many of the proposed margin requirements were thoroughly 
reviewed by the New York Stock Exchange (``NYSE'') Rule 431 Review 
Committee,\64\ which is made up of industry participants who have 
extensive experience in margin and credit matters. Therefore, the 
Commission is confident that the proposed margin requirements are 
consistent with investor protection and properly reflect the risks of 
the underlying options positions.
---------------------------------------------------------------------------

    \64\ NYSE Rule 431 contains the margin requirements that NYSE 
members must observe. See NYSE Rule 431, ``Margin Requirements.''
---------------------------------------------------------------------------

    The Commission notes that the margin requirements approved in this 
order are mandatory minimums. Therefore, an Exchange member may freely 
implement margin requirements that exceed the margin requirements 
adopted by the Exchange.\65\ The Commission recognizes that the 
Exchange's margin requirements serve as non-binding benchmarks, and 
that Exchange members often establish different margin requirements for 
their customers based on a number of factors, including market 
volatility. The Commission encourages Exchange numbers to continue to 
perform independent and rigorous analyses when determining prudent 
levels of margin for customers.
---------------------------------------------------------------------------

    \65\ Exchange Rule 12.3(c), ``Customer Margin Account--
Exception,'' states that nothing in the provision addressing 
customer margin accounts ``shall prevent a broker-dealer from 
requiring margin from any account in excess of the amounts specified 
in these provisions.
---------------------------------------------------------------------------

    The Commission believes that it is appropriate for the Exchange to 
revise Exchange Rule 12.5, ``Determination of Value for Margin 
Purposes.'' to allow the market value of certain long term stock 
options, stock index options, and stock index warrants to be considered 
for margin equity purposes. Under the current terms of Exchange Rule 
12.5, options contracts are not deemed to have market value. Because 
the Exchange's proposal will allow extensions of credit on certain long 
term options and warrants, Exchange Rule 12.5 must be revised to permit 
such marginable options and warrants to be valued at current market 
prices for margin purposes. The Commission notes that unless Rule 12.5 
is revised to recognize the market value of the marginable options and 
warrants, the Exchange's loan value proposal will be ineffective (i.e., 
the market value of an appreciated marginable security would not be 
recognized or allowed to offset any loss in value of other securities 
held in the margin account).
    The Commission believes that is reasonable for the Exchange to 
codify as part of its rules the current margin requirements for short 
options on securities that have been delisted due to a merger or 
acquisition. Under the provision, if any underlying security ceases to 
trade due to a merger or acquisition. Under the provision, if an 
underlying security ceases to trade due to a merger or acquisition, and 
a cash settlement price has been announced by the issuer of the option, 
margin would be required only for in-the-money options and would be set 
at 100% of the in-the-money amount. The Commission believes that it is 
appropriate for the Exchange to not require margin for out-of-the-money 
short options. Given that a fixed settlement price will have been 
announced by the issuer of the option (e.g., Options Clearing 
Corporation) and trading in the delisted security will have stopped, 
the Commission believes that margin for the out-of-the-money short 
option contract is unnecessary because the intrinsic value of the 
option contract will not appreciate or vary such that the seller risks 
assignment (i.e., the intrinsic value will remain nil). The Commission 
believes that because the intrinsic value of short-in-the-money options 
will similarly remain fixed, it is reasonable to require margin that 
corresponds to 100% of the aggregate in-the-money amount.
    The Commission believes that is appropriate for the Exchange to 
clarify the time in which initial and maintenance margin requirements 
are due. This revision should help avoid confusion as to when margin 
payments must be made. By specifying that initial margin requirements 
are due in one payment period--five business days as currently defined 
in Regulation T--the

[[Page 42744]]

Exchange will help to facilitate the prompt collection of initial 
margin. In addition, the proposal revises the time-frame for the 
collection of maintenance margin by replacing the phrase ``within a 
reasonable time'' with ``as promptly as possible,'' and establishing an 
objective cut-off date of 15 days. The Commission believes that these 
changes will provide clear and definite guidelines concerning the 
collection of margin.
    The Commission believes that it is appropriate for the Exchange to 
revise the definition of ``current market value'' by making it 
correspond to the same definition found in Regulation T. A linkage to 
the Regulation T definition should keep the Exchange's definition 
equivalent without requiring a rule filing if there are future changes 
to the Regulation T definition. The Commission also believes that it is 
reasonable for the Exchange to define ``butterfly spread'' and ``box 
spread.'' These definitions will specify which multiple option 
positions, if held together, qualify for classification as buttlerfly 
or box spreads, and consequently are eligible for the proposed cash and 
margin treatment. The Commission believes that it is important for the 
Exchange to clearly define which options strategies are eligible for 
the proposed margin treatment.
    The Commission believes that it is reasonable for the Exchange to 
reorganize its margin provisions and consolidate them into a single 
section--Chapter 12 of the Exchange's Rules. As currently structured, 
the Exchange's margin rules are widely dispersed, appearing in Chapters 
12, 23, 24, and 30. The Commission believes that Exchange members and 
other market participants will find the consolidated margin provisions 
easier to locate and use.
    The Commission also believes that it is reasonable for the Exchange 
to rephrase and update some of the margin provisions that have been 
relocated and consolidated. The revisions are designed to ensure 
consistency among the Exchange's margin provisions. In some instances, 
changes proposed to one particular margin requirement impacted the 
requirements for other positions and products. In other instances, the 
Exchange simply revised language to clarify the meaning of the 
provision.\66\ In addition, the Commission believes that it is 
appropriate for the Exchange to correct the misnomer in Exchange Rule 
12.3(c)(1) that erroneously characterizes nonconvertible debt 
securities as exempted securities.
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    \66\ For example, the Exchange revised the rule language 
regarding straddles comprised of OTC options, but left intact the 
specific margin requirements. See Proposed Exchange Rule 
12.3(c)(5)(C)(5)(B).
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    The revisions to the Exchange's margin rules will significantly 
impact the way Exchange members calculate margin for options customers. 
The Commission believes that it is important for the Exchange to be 
adequately prepared to implement and monitor the revised margin 
requirements. To best accommodate the transition, the Commission 
believes that a phase-in period is appropriate. Therefore, the approved 
margin requirements shall not become effective until the earlier of 
November 3, 1999 or such date the Exchange represents in writing to the 
Commission that the Exchange is prepared to fully implement and monitor 
the approved margin requirements.
    The Commission expects the Exchange to issue a regulatory circular 
to members that discusses the revised margin provisions and provides 
guidance to members regarding their regulatory responsibilities. The 
Commission also believes that it would be helpful for the Exchange to 
publicly disseminate (i.e., via web site posting) a summary of the most 
significant aspects of the new margin rules and provide clear examples 
of how various options positions will be margined under the new 
provisions.
    The Commission finds good cause for approving proposed Amendment 
Nos. 1 and 2 prior to the thirtieth day after the date of publication 
of notice of filing thereof in the Federal Register. Amendment No. 1 
clarified that the margin requirement for non-marginable options and 
warrants is 100% of current market value, rather than 100% of purchase 
price. Unless this revision was made, the margin required for some long 
term options that had wound down to 9 months would have been 
inappropriate.\67\ By linking the margin requirement to current market 
value, rather than purchase price, Amendment No. 1 ensures that 
appropriate margin will be required.
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    \67\ For example, suppose that a long term option, which had 
significantly appreciated in value, reached nine months until 
expiration. A margin requirement of 100% of the purchase price would 
be insufficient given the increase in value. A requirement of 100% 
of the current market value, in contrast, is more appropriate.
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    Amendment No. 1 also revised the provision concerning the use of 
UITs and open-end mutual funds as cover for short index options. The 
revision conformed the Exchange's proposal to the narrower change that 
was recommended by the NYSE Rule 431 Committee. As a result, the 
Exchange's proposal limits the use of mutual funds as cover to short 
S&P 500 call options held in a margin or cash account.\68\ Amendment 
No. 1 also incorporated into the proposal the definition of ``OTC 
margin bond,'' which had been eliminated from Regulation T by the 
Federal Reserve Board as of April 1, 1998. These changes will 
strengthen the proposal by making it consistent with the margin 
requirements supported by the NYSE Rule 431 Committee, and by defining 
an important term that was dropped from Regulation T.
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    \68\ In accordance with an interpretation that the Federal 
Reserve Board provided to the American Stock Exchange, the Exchange 
will continue to permit members to use certain UITs as cover for 
short index option positions in a margin account. For example, the 
Exchange allows members to use S&P 500 Depository Receipts 
(``SPDRs'') as cover for short S&P 500 index options. The Federal 
Reserve Board deemed such practice consistent with Regulation T in 
1993. See Letter from Michael J. Shoenfeld, Federal Reserve Board, 
to James McNeil, American Stock Exchange, dated February 1, 1993.
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    Amendment No. 2 revised the proposal by limiting loan value to long 
term stock options, stock index options, and stock index warrants. The 
Exchange had originally proposed to allow loan value on any long term 
option, regardless of the underlying instrument (e.g., foreign currency 
options and options on interest rate composites would be marginable): 
This change conforms the Exchange's proposal to the measures supported 
by the NYSE Rule 431 Committee and the companion margin filing 
submitted by the NYSE.\69\ Amendment No. 2 will ensure consistency 
among the national securities exchanges regarding the types of 
securities on which credit may be extended.
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    \69\ See Securities and Exchange Act Release (No. 41168 Mar. 12, 
1999), 64 FR 13620 (Mar. 19, 1999) (notice of filing of SR-NYSE-99-
03).
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    Based on the above, the Commission finds that good cause exists, 
consistent with Section 19(b) of the Act,\70\ to accelerate approval of 
Amendment Nos. 1 and 2 to the proposed rule change.
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    \70\ 15 U.S.C. 78s(b).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1 and 2 to the proposed rule 
change, including whether the proposed rule change, as amended, 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 20549-0609. Copies of 
the submissions, all subsequent amendments, all written statements with 
respect to the proposed

[[Page 42745]]

rule change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any persons, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 25049. 
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-97-67 and should be submitted by August 26, 1999.

VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\71\ that the proposed rule change (SR-CBOE-97-67), as amended, is 
approved. The approved margin requirements shall become effective the 
earlier of November 3, 1999 or such date the Exchange represents in 
writing to the Commission that the Exchange is prepared to fully 
implement and monitor the approved margin requirements.

    \71\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\72\
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    \72\ 17 CFR 200.30-3(a)(12)
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-20174 Filed 8-4-99; 8:45 am]
BILLING CODE 8010-01-M