[Federal Register Volume 64, Number 204 (Friday, October 22, 1999)]
[Notices]
[Pages 57172-57180]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-27601]


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

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42011; File No. SR-NYSE-99-03]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 1 and 2 by the New York Stock Exchange, Inc. Relating to 
NYSE Rule 431

October 14, 1999.

1. Introduction

    On January 27, 1999, the New York Stock Exchange, Inc. (``NYSE'' or 
``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``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 amend NYSE rule 431, ``Margin 
Requirements,'' to revise the margin requirements for stock options and 
stock index options. The proposed rule change was published for comment 
in the Federal Register on March 19, 1999.\3\ The Commission received 
16 comment letters regarding the proposal.\4\
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 41168 (March 12, 
1999), 64 FR 13620.
    \4\ See letter from William J. Brodsky, Chairman and Chief 
Executive Officer, CBOE, to Jonathan G. Katz, Secretary, Commission, 
dated April 1, 1999 (``CBOE Letter''); letter from Jack L. Hansen, 
Senior Portfolio Manager and Principal, The Clifton Group, to 
Jonathan Katz, Secretary, Commission, dated March 29, 1999 
(``Clifton Letter''); letter from Ronald M. Egalka, President and 
CEO, Rampart Investment Management, to Jonathan G. Katz, Secretary, 
Commission, dated March 31, 1999 (``Rampart Letter''); letter from 
Robert C. Sheehan, President, Robert C. Sheehan and Associates, to 
Jonathan Katz, Secretary, SEC, dated March 26, 1999 (``Sheehan 
Letter''); letter from Alvin Wilkinson to Jonathan G. Katz, 
Secretary, Commission, dated March 25, 1999 (``Wilkinson Letter''); 
letter from Stewart E. Winner, First Vice President, Director, 
Retail Options, Prudential Securities Inc., to Jonathan Katz, 
Secretary, SEC, dated March 30, 1999 (``Prudential Letter'') letter 
from Jeffrey T. Kaufmann, Lakeshore Securities L.P., to Jonathan 
Katz, Secretary, SEC, dated March 26, 1999 (``Lakeshore Letter''); 
letter from Gary Alan DeWaal, Executive Vice President and General 
Counsel, FIMAT USA, to Jonathan Katz, Secretary, SEC, dated April 8, 
1999 (``FIMAT Letter''); letter from Leslie C. Quick, III, 
President, U.S. Clearing Corp., to Jonathan G. Katz, Secretary, SEC 
dated April 7, 1999 (``U.S. Clearing Letter''); letter from William 
C. Floersch, President and CEO, O'Connor & Company, to Jonathan G. 
Katz, Secretary, SEC, dated April 5, 1999 (``O'Connor Letter''); 
letter from Jeffrey S. Alexander, Vice President and Senior Counsel, 
Office of the General Counsel, Merrill Lynch, to Jonathan Katz, 
Secretary, SEC, dated April 8, 1999 (``Merrill Lynch Letter''), 
letter from Lon Gorman, Executive Vice President, Charles Schwab, to 
Jonathan G. Katz, Secretary, SEC, dated April 13, 1999 (``Schwab 
Letter''); letter from Robin Roger, Principal and Counsel, Morgan 
Stanley Dean Witter, to Jonathan G. Katz, Secretary SEC, dated April 
16, 1999 (``Morgan Stanley Letter''); letter from R. Allan Martin, 
Empire Programs, Inc., to Jonathan Katz, Secretary, SEC, dated May 
12, 1999 (``Empire Letter''); letter from Kevin Wiseman, Chairman of 
the Rules and Regulations Committee, Credit Division, Securities 
Industry Association (``SIA''), to Margaret H. McFarland, Deputy 
Secretary, SEC, dated June 15, 1999 (``SIA Letter''); and letter 
from George Brunelle to Jonathan Katz, Secretary, SEC, dated July 1, 
1999 (``Brunelle Letter'').
---------------------------------------------------------------------------

    The NYSE filed Amendment No. 1 to the proposal on August 11, 
1999,\5\ and Amendment No. 2 to the proposal on September 3, 1999.\6\ 
This order approves the proposed rule change and grants accelerated 
approval to Amendment Nos. 1 and 2.
---------------------------------------------------------------------------

    \5\ See letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Richard C. Strasser, Assistant Director, 
Division of Market Regulation (``Divison''), Commission, dated 
August 10, 1999 (``Amendment No. 1''). Amendment No. 1 revises the 
proposal to: (1) Provide that the minimum margin requirement for a 
short put on a listed option will be the current value of the put 
plus a specified percentage of the put option's exercise price; (2) 
provide that the minimum margin requirement for a short put on an 
over-the-counter (``OTC'') option will be a specified percentage of 
the put's exercise price; (3) clarify that the proposal does not 
provide loan value for long-term foreign currency options 
(``FCOs''); (4) provide examples demonstrating the operation of the 
proposed rule in connection with various options strategies, 
including long box spreads, hedged puts and calls, conversions, 
reverse conversions, and collars; and (5) makes a technical 
correction to the text of the proposed rule.
    \6\ See letter from James E. Buck, Senior Vice President and 
Secretary, NYSE, to Richard C. Strasser, Assistant Director, 
Division, Commission, dated September 3, 1999 (``Amendment No. 2''). 
Amendment No. 2 responds to the Brunelle Letter and revises the 
proposal to provide that butterfly and box spreads carried in the 
cash account must be comprised of listed options or must be 
guaranteed by the carrying broker-dealer.
---------------------------------------------------------------------------

II. Description of the Proposal

A. Background

    Until several years ago, the margin requirements governing listed 
options \7\ were set forth in Regulation T, ``Credit by Brokers and 
Dealers.'' \8\ However, Federal Reserve Board amendments to Regulation 
T that became effective on 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.\9\
---------------------------------------------------------------------------

    \7\ The Options Clearing Corporation (``OCC'') issues listed 
options.
    \8\ 12 CFR 220 et seq. The Board of Governors of the Federal 
Reserve System (``Federal Reserve Board'') issued Regulation T 
pursuant to the Act.
    \9\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (April 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'').
---------------------------------------------------------------------------

    In April 1996, the Exchange established NYSE Rule 431 Committee

[[Page 57173]]

(``431 Committee'') to review the Exchange's margin requirements. The 
431 Committee is comprised of industry representatives with diverse 
areas of expertise. The 431 Committee created various subcommittees, 
including an Options Subcommittee (``Options Subcommittee''), to review 
specific areas of NYSE Rule 431 and make recommendations to the 
Exchange in light of the changes in federal margin regulations and 
changing industry conditions. The Options subcommittee reviewed NYSE 
Rule 431 and recommended changes relating to the margin treatment of 
options. The proposed amendments to NYSE Rule 431 are substantially 
identical to amendments made in a proposal filed by the Chicago Board 
Options Exchange, Inc. (``CBOE'', which the Commission recently 
approved.\10\
---------------------------------------------------------------------------

    \10\ See Securities Exchange Act Release No. 41658 (July 27, 
1999), 64 FR 42736 (August 5, 1999) (order approving File No. SR-
CBOE-97-67) (``CBOE Approval Order'').
---------------------------------------------------------------------------

    Specifically, the NYSE proposes to amend NYSE Rule 431 to: (1) 
Permit the extension of credit on certain listed and over-the-counter 
(``OTC'') options with over nine months until expiration and on certain 
long box spreads; (2) recognize butterfly and box spreads as strategies 
for purposes of margin treatment and establish margin requirements for 
them; (3) 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; (4) 
expand the types of short options positions that will be considered 
``covered'' in a cash account to include certain short positions that 
are components of limited risk spread strategies (e.g., butterfuly and 
box spreads); and (5) allow an escrow agreement that conforms to NYSE 
standards to serve in lieu of cash for certain spread positions held in 
a cash account. In addition, the proposal revises the margin 
requirement for short put options to provide that: (1) The Minimum 
margin requirement for a short put on a listed option will be the 
current value of the put plus a specified percentage of the put 
option's exercise price; and (2) the minimum margin requirement for a 
short put on an OTC option will be a specified percentage of the put's 
exercise price.\11\
---------------------------------------------------------------------------

    \11\ See Amendment No. 1, supra note 5.
---------------------------------------------------------------------------

B. Definitions

    Currently, NYSE Rule 431 defines the ``current market value'' or 
``current market price'' of an option, currency warrant, currency index 
warrant, or stock index warrant as the total cost or net proceeds of 
the option contract or warrant on the day it was purchased or sold. The 
NYSE proposes to revise the definition to indicate that the current 
market value of current market price of an option, currency warrant, 
currency index warrant, or stock index warrant are as defined in 
Section 220.2 of Regulation T.
    The Exchange also proposed to establish definitions for ``butterfly 
spread'' \12\ and ``box spread''\13\ 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 spreads. 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.
---------------------------------------------------------------------------

    \12\ 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 compound 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, (B) a ``short butterfly spread'' 
in which two long options in the same series offset one short option 
and with a higher exercise price and in one short option with a 
lower exercise price.
    \13\ 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.
---------------------------------------------------------------------------

    Finally, the NYSE proposes to define as ``escrow agreement,'' when 
used in connection with cash settled calls, puts, currency warrants, 
currency index warrants or stock index warrants, carried short, as any 
agreement issued in a form acceptable to the NYSE under which a bank 
holding cash, cash equivalents, one or more qualified equity securities 
or a combination thereof is obligated (in the case of an option) to pay 
the creditor the exercise settlement amount in the event an option is 
assigned an exercise notice or, (in the case of a warrant) the funds 
sufficient to purchase a warrant sold short in the event of a buy-in.

C. Extension of Credit on Long Term Options and Warrants

    The proposal will allow extensions of credit on certain long listed 
and OTC \14\ options (i.e., put or call options on a stock or stock 
index) and warrant products (i.e., stock index warrants, but not 
traditional stock warrants issued by a corporation on its own 
stock.)\15\ Only those options or warrants with expirations exceeding 
nine months (``long term'') will be eligible for credit extension.\16\ 
For long term listed options and warrants, the proposal requires 
initial and maintenance margin of not less than 75% of the current 
market value of the option or warrant. Therefore, an NYSE member firm 
would be able to loan up to 25% of the current market value of a long 
term listed option or warrant.\17\
---------------------------------------------------------------------------

    \14\ Unlike listed options, OTC options are not issued by the 
OCC. OTC options and warrants are not listed or traded on a 
registered national securities exchange or though the automated 
quotation system of a registered securities association.
    \15\ Throughout the remainder of this approval order, the term 
``warrant'' means this type of warrant.
    \16\ For any stock option, stock index option, or stock index 
warrant that expires in nine 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.
    \17\ For example, if an investor purchased a 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 NYSE's current margin rules, the 
investor would be required to pay the entire $100. See CBOE Approval 
Order, supra note 10, at footnote 18.
---------------------------------------------------------------------------

    The proposal also permits the extension of credit on certain long 
term OTC options and warrants. Specifically, the proposal will allow a 
member firm to extend credit on an OTC put or call option on a stock or 
stock index, and on an OTC stock index warrant. In addition to being 
more than nine months from expiration, a marginable OTC option or 
warrant must: (1) Be in-the-money; (2) be guaranteed by the carrying 
broker-dealer; and (3) have an American-style exercise provision (i.e., 
may be exercised at any time up to the day before expiration). The 
proposal requires initial and maintenance margin of 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.
    When the time remaining until expiration for an option or warrant 
(listed or OTC) on which credit has been extended reaches nine months, 
the maintenance margin requirement will become 100% of the current 
market value. Thus, options or warrants expiring in less than nine 
months would have no loan value under the proposal. Options or warrants 
with less than nine

[[Page 57174]]

months to expiration will have no loan value because of the leverage 
and volatility of those instruments.\18\
---------------------------------------------------------------------------

    \18\ See Amendment No. 1, supra note 5.
---------------------------------------------------------------------------

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

    The proposal will allow the extension of credit on a long box 
spread comprised entirely of European-style options \19\ that are 
listed or guaranteed by the carrying broker-dealer. A long box spread 
is a strategy that is composed of four option positions and is designed 
to lock in the ability to buy and sell the underlying component or 
index for a profit, even after meeting the cost of establishing the 
long box spread. The two exercise prices embedded in the strategy 
determine the buy and the sell price.\20\
---------------------------------------------------------------------------

    \19\ A European-style index option may be exercised only at its 
expiration pursuant to the rules of the OCC. See NYSE Rule 
700(b)(19).
    \20\ 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,'' 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). See  Amendment No. 1, 
supra note 5, and CBOE Approval Order, supra note 10, at footnote 
22.
---------------------------------------------------------------------------

    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.\21\ The 50% margin requirement is both an initial and 
maintenance margin requirement.\22\ The proposal will afford a long box 
spread a market value for margin equity purposes of not more than 100% 
of the aggregate difference in exercise prices.
---------------------------------------------------------------------------

    \21\ 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\). See CBOE Approval 
Order, supra note 10, at footnote 23.
    \22\ See Amendment No. 1, supra note 5.
---------------------------------------------------------------------------

E. Cash Account Treatment of Butterfly Spreads, Box Spreads, and Other 
Spreads

    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,\23\ and must be comprised of options that 
are listed or guaranteed by the carrying broker-dealer.\24\ In 
addition, the long options must be held in, or purchased for, the 
account on the same day.
---------------------------------------------------------------------------

    \23\ See supra notes 12 and 13.
    \24\ See Amendment No. 2, supra note 6.
---------------------------------------------------------------------------

    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. According to the NYSE, full payment of the 
debit incurred to establish a long butterfly or box spread will cover 
any potential risk to the carrying broker-dealer.\25\
---------------------------------------------------------------------------

    \25\ To create a long butterfly spread, which is comprised of 
call options, an investor may be long 1 ZYZ Jan 45 Call @ 6, short 2 
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). See CBOE Approval Order, supra note 
10, at footnote 25.
---------------------------------------------------------------------------

    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 will 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.
---------------------------------------------------------------------------

    \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). See CBOE 
Approval Order, supra note 10, at footnote 27.
---------------------------------------------------------------------------

    Short box spreads also generate a credit balance when established. 
This credit is nearly equal to total debit (loss) that, in the case of 
a short spread, will accrue to the account if held to expiration. The 
proposal will 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 to be held or deposited.\29\
---------------------------------------------------------------------------

    \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 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). See CBOE Approval Order, 
supra note 10, at footnote 29.
---------------------------------------------------------------------------

    In addition to butterfly spreads and box spreads, the proposal will 
permit investors to hold in their cash accounts other spreads made up 
of European-style, cash-settled stock index options or stock 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 or stock 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

[[Page 57175]]

cash, cash equivalents, or an escrow agreement equal to at least the 
aggregate exercise price differential.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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, investor 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.
---------------------------------------------------------------------------

    \31\ See supra, Section II.E., ``Cash Account Treatment of 
Butterfly Spreads, Box Spreads, and Other Spreads.'' The margin 
requirements would apply to butterfly spreads where all option 
positions are listed or guaranteed by the carrying broker-dealer.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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 differences in the two exercise prices.
---------------------------------------------------------------------------

G. Margin Requirement for Short Put Options

    NYSE Rule 431(f)(2)(D) currently provides that the minimum required 
margin for a short listed put option is an amount equal to the option 
premium plus a percentage of the current value of the underlying 
instrument. The minimum required margin for a short OTC put option is 
an amount equal to a percentage of the current value of the underlying 
component. According to the NYSE, the NYSE's current rule creates a 
margin requirement for a short put option even when the price of the 
underlying instrument rises above the exercise price of the put and the 
risk associated with the put option has decreased because the option is 
out-of-the-money.\33\ The NYSE proposes to amend the margin requirement 
for short put options to provide a minimum margin requirement more in 
line with the risk associated with the option. Specifically, the NYSE 
proposes to amend NYSE Rule 431(f)(2)(D) to provide that the minimum 
margin requirement for a short listed put option will be an amount 
equal to the current value of the option plus a percentage of the 
option's exercise price. The minimum margin required for a short OTC 
put option will be an amount equal to a specified percentage of the 
option's exercise price.\34\
---------------------------------------------------------------------------

    \33\ See Amendment No. 1, supra note 5.
    \34\ Id.
---------------------------------------------------------------------------

H. 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 431(f)(2)(G)(v) will 
define the five strategies and set forth the respective maintenance 
margin requirements for the stock component of each strategy.\35\
---------------------------------------------------------------------------

    \35\ The Exchange's proposal provides maintenance margin relief 
for the stock component (or other underlying instrument) of the five 
identified strategies. 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. See CBOE Approval Order, supra note 10, at footnote 33.
---------------------------------------------------------------------------

1. Long Put/Long Stock
    The 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 percent 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.\36\
---------------------------------------------------------------------------

    \36\ For example, if an investor is long 100 shares of XYZ @ 52 
and long one XYZ Jan 50 Put @ 2, the required 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). See CBOE Approval Order, supra note 
10, at footnote 34.
---------------------------------------------------------------------------

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 component. 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 NYSE Rule 431(c).\37\
---------------------------------------------------------------------------

    \37\ 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 of 30% or the 
current market value, whichever is greater. See NYSE Rule 431(c). 
For example, for an investor who is short 100 shares of XYZ @ 48 and 
long 1 XYZ Jan 50 Call @ 1, the required margin would be the lesser 
of ((10%  x  50) + (100%  x  2) = 7) or (30%  x  48 = 14.4). 
Therefore, the investor would be required to maintain margin equal 
to at least $700 (7  x  100). See CBOE Approval Order, supra note 
10, at footnote 35.

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

[[Page 57176]]

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 
the current market value).\38\ Under the proposal, the maintenance 
margin for a Conversion would be 10% of the exercise price.\39\
---------------------------------------------------------------------------

    \38\ For example, for an investor who is long 100 shares of XYZ 
@ 48, long one XYZ Jan 50 Put at 2, and short one 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, the NYSE currently 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. See CBOE Approval Order, supra 
note 10, at footnote 36.
    \39\ For the 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). See CBOE Approval Order, supra note 10, at footnote 37.
---------------------------------------------------------------------------

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 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 not 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).\40\
---------------------------------------------------------------------------

    \40\ 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 one XYZ Jan 50 Call @ 2\1/2\, and short one 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. See CBOE Approval Order, supra note 10, at footnote 38.
---------------------------------------------------------------------------

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.\41\ Under 
the Exchange's current margin regulations, the stock may not be valued 
at more than the call exercise price.
---------------------------------------------------------------------------

    \41\ 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. See CBOE Approval Order, supra note 10, at footnote 39.
---------------------------------------------------------------------------

III. Summary of Comments

    The Commission received 16 comment letters regarding the proposed 
rule change.\42\ All of the commenters generally supported the 
proposal. One commenter noted, for example, that the NYSE's proposal 
would provide additional flexibility and borrowing capabilities to 
clients while adequately protecting carrying broker-dealers against 
potential risks.\43\ Another commenter maintained that the proposal 
will align margin treatment more closely with the risk associated with 
a position by permitting lower margin treatment for options strategies 
with a defined risk.\44\ The commenter also believed that the proposal 
will benefit customers by providing increased flexibility and lowering 
costs and will ``increase the viability of listed options and the 
competitiveness of the options markets generally.'' \45\
---------------------------------------------------------------------------

    \42\ See note 4, supra.
    \43\ See Merrill Lynch Letter, supra note 4.
    \44\ See Schwab Letter, supra note 4.
    \45\ Id.
---------------------------------------------------------------------------

    Noting the margin requirements for index options often are higher 
than the margin requirements for comparable index futures products, ten 
of the commenters advocated the adoption of a risk-based methodology 
for margining options positions.\46\ One commenter asserted that some 
clients used index futures options rather than index options because 
the margin requirements for index futures options are lower and better 
related to the risk of the overall customer positions.\47\ Another 
commenter, a CBOE market maker in S&P 500 Index options and a member of 
the CBOE's Board of Directors, stated that some market participants 
believe that the margin requirements for offsetting spread positions 
are onerous and that the current options margin requirements are a 
significant barrier to additional customer business.\48\ A third 
commenter noted that listed options strategies often are disadvantaged 
in terms of margin treatment in comparison to comparable futures 
products,\49\ and a fourth commenter urged the securities exchanges and 
regulators to modify the margin requirements for listed options to make 
them more comparable to the margin requirements for futures index 
options.\50\ A fifth commenter maintained that the current margin rules 
preclude cross-margining between index options and futures, thereby 
creating artificial liquidity problems and encouraging customers to 
trade in the OTC market.\51\
---------------------------------------------------------------------------

    \46\ See Letters from CBOE, Clifton, Rampart, Sheehan, 
Wilkinson, Prudential, Lakeshore, U.S. Clearing Corp., O'Connor, and 
Schwab, supra note 4. Two commenters noted that the futures market 
use a risk-based system for calculating margin requirements. See 
CBOE Letter and Lakeshore Letter, supra note 4.
    \47\ See Lakeshore Letter, supra note 4.
    \48\ The commenter alleged that margin requirement for certain 
S&P 500 Index options traded on the CBOE can be as much as two to 16 
times greater than options on S&P 500 Index futures traded on the 
Chicago Mercantile Exchange. See Wilkinson Letter, supra note 4. 
Similarly, another commenter, who is a registered broker-dealer, 
asserted that some clients had complained that the margin 
requirement for certain low-risk index options positions (e.g., 
boxes) is much greater than the risk of the position would indicate. 
See Sheehan Letter, supra note 4.
    \49\ See Schwab Letter, supra note 4.
    \50\ See Clifton Letter, supra note 4.
    \51\ See FIMAT Letter, supra note 4.
---------------------------------------------------------------------------

    In its comment letter, the CBOE supported the NYSE's proposal but 
suggested that the NYSE modify its proposal to: (1) Revise the NYSE's 
customer margin requirement for short equity put options to conform to 
the CBOE's margin requirement for short equity put options;\52\ and (2) 
provide

[[Page 57177]]

loan value for long term foreign currency options (``FCOs'').\53\
---------------------------------------------------------------------------

    \52\ CBOE Rule 12.3(c)(5) provides that the minimum customer 
margin required for a short put on a listed equity option is 100% of 
the current market value of the option or warrant plus 10% of the 
option or warrant's aggregate exercise price. For a short put on an 
OTC equity option, the minimum margin required under CBOE Rule 
12.3(c)(5) is 10% of the option's aggregate exercise price. The SIA 
and Prudential also recommended that the NYSE follow the CBOE's 
margin requirement for short equity put options. See SIA Letter and 
Prudential Letter, supra note 4.
    \53\ After submitting its comment letter, the CBOE revised its 
options margin proposal to eliminate the provision allowing loan 
value for FCOs. See Letter from Mary L. Bender, Senior Vice 
President and Chief Regulatory Officer, Division of Regulatory 
Services, CBOE, to Michael A. Walinskas, Deputy Associate Director, 
Division, Commission, dated May 14, 1999 (Amendment No. 2 to File 
No. SR-CBOE-97-67). Accordingly, neither the NYSE nor the CBOE will 
permit loan value for FCOs.
---------------------------------------------------------------------------

    Another commenter asserted that the NYSE's proposed definition of a 
``butterfly spread'' was ``technically inaccurate in a way which might 
impose unintended restrictions on the marginability of certain types of 
butterfly spreads.'' \54\ The commenter suggested that the NYSE revise 
its definition of butterfly spread to account for long butterfly 
positions established over time and for fully offset butterfly spreads 
involving a different mix of strike prices and different numbers of 
options contracts.\55\
---------------------------------------------------------------------------

    \54\ See Brunelle Letter, supra note 4.
    \55\ In particular, the commenter maintained that ``a long 
butterfly spread should be defined as an aggregate position where, 
if any of the short positions were assigned, the holder could 
exercise the appropriate long positions to cover the assignment.'' 
Id.
---------------------------------------------------------------------------

    Finally, one commenter urged the Commission to confirm that the 
proposal, if approved, would not prevent an NYSE member from requiring 
additional margin from its customers as the member deemed necessary, 
including the margin required currently under NYSE Rule 431.\56\ In 
addition, the commenter believed that, in light of the securities 
industry's efforts to ensure operational capacity to address year 2000 
issues, NYSE members should not be required to make modifications to 
their internal systems that would be necessary to implement the 
proposed changes on an immediate basis.\57\
---------------------------------------------------------------------------

    \56\ See Morgan Stanley Letter, supra note 4.
    \57\ In addition, the commenter maintained that NYSE members 
should have the opportunity to avoid making any systems 
modifications after the approval of the proposal to the extent that 
the member elects to continue operating under the NYSE's current 
margin rules. Id.
---------------------------------------------------------------------------

IV. Discussion

    For the reasons discussed below, the Commission finds that the 
proposed rule change 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) \58\ requirements that the rules of 
an exchange be designed to promote just and 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.\59\
---------------------------------------------------------------------------

    \58\ 15 U.S.C. 78f(b)(5).
    \59\ In approving the proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78f(c)(f).
---------------------------------------------------------------------------

    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.\60\ The NYSE rules approved in this order, which 
will permit the margining of options under the grant of authority from 
the Federal Reserve Board, are substantially identical to CBOE rules, 
which the Commission recently approved.\61\
---------------------------------------------------------------------------

    \60\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (April 24, 1996), 61 FR 20386 (May 6, 1996), and 12 CFR 
220.12(f).
    \61\ See CBOE Approval Order, supra note 10.
---------------------------------------------------------------------------

    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 collateral (i.e., the long term option or warrant) 
that has sufficient value.\62\ 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.\63\
---------------------------------------------------------------------------

    \62\ The value of an option contract is made up of two 
components: intrinsic value and time value. Intrinsic value, or the 
in-the-money-amount, 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.
    \63\ For similar reasons, the Commission believes that it is 
appropriate for the Exchange to permit the extension of credit on 
long box spreads 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 notes 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.\64\ Moreover, some 
creditor, such as the OCC, extend credit on options as part of their 
current business.\65\ The Commission believes

[[Page 57178]]

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.
---------------------------------------------------------------------------

    \64\ 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).
    \65\ In this regard, the Commission notes that the CBOE, in its 
options margin proposal, stated that ``[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 CBOE Approval 
Order, supra note 10.
---------------------------------------------------------------------------

    Furthermore, since 1998, lenders other than broker-dealers have 
been permitted to extend 50% loan value against long listed options 
under Regulation U.\66\ The Commission understands that the current bar 
preventing broker-dealers from extending credit on options may place 
some NYSE 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.
---------------------------------------------------------------------------

    \66\ See Board of Governors of the Federal Reserve System Docket 
Nos. R-0905, R-0923, and R-0944 (January 8, 1998), 63 FR 2806 
(January 16, 1998). In adopting the final rules that permitted non-
broker-dealer lenders to extend credit on listed options, the 
Federal Reserve Board stated 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.\67\ 
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.
---------------------------------------------------------------------------

    \67\ However, for long box spreads made up of European-style 
options, the margin requirement 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 options positions serve to offset each other with 
respect to risk. 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 
stock index options and stock 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 stock index option or stock 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 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 heding strategies such as the Long Put/Long 
Stock, Long Call/Short Stock, Conversion, 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 the 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.\68\ 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.
---------------------------------------------------------------------------

    \68\ For example, for an investor who is long 100 shares of XYZ 
@ 52 and long 1 XYZ Jan 50 Put @ 2, the margin required under the 
proposal 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. See CBOE Approval Order, 
surpa note 10, at footnote 63.
---------------------------------------------------------------------------

    The Commission notes that the proposed changes were reviewed 
carefully by the 431 Committee and the Options Subcommittee, which is 
comprised of industry participants who have extensive experience in 
margin and credit matters. In addition, as noted above, the NYSE's 
proposal is substantially identical to a CBOE proposal, which the 
Commission has approved.\69\ In approving the CBOE's proposal, the 
Commission noted the CBOE's experience in monitoring the credit 
exposures of options strategies and the fact that the CBOE regularly 
examines the coverage of options margins as it relates to price 
movements in the underlying securities and index components.\70\ 
Therefore, the Commission is confident that the

[[Page 57179]]

proposed margin requirements are consistent with investor protection 
and properly reflect the risks of the underlying options positions.
---------------------------------------------------------------------------

    \69\ See CBOE Approval Order, supra, note 10.
    \70\ Id.
---------------------------------------------------------------------------

    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.\71\ 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 members to continue to 
perform independent and rigorous analyses when determining prudent 
levels of margin for customers.
---------------------------------------------------------------------------

    \71\ In this regard, the Commission notes that NYSE Rule 431(d), 
``Additional Margin,'' requires NYSE member to: (1) Review limits 
and types of credit extended to all customers; (2) formulate their 
own margin requirements; and (3) review the need for instituting 
higher margin requirements, mark-to-markets and collateral deposits 
than are required by NYSE Rule 431 for individual securities or 
customer accounts.
---------------------------------------------------------------------------

    The Commission also believes that it is reasonable for the Exchange 
to define ``butterfly spread'' and ``box spread.'' These definitions 
will specify which multiple options positions, if held together, 
qualify for classification as butterfly 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.
    In response to the Brunelle Letter, which recommended that the NYSE 
adopt a more expansive definition of ``butterfly spread,'' the NYSE 
noted that the 431 Committee thoroughly reviewed a wide range of spread 
transactions in compiling its recommendations of strategies to include 
in the proposal.\72\ According to the NYSE, the 431 Committee decided 
to limit its recommendation to less complex, readily identifiable 
strategies. The NYSE maintains that the commenter's broader definition 
of butterfly spread does not meet the 431 Committee's criteria. 
However, the NYSE stated that it would consider the practicality of 
including more sophisticated strategies if there is sufficient industry 
interest.\73\
---------------------------------------------------------------------------

    \72\ See Amendment No. 2, supra note 6.
    \73\ Id.
---------------------------------------------------------------------------

    The Commission believes that the NYSE's approach is reasonable. The 
NYSE's proposed definition of a butterfly spread is consistent with the 
definition adopted by the CBOE \74\ and, accordingly, will establish 
consistent rules for joint NYSE/CBOE members. In addition, the NYSE and 
CBOE definitions of butterfly spread reflect the consensus reached by 
the 431 Committee and the Options Subcommittee, which, as noted above, 
are comprised of industry participants with extensive experience in 
margin and credit matters. The Commission also believes that the NYSE's 
approach will allow the Exchange to gain experience in monitoring the 
new margin requirements in connection with less complex strategies 
before considering whether to include more sophisticated strategies. 
Accordingly, the Commission believes that it is reasonable for the NYSE 
to retain its proposed definition of butterfly spread.
---------------------------------------------------------------------------

    \74\ See CBOE Approval Order, supra note 10.
---------------------------------------------------------------------------

    The Commission also believes that it is reasonable for the NYSE to 
revise its definition of ``current market value'' and ``current market 
price'' in NYSE Rule 431(f)(2)(C) to conform to Regulation T. A linkage 
to the Regulation T definition should keep the Exchange's definition 
equivalent to Regulation T without requiring a rule filing if the 
Federal Reserve Board revises its definition of Regulation T. In 
addition, the Commission believes that it is reasonable for the NYSE to 
define an ``escrow agreement'' to establish clear requirements for an 
escrow agreement.\75\
---------------------------------------------------------------------------

    \76\ The proposal defines an escrow agreement, when used in 
connection with cash settled calls, puts, currency warrants, 
currency index warrants or stock index warrants, carried short, as 
any agreement issued in a forum acceptable to the NYSE under which a 
bank holding cash, cash equivalents, one or more qualified equity 
securities or a combination thereof is obligated (in the case of an 
option) to pay the creditor the exercise settlement amount in the 
event an option is assigned an exercise notice or, (in the case of a 
warrant) the funds sufficient to purchase a warrant sold short in 
the event of a buy-in.
---------------------------------------------------------------------------

    In response to the CBOE's comments regarding short equity put 
options, the NYSE proposed in Amendment No. 1 to modify NYSE Rule 
431(f)(2)(D) to provide that the minimum customer margin requirement 
for a short put on a listed equity will be the current value of the put 
plus 10% of the put's exercise price. The minimum customer margin 
requirement for a short put on an OTC equity will be 10% of the put's 
exercise price. The change proposed in Amendment No. 1 will make the 
NYSE's treatment of short equity put options consistent with the CBOE's 
treatment of short equity put options.\76\ Accordingly, the proposed 
change in the NYSE's margin requirement for short listed and OTC equity 
put options raises no new regulatory issues and provides for consistent 
treatment of short equity put options under the rules of the NYSE and 
the CBOE.
---------------------------------------------------------------------------

    \76\ See CBOE Rule 12.3(c)(5).
---------------------------------------------------------------------------

    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 
January 20, 2000 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 an information 
memorandum 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 
strengthens the NYSE's proposal by revising the margin requirement for 
short listed and OTC equity put options to make the NYSE's rule 
consistent with CBOE Rule 12.3(c)(5). Because this change conforms the 
NYSE's rule to an existing CBOE rule, which was approved by the 
Commission, the change raises no new regulatory issues. In addition, 
this provision will benefit options market participants by providing 
consistent treatment of short equity put options under the rules of the 
NYSE and the CBOE. Amendment No. 1 also clarifies the NYSE's proposal 
by making a technical correction and providing examples of the 
operation of the proposed rule in connection with various options 
strategies.
    Amendment No. 2 strengthens the NYSE's proposal by providing that 
butterfly and box spreads carried in the cash account must be comprised 
of listed options or OTC options

[[Page 57180]]

guaranteed by the carrying broker-dealer. This change conforms the 
NYSE's proposal to the CBOE proposal approved previously by the 
commission.
    Based on the above, the Commission finds that good cause exists, 
consistent with Section 19(b) of the Act,\77\ to accelerate approval of 
Amendment Nos. 1 and 2 to the proposed rule change.
---------------------------------------------------------------------------

    \77\ 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 1 and 2, including whether 
Amendment Nos. 1 and 2 are 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 submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room. Copies of such 
filing will also be available for inspection and copying at the 
principal office of the NYSE. All submissions should refer to file 
number SR-NYSE-99-03 and should be submitted by November 12, 1999.

VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\78\ that the proposed rule change (SR-NYSE-99-03), as amended, is 
approved. The approved margin requirements shall become effective the 
earlier of January 20, 2000 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.

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

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\79\
---------------------------------------------------------------------------

    \79\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Jonathan G. Katz,
Secretary.
[FR Doc. 99-27601 Filed 10-21-99; 8:45 am]
BILLING CODE 8010-01-M