[Federal Register Volume 64, Number 243 (Monday, December 20, 1999)]
[Notices]
[Pages 71158-71160]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-32821]



[[Page 71158]]

=======================================================================
-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42223; File No. SR-Amex-99-40; SR-PCX-99-41; SR-CBOE-
99-59]


Self-Regulatory Organizations; American Stock Exchange LLC; 
Pacific Exchange, Inc.; Chicago Board Options Exchange, Inc.; Order 
Granting Accelerated Approval to Proposed Rule Change Relating to the 
Permanent Approval of the Elimination of Position and Exercise Limits 
for FLEX Equity Options

December 10, 1999.

I. Introduction

    On October 5, 1999, October 13, 1999, and November 4, 1999, the 
American Stock Exchange LLC (``Amex''), Pacific Exchange, Inc. 
(``PCX''), and the Chicago Board Options Exchange, Inc. (``CBOE'') 
(collectively, the ``Exchanges''), submitted to the Securities and 
Exchange Commission (``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ 
and Rule 19b-4 thereunder, \2\ proposed rule changes to make permanent 
their pilot programs to eliminate position and exercise limits for FLEX 
Equity options.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    The proposed rule changes were published for comment in the Federal 
Register on November 11, 1999. \3\ No comments were received on the 
proposals. This order approves the proposals on an accelerated basis.
---------------------------------------------------------------------------

    \3\ See Securities Exchange Act Release No. 42126 (November 10, 
1999), 64 FR 63064 (November 18, 1999).
---------------------------------------------------------------------------

II. Background and Description

    On February 14, 1996 and June 19, 1996, the Commission approved the 
Exchanges' proposals to list and trade FLEX Equity options on specified 
equity securities. \4\ According to the Exchanges, those proposals were 
designed to provide investors with the ability, within specified 
limits, to designate certain terms of the options. In support of their 
proposals, the Exchanges stated that in recent years, an over-the-
counter (``OTC'') market in customized equity options had developed 
which permitted participants to designate the basic terms of the 
options including size, term to expiration, exercise style, exercise 
price, and exercise settlement value. According to the Exchanges, 
participants in this OTC market were typically institutional investors, 
who bought and sold options in large-size transactions through a 
relatively small number of securities dealers. To compete with this 
growing OTC market in customized equity options, the Exchanges proposed 
to expand their FLEX options rules \5\ to permit the introduction of 
trading in FLEX options on specified equity securities that satisfied 
the Exchanges' listing standards for equity options. \6\ The Exchanges' 
proposals allowed FLEX Equity option market participation to designate 
the following contract terms: (1) certain exercise prices; \7\ (2) 
exercise style (i.e., American, European, or capped); \8\ expiration 
date; \9\ and (4) option type (i.e., put call, or spread). In addition, 
the Exchanges set position and exercise limits for FLEX Equity options 
at three times the position limits for the corresponding Non-FLEX 
Equity options on the same underlying security. \10\
---------------------------------------------------------------------------

    \4\ See Securities Exchange Act Release Nos. 36841 (February 14, 
1996), 61 FR 6666 (February 21, 1996) (File Nos. SR-CBOE-95-43 and 
SR-PSE-95-24), and 37336 (June 19, 1996), 61 FR 33558 (June 27, 
1996) (File No. SR-Amex-95-57).
    \5\ See e.g., Amex Rules 900G through 909G. At the time of their 
FLEX Equity option proposals, the Amex and the CBOE had already 
secured Commission approval to list and trade FLEX options on 
several broad-based market indexes composed of equity securities 
(``FLEX Index options''). See, e.g., Securities Exchange Act Release 
Nos. 32781 (August 20, 1993), 58 FR 45360 (August 27, 1993) (order 
approving the trading of FLEX Index options on the Major Market, 
Institutional, and S&P MidCap Indexes) (File No. SR-Amex-93-05), and 
34052 (May 12, 1994), 59 FR 25972 (May 18, 1994) (order approving 
the trading of FLEX Index options on the Nasdaq 100 Index) (File No. 
SR-CBOE-93-46).
    \6\ See e.g., Amex Rule 915, containing initial listing 
standards for a security to be eligible for options trading. In 
addition, the Exchanges may trade FLEX options on any options-
eligible security regardless of whether standardized Non-FLEX 
options overlie that security and regardless of whether such Non-
FLEX options trade on the Exchanges.
    \7\ See Securities Exchange Act Release No. 37726 (September 25, 
1996), 61 FR 51474 (October 2, 1996), regarding restrictions on the 
available exercise prices for FLEX Equity call options.
    \8\ An American-style option is one that may be exercised at any 
time on or before the expiration date. A European-style option is 
one that may be exercised only during a limited period of time prior 
to expiration of the option. A capped-style option is one that is 
exercised automatically prior to expiration when the cap price is 
less than or equal to the closing price of the underlying security 
for calls, or when the cap price is greater than or equal to the 
closing price of the underlying security for puts.
    \9\ The expiration date of a FLEX Equity option cannot, however, 
fall on a day that is on, or within two business days of, the 
expiration date of a Non-FLEX Equity option.
    \10\ At that time, position and exercise limits for FLEX Equity 
options were set as follows as compared to then-existing limits for 
Non-FLEX Equity options on the same underlying security.

    Non-FLEX Equity position limit

    4,500 contracts
    7,500 contracts
    10,500 contracts
    20,000 contracts
    25,000 contracts

    FLEX Equity position limit

    13,500 contracts
    22,500 contracts
    31,500 contracts
    60,000 contracts
    75,000 contracts

    Aggregation of positions or exercises in FLEX Equity options 
with positions or exercises in Non-FLEX Equity options was not 
required for purposes of the limits.
---------------------------------------------------------------------------

    Thereafter, on September 9, 1997, the Commission approved proposed 
rule change from the Exchanges eliminating position and exercise limits 
for FLEX Equity options on a two-year pilot basis. \11\ In addition to 
eliminating position and exercise limits, the pilot program required 
that a member or member organization (other than a Specialist or 
Registered Options Trader) report to the Exchange information for each 
account that maintains a position on the same side of the market in 
excess of three times the position limit level established pursuant to 
the applicable exchange rule for Non-Flex Equity options of the same 
class. The report included information regarding the FLEX Equity option 
position, positions in any related instrument, the purpose or strategy 
for the position, and the collateral used by the account. \12\
---------------------------------------------------------------------------

    \11\ See Securities Exchange Act Release No. 39032 (September 9, 
1997), 62 FR 48683 (September 16, 1997) (approving File Nos. SR-
Amex-96-19; SR-CBOE-96-79; SR-PCX-97-09).
    \12\ The Exchanges also required that an updated report be filed 
when a change in the options position occurred or when a significant 
change in the hedge of that position occurred. See Securities 
Exchange Act Release No. 39032 (September 9, 1997), 62 FR 48683 
(September 16, 1997).
---------------------------------------------------------------------------

    Furthermore, the Commission, in its order approving the pilot 
program, required each of the Exchanges to submit a report containing a 
description of: (i) the types of strategies used by FLEX Equity options 
market participants and whether FLEX Equity options are being used in 
lieu of existing standardized equity options; (ii) the type of market 
participants using FLEX Equity option both before and during the pilot 
program, including how the utilization of FLEX Equity options has 
changed; (iii) the average size of FLEX Equity option contracts both 
before and during the pilot program, the size of the largest FLEX 
Equity option contract on any given day both before and during the 
pilot program, and the size of the largest FLEX Equity option held by 
any single customer/member both before and during the pilot program; 
and (iv) any impact on the prices of underlying stocks during the 
establishment or unwinding of FLEX positions that are greater than 
three times the standard

[[Page 71159]]

position limit. Each of the Exchanges has filed their reports, which 
will be discussed below.
    On September 9, 1999, the Commission approved an extension of the 
pilot programs for another three months.\13\ The current pilot programs 
expired on December 9, 1999. Accordingly, the Exchanges request 
approval of their programs on a permanent basis. All of the terms and 
conditions applicable under the current pilots, including the reporting 
requirements, will remain in effect after the proposals are approved 
permanently.\14\
---------------------------------------------------------------------------

    \13\ See Securities Exchange Act Release No. 41848 (September 9, 
1999), 64 FR 50846 (September 20, 1999).
    \14\ Telephone call between Tim Thompson, CBOE, and Christine 
Richardson, on December 10, 1999; telephone call between Robert 
Pacileo, PCX, and Christine Richardson, on December 10, 1999. The 
Amex proposal explicitly states that the same terms and conditions 
applicable during the pilot will remain in effect after the proposal 
is permanently approved.
---------------------------------------------------------------------------

III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Sections 6 and 11A of the Act.\15\ 
Specifically, the Commission believes that the rule proposals are 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, and are not designed to 
permit unfair discrimination between customers, issuers, brokers, or 
dealers.
---------------------------------------------------------------------------

    \15\ See 15 U.S.C. 78f(b) and 78k-1. In approving this rule 
change, the Commission notes that it has considered the proposal's 
impact on efficiency, competition, and capital formation, consistent 
with Section 3 of the Act. Id. at 78c(f).
---------------------------------------------------------------------------

    The Commission also believes that the proposed rule changes are 
consistent with Section 11A of the Act in that the permanent 
elimination of position and exercise limits for FLEX Equity options 
allows the Exchanges to better compete with the growing OTC market in 
customized equity options, thereby encouraging fair competition among 
brokers and dealers and exchange markets. The attributes of the 
Exchanges' options markets versus an OTC market include, but are not 
limited to, a centralized market center, an auction market with posted 
transparent market quotations and transaction reporting, parameters and 
procedures for clearance and settlement, and the guarantee of the OCC 
for all contracts traded on the Exchanges.
    The Commission has generally taken a gradual, evolutionary approach 
toward expansion of position and exercise limits. Given that the 
current pilot programs have run for the past two years without 
incident, the Commission believes that it is appropriate to approve the 
pilots on a permanent basis. First, the FLEX Equity options market is 
characterized by large, sophisticated institutional investors (or 
extremely high net worth individuals), who have both the experience and 
ability to engage in negotiated, customized transactions. For example, 
with a required minimum size of 250 contracts to open a transaction in 
a new series, FLEX Equity options are designed to appeal to 
institutional investors, and it is unlikely that many retail investors 
would be able to engage in options transactions at that size. Second, 
all of the Exchanges' other current rules and provisions governing FLEX 
Equity options remain applicable.\16\ Third, the OCC will serve as the 
counter-party guarantor in every exchange-traded transaction. Fourth, 
the proposed elimination of position and exercise limits for FLEX 
options could potentially expand the depth and liquidity of the FLEX 
equity market without significantly increasing concerns regarding 
intermarket manipulations or disruptions of the options or the 
underlying securities. Fifth, the enhanced reporting requirements 
should help the Exchanges to monitor accounts under risk and to take 
any appropriate action. Finally, the Exchanges' surveillance programs 
will be applicable to the trading of FLEX Equity options and should 
detect and deter trading abuses arising from the elimination of 
position and exercise limits.
---------------------------------------------------------------------------

    \16\ See, e.g., Amex Rules 900G through 909G.
---------------------------------------------------------------------------

    As described above, the Exchanges have adopted important safeguards 
that will allow them to monitor large positions in order to identify 
instances of potential risk and to assess additional margin and/or 
capital charges, if necessary. The Exchange require each member or 
member organization (other than a Specialist, a Registered Options 
Trader, a Market Maker, or a Designated Primary Market Maker) that 
maintains a position on the same-side of the market in excess of three 
times the position limit level established pursuant to the applicable 
exchange rule for Non-FLEX Equity options of the same class to report 
information to the exchange regarding the FLEX Equity option position, 
positions in any related instrument, the purpose or strategy for the 
position, and the collateral used by the account. By monitoring 
accounts in excess of three times the Non-FLEX Equity option position 
limit in this manner, the Exchanges should be provided with the 
information necessary to determine whether to impose additional margin 
and/or whether to assess capital charges upon a member organization 
carrying the account. In addition, this information should allow the 
Exchanges to determine whether a large position could have an undue 
effect on the underlying market and to take the appropriate action.
    The Commission believes that it is reasonable to treat FLEX Equity 
options differently than regular standardized options. FLEX options 
compete directly with the OTC options. The Commission believes that it 
would be beneficial to attract OTC activity back to a more transparent 
market with a clearinghouse guarantee. Hence, a liberalization of 
position limits for FLEX Equity options is a measured deregulatory 
means to enable the Exchanges to compete with the OTC market while 
preserving important oversight safeguards.
    As noted above, each of the Exchanges was required to submit a 
report assessing the effects of the pilot programs. This information 
was required to allow the Commission to evaluate the consequences of 
the programs and to determine whether permanent approval was 
appropriate. The Commission has reviewed these reports. Although the 
Commission cannot entirely rule out the potential for future adverse 
effects on the securities markets for the FLEX Equity options or 
component securities underlying FLEX Equity options, the reports 
support permanent approval of the pilots because such effects and 
abuses have not occurred over the two year pilot period.
    In reports, the Exchanges indicate that their experiences with the 
pilot programs have been positive. Generally, none of the Exchanges 
note a change in the types of strategies used by FLEX Equity options 
market participants, nor do they believe that market participants are 
using FLEX Equity options in lieu of existing standardized equity 
options. Although the PCX experienced new activity by market makers, 
the Exchanges generally indicate that the types of market participants 
using FLEX Equity options during the pilots remained consistent to 
those using the product before the elimination of position and exercise 
limits. The average size of the FLEX Equity option contract increased 
to varying degrees on all of the Exchanges. The size of the largest 
FLEX Equity option contract also increased to varying degrees on each 
of the Exchanges during the pilots. Despite

[[Page 71160]]

this increase, FLEX Equity options represented a very small percentage 
of options transactions when compared to the standardized equity 
market. Further, although each of the Exchanges generally experienced 
an increase in trading activity and size of contracts during the pilot 
period, a very insignificant number of positions actually exceeded 
three times the standardized options position limit. Based on the 
above, the Exchanges concluded that the elimination of position and 
exercise limits for FLEX Equity options did not have any impact on the 
prices of the underlying stocks during the establishment or unwinding 
of FLEX Equity positions greater than three times the standard position 
limit.
    Finally, given the size and sophisticated nature of the FLEX Equity 
options market, the reporting and margin requirements, and the fact 
that the pilot programs have run the past two years without incident, 
the Commission believes that eliminating position and exercise limits 
for FLEX Equity options on a permanent basis does not substantially 
increase manipulative concerns. The Commission continues to believe 
that the enhanced market surveillance of large positions should help 
the Exchanges to take the appropriate action in order to avoid any 
manipulation or market risk concerns. The Commission expects the 
Exchanges to take prompt action, including timely communication with 
the Commission and other marketplace self-regulatory organizations 
responsible for oversight of trading in FLEX options and the underlying 
stocks, should any unanticipated adverse market effects develop. In 
summary, because of the special nature of the FLEX Equity markets, the 
Commission believes that the Exchanges' proposals should be approved on 
a permanent basis. In permanently approving the proposals, the 
Commission believes that the distinctions between the FLEX Equity 
options market and the standardized equity options market, as described 
above, warrant the different regulatory applications of position and 
exercise limits under the Act.
    The Commission finds good cause for approving the proposed rule 
changes prior to the thirtieth day after the date of publication of 
notice thereof in the Federal Register. Specifically, the Commission 
believes that because approval of the permanent approval of the 
proposals will allow the pilot programs to continue uninterrupted based 
on the same terms and conditions of original pilot, it is consistent 
with the protection of investors and the public interest to approve the 
proposed rule changes on an accelerated basis. Further, a full 21-day 
comment period was provided and no comments were received. Accordingly, 
the Commission believes it is consistent with Section 6(b)(5) and 
Section 19(b)(2) of the Act to grant accelerated approval to the 
proposed rule changes.\17\
---------------------------------------------------------------------------

    \17\ 15 U.S.C. 78f(b)(5) and 78s(b)(2).
---------------------------------------------------------------------------

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule changes (SR-Amex-99-40; SR-PCX-99-41; 
SR-CBOE-99-59) be approved.
---------------------------------------------------------------------------

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

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

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

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-32821 Filed 12-17-99; 8:45 am]
BILLING CODE 8010-01-M