[Federal Register Volume 65, Number 28 (Thursday, February 10, 2000)]
[Notices]
[Pages 6680-6682]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-3088]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42386; File No. SR-Phlx-98-55]


Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.: 
Order Approving Proposed Rule Change and Notice of Filing and Order 
Granting Accelerated Approval to Amendment No. 1 Relating to an 
Increase in Position and Exercise Limits for Certain Broad-Based Index 
Options

February 4, 2000.

I. Introduction

    On December 21, 1998 the Philadelphia Stock Exchange, Inc. 
(``Phlx'' 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 (``Exchange Act'' or ``Act'') \1\ 
and Rule 19b-4 thereunder,\2\ a proposed rule change to increase broad-
based (``market'') index option position and exercise limits on the 
Value Line Composite Index (``VLE''), the US Top 100 Index (``TPX''), 
and the National Over-the-Counter Index (``XOC'').\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Position limits impose a ceiling on the number of option 
contracts in each class on the same side of the market (i.e., 
aggregating long calls and short puts or long puts and short calls) 
that can be held or written by an investor or group of investors 
acting in concert.
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    The proposed rule change was published for comment in the Federal 
Register on April 2, 1999.\4\ No comments were received on the 
proposal. On November 10, 1999, the Phlx filed an amendment to the 
proposed rule change.\5\ This order approves the proposal, as amended.
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    \4\ See Exchange Act Release No. 41216 (March 26, 1999), 64 FR 
16019.
    \5\ See Letter from John Dayton, Phlx, to Nancy Sanow, 
Commission, dated November 9, 1999 (``Amendment No. 1'').
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II. Description

    The Phlx proposed to amend Phlx Rule 1001A(a)(i)-(ii) by increasing 
market index option position limits on the VLE, the TPX, and the 
XOC.\6\ Specifically, the Phlx proposed to triple the current levels of 
25,000 contracts total and 15,000 contracts in the nearest expiration 
month for the VLE and the TPX to 75,000 contracts total and 45,000 
contracts in the nearest expiration month. The Phlx also proposed to 
triple position and exercise limits for the XOC from 25,000 contracts 
total to 75,000 contracts total.
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    \6\ Position limits impose a ceiling on the number of option 
contracts in each class on the same side of the market (i.e., 
aggregating long calls and short puts or long puts and short calls) 
that can be held or written by an investor or group of investors 
acting in concert.
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    Exchange exercise limits,\7\ which are expressed in Phlx Rule 
1002A, are established by reference to position limits, such that any 
increase in position limits would also increase exercise limits. 
Accordingly, the Phlx proposed to increase exercise limits to 
correspond to the proposed increases in position limits.
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    \7\ Exercise limits prohibit an investor or group of investors 
acting in concert from exercising more than a specified number of 
puts or calls in a particular class within five consecutive business 
days.
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III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Sections 6 of the Act.\8\ 
Specifically, the Commission believes that the proposed rule change is 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in facilitating transactions in 
securities, and to remove impediments to and perfect the mechanism of a 
free and open market and a national market system.
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    \8\ See 15 U.S.C. 78f(b). In approving this rule change, the 
Commission notes that it has considered the proposal's impact on 
efficiency, competition, and capital formation, consistent with 
Section 3 of the Act. Id. at 78c(f).
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    Position limits serve as a regulatory tool designed to address 
potential manipulative schemes and adverse market impact surrounding 
the use of options. In the past, the Commission has stated that:

    Since the inception of standardized options trading, the options 
exchanges have had rules imposing limits on the aggregate number of 
options contracts that a member or customer could hold or exercise. 
These rules are intended to prevent the establishment of options 
positions that can be used or might create incentives to manipulate 
or disrupt the underlying market so as to benefit the options 
position. In particular, position and exercise limits are designed 
to minimize the potential for mini-manipulations and for corners or 
squeezes of the underlying market. In addition such limits serve to 
reduce the possibility for disruption of the options market itself, 
especially in illiquid options classes.\9\
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    \9\ Exchange Act Release Nos. 39489 (December 24, 1997), 63 FR 
276 (January 5, 1998) (SR-CBOE-97-11) (order approving an increase 
in OEX position and exercise limits); 31330 (October 16, 1992), 57 
FR 48408 (October 23, 1992) (SR-Amex-92-13) (order approving an 
increase in Institutional Index Options position and exercise 
limits).

    In general, the Commission has taken a gradual, evolutionary 
approach toward expansion of position and exercise limits.\10\ The 
Commission has been careful to balance two competing concerns when 
considering the appropriate level at which to set option position and 
exercise limits. The Commission has recognized that the limits must be 
sufficient to prevent investors from disrupting the market in the 
component securities comprising the indexes. At the same time, the 
Commission has determined that limits must not be established at levels 
that are so low as to discourage participation in the options market by 
institutions and other investors with substantial hedging needs or to 
prevent specialists and market-makers from adequately meeting their 
obligations to maintain a fair and orderly market.\11\
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    \10\ Position and exercise limits for the XOC were raised from 
17,000 to 25,000 contracts in 1996. Position and exercise limits for 
the VLE were raised from approximately 13,000 contracts, based on a 
position limit based on monetary value, to 25,000 contracts in 1988. 
The US Top 100 Index was created with limits of 25,000 contracts in 
1995. See Exchange Act Release No. 36745 (January 19, 1996), 61 FR 
2561 (January 26, 1996) (SR-Phlx-95-38) (establishing XOC position 
and exercise limits); Exchange Act Release No. 35591 (April 11, 
1995), 60 FR 19423 (April 18, 1995) (SR-Phlx-95-07) (establishing 
TPX position and exercise limits); Exchange Act Release No. 25644 
(May 3, 1988), 53 FR 16829 (May 11, 1988) (SR-Phlx-88-06) 
(establishing VLE position and exercise limits). See also Exchange 
Act Release Nos. 37676 (September 13, 1996), 61 FR 49508 (September 
20, 1996) (order approving SR-CBOE-96-01, increasing position limits 
for the SPX from 45,000 to 100,000 contracts); 39789 (December 24, 
1997), 63 FR 276 (January 5, 1998) (order approving SR-CBOE-97-11, 
increasing position limits for the OEX from 75,000 to 150,000 
contracts). See also infra note 19.
    \11\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. At 189-91 
(Comm. Print 1978).
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    The Commission has carefully considered the Phlx's proposal. At the 
outset, the Commission notes that it still believes that the 
fundamental purposes of position and exercise limits are being served 
by their existence. Nevertheless, the Commission believes that the 
Phlx's current experience with the trading of market index options \12\ 
make it

[[Page 6681]]

permissible to increase position and exercise limits for certain market 
index options while still ensuring that large positions in such index 
options will not unduly disrupt the options or underlying cash markets.
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    \12\ The Phlx has been trading market index options sionce 1985. 
See Exchange Act Release No. 22044 (May 17, 1985), 50 FR 21532 (May 
24, 1985) (order approving SR-Phlx-84-28, establishing the XOC index 
option).
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    The Commission believes that an increase in position and exercise 
limits for certain market index options is appropriate for several 
reasons. The Commission notes first that the proposal is limited to 
options on three market indexes, the VLE, TPX and XOC. The Commission 
believes that the capitalization of, and relatively deep, liquid 
markets for, the underlying securities contained in these indexes 
significantly reduces concerns regarding market manipulation or 
disruption in the underlying market.\13\ Increasing position and 
exercise limits for these index options may also bring additional depth 
and liquidity, in terms of both volume and open interest, to the 
affected index options classes without significantly increasing 
concerns regarding intermarket manipulations or disruptions of the 
options or the underlying securities.
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    \13\ VLE is an equally weighted, arithmetically averaged index 
based on the approximately 1,700 listed and over-the-counter stocks 
followed and published by Value Line, Inc. in the Value Line 
Investment Survey. As of September 29, 1999, the total market 
capitalization for VLE was $14.5 trillion. Telephone call between 
John Dayton, Phlx, and Christine Richardson, Commission, September 
30, 1999. TPX is a capitalization-weighted index composed of the 100 
most highly capitalized U.S. corporations, including both listed and 
Nasdaq National Market System traded securities. As of October 14, 
1999, the total market capitalization for TPX was $7.5 trillion. XOC 
is capitalization-weighted and composed of the common stocks of the 
100 largest capitalized corporations whose stocks are traded over-
the-counter. As of October 14, 1999, the total market capitalization 
for XOC was $2.2 trillion. See Phlx website at http://www.Phlx.com.
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    Second, increasing position and exercise limits for these specific 
indexes should better serve the hedging needs of institutions that 
engage in trading strategies different from those covered under the 
index hedge exemption policy (e.g. delta hedges, OTC vs. listed 
hedges).
    Third, the Commission believes that financial requirements imposed 
by Phlx and by the Commission adequately address concerns that a Phlx 
member or its customer may try to maintain an inordinately large 
unhedged position in a market index option. Current margin and risk-
based haircut methodologies serve to limit the size of positions 
maintained by any one account by increasing the margin and/or capital 
that a member must maintain for a large position held by itself or by 
its customer.\14\ Phlx also has the authority under its rules to impose 
a higher margin requirement upon the member or member organization when 
it determines that market conditions so warrant. Monitoring accounts 
maintaining large positions should provide the Exchange with the 
information necessary to determine whether to impose additional margin 
and/or whether to assess capital charges upon a member organization 
carrying the account. In addition, the Commission's net capital rule, 
Rule 15c3-1 under the exchange Act, imposes a capital charge on members 
to the extent of any margin deficiency resulting from the higher margin 
requirement. The significant increases in unhedged options capital 
charges resulting from the September 1997 adoption of risk-based 
haircuts and Phlx's margin requirements applicable to these products 
under Exchange rules serves as an additional form of protection.\15\ 
The Commission also notes that the OCC will serve as the counter-party 
guarantor in every exchange-traded transaction.
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    \14\ Exchange Act Rule 15c3-1 requires a capital charge equal to 
the maximum potential loss on a broker-dealer's aggregate index 
position over a + (-) 10% market move. Exchange margin rules require 
margin on naked index options, which are in or at-the-money equal to 
a 15% move in the underlying index; and a minimum 10% charge for 
naked out-of-the money contracts. At an index value of 9,000 this 
approximates to a $135,000 to $90,000 requirement per each unhedged 
contract.
    \15\ See Exchange Act Release No. 38248 (February 6, 1997), 62 
FR 6474 (February 12, 1997) Adopting Risk-Based Haircuts); and Phlx 
Rule 722 Margins.
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    Fourth, the Commission notes that the index options and other types 
of index-based derivatives (e.g., forwards and swaps) are not subject 
to position and exercise limits in the OTC market. The Commission 
believes that increasing position and exercise limits for the VLE, TPX, 
and XOC options will better allow Phlx to compete with the OTC market.
    Fifth, the Commission believes that Phlx's surveillance procedures 
will adequately allow it to detect and deter potential trading abuses 
arising from the increased position and exercise limits for VLE, TPX 
and XOC options. The absence of any discernible manipulative problems 
for broad-based index options at existing levels leads the Commission 
to conclude that the proposed increases are reasonable and that they 
can be safely implemented. The Commission believes that the Phlx's 
surveillance program is adequate to detect and deter violations of 
position and exercise limits, as well as to detect and deter attempted 
manipulation and other trading abuses through the use of such illegal 
positions by market participants.\16\ In addition, the Phlx has 
submitted to the Commission a detailed description of enhanced 
surveillance procedures the Exchange will implement in order to monitor 
accounts maintaining large positions. The Commission believes that 
Phlx's new surveillance procedures should enable the Exchange to assess 
and respond to market concerns at an early stage. Although it is 
inappropriate to discuss the details of Phlx's enhanced surveillance 
program, the Commission notes that these enhanced procedures were 
critical in its determination to approve the proposed rule change.\17\
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    \16\ The Commission emphasizes that the Phlx must closely 
monitor compliance with position and exercise limits and impose 
appropriate sanctions for failures to comply with the Exchange's 
position and exercise limit rules.
    \17\ Disclosure of specific surveillance procedures could 
provide market participants with information that could aid 
potential attempts at avoiding regulatory detection of inappropriate 
trading activity.
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    Sixth, the Commission believes that the enhanced reporting 
requirements should allow Phlx to detect and deter trading abuses 
arising from the elimination of position and exercise limits for VLE, 
TPX, or XOC. These reports should also allow Phlx to monitor large 
positions in order to identify instances of potential risk and to 
assess additional margin and/or capital charges, if deemed necessary. 
Specifically, Phlx will subject VLE, TPX, and XOC to a 60,000 contract 
reporting requirement. Each member or member organization that 
maintains a position on the same side of the market in excess of these 
contract thresholds for its own account or for the account of a 
customer must file a report that includes, but is not limited to, data 
related to the option position, whether such position is hedged and if 
so, a description of the hedge. If applicable, the report must contain 
information concerning collateral used to carry the position. Exchange 
Registered Option Traders would be exempt from this reporting 
requirement.\18\
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    \18\ See Amendment No. 1.
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    Seventh, the Commission notes that it recently approved proposed 
rule changes from the Chicago Board Options Exchange (``CBOE'') and the 
American Stock Exchange (``Amex''), which were even less restrictive 
than the Phlx's current proposal. Specifically, those proposed rule 
changes eliminated position and exercise limits on a pilot basis for 
certain market index options traded on

[[Page 6682]]

the CBOE and Amex.\19\ Although Phlx's VLE, TPX and XOC options are not 
identical to CBOE's or Amex's, the Commission believes that, given its 
approval of these proposed rule changes, the Phlx's proposed increase 
in position and exercise limits to three times their current level is 
appropriate.
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    \19\ See Exchange Act Release Nos. 41011 (February 1, 1999), 64 
FR 6405 (February 9, 1999) (order approving File No. SR-Amex-98-38, 
eliminating position and exercise limits on a two year pilot basis 
for Institutional Index Options and Major Market Index Options and 
FLEX options on those index options); 40969 (January 22, 1999), 64 
FR 4911 (February 2, 1999) (order approving File No. SR-CBOE-98-23, 
eliminating position and exercise limits on two year pilot basis for 
the S&P 500 Index, the S&P 100 Index, and the Dow Jones Industrial 
Average Index, and FLEX options on those indexes).
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    Finally, the Commission believes it appropriate for the Exchange to 
eliminate language contained in Phlx Rule 1001A and 1101A, concerning 
the Big Cap Index (``MKT'') since MKT is no longer traded on the 
Exchange. The Commission also believes it is appropriate for the 
Exchange to delete all references to options on the Super Cap Index, as 
these options were delisted from the Exchange on September 29, 
1999.\20\
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    \20\ See Amendment No. 1. This includes references in Phlx Rules 
1079(d)(1), 1000A(b)(11), (c); 1047A(a)(i), (d), (f)(iv); and 1101A 
Commentary .01.
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    The Commission finds good cause to approve Amendment No. 1 to the 
proposed rule change prior to the 30th day after the date of 
publication of notice of filing thereof in the Federal Register. 
Amendment No. 1 provides for a reporting requirement for member firms 
that should aid the Exchange in monitoring accounts with large 
positions in VLE, TPX, and XOC. Amendment No. 1 also makes certain 
minor technical changes. Accordingly, the Commission finds that, 
consistent with Sections 6(b) and 19(b)(2) of the Act, there is good 
cause to approve Amendment No. 1 to the proposed rule changes on an 
accelerated basis.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment No. 1, including whether the amendments 
are consistent with the Exchange Act. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 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, located at the 
above address. Copies of such filing will also be available for 
inspection and copying at the principal office of the self-regulatory 
organization. All submissions should refer to File No. SR-Phlx-98-55 
and should be submitted by March 2, 2000.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-Phlx-98-55) be approved, as 
amended.
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    \21\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-3088 Filed 2-9-00; 8:45 am]
BILLING CODE 8010-01-M