[Federal Register Volume 65, Number 229 (Tuesday, November 28, 2000)]
[Notices]
[Pages 70854-70862]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30196]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43581; File No. SR-NASD-00-15]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing and Order Granting Accelerated Approval 
of Proposed Rule Change and Amendment Nos. 1 and 2 to the Proposed Rule 
Change Relating to NASD Rule 2520, ``Margin Requirements''

November 17, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on March 31, 2000, the National Association of Securities Dealers, Inc. 
(``NASD''), through its wholly owned subsidiary, NASD Regulation, Inc. 
(``NASD Regulation'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission''), the proposed rule change as described in 
Items I and II below, which Items have been prepared by NASD 
Regulation. NASD Regulation amended its proposal on July 31, 2000, and 
September 13, 2000.\3\ The

[[Page 70855]]

Commission is publishing this notice to solicit comments on the 
proposed rule change and Amendment Nos. 1 and 2 from interested 
persons, and simultaneously is approving the proposed rule change, as 
amended, on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Alden S. Adkins, Senior Vice President and 
General Counsel, NASD Regulation, to Jack Drogin, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated July 28, 2000 (``Amendment No. 1''); and see letter from Alden 
S. Adkins, Senior Vice President and General Counsel, NASD 
Regulation, to Jack Drogin, Assistant Director, Division, dated 
September 11, 2000 (``Amendment No. 2''). Among other things, 
Amendment No. 1 revises the proposal to: (1) Provide technical 
corrections for various provisions within NASD Rules 2520 and 2522; 
(2) revise the cash account provisions of NASD Rule 
2520(f)(2)(M)(ii)d to indicate that a long warrant or option that is 
not listed must be guaranteed by the carrying broker-dealer to serve 
as an offset for a short position, or the short position will not be 
eligible for the cash account and must be margined separately 
pursuant to NASD Rule 2520(f)(2)(D); (3) amend NASD Rule 2520(f)(2) 
to provide that the margin for a long over-the-counter (``OTC'') 
option or warrant with over nine months until expiration will be 75% 
of the option's or warrant's in-the-money amount; (4) amend NASD 
Rules 2520(f)(2)(D)(i) and 2520(f)(2)(G)(v) to clarify that the 
minimum amount of margin that must be maintained on certain 
positions is a percentage of the aggregate exercise price; (5) 
provide definitions of ``stock index warrant'' and ``escrow 
agreement'' in connection with cash-settled options or warrants; and 
(6) clarify the purpose of NASD Regulation's proposed definitions of 
``current market value,'' ``butterfly spread,'' and ``box spread.'' 
Amendment No. 2: (1) Deletes an incorrect reference to currency 
index warrants in Amendment No. 1 and clarifies that a description 
in Amendment No. 1 refers to NASD Rule 2520(f)(2)(M)(ii)d rather 
than NASD Rule 2520(f)(2)(L)(ii)d; (2) provides a revised definition 
of ``escrow agreement;'' (3) clarifies the definition of American-
style options to indicate that American-style options are 
exercisable at any time up to and including the day of expiration; 
and (4) adds a comma in the title of NASD Rule 2522 after the word 
``Options.''
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation proposes to amend NASD Rules 2520 ``margin 
Requirements,'' and 2522 ``Definitions Related to Options, Currency 
Warrants, Currency Index Warrants, and Stock Index Warrants 
Transactions'' to: (1) Expand the types of short options positions that 
would be considered ``covered'' and eligible for the cash account to 
include short positions that are components of certain limited risk 
spread strategies (box spreads, butterfly spreads, and debits and 
credit spreads), provided that any potential risk to the carrying 
broker-dealer is paid for in full and retained in the account; (2) 
allow an escrow agreement that conforms to NASD standards to serve in 
lieu of cash or cash equivalents for certain spread positions held in a 
cash account; (3) reduce the required margin for butterfly and box 
spreads by recognizing butterfly and box spreads as strategies (rather 
than separate transactions) for purposes of margin treatment; (4) 
recognize various hedging strategies involving stocks (or other 
underlying instruments) paired with long options, and reduce the 
required maintenance margin on such hedged stock positions; (5) permit 
the extension of credit on certain long term options and warrants with 
over nine months until expiration; (6) permit the extension of credit 
on certain long box spreads; and (7) provide that the minimum margin 
requirements 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 
aggregate exercise price, and the minimum margin requirement for a 
short put on an over-the-counter (``OTC'') option will be a specified 
percentage of the put option's aggregate exercise price.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of and basis for the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in Sections A, B, and C below, of the most significant aspects of 
such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

Purpose
    NASD Regulation proposes to amend NASD Rule 2520 to: (1) Expand the 
types of short options positions that would be considered ``covered'' 
and eligible for the cash account to include short positions that are 
components of certain limited risk spread strategies (box spreads, 
butterfly spreads, and debit and credit spreads), provided that any 
potential risk to the carrying broker-dealer is paid for in full and 
retained in the account; (2) allow an escrow agreement that conforms to 
NASD standards to serve in lieu of cash or cash equivalents for certain 
spread positions held in a cash account; (3) reduce the required margin 
for butterfly and box spreads by recognizing butterfly and box spreads 
as strategies (rather than separate transactions) for purposes of 
margin treatment; (4) recognize various hedging strategies involving 
stocks (or other underlying instruments) paired with long options, and 
reduce the required maintenance margin on such hedged stock positions; 
(5) permit the extension of credit on certain long term options and 
warrants with over nine months until expiration; (6) permit the 
extension of credit on certain long box spreads; and (7) provide that 
the minimum margin requirement for a short uncovered put on a listed 
option will be the current value of the put plus a specified percentage 
of the put option's aggregate exercise price, and the minimum margin 
requirement for a short uncovered put on an OTC option will be a 
specified percentage of the put option's aggregate exercise price. In 
addition, NASD Regulation proposes to amend NASD Rule 2522 to include 
certain new definitions relating to the proposed rule change.
A. Background
    Until several years ago, the margin requirements governing listed 
options \4\ were set forth in Regulation T, ``Credit by Brokers and 
Dealers.'' \5\ 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 self-regulatory organizations (``SROs''), subject to 
approval by the Commission.\6\
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    \4\ Listed options are issued by The Options Clearing 
Corporation (``OCC''), a clearing agency registered pursuant to 
Section 17A of the Act.
    \5\ 12 CFR 220 et seq. The Board of Governors of the Federal 
Reserve System (``Federal Reserve Board'') issued Regulation T 
pursuant to the Act.
    \6\ See Board of Governors of the Federal Reserve System Docket 
No. R-0772 (April 24, 1996), 61 FR 20386 (May 6, 1996).
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    Following the amendments to Regulation T, an informal ad hoc 
committee (the ``431 Committee'') was formed to consider changes to the 
margin rules of the New York Stock Exchange (``NYSE'') and the NASD 
(NYSE Rule 431 and NASD Rule 2520, respectively). The 431 Committee 
created various subcommittees, including an Options Subcommittee 
(``Options Subcommittee''), to ensure that the NYSE's and NASD's margin 
rules were consistent in order to prevent confusion and avoid 
conferring advantages on members that are required to comply with one 
rule and not the other. NASD Regulation proposes to amend NASD Rules 
2520 and 2522 based on recommendations by the 431 Committee and the 
Options Subcommittee. The proposed amendments to NASD Rules 2520 and 
2522 are substantially identical to amendments made in proposals filed 
by the Chicago Board Options Exchange, Inc. (``CBOE'') and the NYSE, 
which the Commission approved.\7\
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    \7\ See Securities Exchange Act Release Nos. 41658 (July 27, 
1999), 64 FR 42736 (August 5, 1999) (order approving File No. SR-
CBOE-97-67) (``CBOE Approval Order''); and 42011 (October 14, 1999), 
64 FR 57172 (October 22, 1999) (order approving SR-NYSE-99-03) 
(``NYSE Approval Order'').
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B. Definitions
    Currently, NASD Rule 2520 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. 
NASD Regulation proposes to revise the definition of ``current market 
value'' or ``current market price'' to indicate that the current market 
value or current market price of an option, currency warrant, currency 
index

[[Page 70856]]

warrant, or stock index warrant are as defined in Section 220.2 of 
Regulation T.\8\ The revised definition appears in NASD Rule 2522.
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    \8\ See Amendment No. 1, supra note 3.
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    NASD Regulation also proposes to define the ``butterfly spread'' 
\9\ and ``box spread'' \10\ options strategies.\11\ The definitions are 
important elements of NASD Regulation's proposal to recognize and 
specify the 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 
treatments.
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    \9\ The proposal defines ``butterfly speread'' as: [A]n 
aggegation of positions in three series of either put or call 
options all having the same underlying component or index and time 
of expiration, and based on the same aggregate current underlying 
value, where the interval between the exercise price of each series 
is equal, which positions are structured as either (A) a ``long 
butterfly spread'' in which two short options in the same series are 
offset by one long option with a higher exercise price and one long 
option with a lower exercise price, or (B) a ``short butterfly 
spread'' in which two long options in the same series offset one 
short option with a higher exercise price and one short option with 
a lower exercise price.
    \10\ 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.
    \11\ See Amendment No. 1, supra note 3.
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    In addition, NASD Regulation proposes to define the terms ``stock 
index warrant'' \12\ and ``escrow agreement,'' as used in connection 
with cash-settled calls, puts, currency warrants, currency index 
warrants or stock index warrants carried short and as used in 
connection with non-cash settled put or call options carried short.\13\
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    \12\ The proposal defines a ``stock index warrant'' as a put or 
call warrant that overlies a broad index stock group or an industry 
index stock group. See Amendment No. 1, supra note 3.
    \13\ The proposal defines the term ``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 Association under which 
a bank holding cash, cash equivalents, one or more qualified equity 
securities or a combination thereof in the case of a call option or 
warrant; or cash, cash equivalents or a combination thereof in the 
case of a put option or warrant 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. See Amendment No. 2, supra note 3. The 
proposal defines the term ``escrow agreement'' when used in 
connection with non-cash settled put or call options carried short 
as any agreement issued in a form acceptable to the Association 
under which a bank holding the underlying security (in the case of a 
call option) or required cash or cash equivalents or a combination 
thereof (in the case of a put option) is obligated to deliver to the 
creditor (in the case of a call option) or accept from the creditor 
(in the case of a put option) the underlying security against 
payment of the exercise price in the event the call or put is 
assigned an exercise notice. See Amendment No. 1, supra note 3.
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    Finally, NASD Regulation proposes to move the definitions of 
``exercise settlement amount,'' ``aggregate exercise price'' and 
``aggregate current index value'' from NASD Rule 2520(f)(2)(C) to NASD 
Rule 2522(a) for ease of reference so that the definitions relating to 
transactions in options, currency warrants, currency index warrants and 
stock index warrants will be located in NASD Rule 2522.\14\
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    \14\ See Amendment No. 1, supra note 3.
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C. Extension of Credit on Long Term Options and Warrants
    The proposal would allow extensions of credit on certain long 
listed and OTC \15\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).\16\ The proposal provides no loan value for foreign currency 
options. Only those options or warrants with expirations exceeding nine 
months (``long term'') will be eligible for credit extension.\17\ For 
long term listed options and warrants, the proposed rule change 
requires initial and maintenance margin of cost less than 75% of the 
current market value of the option or warrant. Therefore, NASD members 
would be able to loan up to 25% of the current market value of a long 
term listed option or warrant. 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 the member. Under the current margin 
rules, the investor would be required to pay the entire $100.
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    \15\ 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 through the automated 
quotation system of a registered securities association.
    \16\ Throughout the remainder of this notice and approval order, 
the term ``warrant'' means this type of warrant.
    \17\ 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 purchase 
price of the option or warrant. See Amendment No. 1, supra note 3.
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    The proposal also would permit the extension of credit on certain 
long term OTC options and warrants. Specifically, an NASD member firm 
could 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 and valued at all times for margin purposes 
at an amount not to exceed the in-the-money amount; (2) be guaranteed 
by the carrying broker-dealer; and (3) have an American-style \18\ 
exercise provision. 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., its intrinsic value).
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    \18\ An American-style option is exercisable on any business day 
prior to its expiration date and on its expiration date. See 
Amendment No. 2, supra note 3.
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    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 would become 100% of the current 
market value. Options or warrants expiring in less than nine months 
would have no loan value under the proposal because of the leverage and 
volatility of those instruments.
D. Extension of Credit on Long Box Spread in European-Style Options
    The proposal also would permit the extension of credit on long box 
spreads composed entirely of European-style options \19\ that are 
listed or guaranteed by the carrying broker-dealer. A long box spread 
is a strategy 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 netting the cost of establishing the long box. 
The two exercise prices embedded in the strategy determine the buy and 
the sell price.\20\
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    \19\ A European-style option may be exercised only at its 
expiration pursuant to the rules of the OCC. See NASD Rule 2860(U).
    \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 NASD Regulation'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 CBOE 
Approval Order, supra note 7, at footnote 22.
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    For long box spreads made up of European-style options, the 
proposal would require initial and maintenance

[[Page 70857]]

margin of 50% of the aggregate difference in the two exercise prices 
(buy and sell), which results in a margin requirement slightly higher 
than 50% of the debit typically incurred in establishing such a 
position.\21\ Under the proposal, a long box spread position would be 
allowed market value for margin equity purposes of not more than 100% 
of the aggregate difference in the exercise prices of the options.
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    \21\ Using the example 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 7, at footnote 23.
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E. Cash Account Treatment of Butterfly Spreads, Box Spreads, and Other 
Spreads
    The proposal would make butterfly and box spreads in cash-settled, 
European-style options eligible for the cash amount. 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 proposal's 
definitions of those terms,\22\ and must be comprised of options that 
are listed or guaranteed by the carrying broker-dealer. In addition, 
the long options must be held in, or purchased for, the account on the 
same day.
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    \22\ See notes 9 and 10, supra.
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    For long butterfly spreads and long box spreads, the proposal would 
require full payment of the net nebit that is incurred when the spread 
strategy is established. According to NASD Regulation, full payment of 
th enet debit incurred to establish a long butterfly or box spread will 
cover any potential risk to the carrying broker-dealer.\23\
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    \23\ For example, to create a long butterfly spread comprised of 
all options, an investor may be long 1 XYZ Jan 45 Call @ 6, short 2 
XYZ Jan 50 Calls @ 3 each, and long 1 XYZ Jan 55 Call @ 1. The 
maximum risk for this long butterfly spread is the next debit 
incurred to establish the strategy ((3 + 3) - (6 + 1) = net debit of 
1). Under the proposed rule change, the investor would be required 
to pay the net debit, or $100 (1  x  100). See CBOE Approval Order, 
supra note 7, at footnote 25.
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    Short butterfly spreads generate a credit balance when establish 
(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.\24\ The maximum potential risk in a short butterfly spread 
comprised of all options is the aggregate difference be between the two 
lowest exercise prices.\25\ With respect to short butterfly spreads 
comprised of put options, the maximum potential risk is the aggregate 
difference between the two highest exercise prices. The net credit 
received from the sale of the short option components could be applied 
towards the requirement.
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    \24\ 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 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 
differrence 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.
    \25\ 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 proposed rule change, 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 = 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 7, at footnote 27.
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    NASD Regulation'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.\29\ Specifically, in the case of a long butterfly spread, the 
net debit must be paid in full. For short butterfly spreads comprised 
of call options, the initial and maintenance margin must equal at least 
the aggregate difference between the two lowest exercise prices. For 
short butterfly spreads comprised of put options, the initial and 
maintenance margin must equal at least the aggregate difference between 
the two highest exercise prices. The net credit received from the sale 
of the short option components may be applied towards the margin 
requirement for short butterfly spreads.
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    \29\ 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.
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    The proposed requirements for box spreads held in 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 it incurred when the spread 
strategy is established.\30\ 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; the proposal would 
allow loan value for one type of long box spread where all component 
options have a European-style exercise provision and are listed or 
guaranteed by the carrying broker-dealer.
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    \30\ As discussed above in Section II.D., ``Extension of Credit 
on Long Box Spread in European-Style Options,'' the margin 
requirement for a long box spread made up of European-style options 
is 50% of the aggregate difference in the two exercise prices.
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G. Margin Requirements for Short Put Options
    NASD Rule 2520(f)(2)(D)(i) 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 NASD Regulation, the NASD'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. NASD Regulation 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, NASD Regulation proposes to amend NASD Rule 2520(f)(2)(D) 
to provide 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 aggregate exercise price. The minimum margin 
required for a short OTC put option would be an amount equal to a 
specified percentage of the options' aggregate exercise price.
    Short box spreads also generate a credit balance when established. 
This credit is nearly equal to the total debit

[[Page 70858]]

(loss) that, in the case of a short box spread, will accrue to the 
account if held to expiration. The proposed rule change 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.\26\ The net credit received from the sale of the 
short option components may be applied towards the requirement; if 
applied, only a small fraction of the total requirement need be held or 
deposited.\27\
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    \26\ 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 such 
amount in the event the account is assigned an exercise notice on 
either short option.
    \27\ For example, 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 NASD Regulation's 
proposed definition of ``short box spread (supra note 10),'' the buy 
side exercise price exceeds the sell side exercise price. In this 
example, the maximum risk for the short box spread is equal to the 
difference between the two exercise prices (60-50=10). If the net 
credit received from the sale of short option components ((5\1/
2\+7)-(2+1)=net credit of 9\1/2\) is applied, the investor is 
required to deposit an additional $50 (\1/2\ x 100). Otherwise, the 
investor would be required to deposit $1,000 (10 x 100). See CBOE 
Approval Order, supra note 7, at footnote 29.
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    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.\28\ The long and short 
positions making up the spread must expire concurrently, and the long 
position must be paid in full. Lastly, the cash account must contain 
cash, cash equivalents, or an escrow agreement equal to at least the 
aggregate exercise price differential.
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    \28\ 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. If the long 
position is not listed, it must be guaranteed by the carrying 
broker-dealer; otherwise the short position is not eligible for the 
cash account and must be margined separately pursuant to NASD Rule 
2520(f)(2)(D). See Amendment No. 1, supra note 3.
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F. Margin Account Treatment of Butterfly and Box Spreads
    The NASD's margin rules presently do not recognize butterfly 
spreads for margin purposes. Under NASD's current margin rules, the two 
spreads (bullish and bearish) that make up a butterfly spread each must 
be margined separately. NASD Regulation believes that the two spreads 
should be viewed in combination, and that commensurate with the lower 
combined risk, investors should receive the benefit of lower margin 
requirements.
H. Maintenance Margin Requirements for Stock Positions Held With 
Options Positions
    NASD Regulation 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.\31\ 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 stock positions held in 
conjunction with an overlying option (or options), the proposal is 
structured to apply also to components that underlie index options and 
warrants. For example, these same maintenance margin requirements will 
apply when these strategies are used with a stock basket underlying 
index options or warrants. Proposed NASD Rule 2520(f)(2)(G)(v) will 
define the five strategies and set forth the respective maintenance 
margin requirements for the stock component of each strategy.\32\
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    \31\ Generally, NASD Rule 2520(c) requires maintenance margin of 
25% for all securities ``long'' in an account. For each stock 
carried short that has a current market value of less than $5 per 
share, the maintenance margin is $2.50 per share or 100% of the 
current market value, whichever is greater. For each stock carried 
short that has a current market value of $5 per share or more, the 
maintenance margin is $5 per share or 30% of the current market 
value, whichever is greater.
    \32\ NASD Regulation'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 NASD does not possess independent 
authority to lower the initial margin requirement for the stock.
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1. Long Put/Long Stock
    The Long Put/Long Stock hedging 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. This strategy is designed to limit downside risk 
in the underlying stock while the put is held. The put holder retains 
the right to sell stock at the strike price through the expiration of 
the put. The maintenance margin requirement for the Long Put/Long Stock 
combination would be the lesser of: (a) 10% of the put option aggregate 
exercise price, plus 100% of any amount by which the put option is out-
of-the-money; or (b) 25% of the current market value of the long stock 
position.\33\
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    \33\ 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 7, at footnote 34.
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2. Long Call/Short Stock
    The Long Call/Short Stock hedging 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 the equivalent units of 
the underlying component. This strategy is designed to limit the risk 
associated with upside appreciation in the underlying stock during the 
life of the call. The call holder retains the right to buy the stock at 
the strike price through the expiration of the call. For a Long Call/
Short Stock combination, the maintenance margin requirement would be 
the lesser of: (a) 10% of the call option aggregate exercise price, 
plus 100% of any amount by which the call option is out-of-the-money; 
or (b) the maintenance margin requirement on the short stock position 
as specified in NASD Rule 2520(c).\34\
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    \34\ As discussed in note 29, supra, NASD Rule 2520(c) provides 
a maintenance margin requirement of the greater of $2.50 per share 
or 100% of the current market value for each stock carried short 
that has a current market value of less than $5 per share. For each 
stock carried short that has a current market value of $5 per share 
or more, the maintenance margin is $5 per share or 30% of the 
current market value, whichever is greater. Thus, for an investor 
who is short 100 shares of XYZ @ 48 and long 1 XYZ Jan 50 Call @ 1, 
the proposed 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 7, at footnote 35.
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3. Conversion (Long Stock/Long Put/Short Call)
    A ``Conversion'' is a long stock position in conjunction with a 
long put and a short call. For a Conversion to qualify as hedged, the 
long put and the short call must have the same expiration 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

[[Page 70859]]

of the long put. Thus, regardless of any decline in market value, the 
stock position, in effect, is worth no less than the exercise price of 
the put.
    Current NASD margin rules 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 
current maintenance margin requirement (i.e., 25% of the current market 
value).\35\ Under the proposed rule change, the maintenance margin 
requirement for a Conversion would be 10% of the aggregate exercise 
price.\36\
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    \35\ For example, for an investor who is long 100 shares of XYZ 
@ 48, long one XYZ Jan 50 Put @ 2, and short one XYZ Jan 50 Call @ 
1, the current 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, NASD rules currently specify 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 7, at footnote 36.
    \36\ For example in the preceding footnote, where the investor 
was long 100 shares of XYZ, @ 48, long 1 XYZ Jan 50 Put @ 2, and 
short 1 XYZ Jan 50 Call @ 1, the proposed maintenance margin 
requirement for the Conversion strategy would be $500 
((10% x 50) x 100). See CBOE Approval Order, supra note 7, at 
footnote 37.
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4. Reverse Conversion (Short Stock/Short Put/Long Call)
    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. Regardless of any rise in market value, the stock can 
be acquired for the call exercise price; in effect, the short position 
is valued at no more than the call exercise price. Under the proposed 
rule change, the maintenance margin requirement for a Reverse 
Conversion would be 10% of the aggregate 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).\37\
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    \37\ The seller of a put option has an obligation to buy the 
underlying component at the put exercise price. If assigned an 
exercise, the underling 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 7, at footnote 38.
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5. Collar (Long Stock/Long Put/Short Call)
    A ``Collar'' is a long stock position held in conjunction with a 
long put and a short call. In a Collar, as compared to a Conversion, 
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 under the proposed rule change would be the lesser 
of: (a) 10% of the long put aggregate exercise price, plus 100% of any 
amount by which the long put is out-of-the-money; or (b) 25% of the 
short call aggregate exercise price.\38\ Current NASD margin 
requirements specify that the stock may not be valued at more than the 
call exercise price.
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    \38\ 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 ((100% 
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 7, at footnote 39.
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I. Determination of Value for Margin Purposes
    The proposal would revise NASD Rule 2520(f) to allow the extension 
of credit on certain long-term options and warrants (i.e., stock 
options, stock index options, and stock index warrants that are more 
than nine months from expiration).\39\ Currently, NASD Rule 2520(f) 
does not allow certain long term options or warrants to have market 
value for margin equity purposes. The revision would allow options and 
warrants eligible for loan value under proposed NASD Rule 2520(f) to 
have market value for margin purposes. This change is designed to 
ensure that the value of the marginable option or warrant (the 
collateral) is sufficient to cover the debit carried in conjunction 
with the purchase.
---------------------------------------------------------------------------

    \39\ See Amendment No. 1, supra note 3.
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Statutory Basis

    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) of the Act,\40\ 
which requires, among other things, that the rules of the Association 
be designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest. NASD Regulation believes 
that the proposed rule change will promote the safety and soundness of 
member firms and is consistent with the rules and regulations of the 
Federal Reserve Board because it is designed to prevent the excessive 
use of credit for the purpose or carrying of securities, pursuant to 
Section 7(a) of the Act.
---------------------------------------------------------------------------

    \40\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Commission's Findings and Order Granting Accelerated Approval 
of Proposed Rule Change and Amendment Nos. 1 and 2

    For the reasons discussed below, the commission finds the proposed 
rule change, as amended, is consistent with the Act and the rules and 
regulations under the Act applicable to a national securities 
association. In particular, the commission finds that the proposed rule 
change, as amended, is consistent with the Section 15A(b)(6) \41\ 
requirements that the rules of a national securities association 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 NASD Regulation's margin requirements to 
better reflect the risk of certain hedged options strategies.\42\
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    \41\ 15 U.S.C. 78o-3(b)(6).
    \42\ In approving the proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78f(c)(f).
---------------------------------------------------------------------------

    Specifically, the Commission believes that it is appropriate for 
NASD Regulation 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 SROs to adopt rules permitting the margining of 
options.\43\ As noted above, the NASD rules approved in this order, 
which will permit the margining of options under the grant of authority 
from the Federal Reserve Board, are

[[Page 70860]]

substantially identical to rules adopted recently by the NYSE and the 
CBOE.\44\
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    \43\ See note 6, supra.
    \44\ See CBOE Approval Order and NYSE Approval Order, supra note 
7.
---------------------------------------------------------------------------

    The Commission believes that it is reasonable for NASD Regulation 
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.\45\ Because the expiration dates 
attached to options and warrants make such securities wasting assets by 
nature, it is important that NASD Regulation 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.\46\
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    \45\ 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.
    \46\ For similar reasons, the Commission believes that it is 
appropriate for the NASD 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 long term OTC 
option's or warrant's current market value. 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).\47\ 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).
---------------------------------------------------------------------------

    \47\ See Amendment No. 1, supra note 3.
---------------------------------------------------------------------------

    The Commission recognizes that because current NASD 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 NASD'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 NASD 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.\48\ Moreover, some 
creditors, such as OCC, extend credit on options as part of their 
current business.\49\ The Commission believes that because option 
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.
---------------------------------------------------------------------------

    \48\ 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).
    \49\ 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 7.
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    Furthermore, since 1998, lenders other than broker-dealers have 
been permitted to extend 50% loan value against long listed options 
under Regulation U.\50\ The Commission understands that the current bar 
preventing broker-dealers from extending credit on options may place 
some NASD member firms at a competitive disadvantage relative to other 
financial service firms. By permitting NASD members to extend credit on 
long term options and warrants, the proposal should enable NASD members 
to better serve customers and offer additional financing alternatives.
---------------------------------------------------------------------------

    \50\ 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 Federal Reserve 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 NASD Regulation 
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 NASD 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 aggregate 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 NASD'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.\51\ 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

[[Page 70861]]

may be applied towards the requirement.
---------------------------------------------------------------------------

    \51\ 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 NASD Regulation 
to revise the maintenance margin requirements for several hedging 
strategies that combine stock positions with options positions. The 
Commission recognizes that hedging strategies such as the Long Put/Long 
Stock, Long Call/Short Stock, Conversion, Reverse Conversion, and 
Collar are designed to limit the exposure of the investor holding the 
combined stock and option positions. The proposal would modify the 
maintenance margin required for the stock component of a hedging 
strategy. For example, the stock component of a Long Put/Long Stock 
combination currently is margined without regard to 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: (1) 10% of the put option 
aggregate exercise price, plus 100% of any amount by which the put 
option is out-of-the-money; or (2) 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 may 
other cases it would be lower.\52\
---------------------------------------------------------------------------

    \52\ 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, supra 
note 7, at footnote 63.
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    The Commission notes that the proposed changes were reviewed 
carefully by the 431 Committee and the Options Subcommittee, which are 
comprised of industry participants who have extensive experience in 
margin and credit matters. In addition, as noted above, NASD 
Regulation's proposal is substantially identical to rules adopted by 
the CBOE and the NYSE, which the Commission approved.\53\ 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 margin as it 
relates to price movements in the underlying securities and index 
components.\54\ Therefore, the Commission is confident that the 
proposed margin requirements are consistent with investor protection 
and properly reflect the risks of the underlying options positions.
---------------------------------------------------------------------------

    \53\ See CBOE Approval Order and NYSE Approval Order, supra note 
7.
    \54\ See CBOE Approval Order, supra note 7.
---------------------------------------------------------------------------

    The Commission notes that the margin requirements approved in this 
order are mandatory minimums. Therefore, an NASD member may freely 
implement margin requirements that exceed the margin requirements by 
adopted by NASD Regulation.\55\ The Commission recognizes that the 
NASD's margin requirements serve as non-binding benchmarks, and that 
NASD members often establish different margin requirements for their 
customers based on a number of factors, including market volatity. The 
Commission encourages NASD members to continue to perform independent 
and rigorous analysis when determining prudent levels of margin for 
customers.
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    \55\ In this regard, the Commission notes that NASD Rule 
2520(d). ``Additional Margin,'' requires NASD members to: (1) review 
limits and types of credit extended to all customers; (2) formulate 
their own margin requirement; and (3) review the need for 
instituting higher margin requirements, mark-to-markets and 
collateral deposits than are required by NASD Rule 2520 for 
individual securities or customer accounts.
---------------------------------------------------------------------------

    The Commission believes that it is appropriate for the NASD to 
revise Rule 2520(f) (1) and (2) to allow the market value of certain 
long term stock options, stock index options, and stock index warrants 
to have market value for margin equity purposes. Under the current 
terms of NASD Rule 2520(f) (1) and (2), options contracts are not 
deemed to have market value. Because NASD Regulation's proposal will 
allow extensions of credit on certain long term options and warrants, 
NASD Rule 2520(f) (1) and (2) must be revised to permit such marginable 
options and warrants to have market value for margin purposes. The 
Commission notes that unless NASD Rule 2520(f) (1) and (2) are revised 
to recognize the market value of the marginable options and warrants, 
the NASD's loan value proposal will be ineffective (i.e., the market 
value of an appreciated marginable security would not be recognized or 
allowed to offset any loss in value of other securities held in the 
margin account).
    The Commission also believes that it is reasonable for the NASD 
Regulation 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 treatments. 
The Commission believes that it is important for the NASD to clearly 
define which options strategies are eligible for the proposed margin 
treatment.
    Moreover, the Commission believes that it is reasonable for NASD 
Regulation to define the term ``escrow agreement,'' when used in 
connection with non cash-settled call or put options carried short, and 
when used in connection with cash-settled call or put options carried 
short, to establish clear requirements for both of these types of 
escrow agreements. The Commission believes that the proposed 
definitions will help to clarify the requirements for these types of 
escrow agreements.
    The Commission also finds that the NASD's definition of the term 
``stock index warrant'' is reasonable because it conforms an NASD rule 
to an existing NYSE rule.\56\
---------------------------------------------------------------------------

    \56\ See NYSE Rule 414(a).
---------------------------------------------------------------------------

    The Commission also believes that it is reasonable for NASD 
Regulation to revise its definition of ``current market value'' and 
``current market price'' to provide that the terms ``current market 
value'' and ``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. A linkage to the Regulation T definition should 
keep the NASD's definition equivalent to Regulation T without requiring 
a rule filing if the Federal Reserve Board revises its definition of 
Regulation T. In

[[Page 70862]]

addition, the Commission believes that it is reasonable for NASD 
Regulation to move its definitions of ``current market value,'' 
``current market price,'' ``exercise settlement amount,'' ``aggregate 
exercise price,'' and ``aggregate current index value'' from NASD Rule 
2520 to NASD Rule 2522 for ease of reference purposes so that all the 
definitions relating to transactions in options, currency warrants, 
currency index warrants and stock index warrants will be located under 
NASD Rule 2522. The Commission believes that NASD members and other 
market participants will find the consolidated margin definitions 
easier to locate and use.
    Further, the Commission believes that it is reasonable for NASD 
Regulation to modify NASD Rule 2450(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 aggregate 
exercise price; and that the minimum customer margin requirement for a 
short put on an OTC equity will be 10% of the put's aggregate exercise 
price. The proposed change will make NASD Regulation's treatment of 
short equity put options consistent with the CBOE and NYSE treatment of 
short equity put options.\57\
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    \57\ See CBOE Rule 12.3(c)(5) and NYSE Rule 431(f)(2).
---------------------------------------------------------------------------

    The revisions to NASD margin rules will significantly impact the 
way NASD members calculate margin for options customers. The Commission 
believes that it is important for NASD Regulation 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 February 26, 2001 or 
such date NASD Regulation represents in writing to the Commission that 
NASD Regulation is prepared to fully implement and monitor the approved 
margin requirements.
    The Commission expects NASD Regulations to issue a notice 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 NASD Regulation 
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 the proposal prior to 
the thirtieth day after the date of publication of notice of filing 
thereof in the Federal Register because the proposal is substantially 
identical to proposals filed by the CBOE and NYSE, which the Commission 
approved previously.\58\ The Commission also 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 NASD Regulation's 
proposal by, among other things, clarifying the requirements for stock 
index option and stock index warrant spreads carried in a cash account. 
Specifically, NASD Rule 2520(f)(2)(M)(ii)d, as amended, provides that 
if the long stock index option or warrant position is not listed, it 
must be guaranteed by the carrying broker-dealer or the offsetting 
short position would not be eligible for the cash account and would be 
margined separately pursuant to NASD Rule 2520(f)(2)(D). Because this 
change conforms the NASD's rule to the CBOE and NYSE rules that were 
approved by the Commission,\59\ the change raises no new material 
regulatory issues. In addition, Amendment No. 1 makes technical 
corrections, clarifies the purpose of proposed definitions, and 
indicates that the minimum amount of margin that must be maintained in 
various hedged strategies is the aggregate exercise price (rather than 
the exercise price). Amendment No. 2 strengthens the NASD's proposal by 
making technical corrections and by clarifying the definitions of 
``American-style option,'' and ``escrow agreement,'' as used in 
connection with cash settled instruments.
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    \58\ See CBOE Approval Order and NYSE Approval Order, supra note 
7.
    \59\ Id.
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    Based on the above, the Commission finds that good cause exists, 
consistent with Section 19(b) of the Act,\60\ to accelerate approval of 
the proposal and Amendment Nos. 1 and 2 to the proposal.
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    \60\ 15 U.S.C. 78s(b).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change and 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 NASD. All 
submissions should refer to File No. SR-NASD-00-15 and should be 
submitted by December 19, 2000.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\61\ that the proposed rule change (SR-NASD-00-15), as amended, is 
approved. The approved margin requirements shall become effective the 
earlier of February 26, 2001 or such date the Association represents in 
writing to the Commission that the Association is prepared to fully 
implement and monitor the approved margin requirements.
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    \61\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\62\
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    \62\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 00-30196 Filed 11-27-00; 8:45 am]
BILLING CODE 8010-01-M