[Federal Register Volume 67, Number 17 (Friday, January 25, 2002)]
[Notices]
[Pages 3765-3768]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-1902]



[[Page 3765]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45313; File No. SR-PCX-2002-03]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval to Proposed Rule Change by Pacific 
Exchange, Inc. To Increase Position and Exercise Limits for Nasdaq-100 
Index Tracking Stock Options

January 18, 2002.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 
1934,\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that on 
January 17, 2002, the Pacific Exchange, Inc. (``PCX'' or ``Exchange'') 
filed with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I and II below, which Items 
have been prepared by the Exchange. The Commission is publishing this 
notice to solicit comments on the proposed rule change from interested 
persons. For the reasons discussed below, the Commission is granting 
accelerated approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The PCX proposes to increase position and exercise limits for 
Nasdaq-100 Index Tracking Stock (``QQQ'') options to 300,000 contracts 
on the same side of the market.\3\ The text of the proposed rule change 
is available at the Office of the Secretary, PCX, and at the 
Commission.
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    \3\ The PCX also proposed a non-substantive amendment to Rule 
6.9(a) clarifying that options on securities such as unit investment 
trusts must follow equity position and exercise limit rules.
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II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the PCX 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 III below. The PCX 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

1. Purpose
    The Exchange is proposing to increase position and exercise limits 
for QQQ options up to 300,000 contracts on the same side of the market. 
The Exchange will continue to require that member organizations report 
all QQQ options positions exceeding 200 contracts pursuant to Exchange 
Rule 6.6. Moreover, for accounts holding positions in excess of 10,000 
contracts on the same side of the market, the Exchange will also 
continue to require information concerning the extent to which such 
positions are hedged. The PCX believes that increasing position and 
exercise limits from 75,000 to 300,000 contracts for QQQ options will 
provide greater flexibility for market participants attempting to hedge 
their market risks.\4\ In addition, Exchange staff will be able to re-
focus efforts and resources to other notable areas.
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    \4\ Although the current position limit is 75,000 contracts due 
to a 50% reduction in the value of the underlying QQQ on March 20, 
2000, the limit was adjusted to 150,000.
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Manipulation

    Position limits restrict the number of options contracts that an 
investor, or a group of investors acting in concert, may own or 
control. Similarly, exercise limits prohibit the exercise of more than 
specified a number of contracts on a particular instrument within five 
(5) business days. The Commission, by imposing these limits on 
exchange-traded options, has sought to: (1) Minimize the potential for 
mini-manipulations,\5\ as well as other forms of market manipulations; 
(2) impose a ceiling on the position that an investor with inside 
corporate or market information can establish; and (3) reduce the 
possibility of disruption in the options and underlying cash 
markets.\6\ The PCX believes that the structure of the QQQ option and 
the tremendous liquidity of both the underlying cash and options market 
for QQQs should allay regulatory concerns of potential manipulation. 
The PCX further believes that QQQ options are not readily susceptible 
to manipulation based largely on the liquidity and activity of the 
underlying QQQ as well as the securities comprising the QQQ. Therefore, 
the Exchange submits that increasing position and exercise limits to 
300,000 contracts may generate greater order flow for the PCX and 
provide members with greater flexibility in fulfilling their 
obligations to customers and the market.
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    \5\ Mini-manipulation is an attempt to influence, over a 
relatively small range, the price movement in a stock to benefit a 
previously established options position.
    \6\ See Becker and Burns, Regulation of Exchange-Traded Options 
in The Handbook of Derivatives and Synthetics (1994), Probus 
Publishing Company, and Regulating the Options Market, Institutional 
Investor Forum (November 1991).
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    Although the QQQ option is not itself an index option product, it 
nonetheless is designed to closely track the price and yield 
performance of the Nasdaq-100 index.\7\ Therefore, the PCX believes 
that in evaluating this proposal to increase position and exercise 
limits for QQQ options, the Commission should apply an analysis similar 
to what was used in connection with broadbased index options.\8\
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    \7\ QQQ represents ownership in the Nasdaq-100 Trust, a long-
term unit investment trust established to accumulate and hold a 
portfolio of the equity securities that comprise the Nasdaq-100 
Index. The Nasdaq-100 Index includes 100 of the largest non-
financial companies listed on the Nasdaq National Market. The 
Nasdaq-100 reflects Nasdaq's largest growth companies across major 
industry groups with all index components having a market 
capitalization of at least $500 million and an average daily trading 
volume of at 100,000 shares. QQQ is intended to provide investment 
results that generally correspond to the Nasdaq-100 Index with an 
initial market value approximated at \1/40\th the value of the 
underlying Nasdaq-100 Index. A description and analysis of the 
Nasdaq-100 Index is set forth by the Commission in Securities 
Exchange Act Release No. 33428 (January 4, 1994), 59 FR 1576 
(January 11, 1994) (order approving trading of Nasdaq-100 options by 
the CBOE). As of November 30, 2001, the market capitalization of the 
securities underlying the Nasdaq-100 Index was approximately $1.875 
trillion, while the QQQ had net assets of $23.96 billion and 559.1 
million shares outstanding. By far the largest economic sector 
represented is technology amounting to 68.91%. The top QQQ holding 
is Microsoft, accounting, for 11.97% while the top ten holdings 
constitute 43.22%.
    \8\ See Securities Exchange Act Release Nos. 41011 (February 1, 
1999), 64 FR 6405 (February 9, 1999) (order approving the 
elimination of position and exercise limits for XMI and XII options 
on a two-year pilot basis) and 40969 (January 22, 1999), 64 FR 4911 
(February 1, 1999) (order approving the elimination of position and 
exercise limits for SPX, OEX, DJX and related FLEX options on a two-
year pilot basis).
    The Commission notes that the elimination of position and 
exercise limits for certain broad-based index options was based on 
many factors including the enormous capitalization's of the indexes. 
For example, the market capitalization of the SPX, OEX and DJX as of 
October 2001 was $9.81 trillion, $5.7 trillion and $3.23 trillion, 
respectively. See Securities Exchange Act Release No. 44994 (October 
26, 2001) 66 FR 55722 (November 2, 2001) (permanently approving the 
pilot to eliminate position and exercise limits for OEX, SPX and DJX 
Index options). In contrast, the market capitalization of the NASDAQ 
100 as of November 2001 was 1.875 trillion. The Commission further 
notes that options on QQQs physically settle in the underlying QQQs, 
which had net assets of $23.96 billion as of November 30, 2001. In 
contrast, index options are cash settled based on the underlying 
value of the index.
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    The PCX believes in connection with QQQ options that the 
restrictive

[[Page 3766]]

position and exercise limits no longer serve their stated purpose. The 
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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\

    \9\ Securities Exchange Act Release No. 39489 (December 24, 
1997), 63 FR 276 (January 5, 1998).
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    The Exchange believes that both the size and breadth of the market 
for QQQs dispels concerns regarding market manipulation and disruption. 
The average daily trading volumes for the QQQs and QQQ options from 
January 1, 2001 to November 30, 2001 were 71.21 million shares and 
148,181 contracts, respectively. The QQQ option is by far the most 
actively-traded option product in the U.S., and therefore, the most 
liquid. The underlying QQQ is the most actively-traded equity security 
in the U.S. with greater trading volume than both Microsoft and 
Intel.\10\ Accordingly, the Exchange believes that the liquidity of the 
QQQ option and the underlying cash market for QQQs greatly reduces the 
potential for manipulations in both the options and underlying cash 
market.
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    \10\ For the period of January 1, 2001 to November 30, 2001, 
Microsoft and Intel had average daily trading volumes of 39.38 and 
53.98 million shares, respectively, compared to the QQQ with an 
average daily trading volume of 71.21 million shares.
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    To date, there has not been a single disciplinary action involving 
manipulation or potential manipulation in the QQQ or the QQQ option on 
the Exchange. The PCX further believes that its extensive experience 
conducting surveillance of derivative products and program trading 
activity is sufficient to identify improper activity. Routine oversight 
inspections of the PCX's regulatory programs by the Commission should 
uncover any inconsistencies or shortcomings in the manner in which 
derivative and options surveillance is conducted. These procedures 
entail a daily monitoring of market movements via automated 
surveillance techniques to identify unusual activity in both the 
options and underlying cash markets.

Competition

    The Commission has stated 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\ 
Based on the large trading volume apparent in both the underlying QQQ 
and QQQ options, the Exchange believes that current position and 
exercise limits of the QQQ option are too restrictive and may adversely 
affect the PCX's ability to compete with the OTC market. The Exchange 
believes that investors who trade listed options on the QQQ at the 
Exchange may be placed at a serious disadvantage in comparison to 
certain Nasdaq-100 index derivative products traded in the OTC market 
where some index-based derivatives are not currently subject to 
position and exercise limits.\12\ Member firms also continue to express 
their concern that position limits on popular, actively-traded 
products, such as QQQ options, are an impediment to business 
development on the Exchange. Accordingly, a portion of this business is 
believed to have moved to the OTC market where some index-based 
derivative products are not subject to position limit requirements. In 
addition, the PCX believes that current base limits for the QQQ option 
may not be adequate in many instances for the hedging needs of certain 
institutions, which engage in trading strategies differing from those 
covered under the current index hedge exemption policy (e.g., delta 
hedges; OTC vs listed hedges).\13\
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    \11\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. At 189-91 
(Comm. Print 1978).
    \12\ The Commission notes, however, that as an equity product, 
options on the QQQ are subject to position limits in the OTC market. 
See NASD Rule 2860.
    \13\ The current limit for QQQ options is 150,000 contracts due 
to the 50% reduction in the underlying value of the QQQ that 
occurred on March 20, 2000. At this limit, the QQQ options equate to 
15,000,000 QQQ shares or an aggregate value of $59.47 billion as of 
November 30, 2001. At the time of approval of QQQ options, position 
and exercise limits were set at 25,000 (250,000 QQQ shares) equating 
to an aggregate value of $2,500,000 as of March 9, 1999 
(commencement of trading). When QQQs commenced trading, the volume 
was 10.4 million shares with an opening price of $100.00 per share. 
The average daily trading volumes for the QQQ during 1999, 2000 and 
year-to-day 2001 were 13.9 million, 30.9 million and 71.21 million 
shares respectively, while for the same periods the average daily 
trading contract volume for the QQQ option were 9,206, 91,656, and 
148,181. As of November 30, 2001, the price of a single QQQ was 
$39.65.
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Financial Requirements

    The Exchange believes that financial requirements imposed by the 
Exchange and by the Commission adequately address concerns that a 
member or its customer may try to maintain an inordinately large 
unhedged position in QQQ options. 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. It should also be noted that the Exchange has the authority 
under PCX Rules 2.16 and 6.8 to impose a higher margin requirement upon 
the member or member organization when the Exchange determines a higher 
requirement is warranted.

Reporting Requirements

    Consistent with PCX Rule 6.6, the PCX will continue to require that 
each member or member organization that maintains a position on the 
same side of the market in excess of 10,000 contracts in the QQQ 
option, for its own account or for the account of a customer report 
certain information. This data includes, but is not limited to, the 
option position, whether such position is hedged and if so, a 
description of the hedge and if applicable, the collateral used to 
carry the position. Exchange market-makers are exempt from this 
reporting requirement as market-maker information can be accessed 
through the Exchange's market surveillance systems. Once the 10,000 
contract reporting threshold is attained, the PCX will require members 
and member organizations to similarly report each increase of 2,500 
contracts on the same side of the market for customer accounts and each 
increase of 5,000 contracts on the same side of the market for 
proprietary accounts. The Exchange believes that the reporting level of 
10,000 contracts on the same side of the market for members other than 
Exchange market-makers is consistent with the designation of the QQQ as 
an equity option, and therefore, the existing regulatory regime. 
Pursuant to PCX Rule 6.6, the general reporting requirement for 
customer accounts that maintain a position in excess of 200 contracts 
will remain at this level for QQQ options. Lastly, the Phlx believes 
that the 10,000 contract reporting requirements is above and beyond 
what is currently required in the OTC market. According to the 
Exchange, NASD member firms are only required to report options 
positions in excess of 200 contracts and are not required to report any 
related hedging information.
2. Basis
    The Exchange believes that the proposed rule change is consistent 
with

[[Page 3767]]

Section 6(b) of the Act \14\ in general and furthers the objectives of 
Section 6(b)(5) \15\ in particular in that it 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, to 
remove impediments to and perfect and mechanism of a free and open 
market and a national market system, to protect investors and the 
public interest and is not designed to permit unfair discrimination 
between customers, issuers, brokers, or dealers.
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    \14\ 15 U.S.C. 78f(b).
    \15\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition.

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

    No written comments were solicited or received with respect to the 
proposed rule change.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. 
Copies of the 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 Section. Copies of such filing will also 
be available for inspection and copying at the principal office of the 
PCX. All submissions should refer File No. SR-PCS-2002-03 and should be 
submitted by February 15, 2002.

IV. Commissions Findings and Order Granting Accelerated Approval of 
Proposed Rule Change

    After careful review, 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. In 
particular, the Commission believes the proposal is consistent with the 
requirements of Section 6(b)(5) of the Act \16\ in that it is designed 
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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    \16\ 15 U.S.C. 78f(b)(5). 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 and exercise limits serve as a regulatory tool designed to 
address potential manipulative schemes and adverse market impact 
surrounding the use of options. In general, the Commission has taken a 
gradual, evolutionary approach toward expansion of position and 
exercise limits. The Commission has been careful to balance two 
competing concerns when considering the appropriate level at which to 
set position and exercise limits. The Commission has recognize 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.\17\
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    \17\ Id.
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    The Commission has carefully considered the PCX's proposal to 
increase position and exercise limits for QQQ options. At the outset, 
the Commission notes that it still believes the fundamental purpose of 
position and exercise limits are being served by their existence. 
However, given the surveillance capabilities of the Exchange and the 
depth and liquidity in both the QQQ options and the underlying cash 
market in QQQs, the Commission believes it is permissible to 
significantly raise position limits for QQQ options without risk of 
disruption to the options or underlying cash markets. Specifically, the 
Commission believes that it is appropriate to increase position and 
exercise limits from 75,000 contracts to 300,000 contracts for QQQ 
options for several reasons.
    First, the Commission believes that the structure of the QQQ 
options and the considerable liquidity of both the underlying cash and 
options market for QQQ options lessens the opportunity for manipulation 
of this product and disruption in the underlying market that a lower 
position limit may protect against. In this regard, the PCX notes that 
the average daily trading volumes for the QQQs and QQQ options from 
January 1, 2001 to November 30, 2001 were 71.21 million shares and 
148,181 contracts, respectively. The PCX also notes that the QQQ option 
is the most actively-traded option in the U.S. markets, and the 
underlying QQQ is the most actively-traded equity security in the U.S. 
markets.\18\ These factors provide support for higher limits for the 
QQQ options and differentiate them from other equity options.
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    \18\ The PCX has noted that the QQQ is designed to closely track 
the performance of the Nasdaq-100 Index. According to the PCX, as of 
November 30, 2001, the market capitalization of the securities 
underlying the Nasdaq-100 Index was $1.875 trillion.
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    Second, the Commission notes that 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. Further, the PCX, under Rules 2.16 and 6.8, may impose 
additional margin on options positions if it determines that this is 
warranted. The Commission believes that these financial requirements 
should help to address concerns that a member or its customer may try 
to maintain an inordinately large unhedged position in QQQ options and 
will help to reduce risks if such a position is established.
    Finally, the Commission believes that the reporting requirements 
imposed by the Exchange will help protect against potential 
manipulation. Under PCX Rule 6.6, each member or member organization 
that maintains a position on the same side of the market in excess of 
10,000 contracts in the QQQ option, for its own account or for the 
account of a customer is required to report certain information. The 
Exchange also requires members to report subsequent incremental 
increases in position limits, thus assuring that positions are 
regularly monitored by the Exchange. In particular, information that 
must be reported includes, among other things,

[[Page 3768]]

whether or not the options position is hedged, and if so, a description 
of the hedge. This information should help the PCX to monitor accounts 
and determine whether it is necessary to impose additional margin for 
under-hedged positions, as provided under its rules.
    In summary, the financial and reporting requirements noted above 
should allow the Exchange to detect and deter trading abuses arising 
from the increasing position and exercise limits, and will also allow 
the Exchange to monitor large positions in order to identify instances 
of potential risk and to assess additional margin and/or capital 
charges, if deemed necessary. These requirements, coupled with the 
special trading characteristics of the QQQ options noted above, warrant 
approval of the Exchanges proposal.\19\
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    \19\ Of course, the Commission expects that PCX will take prompt 
action, including timely communication with the Commission and other 
marketplace self-regulatory organizations responsible for oversight 
of trading in the underlying QQQ, should any unanticipated adverse 
market effects develop due to the increased limits.
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    The Commission finds good cause for approving the proposed rule 
change prior to the thirtieth day after the date of publication of the 
notice of filing thereof in the Federal Register. The Commission notes 
that under the current PCX rules, the position and exercise limits 
applicable to QQQ options is 75,000 contracts. However, due to a 50% 
reduction in the value of the underlying QQQ on March 20, 2000, the 
limit was adjusted to 150,000 contracts. The position and exercise 
limits are scheduled to revert back to 75,000 contracts after the 
January options expiration occurring on January 18, 2002. The Exchange 
has represented to the Commission that limits of 75,000 contracts for 
the QQQ options could substantially reduce depth and liquidity in the 
QQQ market. The Exchange has further represented that increasing 
position and exercise limits from 75,000 contracts to 300,000 contracts 
for QQQ options will provide greater flexibility for market 
participants attempting to hedge their market risks. The Commission, 
therefore, believes for the reasons noted above that it is appropriate 
to approve this proposed rule change increasing the position and 
exercise limit to 300,000 contracts on January 18, 2002. The Commission 
also believes it is appropriate to approve the clarifying language 
proposed for Exchange Rule 6.9(a) noted above. Accordingly, the 
Commission finds that there is good cause, consistent with Section 
6(b)(5) of the Act,\20\ to approve the proposal on an accelerated 
basis.
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    \20\ 15 U.S.C. 78f(b)(5).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-PCX-2002-03) is hereby 
approved on an accelerated basis.
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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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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 02-1902 Filed 1-24-02; 8:45 am]
BILLING CODE 8010-01-M