[Federal Register Volume 67, Number 17 (Friday, January 25, 2002)]
[Notices]
[Pages 3768-3771]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-1904]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45310; File No. SR-Phlx-2002-06]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval to Proposed Rule Change by Philadelphia 
Stock Exchange, Inc. to Increase Position And Exercise Limits for 
Nadsaq-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 15, 2002, the Philadelphia Stock Exchange, Inc. (``Phlx'' 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. On January 
16, 2002, the Exchange filed Amendment No. 1 to the proposed rule 
change.\3\ The Commission is publishing this notice to solicit comments 
on the proposed rule change, as amended, from interested persons. For 
the reasons discussed below, the Commission is granting accelerated 
approval of the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 supercedes and replaces the original 19b-4 
filing in its entirety.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The Phlx proposes to increase position and exercise limits for 
Nasdaq-100 Index Tracking Stock \4\ (``QQQ'') options to 300,000 
contracts on the same side of the market. The Phlx represents that its 
reporting requirements for QQQ options will serve to identify options 
holdings and information concerning the hedging of these positions.
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    \4\ The Phlx represents that Nasdaq-100, Nasdaq-100 Index 
(``Index''), Nasdaq, The Nasdaq Stock Market, Nasdaq-100 Shares, 
Nasdaq-100 Trust, Nasdaq-100 Index Tracking Stock, and QQQ are 
trademarks or service marks of The Nasdaq Stock Market, Inc. 
(``Nasdaq'') and have been licensed for use for certain purposes of 
the Phlx (``Licensee'') pursuant to a License Agreement with Nasdaq. 
The Index determined, composed, and calculated by Nasdaq without 
regard to the Licensee, the Nasdaq-100 Trust, or the beneficial 
owners of Nasdaq-100 Shares. The Phlx represents that Nasdaq has 
complete control and sole discretion in determining, comprising, or 
calculating the Index or in modifying in any way its method for 
determining, comprising or calculating the Index in the future.
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    The text of the proposed rule change is available at the Office of 
the Secretary, Phlx, and at the Commission.

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 Phlx 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 Phlx 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 1003(a). 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 Phlx 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.\5\ In addition, Exchange staff will be able to re-
focus efforts and resources to other notable areas.
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    \5\ Although the current position limit is 75,000 contracts, due 
to a 50% reduction in the value of the underlying QQQ on March 20, 
2002, the limit was adjusted to 150,000.
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Potential Manipulation

    Position limits restrict the number of options contracts that an 
investor, or a

[[Page 3769]]

group of investors acting in correct, 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,\6\ 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.\7\ The Phlx 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 Phlx further believes that QQQ 
options are not readily susceptible to manipulation based largely on 
the liquidty 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 Phlx and provide members with 
greater flexibility in fulfilling their obligations to customers and 
the market.
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    \6\ 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.
    \7\ See Becker and Burns, Regulation of Exchange-Traded Options 
in The Handbook of Derivatives and Symthetics (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.\8\ Therefore, the Phlx 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.\9\
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    \8\ 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 in technology amounting to 68.91%. The top QQQ holdings 
Microsoft, accounting, for 11.97% while the top ten holdings 
constitute 43.22%.
    \9\ 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 Phlx does not currently list any broad based index 
products.
    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 contract, 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 
underlyingQQQs, 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 Phlx believes in connection with QQQ options that the 
restrictive position and exercise limits no longer serve their stated 
purpose. The Commission has stated that:

    Since the inception of standardized options trading, the options 
exchanges have had rules imposing limits on the aggregate number of 
options contracts that a member or customer could hold or exercise. 
These rules are intended to prevent the establishment of options 
positions that can be used or might create incentives to manipulate 
or disrupt the underlying market so as to benefit the options 
position. In particular, position and exercise limits are designed 
to minimize the potential for mini-manipulations and for corners or 
squeezes of the underlying market. In addition such limits serve to 
reduce the possibility for disruption of the options market itself, 
especially in illiquid options classes.\10\

    \10\ See Securities Exchange Act Release No. 39489 (December 24, 
1997), 63 FR 276 (January 5, 1998).

    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.\11\ Accordingly, the Exchange believes that the liquidity of the 
QQQ option and the underlying cash market for QQQs greatly reduces the 
potential for manipulation in both the options and underlying cash 
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market.

    \11\ 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 billion shares, respectively, compared to the QQQ with an 
average daily trading volume of 71.21 million shares.
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    To date, the Exchange has not experienced significant disciplinary 
issues in the QQQ or the QQQ option on the Exchange. The Exchange 
represents that it conducts appropriate surveillance of options 
products, such as the QQQ options, to identify improper activity.

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.''\12\ 
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 Exchange's ability to compete with the OTC market. The 
Exchange believes that investors who trade listed options on the QQQ at 
the Phlx 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.\13\ Members 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 Phlx 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

[[Page 3770]]

differing from those covered under the current index hedge exemption 
policy (e.g., delta hedges; OTC vs. listed hedges).\14\
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    \12\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. At 189-91 
(Comm. Print 1978).
    \13\ 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.
    \14\ 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.
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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 Phlx Rule 722(d) and 722(i)(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 Phlx Rule 1003(b), the Phlx 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. This Phlx proposes 
to require members organizations, once the 10,000 contract reporting 
threshold is attained, to report similarly 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 Phlx Rule 1003(a), 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 requirement 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 Section 6(b) of the Act\15\ in general and furthers the objectives 
of Section 6(b)(5)\16\ 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 the 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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    \15\ 15 U.S.C. 78f(b).
    \16\ 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, as amended, 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 Phlx. All submissions should refer File No. SR-Phlx-2002-
06 and should be submitted by February 15, 2002.

IV. Commission 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 \17\ 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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    \17\ 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 recognized that 
the limits must be sufficient to prevent investors from disrupting the 
market in the component securities comprising the indexes. At the same 
time, the Commission has determined that limits must not be established 
at levels that are so low as to discourage participation in the options 
market by institutions and other investors with substantial hedging 
needs or to prevent specialists and market makers from adequately 
meeting their obligations to maintain a fair and orderly market.\18\
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    \18\ Id.
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    The Commission has carefully considered the Phlx's proposal to 
increase position and exercise limits for QQQ options. At the outset, 
the Commission notes that it still believes

[[Page 3771]]

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 form 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 depth and 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 
Phlx notes that the average daily trading volumes of the QQQs and QQQ 
options from January 1, 2001 to November 30, 2001 were 71.21 million 
shares and 148,181 contracts, respectively. The Phlx 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.\19\ These factors provide support for higher limits 
for the QQQ options and differentiate them from other equity options.
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    \19\ The Phlx has noted that the QQQ is designed to closely 
track the performance of the Nasdaq-100 Index. According to the 
Phlx, 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 Phlx, under Phlx Rule 722(d) and 722(i)(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 Phlx Rule 1003(b), 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 positions, thus assuring that positions are 
regularly monitored by the Exchange. In particular, information that 
must be reported includes, among other things, whether or not the 
option position is hedged, and if so, a description of the hedge. This 
information should help the Phlx 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 increased 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 and the underlying 
QQQ noted above, warrant approval of the Exchange's proposal.\20\
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    \20\ Of course, the Commission expects that Phlx 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 Phlx rules, the position and exercise limits 
applicable to QQQ options are 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 a 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 form 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 contract son January 18, 2002. Accordingly, 
the Commission finds that there is good cause, consistent with Section 
6(b)(5) of the Act,\21\ to approve the proposal on an accelerated 
basis.
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    \21\ 15 U.S.C. 78f(b)(5).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\22\ that the proposed rule change (SR-Phlx-2002-06), as amended, 
is hereby approved on an accelerated basis.
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    \22\ 15 U.S.C. 78s(b)(2).

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\23\
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    \23\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 02-1904 Filed 1-24-02; 8:45 am]
BILLING CODE 8010-01-M