[Federal Register Volume 67, Number 17 (Friday, January 25, 2002)]
[Notices]
[Pages 3760-3762]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-1907]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45311; File No. SR-ISE-2001-26]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval to Proposed Rule Change by International 
Securities Exchange LLC 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 
October 8, 2001, the International Securities Exchange LLC (``ISE'' 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 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 ISE 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. The text of the proposed rule change is 
available at the Office of the Secretary, ISE, 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 ISE 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 ISE 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 options on the Nasdaq 100 Index Tracking Stock (``QQQ options'') up 
to 300,000 contracts on the same side of the market. As discussed 
below, the Exchange believes that the current limits for non-flex 
equity options are no longer appropriate for QQQ options given the 
liquidity of the options, the underlying security, and the securities 
that comprise the Nasdaq-100 Index.
    QQQ options are popular hedging instruments in today's market and 
by far the most active listed option product. The average daily trading 
volume for QQQ options was 243,763 contracts during the first quarter 
of 2001, 330,786 contracts during the second quarter, and 316,425 
contracts during the third quarter. As of October 2001, the average 
daily trading volume of QQQ options is 298,858 contracts.\4\
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    \4\ The ISE notes that in comparison, the Commission approved 
the total elimination of position limits for options traded on the 
SPX, OEX and DJX, all of which are broadbased indexes traded solely 
on the Chicago Board of Options Exchange (``CBOE''). Year to date 
the average daily trading volume of options on these three indexes 
is 92,814 contracts, 43,544 contracts, and 35,365 contracts 
respectively. Thus, daily average volume in QQQ options is more than 
3.2 times that of the SPX and nearly 8.5 times that of the DJX. See 
Securities Exchange Act Release No. 41011 (Feb. 1, 1999) (Order 
approving elimination of position and exercise limits for XMI and 
XII options on a two-year pilot basis); and Securities Exchange Act 
Release No. 40969 (Feb. 1, 1999) (Order approving the elimination of 
position and exercise limits for SPX, OEX, DJX on a two-year pilot 
basis).
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    One of the primary purposes for imposing position and exercise 
limits is to minimize the opportunity for mini-manipulation, which is 
an attempt to influence the price movement of an underlying stock to 
benefit a previously established options position.\5\ The Nasdaq 100 
Index Tracking Stock represents ownership in a long-term unit 
investment trust that holds a portfolio of the equity securities that 
track and Nasdaq-100 Index. Thus, while QQQ options are not technically 
index options (for which the Commission has previously approved the 
elimination of position limits for options on certain enormously 
capitalized indexes),\6\ the ISE believes that they are economically 
similar and are used by investors in the same manner and with the same 
investment objectives as index options.\7\ The Nasdaq-100 Index 
includes 100 of the largest non-financial companies listed on Nasdaq, 
each of which has an average daily trading volume of at least 100,000 
shares and a market capitalization of at least $500 million.\8\ The 
Exchange believes that it would be extremely difficult for an investor 
to influence the price of the Nasdaq-100 Index in order to benefit a 
previously established options position.
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    \5\ See Securities Exchange Act Release No. 39489 (Dec. 24, 
1997), 63 FR 276 (Jan. 5, 1998)
    \6\ See supra note 4.
    \7\ 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 capitalizations 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.
    \8\ According to information available on Bloomberg, L.P., an 
information company, the average daily trading volume for the Nasdaq 
100 Index Tracking Stock was 66.8 million shares during the first 
quarter of this year, 69.8 million shares during second quarter, and 
64.6 million during the third quarter.
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    The reporting requirements in ISE Rule 415(b) will continue to 
apply to QQQ options.\9\ Rule 415(b) requires Electronic Access Members 
to report end of day positions in all non-FLEX equity options in excess 
of 10,000 contracts on the same side of the market. The report must 
specify whether such position is hedged and provide documentation as to 
how such position is hedged, including a description of any collateral 
used to carry the position. This report is required at the time the 
account exceeds the 10,000 contract threshold and thereafter, for 
customer accounts, when

[[Page 3761]]

the position increases by 2,500 contracts and for proprietary accounts, 
when the position increases by 5,000. Exchange market-makers are not 
required to report under ISE Rule 415(b) as market-makers account 
positions can be accessed through the Exchange's market surveillance 
systems.
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    \9\ The general reporting requirement contained in ISE Rule 
415(a) for customer accounts that maintain a position in excess of 
200 contracts also will remain applicable for QQQ options.
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    Finally, the Exchange proposes to explicitly state in Supplementary 
Material to ISE Rule 412 that it may use its authority under ISE Rule 
1204(b) to impose additional margin requirements upon an account that 
maintains under-hedged options positions.
2. Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b) of the Act \10\ in general and furthers the 
objectives of section 6(b)(5) \11\ 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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    \10\ 15 U.S.C. 78f(b).
    \11\ 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 ISE. All submissions should refer File No. SR-
ISE-2001-26 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 \12\ 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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    \12\ 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 the past, the Commission has stated 
that:

    Since the inception of standardized options trading, the options 
exchanges have had rules imposing limits on the aggregate number of 
options contracts that a member or customer could hold or exercise. 
These rules are intended to prevent the establishment of options 
positions that can be used or might create incentives to manipulate 
or disrupt the underlying market so as to benefit the options 
position. In particular, position and exercise limits are designed 
to minimize the potential for mini-manipulations and for corners or 
squeezes of the underlying market. In addition such limits serve to 
reduce the possibility for disruption of the options market itself, 
especially in illiquid options classes.\13\
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    \13\ See Securities Exchange Act Release No. 39489 (December 24, 
1997), 63 FR 276 (January 5, 1998).

    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.\14\
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    \14\ Id.
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    The Commission has carefully considered the ISE'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 product that a lower 
position limit may protect against. In this regard, the ISE notes that 
the average daily trading volume for QQQ options was 243,763 contracts 
during the third quarter of 2001, 330,786 contracts during the second 
quarter, and 316,425 contracts during the third quarter. The ISE 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.\15\ These factors provide support for 
higher limits for the QQQ options and differentiate them from other 
equity options.
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    \15\ As noted by the ISE, the QQQ is designed to closely track 
the performance of the Nasdaq-100 Index. 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

[[Page 3762]]

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. In 
this regard, the Commission believes the ISE's adoption of 
Supplementary Material to ISE Rule 412, to state that the ISE has the 
authority to impose additional margin on options positions if it 
determines that this is warranted, is appropriate.
    Finally, the Commission believes that the reporting requirements 
imposed by the Exchange under ISE Rule 415(b), which 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, will help protect against potential 
manipulation. 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 
options position is hedged, and if so, a description of the hedge. The 
information should help the ISE to monitor accounts and determine 
whether it is necessary to impose additional margin for under-hedged 
positions, as provided under its rules. The Commission believes that 
these financial requirements are sufficient to address concerns that a 
member or its customer may try to maintain an inordinately large 
unhedged position in QQQ options.
    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 
QQQs noted above, warrant approval of the Exchange's proposal.\16\
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    \16\ Of course, the Commission expects that ISE 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 Exchange 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 
Commission notes that limits of 75,000 contracts for the QQQ options 
could reduce depth and liquidity in the QQQ market. The Commission 
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. Accordingly, the Commission 
finds that there is good cause, consistent with section 6(b)(5) of the 
Act,\17\ to approve the proposal on an accelerated basis.
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    \17\ 15 U.S.C. 78f(b)(5).
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    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\18\ that the proposed rule change (SR-ISE-2001-26) is hereby 
approved, as amended, on an accelerated basis.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12)
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 02-1907 Filed 1-24-02; 8:45 am]
BILLING CODE 8010-01-M