[Federal Register Volume 67, Number 221 (Friday, November 15, 2002)]
[Notices]
[Pages 69273-69277]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-28988]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46792; File No. SR-CME-2002-01]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment No. 1 Thereto, and Notice of Filing and Order 
Granting Accelerated Approval of Amendment No. 2 Thereto, by Chicago 
Mercantile Exchange, Inc. Relating to Customer Margin Requirements for 
Security Futures

November 8, 2002.
    On September 27, 2002, Chicago Mercantile Exchange, Inc. (``CME'' 
or ``Exchange'') submitted to the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change relating to customer margin 
requirements for security futures. On October 7, 2002, CME submitted 
Amendment No. 1 to the proposed rule change.\3\ The proposed rule 
change was published for comment in the Federal Register on October 21, 
2002.\4\ On November 7, 2002, CME submitted Amendment No. 2 to the 
proposed rule change.\5\ The Commission received no comment letters 
directly addressing the proposed rule change. However, the Commission 
received nine comment letters from ten commenters regarding a proposed 
rule change submitted by OneChicago, LLC (``OneChicago''), which is 
substantially similar to CME's proposed rule change.\6\ Accordingly, 
the Commission has considered those comments in its review of the 
proposed

[[Page 69274]]

rule change.\7\ On November 7, 2002, CME submitted a letter in response 
to those comments.\8\ This order approves the proposed rule change and 
Amendment No. 1 thereto, accelerates approval of Amendment No. 2, and 
solicits comments from interested persons on Amendment No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Phupinder S. Gill, Managing Director and 
President, Clearing House Division, CME, to Office of Market 
Supervision, Division of Market Regulation, Commission, dated 
October 4, 2002 (``Amendment No. 1''). In Amendment No. 1, the 
Exchange replaced in its entirety the Form 19b-4 filed on September 
27, 2002.
    \4\ Securities Exchange Act Release No. 46637 (October 10, 
2002), 67 FR 64672.
    \5\ In Amendment No. 2, CME modified certain aspects of its 
exclusion for market making activity.
    \6\ See Securities Exchange Act Release No. 46555 (September 26, 
2002), 67 FR 61707.
    \7\ See letters to Jonathan Katz, Secretary, Commission, from: 
Philip D. DeFeo, Chairman and Chief Executive Officer, Pacific Stock 
Exchange, dated October 15, 2002 (``PCX Letter''); Marc Menchel, 
Senior Vice President and General Counsel, National Association of 
Securities Dealers, dated October 23, 2002 (``NASD Letter''); 
Richard Ketchum, Deputy Vice Chairman and President, The Nasdaq 
Stock Market, Inc., dated October 23, 2002 (``Nasdaq Letter''); 
Michael J. Simon, Senior Vice President and Secretary, International 
Securities Exchange, Inc., dated October 22, 2002 (``ISE Letter''); 
Michael J. Ryan, Jr., Executive Vice President and General Counsel, 
American Stock Exchange, Inc., dated October 22, 2002 (``Amex 
Letter''); John P. Davidson, Managing Director, Morgan Stanley & Co. 
Inc., and Mitchell J. Lieberman, Managing Director, Goldman, Sachs & 
Co., dated October 23, 2002 (``Morgan/Goldman Letter''); Kathleen M. 
Hamm, Senior Vice President, Nasdaq Liffe Markets, LLC, dated 
October 22, 2002 (``NQLX Letter''); Darla C. Stuckey, Corporate 
Secretary, New York Stock Exchange, Inc., dated October 24, 2002 
(``NYSE Letter''); and Michael R. Schaefer, Managing Director, 
Salomon Smith Barney, dated October 25, 2002 (``SSB Letter'').
    \8\ Letter from CME to Office of Market Supervision, Division of 
Market Regulation, Commission, dated November 7, 2002 (``CME 
Letter'').
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I. Description of the Proposed Rule Change

Introduction

    On August 1, 2002, the Commodity Futures Trading Commission (CFTC) 
and SEC (collectively, the Commissions) jointly adopted customer margin 
requirements for security futures.\9\ Under the Commissions' ``account 
specific'' approach, the Commissions'' margin rules apply certain core 
requirements to all security futures, and direct that the more specific 
requirements depend on the type of account in which the security 
futures are held (i.e., a futures account or securities account).
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    \9\ Securities Exchange Act Release No. 46292, 67 FR 53146 
(August 14, 2002).
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Proposal

    The proposed rule change sets forth margin requirements for 
security futures traded on CME that are held in futures accounts.\10\ 
Specifically, the proposed rule change sets the minimum initial and 
maintenance customer margin rates for such security futures and 
provides for lower margin levels for permitted strategy-based offset 
positions. The proposed rules exclude certain financial relations to 
which the Commissions' margin rules do not apply. The proposed rule 
change also establishes standards under which members may qualify as 
Security Futures Dealers and therefore be excluded from CME's margin 
rules.
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    \10\ The proposed rule change limits the scope of CME's customer 
margin rules to positions in futures accounts.
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Margin Levels

    The Commissions' margin rules require that customers deposit in 
their accounts minimum margin of 20 percent of the current market value 
of security futures.\11\ In addition, the Commissions' rules permit 
national securities exchanges to set margin levels below 20 percent of 
the current market value of security futures for certain offsetting 
positions in security futures and other securities or futures. The 
proposed rule change establishes a minimum margin rate of 20 percent 
for both long and short positions in security futures, except with 
respect to specified, permitted offsetting positions. Under the 
proposed rule change, CME permits reduced margin levels for eighteen 
specific offsetting positions.\12\
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    \11\ Rule 403(b)(1) under the Act and Rule 41.45(b)(1) under the 
Commodity Exchange Act (''CEA'') 17 CFR 240.403(b)(1) and 17 CFR 
41.45(b)(1).
    \12\ In its release adopting the customer margin rules for 
security futures, the Commissions published a table of eighteen 
offsetting positions and corresponding margin levels that are 
consistent with comparable offsets permitted for positions involving 
exchange-traded options. The proposed rule change includes all of 
the offsetting positions that the Commissions included in their 
table. However, CME's customer margin rules only apply to positions 
held in futures accounts. Because any offset that includes a 
security (other than a security future) must be carried in a 
securities account, CME's rule applies only to those offsetting 
positions that may be carried in a futures account (i.e., offsets 
that do not include securities other than security futures).
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Security Futures Dealers

    As noted above, the proposed rule change provides an exclusion from 
CME's margin rules for market makers. Under the proposed rule change, 
CME's market maker exclusion provides that in order to qualify for the 
exclusion from the margin rules, a person must (1) be a CME member that 
is registered with the Exchange as a dealer in security futures; (2) be 
registered as a floor trader or a floor broker with the CFTC under 
section 4f(a)(1) of the CEA or as a dealer with the Commission under 
section 15(b) of the Act; (3) maintain records sufficient to prove 
compliance with the requirements of CME Rule 930 and Rule 
41.42(c)(2)(v) under the CEA and Rule 400(c)(2)(v) under the Act, as 
applicable, including without limitation trading account statements and 
other financial records sufficient to detail activity; and (4) hold 
itself out as being willing to buy and sell security futures for its 
own account on a regular or continuous basis. In addition, the market 
maker exclusion provides that any market maker that fails to comply 
with the applicable rules of the exchange or the margin rules adopted 
by the Commission and the CFTC shall be subject to disciplinary action 
in accordance with Chapter 4 of CME's rules, and that appropriate 
sanctions in the case of any such failure shall include, without 
limitation, a revocation of such market maker's registration as a 
dealer in security futures.
    The CME's proposal, as amended by Amendment No. 1, provided that a 
market maker would be considered to be holding itself out as being 
willing to buy and sell security futures for its own account on a 
regular or continuous basis if either (1) At least 75% of its gross 
revenue on an annual basis is derived from business activities or 
occupations from trading listed financial derivatives and the 
instruments underlying those derivatives, including security futures, 
stock index futures and options, stock and index options, stocks, 
foreign currency futures and options, foreign currencies, interest rate 
futures and options, fixed income instruments and commodity futures and 
options; or (2) except for unusual circumstances, at least fifty 
percent (50%) of its trading activity on CME in any calendar quarter is 
in classes of security futures contracts to which it is assigned by 
CME.
    In Amendment No. 2, CME amended this aspect of its proposed rule 
change. Specifically, the market maker exclusion now provides three 
alternatives ways for a member to satisfy the requirement that a 
security futures dealer hold itself out as being willing to buy and 
sell security futures for its own account on a regular or continuous 
basis. Under the first alternative, the market maker must (1) Provide 
continuous two-sided quotations throughout the trading day for all 
delivery months of security futures representing a meaningful 
proportion of the total trading volume on the Exchange,\13\ subject to 
relaxation during unusual market conditions as determined by CME (such 
as a fast market in either a security future an underlying security) at 
which times the market maker must use its best efforts to quote 
continuously and competitively; and (2) when providing quotations, 
quote with a maximum bid/ask spread of no more than the greater of 
$0.20 or 150% of the bid/ask spread in the

[[Page 69275]]

primary market for the security underlying each security future.
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    \13\ Beginning on the 181st calendar day after the commencement 
of trading on the Exchange, a ``meaningful proportion of the total 
trading volume on the Exchange from time to time'' shall mean a 
minimum of 20% of such trading volume.
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    Under the second alternative, the market maker must (1) respond to 
at least 75% of the requests for quotation for all delivery months of 
security futures representing a meaningful proportion of the total 
trading volume on the Exchange,\14\ subject to relaxation during 
unusual market conditions as determined by the CME (such as a fast 
market in either a security future or an underlying security) at which 
times such Market Maker must use its best efforts to quote 
competitively; and (2) when responding to requests for quotation, quote 
within five seconds with a maximum bid/ask spread of no more than the 
greater of $0.20 or 150% of the bid/ask spread in the primary market 
for the security underlying each security future.
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    \14\ Beginning on the 181st calendar day after the commencement 
of trading on the Exchange, a ``meaningful proportion of the total 
trading volume on the Exchange from time to time'' shall mean a 
minimum of 20% of such trading volume.
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    Under the third alternative, the market maker is assigned to a 
group of security futures that is either unlimited in nature 
(``Unlimited Assignment'') or is assigned to no more than 20% of the 
security futures listed on the Exchange (``Limited Assignment''). In 
addition, this alternative provides that: (a) At least 75% of the 
market maker's total trading activity in CME products is in its 
assigned security futures, measured on a quarterly basis; (b) during at 
least 50% of the trading day the market maker has bids or offers in the 
market that are at or near the best market, except in unusual market 
conditions (such as a fast market in either a security future or an 
underlying security), with respect to at least 25% (in the case of an 
Unlimited Assignment) or at least one (in the case of a Limited 
Assignment) of its assigned security futures; and (c) the first two 
requirements are satisfied on at least 90% (in the case of an Unlimited 
Assignment) or 80% (in the case of a Limited Assignment or in the case 
where the Exchange is listing four or fewer security futures contracts) 
of the trading days in each calendar quarter. CME has requested 
approval of this alternative on a six-month pilot basis beginning on 
the date of this order.

II. Summary of Comments

    As noted above, the Commission received no comment letters directly 
addressing the proposed rule change, but did receive nine comment 
letters from ten commenters regarding a similar proposed rule change 
submitted by OneChicago. Accordingly, the Commission has considered 
those comments in its review of the proposed rule change.\15\ CME 
submitted a letter in response to those comments.\16\
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    \15\ PCX Letter, NASD Letter, Nasdaq Letter, ISE Letter, Amex 
Letter, Morgan/Goldman Letter, NQLX Letter, NYSE Letter, and SSB 
Letter. See supra note 7. The SSB Letter stated that it agreed 
generally with the comments expressed in the Morgan/Goldman Letter.
    \16\ CME Letter, supra note 8.
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Market Maker Exclusion

    All of the comments expressed concern with the proposed market 
maker exclusion. In particular, the commenters objected to the 
provision that would allow members to qualify for the market maker 
exclusion based on the amount of revenue they derive from trading 
listed financial derivatives and underlying instruments. Six comments 
expressed the view that this test was inconsistent with the guidelines 
provided by the Commission and the CFTC,\17\ and six comments 
maintained that the proposed revenue requirement was not consistent 
with the margin requirements for comparable exchange-traded options and 
therefore did not satisfy the requirements of section 7(c)(2) of the 
Act.\18\ Commenters argued that the revenue test would allow members to 
qualify for the market maker exclusion without actually providing 
liquidity to the market for security futures.\19\ Other commenters 
contended that the revenue test would increase systemic risk in the 
marketplace for security futures, and therefore did not satisfy section 
7(c)(2) of the Act, by allowing an excessively high number of market 
professionals to trade security futures with reduced margin 
requirements.\20\
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    \17\ NASD Letter, Morgan/Goldman Letter, NQLX Letter, NYSE 
Letter, Nasdaq Letter, SSB Letter, and Amex Letter.
    \18\ PCX Letter, NASD Letter, ISE Letter, Amex Letter, Morgan/
Goldman Letter, and SSB Letter.
    \19\ PCX Letter, ISE Letter, and NQLX Letter, Morgan/Goldman 
Letter.
    \20\ Morgan/Goldman Letter, NASD Letter, SSB Letter.
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    In response to the commenters' concerns, CME stated that it had 
modified the tests that a CME member must satisfy in order to qualify 
for the market maker exclusion by eliminating the test based on revenue 
and revising the test based on trading activity. CME also stated that 
the futures industry tends to rely upon ``local traders'' acting as 
individual entrepreneurs as a primary source of liquidity, and that 
these local traders are typically not obligated to participate or 
otherwise be tied to a specific marketplace during the course of the 
trading day. In addition, CME stated that electronic trading systems 
developed to support futures trading have been developed to parallel 
open outcry trading practices, under which local traders may be 
physically unable to voice a bid and an offer simultaneously or to 
voice either a bid or offer continuously throughout the entire trading 
day on each and every trading day. CME maintained that, as a result, 
electronic futures trading systems may not necessarily support features 
such as request for quotes or the entry of two-sided quotations.
    CME expressed the view that the first and second revised tests are 
substantively identical to tests that the Commission approved for 
Nasdaq Liffe Markets.\21\ In addition, CME maintained that the third 
revised test is crafted to reflect the realities of the its electronic 
trading platform, as well as the fact that a number of CME's floor 
traders and floor brokers are individual entrepreneurs who cannot 
physically represent themselves in the market at all times on all 
trading days. Finally, CME stated that it requested that the third 
revised test of its market maker exclusion in proposed Rule 
930.B.2.b.(3) be adopted on a six-month pilot basis, subject to public 
comment and subsequent approval by the Commission so that there would 
be an opportunity for the study of the effects and implications of the 
test before it is adopted on a permanent basis.
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    \21\ See Securities Exchange Act Release No. 46771 (November 5, 
2002).
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    In addition, two comments expressed the view that the proposed 
market maker exclusion would encourage imprudent risk taking, 
speculation, and leverage because there would be no net capital 
requirements imposed either on a floor broker that qualifies for the 
market maker exclusion or on its carrying broker-dealer or FCM.\22\ The 
commenters' concern is that the regulatory capital requirements for 
certain security futures market participants is inadequate. Moreover, 
those commenters expressed concern that in the event of a bankruptcy of 
a carrying firm, a bankruptcy receiver or trustee would pay out to the 
floor broker a pro rata share of the available pool of assets on the 
same terms as customers, notwithstanding that the floor broker was not 
required to post customer margin.
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    \22\ Morgan/Goldman Letter and SSB Letter.
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    The Commission believes that the determination of what amount of 
capital is sufficient for a market participant is within the purview of 
the participant's primary regulator and does not believe that it would 
be appropriate to require CME's margin rules to address these

[[Page 69276]]

concerns indirectly. In addition, the Commission believes that any 
concerns regarding a market maker's share of a customer's estate in a 
bankruptcy proceeding would be more properly addressed by changes to 
the insolvency regime applicable to those market participants.
    Finally, one commenter expressed concern with the fact that certain 
aspects of the margin rules would apply to positions carried in 
securities accounts. One commenter objected to the proposal to adopt 
margin levels for offsetting positions that only may be held in 
securities accounts even though its rules only apply to positions in 
futures accounts because the proposal gave the impression that those 
offsets were permitted to be carried in a futures account.\23\ The 
Commission reiterates that because any offset that includes a security 
(other than a security future) must be carried in a securities account, 
CME's rule applies only to those offsetting positions that may be 
carried in a futures account (i.e., offsets that do not include 
securities other than security futures). In addition, the Commission 
emphasizes that approval of the proposed rule change does not affect 
the applicability of the rules of another self-regulatory organization 
to its members.
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    \23\ NQLX Letter.
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III. Discussion

    Under section 19(b)(2) of the Act, the Commission is directed to 
approve the proposed rule change if it finds that it is consistent with 
the requirements of the Act and the rules and the rules and regulations 
thereunder applicable to a national securities exchange.\24\ Section 
6(b)(5) of the Act \25\ requires, among other things, that the rules of 
a national securities exchange be designed to promote just and 
equitable principles of trade and, in general, to protect investors and 
the public interest.\26\ In addition, section 7(c)(2)(B) of the Act 
\27\ provides, among other things, that the margin rules for security 
futures must preserve the financial integrity of markets trading 
security futures, prevent systemic risk, and be consistent with the 
margin requirements for comparable exchange-traded options. Section 
7(c)(2)(B) also provides that the margin levels for security futures 
may be no lower than the lowest level of margin, exclusive of premium, 
required for any comparable exchange-traded option. For the reasons 
discussed below, after careful review and consideration of the 
commenters' views, the Commission finds that the rule change is 
consistent with CME's obligations under the Act and the rules and 
regulations thereunder.
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    \24\ 15 U.S.C. 78s(b)(2).
    \25\ 15 U.S.C. 78f(b)(5).
    \26\ In approving this rule change, the Commission has 
considered its impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78o-3(b)(9).
    \27\ 15 U.S.C. 78g(c)(2)(B).
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    The Commission believes that the rule change is generally 
consistent with the customer margin rules for security futures adopted 
by the Commission and the CFTC. In particular, the Commission notes 
that, consistent with Rule 403 under the Act, CME's proposed rule 
provides for a minimum margin level of 20% of current market value for 
all positions in security futures. The Commission believes that 20% is 
the minimum margin level necessary to satisfy the requirements of 
section 7(c)(2)(B) of the Act. Rule 403 under the Act \28\ also 
provides that a national securities exchange may set margin levels 
lower than 20% of the current market value of the security future for 
an offsetting position involving security futures and related 
positions, provided that an exchange's margin levels for offsetting 
positions meet the criteria set forth in section 7(c)(2)(B) of the Act. 
The offsets proposed by CME are consistent with the strategy-based 
offsets permitted for comparable offset positions involving exchange-
traded options and therefore consistent with Section 7(c)(2)(B) of the 
Act.
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    \28\ 17 CFR 240.403(b)(2).
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    Finally, the Commission believes that the standards for CME's 
market maker exclusion, as amended by Amendment No. 2, are consistent 
with the Act, and Rule 400(c)(2)(v) thereunder.\29\ Specifically, the 
Commissions' margin rules do not apply to a member of a national 
securities exchange that is registered with such exchange as a 
``security futures dealer'' pursuant to exchange rules that must meet 
several criteria, including a requirement that a security futures 
dealer be required ``to hold itself out as being willing to buy and 
sell security futures for its own account on a regular or continuous 
basis.'' The Commission believes that the affirmative obligations 
required by CME Rule 930.B.2.b satisfy this requirement.
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    \29\ 17 CFR 200.400(c)(2)(v).
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IV. Accelerated Approval of Amendment No. 2

    CME has asked the Commission to approve Amendment No. 2 to the 
proposed rule change prior to the thirtieth day after the date of 
publication of notice of the filing. Amendment No. 2 modifies CME's 
market maker exclusion. Specifically, Amendment No. 2 modifies the 
trading obligations that market maker must meet to qualify for the 
exclusion. The amendments to the trading obligations are in response to 
the commenters' concerns, and clarify the minimum trading requirements 
imposed on market makers in order to satisfy the requirement of the 
exclusion that a market maker hold itself out as being willing to buy 
and sell security futures for its own account on a regular or 
continuous basis. CME has also requested that the Commission approve 
the revised test in CME Rule 930.B.2.b.(3) as a pilot program for six 
months beginning on the date of this order.
    The Commission finds good cause for approving the proposed rule 
change, as amended, prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register. The 
Commission believes that accelerated approval of the proposed rule 
change should enable CME to begin trading security futures from the 
outset of security futures trading.\30\ In addition, the Commission 
believes that granting accelerated approval to Amendment No. 2 thereto 
should clarify the obligations that CME members must meet in order to 
qualify for the market maker exclusion from the margin requirements. In 
addition, the Commission notes that certain of the modifications to the 
trading obligations of the market maker exclusion set forth in 
Amendment No. 2 will take effect as a temporary pilot to give members 
of the public an opportunity to comment on the substance of those 
aspects of Amendment No. 2 before CME requests permanent approval. 
Accordingly, the Commission believes that there is good cause, 
consistent with section 19(b) of the Act, to approve Amendment No. 2 to 
the proposed rule change on an accelerated basis.
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    \30\ The Commission understands that trading in security futures 
is scheduled to begin on November 8, 2002.
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether Amendment No. 2 
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

[[Page 69277]]

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 
Exchange. All submissions should refer to File No. SR-CME-2002-01 and 
should be submitted by December 6, 2002.

VI. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\31\ that the proposed rule change, as amended, (File No. SR-CME-
2002-01) be, and hereby is, approved, provided, however, that CME Rule 
930.B.2.b.(3) is approved until May 7, 2003.
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    \31\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\32\
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    \32\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 02-28988 Filed 11-14-02; 8:45 am]
BILLING CODE 8010-01-P