[Federal Register Volume 68, Number 169 (Tuesday, September 2, 2003)]
[Notices]
[Pages 52257-52259]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-22236]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48405; File No. SR-ISE-2003-05]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment No. 1 by the International Securities Exchange, 
Inc. Relating to the Establishment of Trading Rules for Index Options 
and Generic Listing and Maintenance Standards for Narrow-Based Index 
Options

August 25, 2003.

I. Introduction

    On February 24, 2003, the International Securities Exchange, Inc. 
(``ISE'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``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 to enable the ISE to trade index 
options on the Exchange. The ISE filed Amendment No. 1 to the proposed 
rule change on April 17, 2003.\3\ The proposed rule change, as amended, 
was published for comment in the Federal Register on May 2, 2003.\4\ 
The Commission received no comments on the proposal. This order 
approves 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\ See letter from Katherine Simmons, Vice President and 
Associate General Counsel, ISE to Florence Harmon, Senior Special 
Counsel, Division of Market Regulation, Commission, dated April 16, 
2003. In Amendment No. 1, the ISE submitted a new Form 19b-4, which 
replaced the original filing in its entirety.
    \4\ See Securities Exchange Act Release No. 47749 (April 25, 
2003), 68 FR 13348.
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II. Description of the Proposal

A. Introduction

    The ISE proposes to establish trading rules to enable Members to 
trade index options on the Exchange. In addition, the ISE proposes to 
establish generic listing standards and maintenance standards for 
``narrow-based'' index options pursuant to Rule 19b-4(e) under the 
Act.\5\ The ISE represents that all of the proposed new Exchange Rules 
and changes to existing Exchange Rules are based on the existing rules 
of the other four options exchanges.\6\ Many of the new trading rules 
and generic listing standards will comprise the new Chapter 20 in the 
ISE Rules.
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    \5\ 17 CFR 240.19b-4(e). The term ``narrow-based index'' is 
defined as an index designed to be representative of a particular 
industry or a group of related industries. See Proposed ISE Rule 
2001(i). Narrow-based indices listed and traded on the ISE pursuant 
to generic listing and maintenance standards, among other 
characteristics, must consist of ten or more component securities. 
See Proposed ISE Rule 2002(b)(2).
    \6\ See, e.g., CBOE Rules 4.11, 4.16, 6.2, 6.7, 8.7, 11.1, 
15.10, and 24.1 through 24.20, PCX Rules 7.11 and 13.2, Amex Rule 
905C, and Phlx Rule 1033A.
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B. Index Options Trading Rules

    The proposed rules, among other things, establish general rules 
that will govern the trading sessions for index options, including the 
days and hours of business, the rules governing trading rotations at 
the opening, and the rules related to the trading halts or 
suspensions.\7\ The proposed rules further provide for the procedures 
Members must follow with respect to the exercise of American-style, 
cash settled index options.\8\ The proposed rules also provide for 
position limit and

[[Page 52258]]

exercise limits for index options.\9\ In addition, the proposed rules 
provide for exemption standards from position limits and procedures for 
requesting exemptions from those proposed rules.\10\ The proposed 
position limits and exercise limits, as well as the proposed 
exemptions, are different for broad-based index options and narrow-
based index options.\11\ The proposed rules establish standards for 
when a member seeking to sell short a Nasdaq NMS security included in 
an index underlying an index option listed and traded on the Exchange 
is exempt from the NASD short sale rule.\12\
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    \7\ See Proposed ISE Rule 2008.
    \8\ See Proposed ISE Rule 418(a)(3) and 1100(h).
    \9\ See Proposed ISE Rules 2004, 2005, and 2007.
    \10\ See Proposed ISE Rule 2006.
    \11\ See Proposed ISE Rules 2004 to 2007.
    \12\ See Proposed ISE Rule 1407(d)(1)(ii).
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C. Generic Listing Standards and Maintenance Standards for Narrow-Based 
Index Options

    The ISE further proposes to establish generic listing and 
maintenance standards in Proposed ISE Rule 2002 to enable the Exchange 
to list and trade new narrow-based index options pursuant to Rule 19b-
4(e) under the Act.\13\ Proposed ISE Rule 2002 addresses both initial 
listing and maintenance standards for narrow-based index options.\14\ 
The generic listing and maintenance standards are modeled after 
standards that the Commission originally approved for streamlined 
listing and trading pursuant to Section 19(b)(3)(A) of the Act.\15\ The 
options exchange subsequently filed proposed rule changes with the 
Commission to eliminate the Section 19(b)(3)(A) rule filing requirement 
from their existing SRO rules, after the Commission indicated that 
products meeting the listing criteria approved by the Commission in its 
1994 Generic Narrow-Based Index Options Approval Order qualified for 
filing pursuant to Rule 19b-4(e) under the Act.\16\
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    \13\ 17 CFR 240.19b-4(e). Rule 19b-4(e) provides that the 
listing and trading of a new derivative securities product by a 
self-regulatory organization (``SRO'') shall not be deemed a 
proposed rule change, pursuant to paragraph (c)(1) of Rule 19b-4, if 
the Commission has approved, pursuant to Section 19(b) of the Act, 
the SRO's trading rules, procedures, and listing standards for the 
product class that includes the new derivative securities product 
and the SRO has a surveillance program for the product class. When 
relying on Rule 19b-4(e), the SRO must submit Form 19b-4(e) to the 
Commission within five business days after the exchange begins 
trading the new derivative securities products. See Securities 
Exchange Act Release No. 40761 (December 8, 1998), 63 FR 70952 
(December 22, 1998) (File No. S7-13-98).
    \14\ The proposed generic listing standards approved herein do 
not apply to the listing of options on broad-based indices.
    \15\ In 1994, the Commission approved a proposed rule change 
submitted by the American Stock Exchange, Inc. (``Amex''), the 
Chicago Board Options Exchange, Inc. (``CBOE''), the New York Stock 
Exchange, Inc. (``NYSE''), the Pacific Stock Exchange, Inc. 
(``PSE''), and the Philadelphia Stock Exchange, Inc. (``Phlx'') 
(collectively the ``options exchanges''), which permitted the 
options exchanges to list and trade options on narrow-based indexes 
thirty days after submitting a filing pursuant to Section 
19(b)(3)(A) of the Act. The Commission found that such filings would 
constitute a stated policy, practice, or interpretation with respect 
to the administration of an existing Exchange rule, pursuant to 
Section 19(b)(3)(A) of the Act, relieving the Exchange of the former 
requirement of obtaining specific Commission approval of such 
narrow-based index options pursuant to Section 19(b)(2) of the Act. 
See Securities Exchange Act Release No. 34157 (June 3, 1994), 59 FR 
30622 (June 10, 1994) (SR-Amex-92-35) (SR-CBOE-93-59) (SR-NYSE-94-
17) (SR-PSE-94-07) and (SR-Phlx-94-10) (the ``1994 Generic Narrow-
Based Index Options Approval Order'').
    \16\ See Securities Exchange Act Release No. 40761 (December 8, 
1998), 63 FR 70952 (December 22, 1998) (File No. S7-13-98).
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    Notwithstanding the generic listing standards for options on 
narrow-based indexes, the Exchange will need to file additional 
proposed rule changes with the Commission when the Exchange identifies 
specific products because the rules related to trading options on 
indices are product specific in many areas. For purposes of this 
proposed rule change, certain rules indicate that they apply to 
``specified'' indices. ISE Rules 2001(l), 2004(a), 2006(a), 2007(a), 
2009, and 2011 all contain provisions that are dependant upon the 
Exchange identifying specific index products in the rule. Accordingly, 
proposed ISE Rule 2000 states that where the rules in Chapter 20 
indicate that particular indices or requirements with respect to 
particular indices will be ``Specified,'' the ISE shall file a proposed 
rule change with the Commission pursuant to section 19(b)(1) of the Act 
\17\ and Rule 19b-4 thereunder \18\ to specify such indices or 
requirements.
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    \17\ See note 1 supra.
    \18\ See note 2 supra.
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III. Commission Findings and Order Granting Approval of the Proposed 
Rule Change

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of section 
6(b)(5) of the Act \19\ and the rules and regulations thereunder 
applicable to a national securities exchange.\20\ The Commission 
believes that the ISE's proposal to establish trading rules and 
procedures applicable to index options and establish generic listing 
and maintenance standards for narrow-based index options strikes a 
reasonable balance between the Commission's mandates under section 
6(b)(5) of the Act \21\ to remove impediments to and perfect the 
mechanisms of a free and open market and a national market system while 
protecting investors and the public interest.
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    \19\ 15 U.S.C. 78f(b)(5).
    \20\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \21\ See note 19 supra.
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A. Index Options Trading Rules

    The Commission believes that trading options on an index of 
securities (including a narrow-based index) permits investors to 
participate in the price movements of the index's underlying securities 
and allows investors holding positions in some or all of such 
securities to hedge the risks associated with their portfolios. The 
Commission further believes that trading options on an index provides 
investors with an important trading and hedging mechanism that is 
designed to reflect accurately the overall movement of the component 
stocks. In making this finding the Commission notes that all of the 
proposed new Exchange Rules and changes to existing Exchange Rules are 
based on the existing rules of the other four options exchanges.\22\
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    \22\ See, e.g., CBOE Rules 4.11, 4.16, 6.2, 6.7, 8.7, 11.1, 
15.10, and 24.1 through 24.20, PCX Rules 7.11 and 13.2, Amex Rule 
905C, and Phlx Rule 1033A.
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B. Generic Listing and Maintenance Standards for Narrow-Based Index 
Options

    In approving the generic listing and maintenance standards for 
narrow-based index options, the Commission considered the structure of 
these securities, their usefulness to investors and to the markets and 
the ISE rules that govern their trading. The proposal to establish 
generic standards for narrow-based index options should reduce the 
ISE's regulatory burden, as well as benefit the public interest, by 
enabling the ISE to bring qualifying products to the market more 
quickly. Furthermore, the Commission notes that it has previously 
approved similar proposals by the Amex, CBOE, NYSE, PSE, and the Phlx 
to establish generic listing and maintenance standards for narrow-based 
index options.\23\
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    \23\ See note 15 supra.
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    The Commission finds that adopting generic listing and maintenance 
standards for these securities and applying Rule 19b-4(e) should 
fulfill the intended objective of that rule by allowing those index 
option products that satisfy the generic standards to start trading, 
without the need for notice and comment and Commission approval. The 
Exchange's ability to rely on Rule 19b-4(e) for these products 
potentially reduces the time frame for listing and

[[Page 52259]]

trading these securities, and thus enhances investors' opportunities. 
The Exchange, however, must maintain regulatory oversight over any 
products listed under the generic listing standards through adequate 
surveillance. ISE represents that its surveillance procedures are 
sufficient to detect fraudulent trading among members in the trading of 
narrow-based index options pursuant to the generic listing and 
maintenance standards. The Commission believes that these surveillance 
procedures are adequate to address concerns associated with listing and 
trading of the narrow-based index options.
    The Commission believes that the listing and maintenance standards 
set forth herein are consistent with the listing and maintenance 
standards for narrow-based index options that the Amex, CBOE, PCX and 
the Phlx have developed and are reasonably designed to ensure the 
protection of investors and the public interest. Specifically, the 
Commission finds that the generic standards covering minimum 
capitalization, monthly trading volume, and relative weightings of 
component stocks are designed to ensure that the trading markets for 
component stocks are adequately capitalized and sufficiently liquid, 
and that no one stock or stock group dominates the index. Thus, the 
Commission believes that the satisfaction of these requirements 
significantly minimizes the potential for manipulation of the index.
    Two other important requirements included in the proposal are that 
at least 90 percent of the component securities, by weight, and 80 
percent of the total number of component securities, must be eligible 
individually for options trading, and that no more than 20 percent of 
the weight of the index may be comprised of ADRs that are not subject 
to a comprehensive surveillance sharing agreement. The Commission 
believes that these standards are necessary to ensure that index 
options are not used as surrogate instruments to trade options on 
stocks and/or ADRs that otherwise are not eligible for options trading.
    The Commission also believes that the number of securities required 
to constitute the narrow-based index is large enough to ensure that an 
index is not created for the purpose of obtaining more favorable 
regulatory treatment, e.g., with respect to position and exercise 
limits, as compared with the trading of options in the underlying 
stocks.
    The Commission also finds the requirements that all securities 
comprising the index be ``reported securities,'' as defined in Rule 
11Aa3-1 under the Act,\24\ and that the index value be disseminated at 
least once every 15 seconds during trading hours of the index, will 
contribute significantly to the transparency of the market for such 
index options. The Commission further believes that basing the 
settlement value of expiring index options upon the opening prices of 
the component securities on the primary market on which they are listed 
and traded may help contain the volatility of related markets upon 
their expiration.
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    \24\ 17 CFR 240.11Aa3-1.
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    The Commission further notes that ISE's rules that are applicable 
to narrow-based index options, including provisions addressing sales 
practices, floor trading procedures, position and exercise limits, 
margin requirements, and trading halts and suspensions, will continue 
to apply to any narrow-based index listed pursuant Rule 19b-4(e) under 
the Act.
    The Commission believes that a surveillance sharing agreement 
between an Exchange proposing to list a stock index derivative product 
and the exchange(s) trading the stocks underlying the derivative 
product is an important measure for surveillance of the derivative and 
underlying securities markets. The Commission believes that such 
agreements ensure the availability of information necessary to detect 
and deter potential manipulations and other trading abuses, thereby 
making the stock index product less readily susceptible to 
manipulation. When a new derivative securities product based upon 
domestic securities is listed and traded on an exchange pursuant to 
Rule 19b-4(e) under the Act, the exchange should determine that the 
markets upon which all of the U.S. component securities trade are 
members of the Intermarket Surveillance Group (``ISG''),\25\ which 
provides information relevant to the surveillance of the trading of 
securities on other market centers.\26\ In this regard, all of the 
registered national securities exchanges, including the ISE, as well as 
the National Association of Securities Dealers, Inc. (``NASD''), are 
members of the ISG.
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    \25\ ISG was formed on July 14, 1983, to, among other things, 
coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets.
    \26\ See Securities Exchange Act Release No. 40761 (December 8, 
1998), 63 FR 70952 (December 22, 1998) (File No. S7-13-98).
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    For new derivative securities products based on securities from a 
foreign market, the SRO should have a comprehensive Intermarket 
Surveillance Agreement with the market for the securities underlying 
the new securities product.\27\ Accordingly, the Commission finds that 
the requirement that no more than 20 percent of the weight of the index 
may be comprised of ADRs that are not subject to a comprehensive 
surveillance sharing agreement between the particular U.S. exchange and 
the primary market of the underlying security will continue to ensure 
that the Exchanges have the ability to adequately surveil trading in 
the narrow-based index options and the ADR components of the index.
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    \27\ Id.
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IV. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\28\ that the proposed rule change, as amended, (File No. SR-ISE-
2003-05) be, and it hereby is approved.
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    \28\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\29\
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    \29\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-22236 Filed 8-29-03; 8:45 am]
BILLING CODE 8010-01-P