[Federal Register Volume 68, Number 240 (Monday, December 15, 2003)]
[Notices]
[Pages 69753-69758]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-30837]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48884; File No. SR-PHLX-2003-66]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment Nos. 1 and 2 and Notice of Filing Order Granting 
Accelerated Approval to Amendment No. 3 by the Philadelphia Stock 
Exchange, Inc., Relating to the Listing and Trading of Options on the 
Nasdaq Composite Index[reg]

December 5, 2003.

I. Introduction

    On September 29, 2003, the Philadelphia Stock Exchange, Inc. 
(``PHLX'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposal to list and trade cash-settled, European-
style options on the Nasdaq Composite Index[reg] (the ``Nasdaq 
Composite Index'' or ``Index''), a capitalization-weighted, A.M.-
settled index comprised of approximately 3,400 stocks listed and traded 
on The Nasdaq Stock Market, Inc. (``Nasdaq''). The PHLX filed Amendment 
Nos. 1 and 2 to the proposal on October 17, 2003.\3\ and filed 
Amendment No. 3 to the proposal on November 13, 2003.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Mark I. Salvacion, Director and Counsel, 
PHLX, to Kelly Riley, Senior Special Counsel, Division of Market 
Regulation (``Division''), Commission, dated October 17, 2003 
(``Amendment No. 1''); and letter from Mark I. Salvacion, Director 
and Counsel, PHLX, to Yvonne Fraticelli, Special Counsel, Division, 
Commission, dated October 17, 2003 (``Amendment No. 2''). In 
Amendments No. 1, the PHLX revises the position and exercise limits 
for the proposed options. In Amendments No. 2, the PHLX proposes to 
list mini-FLEX options on the Nasdaq Composite Index and provides an 
example of how the proposed mini-FLEX options could be used.
    \4\ See letter from Mark I. Salvacion, Director and Counsel, 
PHLX, to Kelly Riley, Senior Special Counsel, Division. Commission, 
dated November 12, 2003 (``Amendment No. 3''). In Amendment No. 3, 
the PHLX represents that the PHLX will notify the staff of the 
Commission if: (1) Less than 80% of the weight of the Index is 
options eligible; (2) 10% of the weight of the Index is represented 
by stocks trading less than 20,000 shares per day; or (3) the 
largest component of the Index comprises 15% of the weight of the 
Index, or the top five components comprise 50% of the weight of the 
Index.
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    The proposed rule change and Amendment Nos. 1 and 2 were published 
for comment in the Federal Register on October 24, 2003.\5\ The 
Commission received two comment letters regarding the proposal.\6\ On 
November 21, 2003, the PHLX submitted a letter responding to the issues 
raised in the comment letters.\7\ This order approves the proposed rule 
change, as amended. In addition, the Commission is publishing notice to 
solicit comments on and is simultaneously approving, on an accelerated 
basis, Amendment No. 3.
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    \5\ See Securities Exchange Act Release No. 48663 (October 20, 
2003), 68 FR 61029.
    \6\ See letter from Kathryn L. Beck, Senior Vice President, 
General Counsel, Corporate Secretary, and Chief Regulatory Officer, 
Pacific Exchange, Inc. (``PCX''), to Margaret H. McFarland, Deputy 
Secretary, Commission, dated October 24, 2003 (``PCX Letter''); and 
letter from Michael J. Simon, Senior Vice President and Secretary, 
International Securities Exchange, Inc. (``ISE''), to Jonathan G. 
Katz, Secretary, Commission, dated November 10, 2003 (``ISE 
Letter'').
    \7\ See letter from Mark Salvacion, Director and Counsel, PHLX, 
to Kelly Riley, Senior Special Counsel, Division, Commission, dated 
November 21, 2003 (``PHLX Letter'').
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II. Description of the Proposal

    The PHLX proposes to list and trade cash-settled options on the 
Index. In addition trading full-size options on the Index (``Full-Size 
Index Options''), the PHLX proposes to trade mini Index options that 
are \1/10\th the size of Full-Size Index Options (``Mini Index 
Options''), Flexible Exchange Index (``FLEX[reg]'') options on the 
Index (``FLEX Index Options''), and mini-FLEX Index Options (``Mini-
Flex Index Options'') (the Full-Size Index Options, Mini Index Options, 
FLEX Index Options, and Mini-Flex Index Options may be referred to, 
collectively, as the ``Index Options'').\8\ The PHLX will trade the 
Index Options pursuant to current PHLX rules governing the trading of 
index options.\9\ The PHLX's current rules applicable to the trading of 
FLEX index options, including the requirement that the minimum size of 
a Request-for-Quote (``RFQ'') be $10

[[Page 69754]]

million, will apply to Mini-Flex Index Options.\10\
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    \8\ The Full-Size Index Options and the Mini Index Options will 
feature European-style exercise. The FLEX Index Options and the 
Mini-Flex Index Options may feature American-style exercise or 
European-style exercise. See PHLX Rule 1079(a)(5).
    \9\ See, particularly, PHLX Rules 1000A through 1102A (Rules 
Applicable to Trading of Options on Indices) and, generally, PHLX 
Rules 1000 through 1090 (Options Rules of the PHLX).
    \10\ Telephone conversation between Kelly Riley, Senior Special 
Counsel, Division, Commission, and Mark Salvacion, Director and 
Counsel, PHLX, on November 25, 2003.
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Composition of the Index

    The Index is a capitalization-weighted index comprised of 
approximately 3,400 stocks listed and traded on Nasdaq. The Index 
includes Nasdaq National Market and Nasdaq SmallCap Market securities. 
To be eligible for inclusion in the Index, a security must be listed on 
Nasdaq and must be one of the following types of securities: an 
American Depositary Receipt (``ADR''), common stock, ordinary share, 
real estate investment trust (``REIT''), share of beneficial interest, 
of tracking stock. The Index is comprised of all of the foreign and 
domestic ADRs, common stocks, ordinary shares, REITs, shares of 
beneficial interest, and tracking stocks listed on Nasdaq. Convertible 
debentures, preferred stocks, rights, warrants, units, closed-end 
funds, exchange-traded funds (``ETFs''), and derivative securities are 
not included in the Index.
    The Index includes most of the stocks listed and traded on the 
Nasdaq SmallCap Market. Nasdaq SmallCap Market securities are 
``reported securities'' for purposes of Rule 11Aa3-1 under the Act.\11\ 
According to the PHLX, Nasdaq SmallCap Market stocks comprised 1.3% of 
the capitalization of the Index as of July 31, 2003.
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    \11\ See 17 CFR 240.11Aa3-1. A ``reported security'' is defined 
in Rule 11Aa3-1(a)(4) under the Act as ``any listed equity security 
or Nasdaq security for which transaction reports are required to be 
made on a real-time basis pursuant to an effective transaction 
reporting plan.'' In 2001, the Commission approved the extension of 
the Joint Self-Regulatory Organization Plan Governing the 
Collection, Consolidation and Dissemination of Quotation and 
Transaction Information for Nasdaq Listed Securities Traded on 
Exchanges on an Unlisted Trading Privileges Basis (``Nasdaq UTP 
Plan'') to include Nasdaq SmallCap Market securities. Accordingly, 
Nasdaq SmallCap Market securities became securities reported 
pursuant to an effective transaction reporting plan approved by the 
Commission.
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    The Index includes ten industry groups. As of July 31, 2003, the 
top five industry groups and their weights in the Index were: (1) 
computer software and hardware, 52%; (2) healthcare, 14%; (3) 
financials, 11%; (4) consumer discretionary, 8%; and (5) 
telecommunications and media, 6%.
    As of July 31, 2003, the capitalization of the Index's components 
ranged from $284 billion to $55,000,\12\ and the market capitalization 
of the Index totaled $2.6 trillion. The largest Index component 
accounted for 11.12% of the weight of the Index and the smallest 
component accounted for less than 1% of the weight of the Index. The 
median capitalization of the Index's components was $110 million.
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    \12\ For companies that list American Depositary Shares, these 
values represent only the value of the outstanding American 
Depositary Shares and not the global market capitalization of the 
issuer, which is the basis for listing on Nasdaq. Nasdaq's minimum 
listing and maintenance standard for global market capitalization is 
$50 million.
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    During the period from January 1, 2003, through July 31, 2003, the 
average daily trading volume of the component securities representing 
95% of the weight of the Index was 850,000 shares, and the average 
daily trading volume for all of the Index's components was 485,000 
shares. The top 100 components accounted for 64% of the weight of the 
Index and the bottom 100 stocks accounted for 0.01% of the weight of 
the Index. The prices of the Index's components ranged from $0.11 per 
share to $780.00 per share. The average share price was $14.15. The 
share outstanding for each of the Index's components ranged from 10,000 
shares to 11 billion shares, with an average of 43 million shares 
outstanding. According to the PHLX, options eligible securities 
represented 95% of the weight of the Index.

Calculation of the Index

    The value of the Index equals the aggregate value of the Total 
Shares Outstanding (``TSO'') of each Index component security 
multiplied by each security's respective price on Nasdaq, divided by 
the Adjusted Base Period Market (``ABPMV''), and multiplied by the Base 
Value. The Index began on February 5, 1971, at a Base Value of 100.00.
    The Index is disseminated every 15 seconds through the Nasdaq Index 
Dissemination Services SM (``NIDS'') during normal Nasdaq 
trading hours (9:30 a.m. to 4:00 p.m. ET).\13\ According to the PHLX, 
all major market data vendors carry the NIDS data feed.
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    \13\ NIDS is a Nasdaq data feed carrying intra-day index values 
and valuation data for ETFs listed on Nasdaq.
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    The Index is calculated using Nasdaq prices (not consolidated) 
during the day and the Nasdaq Official Closing Price (``NOCP'') for the 
close.\14\ Although the Index is calculated until 4:00 p.m. ET, the 
Index's closing value may change up until 5:15 p.m. ET due to changes 
or corrections to the last sale in the Index's component securities.
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    \14\ See Securities Exchange Act Release No. 47517 (March 18, 
2003), 68 FR 14446 (March 25, 2003) (File No. SR-NASD-2002-158) 
(approving the establishment of the NOCP).
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Maintenance

    Nasdaq will maintain the Index, and the PHLX represented that it 
will not influence any Nasdaq decisions concerning maintenance of the 
Index.
    An Index-eligible security (either an initial public offering or a 
seasoned security) is added to the Index on the business day 
immediately after a last sale is established (usually day two of 
listing on Nasdaq). A component security that is no longer traded on 
Nasdaq or no longer meets the security-type eligibility criteria is 
removed from the Index. The Index is updated on a daily basis and there 
is no periodic rebalancing of Index components.
    Changes in the number of shares outstanding driven by corporate 
events, including stock dividends, splits, and certain spin-offs and 
rights issuances are adjusted on the ex-date. A change in the TSO 
arising from other corporate actions including secondary offerings, 
stock repurchases, conversions, and acquisitions is ordinarily made to 
the Index on the evening prior to the effective date of the corporate 
action or as soon as practicable thereafter. Changes are made after the 
market close and are reflected on http://www.nasdaqtrader.com/asp/nasdaqcomp.asp the following morning.
    To ensure that there is no discontinuity in the value of the Index, 
Nasdaq ordinarily adjusts the ABPMV when there is a change in a 
component security's TSO, a component addition or deletion, or changes 
due to certain spin-offs and rights offerings.
    Although the PHLX is not involved in the maintenance of the Index, 
it has represented that it will monitor the Index on a semi-annual 
basis and will notify Commission staff if and when: (1) 10% of the 
capitalization of the Index comprises securities with a market 
capitalization of less than $100 million; (2) 10% of the capitalization 
of the Index is made up of components with an average daily trading 
volume of less than 10,000 shares over the previous six months; (3) 
less than 80% of the weight of the Index is options eligible; (4) 10% 
of the weight of the Index is represented by stocks trading less than 
20,000 shares per day; or (5) the largest component of the Index 
comprises 15% of the weight of the Index, or the top five components 
comprise 50% of the weight of the Index.\15\ According to the PHLX, as 
of July 31, 2003, component securities representing 2.56% of the 
capitalization of the Index had market capitalizations

[[Page 69755]]

of less than $100 million, and securities representing 2.19% of the 
capitalization of the Index had average daily trading volumes of less 
than 10,000 shares over the previous six months.
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    \15\ See Amendment No. 3, note 4 supra.
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Index Option Trading

    As noted above, the Exchange proposes to trade Full-Size Index 
Options, Mini Index Options, FLEX Index Options, and Mini-Flex Index 
Options. The contract multiplier for Full-Size Index Options will be 
$100 and the contract multiplier for Mini Index Options will be $10. 
Each contract will trade under separate ticker symbols and will not be 
fungible with the other. The size of the underlying Index will remain 
the same for each contract (i.e., Mini Index Options will not overlie a 
separate index calculation reduced by 1/10th) and the PHLX represents 
that it will list similar strikes for each and the settlement values 
will be uniform.
    The Exchange will list strike prices in $5.00 intervals for the 
Index Options. The minimum tick size for series quoted below $3.00 
(i.e., $300 in premium after factoring in the $100 contract multiplier 
for Full-Size Index Options and $30 in premium after factoring in the 
$10 contract multiplier for Mini Index Options) will be $.05 (i.e., 
$5.00 for Full-Size Index Options, and $.50 for Mini Index Options), 
and for the series quoted above $3.00 the minimum tick size will be 
$.10 (i.e. $10.00 for Full-Size Index Options and $1.00 for Mini Index 
Options).
    The PHLX represents that it has adequate system capacity to trade 
the Index Options.\16\ In addition, the PHLX represents that the 
Options Price Reporting Authority (``OPRA'') informed the Exchange that 
trading in the Index Options will have minimal impact on OPRA's current 
quoting capacity.\17\
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    \16\ See letter from Thomas A. Wittman, Senior Vice President, 
Trading Floor Development, PHLX, to Yvonne Fraticelli, Division, 
Commission, dated October 7, 2003.
    \17\ See letter from Joseph P. Corrigan, Executive Director, 
OPRA, to Matthew Holm, Director, PHLX, dated September 16, 2003.
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Settlement of Index Options

    The Full-Size Index Options and Mini Index Options will expire on 
the Saturday following the third Friday of the expiration month.\18\ 
Trading in the expiring contract month will normally cease at 4:15 p.m. 
ET on the immediately preceding Thursday. Nasdaq will calculate the 
exercise settlement value of the Index at option expiration based on 
the volume-weighted opening price (``Nasdaq VWOP'') of the component 
securities in the first four minutes of trading (the ``Extraction 
Period'') on the business day prior to expiration, which normally will 
be a Friday. Each Index component will have a trade extraction history 
independently maintained beginning with the receipt of the first day's 
trade in that issue and continuing for four continuous minutes. Nasdaq 
will record and reflect trade adjustments during the Extraction Period 
for each component until the four-minute window for the last component 
stock closes or 10:30 a.m., whichever is sooner. Nasdaq will then 
calculate the Nasdaq VWOP for each security based on the extracted 
trades and aggregate the Nasdaq VWOPs of the Index's components to 
calculate the Index settlement value. If a stock fails to open for 
trading, the last available price on the stock will be used to 
calculate the Index, as is done for currently listed indexes. A stock 
will be deemed to have failed to open for trading when it does not open 
for trading prior to 10:30 a.m. on such trading day.
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    \18\ Under PHLX Rule 1079(a)(6), a FLEX option on the Index may 
not expire on any day that falls on or within two business days 
prior to or subsequent to an expiration day for a non-FLEX option on 
the Index.
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Surveillance

    To monitor trading in the Index Options, the Exchange will use the 
same surveillance procedures it uses currently for the Exchange's 
sector index options. These procedures include complete access to 
trading activity in the underlying securities. The Intermarket 
Surveillance Group (``ISG'') Agreement, dated July 14, 1983, as 
amended, will be applicable to the trading of the Index Options. 
According to the PHLX, as of July 31, 2003, 315 Index components 
representing 3.27% of the weight of the Index are the securities of 
entities incorporated outside the United States. Of those securities, 
only 125, or 0.64% of the capitalization of the Index, are the 
securities of companies incorporated in countries whose domestic equity 
exchange is not a member of ISG.

Position Limits

    The PHLX proposes to amend PHLX Rule 1001A, ``Position Limits,'' to 
establish position limits of 50,000 contracts for Full-Size Index 
Options, with 30,000 contracts in the nearest expiration month, and 
500,000 contracts for Mini Index Options on either side of the market, 
with 300,000 contracts total in the nearest expiration month. Exercise 
limits will be set at the same level as position limits. The proposed 
amendment to PHLX Rule 1001A will require that the position limits in 
Full-Size Index Options and Mini Index Options be aggregated for the 
purpose of determining compliance with position and exercise limits. 
The PHLX proposes to establish the position limit of the index hedge 
exemption at 150,000 contracts for Full-Size Index Options and 
1,500,000 contracts for Mini Index Options.
    The Exchange proposes to amend PHLX Rule 1079, ``FLEX Index and 
Equity Options,'' to establish a separate position limit of 50,000 
contracts on the same side of the market for FLEX Index Options, with 
30,000 contracts on the same side of the market in the nearest 
expiration month. For Mini-Flex Index Options, the PHLX proposes to 
establish a position limit of 500,000 contracts on the same side of the 
market, with 300,000 contracts on the same side of the market in the 
nearest expiration month.

III. Summary of Comments

    The Commission received two comment letters \19\ regarding the 
proposal, which raise several concerns with respect to the exclusive 
licensing agreement PHLX entered into with Nasdaq, the Index licensor, 
to list and trade the Index Options.\20\ The commenters maintain that 
the PHLX's proposal fails to explain why, in light of the exclusive 
licensing agreement, the proposal does not impose a burden on 
competition that is not necessary or appropriate in furtherance of the 
purposes of the Act as required in Form 19b-4. One commenter also 
expresses concern that the terms of the exclusive licensing agreement 
could create a conflict between the PHLX's financial interests and its 
obligation to fairly monitor trading in the Index Options, because, 
according to the commenter, the licensing agreement might impose 
financial penalties on the PHLX if trading in the Index Options fails 
to meet specified volume thresholds.\21\ In addition, the commenter 
asserts that the exclusive licensing agreement could lead to order 
routing biases.\22\
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    \19\ See note 6 supra.
    \20\ The Commission notes that ISE specifically stated that it 
did not object to the PHLX's proposal to trade the Index Options. 
See ISE Letter, note 6 supra.
    \21\ See PCX Letter, note 6, supra.
    \22\ See PCX Letter, note 6, supra.
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    In response, the PHLX argues that its exclusive licensing agreement 
with Nasdaq will not inhibit competition.\23\ Specifically, the PHLX 
maintains that the Index Options will compete with other index options 
and other investment products, such as equity options and options on 
ETFs. Further,

[[Page 69756]]

PHLX argued that the Commission should consider comments relating to 
its exclusive licensing agreement in light of other similar investment 
products, such as the Nasdaq 100 Index Tracking Stock, Nasdaq 100 Index 
Tracking Stock options, and the Fidelity Nasdaq Composite Index 
Tracking Stock. PHLX believes that the existence of these similar 
competing products negates the argument that the exclusive licensing 
agreement imposes a burden on competition. In addition, the PHLX states 
that Nasdaq and the PHLX have limited the term of exclusively to three 
years, thereby preserving the PHLX's incentives to promote and 
facilitate the sale of the Index Options while allowing Nasdaq to seek 
other promoters of its intellectual property if the PHLX's performance 
fails to meet expectations. The PHLX believes that its exclusive 
licensing agreement with Nasdaq increases the PHLX's incentive to 
promote the Index Options, which should enhance competition.
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    \23\ See PHLX Letter, note 7, supra.
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    In response to the commenter's concerns about potential conflicts 
of interest, the PHLX argues that the Exchange has no conflict of 
interest because it intends to pass on the licensing fees in pays 
Nasdaq to the specialist to whom the PHLX allocates the Index 
Options.\24\ Because the PHLX will pass on the licensing fees to the 
specialist, the PHLX will not experience any financial penalty as a 
result of a disappointing performance in the licensed product. In 
addition, the PHLX maintains that its executive licensing agreement 
with Nasdaq eliminates any conflict of interest between the PHLX's 
regulatory and financial obligations because the agreement imposes no 
financial penalties of the PHLX if it fails to reach certain volume 
thresholds. The PHLX also states that the exclusing licensing agreement 
provides no incentive for the PHLX to inflate trading volumes 
artifically.
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    \24\ See PHLX Rule 511(b)(ii). According to PHLX, it may 
condition the allocation of an options book on the specialist's 
undertaking to pay the Exchange and/or any third party any amounts 
related to the licensing of the product or any amounts related to 
the use of intellectual property.
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IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange and, in particular, the requirements of Section 
6(b)(5) of the Act.\25\ The Commission finds that the trading of Full-
Size Index Options, Mini Index Options, FLEX Index Options, and Mini-
Flex Options will permit investors to participate in the price 
movements of the securities listed and traded on Nasdaq. The Commission 
also believes that the trading of the Index Options will allow 
investors holding positions in some or all of the securities underlying 
the Index to hedge the risks associated with their portfolios, and that 
the trading of FLEX Index Options and Mini-Flex Index Options will 
provide investors with additional flexiblity in hedging the risks 
associated with holding some or all of the Index's component 
securities.\26\ Accordingly, the Commission believes that Index Options 
will provide investors with an important trading and hedging mechanism. 
By broadening the hedging and investment opportunities of investors, 
the Commission believes that the trading of Index Options will serve to 
protect investors, promote the public interest, and contribute to the 
maintenance of fair and orderly markets.\27\
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    \25\ 15 U.S.C. 78f(b)(5). 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).
    \26\ The Commission previously has approved the listing and 
trading by the PHLX of FLEX equity and index options. See Securities 
Exchange Act Release No. 39549 (January 14, 1998), 63 FR 3601 
(January 23, 1998) (order approving File No. SR-PHLX-96-38) 
(``January 23, 1998'') (order approving File No. SR-PHLX-96-38) 
(``FLEX Order''). The Commission's findings and discussion in the 
FLEX Order with respect to FLEX index options are incorporated by 
reference herein.
    \27\ Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new option or warrant proposal upon a 
finding that the introduction of such new derivative instrument is 
in the public interest. Such a finding would be difficult for a 
derivative instrument that served no hedging or other economic 
function, because any benefits that might be derived by market 
participants likely would be outweighted by the potential for 
manipulation, diminished public confidence in the integrity of the 
markets, and other valid regulatory concerns. In this regard, the 
trading of Index Options will provide investors with a hedging 
vehicle that should reflect the overall movement of the Nasdaq 
market. The Commission also believes that the Index Options will 
provide investors with a means by which to make investment decisions 
in the Nasdaq market, allowing them to establish positions or 
increase positions in Nasdaq market stocks in a cost effective 
manner.
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    The trading of Index Options, however, raises several issues, 
including issues related to index design, customer protection, 
surveillance, and market impact. For the reasons discussed below, the 
Commission believes that the PHLX has adequately addressed these 
issues.

A. Index Design and Structure

    The Commission finds that it is appropriate and consistent with the 
Act to classify the Index as broad-based for purposes of index option 
trading, and therefore appropriate to permit PHLIX rules applicable to 
the trading of broad-based options to apply to the Index Options. 
Specifically, the Commission believes that the Index is broad-based 
because it reflects a substantial segement of the U.S. equities market. 
First, as described more fully above, the Index is comprised of 
approximately 3,400 securities and includes all of the foreign and 
domestic ADRs, common stocks, ordinary shares, REITs, shares of 
beneficial interest, and tracking stocks listed and traded on Nasdaq. 
According to the PHLX, as of July 31, 2003, component securities 
representing 95% of the weight of the Index were options eligible.\28\ 
Second, the Index includes ten industry groups, with the top five 
industry groups weighted in the Index as of July 31, 2003, as follows: 
(1) computer software and hardware, 52%; (2) healthcare, 14%; (3) 
financials, 11%; (4) consumer discretionary, 8%; and (5) 
telecommunications and media, 6%. Third, as of July 31, 2003, the total 
capitalization of the Index was $2.6 trillion, the capitalization of 
the Index's components ranged from $284 billion to $55,000,\29\ and the 
medium capitalization of the Index's components was $110 million. As of 
July 31, 2003, the largest Index component accounted for 11.12% of the 
weight of the Index, and the five highest weighted securities accounted 
for 29.76% of the weight of the Index. Fourth, the selection and 
maintenance criteria for the Index's components should serve to ensure 
that the Index maintains its broad representative sample of stocks.
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    \28\ The option listing standards, which are uniform among the 
U.S. options exchanges, provide that a security underlying an option 
must, among other things, meet the following requirements: (1) the 
public float must be at least 7 million shares; (2) there must be a 
minimum of 2,000 holders of the underlying security; (3) trading 
volume must have been at least 2.4 million shares over the preceding 
12 months; and (4) the market price per share must meet specified 
levels. See, e.g., PHLX Rule 1009, ``Criteria for Underlying 
Securities,'' Commentary .01.
    \29\ For companies that list American Depository Shares, these 
values represent only the value of the outstanding American 
Depository Shares and not the global market capitalization of the 
issuer, which is the basis for listing on Nasdaq. Nasdaq's minimum 
listing and maintenance standard for global market capitalization is 
$50 million. See note 12 supra.
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    The Commission also believes that the general broad 
diversification, capitalizations, liquidity, and relative weighting of 
the Index's component securities minimize the potential for 
manipulation of the Index. First, the Index is comprised of 
approximately 3,400 securities listed and traded on Nasdaq, and no 
single security dominates the Index. Second, as of July 31, 2003, the 
total Index capitalization

[[Page 69757]]

was $2.6 trillion, the median capitalization of the Index's components 
was $110 million, the capitalizations of the Index's ten most heavily 
weighted components (representing 37.68% of the weight of the Index) 
ranged from approximately $32 billion to approximately $284 billion, 
and only 2.56% of the capitalization of the Index was comprised of 
securities with a market capitalization of less than $100 million. 
Third, during the period from January 1, 2003, through July 31, 2003, 
the average daily trading volume of the component securities 
representing 95% of the weight of the Index was 850,000 shares and only 
2.19% of the capitalization of the Index was comprised of components 
with an average daily trading volume of less than 10,000 shares. 
Fourth, as of July 31, 2003, component securities representing 95% of 
the weight of the Index were options eligible.\30\ Fifth, the PHLX has 
represented that it will monitor the Index on a semi-annual basis and 
will notify Commission staff if and when: (1) 10% of the capitalization 
of the Index comprises securities with a market capitalization of less 
than $100 million; (2) 10% of the capitalization of the Index is made 
up of components with an average daily trading volume of less than 
10,000 shares over the previous six months; (3) less than 80% of the 
weight of the Index is options eligible; (4) 10% of the weight of the 
index is represented by securities trading less than 20,000 shares per 
day; or (5) the largest component of the Index comprises 15% of the 
weight of the Index, or the top five components comprise 50% of the 
weight of the Index.\31\ In the event the Index fails to satisfy any of 
these criteria, the PHLX will notify the Commission to determine the 
appropriate regulatory response.\32\
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    \30\ See note 28 supra for a description of the PHLX's options 
eligibility standards.
    \31\ See Amendment No. 3, note 4 supra.
    \32\ If the composition of the Index's underlying securities 
were to change substantially, the Commission's decision regarding 
the appropriateness of the Index's current maintenance standards 
would be reevaluated, and additional approval under Section 19(b) of 
the Act might be necessary to continue to trade the Index Options.
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    The Commission believes that these factors minimize the potential 
for manipulation because it is unlikely that attempted manipulations of 
the prices of the Index's components would affect significantly the 
Index's value. Moreover, the surveillance procedures discussed below 
should detect as well as deter potential manipulations and other 
trading abuses.
    Finally, the Commission believes that the position and exercise 
limits for the Index Options are designed to minimize the potential for 
manipulation and other market impact concerns. The position and 
exercise limits for the Index Options are comparable to the position 
and exercise limits approved for other broad-based index options.\33\
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    \33\ See, e.g., Securities Exchange Act Release No. 48591 
(October 2, 2003), 68 FR 58728 (October 10, 2003) (File No. SR-CBOE-
2003-17) (approving options on 11 broad-based Russell Indexes, with 
position limits for each index option of 50,000 contracts on either 
side of the market and no more than 30,000 contracts in the series 
in the nearest expiration month).
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B. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as the Index Options, can 
commence on a national securities exchange. The Commission notes that 
the trading of standardized, exchange-traded options occurs in an 
environment that is designed to ensure, among other things, that: (1) 
the special risks of options are disclosed to public customers; (2) 
only investors capable of evaluating and bearing the risks of options 
trading are engaged in such trading; and (3) special compliance 
procedures are applicable to options accounts. Accordingly, because the 
Index Options, including FLEX Index Options and Mini-Flex Index 
Options, will be subject to the same regulatory regime as the other 
standardized options traded currently on the PHLX, the Commission 
believes that adequate safeguards are in place to ensure the protection 
of investors in Index Options.\34\
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    \34\ The Commission previously has designated FLEX index options 
as standardized options for the purposes of the options disclosure 
framework established under Rule 9b-1 of the Act. See Securities 
Exchange Act Release No. 31910 (February 23, 1993), 58 FR 12056 
(March 2, 1993) (File Nos. SR-CBOE-92-17; SR-OCC-92-33; ODD-93-1).
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    The Commission generally believes that a surveillance sharing 
agreement between an exchange proposing to list a stock index 
derivative product and the market(s) trading the stocks underlying the 
derivative product is an important measure for the surveillance of the 
derivative and underlying securities markets. 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. In this regard, the 
PHLX and the National Association of Securities Dealers, Inc. 
(``NASD'') are members of the ISG and the ISG Agreement will apply to 
the trading of Index Options.\35\ In addition, the PHLX will apply to 
the Index Options the same surveillance procedures it uses currently 
for existing index options trading on the PHLX.
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    \35\ The 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. 
All of the registered national securities exchanges and the NASD are 
members of the ISG. In addition, futures exchanges and non-U.S. 
exchanges and associations are affiliate members of ISG. As noted 
above, the PHLX represents that Index component securities 
comprising only 0.64% of the weight of the Index are incorporated in 
countries where the domestic equity exchange is not a member of the 
ISG.
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D. Market Impact

    The Commission believes that the listing and trading of Index 
Options will not adversely impact the underlying securities 
markets.\36\ First, the Index is broad-based and comprised of 
approximately 3,400 securities, no one of which dominates the Index. 
Second, as described above, the Index components representing a 
significant portion of the weight of the Index are highly capitalized 
and actively traded. Third, the position and exercise limits should 
serve to minimize potential manipulation and market impact concerns. 
Fourth, the risk to investors of contra-party non-performance will be 
minimized because the Index Options, like other standardized options 
traded in the U.S., will be issued and guaranteed by the Options 
Clearing Corporation (``OCC''). Fifth, existing PHLX index options 
rules and surveillance procedures will apply to the Index Options.
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    \36\ As noted above, both the PHLX and OPRA have represented 
that they have the necessary systems capacity to support the new 
series of index options that would result from the introduction of 
the Index Options. See notes 16 and 17, supra, and accompanying 
text.
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    The Commission also believes that settling expiring Full-Size 
Options and Mini Index Options based on the opening prices of component 
securities is reasonable and consistent with the Act. As noted in other 
contexts, valuing options for exercise settlement on expiration based 
on opening prices rather than on closing prices may help to reduce 
adverse effects on markets for securities underlying Full-Size Index 
Options and Mini Index Options.\37\
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    \37\ See, e.g., Securities Exchange Act Release No. 30944 (July 
21, 1992), 57 FR 33376 (July 28, 1992) (order approving File No. SR-
CBOE-92-09) (``1992 Order'').
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E. FLEX Index Options and Mini-Flex Index Options

    The Commission believes that the listing and trading of FLEX Index 
Options and Mini-Flex Index Options

[[Page 69758]]

should provide investors with more tailored options on the Index and 
extend to investors the benefits of a listed, exchange market in 
customized index options.\38\ The benefits of the PHLX's options market 
include, but are not limited to, a centralized market center, an 
auction market with posted transparent market quotations and 
transaction reporting, parameters and procedures for clearance and 
settlement, and the guarantee of OCC for all contracts traded on the 
PHLX. In addition, the Commission believes that the proposal to list 
and trade FLEX Index Options and Mini-Flex Index Options could help the 
PHLX to compete with the over-the-counter (``OTC'') market in 
customized index options and help the PHLX to meet the demands of 
portfolio managers and other institutional investors who may use the 
OTC market to meet their hedging needs. The Commission notes that the 
PHLX rules governing the trading of FLEX index options, including the 
minimum size requirement for an RFQ, will apply to Mini-Flex Index 
Options.\39\
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    \38\ FLEX options allow investors to customize certain terms, 
including size, term to expiration, exercise style, exercise price, 
and exercise settlement value.
    \39\ See note 10 supra and accompanying text.
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    Under the PHLX's rules, FLEX Index Options and Mini-Flex Index 
Options can be constructed with expiration exercise settlement based on 
the closing values of the Index's component securities, which 
potentially could result in adverse effects for the markets in these 
securities.\40\ Although the Commission continues to believe that 
basing the settlement of index products on opening as opposed to 
closing prices on Expiration Friday helps to alleviate stock market 
volatility,\41\ these market impact concerns are reduced in the case of 
FLEX Index Options and Mini-Flex Index Options because the expiration 
of these options will not correspond to the normal expiration of any 
non-FLEX options (including options overlying the Index), stock index 
futures, and options on stock index futures. In particular, FLEX 
options may never expire on any ``Expiration Friday'' because under the 
PHLX's rules the expiration date of a FLEX option may not occur on a 
day that is on, or within, two business days of the expiration date of 
a non-FLEX option.\42\ The Commission believes that this should reduce 
the possibility that the exercise of FLEX Index Options or Mini-Flex 
Index Options at expiration will cause any additional pressure on the 
market for the underlying securities at the same time non-FLEX Index 
Options expire.
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    \40\ See 1992 Order.
    \41\ See 1992 Order.
    \42\ See PHLX Rule 1079(a)(6).
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F. Exclusive Licensing Agreement

    As noted above, both commenters raised concerns about the PHLX's 
exclusive licensing agreement with Nasdaq to trade the Index Options. 
The Commission notes that the ISE has filed a petition for rulemaking 
to amend Rule 19c-5 under the Act \43\ to prohibit options exchanges 
from entering into exclusive licensing agreements with respect to index 
option products.\44\ The Commission believes that the issues raised by 
the commenters and by ISE in its petition for rulemaking regarding the 
exclusive licensing of index option products should be considered 
comprehensively rather than on an ad hoc basis in the context of a 
particular index option product or products, such as the Index Options. 
In addition, the Commission believes that investors will benefit from 
the availability of the Index Options because, as described above, they 
will provide investors with additional hedging and trading vehicles. 
Accordingly, the Commission believes that it is appropriate in the 
public interest to approve the current proposal in order to make the 
Index Options available to investors while the Commission considers the 
issues presented by the exclusive licensing of index option products in 
the context of the ISE's petition for rulemaking.
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    \43\ 17 CFR 240.19c-5.
    \44\ See letter from David Krell, President and Chief Executive 
Officer, ISE, to Jonathan Katz, Secretary, Commission, dated 
November 1, 2002.
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G. Accelerated Approval of Amendment No. 3

    The Commission finds good cause to approve Amendment No. 3 prior to 
the thirtieth day after the date of publication of notice of filing 
thereof in the Federal Register. Amendment No. 3 strengthens the 
proposal by representing that the PHLX will notify the Commission staff 
upon the occurrence of certain changes in the Index. Accordingly, the 
Commission believes that there is good cause, consistent with Sections 
6(b)(5) and 19(b)(2) of the Act,\45\ to approve Amendment 3 on an 
accelerated basis.
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    \45\ 15 U.S.C. 78f(b)(5) and 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 3, including whether Amendment No. 3 
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. Comments 
may also be submitted electronically at the following e-mail address: 
[email protected]. All comment letters should refer to File No. SR-
PHLX-2003-66. This file number should be included on the subject line 
if e-mail is used. To help the Commission process and review comments 
more efficiently, your comments should be sent in hardcopy or by e-mail 
but not by both methods. 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 Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the PHLX. All 
submissions should refer to File No. SR-PHLX-2003-66 and should be 
submitted by January 5, 2004.

VI. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\46\ that Amendment No. 3 be approved on an accelerated basis and 
that the proposed rule change (SR-PHLX-2003-66), as amended, is 
approved.
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    \46\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\47\
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    \47\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-30837 Filed 12-12-03; 8:45 am]
BILLING CODE 8010-01-M