[Federal Register Volume 69, Number 203 (Thursday, October 21, 2004)]
[Notices]
[Pages 61884-61886]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-23558]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50539; File No. SR-NASD-2004-153]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
a Conditional Exemption From Stock Option Position Limits for OTC 
Derivatives Dealers

October 14, 2004.
    Pursuant to section 19(b)(1) of the Securities Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on October 12, 2004, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in items I, II, 
and III below, which items have been prepared by NASD. The Commission 
is publishing this notice to solicit comments on the proposed rule 
change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is proposed to amend NASD Rule 2860 to provide an exemption 
from stock options position limits for OTC Derivatives Dealers provided 
that certain conditions have been satisfied. Below is the text of the 
proposed rule change. Proposed new language is in italics; proposed 
deletions are in brackets.
* * * * *
2800. SPECIAL PRODUCTS
* * * * *
2860. Options
    (a) No Change.
    (b) Requirements
(1) No Change.
(2) Definitions
    (A) through (Q) No Change.
    (R) Delta Neutral--The term ``delta neutral'' described a stock 
options position that has been hedged, in accordance with an SEC-
approved pricing model, with a portfolio of instruments relating to the 
same underlying stock to offset the risk that the value of the options 
position will change with changes in the price of the stock underlying 
the options position.
    Current (R) through (FF) Renumbered as (S) through (GG).
    (HH) Net Delta--The term ``net delta'' means the number of shares 
that must be maintained (either long or short) to offset the risk that 
the value of a stock options position will change with changes in the 
price of the stock underlying the options position.
    Current (GG) through (BBB) Renumbered as (II) through (DDD).
(3) Position Limits
    (A) Stock Options--Except in highly unusual circumstances, and with 
the prior written approval of NASD pursuant to the Rule 9600 Series for 
good cause shown in each instance, no member shall effect for any 
account in which such member has an interest, or for the account of any 
partner, officer, director or employee thereof, or for the account of 
any customer, non-member broker, or non-member dealer, an opening 
transaction through Nasdaq, the over-the-counter market or on any 
exchange in a stock option contract of any class of stock options if 
the member has reason to believe that as a result of such transaction 
the member or partner, officer, director or employee thereof, or 
customer, non-member broker, or non-member dealer, would, acting along 
or in concert with others, directly or indirectly, hold or control or 
be obligated in respect of an aggregate equity options position in 
excess of:
    (i) through (vi) No Change.
    (vii) Equity Options Hedge Exemptions
    a. No Change.
    b. Delta Hedging Exemption for OTC Derivatives Dealer A stock 
options position of an OTC Derivatives Dealer (as that term is defined 
in Rule 3b-12 under the Act) affiliated with a member, in standardized 
or conventional options that is delta neutral, shall be exempt from 
position limits under this rule if the following conditions are 
satisfied:
    1. The member has obtained a written representation from its 
affiliated OTC Derivatives Dealer that such entity is hedging its stock 
options positions in accordance with its internal risk management 
control systems and pricing models approved by the SEC pursuant to 
Rules 15c3-1(a)(5) and 15c3-1f under the Act and that if it ceases to 
hedge stock options positions in accordance with such systems and 
models, that it will provide immediate written notice to the member.
    2. The member must report in accordance with the paragraph (b)(5), 
all stock options positions (including those that are delta neutral) of 
200 or more contracts (whether long or short) on the same side of the 
market covering the same underlying stock that are effected by the 
member.
    3. Any stock options position of an OTC Derivatives Dealer that is 
not delta neutral shall be subject to position limits in accordance 
with this section (subject, however, to the availability of other 
exemptions). For these purpose, only the option contract equivalent of 
the net delta of such positions is subject to position limits. The 
options contract equivalent of the net delta is the net delta divided 
by 100.
    (viii) No change.\3\
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    \3\ Reference to subparagraph (b)(3)(viii) as unchanged was 
added pursuant to telephone conversion between Gary Goldsholle, 
Office of General counsel, Regulatory Policy and Oversight, NASD, 
and Ira Brandriss, Division of Market Regulation, Commission, on 
October 14, 2004.
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    (B) through (D) No Change.
    (4) through (24) No Change.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it had received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. NASD has prepared summaries, set forth in sections A, B, 
and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Over the past several years, NASD has increased in absolute terms 
the size of the options position and exercise limits as well as the 
size and scope of available exemptions for ``hedged'' positions.\4\ 
These increases, however, have generally required a one-to-one hedge 
(e.g., one stock option contract must be

[[Page 61885]]

hedged by one-hundred shares of stock). In practice, however, many 
firms and customers do not hedge their options positions in this way. 
Rather, these firms engage in what is known as ``delta hedging,'' which 
varies the number of shares of stock used to hedge an options position 
based upon the relative sensitivity of the value of the option contract 
to a change in the price of the underlying stock.\5\ Delta hedging is a 
widely accepted risk management tool.
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    \4\ See Securities Exchange Act Release No. 47307 (February 3, 
2003), 68 FR 6977 (February 11, 2003) (SR-NASD-2002-134); Securities 
Exchange Act Release No. 40932 (Jan 11, 1999), 64 FR 2930 (January 
19, 1999) (SR-NASD -98-92); Securities Exchange Act Release No. 
40087 (June 12, 1998), 63 FR 33746 (June 19, 1998), (SR-NASD -98-
23); Securities Exchange Act Release No. 39771 (March 19, 1998), 63 
FR 14743 (March 26, 1998) (SR-NASD -98-15).
    \5\ For example, an option with a delta of .5 will move $0.50 
for every $1.00 move in the underlying stock.
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    In 1998, the Commission approved rules allowing U.S. securities 
firms to establish a separately capitalized entity to engage in dealer 
activities in eligible over-the-counter (``OTC'') derivative 
instruments.\6\ This separately capitalized entity, known as an OTC 
Derivatives Dealer, receives preferential capital treatment and is 
exempt from self-regulatory organization (``SRO'') membership. In 
general, however, most transactions of an OTC Derivatives Dealer 
(including stock options transactions) must be effected through its 
fully regulated broker-dealer affiliate, except to the extent otherwise 
permitted by Rule 15a-1 under the Act.\7\ Thus, SRO rules, including 
stock, options position and exercise limits, continue to apply to 
transactions where a member must effect the transaction between the OTC 
Derivatives Dealer and the counterparty. As a consequence, the 
application of these position and exercise limits often deters parties 
from entering into transactions they otherwise would seek to conduct 
with an OTC Derivatives Dealer in the absence of such limits. Indeed, 
the Commission recognized this issue at the time it approved rules 
applicable to OTC Derivatives Dealers.\8\ Specifically, the Commission 
encouraged NASD to revise its rules to recognize as ``hedged'' those 
option positions of an OTC Derivatives Dealer that are hedged on a 
``delta neutral basis'' (i.e., the position is delta neutral or fully 
hedged with regard to the risk that the price of the stock underlying 
the options position might change).\9\
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    \6\ Securities Exchange Act Release No. 40594 (Oct. 23, 1998), 
63 FR 59362 (Nov. 3, 1998) (SEC File No. S7-30-97) (``OTC 
Derivatives Dealer release'').
    \7\ 17 CFR 240.15a-1.
    \8\ OTC Derivatives Dealer release, supra note 6, at 63 FR 
59380.
    \9\ Id.
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    In June 2003, NASD received a request on behalf of several member 
firms affiliated with OTC Derivatives Dealers to amend its rule 
imposing stock options position and exercise limits so that it applied 
only to a stock options position's net delta.\10\
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    \10\ The proposed rule change does not expressly amend NASD's 
options exercise limits in NASD Rule 2860(b)(4) because such 
exercise limits apply only to the extent NASD Rule 2860(b)(3) 
imposes position limits. Thus, as delta neutral positions of an OTC 
Derivatives Dealer would be exempt from position limits under the 
proposed rule change, such positions also would be exempt from 
exercise limits. See NASD Notice to Members 94-46 at 2 (``* * * 
exercise limits correspond to position limits, such that investors 
in options classes on the same side of the market are allowed to 
exercise * * * only the number of options contracts set forth as the 
applicable position limit for those options classes.''). Similarly, 
for positions held by an OTC Derivatives Dealer that are not delta 
neutral, only the option contract equivalent of the net delta of 
such positions would be subject to exercise limits.
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    NASD believes that the rigor of the OTC Derivatives Dealer approval 
process and the ongoing oversight by the Commission staff provides an 
appropriate basis for exempting delta neutral positions in stock 
options at such entities from position limits. The proposed rule change 
would exempt from NASD Rule 2860 delta neutral stock options positions 
of an OTC Derivatives Dealer and would provide that only the option 
contract equivalent of the net delta of a stock options position is 
subject to position limits provided that the member satisfies three 
conditions.
    The first condition would require a member to receive a written 
representation from its affiliated OTC Derivatives Dealer stating that 
the OTC Derivatives Dealer is hedging its stock options positions in 
accordance with risk management and pricing models approved by the 
Commission. This written representation would enable NASD to identify 
those firms that will be relying on the delta hedging exemption on 
behalf of their OTC Derivatives Dealer affiliates and would be required 
to be maintained in accordance with the recordkeeping provisions of 
NASD Rule 3110.
    The second condition would require that the member must report 
stock options positions of the OTC Derivatives Dealer, including those 
that are delta neutral, in accordance with NASD Rule 2860(b)(5). These 
reports would inform NASD of the OTC Derivatives Dealer's aggregate 
stock options positions and permit NASD to conduct surveillance for 
market manipulation, insider trading, and other trading abuses.
    The third condition would provide that any stock options position 
that is not delta neutral must remain subject to position and, by 
extension, exercise limits (subject, however, to the availability of 
other exemptions). An OTC Derivatives Dealer generally employs delta 
hedging as part of its risk management program, but it is nevertheless 
possible that an OTC Derivatives Dealer may maintain some positions 
that are not fully hedged, so long as the entity as a whole meets the 
conditions imposed by the Commission. In such cases, only the option 
contract equivalent of the ``net delta'' of any such stock options 
positions, which is the net delta divided by 100, would be subject to 
position limits. This calculation of an options contract equivalent 
conforms to existing NASD Rule 2860(b)(2)(JJ), which provides that, for 
purposes of subparagraphs (3) through (12) of NASD Rule 2860(b), a 
stock option overlying more or less than 100 shares ``shall be deemed 
to constitute as many option contracts as that other number of shares 
divided by 100 (e.g., an option to buy or sell five hundred shares of 
common stocks shall be considered as five option contracts).''
    It is important to note that, for purposes of the proposed rule 
change, only financial instruments relating to the stock underlying a 
stock options position could be included in any determination of a 
stock options position's net delta or whether the stock options 
position is delta neutral. For example, warrants granting the right to 
purchase Microsoft stock might be used to offset the risk associated 
with a position in Microsoft puts granting the holder the right to sell 
Microsoft stock. However, for purposes of the proposed rule change, a 
position in Microsoft calls granting the holder the right to purchase 
Microsoft stock may not be hedged by puts (or any other financial 
instrument) overlying any security other than Microsoft stock.
    NASD will announce the effective date of the proposed rule change 
in a Notice to Members to be published no later than 60 days following 
Commission approval. The effective date will be no later than 30 days 
following publication of the Notice to Members announcing Commission 
approval.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of section 15A(b)(6) of the Act,\11\ which requires, among 
other things, that NASD rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. NASD believes that it is appropriate, subject to 
certain conditions, to exempt stock options positions of OTC

[[Page 61886]]

Derivatives Dealers from position limits and require that only the 
option contract equivalent of the net delta of a stock options position 
be subject to position limits. Moreover, NASD's proposed rule change 
would implement an approach that the Commission encouraged NASD to 
adopt at the time the Commission approved the regulatory model for OTC 
Derivatives Dealers.\12\
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    \11\ 15 U.S.C. 78o-3(b)(6).
    \12\ OTC Derivatives Dealer release, supra note 6, at 63 FR 
59380.
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD does not believe that the proposed rule change could result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding, or (ii) as to 
which NASD consents, the Commission will:
    (A) By order approve such proposed rule change; or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-NASD-2004-153 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-NASD-2004-153. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of NASD. 
All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make publicly 
available. All submissions should refer to File Number SR-NASD-2004-153 
and should be submitted on or before November 12, 2004.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-23558 Filed 10-20-04; 8:45 am]
BILLING CODE 8010-01-M