[Federal Register Volume 70, Number 70 (Wednesday, April 13, 2005)]
[Notices]
[Pages 19536-19538]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-7375]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 51497; File No. SR-CBOE-2004-54]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Partial Amendment No. 1 Thereto By the Chicago Board Options 
Exchange, Incorporated To Amend Rules Relating Margin Treatment on 
Stock Transactions Effected By an Options Market Maker To Hedge Options 
Positions

April 6, 2005.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``the Act'') \1\ and Rule 19b-4 \2\ thereunder, notice is hereby given 
that on July 30, 2004, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the Exchange. On February 22, 2005, the CBOE filed a partial 
amendment to its proposed rule change.\3\ The Commission is publishing 
this notice to solicit comments on the proposed rule change, as 
amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ SR-CBOE-2004-54: Amendment No. 1. Under the partial 
amendment, the options market maker must be able to demonstrate that 
it effected its permitted offset transactions for market-making 
purposes.
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Self-Regulatory Organization's Statement of the Terms of Substance of 
the Proposed Rule Change

    The Chicago Board Options Exchange, Incorporated (the ``CBOE'' or 
``Exchange'') is proposing to eliminate a rule that essentially 
disallows favorable margin treatment on stock transactions initiated by 
options market makers to hedge an option position if the exercise price 
of the option is more than two standard exercise price intervals above 
the price of the stock in the case of a call option, or below in the 
case of a put option. The text of the proposed rule change is available 
on CBOE's Web site (http://www.cboe.com), at the CBOE's Office of the 
Secretary, and at the Commission's Public Reference Room.

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

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

1. Purpose
    When options market makers hedge their option positions by taking a 
long or short position in the underlying security, the underlying 
security is allowed ``good faith'' margin treatment,\4\ provided the 
underlying security meets the definition of a ``permitted offset.'' \5\ 
To qualify as a permitted offset, CBOE Rule 12.3(f)(3) requires, among 
other things, that the transaction price of the underlying security be 
not more than two standard exercise price intervals below the exercise 
price of the option being hedged in the case of a call option, or above 
in the case of a put option. The term ``in-or-at-the-money'' is used in 
CBOE Rule 12.3(f)(3) to refer to the two standard strike price interval 
requirement. Stated another way, ``in-or-at-the-money'' means the 
option being hedged cannot be ``out-of-the-money'' by more than two 
standard exercise price intervals.\6\
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    \4\ Good faith margin is defined in Regulation T of the Board of 
Governors of the Federal Reserve System (``Regulation T''), the 
margin setting authority for the securities industry, as the amount 
of margin a creditor would require in exercising sound credit 
judgment.
    \5\ A ``permitted offset'' is defined in CBOE Rule 12.3(f)(3).
    \6\ An option is ``out-of-the-money'' when, based on comparison 
of the exercise price to the current market price of the underlying 
security, it makes no economic sense to exercise the option. For 
example, a call option with the right to purchase the underlying 
security at $50 per share would not be exercised if the underlying 
security were trading in the market for $46 per share.
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    The intent of this requirement was to confine good faith margining 
of transactions in the underlying security to those that constituted 
meaningful hedges of an option position. The need to hedge with 100 
shares or units of the underlying security diminishes the more the 
exercise price of a call option is above the price of the underlying 
security, and the more the exercise price of a put option is below. If 
these inexpensive, ``out-of-the-money'' options are offset with a 
position in the underlying security equivalent in size (that is, units 
or shares) to that represented by the option, the risk of the combined 
positions is nearly the same as the underlying security position 
without the option. The option has very little effect. To prevent 
inexpensive, ``out-of-the-money'' options from being used as a means to 
gain good faith margin for trading in the underlying security, the two 
standard strike price interval limitation was imposed.
    The Exchange is proposing to remove the ``in-or-at-the-money'' 
requirement.\7\ The Exchange believes that a hedging transaction in the 
underlying security by an options market-maker can constitute a 
reasonable hedge, and is deserving of good faith margin, even if the 
exercise price of the option is out-of-the-money by more than two 
standard exercise price intervals. The listing of option series is not 
limited to options that meet the ``in-or-at-the-money'' requirement and 
options market-makers are obligated to provide liquidity in such ``out-
of-the money'' options. In today's listed options market, there can be 
numerous options series that are out-of-the-money, more so than when 
the idea of an ``in-or-at-the-money'' requirement was first conceived. 
Moreover, in today's listed options market, smaller standard exercise 
price intervals have been introduced in some options (for example, 1 
point and 2\1/2\ points), in contrast to the earlier days of the listed

[[Page 19537]]

options market when the only standard was a five-point interval.
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    \7\ The New York Stock Exchange (``NYSE'') also has filed a 
proposed rule change to remove the ``in-or-at-the-money'' language 
from its rules on permitted offsets. Although the language of the 
NYSE's proposed rule change differs from the language of the CBOE's 
proposed rule change, the proposed changes from the two exchanges 
are substantively identical. The Commission is publishing a notice 
to solicit comments on the NYSE's proposed rule change.
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    The need for relief from the ``in-or-at-the-money'' constraint has 
been addressed before. Prior to June 1, 1997, ``in-or-at-the-money'' 
was defined in Regulation T to mean the price of the underlying 
security is not more than one standard exercise price interval below 
the exercise price of the option being hedged in the case of a call 
option, or above in the case of a put option. Provisions pertaining to 
market-makers and specialists were removed from Regulation T effective 
June 1, 1997, due to an exemption for market-makers and specialists 
that resulted from passage of the National Securities Markets 
Improvement Act of 1996. The Exchange, as well as the New York Stock 
Exchange, adopted the provisions of Regulation T applicable to market-
makers and implemented them as exchange rules effective June 1, 1997, 
except for the definition of ``in-or-at-the-money.'' The current 
definition of ``in-or-at-the-money,'' requiring two standard exercise 
price intervals, was proposed by the exchanges and approved by the 
Commission at that time.\8\ This was done based upon the recommendation 
of an industry committee organized by the New York Stock Exchange to 
review its margin rules. That committee did consider relief in the form 
of eliminating the ``in-or-at-the-money'' requirement altogether, but a 
majority in favor of elimination was not attained at that time.
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    \8\ See Securities Exchange Act Release No. 34-38709 (June 2, 
1997), 62 FR 31643 (approving SR-CBOE-97-17).
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    The Exchange also believes that the ``in-or-at-the-money'' 
requirement is not in tune with current options market-maker hedging 
technique. Options market-makers generally seek to create a risk-
neutral hedge when they offset an option with a position in the 
underlying security. In the case of an ``out-of-the-money'' option, 
they cannot create a risk-neutral hedge if they take a full 100 share 
position per option in the underlying security, because any gain/loss 
on the option being hedged would be outweighed by the loss/gain in the 
underlying security position. Therefore, losses on the underlying 
security position are not equally hedged and pose a risk. Instead, 
options market-makers will take a less than 100 share position in the 
underlying security per option being hedged so that any gain/loss on 
that position in dollar terms closely tracks that of the dollar gain/
loss on the option position. When options market-makers hedge in this 
manner, known as ``delta neutral hedging,'' they cannot benefit from 
any gain on a position in the underlying security because it is equally 
offset by a loss in the option being hedged. Therefore, there is no 
need for a rule provision that was originally intended to guard against 
options market-makers obtaining good faith credit for trading in the 
underlying security that is unrelated to the options market-making 
business.
    It should be noted that internal risk control systems at all of the 
broker-dealers that clear and carry the accounts of options market-
makers impose a delta neutral trading standard on options market-
makers, monitor options marker-makers' compliance with the clearing 
firm's risk limits, and intervene as necessary to counter any deviation 
from acceptable risk levels. The internal risk control systems employed 
by the clearing firms thus provide as good a deterrent against 
unrelated trading in the underlying security or instrument as the 
current ``in-or-at-the-money'' requirement.
    Another reason why the Exchange deems the ``in-or-at-the-money'' 
requirement unnecessary is the fact that, when a clearing firm extends 
good faith margin on a security underlying an option, it must reduce 
its net capital by any amount by which the deduction required by Rule 
15c3-1 under the Securities Exchange Act of 1934 (the ``haircut'') 
exceeds the amount of equity in the options market maker's account. 
Thus, the market-maker must post enough margin to cover the haircut 
requirement or the clearing firm must, in effect, post the margin, or 
any portion not on deposit in the market-maker's account, by setting 
aside its capital. In this way there is a safety cushion to cover the 
credit risk when good faith margin is extended and the good faith 
requirement is less than the haircut requirement. Thus, when good faith 
margin is extended, the haircut requirement is a de facto minimum 
margin requirement.
    In further support of eliminating the ``in-or-at-the-money'' 
requirement is the fact that, according to each of the options market 
maker clearing firms, a violation of the ``in-or-at-the-money'' 
requirement is very rare. The clearing firms also point out that when 
the price of an underlying security established for hedging purposes 
changes in a manner so a to exceed the two standard exercise price 
interval, the underlying security maintains its permitted offset 
status, and it becomes impractical to determine which shares are not 
qualified for permitted offset treatment.
2. Statutory Basis
    The proposed rule is intended to eliminate a requirement that 
impedes options market makers from hedging, on a good faith margin 
basis, ``out-of-the-money'' options having standard exercise price 
intervals of less than five points. As such, the proposed rule change 
is consistent with and furthers the objectives of Section 6(b)(5) of 
the Act, in that it is designated to perfect the mechanisms of a free 
and open market and to protect investors and the public interest.

B. Self-Regulatory Organization's Statement on Burden on Competition

    CBOE does not believe that the proposed rule change will impose any 
burden on competition that is not necessary or appropriate in 
furtherance of purposes of the Act.

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

    No written comments were either solicited or received with respect 
to the proposed rule change.

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 the Exchange 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 proposal 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-CBOE-2004-54 on the subject line.

[[Page 19538]]

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-CBOE-2004-54. 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. 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 CBOE. 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 available publicly. All 
submissions should refer to File Number SR-CBOE-2004-54 and should be 
submitted on or before May 4, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 05-7375 Filed 4-12-05; 8:45 am]
BILLING CODE 8010-01-M