[Federal Register Volume 70, Number 84 (Tuesday, May 3, 2005)]
[Notices]
[Pages 22935-22947]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-2127]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-51614; File No. SR-CBOE-2002-03]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change and Amendment Nos. 1 and 2 Thereto by the Chicago Board Options
Exchange, Incorporated Relating to Customer Portfolio and Cross-
Margining Requirements
April 26, 2005.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on April 15, 2005, the Chicago Board Options Exchange, Incorporated
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission'') Amendment No. 2 \3\ to the proposed rule
change as described in Items I, II, and III below, which Items have
been prepared by the CBOE. The Exchange submitted this partial
amendment, constituting Amendment No. 2, pursuant to the request of
Commission staff. Specifically, the Exchange proposes to amend the
proposed rule (Rule 12.4) to remove current paragraph (b)(2) under
which any affiliate of a self-clearing member organization can
participate in portfolio margining, without being subject to the $5
million equity requirement.\4\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Partial Amendment No. 2 (``Amendment No. 2'').
\4\ This partial amendment would not exclude these affiliates
from participating in portfolio margining; rather, it would subject
them to the $5 million equity requirement in paragraph (b)(3) of
proposed Rule 12.4 in Amendment No. 2.
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The CBOE submitted the original proposed rule change to the
Commission on January 15, 2002 (``Original Proposal''). The proposed
rule change was published in the Federal Register on March 29, 2002.\5\
The Commission received one comment letter in response to the March 29,
2002 Federal Register notice.\6\ On April 2, 2004, the Exchange filed
Amendment No. 1 to the proposed rule change.\7\ The
[[Page 22936]]
proposed rule change and Amendment No. 1 were published in the Federal
Register on December 27, 2004.\8\ The Commission received eleven
comment letters in response to the December 27, 2004 Federal Register
notice.\9\
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\5\ See Securities Exchange Act Release No. 45630 (March 22,
2002), 67 FR 15263 (March 29, 2002).
\6\ See E-mail from Mike Ianni, Private Investor to [email protected], dated November 7, 2002 (``Ianni E-mail'').
\7\ See letter from Richard Lewandowski, Vice President,
Division of Regulatory Services, CBOE, to Michael A. Macchiaroli,
Associate Director, Division of Market Regulation (``Division''),
Commission, dated April 1, 2004 (``Amendment No. 1''). The CBOE
proposed Amendment No. 1 to make corrections or clarifications to
the proposed rule, or to reconcile differences between the proposed
rule and a parallel filing by the NYSE. See Securities Exchange Act
Release No. 46576 (October 1, 2002), 67 FR 62843 (October 8, 2002)
(File No. SR-NYSE-2002-19).
\8\ See Securities Exchange Act Release No. 50886 (December 20,
2004), 69 FR 77275 (December 27, 2004); see also Securities Exchange
Act Release No. 50885 (December 20, 2004), 69 FR 77287 (December 27,
2004).
\9\ One of the comments responded exclusively to CBOE Amendment
No. 1. See letter from Anthony J. Saliba, President, LiquidPoint,
LLC, to Jonathan G. Katz, Secretary, Commission, dated February 24,
2005 (``Saliba Letter''). Ten of the written comments (letters and
emails) responded jointly to CBOE Amendment No. 1 and NYSE Amendment
No. 2. See letter from Barbara Wierzynski, Executive Vice President
and General Counsel, Futures Industry Association, and Gerard J.
Quinn, Vice President and Associate General Counsel, Securities
Industry Association, to Jonathan G. Katz, Secretary, Commission,
dated January 14, 2005 (``Wierzynski/Quinn Letter''); letter from
Craig S. Donohue, Chief Executive Officer, Chicago Mercantile
Exchange, to Jonathan G. Katz, Secretary, Commission, dated January
18, 2005 (``Donohue Letter''); letter from Robert C. Sheehan,
Chairman, Electronic Brokerages Systems, LLC, to Jonathan G. Katz,
Secretary, Commission, dated January 19, 2005 (``Sheehan Letter'');
letter from William O. Melvin, Jr., President, Acorn Derivatives
Management, to Jonathan G. Katz, Secretary, Commission, dated
January 19, 2005 (``Melvin Letter''); letter from Margaret
Wiermanski, Chief Operating & Compliance Officer, Chicago Trading
Company, to Jonathan G. Katz, Secretary, Commission, dated January
20, 2005 (``Wiermanski Letter''); email from Jeffrey T. Kaufmann,
Lakeshore Securities, L.P., to Jonathan G. Katz, Secretary,
Commission, dated January 24, 2005 (``Kaufmann Letter''); letter
from J. Todd Weingart, Director of Floor Operations, Mann
Securities, to Jonathan G. Katz, Secretary, Commission, dated
January 25, 2005 (``Weingart Letter''); letter from Charles Greiner
III, LDB Consulting, Inc., to Jonathan G. Katz, Secretary,
Commission, dated January 26, 2005 (``Greiner Letter''); letter from
Jack L. Hansen, Chief Investment Officer and Principal, The Clifton
Group, to Jonathan G. Katz, Secretary, Commission, dated February 1,
2005 (``Hansen Letter''); See letter from Barbara Wierzynski,
Executive Vice President and General Counsel, Futures Industry
Association, and Ira D. Hammerman, Senior Vice President and General
Counsel, Securities Industry Association, to Jonathan G. Katz,
Secretary, Commission, dated March 2, 2005 (``Wierzynski/Hammerman
Letter'').
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The Commission is publishing this notice to solicit comments on the
proposed rule change, as amended, from interested persons.\10\
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\10\ This release (Release No. 34-51614) seeks comment on the
proposed rule change, as amended, by Amendment Nos. 1 and 2.
Therefore, the language of the proposed rule change, as amended, is
set forth in the release in its entirety.
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1. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
The CBOE proposes to amend its rules, for certain customer
accounts, to allow member organizations to margin listed, broad-based,
market index options, index warrants and related exchange-traded funds
according to a portfolio margin methodology as an alternative to the
current strategy-based margin methodology. The proposed rule change
also will provide for cross-margining by allowing broad-based index
futures and options on such futures to be included with listed, broad-
based index options, index warrants and related exchange-traded funds
for portfolio margin treatment, in a separate cross-margin account. The
text of the proposed rule change is below. Additions are in italics.
Deletions are in brackets.
* * * * *
CHAPTER XII
Margins
[Covered Options Contracts]
Portfolio Margin and Cross-Margin for Index Options
Rule 12.4. [Deleted January 15, 1975.] As an alternative to the
transaction/position specific margin requirements set forth in Rule
12.3 of this Chapter 12, members may require margin for listed, broad-
based U.S. index options, index warrants and underlying instruments (as
defined below) in accordance with the portfolio margin requirements
contained in this Rule 12.4.
In addition, members, provided they are a Futures Commission
Merchant (``FCM'') and are either a clearing member of a futures
clearing organization or have an affiliate that is a clearing member of
a futures clearing organization, are permitted under this Rule 12.4 to
combine a customer's related instruments (as defined below) and listed,
broad based U.S. index options, index warrants and underlying
instruments and compute a margin requirement (``cross-margin'') on a
portfolio margin basis. Members must confine cross-margin positions to
a portfolio margin account dedicated exclusively to cross-margining.
Application of the portfolio margin and cross-margining provisions
of this Rule 12.4 to IRA accounts is prohibited.
(a) Definitions.
(1) The term ``listed option'' shall mean any option traded on a
registered national securities exchange or automated facility of a
registered national securities association.
(2) The term ``unlisted option'' means any option not included in
the definition of listed option.
(3) The term ``options class'' refers to all options contracts
covering the same underlying instrument.
(4) The term ``portfolio'' means options of the same options class
grouped with their underlying instruments and related instruments.
(5) The term ``option series'' relates to listed options and means
all option contracts of the same type (either a call or a put) and
exercise style, covering the same underlying instrument with the same
exercise price, expiration date, and number of underlying units.
(6) The term ``related instrument'' within an option class or
product group means futures contracts and options on futures contracts
covering the same underlying instrument.
(7) The term ``underlying instrument'' means long and short
positions in an exchange traded fund or other fund product registered
under the Investment Company Act of 1940 that holds the same
securities, and in the same proportion, as contained in a broad based
index on which options are listed. The term underlying instrument shall
not be deemed to include, futures contracts, options on futures
contracts, underlying stock baskets, or unlisted instruments.
(8) The term ``product group'' means two or more portfolios of the
same type (see subparagraph (a)(9) below) for which it has been
determined by Rule 15c3-1a under the Securities Exchange Act of 1934
that a percentage of offsetting profits may be applied to losses at the
same valuation point.
(9) The term ``theoretical gains and losses'' means the gain and
loss in the value of individual option series and related instruments
at 10 equidistant intervals (valuation points) ranging from an assumed
movement (both up and down) in the current market value of the
underlying instrument. The magnitude of the valuation point range shall
be as follows:
------------------------------------------------------------------------
Up/down market
Portfolio type move (high & low
valuation points)
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Non-high capitalization, broad based U.S. market +/-10%
index option \1\\1\................................
High capitalization, broad based U.S. market index +6%/-8%
option \1\.........................................
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\1\ In accordance with sub-paragraph (b)(1)(i)(B) of Rule 15c3-1a under
the Securities Exchange Act of 1934.
(b) Eligible Participants. The application of the portfolio margin
provisions of this Rule 12.4, including cross-margining, is limited to
the following:
(1) any broker or dealer registered pursuant to Section 15 of the
Securities Exchange Act of 1934;
(2) any member of a national futures exchange to the extent that
listed index
[[Page 22937]]
options hedge the member's index futures; and
(3) any other person or entity not included in (b)1 through (b)2
above that has or establishes, and maintains, equity of at least 5
million dollars. For purposes of this equity requirement, all
securities and futures accounts carried by the member for the same
customer may be combined provided ownership across the accounts is
identical. A guarantee by any other account for purposes of the minimum
equity requirement is not to be permitted.
(c) Opening of Accounts.
(1) Only customers that, pursuant to Rule 9.7, have been approved
for options transactions, and specifically approved to engage in
uncovered short option contracts, are permitted to utilize a portfolio
margin account.
(2) On or before the date of the initial transaction in a portfolio
margin account, a member shall:
A. furnish the customer with a special written disclosure statement
describing the nature and risks of portfolio margining and cross-
margining which includes an acknowledgement for all portfolio margin
account owners to sign, and an additional acknowledgement for owners
that also engage in cross-margining to sign, attesting that they have
read and understood the disclosure statement, and agree to the terms
under which a portfolio margin account and the cross-margin account,
respectively, are provided [see Rule 9.15(d)], and
B. obtain a signed acknowledgement(s) from the customer, both of
which are required for cross-margining customers, and record the date
of receipt.
(d) Establishing Account and Eligible Positions.
(1) Portfolio Margin Account. For purposes of applying the
portfolio margin requirements provided in this Rule 12.4, members are
to establish and utilize a dedicated securities margin account, or sub-
account of a margin account, clearly identified as a portfolio margin
account that is separate from any other securities account carried for
a customer.
(2) Cross-Margin Account. For purposes of combining related
instruments and listed, broad-based U.S. index options, index warrants
and underlying instruments and applying the portfolio margin
requirements provided in this Rule 12.4, members are to establish and
utilize a portfolio margin account, clearly identified as a cross-
margin account, that is separate from any other securities account or
portfolio margin account carried for a customer.
A margin deficit in either the portfolio margin account or the
cross-margin account of a customer may not be considered as satisfied
by excess equity in the other account. Funds and/or securities must be
transferred to the deficient account and a written record created and
maintained.
(3) Portfolio Margin Account--Eligible Positions
(i) A transaction in, or transfer of, a listed, broad-based U.S.
index option or index warrant may be effected in the portfolio margin
account.
(ii) A transaction in, or transfer of, an underlying instrument may
be effected in the portfolio margin account provided a position in an
offsetting listed, broad-based U.S. index option or index warrant is in
the account or is established in the account on the same day.
(iii) If, in the portfolio margin account, the listed, broad-based
U.S. index option or index warrant position offsetting an underlying
instrument position ceases to exist and is not replaced within 10
business days, the underlying instrument position must be transferred
to a regular margin account, subject to Regulation T initial margin and
the margin required pursuant to the other provisions of this chapter.
Members will be expected to monitor portfolio margin accounts for
possible abuse of this provision.
(iv) In the event that fully paid for long options and/or index
warrants are the only positions contained within a portfolio margin
account, such long positions must be transferred to a securities
account other than a portfolio margin account or cross-margin account
within 10 business days, subject to the margin required pursuant to the
other provisions of this chapter, unless the status of the account
changes such that it is no longer composed solely of fully paid for
long options and/or index warrants.
(4) Cross-Margin Account--Eligible Positions
(i) A transaction in, or transfer of, a related instrument may be
effected in the cross-margin account provided a position in an
offsetting listed, U.S. broad based index option, index warrant or
underlying instrument is in the account or is established in the
account on the same day.
(ii) If the listed, U.S. broad-based index option, index warrant or
underlying instrument position offsetting a related instrument ceases
to exist and is not replaced within 10 business days, the related
instrument position must be transferred to a futures account. Members
will be expected to monitor cross-margin accounts for possible abuse of
this provision.
(iii) In the event that fully paid for long options and/or index
warrants (securities) are the only positions contained within a cross-
margin account, such long positions must be transferred to a securities
account other than a portfolio margin account or cross-margin account
within 10 business days, subject to the margin required pursuant to the
other provisions of this chapter, unless the status of the account
changes such that it is no longer composed solely of fully paid for
long options and/or index warrants.
(e) Initial and Maintenance Margin Required. The amount of margin
required under this Rule 12.4 for each portfolio shall be the greater
of:
(1) the amount for any of the 10 equidistant valuation points
representing the largest theoretical loss as calculated pursuant to
paragraph (f) below or
(2) $.375 for each listed index option and related instrument
multiplied by the contract or instrument's multiplier, not to exceed
the market value in the case of long positions in listed options and
options on futures contracts.
(f) Method of Calculation.
(1) Long and short positions in listed options, underlying
instruments and related instruments are to be grouped by option class;
each option class group being a ``portfolio''. Each portfolio is
categorized as one of the portfolio types specified in paragraph (a)(9)
above.
(2) For each portfolio, theoretical gains and losses are calculated
for each position as specified in paragraph (a)(9) above. For purposes
of determining the theoretical gains and losses at each valuation
point, members shall obtain and utilize the theoretical value of a
listed index option, underlying instrument or related instrument
rendered by a theoretical pricing model that, in accordance with
paragraph (b)(1)(i)(B) of Rule 15c3-1a under the Securities Exchange
Act of 1934, qualifies for purposes of determining the amount to be
deducted in computing net capital under a portfolio based methodology.
(3) Offsets. Within each portfolio, theoretical gains and losses
may be netted fully at each valuation point.
Offsets between portfolios within the High Capitalization, Broad
Based Index Option product group and the Non-High Capitalization, Broad
Based Index Option product group may then be applied as permitted by
Rule 15c3-1a under the Securities Exchange Act of 1934.
(4) After applying paragraph (3) above, the sum of the greatest
loss from
[[Page 22938]]
each portfolio is computed to arrive at the total margin required for
the account (subject to the per contract minimum).
(g) Equity Deficiency. If, at any time, equity declines below the 5
million dollar minimum required under Paragraph (b)(4) of this Rule
12.4 and is not brought back up to at least 5 million dollars within
three (3) business days (T+3) by a deposit of funds or securities, or
through favorable market action; members are prohibited from accepting
opening orders starting on T+4, except that opening orders entered for
the purpose of hedging existing positions may be accepted if the result
would be to lower margin requirements. This prohibition shall remain in
effect until such time as an equity of 5 million dollars is
established.
(h) Determination of Value for Margin Purposes. For the purposes of
this Rule 12.4, all listed index options and related instrument
positions shall be valued at current market prices. Account equity for
the purposes of this Rule 12.4 shall be calculated separately for each
portfolio margin account by adding the current market value of all long
positions, subtracting the current market value of all short positions,
and adding the credit (or subtracting the debit) balance in the
account.
(i) Additional Margin.
(1) If at any time, the equity in any portfolio margin account,
including a cross-margin account, is less than the margin required,
additional margin must be obtained within one business day (T+1). In
the event a customer fails to deposit additional margin within one
business day, the member must liquidate positions in an amount
sufficient to, at a minimum, lower the total margin required to an
amount less than or equal to account equity. Exchange Rule 12.9--
Meeting Margin Calls by Liquidation shall not apply to portfolio margin
accounts. However, members will be expected to monitor the risk of
portfolio margin accounts pursuant to the risk monitoring procedures
required by Rule 15.8A. Guarantees by any other account for purposes of
margin requirements are not to be permitted.
(2) The day trading requirements of Exchange Rule 12.3(j) shall not
apply to portfolio margin accounts, including cross-margin accounts.
(j) Cross-Margin Accounts--Requirement to Liquidate.
(1) A member is required immediately either to liquidate, or
transfer to another broker-dealer eligible to carry cross-margin
accounts, all customer cross-margin accounts that contain positions in
futures and/or options on futures if the member is:
(i) insolvent as defined in section 101 of title 11 of the United
States Code, or is unable to meet its obligations as they mature;
(ii) the subject of a proceeding pending in any court or before any
agency of the United States or any State in which a receiver, trustee,
or liquidator for such debtor has been appointed;
(iii) not in compliance with applicable requirements under the
Securities Exchange Act of 1934 or rules of the Securities and Exchange
Commission or any self-regulatory organization with respect to
financial responsibility or hypothecation of customers' securities; or
(iv) unable to make such computations as may be necessary to
establish compliance with such financial responsibility or
hypothecation rules.
(2) Nothing in this paragraph (j) shall be construed as limiting or
restricting in any way the exercise of any right of a registered
clearing agency to liquidate or cause the liquidation of positions in
accordance with its by-laws and rules.
* * * * *
Chapter XIII
Net Capital
Customer Portfolio Margin Accounts
Rule 13.5. (a) No member organization that requires margin in any
customer accounts pursuant to Rule 12.4--Portfolio Margin and Cross-
Margin for Index Options, shall permit gross customer portfolio margin
requirements to exceed 1,000 percent of its net capital for any period
exceeding three business days. The member organization shall, beginning
on the fourth business day of any non-compliance, cease opening new
portfolio margin accounts until compliance is achieved.
(b) If, at any time, a member organization's gross customer
portfolio margin requirements exceed 1,000 percent of its net capital,
the member organization shall immediately transmit telegraphic or
facsimile notice of such deficiency to the Securities and Exchange
Commission, 450 Fifth Street NW., Washington, DC 20549; to the district
or regional office of the Securities and Exchange Commission for the
district or region in which the member organization maintains its
principal place of business; and to its Designated Examining Authority.
* * * * *
Chapter XV
Records, Reports and Audits
Risk Analysis of Portfolio Margin Accounts
Rule 15.8A. (a) Each member organization that maintains any
portfolio margin accounts for customers shall establish and maintain
written procedures for assessing and monitoring the potential risk to
the member organization's capital over a specified range of possible
market movements of positions maintained in such accounts. Current
procedures shall be filed and maintained with the Department of
Financial and Sales Practice Compliance. The procedures shall specify
the computations to be made, the frequency of computations, the records
to be reviewed and maintained, and the position(s) within the
organization responsible for the risk function.
(b) Upon direction by the Department of Financial and Sales
Practice Compliance, each affected member organization shall provide to
the Department such information as the Department may reasonably
require with respect to the member organization's risk analysis for any
or all of the portfolio margin accounts it maintains for customers.
(c) In conducting the risk analysis of portfolio margin accounts
required by this Rule 15.8A, each affected member organization is
required to follow the Interpretations and Policies set forth under
Rule 15.8--Risk Analysis of Market-Maker Accounts. In addition, each
affected member organization shall include in written procedures
required pursuant to paragraph (a) above the following:
(1) Procedures and guidelines for the determination, review and
approval of credit limits to each customer, and across all customers,
utilizing a portfolio margin account.
(2) Procedures and guidelines for monitoring credit risk exposure
to the member organization, including intra-day credit risk, related to
portfolio margin accounts.
(3) Procedures and guidelines for the use of stress testing of
portfolio margin accounts in order to monitor market risk exposure from
individual accounts and in the aggregate.
(4) Procedures providing for the regular review and testing of
these risk analysis procedures by an independent unit such as internal
audit or other comparable group.
* * * * *
[[Page 22939]]
Chapter 9
Doing Business with the Public
Delivery of Current Options Disclosure Documents and Prospectus
Rule 9.15. (a) no change
(b) no change
(c) no change
(d) The special written disclosure statement describing the nature
and risks of portfolio margining and cross-margining, and
acknowledgement for customer signature, required by Rule 12.4(c)(2)
shall be in a format prescribed by the Exchange or in a format
developed by the member organization, provided it contains
substantially similar information as the prescribed Exchange format and
has received prior written approval of the Exchange.
Sample Risk Description for Use by Firms to Satisfy Requirements of
Exchange Rule 9.15(d)
Portfolio Margining and Cross-Margining Disclosure Statement and
Acknowledgement
For a Description of the Special Risks Applicable to a Portfolio Margin
Account and its Cross-Margining Features, See the Material Under Those
Headings Below.
Overview of Portfolio Margining
1. Portfolio margining is a margin methodology that sets margin
requirements for an account based on the greatest projected net loss of
all positions in a ``product class'' or ``product group'' as determined
by an options pricing model using multiple pricing scenarios. These
pricing scenarios are designed to measure the theoretical loss of the
positions given changes in both the underlying price and implied
volatility inputs to the model. Portfolio margining is currently
limited to product classes and groups of index products relating to
broad-based market indexes.
2. The goal of portfolio margining is to set levels of margin that
more precisely reflect actual net risk. The customer benefits from
portfolio margining in that margin requirements calculated on net risk
are generally lower than alternative ``position'' or ``strategy'' based
methodologies for determining margin requirements. Lower margin
requirements allow the customer more leverage in an account.
Customers Elibible for Portfolio Margining
3. To be eligible for portfolio margining, customers (other than
broker-dealers) must meet the basic standards for having an options
account that is approved for uncovered writing and must have and
maintain at all times account net equity of not less than $5 million,
aggregated across all accounts under identical ownership at the
clearing broker. The identical ownership requirement excludes accounts
held by the same customer in different capacities (e.g., as a trustee
and as an individual) and accounts where ownership is overlapping but
not identical (e.g., individual accounts and joint accounts).
Positions Eligible for a Portfolio Margin Account
4. All positions in broad-based U.S. market index options and index
warrants listed on a national securities exchange, and exchange traded
funds and other fund products registered under the Investment Company
Act of 1940 that are managed to track the same index that underlies
permitted index options, are eligible for a portfolio margin account.
Special Rules for Portfolio Margin Accounts
5. A portfolio margin account may be either a separate account or a
subaccount of a customer's regular margin account. In the case of a
subaccount, equity in the regular account will be available to satisfy
any margin requirement in the portfolio margin subaccount without
transfer to the subaccount.
6. A portfolio margin account or subaccount will be subject to a
minimum margin requirement of $.375 multiplied by the index multiplier
for every options contract or index warrant carried long or short in
the account. No minimum margin is required in the case of eligible
exchange traded funds or other eligible fund products.
7. Margin calls in the portfolio margin account or subaccount,
regardless of whether due to new commitments or the effect of adverse
market moves on existing positions, must be met within one business
day. Any shortfall in aggregate net equity across accounts must be met
within three business days. Failure to meet a margin call when due will
result in immediate liquidation of positions to the extent necessary to
reduce the margin requirement. Failure to meet an equity call prior to
the end of the third business day will result in a prohibition on
entering any opening orders, with the exception of opening orders that
hedge existing positions, beginning on the fourth business day and
continuing until such time as the minimum equity requirement is
satisfied.
8. A position in an exchange traded index fund or other eligible
fund product may not be established in a portfolio margin account
unless there exists, or there is established on the same day, an
offsetting position in securities options or other eligible securities.
Exchange traded index funds and/or other eligible funds will be
transferred out of the portfolio margin account and into a regular
securities account subject to strategy based margin if, for more than
10 business days and for any reason, the offsetting securities options
or other eligible securities no longer remain in the account.
9. When a broker-dealer carries a regular cash account or margin
account for a customer, the broker-dealer is limited by rules of the
Securities and Exchange Commission and of The Options Clearing
Corporation (``OCC'') in the extent to which the broker-dealer may
permit OCC to have a lien against long option positions in those
accounts. In contrast, OCC will have a lien against all long option
positions that are carried by a broker-dealer in a portfolio margin
account, and this could, under certain circumstances, result in greater
losses to a customer having long option positions in such an account in
the event of the insolvency of the customer's broker. Accordingly, to
the extent that a customer does not borrow against long option
positions in a portfolio margin account or have margin requirements in
the account against which the long option can be credited, there is no
advantage to carrying the long options in a portfolio margin account
and the customer should consider carrying them in an account other than
a portfolio margin account.
Special Risks of Portfolio Margin Accounts
10. Portfolio margining generally permits greater leverage in an
account, and greater leverage creates greater losses in the event of
adverse market movements.
11. Because the time limit for meeting margin calls is shorter than
in a regular margin account, there is increased risk that a customer's
portfolio margin account will be liquidated involuntarily, possibly
causing losses to the customer.
12. Because portfolio margin requirements are determined using
sophisticated mathematical calculations and theoretical values that
must be calculated from market data, it may be more difficult for
customers to predict the size of future margin calls in a portfolio
margin account. This is particularly true in the case of customers who
do not have access to specialized software necessary to make
[[Page 22940]]
such calculations or who do not receive theoretical values calculated
and distributed periodically by The OCC.
13. For the reasons noted above, a customer that carries long
options positions in a portfolio margin account could, under certain
circumstances, be less likely to recover the full value of those
positions in the event of the insolvency of the carrying broker.
14. Trading of securities index products in a portfolio margin
account is generally subject to all the risks of trading those same
products in a regular securities margin account. Customers should be
thoroughly familiar with the risk disclosure materials applicable to
those products, including the booklet entitled Characteristics and
Risks of Standardized Options.
15. Customers should consult with their tax advisers to be certain
that they are familiar with the tax treatment of transactions in
securities index products.
16. The descriptions in this disclosure statement relating to
eligibility requirements for portfolio margin accounts, and minimum
equity and margin requirements for those accounts, are minimums imposed
under exchange rules. Time frames within which margin and equity calls
must be met are maximums imposed under exchange rules. Broker-dealers
may impose their own more stringent requirements.
Overview of Cross-Margining
17. With cross-margining, index futures and options on index
futures are combined with offsetting positions in securities index
options and underlying instruments, for the purpose of computing a
margin requirement based on the net risk. This generally produces lower
margin requirements than if the futures products and securities
products are viewed separately, thus providing more leverage in the
account.
18. Cross-margining must be done in a portfolio margin account
type. A separate portfolio margin account must be established
exclusively for cross-margining.
19. When index futures and options on futures are combined with
offsetting positions in index options and underlying instruments in a
dedicated account, and a portfolio margining methodology is applied to
them, cross-margining is achieved.
Customers Eligible for Cross-Margining
20. The eligibility requirements for cross-margining are generally
the same as for portfolio margining, and any customer eligible for
portfolio margining is eligible for cross-margining.
21. Members of futures exchanges on which cross-margining eligible
index contracts are traded are also permitted to carry positions in
cross-margin accounts without regard to the minimum aggregate account
equity.
Positions Eligible for Cross-Margining
22. All securities products eligible for portfolio margining are
also eligible for cross-margining.
23. All broad-based U.S. market index futures and options on index
futures traded on a designated contract market subject to the
jurisdiction of the Commodity Futures Trading Commission are eligible
for cross-margining.
Special Rules for Cross-Margining
24. Cross-margining must be conducted in a portfolio margin account
type. A separate portfolio margin account must be established
exclusively for cross-margining. A cross-margin account is a securities
account, and must be maintained separate from all other securities
accounts.
25. Cross-margining is automatically accomplished with the
portfolio margining methodology. Cross-margin positions are subject to
the same minimum margin requirement for every contract, including
futures contracts.
26. Margin calls arising in the cross-margin account, and any
shortfall in aggregate net equity across accounts, must be satisfied
within the same time frames, and subject to the same consequences, as
in a portfolio margin account.
27. A position in a futures product may not be established in a
cross-margin account unless there exists, or there is established on
the same day, an offsetting position in securities options and/or other
eligible securities. Futures products will be transferred out of the
cross-margin account and into a futures account if, for more than 10
business days and for any reason, the offsetting securities options
and/or other eligible securities no longer remain in the account. If
the transfer of futures products to a futures account causes the
futures account to be undermargined, a margin call will be issued or
positions will be liquidated to the extent necessary to eliminate the
deficit.
28. According to the rules of the exchanges, a broker-dealer is
required to immediately liquidate, or, if feasible, transfer to another
broker-dealer eligible to carry cross-margin accounts, all customer
cross-margin accounts that contain positions in futures and/or options
on futures in the event that the carrying broker-dealer becomes
insolvent.
29. Customers participating in cross-margining will be required to
sign an agreement acknowledging that their positions and property in
the cross-margin account will be subject to the customer protection
provisions of Rule 15c3-3 under the Securities Exchange Act of 1934 and
the Securities Investor Protection Act, and will not be subject to the
provisions of the Commodity Exchange Act, including segregation of
funds.
30. In signing the agreement referred to in paragraph 29 above, a
customer also acknowledges that a cross-margin account that contains
positions in futures and/or options on futures will be immediately
liquidated, or, if feasible, transferred to another broker-dealer
eligible to carry cross-margin accounts, in the event that the carrying
broker-dealer becomes insolvent.
Special Risks of Cross-Margining
31. Cross-margining must be conducted in a portfolio margin account
type. Generally, cross-margining and the portfolio margining
methodology both contribute to provide greater leverage than a regular
margin account, and greater leverage creates greater losses in the
event of adverse market movements.
32. As cross-margining must be conducted in a portfolio margin
account type, the time required for meeting margin calls is shorter
than in a regular securities margin account and may be shorter than the
time ordinarily required by a futures commission merchant for meeting
margin calls in a futures account. As a result, there is increased risk
that a customer's cross-margin positions will be liquidated
involuntarily, causing possible loss to the customer.
33. As noted above, cross-margin accounts are securities accounts
and are subject to the customer protections set-forth in Rule 15c3-3
under the Securities Exchange Act of 1934 and the Securities Investor
Protection Act. Cross-margin positions are not subject to the customer
protection rules under the segregation provisions of the Commodity
Exchange Act and the rules of the Commodity Futures Trading Commission
(``CFTC'') adopted pursuant to the Commodity Exchange Act.
34. Trading of index options and futures contracts in a cross-
margin account is generally subject to all the risks of trading those
same products in a futures account or a regular securities margin
account, as the case may be. Customers should be thoroughly familiar
with the risk disclosure materials applicable to those products,
including the booklet entitled
[[Page 22941]]
Characteristics and Risks of Standardized Options and the risk
disclosure document required by the CFTC to be delivered to futures
customers. Because this disclosure statement does not disclose the
risks and other significant aspects of trading in futures and options,
customers should review those materials carefully before trading in a
cross-margin account.
35. Customers should bear in mind that the discrepancies in the
cash flow characteristics of futures and certain options are still
present even when those products are carried together in a cross-margin
account. Both futures and options contracts are generally marked to the
market at least once each business day, but the marks may take place
with different frequency and at different times within the day. When a
futures contract is marked to the market, the gain or loss is
immediately credited to or debited from, respectively, the customer's
account in cash. While an increase in value of a long option contract
may increase the equity in the account, the gain is not realized until
the option is sold or exercised. Accordingly, a customer may be
required to deposit cash in the account in order to meet a variation
payment on a futures contract even though the customer is in a hedged
position and has experienced a corresponding (but as yet unrealized)
gain on a long option. On the other hand, a customer who is in a hedged
position and would otherwise be entitled to receive a variation payment
on a futures contract may find that the cash is required to be held in
the account as margin collateral on an offsetting option position.
36. Customers should consult with their tax advisers to be certain
that they are familiar with the tax treatment of transactions in index
products, including tax consequences of trading strategies involving
both futures and option contracts.
37. The descriptions in this disclosure statement relating to
eligibility requirements for cross-margining, and minimum equity and
margin requirements for cross-margin accounts, are minimums imposed
under exchange rules. Time frames within which margin and equity calls
must be met are maximums imposed under exchange rules. The broker-
dealer carrying a customer's portfolio margin account, including any
cross-margin account, may impose its own more stringent requirements.
* * * * *
Acknowledgement for Customers Utilizing a Portfolio Margin Account--
Cross-Margining and non Cross-Margining
Rule 15c3-3 under the Securities Exchange Act of 1934 requires that
a broker or dealer promptly obtain and maintain physical possession or
control of all fully-paid securities and excess margin securities of a
customer. Fully-paid securities are securities carried in a cash
account and margin equity securities carried in a margin or special
account (other than a cash account) that have been fully paid for.
Excess margin securities are a customer's margin securities having a
market value in excess of 140% of the total of the debit balances in
the customer's non-cash accounts. For the purposes of Rule 15c3-3,
securities held subject to a lien to secure obligations of the broker-
dealer are not within the broker-dealer's physical possession or
control. The Commission staff has taken the position that all long
option positions in a customer's portfolio-margining account (including
any cross-margining account) may be subject to such a lien by OCC and
will not be deemed fully-paid or excess margin securities under Rule
15c3-3.
The hypothecation rules under the Securities Exchange Act of 1934
(Rules 8c-1 and 15c2-1), prohibit broker-dealers from permitting the
hypothecation of customer securities in a manner that allows those
securities to be subject to any lien or liens in an amount that exceeds
the customer's aggregate indebtedness. However, all long option
positions in a portfolio-margining account (including any cross-
margining account) will be subject to OCC's lien, including any
positions that exceed the customer's aggregate indebtedness. The
Commission staff has taken a position that would allow customers to
carry positions in portfolio-margining accounts (including any cross-
margining account), even when those positions exceed the customer's
aggregate indebtedness. Accordingly, within a portfolio margin account
or cross-margin account, to the extent that you have long option
positions that do not operate to offset your aggregate indebtedness and
thereby reduce your margin requirement, you receive no benefit from
carrying those positions in your portfolio margin account or cross-
margin account and incur the additional risk of OCC's lien on your long
option position(s).
BY SIGNING BELOW, THE CUSTOMER AFFIRMS THAT THE CUSTOMER HAS READ
AND UNDERSTOOD THE FOREGOING DISCLOSURE STATEMENT AND ACKNOWLEDGES AND
AGREES THAT LONG OPTION POSITIONS IN PORTFOLIO-MARGINING ACCOUNTS AND
CROSS-MARGINING ACCOUNTS WILL BE EXEMPTED FROM CERTAIN CUSTOMER
PROTECTION RULES OF THE SECURITIES AND EXCHANGE COMMISSION AS DESCRIBED
ABOVE AND WILL BE SUBJECT TO A LIEN BY THE OPTIONS CLEARING CORPORATION
WITHOUT REGARD TO SUCH RULES.
CUSTOMER NAME:---------------------------------------------------------
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BY:--------------------------------------------------------------------
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(signature/title)
DATE:------------------------------------------------------------------
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* * * * *
ACKNOWLEDGEMENT FOR CUSTOMERS ENGAGED IN CROSS-MARGINING
As disclosed above, futures contracts and other property carried in
customer accounts with Futures Commission Merchants (``FCM'') are
normally subject to special protection afforded under the customer
segregation provisions of the Commodity Exchange Act (``CEA'') and the
rules of the CFTC adopted pursuant to the CEA. These rules require that
customer funds be segregated from the accounts of financial
intermediaries and be separately accounted for, however, they do not
provide for, and regular futures accounts do not enjoy the benefit of,
insurance protecting customer accounts against loss in the event of the
insolvency of the intermediary carrying the accounts.
As also has been discussed above, cross-margining must be conducted
in a portfolio margin account dedicated exclusively to cross-margining,
and cross-margin accounts are not treated as a futures account with an
FCM. Instead, cross-margin accounts are treated as securities accounts
carried with broker-dealers. As such, cross-margin accounts are covered
by Rule 15c3-3 under the Securities Exchange Act of 1934, which
protects customer accounts. Rule 15c3-3, among other things, requires a
broker-dealer to maintain physical possession or control of all fully-
paid and excess margin securities and maintain a special reserve
account for the benefit of their customers. However, in respect of
cross-margin accounts, there is an exception to the possession or
control requirement of Rule 15c3-3 that permits The Options Clearing
Corporation to have a lien on long positions. This aspect is outlined
in a separate
[[Page 22942]]
acknowledgement form that must be signed prior to or concurrent with
this form. Additionally, the Securities Investor Protection Corporation
(``SIPC'') insures customer accounts against the financial insolvency
of a broker-dealer in the amount of up to $500,000 to protect against
the loss of registered securities and cash maintained in the account
for purchasing securities or as proceeds from selling securities
(although the limit on cash claims is $100,000). According to the rules
of the exchanges, a broker-dealer is required to immediately liquidate,
or, if feasible, transfer to another broker-dealer eligible to carry
cross-margin accounts, all customer cross-margin accounts that contain
positions in futures and/or options on futures in the event that the
carrying broker-dealer becomes insolvent.
BY SIGNING BELOW, THE CUSTOMER AFFIRMS THAT THE CUSTOMER HAS READ
AND UNDERSTOOD THE FOREGOING DISCLOSURE STATEMENT AND ACKNOWLEDGES AND
AGREES THAT: 1) POSITIONS AND PROPERTY IN CROSS-MARGINING ACCOUNTS,
WILL NOT BE SUBJECT TO THE CUSTOMER PROTECTION RULES UNDER THE CUSTOMER
SEGREGATION PROVISIONS OF THE COMMODITY EXCHANGE ACT (``CEA'') AND THE
RULES OF THE COMMODITY FUTURES TRADING COMMISSION ADOPTED PURSUANT TO
THE CEA, AND 2) CROSS-MARGINING ACCOUNTS THAT CONTAIN POSITIONS IN
FUTURES AND/OR OPTIONS ON FUTURES WILL BE IMMEDIATELY LIQUIDATED, OR,
IF FEASIBLE, TRANSFERED TO ANOTHER BROKER-DEALER ELIGIBLE TO CARRY
CROSS-MARGIN ACCOUNTS, IN THE EVENT THAT THE CARRYING BROKER-DEALER
BECOMES INSOLVENT.
CUSTOMER NAME:---------------------------------------------------------
-----------------------------------------------------------------------
BY:--------------------------------------------------------------------
-----------------------------------------------------------------------
(signature/title)
DATE:------------------------------------------------------------------
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* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the CBOE included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. The CBOE 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
a. Introduction
The CBOE proposes to expand its margin rules by providing a
portfolio margin methodology for listed, broad-based market index
options, index warrants and related exchange-traded funds that clearing
member organizations may extend to eligible customers as an alternative
to the current strategy-based option margin requirements. The proposed
rule change would also allow broad-based index futures and options on
such futures to be included in a separate portfolio margin account,
thus providing a cross-margin capability. The CBOE seeks to introduce
the proposed new rule as a two-year pilot program that would be made
available to member organizations on a voluntary basis.
The proposed rule change would permit self-clearing member
organizations to apply a prescribed portfolio margin methodology to an
account \11\ of another broker-dealer and an account of a member of a
national futures exchange who is a futures floor trader. Any other
customers or affiliates of the clearing member would be required to
have account equity of at least $5 million to be eligible for portfolio
margin treatment. This circumscribes the number of accounts able to
participate and adds safety in that such accounts are more likely to be
of significant financial means and investment sophistication.
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\11\ An account dedicated to portfolio margining.
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The Exchange submitted this partial amendment, constituting
Amendment No. 2, pursuant to the request of Commission staff.
Specifically, the Exchange proposes to amend the proposed rule (Rule
12.4) to remove the provision in current paragraph (b)(2) that makes
``any affiliate of a self-clearing member organization'' eligible for
portfolio margining. Removal of this provision would not exclude an
affiliate of a self-clearing member organization from participation,
but would necessitate that such entities have minimum account equity of
five million dollars in order to participate, as required under current
paragraph (b)(4). Current paragraph (b)(3) would be renumbered (b)(2),
and current paragraph (b)(4) would be renumbered (b)(3).
In relation to the change noted above, the Exchange also proposes
in Amendment No. 2 to revise paragraph number 3 of the Sample Risk
Description for Use by Firms To Satisfy Requirements of Exchange Rule
9.15(d) to remove the words ``and certain non-broker-dealer affiliates
of the carrying broker-dealer'' in the first sentence. This change to
the notice would reflect that non-broker-dealer affiliates would be
subject to the $5 million equity requirement. With the exception of
these changes, the rest of the proposed rule changes, as contained in
the Original Proposal, as amended by Amendment No. 1,\12\ remain
unchanged.
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\12\ A number of revisions contained in Amendment No. 1 were
deemed warranted, or requested or recommended by staff of the
Commission. In either case, the reason for these revisions was to
make corrections or clarifications to the proposed rule, or to
reconcile differences between the proposed rule and a parallel
filing by the NYSE. See, supra notes 7 and 8.
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Portfolio margining is most effective when applied to larger
accounts with diverse option positions and related securities, and any
related futures contracts. It is expected that institutional customers
will be the primary participants. Whether the account equity
requirement should be lowered to allow participation of more customers
will be assessed at the end of the pilot program period. Application of
portfolio margin, including cross-margin, to an IRA account would be
prohibited under the proposed rule change.
The proposed portfolio margin and cross-margin rules have been
developed by the CBOE in cooperation with The Options Clearing
Corporation (``The OCC''), the New York Stock Exchange, Inc.
(``NYSE''), the American Stock Exchange LLC, the Board of Trade of the
City of Chicago, Inc., and the Chicago Mercantile Exchange Inc.
(``CME''). The CBOE intends to provide a written overview describing
the operational details of the portfolio margin and cross-margin pilot
program to potential member organization participants to introduce and
explain the pilot program.
A committee of representatives from the member organizations
identified as potential participants, and staff of the sponsoring
exchanges and The OCC (the ``Portfolio Margin Committee'') was formed
and met several times in 1999 and 2000 to refine the portfolio margin
and cross-margin pilot program. This
[[Page 22943]]
group has recommended adoption of the portfolio margin and cross-margin
pilot program, as finalized by the group, and the related rule
proposals. In addition, the portfolio margin and cross-margin pilot
program has been presented to the NYSE's Rule 431 Committee \13\ on two
occasions, with draft rules included on the second occasion, and has
received the NYSE's Rule 431 Committee's support.
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\13\ The NYSE Rule 431 Committee is comprised of securities
industry representatives, primarily representatives of NYSE member
organizations. NYSE Rule 431 contains the NYSE's margin rules. The
function of the NYSE Rule 431 Committee is to assess the adequacy of
NYSE Rule 431 on an ongoing basis, review proposals for changes to
NYSE Rule 431, and recommend changes that are deemed appropriate.
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b. Overview--Portfolio Margin Computation
(1) Portfolio Margin
Under a portfolio margin system, margin is required based on the
greatest loss that would be incurred in a portfolio if the value of
components (underlying instruments in the case of options) move up or
down by a predetermined amount (e.g., +/-5%). Under the Exchange's
proposed portfolio margin rule, listed index options and underlying
instruments (also related instruments \14\ in the case of a cross-
margin account) would be grouped by class \15\ (e.g., S&P 500, S&P 100,
etc.), each class group being a portfolio.\16\ The gain or loss on each
position in a portfolio would be calculated at each of 10 equidistant
points (``valuation points'') set at and between the upper and lower
market range points. A theoretical options pricing model would be used
to derive position values \17\ at each valuation point for the purpose
of determining the gain or loss. Gains and losses would then be netted
for positions within the class or portfolio at each valuation point.
The greatest net loss among the 10 valuation points would be the margin
required on the portfolio or class. The margin for all other portfolios
within an account would be calculated in a similar manner. Broad-based
index classes (portfolios) that are highly correlated would be allowed
offsets such that, at the same valuation point, for example, 90% of a
gain in one class may reduce or offset a loss in another class. The
amount of offset allowed between portfolios would be the same amount
that is permitted under the risk-based haircut methodology set forth in
Appendix A of the Commission's net capital rule.\18\ A per contract
minimum would be established and would override if a lesser requirement
is rendered by the portfolio margin computation.\19\ Member
organizations would not be permitted to use any theoretical pricing
model to generate the prices used to calculate theoretical profits and
losses. Under the proposed rule change, the theoretical prices used for
computing profits and losses must come from a theoretical pricing model
that, pursuant to the Commission's net capital rule,\20\ qualifies for
purposes of determining the amount to be deducted in computing net
capital under a portfolio-based methodology. CBOE believes that
delineating acceptable theoretical pricing models is best achieved by
applying the Commission's net capital rule by reference. In this way,
consistency with the Commission's net capital rule is maintained. In
addition, since theoretical pricing models must be approved by a
Designated Examining Authority and reviewed by the Commission to
qualify, uniformity across models can be assured. As a result,
portfolio margin and cross-margin requirements will not vary materially
from firm to firm. Currently, the theoretical model used by The OCC is
the only model qualified pursuant to the Commission's net capital rule.
Consequently, all member organizations participating in the pilot
program would, at least for the foreseeable future, obtain their
theoretical values from The OCC.
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\14\ Under the proposed rule change, the term ``related
instrument'' would mean, with respect to an options class or product
group, futures contracts and options on futures contracts covering
the same underlying instrument.
\15\ Under the proposed rule change, the term ``options class''
would refer to all options contracts covering the same underlying
instrument.
\16\ CBOE's pilot program would permit an exchange-traded fund
structured to replicate the composition of the index to be included;
however, stock baskets would not be permitted at this time.
\17\ Position values would represent the difference between the
position closing price and the theoretical value at each valuation
point.
\18\ Rule 15c3-1a under the Act, 17 CFR 240.15c3-1a.
\19\ The proposed rules set a per contract minimum of $37.50.
\20\ See Rule 15c3-1a(b)(1)(i)(B) under the Act, 17 CFR
240.15c3-1a(b)(1)(i)(B).
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The Exchange's proposed rule would propose a market range of +/-10%
for computing theoretical gains and losses in broad-based, non-high
capitalization index portfolios. A market range of +6% /-8% is proposed
for broad-based, high capitalization index portfolios.\21\ These are
the same ranges currently applied to options market makers for the
purpose of computing portfolio or risk-based haircuts. On a historical
basis, these ranges cover one day moves at a very high level of
confidence, and would be competitive with the market range coverage
applied for performance bond (margin) purposes in the futures industry
on comparable index futures. The proposed rule change requires that a
separate securities margin account (or subaccount of a securities
margin account) be used for portfolio margining.
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\21\ CBOE believes that it is imperative that these market move
ranges be competitive with the range used in the futures industry
for computing margin (performance bond) on broad-based index
futures. The proposed ranges accomplish this goal. Customer
performance bond in the futures industry is computed using a
portfolio margining system known as the Standard Portfolio Analysis
of Risk (``SPAN''). The terms ``high capitalization'' and ``non-high
capitalization'' have the same meaning as they do for the purposes
of risk-based haircuts (Rule 15c3-1 under the Act, 17 CFR 240.15c3-
1).
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Amendment No. 1 to the proposed rule change also adds rule language
that requires fully paid for long options (and/or index warrants) to be
transferred out of the portfolio margin account and/or cross-margin
account and into a securities account that is not a portfolio margin
account, in the event that such long positions are the only components.
(2) Cross-Margining
The proposed rule permits related index futures and options on such
futures to be carried in a separate portfolio margin account, thus
affording a cross-margin capability. Amendment No. 1 contains changes
that primarily relate to the addition of rule language (i.e., Rule
12.4(j)) that, pursuant to agreement between Commission staff, the
Exchange and The OCC, requires cross-margin positions to be liquidated
or transferred in the event the carrying broker-dealer becomes
insolvent. The Original Proposal allowed cross-margining to be
commingled with other, non-cross margin portfolio margin positions in
the same account. However, the proposal of Amendment No. 1 to require
liquidation or transfer of the cross-margin account necessitates that
cross-margining be conducted in an account separate from non-cross-
margining activity. Therefore, Amendment No. 1 contains a number of
proposed revisions that relate to isolation of cross-margin positions
in a separate account.
In a portfolio margin account, including one that is used
exclusively for cross-margining, constituent portfolios may be formed
containing index options, index warrants and exchange-traded funds
structured to replicate the composition of the index underlying a
particular portfolio, as well as related index futures and options on
such futures. Cross-margining would operate similar to the cross-margin
program that was approved by the
[[Page 22944]]
Commission and the Commodity Futures Trading Commission (``CFTC'') for
listed options market-makers and proprietary accounts of clearing
member organizations. For determining theoretical gains and losses, and
resultant margin requirements, the same portfolio margin computation
program will be applied to portfolio margin accounts, as well as cross-
margin accounts.
c. Margin or Minimum Equity Deficiency
Under proposed CBOE Rule 12.4(h), positions in a portfolio margin
account would be valued at current market prices, as currently defined
in the Exchange's margin rules. Under the proposed rule change, account
equity would be calculated and maintained separately for each portfolio
margin account. For purposes of the $5 million minimum account equity
requirement, all accounts owned by an individual or entity may be
combined. Proposed CBOE Rule 12.4(i) requires that additional margin
must be obtained within one business day (T+1) whenever equity is below
the margin required, regardless of whether the deficiency is caused by
the addition of new positions, the effect of unfavorable market
movement on existing positions, or a combination of both. The portfolio
margin requirement, therefore, would be both the initial and
maintenance margin requirement, and no differentiation would be
necessary. In addition, proposed CBOE Rule 12.4(g) would require that,
in the event account equity falls below the $5 million minimum,
additional equity must be deposited within 3 business days (T+3). If
the deficiency were not resolved within 3 business days, the carrying
member organization would be prohibited under the proposed rule change
from accepting any new opening orders beginning on T+4, with the
exception of opening orders that hedge existing positions. This
prohibition would remain in effect until a $5 million equity was
established.
d. Risk Disclosure Statement and Acknowledgement
In addition, the Exchange proposes that member organizations
provide every portfolio margin customer with a written risk disclosure
statement at or prior to the initial opening of a portfolio margin
account.\22\ This disclosure statement highlights the risks and
operation of portfolio margin accounts, including cross-margining, and
the differences between portfolio margin and strategy-based margin
requirements. The disclosure statement is divided into two sections,
one dealing with portfolio margining and the other with cross-
margining. The disclosure statement clearly notes that additional
leverage is possible in an account margined on a portfolio basis in
relation to strategy-based margin. Among other things, the disclosure
statement covers who is eligible to open a portfolio margin account,
the instruments that are allowed, and when deposits to meet margin and
minimum equity are due. The fact that long option positions held in a
portfolio margin account are not segregated, as they generally would be
in the case of a regular margin account under the Commission's customer
protection rules, is explained. Also included within the portfolio
margin section is a summary list of the special risks of portfolio
margin accounts, such as: Increased leverage; shorter time for meeting
margin; involuntary liquidation if margin not received; inability to
calculate future margin requirements because of the data and
calculations required; and that long positions are subject to a lien.
The risks and operation of a cross-margin feature are outlined in the
cross-margin section of the disclosure statement, and a summary list of
the special risks associated with cross-margining is included.
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\22\ Even a customer that engages exclusively in cross-margining
is a portfolio margin customer, as the proposed rule change permits
cross-margining to be conducted only by applying the portfolio
margin methodology.
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Further, at or prior to the time a portfolio margin account is
initially opened, member organizations would be required to obtain a
signed acknowledgement concerning portfolio margining in general from
the customer. In addition, prior to accommodating cross-margining,
member organizations would be required to obtain a second signed
acknowledgement within the same time frame that pertains to cross-
margin.
By signing the general acknowledgement required of all customers,
the customer would attest to having read the disclosure statement and
being aware of the fact that long option positions in a portfolio
margin account (which includes cross-margin accounts) are not subject
to the segregation requirements under the customer protection rules of
the Commission, and would be subject to a lien by The OCC. In signing
the additional acknowledgement applicable to cross-margining, the
customer would attest to having read the disclosure statement and being
aware of the fact that futures positions are being carried in a
securities account, are subject to the Commission's customer protection
rules,\23\ and fall under the authority of the SIPC in the event the
carrying broker-dealer becomes financially insolvent. Within Chapter 9
of the Exchange's rules (``Doing Business with the Public''), the
Exchange would prescribe the format of the written disclosure statement
and acknowledgements in proposed Exchange Rule 9.15(d)--Delivery of
Current Options Disclosure Documents and Prospectus. Like a current
Exchange rule that prescribes the format for a Special Statement for
Uncovered Options Writers (CBOE Rule 9.15(c)), proposed Exchange Rule
9.15(d) would allow member organizations to develop their own format,
provided it contains substantially similar information and it is
approved in advance by the Exchange.
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\23\ As disclosed in the general acknowledgement form (required
of any portfolio or cross-margin customer), portfolio margin and
cross-margin accounts operate pursuant to an exception to the
customer protection rules in that fully paid long positions will not
be segregated.
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e. Net Capital
The Exchange also proposes to add a new requirement in CBOE Rule
13.5 to mandate that the gross customer portfolio margin requirements
of a broker-dealer may at no time exceed 1,000 percent of a carrying
broker-dealer's net capital (a 10:1 ratio). This requirement is
intended to place a ceiling on the amount of margin a broker-dealer can
extend to its customers in relation to its net capital.
f. Internal Risk Monitoring Procedures
The Exchange further proposes a separate, related rule that would
require member organizations that carry portfolio margin or cross-
margin accounts to establish and maintain written procedures for
assessing and monitoring the potential risks to their capital.
Specifically, proposed CBOE Rule 15.8A (Risk Analysis of Portfolio
Margin and Cross-Margin Accounts) would require that the member
organization file and maintain its current procedures with its DEA, and
provide the DEA with such information as the DEA may reasonably require
regarding the member organization's risk analysis of any and all
portfolio margin and cross-margin accounts carried for customers.
Proposed CBOE Rule 15.8A would incorporate current Exchange Rule 15.8--
Risk Analysis of Market-Maker Accounts--by reference to require that
the risk analysis be conducted in the same manner as prescribed in
Exchange Rule 15.8. Additionally, proposed CBOE Rule 15.8A would set
forth certain
[[Page 22945]]
undertakings that must be included in the written procedures (e.g.,
review and approval of credit limits for each customer and across all
accounts).
Because member organizations would be required under the proposed
rule change to have risk monitoring procedures, proposed CBOE Rule
12.4(i) states that the current CBOE Rule 12.9--Meeting Margin Calls by
Liquidation Prohibited--prohibiting excessive liquidations to meet
margin requirements will not apply to portfolio margin and cross-margin
accounts. Furthermore, given the proposed risk monitoring procedures,
CBOE proposes that day trading margin requirements would not apply to
portfolio margin and cross-margin accounts. Through these risk-
monitoring procedures, member organizations will be expected to oversee
portfolio margin and cross-margin accounts for excessive liquidations
and day trading and take appropriate action according to their
procedures.
It should be noted that the disclosure statement delivery
requirement, the $5 million minimum equity requirement, and the next
day deposit condition for additionally required margin were all added
by the Portfolio Margin Committee. The Portfolio Margin Committee
deemed these requirements prudent given that less margin is generally
required under a portfolio margining approach than under the current
strategy-based methodology, and these measures made the plan entirely
acceptable to the member firm representatives.
g. Margin at the Clearing House Level \24\
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\24\ The Commission anticipates that the clearing arrangements
described in this section will be the subject of a separate proposed
rule change filed by The OCC.
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The Exchange proposes that all customer portfolio margin account
transactions not involving a futures transaction (e.g., cross-margin)
be cleared in one special omnibus account for the clearing firm at The
OCC. In addition, the Exchange proposes that all transactions involving
cross-margining, both the security and futures products, be cleared in
one of two additional special omnibus accounts for cross-margining,
depending on the entity that clears the futures product being cross-
margined. One cross-margin omnibus account corresponds to a cross-
margining agreement between The OCC, the CME and the New York Clearing
Corporation. The other omnibus account corresponds to a cross-margining
agreement between The OCC and the Board of Trade Clearing Corporation.
The OCC will compute margin for the special omnibus accounts using the
same portfolio margin methodology applied at the customer level. The
OCC will continue to require full payment from the clearing firm for
all long option positions. However, as previously noted, long positions
will not be segregated like they are in the firm's regular customer
range account at The OCC. This is necessary and preferred with a
portfolio margining methodology because all long positions must be
available for margin offset. Margin relief is based on a dollar offset
basis as opposed to identifying specific contract to contract offsets
under a strategy-based methodology. This may result in situations where
the long positions of a given customer could serve to offset the risk
in another customer's short position. Long positions would, therefore,
be subject to The OCC lien. An OCC clearing member currently has the
ability to unsegregate a long position in order to pair it with a short
position (contract to contract basis) and form a qualified spread.
Under the proposed treatment of long positions in a portfolio margin
omnibus account at The OCC, all long positions would be unsegregated,
freeing The OCC clearing member from the task of determining which long
positions offset risk and from specifying each position to be
unsegregated.
h. Rationale for Portfolio Margin
Portfolio margining brings a modern approach to quantifying risk
and offers a number of efficiencies. It eliminates the task of
analyzing the portfolio and sorting it according to currently
recognized strategies (e.g., spreads), and computing a margin
requirement for each individual position or strategy. This process
becomes quite cumbersome in an account with multiple positions and
complex strategies. More importantly, for a given market move, up or
down, in a diverse portfolio there will be listed option positions that
appreciate and other option positions that will depreciate. Under a
portfolio margin system, offsets are fully realized, whereas, under the
current strategy-based system, positions and/or a group of positions
comprising a single strategy are margined independent of each other and
offsets between them do not figure into the total margin requirement as
efficiently. In addition, under a portfolio margin system, the
volatility of an individual listed option series is used in the
theoretical pricing model that renders the price used to compute a
gain/loss on that option position at each valuation point. This links
the margin required to the risk in each particular position in contrast
to the strategy-based margin. Strategy-based margin applies a universal
percentage requirement (of the underlying index value) to all short
option positions in the same category (e.g., broad-based), irrespective
of the fact that all options prices do not change equally (in
percentage terms) with a change in the price or level of the underlying
instrument.
Theoretical options pricing models have become widely accepted and
utilized since Fischer Black and Myron Scholes first introduced a
formula for calculating the value of a European style option in 1973.
Other formulas, such as the Cox-Ross-Rubinstein model have since been
developed. Option pricing formulas are now used routinely by option
market participants to analyze and manage risk and have proven to be
highly effective and preferred. In addition, essentially the same
portfolio methodology described above has been used successfully by
broker-dealers since 1994 to calculate haircuts on option positions for
net capital purposes.\25\
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\25\ On March 15, 1994, the Commission issued a no-action letter
allowing the implementation of a risk-based haircut pilot program.
See letter from Brandon Becker, Director, Division, Commission, to
Mary Bender, First Vice President, Division of Regulatory Services,
CBOE, and Timothy Hinkes, Vice President, The OCC, dated March 15,
1994. The risk-based haircut program took full effect on September
1, 1997. See ``Net Capital Rule,'' Securities Exchange Act Release
No. 38248 (February 6, 1997), 62 FR 6474 (February 12, 1997).
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The Board of Governors of the Federal Reserve System (the ``Federal
Reserve Board'' or ``FRB'') in its amendments to Regulation T in 1998
permitted SROs to implement portfolio margin rules, provided they are
approved by the Commission.\26\ A portfolio margin system recognizes
the offsetting gains from positions that react favorably in market
declines, while market rises are tempered by offsetting losses from
positions that react negatively. A portfolio margin approach can thus
have a neutralizing effect on option portfolio volatility. In times of
market stress, the current strategy-based margin can result in margin
calls and forced liquidations, thus contributing to the selling
pressure in the market. The offset ability of portfolio margining can
alleviate the need for liquidations, slowing acceleration of volatility
in a crisis.
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\26\ See Federal Reserve System, ``Securities Credit
Transactions; Borrowing by Brokers and Dealers''; Regulations G, T,
U and X; Docket Nos. R-0905, R-0923 and R-0944, 63 FR 2806 (January
16, 1998).
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More recently, the FRB encouraged the development of a portfolio
margin approach in a letter to the Commission and the CFTC delegating
authority to the agencies to jointly prescribe margin
[[Page 22946]]
regulations for security futures products.\27\ In that letter, the FRB
wrote that it ``has encouraged the development of [portfolio margin
approaches] by, for example, amending its Regulation T so that
portfolio margining systems approved by the Commission can be used in
lieu of the strategy-based system embodied in the Board's regulation.''
The FRB concluded that letter by writing ``The Board anticipates that
the creation of security future products will provide another
opportunity to develop more risk sensitive, portfolio-based approaches
for all securities, including security options and security futures
products.''
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\27\ See letter from the FRB to James E. Newsome, Acting
Chairman, CFTC, and Laura S. Unger, Acting Chairman, Commission,
dated March 6, 2001.
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An ability to cross-margin listed index options with index futures,
and options on such futures, is critical because many professional
investors hedge their listed index options with futures. Although
haircuts assessed on broker-dealers with respect to computing their net
capital requirement recognize offsets between securities index options
and index futures, current margin practice does not allow these
offsets. Cross-margin benefits the financial markets and clearing
system in general, not just individual investors. Cross-margin would
reduce the number of forced liquidations. Currently, an option
(securities) account and futures account of the same customer are
viewed as separate and unrelated. In addition, currently an option
account must be liquidated if the risk in the positions has increased
dramatically or margin calls cannot be met, even if gains in the
customer's futures account offset the losses in the options account. If
the accounts can be combined (i.e., cross-margined), there is little or
no net change in risk and unnecessary liquidation can be avoided. The
severity of a period of high volatility in the market is lessened if
the number of liquidations is reduced because, for example, liquidating
into a declining market exacerbates the decline. A capability to cross-
margin listed index options and index futures would further alleviate
excessive margin calls, improve cash flows and liquidity, and reduce
volatility, particularly in times of market downturns. Various
government agencies and task groups have previously advocated
implementation of a cross-margin system. Those groups include the
Presidential Task Force on Market Mechanics (also know as the Brady
Commission) \28\ and the Commission.\29\
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\28\ See ``The Brady Report,'' Report of the Presidential Task
Force on Market Mechanisms, January 1988, p. 59 and pp. 65-66.
\29\ See ``The October 1987 Market Break: Report by the
Division,'' Commission, February 1988, pp. 10-57. See also the
interim report of the ``Working Group on Financial Markets,''
(Department of the Treasury, CFTC, Commission and FRB), May 1988,
Appendix D III A.
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Listed index options are now at a disadvantage to economically
equivalent derivative products traded on futures exchanges in terms of
margin requirements. Since 1988, index futures and options have been
margined under a portfolio margin system known as SPAN. While the risks
of listed index options are no greater than an equivalent position in
an index future or option on the future, margin required on listed
securities index options is significantly higher in many cases.
Currently, listed index options margin (excluding the option premium)
for a short at-the-money contract approximates 15% of the underlying
index value while SPAN margin on a comparable futures index option
contract is approximately 6% of the index value. When faced with such a
disparity, investment managers discerningly choose futures products
over listed index options for their hedging to reduce their costs. A
portfolio style margin application for listed index options will reduce
disparities between securities index options and futures products, thus
making listed index products more competitive and more effective tools
for investors.
Relief provided by a portfolio margin system is also needed so that
listed index options can compete with over-the-counter derivatives,
which can be margined on a good faith basis if hedged with a listed
option.\30\
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\30\ See ``OTC Derivatives Dealers,'' Securities Exchange Act
Release No. 40594 (October 23, 1998), 63 FR 59362 (November 3,
1998).
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2. Statutory Basis
The Exchange believes the proposed rule change, as amended, is
consistent with Section 6(b) of the Act \31\ in general, and furthers
the objectives of Section 6(b)(5) of the Act \32\ in particular, in
that it is designed perfect the mechanism of a free and open market and
to protect investors and the public interest. The proposed portfolio
margin rule change is intended to promote greater reasonableness,
accuracy and efficiency in respect of Exchange margin requirements for
complex, multiple position listed index option strategies, and to offer
a cross-margin capability with related index futures positions in
eligible accounts.
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\31\ 15 U.S.C. 78f(b).
\32\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition
The Exchange does not believe that the proposed rule change will
impose any burden on competition that is not necessary or appropriate
in the furtherance of the 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.
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, as amended, 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, as amended, 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-2002-03 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-CBOE-2002-03. 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
[[Page 22947]]
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 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-2002-03 and should be submitted on
or before May 24, 2005.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\33\
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\33\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E5-2127 Filed 5-2-05; 8:45 am]
BILLING CODE 8010-01-P