[Federal Register Volume 70, Number 139 (Thursday, July 21, 2005)]
[Notices]
[Pages 42118-42122]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-3870]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52032; File No. SR-CBOE-2002-03]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Approving a Proposed Rule Change and Amendment Nos. 
1 and 2 Thereto Relating to Customer Portfolio and Cross-Margining 
Requirements

July 14, 2005.

I. Introduction

    On January 15, 2002, the Chicago Board Options Exchange, 
Incorporated (``CBOE'' or ``Exchange'') filed with the Securities and 
Exchange Commission (``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b- 4\2\ 
thereunder, a proposed rule change seeking to amend its rules, for 
certain customer accounts, to allow member organizations to margin 
listed, broad-based, market index options, index warrants, futures, 
futures options and related exchange-traded funds according to a 
portfolio margin methodology. The CBOE seeks to introduce the proposed 
rule as a two-year pilot program that would be made available to member 
organizations on a voluntary basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published in the Federal Register on 
March 29, 2002.\3\ The Commission received two comment letters in 
response to the March 29, 2002 Federal Register notice.\4\ On April 2, 
2004, the Exchange filed Amendment No. 1 to the proposed rule 
change.\5\ The proposed rule change and Amendment No. 1 were published 
in the Federal Register on December 27, 2004.\6\ The Commission 
received eleven comment letters in response to the December 27, 2004 
Federal Register notice.\7\
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    \3\ See Securities Exchange Act Release No. 45630 (March 22, 
2002), 67 FR 15263 (March 29, 2002).
    \4\ See letter from Carl E. Vander Wilt, Federal Reserve Bank of 
Chicago, to Jonathan G. Katz, Secretary, Commission, dated July 18, 
2002 (``Vander Wilt Letter''); and e-mail from Mike Ianni, Private 
Investor to [email protected], dated November 7, 2002 (``Ianni 
E-mail'').
    \5\ 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).
    \6\ 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).
    \7\ See letter from Anthony J. Saliba, President, LiquidPoint, 
LLC, to Jonathan G. Katz, Secretary, Commission, dated January 21, 
2005 (``Saliba Letter''); letter from Barbara Wierzynski, Executive 
Vice President and General Counsel, Futures Industry Association 
(``FIA''), and Gerard J. Quinn, Vice President and Associate General 
Counsel, Securities Industry Association (``SIA''), 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''); e-mail 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''); and 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 4, 2005 
(``Wierzynski/Hammerman Letter'').
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    On April 15, 2005, the Exchange filed Amendment No. 2 \8\ to the 
proposed rule change. The proposed rule change and Amendment Nos. 1 and 
2 were published in the Federal Register on May 3, 2005.\9\ The 
Commission received one comment in response to the May 3, 2005 Federal 
Register notice.\10\
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    \8\ See Partial Amendment No. 2 (``Amendment No. 2''). The 
Exchange submitted this partial amendment, pursuant to the request 
of Commission staff, to remove the paragraph under which any 
affiliate of a self-clearing member organization could participate 
in portfolio margining, without being subject to the $5 million 
equity requirement.
    \9\ See Securities Exchange Act Release No. 34-51614 (April 26, 
2005), 70 FR 22935 (May 3, 2005); see also Securities Exchange Act 
Release No. 34-51615 (April 26, 2005), 70 FR 22953 (May 3, 2005).
    \10\ See letter from William H. Navin, Executive Vice President, 
General Counsel, and Secretary, The Options Clearing Corporation, to 
Jonathan G. Katz, Secretary, Commission, dated May 27, 2005 (``Navin 
Letter'').
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    The comment letters and the Exchange's responses to the comments 
\11\ are summarized below.

[[Page 42119]]

 This Order approves the proposed rule, as amended.\12\
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    \11\ See letter from Timothy H. Thompson, Senior Vice President, 
Chief Regulatory Officer, Regulatory Services Division, CBOE, to 
Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, dated May 2, 2005 (``CBOE Response''). The 
Commission received the CBOE Response on June 1, 2005; see also 
letter from Timothy H. Thompson, Senior Vice President, Chief 
Regulatory Officer, Regulatory Services Division, CBOE, to Michael 
A. Macchiaroli, Associate Director, Division of Market Regulation, 
Commission, dated June 29, 2005.
    \12\ By separate orders, the Commission also is approving a 
parallel rule filing by the NYSE [SR-NYSE-2002-19], and a related 
rule filing by the Options Clearing Corporation (``OCC'') [SR-OCC-
2003-04]. See Securities Exchange Act Release No. 52031 (July 14, 
2005) and Securities Exchange Act Release No. 52030 (July 14, 2005). 
In addition, the staff of the Division of Market Regulation is 
issuing certain no-action relief related to the OCC's rule filing. 
See letter from Bonnie Gauch, Attorney, Division of Market 
Regulation, Commission, to William H. Navin, General Counsel, OCC, 
dated July 14, 2005.
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II. Description

a. Summary of Proposed Rule Change

    The CBOE has proposed to amend its rules, for certain customer 
accounts, to allow member organizations to margin listed broad-based 
securities index options, warrants, futures, futures options and 
related exchange-traded funds according to a portfolio margin 
methodology. The CBOE seeks to introduce the proposed rule as a two-
year pilot program that would be made available to member organizations 
on a voluntary basis.

b. Overview--Portfolio Margin Computation

(1) Portfolio Margin
    Portfolio margining is a methodology for calculating a customer's 
margin requirement by ``shocking'' a portfolio of financial instruments 
at different equidistant points along a range representing a potential 
percentage increase and decrease in the value of the instrument or 
underlying instrument in the case of a derivative product. For example, 
the calculation points could be spread equidistantly along a range 
bounded on one end by a 10% increase in market value of the instrument 
and at the other end by a 10% decrease in market value. Gains and 
losses for each instrument in the portfolio are netted at each 
calculation point along the range to derive a potential portfolio-wide 
gain or loss for the point. The margin requirement is the amount of the 
greatest portfolio-wide loss among the calculation points.
    Under the Exchange's proposed rule, a portfolio would consist of, 
and be limited to, financial instruments in the customer's account 
within a given broad-based US securities index class (e.g., the S&P 500 
or S&P 100).\13\ The gain or loss on each position in the portfolio 
would be calculated at each of 10 equidistant points (``valuation 
points'') set at and between the upper and lower market range points. 
The range for non-high capitalization indices would be between a market 
increase of 10% and a decrease of 10%. High capitalization indices 
would have a range of between a market increase of 6% and a decrease of 
8%.\14\ A theoretical options pricing model would be used to derive 
position values at each valuation point for the purpose of determining 
the gain or loss. The amount of margin (initial and maintenance) 
required with respect to a given portfolio would be the larger of: (1) 
The greatest loss amount among the valuation point calculations; or (2) 
the sum of $.375 for each option and future in the portfolio multiplied 
by the contract's or instrument's multiplier. The latter computation 
establishes a minimum margin requirement to ensure that a certain level 
of margin is required from the customer. The margin for all other 
portfolios of broad based US securities index instruments within an 
account would be calculated in a similar manner.
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    \13\ A``portfolio'' is defined in the rule as ``options of the 
same options class grouped with their underlying instruments and 
related instruments.''
    \14\ These are the same ranges applied to options market makers 
under Appendix A to Rule 15c3-1 (17 CFR 240.15c3-1a), which permits 
a broker-dealer when computing net capital to calculate securities 
haircuts on options and related positions using a portfolio margin 
methodology. See 17 CFR 240.15c3-1a(b)(1)(iv)(A); Letter from 
Michael Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, to Richard Lewandowski, Vice President, 
Regulatory Division, The Chicago Board Options Exchange, Inc. (Jan. 
13, 2000).
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    Certain portfolios would be allowed offsets such that, at the same 
valuation point, for example, 90% of a gain in one portfolio may reduce 
or offset a loss in another portfolio.\15\ The amount of offset allowed 
between portfolios would be the same as permitted under Rule 15c3-1a 
for computing a broker-dealer's net capital.\16\
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    \15\ These offsets would be allowed between portfolios within 
the High Capitalization, Broad Based Index Option product group and 
the Non-High Capitalization, Broad Based Index product group.
    \16\ 17 CFR 240.15c3-1a.16
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    Under the Exchange's proposed rule, the theoretical prices used for 
computing profits and losses must be generated by a theoretical pricing 
model that meets the requirements in Rule 15c3-1a.\17\ These 
requirements include, among other things, that the model be non-
proprietary, approved by a Designated Examining Authority (``DEA'') and 
available on the same terms to all broker-dealers.\18\ Currently, the 
only model that qualifies under Rule 15c3-1a is the OCC's Theoretical 
Intermarket Margining System (``TIMS'').
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    \17\ See 17 CFR 240.15c3-1a(b)(1)(i)(B).
    \18\ Id.
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(2) Cross-Margining
    The Exchange's proposed rule permits futures and futures options on 
broad-based US securities indices to be included in the portfolios. 
Consequently, futures and futures options would be permitted offsets to 
the securities positions in a given portfolio. Operationally, these 
offsets would be achieved through cross-margin agreements between the 
OCC and the futures clearing organizations holding the customer's 
futures positions. Cross-margining would operate similar to the cross-
margin program that the Commission and the Commodity Futures Trading 
Commission (``CFTC'') approved for listed options market-makers and 
proprietary accounts of clearing member organizations.\19\ For 
determining theoretical gains and losses, and resultant margin 
requirements, the same portfolio margin computation program will be 
applied to portfolio margin accounts that include futures. Under the 
proposed rule, a separate cross-margin account must be established for 
a customer.
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    \19\ See Securities Exchange Act Release 26153 (Oct. 3, 1988), 
53 FR 39567 (Oct. 7, 1988).
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c. Margin Deficiency

    Under the Exchange's proposed rule, account equity would be 
calculated and maintained separately for each portfolio margin account 
and a margin call would need to be met by the customer within one 
business day (T+1), regardless of whether the deficiency is caused by 
the addition of new positions, the effect of an unfavorable market 
movement, or a combination of both. The portfolio margin methodology, 
therefore, would establish both the customer's initial and maintenance 
margin requirement.

d. $5.0 Million Equity Requirement

    The Exchange's proposed rule would require a customer (other than a 
broker-dealer or a member of a national futures exchange) to maintain a 
minimum account equity of not less than $5.0 million. This requirement 
can be met by combining all securities and futures accounts owned by 
the customer and carried by the broker-dealer (as broker-dealer and 
futures commission merchant), provided ownership is identical across 
all combined accounts. The proposed rule would require that, in the 
event account equity falls below the $5 million minimum, additional

[[Page 42120]]

equity must be deposited within three business days (T+3).

e. Net Capital

    The Exchange's proposed rule would provide that the gross customer 
portfolio margin requirements of a broker-dealer may at no time exceed 
1,000 percent of the broker-dealer's net capital (a 10:1 ratio), as 
computed under Rule 15c3-1.\20\ This requirement is intended to place a 
ceiling on the amount of portfolio margin a broker-dealer can extend to 
its customers.
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    \20\ 17 CFR 240.15c3-1.
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f. Internal Risk Monitoring Procedures

    The Exchange's proposed rule would require a broker-dealer that 
carries portfolio margin accounts to establish and maintain written 
procedures for assessing and monitoring the potential risks to capital 
arising from portfolio margining.

g. Margin at the Clearing House Level

    The OCC will compute clearing house margin for the broker-dealer 
using the same portfolio margin methodology applied at the customer 
level. The OCC will continue to require full payment for all customer 
long option positions. These positions, however, would be subject to 
the OCC's lien. This would permit the long options positions to offset 
short positions in the customer's portfolio margin account. In 
conjunction with the Exchange's rule proposal, the OCC proposed 
amending OCC Rule 611 and establishing a new type of omnibus account to 
be carried at the OCC and known as the ``customer's lien account.'' 
\21\ In order to unsegregate the long option positions, the Commission 
staff would have to grant certain relief from some requirements of 
Commission Rules 8c-1, 15c2-1, and 15c3-3.\22\ The OCC requested such 
relief on behalf of its members.\23\
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    \21\ See SR-OCC-2003-04, Securities Exchange Act Release No. 
51330 (March 8, 2005). As noted above, the Commission is approving 
the OCC's rule filing. See Securities Exchange Act Release No. 52030 
(July 14, 2005).
    \22\ 17 CFR 240.8c-1, 17 CFR 240.15c2-1 and 17 CFR 240.15c3-3, 
respectively.
    \23\ See Letter from William H. Navin, Executive Vice President, 
General Counsel, and Secretary, The Options Clearing Corporation, to 
Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, dated January 13, 2005. As noted above, the 
staff of the Division of Market Regulation is issuing a no-action 
letter providing such relief. See letter from Bonnie Gauch, 
Attorney, Division of Market Regulation, Commission, to William H. 
Navin, General Counsel, OCC, dated July 14, 2005.
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h. Risk Disclosure Statement and Acknowledgement

    The Exchange's proposed rule would require a broker-dealer to 
provide a portfolio margin customer with a written risk disclosure 
statement at or prior to the initial opening of a portfolio margin 
account. This disclosure statement would highlight the risks and 
describe the operation of a portfolio margin account. The disclosure 
statement would be divided into two sections, one dealing with 
portfolio margining and the other with cross-margining. The disclosure 
statement would note that additional leverage is possible in an account 
margined on a portfolio basis in relation to existing margin 
requirements. The disclosure statement also would describe, among other 
things, eligibility requirements for opening a portfolio margin 
account, the instruments that are allowed in the account, and when 
deposits to meet margin and minimum equity requirements are due. 
Further, there would be a summary list of the special risks of a 
portfolio margin account, including the increased leverage, time frame 
for meeting margin calls, potential for involuntary liquidation if 
margin is not received, inability to calculate future margin 
requirements because of the data and calculations required, and the OCC 
lien on long option positions. The risks and operation of the cross-
margin account are outlined in a separate section of the disclosure 
statement.
    Further, at or prior to the time a portfolio margin account is 
initially opened, the broker-dealer would be required to obtain a 
signed acknowledgement concerning portfolio margining from the 
customer. A separate acknowledgement would be required for cross-
margining. The acknowledgements would contain statements to the effect 
that the customer has read the disclosure statement and is aware of the 
fact that long option positions in a portfolio margin account are not 
subject to the segregation requirements under the Commission's customer 
protection rules, and would be subject to a lien by the OCC.
    An additional acknowledgement form would be required for a cross-
margin account. It would contain similar statements as well as 
statement to the effect that the customer is aware that futures 
positions are being carried in a securities account, which would make 
them subject to the Commission's customer protection rules, and 
Securities Investor Protection Act of 1970 (``SIPA'') \24\ in the event 
the broker-dealer becomes financially insolvent. The Exchange would 
prescribe the format of the written disclosure statements and 
acknowledgements, which would allow a broker-dealer to develop its own 
format, provided the acknowledgement contains substantially similar 
information and is approved by the Exchange in advance.
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    \24\ 24 5 U.S.C. 78aaa et seq.
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i. Rationale for Portfolio Margin

    Theoretical options pricing models have become widely utilized 
since Fischer Black and Myron Scholes first introduced a formula for 
calculating the value of a European style option in 1973.\25\ 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. In addition, as noted, 
a portfolio margin methodology has been used by broker-dealers since 
1994 to calculate haircuts on option positions for net capital 
purposes.\26\
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    \25\ See Securities Exchange Act Release No. 34-38248 (Feb. 6, 
1997), 62 FR 6474 (Feb. 12, 1997) (discussing the development of the 
options pricing approach to capital); see also Securities Exchange 
Act Release No. 33761 (March 15, 1994), 59 FR 13275 (March 21, 
1994).
    \26\ See letter from Brandon Becker, Director, Division, 
Commission, to Mary Bender, First Vice President, Division of 
Regulatory Services, CBOE, and Timothy Hinkes, Vice President, OCC, 
dated March 15, 1994; see also ``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.\27\
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    \27\ 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). 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 
regulations for security futures products. 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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    Portfolio margining brings a more risk sensitive approach to 
establishing margin requirements. For example, in a diverse portfolio 
some positions may appreciate and others depreciate in response to a 
given change in market prices. The portfolio margin methodology 
recognizes offsetting potential changes among the full portfolio of 
related instruments. This links the margin required to the risk of the 
entire portfolio as opposed to the individual positions on a position-
by-position basis.
    Professional investors frequently hedge listed index options with 
futures positions. Cross-margining would better

[[Page 42121]]

align their margin requirements with the actual risks of these hedged 
positions. This could reduce the risk of forced liquidations. 
Currently, an option (securities) account and futures account of the 
same customer are viewed as separate and unrelated. Moreover, an option 
account currently 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 are combined (i.e., cross-margined), 
unnecessary liquidation may be avoided. This could lessen the severity 
of a period of high volatility in the market by reducing the number of 
liquidations.

III. Summary of Comments Received and CBOE Response

    The Commission received a total of fourteen comment letters to the 
proposed rule.\28\ The comments, in general, were supportive. One 
commenter stated that ``portfolio margining would enable CBOE to more 
accurately reflect the risk exposure of options and related positions-
potentially reducing the trading costs of market participants and 
increasing the liquidity and efficiency of the market.'' \29\ Some 
commenters, however, recommended changes to specific provisions of the 
proposed rule change.
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    \28\ See supra notes 4, 7 and 10.
    \29\ See Vander Wilt Letter.
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    Seven of the comment letters specifically objected to the $5.0 
million equity requirement.\30\ Three commenters noted that the 
requirement blocks certain large institutions from participating in 
portfolio margining because these institutions hold assets at a 
custodian bank and, consequently, would not hold $5.0 million in an 
account with a broker-dealer.\31\ Five commenters raised the issue that 
securities index options will be at a disadvantage compared with 
economically similar CFTC regulated index futures, because futures 
accounts have no minimum equity requirement.\32\
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    \30\ See Ianni Letter; Weingart Letter; Wiermanski Letter; 
Hansen Letter; Greiner Letter; Saliba Letter; and Melvin Letter.
    \31\ See Weingart Letter; Wiermanski Letter; and Melvin Letter.
    \32\ See Weingart Letter, Wiermanski Letter; Hansen Letter; 
Saliba Letter; and Sheehan Letter.
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    The Exchange believes that the comments directed at the $5.0 
million equity requirements have merit, particularly with respect to 
certain types of accounts that must hold assets at a custodial 
bank.\33\ The Exchange, however, stated that these comments should not 
delay implementation of the proposed rule change and noted that it 
intends to file a proposed rule amendment that would offer alternative 
methods for meeting the minimum equity requirement after the industry 
becomes acclimated to the portfolio margin methodology and its 
operational aspects.
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    \33\ See CBOE Response.
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    Several commenters stated that other products should be eligible 
for portfolio margining,\34\ such as equities,\35\ as well as OCC-
cleared equity derivatives.\36\ One commenter stated that other risk-
based algorithms, such as SPAN,\37\ that are recognized by other 
clearing organizations should be permitted for calculating the 
portfolio margin requirement, in addition to the OCC's TIMS.\38\
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    \34\ See Wiermanski Letter; Saliba Letter; and Donohue Letter.
    \35\ See Saliba Letter.
    \36\ See Sheehan Letter.
    \37\ SPAN is the Chicago Mercantile Exchange's Standard 
Portfolio Analysis System, which is used by many futures exchanges 
to calculate margin.
    \38\ See Donohue Letter.
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    In addition, one commenter stated that the Securities Investor 
Protection Corporation (``SIPC'') would need to amend its rules in 
order to provide SIPA protection to futures and options on futures in a 
securities account.\39\ The Exchange disagrees and notes that the 
proposed rule change was amended, at the request of Commission staff, 
to require the immediate transfer to another broker-dealer or the 
liquidation of a cross-margin account in the event that a broker-dealer 
becomes insolvent. In addition, the Exchange believes that amendments 
to Commission Rule 15c3-3 could provide customers holding both 
securities and futures with protection under SIPA.
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    \39\ See Wierzynski/Hammerman Letter.
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    One commenter, the OCC, strongly urged the Commission to move 
forward promptly with the approval of the proposed rule changes, and 
contended that additional regulatory actions are necessary in order to 
implement the proposed pilot programs.\40\ These other regulatory 
actions include: Commission approval of SR-OCC-2003-04; a Commission 
``no-action'' letter in connection with SR-OCC-2003-04; an exemptive 
order from the CFTC; and amendments to Commission Rule 15c3-3. The 
Exchange agrees with the OCC that approval of the OCC rule filing and 
issuance of the ``no-action'' letter are necessary to enable portfolio 
margining, including cross-margining, to be utilized.\41\ The Exchange 
also urged the Commission to complete all regulatory actions necessary 
to enable portfolio margining along with the cross-margin component.
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    \40\ See Navin Letter.
    \41\ See supra notes 21 and 23.
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IV. Discussion and Commission Findings

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\42\ In particular, the Commission believes that 
the proposed rule change is consistent with Section 6(b)(5) of the Act 
\43\ in particular, in that it is designed to perfect the mechanism of 
a free and open market and to protect investors and the public 
interest. The Commission notes that the proposed portfolio margin rule 
change is intended to promote greater reasonableness, accuracy and 
efficiency with respect to Exchange margin requirements for complex 
listed securities index option strategies. The Commission further notes 
that the cross-margining capability with related index futures 
positions in eligible accounts may alleviate excessive margin calls, 
improve cash flows and liquidity, and reduce volatility. Moreover, the 
Commission notes that approving the proposed rule change would be 
consistent with the FRB's 1998 amendments to Regulation T, which sought 
to advance the use of portfolio margining.
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    \42\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \43\ 15 U.S.C. 78f(b)(5).
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    Under the proposed rule changes, the Commission notes that a 
broker-dealer choosing to offer portfolio margining to its customers 
must employ a methodology that has been approved by the Commission for 
use in calculating haircuts under Rule 15c3-1a. As stated above, 
currently, TIMS is the only approved methodology. While some commenters 
recommended expanding the choice of models, the Commission believes 
that requiring a broker-dealer to use a model that qualifies for 
calculating haircuts under Commission Rule 15c3-1a maintains a 
consistency with the Commission's net capital rule and across potential 
portfolio margin pricing models. As a result, portfolio margin 
requirements would vary less from firm to firm. The Commission notes, 
however, that like Rule 15c3-1a, the proposed rule permits the use of 
another theoretical pricing model, should one be developed in the 
future.\44\
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    \44\ See also Securities Exchange Act Release No. 34-38248 
(February 6, 1997), 62 FR 6474 (February 12, 1997) (discussing in 
Part II.A. the use of TIMS versus other pricing models).

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[[Page 42122]]

    The Commission notes the objections of certain commenters to the $5 
million minimum equity requirement. The Commission believes that the 
requirement 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.
    Finally, the Commission notes that several commenters recommended 
expanding the products eligible for portfolio margining. The Exchange's 
proposed rule limits the instruments eligible for portfolio margining 
to listed products based on broad-based US securities indices, which 
tend to be less volatile than narrow-based indices and non-index 
equities. The Commission believes this limitation is appropriate for 
the pilot program, which should serve as a first step toward the 
possible expansion of portfolio margining to other classes of 
securities.

V.Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\45\ that the proposed rule change (File No. SR-CBOE-2002-03), as 
amended, is approved on a pilot basis to expire on July 31, 2007.
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    \45\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\46\
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    \46\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E5-3870 Filed 7-20-05; 8:45 am]
BILLING CODE 8010-01-P