[Federal Register Volume 71, Number 137 (Tuesday, July 18, 2006)]
[Notices]
[Pages 40766-40768]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-11312]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54125; File No. SR-NYSE-2005-93]


Self-Regulatory Organizations; New York Stock Exchange LLC; Order 
Approving a Proposed Rule Change to Rule 431 (``Margin Requirements'') 
and Rule 726 (``Delivery of Options Disclosure Document and 
Prospectus'') To Expand the Products Eligible for Customer Portfolio 
Margining and Cross-Margining Pilot Program

July 11, 2006.

I. Introduction

    On December 29, 2005, the New York Stock Exchange LLC (``NYSE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``Commission''), pursuant to section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'' or ``Exchange Act'') \1\ and Rule 19b-4 
\2\ thereunder, a proposed rule change seeking to amend NYSE Rules 431 
and 726 to expand the scope of products that are eligible for treatment 
as part of the Commission's approved portfolio margin pilot program 
(the ``Pilot'').\3\ The NYSE seeks to expand the list of eligible 
products in the Pilot to include security futures contracts \4\ and 
listed single stock options. The proposed rule change was published in 
the Federal Register on Monday, January 23, 2006.\5\ The Commission 
received three comment letters in response to the Federal Register 
notice.\6\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Exchange Act Release No. 52031 (July 14, 2005), 70 FR 
42130 (July 21, 2005) (SR-NYSE-2002-19). On July 14, 2005, the 
Commission approved on a Pilot Basis expiring July 31, 2007, 
amendments to Exchange Rule 431 to permit the use of a prescribed 
risk-based margin requirement (``portfolio margin'') for certain 
specified products as an alternative to the strategy based margin 
requirements currently required in section (a) through (f) of the 
Rule. Amendments to Rule 726 were also approved to require 
disclosure to, and written acknowledgment from, customers in 
connection with the use of portfolio margin. See also NYSE 
Information Memo 05-56, dated August 18, 2005 for additional 
information.
    \4\ For purposes of the proposed rule change, term ``security 
futures'' utilizes the definition at section 3(a)(55) of the 
Exchange Act, excluding narrow-based security indexes.
    \5\ See Exchange Act Release No. 53126 (Jan. 13, 2006), 71 FR 
3586 Jan. 23, 2006).
    \6\ See letter from Gerard J. Quinn, Vice President and 
Associate General Counsel, Securities Industry Association, to Nancy 
M. Morris, Secretary, Commission, dated February 13, 2006 (``SIA 
Letter''); letter from Barbara Wierzynski, Executive Vice President 
and General Counsel, Futures Industry Association, to Nancy M. 
Morris, Secretary, Commission, dated February 13, 2006 (``FIA 
Letter''); and letter from Severino Renna, Director, Citigroup 
Global Markets, Inc., to Nancy M. Morris, Secretary, dated February 
13, 2006 (``Citigroup Letter'').
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    The comment letters and the Exchange's responses to the comments 
\7\ are summarized below. This order approves the proposed rule change.
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    \7\ See letter from Mary Yeager, Assistant Secretary, NYSE, to 
Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, dated June 2, 2006 (``NYSE Response'').
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II. Description of the Proposed Rule Change

a. Summary of Proposed Rule Change

    The proposed rule change consists of amendments to NYSE Rule 431 to 
include listed security futures and listed single stock options as 
eligible products for customer portfolio margining under the Pilot.\8\ 
The proposed rule change also includes amendments to NYSE Rule 726 to 
conform the required customer disclosure to the changes made in the 
proposed rule change, including the expansion of eligible products.
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    \8\ The list of eligible products under the Pilot currently 
includes listedbroad-based securities index options, warrants, 
futures, futures options and related exchange-traded funds. The NYSE 
also has filed an additional rule change to, among other things, 
further expand the list of eligible products for the Pilot to 
include equities and unlisted derivatives. See Exchange Act Release 
No. 53577 (March 30, 2006), 71 FR 17536 (April 6, 2006) (SR-NYSE-
2006-13); see also Exchange Act Release No. 53576 (March 30, 2006), 
71 FR 17519 (April 6, 2006) (SR-CBOE-2006-14). The comment period 
for these proposed rule filings ended on May 11, 2006.
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    Section 7(a) \9\ of the Exchange Act \10\ empowers the Board of 
Governors of the Federal Reserve System (``Federal Reserve Board'') to 
prescribe rules and regulations regarding credit that broker-dealers 
can extend to their customers on securities transactions. Pursuant to 
this authority, the Federal Reserve Board adopted Regulation T.\11\ The 
Federal Reserve Board, in the 1998 amendments, removed from the scope 
of Regulation T transactions governed by a portfolio margin rule 
approved by the Commission.\12\ The Commodity Futures Modernization Act 
of 2000 (``CFMA'') authorized the trading of futures on individual 
stocks and narrow-based stock indexes, i.e., securities futures 
products.\13\ Under the CFMA, the Federal Reserve Board has authority 
to either issue margin rules for securities futures or delegate joint 
authority to the Commission and the Commodity Futures Trading 
Commission (``CFTC'') to issue such rules. The Federal Reserve Board 
delegated authority to the Commission and CFTC, and in 2002 the 
Commission and the CFTC jointly issued margin requirements for 
securities futures products.\14\ The jointly issued rules exempted from 
their scope transactions in securities futures products subject to SRO 
portfolio margin rules.\15\
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    \9\ 15 U.S.C. 78g.
    \10\ 15 U.S.C. 78a et seq.
    \11\ 12 CFR 220.1 et seq.
    \12\ 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).
    \13\ Public Law 106-554, 114 Stat. 2763 (2000).
    \14\ Exchange Act Release 46292 (August 1, 2002), 67 FR 53146 
(August14, 2002).
    \15\ 17 CFR 242.400(c)(2).
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    NYSE Rule 431 prescribes specific margin requirements for customers 
based on the type of securities products held in their accounts. In 
April 1996, the Exchange established the Rule 431 Committee (the 
``Committee'') to assess the adequacy of Rule 431 on an ongoing basis, 
review margin requirements and make recommendations for change. The 
Exchange's Board of Directors has approved a number of proposed 
amendments resulting from the Committee's recommendations since the 
Committee was established.\16\ The NYSE noted in its rule proposal that 
the Committee endorsed the proposed rule change discussed below.
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    \16\ The Committee is composed of several member 
organizations,including Goldman, Sachs & Co., Morgan Stanley & Co., 
Inc., Merrill Lynch, Pierce, Fenner and Smith, Inc., Bear Stearns 
Corp. and Credit Suisse First Boston Corp. and several self-
regulatory organizations, including: the NYSE, the Chicago Board 
Options Exchange, the Options Clearing Corporation (``OCC''), the 
American Stock Exchange, the Chicago Board of Trade, the Chicago 
Mercantile Exchange, and the National Association of Securities 
Dealers.
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b. Portfolio Margining

    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 15% increase in market value of the instrument 
and at the other end by a 15% decrease in market value. Gains and 
losses for each instrument in the portfolio are netted at

[[Page 40767]]

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, the range of products eligible 
for portfolio margining would be expanded from securities and futures 
based on broad-based U.S. securities indexes (e.g., the S&P 500 or S&P 
100) to include security futures products and listed single stock 
options. The gain or loss on each position in the portfolio is 
calculated at each of 10 equidistant points (``valuation points'') set 
at and between the upper and lower market range points. Under the 
current rule, the range for non-high capitalization indexes is between 
a market increase of 10% and a decrease of 10%. The range for high 
capitalization indexes is between a market increase of 6% and a 
decrease of 8%.\17\ The range for portfolios of securities futures 
products and single stock options under the proposed rule change would 
be a market increase of 15% and a decrease of 15% (i.e., the valuation 
points would be 3%, 6%, 9%, 12%, and 15%).\18\ As with the 
current Pilot, 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.\19\
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    \17\ 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); see also 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).
    \18\ This range also is consistent with Rule 15c3-1a. See supra 
note 17.
    \19\ The pricing model would need to meet the requirements in 
Rule 15c3-1a. Currently, the only model that qualifies under Rule 
15c3-1a is the OCC's Theoretical Intermarket Margining System 
(TIMS).
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    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 second computation 
establishes a minimum margin requirement to ensure that a certain level 
of margin is required from the customer in the event the greatest loss 
among the valuation points is de minimis.
    Finally, under the proposed rule change, member organizations would 
need to notify and receive approval from the Exchange prior to 
establishing a portfolio margin program for eligible customers.

c. Margin Deficiency

    The proposed amendments would require a member organization to 
deduct from its net capital the amount of any portfolio margin 
maintenance call not met by the close of business of trade date plus 
one day (T+1). This condition would be different from the current 
requirement of T+3 and would apply to margin calls related to 
portfolios of all eligible products. NYSE member organizations would 
not be permitted to deduct any portfolio margin maintenance call amount 
from net capital in lieu of collecting the required margin from the 
customer.

d. Waiver of $5.0 Million Equity Requirement

    The proposed amendments would permit customers that are not broker-
dealers or members of a national futures exchange to effect 
transactions solely in security futures and listed single stock options 
without maintaining $5.0 million in equity as required under the Pilot 
for broad-based securities index products.\20\
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    \20\ See proposed rule 431(g)(9)(A).
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e. Risk Disclosure Statement and Acknowledgement

    The Pilot requires 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 highlights the risks and describes the operation of a 
portfolio margin account. The disclosure statement also describes, 
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, at or prior to the time a portfolio margin account is 
initially opened, the broker-dealer is required to obtain a signed 
acknowledgement concerning portfolio margining from the customer. Under 
the current Pilot, a separate acknowledgement is required for cross-
margining.\21\
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    \21\ ``Cross-margining'' refers to the inclusion of futures that 
are not securities in a portfolio as is permitted under the current 
Pilot for portfolios of broad-based securities index products.
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    The proposed rule change amends the disclosure requirements under 
Rule 726 to incorporate the expanded list of eligible products in the 
Pilot and other changes contained in the proposed rule change.

III. Summary of Comments Received and NYSE Response

    The Commission received a total of three comment letters to the 
proposed rule change.\22\ The comments, in general, were supportive. 
One commenter stated that it ``is strongly supportive of the NYSE's 
efforts to incorporate portfolio margining into Rule 431 and hopes the 
Commission will speedily approve amendments to Rule 431 to increase the 
scope of portfolio margining.'' \23\ Each commenter, however, 
recommended changes to specific provisions of the proposed rule change.
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    \22\ See supra note 6.
    \23\ See SIA Letter.
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    Two of the commenters stated that the list of eligible products 
should be expanded under the Pilot to include a broader range of assets 
including all listed and OTC equity securities.\24\ Three commenters 
stated that operational and legal issues make it difficult to have 
separate accounts for portfolio margining and cross margining as 
required under the Pilot.\25\ One commenter suggested that the Pilot 
should allow for portfolio margining to be done through a single 
account, rather than requiring that cross-margining be done through a 
separate account.\26\ The NYSE's subsequent rule filing responds to 
these comments through further proposed amendments.\27\ Specifically, 
in that expanded filing, the Exchange proposed eliminating the cross 
margin account and expanding the types of eligible products that can be 
included in a portfolio margin account.\28\ In its response to 
comments, the Exchange also encouraged the Commission to adopt this 
subsequent proposed rule filing.\29\
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    \24\ See SIA Letter and Citigroup Letter.
    \25\ See SIA Letter; Citigroup Letter; and FIA Letter.
    \26\ See SIA Letter.
    \27\ See SR-NYSE-2006-13 (proposal to expand list of eligible 
products in the Pilot and eliminate the separate cross-margin 
account). See supra note 8.
    \28\ Id.
    \29\ Id.; see also NYSE Response.
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    One commenter stated that the multiplier of $.375 should be changed 
to $.25 per contract to be more consistent with Appendix A to Rule 
15c3-1.\30\ The Exchange noted that it is concerned about the amount of 
potential leverage that can be created at each broker-dealer and 
believes that the higher minimum requirement would serve as an added 
cushion in the event of a severe market movement. Even though positions 
in the

[[Page 40768]]

account are hedged, the Exchange noted that it is concerned about 
potential illiquidity in the market that could create sizeable gap risk 
in the event that both sides of a hedge cannot be closed out at the 
same time.\31\
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    \30\ See SIA Letter. 17 CFR 240.15c3-1a.
    \31\ See NYSE Response.
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    One commenter also suggested that sophisticated member firms should 
be able to utilize proprietary models to estimate potential losses in 
determining portfolio margin requirements.\32\ In response to this 
comment, the Exchange stated that it would like to gain additional 
experience with the use of such risk models before it could permit its 
member organizations to utilize these models for margining 
purposes.\33\
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    \32\ See Citigroup Letter.
    \33\ See NYSE Response.
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    Finally, the Exchange stated that it will continue to work with the 
Commission staff and respective industry committees to address future 
enhancements to portfolio margining.\34\
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    \34\ See NYSE Response.
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IV. Discussion and Commission Findings

    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.\35\ In particular, the Commission believes that the proposed 
rule change is consistent with section 6(b)(5) of the Act,\36\ 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 and will better align margin requirements 
with the actual risk of hedged positions. Moreover, the Commission 
notes that approving the proposed rule change would be consistent with 
the Federal Reserve Board's 1998 amendments to Regulation T, which 
sought to advance the use of portfolio margining.
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    \35\ In approving this proposed rule change, the Commission 
notes thatit has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \36\ 15 U.S.C. 78f(b)(5).
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\37\ that the proposed rule change (File No. SR-NYSE-2005-93), is 
approved on a pilot basis to expire on July 31, 2007.
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    \37\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\38\
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    \38\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E6-11312 Filed 7-17-06; 8:45 am]
BILLING CODE 8010-01-P