[Federal Register Volume 72, Number 42 (Monday, March 5, 2007)]
[Notices]
[Pages 9826-9828]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-3773]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55362; File No. SR-OCC-2007-01]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change Relating to Credit Default 
Options

February 27, 2007.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on February 13, 2007, The 
Options Clearing Corporation (``OCC'') filed with the Securities and 
Exchange Commission (``Commission'') the proposed rule change described 
in Items I, II, and III below, which items have been prepared primarily 
by OCC. The Commission is publishing this notice to solicit comments on 
the proposed rule change from interested parties.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The proposed rule change would permit OCC to clear and settle 
credit default options (``CDOs''), which are options related to the 
creditworthiness of an issuer or guarantor of one or more specified 
debt securities. Credit default options are proposed to be traded by 
the Chicago Board Options Exchange (``CBOE'').\2\
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    \2\ File No. SR-CBOE-2006-84, Securities Exchange Act Release 
No. 55251 (February 7, 2007), 72 FR 7091 (February 14, 2007) (notice 
of filing of proposed rule change).
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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, OCC 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. OCC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of these 
statements.\3\
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    \3\ The Commission has modified the text of the summaries 
prepared by OCC.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The purpose of this rule change is to permit OCC to clear and 
settle CDOs, which are options related to the creditworthiness of an 
issuer or guarantor (``reference entity'') of one or more specified 
debt securities (``reference obligation(s)''). CDOs are binary options 
that pay a fixed amount to the holder of the option upon the occurrence 
of a ``credit event'' affecting the reference obligations.\4\ 
Characteristics of CDOs are described below, followed by an explanation 
of the specific rule changes being proposed to clear them.
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    \4\ ``Binary'' options (also sometimes referred to as 
``digital'' options) are ``all-or-nothing'' options that pay a fixed 
amount if automatically exercised and otherwise pay nothing.
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Description of Credit Default Options
    CDOs are structured as binary options that are automatically 
exercised and the exercise settlement amount payable if a ``credit 
event'' occurs at any time prior to the last day of trading. A ``credit 
event'' is generally defined as any failure to pay on any of the 
reference obligations or any other occurrence that would constitute an 
``event of default'' or ``restructuring'' under the terms of any of the 
reference obligations and that the listing exchange has determined 
would be a credit event for purposes of the CDO. Under CBOE's current 
proposal, the payout or ``settlement amount'' for a single exercised 
option would be $100,000.
    OCC does not currently clear any binary options although OCC has 
filed a rule change \5\ seeking to clear binary options on securities 
and securities indexes that have been proposed for trading by CBOE and 
the American Stock Exchange (``Amex'').\6\ The binary options rule 
filings of OCC, Amex, and CBOE are still pending approval by the 
Commission, and OCC expects to amend its binary options rule filing in 
the near future in order to conform it to the changes made in this 
filing and to make any additional changes necessary to accommodate the 
Amex and CBOE products. Under the binary options rule filings, binary 
options are proposed to be traded on the price of single securities or 
on the price of indexes of securities where the option is exercised if 
the closing value of the underlying interest meets the specified 
criterion for automatic exercise, which could be defined as ``at or 
above'' a certain value, ``below'' a certain value, or in other ways. 
In other words, the underlying interest is a continuous measure that 
could have a wide range of positive values. CDOs, on the other hand, 
are options for which the payout is determined by the occurrence or 
non-occurrence of a discrete credit event affecting underlying 
securities. The rules proposed in the current rule filing for CDOs are 
intended to be sufficiently generic to be the basis for clearing CDOs 
as well as other binary options although certain provisions specific to 
other binary options proposals will be filed separately.
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    \5\ File No. SR-OCC-2004-21.
    \6\ File Nos. SR-Amex-2004-27 and SR-CBOE-2006-105.
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By-Law and Rule Amendments Applicable to CDOs
    In order to accommodate trading in CDOs and to provide a framework 
of rules that can accommodate other binary option products as well, OCC 
proposes to add a new By-Law Article and a new Chapter to its Rules to 
incorporate several new defined terms and procedures for clearing and 
settling binary options generally and CDOs specifically.
1. Terminology--Article I, Section 1 and Article XIV, Section 1 of the 
By-Laws
    ``Binary Option'' is defined in Article XIV, Section 1 of the By-
Laws, and that definition is cross-referenced in Article I of the By-
Laws. The definition of ``expiration time'' in Article I is modified to 
be a default provision, permitting the expiration time to be defined 
differently for different classes of options. The definition of 
``option contract'' in Article I of the By-Laws is amended to include a 
binary option and

[[Page 9827]]

to provide a more generic definition of ``cash-settled option.''
    ``Adjustment event'' is defined in Article XIV by reference to the 
rules of the listing exchange. Similarly, ``credit event'' is defined 
by reference to exchange rules. The terms ``credit event confirmation'' 
and ``credit event confirmation deadline'' are used, respectively, to 
refer to the notice that must be provided by the listing exchange or 
other reporting authority to OCC that a credit event has occurred (and 
that a CDO will therefore automatically be exercised) and to the 
deadline for receipt of such notice if it is to be treated as having 
been received on the business day on which it is submitted. Credit 
event confirmations received after the deadline on the expiration date 
but before the expiration time will be given effect but may result in 
delayed exercise settlement.
    The definition of ``exercise price'' in Article I is replaced with 
respect to CDOs with a revised definition in Article XIV, Section 1 
which recognizes that binary options will be settled by a fixed cash 
payment. The ``exercise price'' of a binary option is not, as defined 
in Article I, an amount that is paid in exchange for an underlying 
interest and is not used to determine the exercise settlement amount as 
in the case of other cash-settled options. In the case of a binary 
option other than a CDO, the exercise price is simply a defined value 
or range of values for the underlying interest. If the underlying 
interest falls within the defined range at expiration of the option, 
the option will be automatically exercised. Otherwise, it will expire 
unexercised. A CDO is said to have no exercise price.
    OCC is also redefining the term ``exercise settlement amount'' in 
Article XIV for purposes of binary options. The exercise settlement 
amount of a binary option is the amount specified by the exchange on 
which the option is traded that will be paid in settlement of an 
automatically exercised option. CBOE has specified the exercise 
settlement amount for a single CDO as $100,000. OCC's proposed 
definition would permit an exchange to specify a different exercise 
settlement amount. The exercise settlement amount will be determined by 
the exchange at the time of listing when the exchange fixes the other 
variable terms for the options of a particular class or series.
    OCC is replacing the definitions of ``variable terms,'' 
``premium,'' and ``multiplier'' in Article I with revised definitions 
in Article XIV, Section 1 that are applicable to binary options 
generally. The term ``class'' is also redefined in Article XIV, Section 
1. This new definition of ``class'' does not apply to binary options 
other than CDOs and will need to be supplemented for other binary 
options. To be within the same class, CDOs must have the same reporting 
authority, which OCC anticipates will ordinarily be the listing 
exchange. This is necessary because of the degree of discretion that 
the reporting authority will have in determining whether a credit event 
has occurred.
    CDOs will be a subcategory of binary options where exercise is 
triggered by a discrete event such as a ``credit event'' affecting the 
``reference obligations'' issued by a ``reference entity,'' which terms 
are defined to have the meanings given to them in the rules of the 
listing exchange. The term ``underlying interest'' is defined in the 
case of CDOs to be the reference obligation(s) with respect to which 
the credit event will or will not occur. In the case of other binary 
options, ``underlying interest'' is defined as the underlying security, 
index, or measure whose underlying interest value is compared to the 
option's exercise price to determine whether the option will be 
automatically exercised. ``Underlying interest value'' is defined to 
mean the value or level of the underlying interest used to determine 
whether a binary option will be automatically exercised. The term 
``underlying interest value'' is not applicable to CDOs.
2. Terms of Cleared Contracts--Article VI, Section 10(e)
    A new paragraph (e) is added to Article VI, Section 10 so that an 
exchange is required to designate the exercise settlement amount, 
expiration date, and exercise price for a series of binary options at 
the time the series is opened for trading. Section 10(e) also reminds 
the reader that binary options are subject to adjustment under Article 
XIV.
3. Rights and Obligations--Article XIV, Section 2
    Article XIV, Section 2 defines the general rights and obligations 
of holders and writers of binary options. As noted above, the holder of 
a binary option that is automatically exercised has the right to 
receive the fixed exercise settlement amount from OCC, and the assigned 
writer has the obligation to pay that amount to OCC.
4. Adjustments of Credit Default Options--Article XIV, Section 3; 
Determination of Occurrence of Credit Event--Article XIV, Section 4
    Article XIV, Section 3 provides for adjustment of CDOs in 
accordance with the rules of the listing exchange. CBOE's proposed 
rules provide for adjustment of CDOs in the case of certain corporate 
events affecting the reference obligations, and OCC proposes simply to 
defer to those rules and to the determinations of CBOE pursuant to 
those rules. Accordingly, OCC will have no responsibility for 
adjustment determinations with respect to CDOs. Adjustment rules for 
other binary options will be supplied as necessary for other products.
    Similarly, Section 4 provides that the listing exchange for a class 
of CDOs will have responsibility for determining the occurrence of a 
credit event that will result in automatic exercise of the options of 
that class. The listing exchange has the obligation to provide a credit 
event confirmation to OCC in order to trigger the automatic exercise.
    New Article XIV, Section 5 provides, in essence, that the 
underlying interest value of a series of binary options other than CDOs 
will be determined by the exchange or exchanges on which such series is 
traded. OCC reserves the right to override that determination in 
certain circumstances. If a series of binary options is traded on more 
than one exchange, OCC may use the underlying interest value received 
from the exchange deemed by OCC to be the principal exchange, or OCC 
may employ a procedure to derive a single value based on some or all of 
the values received.
5. Exercise and Settlement--Chapter XV of the Rules and Rule 801
    Binary options would not be subject to the exercise-by-exception 
procedures applicable to most other options under OCC's Rules but would 
instead be automatically exercised at expiration if the specified 
criterion for exercise is met. The procedures for the automatic 
exercise of binary options, as well as their assignment and settlement 
(including during periods when a clearing member is suspended), are set 
forth in Rules 1501 through 1505 of new Chapter XV and in revised Rule 
801(b).
6. Special Margin Requirements--Rule 601; Deposits in Lieu of Margin--
Rule 1506
    OCC will not initially margin CDOs through its usual ``STANS'' 
system. Because of CDOs' fixed payout feature, further systems 
development is needed to accommodate these options in STANS. Until such 
development is completed, OCC has initially determined to require that 
writers of such options post margin in a fixed amount that will be set 
at 100% of the fixed exercise settlement amount

[[Page 9828]]

applicable to each series of CDOs. OCC would have discretion to reduce 
the requirement to something less than 100% if research, analysis, and 
experience suggest that a lower percentage is sufficient. Initially, 
long positions in CDOs will be valued at zero and will provide no 
offset against margin requirements on the shorts. Again, based on 
research, analysis, and experience, OCC may determine to give some 
value to the longs. Ultimately, CDOs will be incorporated into the 
STANS system and valued and will be margined on a risk basis.
    OCC does not propose to accept escrow deposits in lieu of clearing 
margin for binary options. Therefore, Rule 1506 states that Rule 610, 
which otherwise would permit such deposits, does not apply to binary 
options.
7. Acceleration of Expiration Date--Rule 1507
    This provision permits OCC to accelerate the expiration date of a 
binary option when the value of the underlying interest has become 
fixed (e.g., where a stock underlying a binary option has been 
converted by a merger into the right to receive a fixed amount of 
cash). If the value of the underlying interest does not meet the 
specified criterion for automatic exercise, it will expire unexercised. 
Otherwise, it will be automatically exercised.
    The proposed changes to OCC's By-Laws and Rules are consistent with 
the purposes and requirements of Section 17A of the Act, as amended, 
because they are designed to promote the prompt and accurate clearance 
and settlement of transactions in, including exercises of, credit 
default options and other binary options, and to foster cooperation and 
coordination with persons engaged in the clearance and settlement of 
such transactions, to remove impediments to and perfect the mechanism 
of a national system for the prompt and accurate clearance and 
settlement of such transactions, and, in general, to protect investors 
and the public interest. They accomplish these purposes by applying 
substantially the same rules and procedures to binary options and 
specifically CDOs as OCC applies to similar transactions in other cash-
settled options. Other than as described in this Item II, the proposed 
rule change is not inconsistent with the existing rules of OCC, 
including rules proposed to be amended.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    OCC does not believe that the proposed rule change would impose any 
burden on competition.

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

    Written comments were not and are not intended to be solicited with 
respect to the proposed rule change, and none have been received.

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

    Within thirty-five 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 ninety 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 self-regulatory organization consents, 
the Commission will:
    (A) By order approve such proposed rule change or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

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

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml) or
     Send an e-mail to [email protected]. Please include 
File Number SR-OCC-2007-01 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number SR-OCC-2007-01. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 100 F Street, 
NE., Washington, DC 20549. The text of the proposed rule change is 
available at OCC, the Commission's Public Reference Room, and http://www.theocc.com/publications/rules/proposed_changes/sr_occ_07_01.pdf. 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-OCC-
2007-01 and should be submitted on or before March 26, 2007.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E7-3773 Filed 3-2-07; 8:45 am]
BILLING CODE 8010-01-P