[Federal Register Volume 72, Number 113 (Wednesday, June 13, 2007)]
[Notices]
[Pages 32693-32695]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-11370]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55872; File No. SR-OCC-2007-01]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Granting Approval of a Proposed Rule Change Relating to Credit 
Default Options

June 6, 2007.

I. Introduction

    On February 13, 2007, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
proposed rule change File No. SR-OCC-2007-01 pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'').\1\ On March 
7, 2007, OCC filed an amendment to the proposed rule change.\2\ Notice 
of the proposal was published in the Federal Register on March 5, 
2007.\3\ No comment letters were received. This order approves the 
proposed rule change as amended.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ The March 7, 2007, amendment reflects OCC's determination to 
seek approval for the credit default option product only and not for 
binary options in general. Because Amendment No. 1 is technical in 
nature, the Commission is not republishing the notice of filing for 
public comment.
    \3\ Securities Exchange Act Release No. 55362 (February 27, 
2007), 72 FR 9826.
---------------------------------------------------------------------------

II. Description

    The purpose of the proposed rule change is to permit OCC to clear 
and settle credit default options (``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\ CDOs will be traded by the 
Chicago Board Options Exchange (``CBOE'').\5\
---------------------------------------------------------------------------

    \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.
    \5\ Securities Exchange Act Release Nos. 55251 (February 7, 
2007), 72 FR 7091 (February 14, 2007) (notice of filing of proposed 
rule change); 55871 (June 6, 2007) (order approving proposed rule 
change) [File No. SR-CBOE-2006-84].
---------------------------------------------------------------------------

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

[[Page 32694]]

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. The payout or settlement amount 
for a single exercised option CBOE CDO will be $100,000.

By-Law and Rule Amendments Applicable to CDOs

    In order to accommodate trading in CDOs, OCC is adding a new By-Law 
Article and a new Chapter to its Rules to incorporate several new 
defined terms and procedures for clearing and settling CDOs.
1. Terminology--Article I, Section 1 and Article XIV, Section 1 of the 
By-Laws
    The definition of ``expiration time'' in Article I of the By-Laws 
is modified to be a default provision to permit 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 credit default option and 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.
    OCC is also defining the term ``exercise settlement amount'' in 
Article XIV for purposes of credit default options. The exercise 
settlement amount of a credit default 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 credit default 
options. The term ``class'' is also redefined in Article XIV, Section 
1. 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 category of 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 to be the 
reference obligation(s) with respect to which the credit event will or 
will not occur.
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 credit default 
options at the time the series is opened for trading. Section 10(e) 
also reminds the reader that credit default 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 credit default options. As noted above, the 
holder of a credit default 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 rules provide 
for adjustment of CDOs in the case of certain corporate events 
affecting the reference obligations, and OCC proposes simply to defer 
to the rules and to the determinations of the listing exchange pursuant 
to its rules. Accordingly, OCC will have no responsibility for 
adjustment determinations with respect to CDOs.
    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.
5. Exercise and Settlement--Chapter XV of the Rules and Rule 801
    Credit default options will 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 credit default 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 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 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 will be 
valued and margined on a risk basis.
    OCC does not propose to accept escrow deposits in lieu of clearing 
margin for credit default options. Therefore, Rule 1506 states that 
Rule 610, which otherwise would permit such deposits, does not apply to 
credit default options.

[[Page 32695]]

7. Acceleration of Expiration Date--Rule 1507
    This provision permits OCC to accelerate the expiration date of a 
credit default option when the option is deemed to have been exercised 
on any day prior to the expiration date.

III. Discussion

    Section 17A(b)(3)(F) of the Act requires that the rules of a 
clearing agency be designed to promote the prompt and accurate 
clearance and settlement of securities transactions.\6\ The Commission 
finds the proposed rule change to be consistent with Section 
17A(b)(3)(F) of the Act because it is designed to promote the prompt 
and accurate clearance and settlement of transactions in, including 
exercises of, credit default options and to remove impediments to and 
perfect the mechanism of a national system for the prompt and accurate 
clearance and settlement of such transactions.\7\ These purposes are 
accomplished by having the clearance and settlement of CDOs take place 
at OCC and by OCC applying substantially the same rules and procedures 
to CDOs as it applies to similar transactions in other cash-settled 
options.
---------------------------------------------------------------------------

    \6\ 15 U.S.C. 78q-1(b)(3)(F).
    \7\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular Section 17A of the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-2007-01) as modified by 
Amendment No. 1 be and hereby is approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\8\

---------------------------------------------------------------------------

    \8\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-11370 Filed 6-12-07; 8:45 am]
BILLING CODE 8010-01-P