[Federal Register Volume 73, Number 105 (Friday, May 30, 2008)]
[Notices]
[Pages 31169-31172]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E8-12031]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-57850; File No. SR-CBOE-2006-105]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Approving a Proposed Rule Change, as Modified by 
Amendment No. 2, Regarding the Listing and Trading of Binary Options on 
Broad-Based Security Indexes

May 22, 2008.

I. Introduction

    On December 29, 2006, 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 
thereunder,\2\ a proposed rule change to list and trade binary options 
on broad-based security indexes. The CBOE filed Amendment Nos. 1 and 2 
to the proposal on September 6, 2007, and April 4, 2008,\3\ 
respectively. The proposed rule change, as modified by Amendment No. 2, 
was published for comment in the Federal Register on April 17, 2008.\4\ 
The Commission received no comments regarding the proposal. This order 
approves the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 2 replaces the original filing and Amendment 
No. 1 in their entirety.
    \4\ See Securities Exchange Act Release No. 57642 (April 9, 
2008), 73 FR 20985.
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II. Description of the Proposal

A. Generally

    The CBOE proposes to list and trade certain cash-settled, European-
style binary options on broad-based security indexes. At expiration, an 
option listed pursuant to this proposal would pay an exercise 
settlement amount equal to the exercise settlement value multiplied by 
the contract multiplier.\5\ Unlike a traditional option, a binary 
option will pay a fixed sum at expiration regardless of the magnitude 
of the difference between the settlement value and the option's 
exercise price. A call binary index option would pay out if the 
settlement value of the underlying index were at or above the option's 
exercise price at expiration, and a put binary index option would pay 
out if the underlying index were below the option's exercise price at 
expiration.\6\
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    \5\ The exercise settlement value will be an amount determined 
by the CBOE on a class-by-class basis and will be equal to or 
between $10 or $1,000, unless otherwise adjusted pursuant to CBOE 
Rule 5.7. See CBOE Rule 22.1(e).
    \6\ See CBOE Rules 22.1(b) and (c).
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    The Exchange is proposing to add a new series of rules to Chapter 
XXII of its rulebook (which is currently ``reserved'') relating to 
binary options. Trading of binary options would also be subject to 
Chapters I through XIX, XXIV, XXIVA, and XXIVB, as supplemented by the 
new rules of Chapter XXII.

B. Listing Standards

    Under the proposal, the Exchange may from time to time approve for 
listing and trading on the Exchange binary option contracts on a broad-
based index \7\ which has been selected in accordance with CBOE Rule 
24.2 and the Interpretations and Policies thereunder.\8\ After a 
particular binary option class has been approved for listing and 
trading on the Exchange, the Exchange may from time to time open for 
trading series of options on that class.\9\ The Exchange may add new 
series of options on the same class, as provided for in CBOE Rule 24.9 
and the Interpretations and Policies thereunder. Additional series of 
the same binary option class may be opened for trading on the Exchange 
when the Exchange deems it necessary to maintain an orderly market or 
to meet customer demand.\10\ The maintenance listing standards for 
options on broad-based indexes set forth in CBOE Rule 24.2 and the 
Interpretations and Policies thereunder will be applicable to binary 
options on broad-based indexes.\11\ Binary options form a separate 
class from other options overlying the same broad-based index.\12\
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    \7\ CBOE Rule 24.1(i)(1) defines a ``broad-based index'' as ``an 
index designed to be representative of a stock market as a whole or 
of a range of companies in unrelated industries.''
    \8\ See CBOE Rule 22.3(a).
    \9\ See CBOE Rule 22.3(c).
    \10\ See CBOE Rule 22.3(d).
    \11\ See CBOE Rule 22.4.
    \12\ See CBOE Rule 22.3(a).
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    Binary options traded on the Exchange will be designated as to 
expiration date, exercise price, exercise settlement amount, contract 
multiplier, and underlying broad-based index.\13\ Binary index options 
will be a.m.-settled unless the traditional options on

[[Page 31170]]

the same underlying index (i.e., the S&P 100 Index (``OEX'')) are p.m.-
settled.\14\ Under the proposal, binary options may expire from one day 
to 36 months from the time that they are listed.\15\
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    \13\ See CBOE Rule 22.3(b).
    \14\ See id.
    \15\ See CBOE Rule 22.3(c).
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C. The Options Clearing Corporation

    The Options Clearing Corporation (``OCC'') will issue, clear, and 
settle the binary options contemplated in this proposal. The OCC has 
amended its by-laws and rules to accommodate the listing and trading of 
binary options.\16\ In addition, the CBOE understands that the OCC will 
submit to the Commission a proposed supplement to the Options 
Disclosure Document required by Rule 9b-1 under the Act \17\ to 
incorporate binary options on broad-based security indexes.
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    \16\ See Securities Exchange Act Release No. 56875 (November 30, 
2007), 72 FR 69274 (December 7, 2007) (order approving File No. SR-
OCC-2007-08).
    \17\ 17 CFR 240.9b-1.
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D. Position and Exercise Limits and Position Reporting Requirements

    The Exchange is adopting a two-pronged approach to determine 
position limits for binary options.\18\ In determining compliance with 
CBOE Rule 4.11, the Exchange proposes a fixed position limit of 15,000 
contracts for binary options on a broad-based index for which 
traditional options on the same broad-based index have no position 
limit, provided that the exercise settlement amount is $10,000.\19\ For 
binary options that have an exercise settlement amount that is not 
equal to $10,000, the position limit will be 15,000 times the ratio of 
10,000 to the exercise settlement amount (e.g., if the binary option 
exercise settlement amount is $1,000, then the position limit is 
150,000 contracts. If the binary option exercise settlement amount is 
$12,000, then the position limit is 12,500 contracts).\20\
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    \18\ See CBOE Rule 22.6.
    \19\ See CBOE Rule 22.6(a).
    \20\ See id.
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    The Exchange is adopting a formulaic position limit for binary 
options on a broad-based index for which traditional options on the 
same broad-based index have a position limit.\21\ The formulaic 
position limit will be calculated in accordance with the following 
methodology: (1) Determine the Market Capitalization of the S&P 500 
Index; (2) determine the Market Capitalization of the broad-based index 
underlying the binary option; and (3) calculate the Market 
Capitalization Ratio of the broad-based index underlying the binary 
option to the Market Capitalization of the S&P 500 Index. The position 
limit for binary options subject to a formulaic limit with an exercise 
settlement amount of $10,000 will be: (1) 10,000 contracts if the 
Market Capitalization Ratio is greater than or equal to 0.50; (2) 5,000 
contracts if the Market Capitalization Ratio is less than 0.50 but 
greater than or equal to 0.25; or (3) 2,500 contracts if the Market 
Capitalization Ratio is less than 0.25 but greater than or equal to 
0.10.\22\ The Exchange will seek Commission approval prior to 
establishing position limits for binary options on broad-based indexes 
that have a Market Capitalization Ratio that is less then 0.10.\23\ For 
binary options that have an exercise settlement amount that is not 
equal to $10,000, the position limit will be the ratio of 10,000 to the 
exercise settlement amount multiplied by the applicable formulaic 
limit.\24\
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    \21\ See CBOE Rule 22.6(b).
    \22\ See CBOE Rule 22.6(b)(4).
    \23\ See CBOE Rule 22.6(b)(4)(iv).
    \24\ See CBOE Rule 22.6(b)(5).
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    CBOE Rule 22.6 also provides that positions in binary options on 
the same broad-based index that have different exercise settlement 
amounts will be aggregated.\25\ In determining compliance with the 
position limits set forth in Rule 22.6, binary options will not be 
aggregated with non-binary option contracts on the same or similar 
underlying security or broad-based index.\26\ In addition, binary 
options on broad-based indexes will not be aggregated with non-binary 
option contracts on an underlying stock or stocks included within such 
broad-based index, and binary options on one broad-based index shall 
not be aggregated with binary options on any other broad-based 
index.\27\
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    \25\ See CBOE Rule 22.6(b)(5)(c).
    \26\ See CBOE Rule 22.6(b)(5)(d).
    \27\ See id.
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    For purposes of the position limits established in Rule 22.6, a 
long position in a put binary option and a short position in a call 
binary option will be considered to be on the same side of the market; 
and a short position in a put binary option and a long position in a 
call binary option will be considered to be on the same side of the 
market.\28\ Binary options will not be subject to the hedge exemption 
to the standard position limits found in Rule 4.11.\29\ Under Rule 
22.6, the following qualified hedge exemption strategies and positions 
will be exempt from the established binary option position limits: (1) 
A binary option position ``hedged'' or ``covered'' by an appropriate 
amount of cash to meet the settlement obligation (e.g., $1,000 for a 
binary option with an exercise settlement amount of $1,000); (2) a 
binary option position ``hedged'' or ``covered'' by a sufficient amount 
of a related or similar security to meet the settlement obligation; or 
(3) a binary option position ``hedged'' or ``covered'' by a traditional 
option covering the same underlying broad-based index sufficient to 
meet the settlement obligation.\30\
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    \28\ See CBOE Rule 22.6(e).
    \29\ See CBOE Rule 22.6(f).
    \30\ See CBOE Rule 22.6(f)(1)-(3).
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    Binary options will not be subject to exercise limits due to the 
fact that they are European-style options and are automatically 
exercised at expiration if the settlement value of the underlying index 
is equal to or greater than the exercise price of a call binary option 
or less than the exercise price in the case of a put binary option.\31\
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    \31\ See CBOE Rule 22.7.
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    CBOE Rule 22.8, ``Reports Related to Position Limits and 
Liquidation of Positions,'' states that references in Rules 4.13, 
``Reports Related to Position Limits,'' and 4.14, ``Liquidation of 
Positions,'' to Rule 4.11 in connection with position limits will be 
deemed, in the case of binary options, to be to Rule 22.6. As such, in 
accordance with CBOE Rule 4.13(a), a position in a binary option must 
be reported to the Exchange via the Large Option Positions Report when 
an account establishes an aggregate same side of the market position of 
200 or more binary options. In computing reportable binary options 
under existing Rule 4.13: (1) Positions in binary options that have 
different exercise settlement amounts will be aggregated; (2) positions 
in binary options will not be aggregated with non-binary option 
contracts on the same or similar underlying security or broad-based 
index; (3) positions in binary options on broad-based indexes will not 
be aggregated with non-binary option contracts on an underlying stock 
or stocks included within such broad-based index; and (4) positions in 
binary options on one broad-based index will not be aggregated with 
binary options on any other broad-based index.\32\ The Exchange 
believes that the reporting requirements and the surveillance 
procedures for hedged positions will enable the Exchange to closely 
monitor sizable positions and corresponding hedges.
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    \32\ See CBOE Rule 22.8.
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E. Margin

    The Exchange is amending Rule 12.3, ``Margin Requirements,'' to 
include

[[Page 31171]]

requirements applicable to binary options. Under Rule 12.3, as amended, 
for a Margin Account, no binary option carried for a customer shall be 
considered of any value for purposes of computing the margin required 
in the account of such customer.\33\ The initial and maintenance margin 
required on any binary option carried long in a customer's account is 
100% of the purchase price of such binary option (i.e., the 
premium).\34\ In connection with a short position in a binary option, 
the customer margin required is the exercise settlement amount.\35\ As 
for spreads, no margin is required on a binary call option (put option) 
carried short in a customer's account that is offset by a long binary 
call option (put option) for the same underlying security or instrument 
that expires at the same time and has an exercise price that is less 
than (greater than) the exercise price of the short call (put).\36\ The 
long call (put) must be paid for in full.\37\ As for a straddle/
combination, when a binary call option is carried short in a customer's 
account and there is also carried a short binary put option that 
expires at the same time and has an exercise price that is less than or 
equal to the exercise price of the short call, the initial and 
maintenance margin required is the exercise settlement amount 
applicable to one contract.\38\
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    \33\ See CBOE Rule 12.3(m)(1).
    \34\ See CBOE Rule 12.3(m)(1)(i).
    \35\ See CBOE Rule 12.3(m)(1)(ii).
    \36\ See CBOE Rule 12.3(m)(1)(iii).
    \37\ See id.
    \38\ See CBOE Rule 12.3(m)(1)(iv).
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    For a cash account, a binary option carried short in a customer's 
account will be deemed a covered position, and eligible for the cash 
account, if either one of the following is held in the account at the 
time the option is written or is received into the account promptly 
thereafter: (1) Cash or cash equivalents equal to 100% of the exercise 
settlement amount; (2) a long binary option of the same type (put or 
call) for the same underlying security or instrument that is paid for 
in full and expires at the same time, and has an exercise price that is 
less than the exercise price of the short in the case of a call or 
greater than the exercise price of the short in the case of a put; or 
(3) an escrow agreement.\39\ The escrow agreement must certify that the 
bank holds for the account of the customer as security for the 
agreement cash, cash equivalents, one or more qualified equity 
securities, or a combination thereof having an aggregate market value 
of not less than 100% of the exercise settlement amount and that the 
bank will promptly pay the member organization the cash settlement 
amount in the event the account is assigned an exercise notice.\40\ The 
Exchange believes that these levels are appropriate because risk 
exposure is limited with binary options and the customer initial and 
maintenance margin would be equal to the maximum risk exposure. In 
addition, under CBOE Rule 12.10, the CBOE may determine at any time to 
impose higher margin requirements than those described above when it 
deems such higher margin requirements to be advisable.
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    \39\ See CBOE Rule 12.3(m)(2).
    \40\ See id.
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F. Bid-Ask Differentials, Minimum Price Variations, and Strike Price 
Intervals

    For each binary index option traded on the Exchange, a market maker 
is expected to quote so as to create differences between the bid and 
the offer of no more than the wider of 25% of the designated exercise 
settlement value or $5.00, except during the last trading day prior to 
the expiration, when the maximum permissible price differential is the 
wider of 50% of the designated exercise settlement value or $5.00.\41\ 
The minimum price variation for binary index options, established by 
class, will be no less than $0.01.\42\ The CBOE will list binary index 
options using the strike price intervals currently used for traditional 
index options.\43\
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    \41\ See CBOE Rule 22.14(a).
    \42\ See CBOE Rule 22.13(b).
    \43\ See CBOE Rule 22.3(d).
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G. FLEX Trading

    Binary options will be eligible for trading as Flexible Exchange 
Options as provided for in Chapters XXIVA and XXIVB of the CBOE's 
rules.\44\ The position limit methodology in CBOE Rule 22.6, discussed 
above, will apply to binary index options traded as Flexible Exchange 
Options.\45\
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    \44\ See CBOE Rule 22.16.
    \45\ See CBOE Rule 22.16.
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H. Other Considerations

    The CBOE represents that it believes that the Exchange and the 
Options Price Reporting Authority have the necessary systems capacity 
to handle the additional message traffic associated with the listing 
and trading of binary options on broad-based indexes. In addition, the 
CBOE represents that it has an adequate surveillance program to monitor 
trading in binary options on broad-based indexes, and that the Exchange 
intends to largely apply its existing surveillance program for options 
to the trading of binary index options.\46\
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    \46\ See e-mail message from Jennifer Yeadon, Senior Attorney, 
CBOE, to Yvonne Fraticelli, Special Counsel, Division of Trading and 
Markets, dated May 20, 2008.
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III. Discussion

    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.\47\ Specifically, the Commission finds that the proposal is 
consistent with Section 6(b)(5) of the Act,\48\ which requires, among 
other things, that the rules of a national securities exchange be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to remove impediments 
to and perfect the mechanism of a free and open market and a national 
market system, and, in general, to protect investors and the public 
interest. The Commission believes that binary options on broad-based 
indexes will provide investors with a potentially useful investment 
choice. The proposal will extend to these options the benefits of a 
listed exchange market, which include a centralized forum for price 
discovery, pre- and post-trade transparency, standardized contract 
specifications, and the guarantee of the OCC.
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    \47\ 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).
    \48\ 15 U.S.C. 78f(b)(5).
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    The Commission believes that the proposal is reasonably designed to 
address potential manipulation concerns associated with binary options' 
non-linear return. The initial and continued listing standard 
established herein provide that the Exchange may list and trade binary 
options only on broad-based indexes. In addition, these binary options 
will be a.m.-settled, unless the traditional options on the underlying 
index are p.m.-settled. These elements should reduce the potential for 
manipulating the index underlying a binary option to benefit a binary 
index option position.
    The Commission believes that the proposed position limits and 
margin rules are reasonable and consistent with the Act. The proposed 
position limits for binary index options appear to reasonably balance 
the promotion of a free and open market for these securities with 
minimization of incentives for market manipulation. The proposed margin 
rules appear reasonably designed to deter a member or its

[[Page 31172]]

customer from assuming an imprudent position in binary index options.
    In support of this proposal, the CBOE made the following 
representations:
     The CBOE has in place an adequate surveillance program to 
monitor trading in binary options on broad-based indexes and intends to 
largely apply its existing surveillance program for options to the 
trading of binary options on broad-based indexes; and
     The CBOE has the necessary systems capacity to support the 
new options series that would result from the introduction of binary 
options on broad-based indexes.
    This approval order is based on the CBOE's representations.

IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\49\ that the proposed rule change (SR-CBOE-2006-105), as modified 
by Amendment No. 2, is approved.
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    \49\ 15 U.S.C. 78s(b)(2).

     For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\50\
J. Lynn Taylor,
Assistant Secretary.
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    \50\ 17 CFR 200.30-3(a)(12).
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 [FR Doc. E8-12031 Filed 5-29-08; 8:45 am]
BILLING CODE 8010-01-P