[Federal Register Volume 69, Number 247 (Monday, December 27, 2004)]
[Notices]
[Pages 77275-77286]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-28184]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50886; File No. SR-CBOE-2002-03]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendment No. 1 Thereto by the Chicago Board Options 
Exchange, Incorporated Relating to Customer Portfolio and Cross-
Margining Requirements

December 20, 2004.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on April 2, 2004, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') Amendment No. 1\3\ to the proposed rule 
change as described in Items I, II, and III below, which Items have 
been prepared by the CBOE. The CBOE submitted the original proposed 
rule change to the Commission on January 15, 2002 (``Original 
Proposal''). The proposed rule change was published in the Federal 
Register on March 29, 2002.\4\ The Commission received one comment 
letter in response to the proposed rule change.\5\ The CBOE is 
proposing 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.\6\ The Commission is publishing this 
notice to solicit comments on the proposed rule change, as amended, 
from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ 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'').
    \4\ See Securities Exchange Act Release No. 45630 (March 22, 
2002), 67 FR 15263 (March 29, 2002).
    \5\ See E-mail from Mike Ianni, Private Investor to <a href="/cdn-cgi/l/email-protection#9eecebf2fbb3fdf1f3f3fbf0eaeddeedfbfdb0f9f1e8"><span class="__cf_email__" data-cfemail="ee9c9b828bc38d8183838b809a9dae9d8b8dc0898198">[email protected]</span></a>, dated November 7, 2002 (``Ianni E-mail'').
    \6\ See Securities Exchange Act Release No. 46576 (October 1, 
2002), 67 FR 62843 (October 8, 2002) (File No. SR-NYSE-2002-19) 
(``NYSE Proposal'').
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The CBOE proposes to amend its rules, for certain customer 
accounts, to allow member organizations to margin listed, broad-based, 
market index options, index warrants and related exchange-traded funds 
according to a portfolio margin methodology as an alternative to the 
current strategy-based margin methodology. The proposed rule change 
also will provide for cross-margining by allowing broad-based index 
futures and options on such futures to be included with listed, broad-
based index options, index warrants and related exchange-traded funds 
for portfolio margin treatment, in a separate cross-margin account. The 
text of the proposed rule change is below. Additions are in italics. 
Deletions are in brackets.
* * * * *

Chapter XII Margins

[Covered Options Contracts]

Portfolio Margin and Cross-Margin for Index Options

    Rule 12.4. [Deleted January 15, 1975.] As an alternative to the 
transaction / position specific margin requirements set forth in Rule 
12.3 of this Chapter 12, members may require margin for listed, broad-
based U.S. index options, index warrants and underlying instruments (as 
defined below) in accordance with the portfolio margin requirements 
contained in this Rule 12.4.
    In addition, members, provided they are a Futures Commission 
Merchant (``FCM'') and are either a clearing member of a futures 
clearing organization or have an affiliate that is a clearing member of 
a futures clearing organization, are permitted under this Rule 12.4 to 
combine a customer's related instruments (as defined below) and listed, 
broad based U.S. index options, index warrants and underlying 
instruments and compute a margin requirement (``cross-margin'') on a 
portfolio margin basis. Members must confine cross-margin positions to 
a portfolio margin account dedicated exclusively to cross-margining.
    Application of the portfolio margin and cross-margining provisions 
of this Rule 12.4 to IRA accounts is prohibited.
    (a) Definitions.
    (1) The term ``listed option'' shall mean any option traded on a 
registered national securities exchange or automated facility of a 
registered national securities association.
    (2) The term ``unlisted option'' means any option not included in 
the definition of listed option.
    (3) The term ``options class'' refers to all options contracts 
covering the same underlying instrument.
    (4) The term ``portfolio'' means options of the same options class 
grouped with their underlying instruments and related instruments.
    (5) The term ``option series'' relates to listed options and means 
all option contracts of the same type (either a call or a put) and 
exercise style, covering the same underlying instrument with the same 
exercise price, expiration date, and number of underlying units.
    (6) The term ``related instrument'' within an option class or 
product group means futures contracts and options on futures contracts 
covering the same underlying instrument.
    (7) The term ``underlying instrument'' means long and short 
positions in an exchange traded fund or other fund product registered 
under the Investment Company Act of 1940 that holds the same 
securities, and in the same proportion, as contained in a broad based 
index on which options are listed. The term underlying instrument shall 
not be deemed to include, futures contracts, options on futures 
contracts, underlying stock baskets, or unlisted instruments.
    (8) The term ``product group'' means two or more portfolios of the 
same type (see subparagraph (a)(9) below) for which it has been 
determined by Rule 15c3-1a under the Securities Exchange Act of 1934 
that a percentage of offsetting profits may be applied to losses at the 
same valuation point.
    (9) The term ``theoretical gains and losses'' means the gain and 
loss in the value of individual option series and related instruments 
at 10 equidistant intervals (valuation points) ranging from an assumed 
movement (both up and down) in the current market value of the 
underlying instrument. The magnitude of the valuation point range shall 
be as follows:

[[Page 77276]]



------------------------------------------------------------------------
                                                     Up/Down market move
                  Portfolio type                         (high & low
                                                      valuation points)
------------------------------------------------------------------------
non-high capitalization, broad based U.S. market                  +/-10%
 index option \1\.................................
high capitalization, broad based U.S. market index              +6%/-8%
 option \1\.......................................
------------------------------------------------------------------------
\1\ In accordance with sub-paragraph (b)(1)(i)(B) of Rule 15c3-1a under
  the Securities Exchange Act of 1934.

    (b) Eligible Participants. The application of the portfolio margin 
provisions of this Rule 12.4, including cross-margining, is limited to 
the following:
    (1) any broker or dealer registered pursuant to Section 15 of the 
Securities Exchange Act of 1934;
    (2) any affiliate of a self-clearing member organization;
    (3) any member of a national futures exchange to the extent that 
listed index options hedge the member's index futures; and
    (4) any other person or entity not included in (b)1 through (b)3 
above that has or establishes, and maintains, equity of at least 5 
million dollars. For purposes of this equity requirement, all 
securities and futures accounts carried by the member for the same 
customer may be combined provided ownership across the accounts is 
identical. A guarantee by any other account for purposes of the minimum 
equity requirement is not to be permitted.
    (c) Opening of Accounts.
    (1) Only customers that, pursuant to Rule 9.7, have been approved 
for options transactions, and specifically approved to engage in 
uncovered short option contracts, are permitted to utilize a portfolio 
margin account.
    (2) On or before the date of the initial transaction in a portfolio 
margin account, a member shall:
    A. furnish the customer with a special written disclosure statement 
describing the nature and risks of portfolio margining and cross-
margining which includes an acknowledgement for all portfolio margin 
account owners to sign, and an additional acknowledgement for owners 
that also engage in cross-margining to sign, attesting that they have 
read and understood the disclosure statement, and agree to the terms 
under which a portfolio margin account and the cross-margin account, 
respectively, are provided [see Rule 9.15(d)], and
    B. obtain a signed acknowledgement(s) from the customer, both of 
which are required for cross-margining customers, and record the date 
of receipt.
    (d) Establishing Account and Eligible Positions.
    (1) Portfolio Margin Account. For purposes of applying the 
portfolio margin requirements provided in this Rule 12.4, members are 
to establish and utilize a dedicated securities margin account, or sub-
account of a margin account, clearly identified as a portfolio margin 
account that is separate from any other securities account carried for 
a customer.
    (2) Cross-Margin Account. For purposes of combining related 
instruments and listed, broad-based U.S. index options, index warrants 
and underlying instruments and applying the portfolio margin 
requirements provided in this Rule 12.4, members are to establish and 
utilize a portfolio margin account, clearly identified as a cross-
margin account, that is separate from any other securities account or 
portfolio margin account carried for a customer.
    A margin deficit in either the portfolio margin account or the 
cross-margin account of a customer may not be considered as satisfied 
by excess equity in the other account. Funds and/or securities must be 
transferred to the deficient account and a written record created and 
maintained.
    (3) Portfolio Margin Account--Eligible Positions
    (i) A transaction in, or transfer of, a listed, broad-based U.S. 
index option or index warrant may be effected in the portfolio margin 
account.
    (ii) A transaction in, or transfer of, an underlying instrument may 
be effected in the portfolio margin account provided a position in an 
offsetting listed, broad-based U.S. index option or index warrant is in 
the account or is established in the account on the same day.
    (iii) If, in the portfolio margin account, the listed, broad-based 
U.S. index option or index warrant position offsetting an underlying 
instrument position ceases to exist and is not replaced within 10 
business days, the underlying instrument position must be transferred 
to a regular margin account, subject to Regulation T initial margin and 
the margin required pursuant to the other provisions of this chapter. 
Members will be expected to monitor portfolio margin accounts for 
possible abuse of this provision.
    (iv) In the event that fully paid for long options and/or index 
warrants are the only positions contained within a portfolio margin 
account, such long positions must be transferred to a securities 
account other than a portfolio margin account or cross-margin account 
within 10 business days, subject to the margin required pursuant to the 
other provisions of this chapter, unless the status of the account 
changes such that it is no longer composed solely of fully paid for 
long options and/or index warrants.
    (4) Cross-Margin Account--Eligible Positions
    (i) A transaction in, or transfer of, a related instrument may be 
effected in the cross-margin account provided a position in an 
offsetting listed, U.S. broad based index option, index warrant or 
underlying instrument is in the account or is established in the 
account on the same day.
    (ii) If the listed, U.S. broad-based index option, index warrant or 
underlying instrument position offsetting a related instrument ceases 
to exist and is not replaced within 10 business days, the related 
instrument position must be transferred to a futures account. Members 
will be expected to monitor cross-margin accounts for possible abuse of 
this provision.
    (iii) In the event that fully paid for long options and/or index 
warrants (securities) are the only positions contained within a cross-
margin account, such long positions must be transferred to a securities 
account other than a portfolio margin account or cross-margin account 
within 10 business days, subject to the margin required pursuant to the 
other provisions of this chapter, unless the status of the account 
changes such that it is no longer composed solely of fully paid for 
long options and/or index warrants.
    (e) Initial and Maintenance Margin Required. The amount of margin 
required under this Rule 12.4 for each portfolio shall be the greater 
of:
    (1) the amount for any of the 10 equidistant valuation points 
representing the largest theoretical loss as calculated pursuant to 
paragraph (f) below or
    (2) $.375 for each listed index option and related instrument 
multiplied by the contract or instrument's multiplier, not to exceed 
the market value in the case of long positions in listed options and 
options on futures contracts.

[[Page 77277]]

    (f) Method of Calculation.
    (1) Long and short positions in listed options, underlying 
instruments and related instruments are to be grouped by option class; 
each option class group being a ``portfolio''. Each portfolio is 
categorized as one of the portfolio types specified in paragraph (a)(9) 
above.
    (2) For each portfolio, theoretical gains and losses are calculated 
for each position as specified in paragraph (a)(9) above. For purposes 
of determining the theoretical gains and losses at each valuation 
point, members shall obtain and utilize the theoretical value of a 
listed index option, underlying instrument or related instrument 
rendered by a theoretical pricing model that, in accordance with 
paragraph (b)(1)(i)(B) of Rule 15c3-1a under the Securities Exchange 
Act of 1934, qualifies for purposes of determining the amount to be 
deducted in computing net capital under a portfolio based methodology.
    (3) Offsets. Within each portfolio, theoretical gains and losses 
may be netted fully at each valuation point.
    Offsets between portfolios within the High Capitalization, Broad 
Based Index Option product group and the Non-High Capitalization, Broad 
Based Index Option product group may then be applied as permitted by 
Rule 15c3-1a under the Securities Exchange Act of 1934.
    (4) After applying paragraph (3) above, the sum of the greatest 
loss from each portfolio is computed to arrive at the total margin 
required for the account (subject to the per contract minimum).
    (g) Equity Deficiency. If, at any time, equity declines below the 5 
million dollar minimum required under Paragraph (b)(4) of this Rule 
12.4 and is not brought back up to at least 5 million dollars within 
three (3) business days (T+3) by a deposit of funds or securities, or 
through favorable market action; members are prohibited from accepting 
opening orders starting on T+4, except that opening orders entered for 
the purpose of hedging existing positions may be accepted if the result 
would be to lower margin requirements. This prohibition shall remain in 
effect until such time as an equity of 5 million dollars is 
established.
    (h) Determination of Value for Margin Purposes. For the purposes of 
this Rule 12.4, all listed index options and related instrument 
positions shall be valued at current market prices. Account equity for 
the purposes of this Rule 12.4 shall be calculated separately for each 
portfolio margin account by adding the current market value of all long 
positions, subtracting the current market value of all short positions, 
and adding the credit (or subtracting the debit) balance in the 
account.
    (i) Additional Margin.
    (1) If at any time, the equity in any portfolio margin account, 
including a cross-margin account, is less than the margin required, 
additional margin must be obtained within one business day (T+1). In 
the event a customer fails to deposit additional margin within one 
business day, the member must liquidate positions in an amount 
sufficient to, at a minimum, lower the total margin required to an 
amount less than or equal to account equity. Exchange Rule 12.9--
Meeting Margin Calls by Liquidation shall not apply to portfolio margin 
accounts. However, members will be expected to monitor the risk of 
portfolio margin accounts pursuant to the risk monitoring procedures 
required by Rule 15.8A. Guarantees by any other account for purposes of 
margin requirements are not to be permitted.
    (2) The day trading requirements of Exchange Rule 12.3(j) shall not 
apply to portfolio margin accounts, including cross-margin accounts.
    (j) Cross-Margin Accounts--Requirement to Liquidate.
    (1) A member is required immediately either to liquidate, or 
transfer to another broker-dealer eligible to carry cross-margin 
accounts, all customer cross-margin accounts that contain positions in 
futures and/or options on futures if the member is:
    (i) insolvent as defined in section 101 of title 11 of the United 
States Code, or is unable to meet its obligations as they mature;
    (ii) the subject of a proceeding pending in any court or before any 
agency of the United States or any State in which a receiver, trustee, 
or liquidator for such debtor has been appointed;
    (iii) not in compliance with applicable requirements under the 
Securities Exchange Act of 1934 or rules of the Securities and Exchange 
Commission or any self-regulatory organization with respect to 
financial responsibility or hypothecation of customers' securities; or
    (iv) unable to make such computations as may be necessary to 
establish compliance with such financial responsibility or 
hypothecation rules.
    (2) Nothing in this paragraph (j) shall be construed as limiting or 
restricting in any way the exercise of any right of a registered 
clearing agency to liquidate or cause the liquidation of positions in 
accordance with its by-laws and rules.
* * * * *

Chapter XIII--Net Capital

Customer Portfolio Margin Accounts

    Rule 13.5. (a) No member organization that requires margin in any 
customer accounts pursuant to Rule 12.4--Portfolio Margin and Cross-
Margin for Index Options, shall permit gross customer portfolio margin 
requirements to exceed 1,000 percent of its net capital for any period 
exceeding three business days. The member organization shall, beginning 
on the fourth business day of any non-compliance, cease opening new 
portfolio margin accounts until compliance is achieved.
    (b) If, at any time, a member organization's gross customer 
portfolio margin requirements exceed 1,000 percent of its net capital, 
the member organization shall immediately transmit telegraphic or 
facsimile notice of such deficiency to the Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC, 20549; to the 
district or regional office of the Securities and Exchange Commission 
for the district or region in which the member organization maintains 
its principal place of business; and to its Designated Examining 
Authority.
* * * * *

Chapter XV Records, Reports and Audits

Risk Analysis of Portfolio Margin Accounts

    Rule 15.8A. (a) Each member organization that maintains any 
portfolio margin accounts for customers shall establish and maintain 
written procedures for assessing and monitoring the potential risk to 
the member organization's capital over a specified range of possible 
market movements of positions maintained in such accounts. Current 
procedures shall be filed and maintained with the Department of 
Financial and Sales Practice Compliance. The procedures shall specify 
the computations to be made, the frequency of computations, the records 
to be reviewed and maintained, and the position(s) within the 
organization responsible for the risk function.
    (b) Upon direction by the Department of Financial and Sales 
Practice Compliance, each affected member organization shall provide to 
the Department such information as the Department may reasonably 
require with respect to the member organization's risk analysis for any 
or all of the portfolio margin accounts it maintains for customers.

[[Page 77278]]

    (c) In conducting the risk analysis of portfolio margin accounts 
required by this Rule 15.8A, each affected member organization is 
required to follow the Interpretations and Policies set forth under 
Rule 15.8--Risk Analysis of Market-Maker Accounts. In addition, each 
affected member organization shall include in written procedures 
required pursuant to paragraph (a) above the following:
    (1) Procedures and guidelines for the determination, review and 
approval of credit limits to each customer, and across all customers, 
utilizing a portfolio margin account.
    (2) Procedures and guidelines for monitoring credit risk exposure 
to the member organization, including intra-day credit risk, related to 
portfolio margin accounts.
    (3) Procedures and guidelines for the use of stress testing of 
portfolio margin accounts in order to monitor market risk exposure from 
individual accounts and in the aggregate.
    (4) Procedures providing for the regular review and testing of 
these risk analysis procedures by an independent unit such as internal 
audit or other comparable group.
* * * * *

Chapter 9 Doing Business With the Public

Delivery of Current Options Disclosure Documents and Prospectus
    Rule 9.15. (a) no change
    (b) no change
    (c) no change
    (d) The special written disclosure statement describing the nature 
and risks of portfolio margining and cross-margining, and 
acknowledgement for customer signature, required by Rule 12.4(c)(2) 
shall be in a format prescribed by the Exchange or in a format 
developed by the member organization, provided it contains 
substantially similar information as the prescribed Exchange format and 
has received prior written approval of the Exchange.

Sample Risk Description for Use by Firms to Satisfy Requirements of 
Exchange Rule 9.15(d)

Portfolio Margining and Cross-Margining Disclosure Statement and 
Acknowledgement

    For a Description of the Special Risks Applicable to a Portfolio 
Margin Account and its Cross-Margining Features, See the Material Under 
Those Headings Below.

Overview of Portfolio Margining

    1. Portfolio margining is a margin methodology that sets margin 
requirements for an account based on the greatest projected net loss of 
all positions in a ``product class'' or ``product group'' as determined 
by an options pricing model using multiple pricing scenarios. These 
pricing scenarios are designed to measure the theoretical loss of the 
positions given changes in both the underlying price and implied 
volatility inputs to the model. Portfolio margining is currently 
limited to product classes and groups of index products relating to 
broad-based market indexes.
    2. The goal of portfolio margining is to set levels of margin that 
more precisely reflect actual net risk. The customer benefits from 
portfolio margining in that margin requirements calculated on net risk 
are generally lower than alternative ``position'' or ``strategy'' based 
methodologies for determining margin requirements. Lower margin 
requirements allow the customer more leverage in an account.

Customers Eligible for Portfolio Margining

    3. To be eligible for portfolio margining, customers (other than 
broker-dealers and certain non-broker-dealer affiliates of the carrying 
broker-dealer) must meet the basic standards for having an options 
account that is approved for uncovered writing and must have and 
maintain at all times account net equity of not less than $5 million, 
aggregated across all accounts under identical ownership at the 
clearing broker. The identical ownership requirement excludes accounts 
held by the same customer in different capacities (e.g., as a trustee 
and as an individual) and accounts where ownership is overlapping but 
not identical (e.g., individual accounts and joint accounts).

Positions Eligible for a Portfolio Margin Account

    4. All positions in broad-based U.S. market index options and index 
warrants listed on a national securities exchange, and exchange traded 
funds and other fund products registered under the Investment Company 
Act of 1940 that are managed to track the same index that underlies 
permitted index options, are eligible for a portfolio margin account.

Special Rules for Portfolio Margin Accounts

    5. A portfolio margin account may be either a separate account or a 
subaccount of a customer's regular margin account. In the case of a 
subaccount, equity in the regular account will be available to satisfy 
any margin requirement in the portfolio margin subaccount without 
transfer to the subaccount.
    6. A portfolio margin account or subaccount will be subject to a 
minimum margin requirement of $.375 multiplied by the index multiplier 
for every options contract or index warrant carried long or short in 
the account. No minimum margin is required in the case of eligible 
exchange traded funds or other eligible fund products.
    7. Margin calls in the portfolio margin account or subaccount, 
regardless of whether due to new commitments or the effect of adverse 
market moves on existing positions, must be met within one business 
day. Any shortfall in aggregate net equity across accounts must be met 
within three business days. Failure to meet a margin call when due will 
result in immediate liquidation of positions to the extent necessary to 
reduce the margin requirement. Failure to meet an equity call prior to 
the end of the third business day will result in a prohibition on 
entering any opening orders, with the exception of opening orders that 
hedge existing positions, beginning on the fourth business day and 
continuing until such time as the minimum equity requirement is 
satisfied.
    8. A position in an exchange traded index fund or other eligible 
fund product may not be established in a portfolio margin account 
unless there exists, or there is established on the same day, an 
offsetting position in securities options or other eligible securities. 
Exchange traded index funds and/or other eligible funds will be 
transferred out of the portfolio margin account and into a regular 
securities account subject to strategy based margin if, for more than 
10 business days and for any reason, the offsetting securities options 
or other eligible securities no longer remain in the account.
    9. When a broker-dealer carries a regular cash account or margin 
account for a customer, the broker-dealer is limited by rules of the 
Securities and Exchange Commission and of The Options Clearing 
Corporation (``OCC'') in the extent to which the broker-dealer may 
permit OCC to have a lien against long option positions in those 
accounts. In contrast, OCC will have a lien against all long option 
positions that are carried by a broker-dealer in a portfolio margin 
account, and this could, under certain circumstances, result in greater 
losses to a customer having long option positions in such an account in 
the event of the insolvency of the customer's broker. Accordingly, to 
the extent that a customer does not borrow against long option 
positions in a portfolio margin

[[Page 77279]]

account or have margin requirements in the account against which the 
long option can be credited, there is no advantage to carrying the long 
options in a portfolio margin account and the customer should consider 
carrying them in an account other than a portfolio margin account.

Special Risks of Portfolio Margin Accounts

    10. Portfolio margining generally permits greater leverage in an 
account, and greater leverage creates greater losses in the event of 
adverse market movements.
    11. Because the time limit for meeting margin calls is shorter than 
in a regular margin account, there is increased risk that a customer's 
portfolio margin account will be liquidated involuntarily, possibly 
causing losses to the customer.
    12. Because portfolio margin requirements are determined using 
sophisticated mathematical calculations and theoretical values that 
must be calculated from market data, it may be more difficult for 
customers to predict the size of future margin calls in a portfolio 
margin account. This is particularly true in the case of customers who 
do not have access to specialized software necessary to make such 
calculations or who do not receive theoretical values calculated and 
distributed periodically by The OCC.
    13. For the reasons noted above, a customer that carries long 
options positions in a portfolio margin account could, under certain 
circumstances, be less likely to recover the full value of those 
positions in the event of the insolvency of the carrying broker.
    14. Trading of securities index products in a portfolio margin 
account is generally subject to all the risks of trading those same 
products in a regular securities margin account. Customers should be 
thoroughly familiar with the risk disclosure materials applicable to 
those products, including the booklet entitled Characteristics and 
Risks of Standardized Options.
    15. Customers should consult with their tax advisers to be certain 
that they are familiar with the tax treatment of transactions in 
securities index products.
    16. The descriptions in this disclosure statement relating to 
eligibility requirements for portfolio margin accounts, and minimum 
equity and margin requirements for those accounts, are minimums imposed 
under exchange rules. Time frames within which margin and equity calls 
must be met are maximums imposed under exchange rules. Broker-dealers 
may impose their own more stringent requirements.

Overview of Cross-Margining

    17. With cross-margining, index futures and options on index 
futures are combined with offsetting positions in securities index 
options and underlying instruments, for the purpose of computing a 
margin requirement based on the net risk. This generally produces lower 
margin requirements than if the futures products and securities 
products are viewed separately, thus providing more leverage in the 
account.
    18. Cross-margining must be done in a portfolio margin account 
type. A separate portfolio margin account must be established 
exclusively for cross-margining.
    19. When index futures and options on futures are combined with 
offsetting positions in index options and underlying instruments in a 
dedicated account, and a portfolio margining methodology is applied to 
them, cross-margining is achieved.

Customers Eligible for Cross-Margining

    20. The eligibility requirements for cross-margining are generally 
the same as for portfolio margining, and any customer eligible for 
portfolio margining is eligible for cross-margining.
    21. Members of futures exchanges on which cross-margining eligible 
index contracts are traded are also permitted to carry positions in 
cross-margin accounts without regard to the minimum aggregate account 
equity.

Positions Eligible for Cross-Margining

    22. All securities products eligible for portfolio margining are 
also eligible for cross-margining.
    23. All broad-based U.S. market index futures and options on index 
futures traded on a designated contract market subject to the 
jurisdiction of the Commodity Futures Trading Commission are eligible 
for cross-margining.

Special Rules for Cross-Margining

    24. Cross-margining must be conducted in a portfolio margin account 
type. A separate portfolio margin account must be established 
exclusively for cross-margining. A cross-margin account is a securities 
account, and must be maintained separate from all other securities 
accounts.
    25. Cross-margining is automatically accomplished with the 
portfolio margining methodology. Cross-margin positions are subject to 
the same minimum margin requirement for every contract, including 
futures contracts.
    26. Margin calls arising in the cross-margin account, and any 
shortfall in aggregate net equity across accounts, must be satisfied 
within the same time frames, and subject to the same consequences, as 
in a portfolio margin account.
    27. A position in a futures product may not be established in a 
cross-margin account unless there exists, or there is established on 
the same day, an offsetting position in securities options and/or other 
eligible securities. Futures products will be transferred out of the 
cross-margin account and into a futures account if, for more than 10 
business days and for any reason, the offsetting securities options 
and/or other eligible securities no longer remain in the account. If 
the transfer of futures products to a futures account causes the 
futures account to be undermargined, a margin call will be issued or 
positions will be liquidated to the extent necessary to eliminate the 
deficit.
    28. According to the rules of the exchanges, a broker-dealer is 
required to immediately liquidate, or, if feasible, transfer to another 
broker-dealer eligible to carry cross-margin accounts, all customer 
cross-margin accounts that contain positions in futures and/or options 
on futures in the event that the carrying broker-dealer becomes 
insolvent.
    29. Customers participating in cross-margining will be required to 
sign an agreement acknowledging that their positions and property in 
the cross-margin account will be subject to the customer protection 
provisions of Rule 15c3-3 under the Securities Exchange Act of 1934 and 
the Securities Investor Protection Act, and will not be subject to the 
provisions of the Commodity Exchange Act, including segregation of 
funds.
    30. In signing the agreement referred to in paragraph 29 above, a 
customer also acknowledges that a cross-margin account that contains 
positions in futures and/or options on futures will be immediately 
liquidated, or, if feasible, transferred to another broker-dealer 
eligible to carry cross-margin accounts, in the event that the carrying 
broker-dealer becomes insolvent.

Special Risks of Cross-Margining

    31. Cross-margining must be conducted in a portfolio margin account 
type. Generally, cross-margining and the portfolio margining 
methodology both contribute to provide greater leverage than a regular 
margin account, and greater leverage creates greater losses in the 
event of adverse market movements.
    32. As cross-margining must be conducted in a portfolio margin 
account type, the time required for meeting margin calls is shorter 
than in a regular securities margin account and may be shorter than the 
time ordinarily required

[[Page 77280]]

by a futures commission merchant for meeting margin calls in a futures 
account. As a result, there is increased risk that a customer's cross-
margin positions will be liquidated involuntarily, causing possible 
loss to the customer.
    33. As noted above, cross-margin accounts are securities accounts 
and are subject to the customer protections set-forth in Rule 15c3-3 
under the Securities Exchange Act of 1934 and the Securities Investor 
Protection Act. Cross-margin positions are not subject to the customer 
protection rules under the segregation provisions of the Commodity 
Exchange Act and the rules of the Commodity Futures Trading Commission 
(``CFTC'') adopted pursuant to the Commodity Exchange Act.
    34. Trading of index options and futures contracts in a cross-
margin account is generally subject to all the risks of trading those 
same products in a futures account or a regular securities margin 
account, as the case may be. Customers should be thoroughly familiar 
with the risk disclosure materials applicable to those products, 
including the booklet entitled Characteristics and Risks of 
Standardized Options and the risk disclosure document required by the 
CFTC to be delivered to futures customers. Because this disclosure 
statement does not disclose the risks and other significant aspects of 
trading in futures and options, customers should review those materials 
carefully before trading in a cross-margin account.
    35. Customers should bear in mind that the discrepancies in the 
cash flow characteristics of futures and certain options are still 
present even when those products are carried together in a cross-margin 
account. Both futures and options contracts are generally marked to the 
market at least once each business day, but the marks may take place 
with different frequency and at different times within the day. When a 
futures contract is marked to the market, the gain or loss is 
immediately credited to or debited from, respectively, the customer's 
account in cash. While an increase in value of a long option contract 
may increase the equity in the account, the gain is not realized until 
the option is sold or exercised. Accordingly, a customer may be 
required to deposit cash in the account in order to meet a variation 
payment on a futures contract even though the customer is in a hedged 
position and has experienced a corresponding (but as yet unrealized) 
gain on a long option. On the other hand, a customer who is in a hedged 
position and would otherwise be entitled to receive a variation payment 
on a futures contract may find that the cash is required to be held in 
the account as margin collateral on an offsetting option position.
    36. Customers should consult with their tax advisers to be certain 
that they are familiar with the tax treatment of transactions in index 
products, including tax consequences of trading strategies involving 
both futures and option contracts.
    37. The descriptions in this disclosure statement relating to 
eligibility requirements for cross-margining, and minimum equity and 
margin requirements for cross-margin accounts, are minimums imposed 
under exchange rules. Time frames within which margin and equity calls 
must be met are maximums imposed under exchange rules. The broker-
dealer carrying a customer's portfolio margin account, including any 
cross-margin account, may impose its own more stringent requirements.
* * * * *

Acknowledgement for Customers Utilizing a Portfolio Margin Account --
Cross-Margining and Non Cross-Margining--

    Rule 15c3-3 under the Securities Exchange Act of 1934 requires that 
a broker or dealer promptly obtain and maintain physical possession or 
control of all fully-paid securities and excess margin securities of a 
customer. Fully-paid securities are securities carried in a cash 
account and margin equity securities carried in a margin or special 
account (other than a cash account) that have been fully paid for. 
Excess margin securities are a customer's margin securities having a 
market value in excess of 140% of the total of the debit balances in 
the customer's non-cash accounts. For the purposes of Rule 15c3-3, 
securities held subject to a lien to secure obligations of the broker-
dealer are not within the broker-dealer's physical possession or 
control. The Commission staff has taken the position that all long 
option positions in a customer's portfolio-margining account (including 
any cross-margining account) may be subject to such a lien by OCC and 
will not be deemed fully-paid or excess margin securities under Rule 
15c3-3.
    The hypothecation rules under the Securities Exchange Act of 1934 
(Rules 8c-1 and 15c2-1), prohibit broker-dealers from permitting the 
hypothecation of customer securities in a manner that allows those 
securities to be subject to any lien or liens in an amount that exceeds 
the customer's aggregate indebtedness. However, all long option 
positions in a portfolio-margining account (including any cross-
margining account) will be subject to OCC's lien, including any 
positions that exceed the customer's aggregate indebtedness. The 
Commission staff has taken a position that would allow customers to 
carry positions in portfolio-margining accounts (including any cross-
margining account), even when those positions exceed the customer's 
aggregate indebtedness. Accordingly, within a portfolio margin account 
or cross-margin account, to the extent that you have long option 
positions that do not operate to offset your aggregate indebtedness and 
thereby reduce your margin requirement, you receive no benefit from 
carrying those positions in your portfolio margin account or cross-
margin account and incur the additional risk of OCC's lien on your long 
option position(s).
    BY SIGNING BELOW, THE CUSTOMER AFFIRMS THAT THE CUSTOMER HAS READ 
AND UNDERSTOOD THE FOREGOING DISCLOSURE STATEMENT AND ACKNOWLEDGES AND 
AGREES THAT LONG OPTION POSITIONS IN PORTFOLIO-MARGINING ACCOUNTS AND 
CROSS-MARGINING ACCOUNTS WILL BE EXEMPTED FROM CERTAIN CUSTOMER 
PROTECTION RULES OF THE SECURITIES AND EXCHANGE COMMISSION AS DESCRIBED 
ABOVE AND WILL BE SUBJECT TO A LIEN BY THE OPTIONS CLEARING CORPORATION 
WITHOUT REGARD TO SUCH RULES.
CUSTOMER NAME:---------------------------------------------------------
BY:--------------------------------------------------------------------
    (signature/title)
DATE:------------------------------------------------------------------
* * * * *

Acknowledgement for Customers Engaged in Cross-Margining

    As disclosed above, futures contracts and other property carried in 
customer accounts with Futures Commission Merchants (``FCM'') are 
normally subject to special protection afforded under the customer 
segregation provisions of the Commodity Exchange Act (``CEA'') and the 
rules of the CFTC adopted pursuant to the CEA. These rules require that 
customer funds be segregated from the accounts of financial 
intermediaries and be separately accounted for, however, they do not 
provide for, and regular futures accounts do not enjoy the benefit of, 
insurance protecting customer accounts against loss in the event of the 
insolvency of the intermediary carrying the accounts.

[[Page 77281]]

    As also has been discussed above, cross-margining must be conducted 
in a portfolio margin account dedicated exclusively to cross-margining, 
and cross-margin accounts are not treated as a futures account with an 
FCM. Instead, cross-margin accounts are treated as securities accounts 
carried with broker-dealers. As such, cross-margin accounts are covered 
by Rule 15c3-3 under the Securities Exchange Act of 1934, which 
protects customer accounts. Rule 15c3-3, among other things, requires a 
broker-dealer to maintain physical possession or control of all fully-
paid and excess margin securities and maintain a special reserve 
account for the benefit of their customers. However, in respect of 
cross-margin accounts, there is an exception to the possession or 
control requirement of Rule 15c3-3 that permits The Options Clearing 
Corporation to have a lien on long positions. This aspect is outlined 
in a separate acknowledgement form that must be signed prior to or 
concurrent with this form. Additionally, the Securities Investor 
Protection Corporation (``SIPC'') insures customer accounts against the 
financial insolvency of a broker-dealer in the amount of up to $500,000 
to protect against the loss of registered securities and cash 
maintained in the account for purchasing securities or as proceeds from 
selling securities (although the limit on cash claims is $100,000). 
According to the rules of the exchanges, a broker-dealer is required to 
immediately liquidate, or, if feasible, transfer to another broker-
dealer eligible to carry cross-margin accounts, all customer cross-
margin accounts that contain positions in futures and/or options on 
futures in the event that the carrying broker-dealer becomes insolvent.
    BY SIGNING BELOW, THE CUSTOMER AFFIRMS THAT THE CUSTOMER HAS READ 
AND UNDERSTOOD THE FOREGOING DISCLOSURE STATEMENT AND ACKNOWLEDGES AND 
AGREES THAT: 1) POSITIONS AND PROPERTY IN CROSS-MARGINING ACCOUNTS, 
WILL NOT BE SUBJECT TO THE CUSTOMER PROTECTION RULES UNDER THE CUSTOMER 
SEGREGATION PROVISIONS OF THE COMMODITY EXCHANGE ACT (``CEA'') AND THE 
RULES OF THE COMMODITY FUTURES TRADING COMMISSION ADOPTED PURSUANT TO 
THE CEA, AND 2) CROSS-MARGINING ACCOUNTS THAT CONTAIN POSITIONS IN 
FUTURES AND/OR OPTIONS ON FUTURES WILL BE IMMEDIATELY LIQUIDATED, OR, 
IF FEASIBLE, TRANSFERED TO ANOTHER BROKER-DEALER ELIGIBLE TO CARRY 
CROSS-MARGIN ACCOUNTS, IN THE EVENT THAT THE CARRYING BROKER-DEALER 
BECOMES INSOLVENT.
CUSTOMER NAME:---------------------------------------------------------
BY:--------------------------------------------------------------------
    (signature/title)
DATE:------------------------------------------------------------------
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the CBOE 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. The CBOE has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
a. Introduction
    The CBOE proposes to expand its margin rules by providing a 
portfolio margin methodology for listed, broad-based market index 
options, index warrants and related exchange-traded funds that clearing 
member organizations may extend to eligible customers as an alternative 
to the current strategy-based option margin requirements. The proposed 
rule change would also allow broad-based index futures and options on 
such futures to be included in a separate portfolio margin account, 
thus providing a cross-margin capability. The CBOE seeks to introduce 
the proposed new rule as a two-year pilot program that would be made 
available to member organizations on a voluntary basis.
    The proposed rule change would permit self-clearing member 
organizations to apply a prescribed portfolio margin methodology to an 
account \7\ of an affiliate, another broker-dealer, and an account of a 
member of a national futures exchange who is a futures floor trader. 
Any other customers of the clearing member would be required to have 
account equity of at least $5 million to be eligible for portfolio 
margin treatment. This 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. Further, 
portfolio margining is most effective when applied to larger accounts 
with diverse option positions and related securities, and any related 
futures contracts. It is expected that institutional customers will be 
the primary participants. Whether the account equity requirement should 
be lowered to allow participation of more customers will be assessed at 
the end of the pilot program period. Application of portfolio margin, 
including cross-margin, to an IRA account would be prohibited under the 
proposed rule change.
---------------------------------------------------------------------------

    \7\ An account dedicated to portfolio margining.
---------------------------------------------------------------------------

    A number of revisions contained in Amendment No. 1 were deemed 
warranted, or requested or recommended by staff of the Commission. In 
either case, the reason for these revisions is to make corrections or 
clarifications to the proposed rule, or to reconcile differences 
between the proposed rule and a parallel filing by the NYSE.\8\
---------------------------------------------------------------------------

    \8\ See NYSE Proposal, supra note 6.
---------------------------------------------------------------------------

    The proposed portfolio margin and cross-margin rules have been 
developed by the CBOE in cooperation with The Options Clearing 
Corporation (``The OCC''), the New York Stock Exchange, Inc. 
(``NYSE''), the American Stock Exchange LLC (``AMEX''), the Board of 
Trade of the City of Chicago, Inc. (``CBOT''), and the Chicago 
Mercantile Exchange Inc. (``CME''). The CBOE intends to provide a 
written overview describing the operational details of the portfolio 
margin and cross-margin pilot program to potential member organization 
participants to introduce and explain the pilot program.
    A committee of representatives from the member organizations 
identified as potential participants, and staff of the sponsoring 
exchanges and The OCC (the ``Portfolio Margin Committee'') was formed 
and met several times in 1999 and 2000 to refine the portfolio margin 
and cross-margin pilot program. This group has recommended adoption of 
the portfolio margin and cross-margin pilot program, as finalized by 
the group, and the related rule proposals. In addition, the portfolio 
margin and cross-margin pilot program has been presented to the NYSE's 
Rule 431 Committee \9\ on two

[[Page 77282]]

occasions, with draft rules included on the second occasion, and has 
received the NYSE's Rule 431 Committee's support.
---------------------------------------------------------------------------

    \9\ The NYSE Rule 431 Committee is comprised of securities 
industry representatives, primarily representatives of NYSE member 
organizations. NYSE Rule 431 contains the NYSE's margin rules. the 
function of the NYSE Rule 431 Committee is to assess the adequacy of 
NYSE Rule 431 on an ongoing basis, review proposals for changes to 
NYSE Rule 431, and recommend changes that are deemed appropriate.
---------------------------------------------------------------------------

b. Overview--Portfolio Margin Computation
(1) Portfolio Margin
    Under a portfolio margin system, margin is required based on the 
greatest loss that would be incurred in a portfolio if the value of 
components (underlying instruments in the case of options) move up or 
down by a predetermined amount (e.g., <plus-minus>5%). Under the 
Exchange's proposed portfolio margin rule, listed index options and 
underlying instruments (also related instruments \10\ in the case of a 
cross-margin account) would be grouped by class \11\ (e.g., S&P 500, 
S&P 100, etc.), each class group being a portfolio.\12\ The gain or 
loss on each position in a portfolio would be calculated at each of 10 
equidistant points (``valuation points'') set at and between the upper 
and lower market range points. A theoretical options pricing model 
would be used to derive position values \13\ at each valuation point 
for the purpose of determining the gain or loss. Gains and losses would 
then be netted for positions within the class or portfolio at each 
valuation point. The greatest net loss among the 10 valuation points 
would be the margin required on the portfolio or class. The margin for 
all other portfolios within an account would be calculated in a similar 
manner. Broad-based index classes (portfolios) that are highly 
correlated would be allowed offsets such that, at the same valuation 
point, for example, 90% of a gain in one class may reduce or offset a 
loss in another class. The amount of offset allowed between portfolios 
would be the same amount that is permitted under the risk-based haircut 
methodology set forth in Appendix A of the Commission's net capital 
rule.\14\ A per contract minimum would be established and would 
override if a lesser requirement is rendered by the portfolio margin 
computation.\15\ Member organizations would not be permitted to use any 
theoretical pricing model to generate the prices used to calculate 
theoretical profits and losses. Under the proposed rule change, the 
theoretical prices used for computing profits and losses must come from 
a theoretical pricing model that, pursuant to the Commission's net 
capital rule,\16\ qualifies for purposes of determining the amount to 
be deducted in computing net capital under a portfolio-based 
methodology. CBOE believes that delineating acceptable theoretical 
pricing models is best achieved by applying the Commission's net 
capital rule by reference. In this way, consistency with the 
Commission's net capital rule is maintained. In addition, since 
theoretical pricing models must be approved by a Designated Examining 
Authority (``DEA'') and reviewed by the Commission to qualify, 
uniformity across models can be assured. As a result, portfolio margin 
and cross-margin requirements will not vary materially from firm to 
firm. Currently, the theoretical model used by The OCC is the only 
model qualified pursuant to the Commission's net capital rule. 
Consequently, all member organizations participating in the pilot 
program would, at least for the foreseeable future, obtain their 
theoretical values from The OCC.
---------------------------------------------------------------------------

    \10\ Under the proposed rule change, the term ``related 
instrument'' would mean, with respect to an options class or product 
group, futures contracts and options on futures contracts covering 
the same underlying instrument.
    \11\ Under the proposed rule change, the term ``options class'' 
would refer to all options contracts covering the same underlying 
instrument.
    \12\ CBOE's pilot program would permit an exchange-traded fund 
structured to replicate the composition of the index to be included; 
however, stock baskets would not be permitted at this time.
    \13\ Position values would represent the difference between the 
position closing price and the theoretical value at each valuation 
point.
    \14\ Rule 15c3-1a under the Act, 17 CFR 240.15c3-1a.
    \15\ The proposed rules set a per contract minimum of $37.50.
    \16\ See Rule 15c3-1a(b)(1)(i)(B) under the Act, 17 CFR 
240.15c3-1a(b)(1)(i)(B).
---------------------------------------------------------------------------

    The Exchange's proposed rule would propose a market range of <plus-
minus>10% for computing theoretical gains and losses in broad-based, 
non-high capitalization index portfolios. A market range of +6%/-8% is 
proposed for broad-based, high capitalization index portfolios.\17\ 
These are the same ranges currently applied to options market makers 
for the purpose of computing portfolio or risk-based haircuts. On a 
historical basis, these ranges cover one day moves at a very high level 
of confidence, and would be competitive with the market range coverage 
applied for performance bond (margin) purposes in the futures industry 
on comparable index futures. The proposed rule change requires that a 
separate securities margin account (or subaccount of a securities 
margin account) be used for portfolio margining.
---------------------------------------------------------------------------

    \17\ CBOE believes that it is imperative that these market move 
ranges be competitive with the range used in the futures industry 
for computing margin (performance bond) on broad-based index 
futures. The proposed ranges accomplish this goal. Customer 
performance bond in the futures industry is computed using a 
portfolio margining system known as the Standard Portfolio Analysis 
of Risk (``SPAN''). The terms ``high capitalization'' and ``non-high 
capitalization'' have the same meaning as they do for the purposes 
of risk-based haircuts (Rule 15c3-1 under the Act, 17 CFR 240.15c3-
1).
---------------------------------------------------------------------------

    Amendment No. 1 to the proposed rule change also adds rule language 
that requires fully paid for long options (and/or index warrants) to be 
transferred out of the portfolio margin account and/or cross-margin 
account and into a securities account that is not a portfolio margin 
account, in the event that such long positions are the only components.
(2) Cross-Margining
    The proposed rule permits related index futures and options on such 
futures to be carried in a separate portfolio margin account, thus 
affording a cross-margin capability. Amendment No. 1 contains changes 
that primarily relate to the addition of rule language (i.e., Rule 
12.4(j)) that, pursuant to agreement between Commission staff, the 
Exchange and The Options Clearing Corporation, requires cross-margin 
positions to be liquidated or transferred in the event the carrying 
broker-dealer becomes insolvent. The Original Proposal allowed cross-
margining to be commingled with other, non-cross margin portfolio 
margin positions in the same account. However, the proposal of 
Amendment No. 1 to require liquidation or transfer of the cross-margin 
account necessitates that cross-margining be conducted in an account 
separate from non-cross-margining activity. Therefore, Amendment No. 1 
contains a number of proposed revisions that relate to isolation of 
cross-margin positions in a separate account.
    In a portfolio margin account, including one that is used 
exclusively for cross-margining, constituent portfolios may be formed 
containing index options, index warrants and exchange-traded funds 
structured to replicate the composition of the index underlying a 
particular portfolio, as well as related index futures and options on 
such futures. Cross-margining would operate similar to the cross-margin 
program that was approved by the Commission and the Commodity Futures 
Trading Commission (``CFTC'') for listed options market-makers and 
proprietary accounts of clearing member organizations. For determining 
theoretical gains and losses, and resultant margin requirements, the 
same portfolio margin computation program will be applied to portfolio 
margin accounts, as well as cross-margin accounts.

[[Page 77283]]

c. Margin or Minimum Equity Deficiency
    Under proposed CBOE Rule 12.4(h), positions in a portfolio margin 
account would be valued at current market prices, as currently defined 
in the Exchange's margin rules. Under the proposed rule change, account 
equity would be calculated and maintained separately for each portfolio 
margin account. For purposes of the $5 million minimum account equity 
requirement, all accounts owned by an individual or entity may be 
combined. Proposed CBOE Rule 12.4(i) requires that additional margin 
must be obtained within one business day (T+1) whenever equity is below 
the margin required, regardless of whether the deficiency is caused by 
the addition of new positions, the effect of unfavorable market 
movement on existing positions, or a combination of both. The portfolio 
margin requirement, therefore, would be both the initial and 
maintenance margin requirement, and no differentiation would be 
necessary. In addition, proposed CBOE Rule 12.4(g) would require that, 
in the event account equity falls below the $5 million minimum, 
additional equity must be deposited within 3 business days (T+3). If 
the deficiency were not resolved within 3 business days, the carrying 
member organization would be prohibited under the proposed rule change 
from accepting any new opening orders beginning on T+4, with the 
exception of opening orders that hedge existing positions. This 
prohibition would remain in effect until a $5 million equity was 
established.
d. Risk Disclosure Statement and Acknowledgement
    In addition, the Exchange proposes that member organizations 
provide every portfolio margin customer with a written risk disclosure 
statement at or prior to the initial opening of a portfolio margin 
account.\18\ This disclosure statement highlights the risks and 
operation of portfolio margin accounts, including cross-margining, and 
the differences between portfolio margin and strategy-based margin 
requirements. The disclosure statement is divided into two sections, 
one dealing with portfolio margining and the other with cross-
margining. The disclosure statement clearly notes that additional 
leverage is possible in an account margined on a portfolio basis in 
relation to strategy-based margin. Among other things, the disclosure 
statement covers who is eligible to open a portfolio margin account, 
the instruments that are allowed, and when deposits to meet margin and 
minimum equity are due. The fact that long option positions held in a 
portfolio margin account are not segregated, as they generally would be 
in the case of a regular margin account under the Commission's customer 
protection rules, is explained. Also included within the portfolio 
margin section is a summary list of the special risks of portfolio 
margin accounts, such as: increased leverage; shorter time for meeting 
margin; involuntary liquidation if margin not received; inability to 
calculate future margin requirements because of the data and 
calculations required; and that long positions are subject to a lien. 
The risks and operation of a cross-margin feature are outlined in the 
cross-margin section of the disclosure statement, and a summary list of 
the special risks associated with cross-margining is included.
---------------------------------------------------------------------------

    \18\ Even a customer that engages exclusively in cross-margining 
is a portfolio margin customer, as the proposed rule change permits 
cross-margining to be conducted only by applying the portfolio 
margin methodology.
---------------------------------------------------------------------------

    Further, at or prior to the time a portfolio margin account is 
initially opened, member organizations would be required to obtain a 
signed acknowledgement concerning portfolio margining in general from 
the customer. In addition, prior to accommodating cross-margining, 
member organizations would be required to obtain a second signed 
acknowledgement within the same time frame that pertains to cross-
margin.
    By signing the general acknowledgement required of all customers, 
the customer would attest to having read the disclosure statement and 
being aware of the fact that long option positions in a portfolio 
margin account (which includes cross-margin accounts) are not subject 
to the segregation requirements under the customer protection rules of 
the Commission, and would be subject to a lien by the OCC. In signing 
the additional acknowledgement applicable to cross-margining, the 
customer would attest to having read the disclosure statement and being 
aware of the fact that futures positions are being carried in a 
securities account, are subject to the Commission's customer protection 
rules,\19\ and fall under the authority of the SIPC in the event the 
carrying broker-dealer becomes financially insolvent. Within Chapter 9 
of the Exchange's rules (``Doing Business with the Public''), the 
Exchange would prescribe the format of the written disclosure statement 
and acknowledgements in proposed Exchange Rule 9.15(d)--Delivery of 
Current Options Disclosure Documents and Prospectus. Like a current 
Exchange rule that prescribes the format for a Special Statement for 
Uncovered Options Writers (CBOE Rule 9.15(c)), proposed Exchange Rule 
9.15(d) would allow member organizations to develop their own format, 
provided it contains substantially similar information and it is 
approved in advance by the Exchange.
---------------------------------------------------------------------------

    \19\ As disclosed in the general acknowledgement form (required 
of any portfolio or cross-margin customer), portfolio margin and 
cross-margin accounts operate pursuant to an exception to the 
customer protection rules in that fully paid long positions will not 
be segregated.
---------------------------------------------------------------------------

e. Net Capital
    The Exchange also proposes to add a new requirement in CBOE Rule 
13.5 to mandate that the gross customer portfolio margin requirements 
of a broker-dealer may at no time exceed 1,000 percent of a carrying 
broker-dealer's net capital (a 10:1 ratio). This requirement is 
intended to place a ceiling on the amount of margin a broker-dealer can 
extend to its customers in relation to its net capital.
f. Internal Risk Monitoring Procedures
    The Exchange further proposes a separate, related rule that would 
require member organizations that carry portfolio margin or cross-
margin accounts to establish and maintain written procedures for 
assessing and monitoring the potential risks to their capital. 
Specifically, proposed CBOE Rule 15.8A (Risk Analysis of Portfolio 
Margin and Cross-Margin Accounts) would require that the member 
organization file and maintain its current procedures with its DEA, and 
provide the DEA with such information as the DEA may reasonably require 
regarding the member organization's risk analysis of any and all 
portfolio margin and cross-margin accounts carried for customers. 
Proposed CBOE Rule 15.8A would incorporate current Exchange Rule 15.8--
Risk Analysis of Market-Maker Accounts--by reference to require that 
the risk analysis be conducted in the same manner as prescribed in 
Exchange Rule 15.8. Additionally, proposed CBOE Rule 15.8A would set 
forth certain undertakings that must be included in the written 
procedures (e.g., review and approval of credit limits for each 
customer and across all accounts).
    Because member organizations would be required under the proposed 
rule change to have risk monitoring procedures, proposed CBOE Rule 
12.4(i) states that the current CBOE Rule 12.9--Meeting Margin Calls by 
Liquidation Prohibited--prohibiting excessive

[[Page 77284]]

liquidations to meet margin requirements will not apply to portfolio 
margin and cross-margin accounts. Furthermore, given the proposed risk 
monitoring procedures, CBOE proposes that day trading margin 
requirements would not apply to portfolio margin and cross-margin 
accounts. Through these risk-monitoring procedures, member 
organizations will be expected to oversee portfolio margin and cross-
margin accounts for excessive liquidations and day trading and take 
appropriate action according to their procedures.
    It should be noted that the disclosure statement delivery 
requirement, the $5 million minimum equity requirement, and the next 
day deposit condition for additionally required margin were all added 
by the Portfolio Margin Committee. The Portfolio Margin Committee 
deemed these requirements prudent given that less margin is generally 
required under a portfolio margining approach than under the current 
strategy-based methodology, and these measures made the plan entirely 
acceptable to the member firm representatives.
g. Margin at the Clearing House Level \20\
---------------------------------------------------------------------------

    \20\ The Commission anticipates that the clearing arrangements 
described in this section will be the subject of a separate proposed 
rule change filed by the OCC.
---------------------------------------------------------------------------

    The Exchange proposes that all customer portfolio margin account 
transactions not involving a futures transaction (e.g., cross-margin) 
be cleared in one special omnibus account for the clearing firm at The 
OCC. In addition, the Exchange proposes that all transactions involving 
cross-margining, both the security and futures products, be cleared in 
one of two additional special omnibus accounts for cross-margining, 
depending on the entity that clears the futures product being cross-
margined. One cross-margin omnibus account corresponds to a cross-
margining agreement between The OCC, the CME and the New York Clearing 
Corporation. The other omnibus account corresponds to a cross-margining 
agreement between The OCC and the Board of Trade Clearing Corporation. 
The OCC will compute margin for the special omnibus accounts using the 
same portfolio margin methodology applied at the customer level. The 
OCC will continue to require full payment from the clearing firm for 
all long option positions. However, as previously noted, long positions 
will not be segregated like they are in the firm's regular customer 
range account at The OCC. This is necessary and preferred with a 
portfolio margining methodology because all long positions must be 
available for margin offset. Margin relief is based on a dollar offset 
basis as opposed to identifying specific contract to contract offsets 
under a strategy-based methodology. This may result in situations where 
the long positions of a given customer could serve to offset the risk 
in another customer's short position. Long positions would, therefore, 
be subject to The OCC lien. An OCC clearing member currently has the 
ability to unsegregate a long position in order to pair it with a short 
position (contract to contract basis) and form a qualified spread. 
Under the proposed treatment of long positions in a portfolio margin 
omnibus account at The OCC, all long positions would be unsegregated, 
freeing The OCC clearing member from the task of determining which long 
positions offset risk and from specifying each position to be 
unsegregated.
h. Rationale For Portfolio Margin
    Portfolio margining brings a modern approach to quantifying risk 
and offers a number of efficiencies. It eliminates the task of 
analyzing the portfolio and sorting it according to currently 
recognized strategies (e.g., spreads), and computing a margin 
requirement for each individual position or strategy. This process 
becomes quite cumbersome in an account with multiple positions and 
complex strategies. More importantly, for a given market move, up or 
down, in a diverse portfolio there will be listed option positions that 
appreciate and other option positions that will depreciate. Under a 
portfolio margin system, offsets are fully realized, whereas, under the 
current strategy-based system, positions and/or a group of positions 
comprising a single strategy are margined independent of each other and 
offsets between them do not figure into the total margin requirement as 
efficiently. In addition, under a portfolio margin system, the 
volatility of an individual listed option series is used in the 
theoretical pricing model that renders the price used to compute a 
gain/loss on that option position at each valuation point. This links 
the margin required to the risk in each particular position in contrast 
to the strategy-based margin. Strategy-based margin applies a universal 
percentage requirement (of the underlying index value) to all short 
option positions in the same category (e.g., broad-based), irrespective 
of the fact that all options prices do not change equally (in 
percentage terms) with a change in the price or level of the underlying 
instrument.
    Theoretical options pricing models have become widely accepted and 
utilized since Fischer Black and Myron Scholes first introduced a 
formula for calculating the value of a European style option in 1973. 
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 and have proven to be 
highly effective and preferred. In addition, essentially the same 
portfolio methodology described above has been used successfully by 
broker-dealers since 1994 to calculate haircuts on option positions for 
net capital purposes.\21\
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    \21\ On March 15, 1994, the Commission issued a no-action letter 
allowing the implementation of a risk-based haircut pilot program. 
See letter from Brandon Becker, Director, Division, Commission, to 
Mary Bender, First Vice President, Division of Regulatory Services, 
CBOE, and Timothy Hinkes, Vice President, The OCC, dated March 15, 
1994. The risk-based haircut program took full effect on September 
1, 1997. See ``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.\22\ A portfolio margin system recognizes 
the offsetting gains from positions that react favorably in market 
declines, while market rises are tempered by offsetting losses from 
positions that react negatively. A portfolio margin approach can thus 
have a neutralizing effect on option portfolio volatility. In times of 
market stress, the current strategy-based margin can result in margin 
calls and forced liquidations, thus contributing to the selling 
pressure in the market. The offset ability of portfolio margining can 
alleviate the need for liquidations, slowing acceleration of volatility 
in a crisis.
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    \22\ 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).
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    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.\23\ In that letter, the FRB wrote that it 
``has encouraged the development of [portfolio margin approaches] by, 
for example, amending its Regulation T so that portfolio margining 
systems approved by the Commission can be used in lieu of the strategy-
based system

[[Page 77285]]

embodied in the Board's regulation.'' The FRB concluded that letter by 
writing ``The Board anticipates that the creation of security future 
products will provide another opportunity to develop more risk 
sensitive, portfolio-based approaches for all securities, including 
security options and security futures products.''
---------------------------------------------------------------------------

    \23\ 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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    An ability to cross-margin listed index options with index futures, 
and options on such futures, is critical because many professional 
investors hedge their listed index options with futures. Although 
haircuts assessed on broker-dealers with respect to computing their net 
capital requirement recognize offsets between securities index options 
and index futures, current margin practice does not allow these 
offsets. Cross-margin benefits the financial markets and clearing 
system in general, not just individual investors. Cross-margin would 
reduce the number of forced liquidations. Currently, an option 
(securities) account and futures account of the same customer are 
viewed as separate and unrelated. In addition, currently an option 
account 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 can be combined (i.e., cross-margined), there is little or 
no net change in risk and unnecessary liquidation can be avoided. The 
severity of a period of high volatility in the market is lessened if 
the number of liquidations is reduced because, for example, liquidating 
into a declining market exacerbates the decline. A capability to cross-
margin listed index options and index futures would further alleviate 
excessive margin calls, improve cash flows and liquidity, and reduce 
volatility, particularly in times of market downturns. Various 
government agencies and task groups have previously advocated 
implementation of a cross-margin system. Those groups include the 
Presidential Task Force on Market Mechanics (also know as the Brady 
Commission) \24\ and the Commission.\25\
    Listed index options are now at a disadvantage to economically 
equivalent derivative products traded on futures exchanges in terms of 
margin requirements. Since 1988, index futures and options have been 
margined under a portfolio margin system known as SPAN. While the risks 
of listed index options are no greater than an equivalent position in 
an index future or option on the future, margin required on listed 
securities index options is significantly higher in many cases. 
Currently, listed index options margin (excluding the option premium) 
for a short at-the-money contract approximates 15% of the underlying 
index value while SPAN margin on a comparable futures index option 
contract is approximately 6% of the index value. When faced with such a 
disparity, investment managers discerningly choose futures products 
over listed index options for their hedging to reduce their costs. A 
portfolio style margin application for listed index options will reduce 
disparities between securities index options and futures products, thus 
making listed index products more competitive and more effective tools 
for investors.
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    \24\ See ``The Brady Report,'' Report of the Presidential Task 
Force on Market Mechanisms, January 1988, p. 59 and pp. 65-66.
    \25\ See ``The October 1987 Market Break: Report by the 
Division,'' Commission, February 1988, pp. 10-57. See also the 
interim report of the ``Working Group on Financial Markets,'' 
(Department of the Treasury, CFTC, Commission and FRB), May 1988, 
Appendix D III A.
---------------------------------------------------------------------------

    Relief provided by a portfolio margin system is also needed so that 
listed index options can compete with over-the-counter derivatives, 
which can be margined on a good faith basis if hedged with a listed 
option.\26\
---------------------------------------------------------------------------

    \26\ See ``OTC Derivatives Dealers,'' Securities Exchange Act 
Release No. 40594, (October 23, 1998), 63 FR 59362 (November 3, 
1998).
---------------------------------------------------------------------------

2. Statutory Basis
    The Exchange believes the proposed rule change, as amended, is 
consistent with Section 6(b) of the Act \27\ in general, and furthers 
the objectives of Section 6(b)(5) of the Act \28\ in particular, in 
that it is designed perfect the mechanism of a free and open market and 
to protect investors and the public interest. The proposed portfolio 
margin rule change is intended to promote greater reasonableness, 
accuracy and efficiency in respect of Exchange margin requirements for 
complex, multiple position listed index option strategies, and to offer 
a cross-margin capability with related index futures positions in 
eligible accounts.
---------------------------------------------------------------------------

    \27\ 15 U.S.C. 78f(b).
    \28\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is not necessary or appropriate 
in the furtherance of the purposes of the Act.

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

    No written comments were either solicited or received.

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

    Within 35 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 90 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 Exchange consents, the Commission will:
    (A) By order approve such proposed rule change, as amended, 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

    <bullet> Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
    <bullet> Send an e-mail to <a href="/cdn-cgi/l/email-protection#bbc9ced7de96d8d4d6d6ded5cfc8fbc8ded895dcd4cd"><span class="__cf_email__" data-cfemail="0775726b622a64686a6a626973744774626429606871">[email protected]</span></a>. Please include 
File Number SR-CBOE-2002-03 on the subject line.

Paper Comments

    <bullet> Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-CBOE-2002-03. 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

[[Page 77286]]

provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Section, 450 Fifth Street, 
NW., Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of the CBOE. 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-CBOE-2002-03 and should be 
submitted on or before January 18, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\29\
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    \29\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-28184 Filed 12-23-04; 8:45 am]
BILLING CODE 8010-01-P


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