[Federal Register Volume 62, Number 179 (Tuesday, September 16, 1997)]
[Notices]
[Pages 48683-48686]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-24443]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39032; File Nos. SR-Amex-96-19; SR-DBOE-96-79; SR-PCX-
97-09]


Self-Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change and Notice of Filing and Order Granting 
Accelerated Approval to Amendment No. 1 to Proposed Rule Change by the 
American Stock Exchange, Inc. and the Chicago Board Options Exchange, 
Inc., and Order Granting Approval to Proposed Rule Change by the 
Pacific Exchange, Inc., Relating to the Elimination of Position and 
Exercise Limits for FLEX Equity Options

September 9, 1997.

I. Introduction

    On May 21, 1996, December 27, 1996, and April 1, 1997, 
respectively, the American Stock Exchange, Inc. (``Amex''), the Chicago 
Board Options Exchange, Inc. (``CBOE''), and the Pacific Exchange, Inc. 
(``PCX'') (collectively the ``Exchanges''), submitted to 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\ proposed rule changes to eliminate position and exercise 
limits \3\ for FLEX Equity options under a two-year pilot program.\4\
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    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4.
    \3\ Position limits impose a ceiling on the aggregate number of 
option contracts on the same-side of the market that an investor, or 
group of investors acting in concern, may hold or write. Exercise 
limits impose a ceiling on the aggregate long positions in option 
contracts that an investor, or group of investors acting in concert, 
can or will have exercised within five consecutive business days.
    \4\ In general, FLEX Equity options provide investors with the 
ability to customize basic option features including size, 
expiration date, exercise style, and certain exercise prices. (See 
Securities Exchange Act Release No. 37726 (September 25, 1996), 61 
FR 51474 (October 2, 1996), regarding restrictions on the available 
exercise prices for FLEX Equity call options (File Nos. SR-Amex-96-
29, SR-CBOE-96-56, and SR-PSE-96-31)).
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    Notice of the proposed rule changes appeared in the Federal 
Register on June 12, 1996, January 17, 1997, and May 20, 1997, 
respectively.\5\ No comments were received on the proposed rule 
changes. The Amex subsequently filed Amendment No. 1 to its proposed 
rule change on February 3,

[[Page 48684]]

1997.\6\ The CBOE subsequently filed Amendment No. 1 to its proposed 
rule change on May 13, 1997.\7\ This order approves the Exchanges' 
proposals, as amended, and solicits comments on Amex Amendment No. 1 
and CBOE Amendment No. 1.
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    \5\ See Securities Exchange Act Release Nos. 37280 (June 5, 
1996), 61 FR 29774 (June 12, 1996) (File No. SR-Amex-96-19); 38152 
(January 10, 1997), 62 FR 2702 (January 17, 1997) (File No. SR-CBOE-
96-79); and 38616 (May 12, 1997), 62 FR 27642 (May 20, 1997) (File 
No. SR-PCX-97-09).
    \6\ See letter from Claire P. McGrath, Managing Director and 
Special Counsel, Derivative Securities, Amex, to Lvette Lopez, 
Assistant Director, Office of Market Supervision, Division of Market 
Regulation (``Division''), Commission, dated February 3, 1997 
(``Amex Amendment No. 1''). In Amex Amendment No. 1, the Amex 
amended its rule filing to eliminate position and exercise limits 
for FLEX Equity options under a two-year pilot program and revised 
the proposed text of Amex Rule 906G to include a reporting 
requirement and the ability of the Amex to impose higher margin 
requirements and/or to assess capital charges.
    \7\ See letter from Timothy H. Thompson, Senior Attorney, CBOE, 
to Sharon Lawson, Division, Commission, dated May 13, 1997 (``CBOE 
Amendment No. 1''). In CBOE Amendment No. 1, the CBOE amended its 
rule filing to eliminate position and exercise limits for FLEX 
Equity options under a two-year pilot program and revised the 
proposed text of CBOE Rule 24A.7 to include a reporting requirement 
and the ability of the CBOE to impose higher margin requirements 
and/or to assess capital charges.
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II. Background

    On February 14, 1996 and June 19, 1996, the Commission approved the 
Exchanges' proposals to list and trade FLEX Equity options on specified 
equity securities.\8\ According to the Exchanges, those proposals were 
designed to provide investors with the ability, within specified 
limits, to designate certain terms of the options. In support of their 
proposals, the Exchanges stated that in recent years, an over-the-
counter (``OTC'') market in customized equity options had developed 
which permitted participants to designate the basic terms of the 
options including size, term to expiration, exercise style, exercise 
price, and exercise settlement value. According to the Exchanges, 
participants in this OTC market were typically institutional investors, 
who bought and sold options in large-size transactions through a 
relatively small number of securities dealers. To compete with this 
growing OTC market in customized equity options, the Exchanges proposed 
to expand their FLEX options rules \9\ to permit the introduction of 
trading in FLEX options on specified equity securities that satisfied 
the Exchanges' listing standards for equity options.\10\ The Exchanges' 
proposals allowed FLEX Equity option market participants to designate 
the following contract terms: (1) Certain exercise prices; (2) exercise 
style (i.e., American, European, or capped); \11\ (3) expiration 
date;\12\ and (4) option type (i.e., put, call, or spread). In 
addition, the Exchanges set position and exercise limits for FLEX 
Equity options at three times the position limits for the corresponding 
Non-FLEX Equity options on the same underlying security.\13\ The 
Exchanges now propose to eliminate position and exercise limits for 
FLEX Equity options.
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    \8\ See Securities Exchange Act Release Nos. 36841 (February 14, 
1996), 61 FR 6666 (February 21, 1996) (File Nos. SR-CBOE-95-43 and 
SR-PSE-95-24), and 37336 (June 19, 1996), 61 FR 33558 (June 27, 
1996) (File No. SR-Amex-95-57).
    \9\ See, e.g., Amex Rules 900G through 909G. At the time of 
their FLEX Equity option proposals, the Amex and the CBOE had 
already secured Commission approval to list and trade FLEX options 
on several broad-based market indexes market indexes composed of 
equity securities (``FLEX Index options''). See, e.g., Securities 
Exchange Act Release Nos. 32781 (August 20, 1993), 58 FR 45360 
(August 27, 1993) (Order approving the trading of FLEX Index options 
on the Major Market, Institutional, and S&P MidCap Indexes) (File 
No. SR-Amex-93-05), and 34052 (May 12, 1994), 59 FR 25972 (May 18, 
1994) (order approving the trading of FLEX Index options on the 
Nasdaq 100 Index) (File No. SR-CBOE-93-46).
    \10\ See, e.g., Amex Rule 915 which contains initial listing 
standards for a security to be eligible for options trading. In 
addition, the Exchanges may trade FLEX options on any options-
eligible security regardless of whether standardized Non-FLEX 
options overlie that security and regardless of whether such Non-
FLEX options trade on the Exchanges.
    \11\ An American-style option is one that may be exercised at 
any time on or before the expiration date. A European-style option 
is one that may be exercised only during a limited period of time 
prior to expiration of the option. A capped-style option is one that 
is exercised automatically prior to expiration when the cap price is 
less than or equal to the closing price of the underlying security 
for calls, or when the cap price is greater than or equal to the 
closing price of the underlying security for puts.
    \12\ The expiration date of a FLEX Equity option cannot, 
however, fall on a day that is on, or within two business days of, 
the expiration date of a Non-FLEX Equity option.
    \13\ Position and exercise limits for FLEX Equity options are 
set forth below as compared to existing limits for Non-FLEX Equity 
options on the same underlying security.
    Non-FLEX Equity position limit
      4,500 contracts.
      7,500 contracts.
      10,500 contracts.
      20,000 contracts.
      25,000 contracts.
    FLEX Equity position limit
      13,500 contracts.
      22,500 contracts.
      31,500 contracts.
      60,000 contracts.
      75,000 contracts.
    The Commission notes that there is no aggregation of positions 
or exercises in FLEX Equity options with positions or exercises in 
Non-FLEX Equity options for purposes of the limits.
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III. Description

    The Exchanges believe that the elimination of position and exercise 
limits for FLEX Equity options is appropriate given the institutional 
nature of the market for this derivative product. The Exchanges also 
believe that large investors currently find the use of exchange-traded 
options impractical because of the constraints imposed by position 
limits. According to the Exchanges, with no position limits, additional 
investors will be attracted to exchange-traded options, thereby 
reducing transaction costs as well as improving price efficiency for 
all exchange-traded option market participants.
    In addition, the Exchanges believe that FLEX Equity options, 
unconstrained by position limits, may become an important part of large 
investors' investment strategies. For instance, according to the 
Exchanges, in the absence of position limits, investors will be able to 
use exchange-traded options to implement specific viewpoints regarding 
the underlying common stock; viewpoints that take into account specific 
near- and long-term expectations for the underlying stock price as well 
as judgments on price volatility. Similarly, in the Exchanges' view, 
the ability to execute large exchange-traded option transactions will 
permit large investors to implement transactions that reflect the 
strength of their interest in buying or selling the underlying shares, 
as well as their specific viewpoints on the purchase or sale of the 
underlying shares.
    In further support for their proposals, the Exchanges note that 
issuers of stocks underlying FLEX Equity options will be able to use 
such options, primarily through the sale of puts, as part of their 
stock repurchase programs.\14\ While the Exchanges do not expect that 
corporate issuers will use the sale of put options to buy all the 
securities that are covered by their repurchase programs, the Exchanges 
believe that FLEX Equity options without position limits will at least 
provide issuers with a meaningful alternative.
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    \14\ The Commission notes that issuers would, of course, need to 
comply with all applicable provisions of the federal securities laws 
in conducting their share repurchase programs.
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    The Exchanges believe that making the exchange-traded options 
market more accessible to large investors will create more ``complete'' 
markets and thereby better serve investors and issuers. In addition, 
the Exchanges believe that institutional investors, large individual 
investors, and corporate issuers repurchasing their own shares will 
find FLEX Equity options without position limits extremely attractive. 
Moreover, the Exchanges note that such activity will occur in the 
regulated, transparent domestic FLEX Equity options markets rather than 
in the less transparent OTC market or an offshore

[[Page 48685]]

market which do not come under Commission oversight.
    Finally, the Exchanges have represented that they intend to 
implement increased surveillance and reporting procedures in order to 
ensure an enhanced monitoring of the uses and risks associated with 
both the elimination of position limits and the underlying strategies 
resulting in such increased positions. Specifically, whenever a member 
files a report with an exchange (indicating that an account is carrying 
a position in excess of three times the standardized option position 
limit or that class), the Options Clearing Corporation (``OCC'') will 
be asked to perform a risk evaluation of the account and its position. 
If OCC's risk evaluation indicates a cause for concern, the exchange 
will notify the member carrying the account and assess the 
circumstances of the transactions along with the firm's view of the 
exposure of the account, as well as determine whether the account is 
approved and suitable for the strategies being utilized. According to 
the Exchanges, this monitoring of accounts should provide the 
information necessary to determine whether additional margin and/or 
capital charges should be imposed. Similarly, the adoption of the 
Exchanges' proposals under a two-year pilot period, with a status 
report provided to the Commission after one-and-a-half years, should 
enable the Commission to assess the effects on the markets of the 
elimination of position and exercise limits on FLEX Equity options.

IV. Discussion

    The Commission finds that the proposed rule changes are consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, with the requirements of Section 6(b) (5). Specifically, 
the Commission believes that the rule proposals are designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and are not designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.
    The Commission also believes that the proposed rule changes are 
consistent with Section 11A of the Act in that the elimination of 
position and exercise limits for FLEX Equity options allows the 
Exchange to better compete with the growing OTC market in customized 
equity options, thereby encouraging fair competition among brokers and 
dealers and exchange markets. The attributes of the Exchanges' options 
markets versus an OTC market include, but are not limited to, a 
centralized market center, an auction market with posted transparent 
market quotations and transaction reporting, parameters and procedures 
for clearance and settlement, and the guarantee of the OCC for all 
contracts traded on the Exchanges.
    While the Commission has generally taken a gradual, evolutionary 
approach toward expansion of position and exercise limits, the 
Commission is willing to approve the two-year pilot program for FLEX 
Equity options for several reasons. First, the FLEX Equity options 
market is characterized by large, sophisticated institutional investors 
(or extremely high net worth individuals), who have both the experience 
and ability to engage in negotiated, customized transactions. For 
example, with a required minimum size of 250 contracts to open a 
transaction in a new series, FLEX Equity options are designed to appeal 
to institutional investors, and it is unlikely that many retail 
investors would be able to engage in options transactions at that size. 
Second, all of the Exchanges' other current rules and provisions 
governing FLEX Equity options remain applicable.\15\ Third, the OCC 
will serve as the counter-party guarantor in every exchange-traded 
transaction. Fourth, the proposed eliminated of position and exercise 
limits for FLEX Equity options could potentially expand the depth and 
liquidity of the FLEX equity market without significantly increasing 
concerns regarding intermarket manipulations or disruptions of the 
options or the underlying securities. Finally, the Exchanges' 
surveillance programs will be applicable to the trading of FLEX Equity 
options and should detect and deter trading abuses arising from the 
elimination of position and exercise limits.
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    \15\ See, e.g., Amex Rules 900G through 909G.
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    As described above, the Exchanges have adopted important safeguards 
that will allow them to monitor large positions in order to identify 
instances of potential risk and to assess additional margin and/or 
capital charges, if necessary. The Exchanges require each member or 
member organization (other than a Specialist, a Registered Options 
Trader, a Market Maker, or a Designated Primary Market Maker) that 
maintains a position on the same-side of the market in excess of three 
times the position limit level established pursuant to the applicable 
exchange rule for Non-FLEX Equity options of the same class, to report 
information to the exchange regarding the FLEX Equity option position, 
positions in any related instrument, the purpose or strategy for the 
position, and the collateral used by the account.\16\ By monitoring 
accounts in excess of three times the Non-FLEX Equity option position 
limit in this manner, the Exchanges should be provided with the 
information necessary to determine whether to impose additional margin 
and/or whether to assess capital charges upon a member organization 
carrying the account. In addition, this information should allow the 
Exchanges to determine whether a large position could have an undue 
effect on the underlying market and to take the appropriate action.
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    \16\ The Exchanges also require that an updated report be filed 
when a change in the options position occurs or when a significant 
change in the hedge of that position occurs.
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    Given the size and sophisticated nature of the FLEX Equity options 
market, along with the new reporting and margin requirements, the 
Commission believes that eliminating position and exercise limits for 
FLEX Equity options for a two-year pilot period should not 
substantially increase manipulative concerns. Nevertheless, the 
Commission will be able to assess the effects on the markets of the 
Exchanges' proposals during the two-year pilot period. If problems were 
to arise during such pilot period, the Commission believes that the 
enhanced market surveillance of large positions should help the 
Exchanges to take the appropriate action in order to avoid any 
manipulation or market risk concerns.
    Preliminarily, the Commission believes that it is reasonable to 
treat FLEX Equity options differently than regular standardized 
options. FLEX options compete directly with OTC options. The Commission 
believes that it would be beneficial to attract OTC activity back to a 
more transparent market with a clearinghouse guarantee. Hence, a 
liberalization of position limits for FLEX Equity options is a measured 
deregulatory means to enable the Exchanges to compete with the OTC 
market while preserving important oversight safeguards.
    In summary, because of the special nature of the Flex Equity 
markets, the Commission believes that the Exchanges' proposals should 
be approved. Nevertheless, because this is the first time the 
Commission has agreed to eliminate position and exercise limits for a 
derivative product, the Commission cannot rule out the potential for 
adverse effects on the securities markets for the component securities 
underlying FLEX Equity options. To address this concern, the

[[Page 48686]]

Commission has approved the proposals for a two-year pilot period. The 
Exchanges will undertake to monitor, among other things, open interest 
and potential adverse market effects and to report to the Commission on 
the status of the program no later than eighteen months after the 
order's date of effectiveness. The reporting of the Exchanges' 
experiences should include, among other things, such information as: 
(i) The type of strategies used by FLEX Equity options market 
participants and whether FLEX Equity options are being used in lieu of 
existing standardized equity options; (ii) the type of market 
participants using FLEX Equity options both before and during the pilot 
program, including how the utilization of FLEX Equity options has 
changed; (iii) the average size of the FLEX Equity option contract both 
before and during the pilot program, the size of the largest FLEX 
Equity option contract on any given day both before and during the 
pilot program, and the size of the largest FLEX Equity option held by 
any single customer/member both before and during the pilot program; 
and (iv) any impact on the prices of underlying stocks during the 
establishment or unwinding of FLEX positions that are greater than 
three times the standard position limit. Finally, the Commission 
expects the Exchanges to take prompt action, including timely 
communication with the Commission and other marketplace self-regulatory 
organizations responsible for oversight of trading in component stocks, 
should any unanticipated adverse market effects develop.
    The Commission finds good cause to approve Amex Amendment No. 1 and 
CBOE Amendment No. 1 to the proposed rule filings prior to the 
thirtieth day after the date of publication of notice of filing thereof 
in the Federal Register. Specifically, by restricting the elimination 
of position and exercise limits for FLEX Equity options to a two-year 
pilot period, as well as requiring members holding large positions to 
report such positions to the Amex and to the CBOE, the proposed rule 
changes are more restrictive than the original proposals, which are 
published for the entire twenty-one day comment period and generated no 
responses. In addition, by authorizing the Amex and the CBOE to impose 
margin and/or assess capital charges, the Commission believes that the 
Amex and the CBOE have established important safeguards to address 
concerns regarding potential manipulation or other market disruptions. 
Accordingly, the Commission believes that it is consistent with Section 
6(b)(5) of the Act to approve Amex Amendment No. 1 and CBOE Amendment 
No. 1 to the proposed rule changes on an accelerated basis.
    Interested persons are invited to submit written data, views, and 
arguments concerning Amex Amendment No. 1 and CBOE Amendment No. 1 to 
the rule proposals. Persons making written submissions should file six 
copies thereof with the Secretary, Securities and Exchange Commission, 
450 Fifth Street, NW., Washington, DC 20549. Copies of the submission, 
all subsequent amendments, all written statements with respect to the 
proposed rule changes that are filed with the Commission, and all 
written communications relating to the proposed rule changes between 
the Commission and any person, other than those that may be withheld 
from the public in accordance with the provisions of 5 U.S.C. Sec. 552, 
will be available for inspection and copying at the Commission's Public 
Reference Section, 450 Fifth Street, NW., Washington, DC 20549. Copies 
of such filings also will be available for inspection and copying at 
the principal offices of the Amex and the CBOE. All submissions should 
refer to File Nos. SR-Amex-96-19 and SR-CBOE-96-79 and should be 
submitted by October 7, 1997.

V. Conclusion

    For the foregoing reasons, the Commission finds that the Exchanges' 
proposals to eliminate position and exercise limits for FLEX Equity 
options for a two-year pilot period, as amended, is consistent with the 
requirements of the Act and the rules and regulations thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\17\ that the proposed rule changes (SR-Amex-96-19), SR-CBOE-96-79 
and SR-PCX-97-09), as amended, are approved on a pilot basis until 
September 9, 1999.

    \17\ 15 U.S.C. 78s(b)(2) (1988).
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    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-24443 Filed 9-15-97; 8:45 am]
BILLING CODE 8010-01-M