6474 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

1Securities Exchange Act Release No. 32256 (May

4, 1993), 58 FR 27486 (May 10, 1993) (‘‘Concept

Release’’).

2Securities Exchange Act Release No. 33761

(March 15, 1994), 59 FR 13275 (March 21, 1994)

(‘‘Proposing Release’’).

3Letter from Brandon Becker, Division of Market

Regulation, SEC to Mary L. Bender, First Vice

President, CBOE and Timothy Hinkas, Vice

President, The Options Clearing Corporation

(‘‘OCC’’) (March 15, 1994) (‘‘1994 No-Action

Letter’’).

regulatory organizations of which the

broker or dealer is a member.

(B) Each index must be duplicated

and the duplicate copies must be stored

separately from the original copy of

each index.

(C) Original and duplicate indexes

must be preserved for the time required

for the indexed records.

(v) The member, broker, or dealer

must have in place an audit system

providing for accountability regarding

inputting of records required to be

maintained and preserved pursuant to

§§ 240.17a–3 and 240.17a–4 to

electronic storage media and inputting

of any changes made to every original

and duplicate record maintained and

preserved thereby.

(A) At all times, a member, broker, or

dealer must be able to have the results

of such audit system available for

examination by the staffs of the

Commission and the self-regulatory

organizations of which the broker or

dealer is a member.

(B) The audit results must be

preserved for the time required for the

audited records.

(vi) The member, broker, or dealer

must maintain, keep current, and

provide promptly upon request by the

staffs of the Commission or the selfregulatory organizations of which the

member, broker, or broker-dealer is a

member all information necessary to

access records and indexes stored on the

electronic storage media; or place in

escrow and keep current a copy of the

physical and logical file format of the

electronic storage media, the field

format of all different information types

written on the electronic storage media

and the source code, together with the

appropriate documentation and

information necessary to access records

and indexes.

(vii) For every member, broker, or

dealer exclusively using electronic

storage media for some or all of its

record preservation under this section,

at least one third party (‘‘the

undersigned’’), who has access to and

the ability to download information

from the member’s, broker’s, or dealer’s

electronic storage media to any

acceptable medium under this section,

shall file with the designated examining

authority for the member, broker, or

dealer the following undertakings with

respect to such records:

The undersigned hereby undertakes to

furnish promptly to the U.S. Securities and

Exchange Commission (‘‘Commission’’), its

designees or representatives, upon reasonable

request, such information as is deemed

necessary by the Commission’s or designee’s

staff to download information kept on the

broker’s or dealer’s electronic storage media

to any medium acceptable under Rule 17a–

4.

Furthermore, the undersigned hereby

undertakes to take reasonable steps to

provide access to information contained on

the broker’s or dealer’s electronic storage

media, including, as appropriate,

arrangements for the downloading of any

record required to be maintained and

preserved by the broker or dealer pursuant to

Rules 17a–3 and 17a–4 under the Securities

Exchange Act of 1934 in a format acceptable

to the Commission’s staff or its designee.

Such arrangements will provide specifically

that in the event of a failure on the part of

a broker or dealer to download the record

into a readable format and after reasonable

notice to the broker or dealer, upon being

provided with the appropriate electronic

storage medium, the undersigned will

undertake to do so, as the Commission’s staff

or its designee may request.

* * * * *

By the Commission.

Dated: February 5, 1997.

Margaret H. McFarland,

Deputy Secretary.

Note: Appendix A to the Preamble will not

appear in the Code of Federal Regulations.

Appendix A—Regulatory Flexibility Act

Certification

I, Arthur Levitt, Chairman of the Securities

and Exchange Commission, hereby certify

pursuant to 5 U.S.C. 605(b) that the final

amendments to Rule 17a–4 set forth in

Securities Exchange Release No. 34–38245

will not have a significant economic impact

on a substantial number of small entities.

Specifically, the amendments do not alter the

regulatory requirements for broker-dealers

using currently accepted media for record

retention purposes (i.e., paper, microfilm, or

microfiche). Instead, the amendments expand

the record retention media options by

allowing broker-dealers to utilize certain

electronic storage media to store records

required under 17 CFR 240.17a–3 and

240.17a–4. Accordingly, the amendments

will not change the impact of current

regulatory record preservation requirements

on a substantial number of small entities.

Dated: January 31, 1997.

Arthur Levitt,

Chairman.

[FR Doc. 97–3426 Filed 2–11–97; 8:45 am]

BILLING CODE 8010–01–P

17 CFR Part 240

[Release No. 34–38248; File No. S7–7–94]

RIN 3235–AG14

Net Capital Rule

AGENCY: Securities and Exchange

Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange

Commission (‘‘Commission’’) is

amending Rule 15c3–1 under the

Securities Exchange Act of 1934

(‘‘Exchange Act’’), the net capital rule,

to permit broker-dealers to employ

theoretical option pricing models in

determining net capital requirements for

listed options and related positions.

Alternatively, broker-dealers may elect a

strategy-based methodology. The

amendments are intended to simplify

the net capital rule’s treatment of

options for capital purposes and more

accurately reflect the risk inherent in

broker-dealer options positions.

EFFECTIVE DATE: The amendments

become effective September 1, 1997.

FOR FURTHER INFORMATION CONTACT:

Michael A. Macchiaroli, Associate

Director (202) 942–0131, Peter R.

Geraghty, Assistant Director (202) 942–

0177, or Louis A. Randazzo, Special

Counsel (202) 942–0191, Division of

Market Regulation, Securities and

Exchange Commission, 450 Fifth Street,

N.W., Mail Stop 5–1, Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

The Commission is adopting

amendments to Rule 15c3–1 under the

Exchange Act to permit broker-dealers

to employ theoretical option pricing

models to calculate required net capital

for listed options and the related

positions that hedge those options. In

adopting these amendments, the

Commission is continuing its process of

revising the net capital rule that was

contemplated when the Commission

solicited comments on a range of capital

related issues in 1993.1 The

amendments being adopted today were

proposed in initial form in March of

1994 and would allow broker-dealers to

use an options pricing model to

determine capital charges for listed

options and related positions.2

Simultaneously with the Commission’s

proposal, the Division of Market

Regulation (‘‘Division’’) issued a noaction letter allowing broker-dealers to

utilize the options pricing approach

immediately.3 Based on the experience

gained by the Commission under the noaction letter, and the nature of the

comments received during the public

comment period, the Commission is
Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations 6475

4The section 8(b) of the Securities Exchange Act

that was adopted in 1934 contained a rudimentary

net capital ratio requirement for members of

national securities exchanges and broker-dealers

conducting business through members. In 1942, the

Commission adopted its first net capital rule.

Section 8(b) was repealed by section 5(2) of the

Securities Act Amendments of 1975, which also

required the adoption of the uniform net capital

rule applicable to all broker-dealers. 5 15 U.S.C. 78aaa et seq.

adopting the proposed amendments

with certain changes discussed herein.

The rules will become effective on

September 1, 1997; however, brokerdealers that desire to apply the rule

before the effective date may do so.

A. The Net Capital Rule Generally

The Commission adopted its first net

capital rule in 1942.4 The rule requires

that every registered broker-dealer

maintain certain specified minimum

levels of net capital. The primary

purpose of the rule is to protect the

customers of a broker-dealer from losses

that can be incurred upon the brokerdealer’s failure. Rule 15c3–1 requires

registered broker-dealers to maintain

sufficient liquid assets to enable those

firms that fall below the minimum net

capital requirements to liquidate in an

orderly fashion without the need for a

formal legal proceeding. The rule

prescribes different required minimum

levels based upon both the method a

firm adopts in computing its net capital

and the type of securities business it

conducts. A firm engaging in a general

securities business (which would allow

the firm to clear and carry customer

accounts) must maintain a minimum net

capital level of the greater of $250,000

or 62⁄3 percent of its liabilities (with

certain exclusions), or if the firm

chooses the alternative method, the

greater of $250,000 or 2 percent of its

customer-related receivables. The

different minimum levels of net capital

for firms based on categories of business

activity are designed to address the

perceived risk in the broker-dealers’

business. For example, if a broker-dealer

carries no customer accounts and does

not engage in certain specified

activities, it can maintain as little as

$5,000 in net capital.

Under the net capital rule, a brokerdealer takes its net worth, computed in

accordance with generally accepted

accounting principles, deducts certain

illiquid assets (such as goodwill),

certain percentages from its proprietary

securities or commodities inventory,

and adds back certain liabilities to

arrive at net capital. This number is

then compared to its requirement to

determine compliance. Much of the rule

itself is comprised of the haircut

deductions which account for the

market and other risks inherent in a

trading business. The Commission

believes the net capital rule has

performed its customer protection

function well over the years, has

enabled the Commission and the selfregulatory organizations (‘‘SROs’’) to

identify financial problems at early

stages, and has allowed the Commission

and the SROs to perform selfliquidations of failing securities firms

without both customer loss and the

need for proceedings under the

Securities Investor Protection Act of

1970.5

Currently, the net capital rule

provides two basic capital treatments for

option positions held by broker-dealers.

The first approach, which is set forth in

Appendix A to Rule 15c3–1, was

designed for firms clearing their

proprietary listed option and related

positions, and assumes that the option

will be exercised or held to expiration.

The second approach, which is set forth

in Rule 15c3–1(c)(2)(x), is a premiumbased approach. Both methodologies of

computing charges provide for lower

haircuts for certain risk offsetting

positions held by broker-dealers,

although the premium-based approach

recognizes more types of offsetting

positions and gives value for the portion

of the premium which is related to time.

B. The Development of the Options

Pricing Approach to Capital

In 1973, Fischer Black and Myron

Scholes introduced a formula to

calculate the value of European style

options. The Black-Scholes formula

assumes that the primary factors

affecting the price of an option are: the

value of the underlying asset, the

exercise price of the option, the

volatility of the underlying asset, the

risk-free rate of interest, and the

remaining time to expiration.

Subsequent to the development of the

Black-Scholes formula, the Cox-RossRubinstein binomial pricing formula

was developed. By calculating different

probable option values at various

intervals, the formula is able to more

easily incorporate dividends, the term

structure of the yield curve, and the

early exercise feature of American style

options. Other models which are based

on the Cox-Ross-Rubinstein formula

have since been developed, including

OCC’s Theoretical Intermarket

Margining System (‘‘TIMS’’), which is

used to measure the market risk

associated with participants’ positions

and to establish clearing house margin

requirements.

The sharp market breaks in 1987 and

1989 made it imperative for the

Commission to review the adequacy of

the current options haircut

methodology. The Chicago Board

Options Exchange (‘‘CBOE’’) and OCC

formed a task force to determine

whether a more rigorous and predictive

approach to haircuts could be

developed. As noted, the current

methodology requires that positions be

allocated to specific recognized

strategies which are then haircut at the

prescribed levels. The aggregate haircut

for a class, or product group in the case

of indexes, is the sum of the haircuts

calculated for each individually

identified strategy. CBOE and OCC

believed that the current strategy-based

approach did not effectively recognize

the risk reduction of offsetting positions

within a class or product group, and

therefore such approach required

excessive amounts of capital to maintain

such offsetting positions. In addition,

CBOE and OCC maintained that the

haircuts associated with short,

unhedged, out-of-the-money options

were an insufficient measure of capital

adequacy with respect to rapid, material

changes in market prices. At that time,

OCC had been utilizing an options

pricing model to establish clearing

house margin requirements. In addition,

traders and risk managers had been

using options pricing models in the

development of trading strategies and

the management of market risk. Thus,

the task force determined to explore the

impact of haircuts calculated through

the use of an options pricing model.

CBOE and OCC conducted a

preliminary study which compared

haircut and account equity data

obtained from three options marketmaker clearing firms with position risk

calculated using a derivation of TIMS

for a three month time frame in late

1990. Current haircuts and equity were

compared to the maximum loss under

TIMS per class or product group for

each market-maker account. The

preliminary study disclosed that

haircuts would be reduced for wellhedged, strategy-diverse positions, and

increased for unhedged positions. The

study further disclosed that the subject

clearing firms maintained sufficient

capital to continue in capital

compliance under the new approach.

Based upon the results of this study, the

Division invited CBOE and OCC to

propose a formal pilot program

specifically designed for calculating

haircuts for listed options on currencies,

equities, and securities and futures

indexes.

The Division, CBOE, and OCC agreed

upon the criteria to be used in the pilot

program, and OCC staff developed the

software and performed the operations
6476 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

6An option series includes 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. The Commission notes that for

the purposes of the final amendments, the term

listed option includes listed warrants.

7Under the proposed rule, OCC would collect the

following information: (1) the dividend streams for

the underlying securities, (2) interest rates (either

the current call rate or the Eurodollar rate for the

maturity date which approximates the expiration

date of the option), (3) days to expiration, and (4)

closing underlying security and option prices from

various vendors.

8 In order to avoid confusion with the designation

of indexes for margin or futures eligibility, the final

amendments and the remainder of this release refer

to ‘‘broad-based’’ indexes as ‘‘diversified’’ indexes.

9The major market currencies are: Deutsche

Mark, British Pound, Swiss Franc, French Franc,

Canadian Dollar, Japanese Yen and European

Currency Unit.

10The Commission indicated in the Proposing

Release that underlying price movement

assumptions for the proposed theoretical pricing

model should be consistent with the volatility

assumptions currently incorporated in the net

capital rule.

11For those broker-dealers which choose to use

TIMS but do not obtain a computer interface with

OCC, OCC has developed a dial-up service by

which such broker-dealers may obtain, on a daily

basis, theoretical gains and losses. Other third-party

vendors would presumably offer a similar service.

Any such dial-up service may be a more practical

option for those broker-dealers that do not find it

economically feasible to maintain a computerized

interface with a third-party source, but that do not

wish to apply the alternative strategy-based

methodology, as discussed below.

12The spreadsheet would be programmed to

compute a minimum haircut charge and identify

the greater of the computed or minimum charge as

the haircut. For example, assume a portfolio

consisting of IBM common stock and various puts

and calls on IBM common stock with different

strikes and expiration dates. OCC would re-price

each option position assuming that the price of the

IBM common stock had moved up or down by a

maximum of 15%, at 10 valuation points (i.e.,

¥15%, ¥12%, ¥9%, ¥6%, ¥3%, +3%, +6%,

+9%, +12%, +15%). The single, maximum net loss

amount at any one of the 10 valuation points would

become the haircut for the portfolio.

13As noted earlier, the pilot program applied a

minimum haircut of 1⁄8 of a point. Pursuant to a

recommendation by CBOE and OCC, the Proposing

Release increased the minimum charge to 1⁄4 of a

point per option contract. The Commission believed

this increase was appropriate to account for

liquidation and decay risk in options prices in

situations where application of the proposed

amendments resulted in little or no charge.

to calculate the risk-based haircuts.

TIMS was used to project prices.

Projected price moves were calculated

based upon the closing underlying asset

price for each day plus and minus

moves at ten equidistant data points

over a range of market movements. The

greatest loss at any one of these points

would become the haircut. The

volatility implied from the closing price

of the options series was used for the

calculation of each projected price for

that series. To account for liquidation

risk, a minimum charge of 1⁄8 point per

option contract was applied when the

haircut for the class or product group

reflected little or no market exposure.

The results of the pilot program were

consistent with earlier findings in that

accounts having primarily hedged

positions reflected significant haircut

reductions; unhedged portfolios

received higher capital charges. Based

in part on this experience, the

Commission issued the Proposing

Release for comment.

C. The Commission’s Proposal

The proposed amendments provided

that, with respect to each option series 6

it clears, OCC would collect certain

information on a daily basis.7 Using this

information and TIMS, OCC would

measure the implied volatility for each

option series. After measuring the

implied volatility for each option series,

OCC would input to the model the

resulting implied volatility for each

option series. For each option series, the

model would calculate theoretical

prices at 10 equidistant valuation points

within a range consisting of an increase

or a decrease of the following

percentages of the daily market price of

the underlying instrument:

(i) +(¥) 15% for equity securities with

a ready market, narrow-based indexes,

and non-high-capitalization

diversified indexes,8

(ii) +(¥) 6% for major market

currencies,9

(iii) +(¥) 10% for high-capitalization

diversified indexes,10 and

(iv) +(¥) 20% for currencies other than

major market currencies.

After the model calculated the

theoretical gain/loss valuations, OCC

would provide the valuations to brokerdealers. Broker-dealers would download

this information into a spreadsheet from

which the broker-dealer would calculate

the profit/loss for each of its proprietary

and market-maker options positions.11

The greatest loss at any one valuation

point would be the haircut.12

Depending upon the type of positions

a broker-dealer sought to offset, a

percentage of a position’s gain at any

one valuation point would offset

another position’s loss at the same

valuation point. The proposed

amendments allowed the following

offsets: (1) within any portfolio type

involving the same underlying stock,

index, or currency, 100% of a position’s

gain at any one valuation point would

offset another position’s loss at the same

valuation point; (2) between qualified

stock baskets (provided the stock basket

represented no less than 90% of a highcapitalization diversified index’s

capitalization or 100% of the

capitalization of a narrow diversified

index) offset by index options, or

futures, or futures options on the same

underlying index, 95% of gains would

offset losses at the same valuation point;

(3) among high-capitalization

diversified index options, futures, and

futures options, 90% of the gain on one

high-capitalization index position in the

same product group would offset the

loss on a position on a different highcapitalization diversified index at the

same valuation point; and (4) among

non-high-capitalization diversified

index options, futures, and futures

options, 75% of the gain on one nonhigh-capitalization diversified index

position would offset the loss on a

different non-high-capitalization

diversified index at the same valuation

point.

Under the proposed amendments,

required deductions were: (1) the

amount of losses at any of the 10

equidistant valuation points

representing the largest theoretical loss

after applying the permissible offsets; or

(2) a minimum charge equal to 1⁄4 of a

point 13 times the multiplier for each

options contract (or $25.00 per option

contract assuming that option contract

covers 100 shares) and each related

instrument within the option’s class or

product group, or $25 for each option on

a major market foreign currency; plus

(3) in the case of portfolio types

involving index options and related

instruments offset by a qualified stock

basket, a minimum charge of 5% of the

market value of the qualified stock

basket for high-capitalization indexes,

whether diversified or narrow-based; or

(4) in the case of portfolio types

involving index options and related

instruments offset by a qualified stock

basket, a minimum charge of 10% of the

market value of the qualified stock

basket for diversified non-highcapitalization indexes.

In proposing the amendments, the

Commission recognized that certain

broker-dealers may not want to, or may

not find it cost effective to use an

options pricing methodology because of

their limited dealings in options.

Accordingly, the proposed amendments

also included an alternative strategybased haircut methodology that

generally followed, but was more

limited than, the haircut approach

embodied in the current rule.

Under the current rule, a brokerdealer that carries accounts of listed

options specialists must take a charge

against capital as of the close of

business each day even though the

broker-dealer does not know the level of

the charges until the following day. The

proposed amendments provided broker-
Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations 6477

14The comment letters are available for public

inspection and copying in the Commission’s public

reference room located at 450 Fifth Street, N.W.,

Washington, D.C. 20549 (File No. S7–7–94).

15Some commenters suggested the use of brokerdealer proprietary models or the Chicago Mercantile

Exchange’s Standard Portfolio Analysis System

(‘‘SPAN’’) which is used by many futures exchanges

to calculate margin requirements. Letter from Jeffrey

Bernstein, Chairman, Capital Committee of the

Securities Industry Association (‘‘SIA’’) to Jonathan

G. Katz, Secretary, SEC (September 16, 1994), and

Letter from Thomas R. Donovan, President and

Chief Executive Officer, Chicago Board of Trade to

Jonathan G. Katz, Secretary, SEC (May 13, 1994).

16The Commission notes that any such thirdparty source, including OCC, may charge brokerdealers a fee for the services they provide in

connection with these amendments.

17See 1994 No-Action Letter, supra note 3, at note

5.

dealers with additional time by which

to take the capital charge. Specifically,

the proposed amendments provided that

broker-dealers could adjust their net

worth by deducting as of noon of the

next business day the charges computed

as of the prior business day. In addition,

the proposed amendments provided that

the required deductions could be

reduced by the deposit of funds or

securities by noon of the next business

day.

D. Summary of Comments

The Commission received ten

comment letters in response to the

Proposing Release.14 The comments, in

general, were supportive of the

Commission’s proposal. Most

commenters, however, suggested that, in

addition to TIMS, the Commission

permit the use of other pricing models.15

In addition, some commenters suggested

that the Commission allow the use of

theoretical pricing models in connection

with over-the-counter (‘‘OTC’’) options

and positions in U.S. Treasury

securities.

The commenters also suggested that

the underlying price assumption for

high-capitalization diversified indexes

be reduced and that the rule permit

implied volatility inputs to fluctuate

within certain parameters. In addition, a

few commenters suggested that the

minimum charge of 1⁄4 of a point per

option contract be reduced. These

issues, as well as others, are discussed

below.

II. Description of Rule Amendments

A. Use of TIMS Versus Other Pricing

Models

In the Proposing Release and under

the 1994 No-Action Letter, brokerdealers were required to use the OCC

TIMS system as the exclusive means of

determining theoretical options prices.

While TIMS is a theoretically sound

options pricing methodology, it is not

the only recognized methodology in the

marketplace. Other models, using

different formulae, are also capable of

arriving at legitimate results. In

response to the comments and based on

additional experience with models, the

Commission is removing the

requirement that TIMS be used. The

final rule permits the use of a model

(other than a proprietary model)

maintained and operated by any thirdparty source and approved by an

examining authority designated

pursuant to Section 17(d) of the

Exchange Act (‘‘DEA’’). The DEA shall

submit to the Commission for

consideration a description of its

methods for approving models.16 The

model must consider at a minimum the

following factors in pricing the option:

(1) the current spot price of the

underlying asset; (2) the exercise price

of the option; (3) the remaining time

until the option’s expiration; (4) the

volatility of the underlying asset; (5) any

cash flows associated with ownership of

the underlying asset that can reasonably

be expected to occur during the

remaining life of the option; and (6)

current information about interest rates.

Any such approval of a model by a DEA

must include appropriate provisions

relating to the obligations of the thirdparty vendor to supply timely and

accurate information to the brokerdealers. Once a model has been

approved by a DEA, broker-dealers may

use the model in order to calculate

haircuts. For purposes of this rule, the

TIMS system as operated by OCC will

be deemed to be an approved model for

a period of two years from the effective

date of these amendments. OCC,

however, should clarify its vendor

status by appropriate DEA approval.

In addition to the commenters’

suggestions that the final amendments

permit broker-dealers to utilize

theoretical pricing systems other than

TIMS, certain commenters argued that

the Commission should permit the use

of internal proprietary models for both

listed products and OTC options. The

staff of the Division is preparing a

separate release which will propose for

comment further amendments to the net

capital rule to permit the use of

proprietary models to value listed

options.

B. Implied Volatilities

The TIMS model uses implied options

volatilities to calculate theoretical prices

of options. It was suggested that because

TIMS does not alter implied volatilities

as the theoretical price of the option

changes, the model overlooks an

important element that could have a

major effect on capital requirements. In

fact, requiring alteration of the implied

volatilities would cause numerous

additional computations without

substantial benefits given the wide

range in assumed underlying price

movements. The Commission notes,

however, that the amendments have

been liberalized and permit the use of

differing options pricing models. The

properties of each model can then be

evaluated during the model approval

process established in the amendments.

C. Underlying Price Movement

Assumptions

The proposed amendments included

underlying price movement

assumptions for the theoretical pricing

model that are consistent with the

volatility assumptions currently

incorporated in the net capital rule. The

Commission believes that requiring the

model to ‘‘shock’’ the portfolio in the

amounts currently incorporated into the

net capital rule is necessary to ensure

consistent treatment of options and the

underlying positions. Since the

amendments permit broker-dealers to

take haircuts on equities after taking

into consideration options on those

equities, broker-dealers with limited

options positions might seek to apply

the assumptions to all of their positions

(both equities and options) if the

options pricing amendments utilized

assumptions that were less robust than

those currently in the net capital rule for

the underlying positions. If this were

the case, broker-dealers could

potentially obtain more favorable

treatment on their equity positions than

currently contemplated by the net

capital rule.

The Commission notes that the 1994

No-Action Letter contained a reduction

in the underlying price movements for

non-clearing specialists and marketmakers to +(¥)41⁄2% for major market

foreign currency positions, +(¥)10% for

non-high-capitalization diversified

indexes, and +6(¥8)% for highcapitalization diversified indexes. In

that letter, the Division expressly

declined to extend this position to other

broker-dealers.17 The concession for

market-makers and non-clearing

specialists was based upon the

important role that non-clearing

specialists and market-makers perform

in maintaining fair and orderly markets.

The Commission is incorporating the

reduced requirements for market-makers

into the final rule in light of these

considerations, however, this

concession expires two years from the

effective date of the amendments unless
6478 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

it can be demonstrated by the nonclearing specialists and market-makers

that retention of reduced capital

requirements is in the public interest.

Therefore, the Commission is adopting

the minimum price movements

substantially as proposed.

Similarly, some commenters

suggested that the +(¥)10% price move

assumption for high-capitalization

diversified indexes (such as the S&P

500) was too high and should be

reduced. During the time the 1994 NoAction Letter has been in effect using a

+(¥)10% assumption, there does not

appear to have been any evidence of

liquidity or execution problems in the

option markets from application of this

assumption. The Commission notes that

this assumption is intended to cover the

risks of uncovered, out-of-the-money

option positions. Accordingly, the

amendment retains the +(¥)10%

underlying assumption for highcapitalization diversified indexes.

D. Permissible Offsets

The proposed amendments permitted

specified offsets between differing

categories of instruments. The rule

being adopted today maintains the

concept of specifying offsets, but with a

few significant changes. With respect to

the offset between qualified stock

baskets, the Commission received one

comment which contended that rather

than requiring that a basket contain a

certain minimum amount of stock to be

considered a qualified stock basket, the

rule should permit a broker-dealer to

convert every basket into a qualified

stock basket by taking a haircut on the

missing or excess stocks, depending on

whether too little or too much of a stock

was in the basket.

The Commission believes that the

better approach is to maintain the stock

basket capitalization requirement. The

purpose of the minimum capitalization

requirement is to ensure that a brokerdealer has a sufficient number of stocks

that match those in the index so that the

stocks correlate with the index. The

Commission, however, believes that a

decrease in the capitalization

requirement is appropriate.

Accordingly, under the rule

amendment, to be a qualified stock

basket, the basket must represent no less

than 50% of a diversified index’s

capitalization and, for a narrow-based

index, the basket must represent no less

than 95% capitalization. The proposed

amendments allowed offsets only

between the same type of indexes and

related positions. Commenters

suggested that offsets be allowed

between different diversified index

product groups, and the Commission

agrees it is appropriate to permit offsets

for positions among different diversified

index product groups. The groupings

and netting allowances are set forth

below.

In addition, questions have arisen

regarding the methodology that should

be used to designate indexes as highcapitalization diversified or non-high

capitalization diversified for purposes of

the rule. Set forth below is a list of those

indexes which are to be treated as high

capitalization diversified or non-high

capitalization diversified, and the

appropriate offsets. The offsets

designated in the groupings are based

on historical correlations. The

Commission recognizes that this

approach does not provide for the

treatment of new indexes, however, the

Commission intends to issue a release

which will set forth generic guidelines

for adding and deleting indexes (and

designating appropriate offsets) for

purposes of the net capital rule.

• U.S. Market Group A (i)

Institutional Index (‘‘XII’’), (ii) Major

Market Index (‘‘XMI’’), (iii) S&P 100

Index (‘‘OEX’’), (iv) S&P 500 Index

(‘‘SPX’’), (v) New York Stock Exchange

Composite Index (‘‘NYA’’), (vi) Big-Cap

Sector Index (‘‘MKT’’), and (vii) PHLX

US Top 100 Index (‘‘TPX’’). A 90%

offset is permitted between classes

within this product group, an 85%

offset with U.S. Market Group B, and a

50% offset with the non-high

capitalization diversified U.S. Market

Product Group and the U.S. NASD

Market Group.

• U.S. Market Group B (i) S&P Barra

Growth Index, and (ii) S&P Barra Value

Index. An 80% offset is permitted

within this product group, an 85%

offset with U.S. Market Group A, and a

50% offset with the non-high

capitalization diversified U.S. Market

Product Group and the U.S. NASD

Market Group.

• Japan Market Group A (i) Japan

Index (‘‘JPN’’), (ii) CBOE Nikkei 300

Index (‘‘NIK’’), and (iii) the Nikkei 225

Index (‘‘NK’’). A 90% offset is permitted

within this product group.

• Japan Market Group B consists of

the CBOE Japanese Export Warrant

Index.

• European Market Product Group

consists of the EuroTop 100 Index

(‘‘TOP’’).

• United Kingdom Market Product

Group consists of the Financial Times

Exchange Index (‘‘FT–SE’’).

The following indexes are designated

non high-capitalization diversified

market indexes:

• U.S. Market Product Group (i)

MidCap Index (‘‘MID’’), (ii) Russell 2000

Index (‘‘RUT’’), (iii) Value Line Index

(‘‘VLE’’), (iv) Wilshire 250 Index

(‘‘WSX’’), and (v) the S&P 600 Smallcap

Index (‘‘SML’’). A 75% offset is

permitted within this product group,

and a 50% offset with the U.S. NASD

Market Group and with highcapitalization diversified U.S. Market

Groups A and B.

• U.S. NASD Market Group (i)

NASDAQ 100 Index (‘‘NDX’’), and (ii)

National OTC Index (‘‘XOC’’). A 75%

offset is permitted within this product

group and a 50% offset with the U.S.

Market Product Group and with highcapitalization diversified U.S. Market

Groups A and B.

• Mexican Market Product Group

consists of the Index of Prices and

Quotations (‘‘IPC’’).

The following indexes are designated

narrow-based index options within the

following sector product groups.

• Bank Sector Product Group (i) S&P

Banking Index (‘‘BIX’’), and (ii) PHLX

KBW Bank Index (‘‘BKX’’). A 90% offset

is permitted within this product group.

• Technology Sector Product Group

(i) Morgan Stanley High Tech 35 Index

(‘‘MSH’’), (ii) PSE Technology Index

(‘‘PSE’’), (iii) CBOE Technology Index

(‘‘TXX’’), (iv) AMEX Computer

Technology Index (‘‘XCI’’), (v) Goldman

Sachs Technology Index (‘‘GSTI’’)

Composit Index (‘‘GTC’’), (vi) GSTI

Hardware Index (‘‘GHA’’), (vii) GSTI

Multimedia Network Index (‘‘GIP’’), and

(viii) GSTI Software Index (‘‘GSO’’). A

75% offset is permitted within this

group. In addition, the PSE may be

offset 75% with the U.S. NASD Market

Group.

• Internet Product Group (i) CBOE

Internet Index, (ii) AMEX Internet

Index, and (iii) GSTI Internet Index

(‘‘GIN’’). A 75% offset is permitted

within this group.

• Oil Product Group (i) CBOE Oil

Index (‘‘OIX’’), and (ii) AMEX Oil and

Gas Index (‘‘XOI’’). A 90% offset is

permitted within this product group.

• Gold Product Group (i) CBOE Gold

Index (‘‘GOX’’), and (ii) PHLX Gold/

Silver Index (‘‘XAU’’). A 90% offset is

permitted within this product group.

• Semiconductor Product Group (i)

PHLX Semiconductor Index (‘‘SOX’’),

and (ii) GSTI Semiconductor Index

(‘‘GSM’’). A 90% offset is permitted

within this product group.

• Semiconductor Product Group

(General) All remaining narrow-based

indexes. No offset is permitted within

this product group.

E. Minimum Charges

The minimum charge specified in the

rule is designed to account for

liquidation and decay risk in the prices

of long and short options in those
Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations 6479

18Letter from Lee A. Pickard, Director, Division

of Market Regulation, SEC, to Joseph W. Sullivan,

President, CBOE (April 8, 1977).

19Currently, paragraph (c)(2)(x)(F) of Rule 15c3–

1 provides that, if the haircuts for a particular

market-maker’s account exceed the equity in the

account, the carrying broker-dealer may not extend

further credit to the market-maker unless the

carrying broker-dealer requires the additional

deposit of sufficient equity to eliminate the net

capital charge.

20Although Section 601(b) of the Regulatory

Flexibility Act defines the term ‘‘small entity,’’ the

Continued

instances in which applications of the

theoretical pricing methodology results

in little or no capital requirement. One

commenter noted that the use of a

minimum charge of a 1⁄4 of a point was

a fair method of estimating the

liquidation risk of out-of-the-money

options. Another commenter indicated

that the impact of the minimum charge

was to cause spreads for out-of-themoney calls and puts to expand because

market-makers are reluctant to sell these

options.

Thus far, there is no evidence that

these concerns have been borne out,

however, the Commission intends to

monitor the impact of the amendments

and whether these concerns arise in

fact. In the meantime, the Commission

believes that the minimum charge

should be retained as proposed. The

rule as adopted, therefore, requires a

minimum charge of 1⁄4 of a point or

$25.00 per option contract assuming

that the basic equity option contract

covers 100 shares. To the extent that an

option or futures contract exceeds the

size of a basic option contract, the

minimum charge will be increased by

the additional percentage amount of

underlying units. For example, an

option or a futures contract on the S&P

500 Index covers 500 shares (rather than

100 shares for a basic equity option

contract) and therefore the minimum

charge would be $125.00 (5×$25.00).

In addition to the 1⁄4 of a point

minimum charge, the proposed

amendments required an additional

deduction of 10% for each qualified

stock basket of non-high-capitalization

diversified indexes, and 5% for each

qualified stock basket of highcapitalization diversified and narrowbased indexes for those positions

hedging an options or futures contract

subject to the minimum charge. In

response to concerns that, in the case of

non-high-capitalization indexes, the

10% charge was excessive, the

Commission believes it is appropriate to

decrease this charge to 7.5%. For highcapitalization indexes, the proposed 5%

charge will be adopted.

F. Alternative Strategy-Based

Methodology

The proposed amendments provided

that broker-dealers could elect to use the

alternative strategy-based method for

calculating haircuts. One commenter

contended that the alternative strategybased methodology contained in the

proposal, because it contained very few

simple strategies, would impose

haircuts on a trading book which are

larger than the haircuts in the current

rule. The commenter recommended that

the Commission explore the possibility

of adopting a strategy-based calculation

that would include common strategies

currently used by firms.

The Commission notes that the new

rule is designed in part to eliminate the

complicated overlay of strategies and

interpretations that developed out of the

necessity to accommodate all dealer

options strategies. To attempt to

recognize many classes of strategies in

the alternative section would result in a

return to the system the Commission is

revising today. Hence, the Commission

believes that a simple strategy-based

alternative should be retained in the

rule. Limiting the alternative to simple

strategies will tend to encourage firms

with any options positions of substance

to utilize the pricing model

methodology. Because the recognized

strategies in the alternative section are

minimal, limited hedges will be

recognized with the result that a book of

any significance will incur larger

charges under the strategy-based

method than the options pricing

methodology. This will provide an

economic incentive for firms active in

options to develop the capability to use

up-to-date modelling techniques.

G. Clearing Firm Capital Deposits

The net capital rule requires brokerdealers carrying the accounts of listed

options specialists to take capital

charges reflecting haircuts required due

to specialists’ trading activity. The

capital rule historically has required the

clearing firm to take the required charge

as of the close of business each day to

ensure it has sufficient capital to open

the next morning. However, the carrying

firm generally will not know the full

extent of its requirements as to its

specialists until that next morning.

Generally, clearing firms will seek to

bring in money, either from the

specialist or from elsewhere during the

morning. This is a conservative charge

considering the rule’s usual acceptance

of allowing time for margin calls. To

remedy this, the proposal allowed the

clearing firm until noon to obtain funds

or arrange financing. All of the

commenters who addressed the issue

supported it; accordingly, the

Commission is adopting the provision

with the clarification that ‘‘noon’’ is

determined according to the local time

where the carrying firm has its

headquarters. In any event, this

provision will not be available for a

market-maker account in deficit.

III. Technical Amendments to the Rule

As noted in the Proposing Release, in

connection with the adoption of the

amendments, the Commission is making

the following technical amendments to

the net capital rule necessitated by the

new amendments and to codify a longstanding staff interpretation:

A. Deletion of Paragraph (a)(7) of the

Net Capital Rule

As previously stated, the net capital

rule, as it currently is written, contains

two haircut methodologies, the

premium-based approach set forth in

Rule 15c3–1(c)(2)(x) and the approach

embodied in Appendix A to Rule 15c3–

1. Currently, pursuant to the provisions

of paragraph (a)(7) of the net capital

rule, the premium-based approach is

available to a clearing firm if its

business is limited almost exclusively to

effecting (either directly or as agent) and

clearing market-making transactions in

listed options.

The final rule deletes paragraph (a)(7)

of the net capital rule. The Commission

believes that this provision is no longer

necessary because the final rule

eliminates the distinction between the

premium-based approach set forth in

15c3–1(c)(2)(x) and the approach set

forth in Appendix A to 17 CFR

240.15c3–1.

B. Steps To Be Taken by a Broker-Dealer

Carrying the Account of an Option

Market-Maker When Equity in That

Account is Insufficient to Cover

Haircuts

Pursuant to an interpretation letter,18

carrying broker-dealers may extend

credit in a market-maker account even

when haircuts for that account exceed

the equity in the account.19 This

interpretation is conditioned upon the

carrying broker-dealer taking a charge

against its capital to the extent that the

equity in the market-maker’s account is

insufficient to cover the haircuts. The

amendments incorporate this

interpretation into the net capital rule.

IV. Summary of the Final Regulatory

Flexibility Analysis

The Regulatory Flexibility Act, which

became effective on January 1, 1981,

imposes procedural steps applicable to

agency rule making which has a

‘‘significant economic impact on a

substantial number of small entities.’’ 20
6480 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

statute permits agencies to formulate their own

definitions. The Commission has adopted

definitions of the term ‘‘small entity’’ for purposes

of Commission rulemaking in accordance with the

Regulatory Flexibility Act. Those definitions are set

forth in Rule 0–10, 17 CFR 240.0–10. See Securities

Exchange Act Release No. 18452 (January 28, 1982),

47 FR 5215 (February 4, 1982). A broker-dealer is

a ‘‘small business’’ or ‘‘small organization’’ under

Rule 0–10, if the broker-dealer (i) had total capital

(net worth plus subordinated liabilities) of less than

$500,000 on the date in the prior fiscal year as of

which its audited financial statements were

prepared pursuant to 17 CFR 240.17–5(d) or, if not

required to file such statements, a broker-dealer that

had total net capital (net worth plus subordinated

liabilities) of less than $500,000 on the last business

day of the preceding fiscal year (or in the time that

it has been in business, if shorter); and (ii) is not

affiliated with any person (other than a natural

person) that is not a small business or small

organization as defined in 17 CFR 240.0–10.

21 44 U.S.C. § 3501 et seq.

22See Rule 15c3–1(c)(2)(x).

The Commission has prepared a Final

Regulatory Flexibility Analysis

(‘‘Analysis’’) in accordance with 5

U.S.C. § 604 regarding the amendments.

The Analysis states that the Commission

did not receive any comments

concerning the Initial Regulatory

Flexibility Analysis.

The Analysis notes that the

amendments implement a haircut

methodology which employs a

mathematical formula to determine the

theoretical value of options. The

purpose of the amendments is to make

haircuts more accurately reflect the risks

associated with dealer option positions

than is possible under the current rule

and to simplify the net capital rule’s

treatment of options for capital

purposes. The amendments permit the

use of a model (other than a proprietary

model) maintained and operated by a

third-party source, including OCC, and

approved according to the terms of the

amendments. The amendments will

impact approximately 247 ‘‘small

entities’’ which are subject to the

provisions of Rule 15c3–1 and have

listed options positions insofar as they

would be required to implement a

computer interface with a third-party

vendor in order to receive reliable data

to calculate haircuts. The Commission

recognizes, however, that some brokerdealers with very limited options

positions might find it cost prohibitive

to install such computerized interface

with a model provider. In order to

reduce the economic impact on these

broker-dealers, the amendments include

an alternative haircut methodology that

is based on the basic options strategies

used by broker-dealers, and is similar to

the approach used in the current rule.

The Analysis also states that no

federal securities laws duplicate,

overlap, or conflict with the

amendments, and adds that the

Commission does not believe any less

burdensome alternatives are available to

accomplish the objectives of the

amendments. In addition, the Analysis

notes that the staff carefully considered

the possibility that smaller brokerdealers who elect the strategy-based

approach may receive more severe

haircut treatment than under the current

rule because the strategy-based

approach under the amendments is

limited to a few very simple strategies.

Because the Commission intended to

eliminate the complicated overlay of

strategies and interpretations that

developed under the former rule to

accommodate all dealer options

strategies, and because smaller brokerdealers which elect the alternate

approach will not be required to incur

the costs associated with adopting a

new system to employ models, the

Commission believes the amendments

should have a minimal adverse impact

on small businesses or small

organizations. As such, the amendments

contain no additional reporting,

recordkeeping, or other compliance

requirements. For additional

information, a copy of the Analysis may

be obtained by contacting Peter

Geraghty (202/942–0177) or Louis A.

Randazzo (202/942–0191), Division of

Market Regulation, Securities and

Exchange Commission, Washington,

D.C. 20549.

V. Paperwork Reduction Act

The text of the amendments contain

‘‘collection of information’’

requirements within the meaning of the

Paperwork Reduction Act of 1995

(‘‘PRA’’).21 Broker-dealers subject to the

rule are required to notify the

Commission and the appropriate

designated examining authority

whenever their level of net capital falls

below a prescribed level for any period

exceeding three business days, and

whenever there is a liquidating deficit

in a specialist’s market-maker account.

These same notification obligations

exist under the present rule before

adoption of the amendments.22

Consequently, the amendment does not

change the PRA collection of

information requirements or burden

under Rule 15c3–1. The Commission

recently received an extension from the

Office of Management and Budget

(‘‘OMB’’) for the collection of

information requirements contained in

Rule 15c3–1. The title of the collection

of information is ‘‘Net Capital

Requirements for Brokers and Dealers,

Rule 15c3–1.’’ The OMB control number

is 3235–0200. The Commission also

reminds brokers and dealers subject to

the amendments about their related

recordkeeping obligations under Rule

17a–4.

VI. Statutory Analysis

Pursuant to the Securities Exchange

Act of 1934 and particularly Section

15(c)(3), (15 U.S.C. 78o(c)(3)) thereof,

the Commission is adopting

amendments to § 240.15c3–1 of Title 17

of the Code of Federal Regulations in

the manner set forth below.

List of Subjects in 17 CFR Part 240

Brokers, Reporting and recordkeeping

requirements, Securities.

Text of Final Rule

In accordance with the foregoing,

Title 17, chapter II, part 240 of the Code

of Federal Regulations is amended as

follows:

Part 240—GENERAL RULES AND

REGULATIONS, SECURITIES

EXCHANGE ACT OF 1934

1. The authority citation for Part 240

continues to read in part as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j,

77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c,

78d, 78f, 78i, 78j, 78k, 78k–1, 78l, 78m, 78n,

78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q,

79t, 80a–20, 80a–23, 80a–29, 80a–37, 80b–3,

80b–4 and 80b–11, unless otherwise noted.

* * * * *

2. Section 240.15c3–1 is amended by

removing and reserving paragraph (a)(7).

3. Section 240.15c3–1 is amended by

adding an undesignated center heading

before paragraph (c)(2)(x) and revising

paragraph (c)(2)(x) to read as follows:

§ 240.15c3–1 Net capital requirements for

brokers or dealers.

* * * * *

(c) * * *

(2) * * *

Brokers or Dealers Carrying Accounts of

Listed Options Specialists

(x)(A) With respect to any transaction

of a specialist in listed options, who is

either not otherwise subject to the

provisions of this section or is described

in paragraph (c)(2)(vi)(N) of this section,

for whose specialist account a broker or

dealer acts as a guarantor, endorser, or

carrying broker or dealer, such broker or

dealer shall adjust its net worth by

deducting as of noon of each business

day the amounts computed as of the

prior business day pursuant to

§ 240.15c3–1a. The required deductions

may be reduced by any liquidating

equity that exists in such specialist’s

market-maker account as of that time

and shall be increased to the extent of

any liquidating deficit in such account.

Noon shall be determined according to
Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations 6481

the local time where the broker or dealer

is headquartered. In no event shall

excess equity in the specialist’s marketmaker account result in an increase of

the net capital of any such guarantor,

endorser, or carrying broker or dealer.

(B) 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) For purposes of this section, the

equity in an individual specialist’s

market-maker account shall be

computed by:

(i) Marking all securities positions

long or short in the account to their

respective current market values;

(ii) Adding (deducting in the case of

a debit balance) the credit balance

carried in such specialist’s marketmaker account; and

(iii) Adding (deducting in the case of

short positions) the market value of

positions long in such account.

(C) No guarantor, endorser, or

carrying broker or dealer shall permit

the sum of the deductions required

pursuant to § 240.15c3–1a in respect of

all transactions in specialists’ marketmaker accounts guaranteed, endorsed,

or carried by such broker or dealer to

exceed 1,000 percent of such broker’s or

dealer’s net capital as defined in

§ 240.15c3–1(c)(2) for any period

exceeding three business days. If at any

time such sum exceeds 1,000 percent of

such broker’s or dealer’s net capital,

then the broker or dealer shall:

(1) Immediately transmit telegraphic

or facsimile notice of such event to the

Division of Market Regulation in the

headquarters office of the Commission

in Washington, D.C., to the district or

regional office of the Commission for

the district or region in which the

broker or dealer maintains its principal

place of business, and to its examining

authority designated pursuant to section

17(d) of the Act (15 U.S.C. 78q(d))

(‘‘Designated Examining Authority’’);

and

(2) Be subject to the prohibitions

against withdrawal of equity capital set

forth in § 240.15c3–1(e) and to the

prohibitions against reduction,

prepayment, and repayment of

subordination agreements set forth in

paragraph (b)(11) of § 240.15c3–1d, as if

such broker or dealer’s net capital were

below the minimum standards specified

by each of those paragraphs.

(D) If at any time there is a liquidating

deficit in a specialist’s market-maker

account, then the broker or dealer

guaranteeing, endorsing, or carrying

listed options transactions in such

specialist’s market-maker account may

not extend any further credit in that

account, and shall take steps to

liquidate promptly existing positions in

the account. This paragraph shall not

prevent the broker or dealer from, upon

approval by the broker’s or dealer’s

Designated Examining Authority,

entering into hedging positions in the

specialist’s market-maker account. The

broker or dealer also shall transmit

telegraphic or facsimile notice of the

deficit and its amount by the close of

business of the following business day

to its Designated Examining Authority

and the Designated Examining

Authority of the specialist, if different

from its own.

(E) Upon written application to the

Commission by the specialist and the

broker or dealer guaranteeing,

endorsing, or carrying options

transactions in such specialist’s marketmaker account, the Commission may

approve upon specified terms and

conditions lesser adjustments to net

worth than those specified in

§ 240.15c3–1a.

* * * * *

4. Section 240.15c3–1a is revised to

read as follows:

§ 240.15c3–1a Options (Appendix A to 17

CFR 240.15c3–1).

(a) Definitions. (1) The term unlisted

option shall mean any option not

included in the definition of listed

option provided in paragraph (c)(2)(x) of

§ 240.15c3–1.

(2) The term option series refers to

listed option contracts of the same type

(either a call or a put) and exercise style,

covering the same underlying security

with the same exercise price, expiration

date, and number of underlying units.

(3) The term related instrument

within an option class or product group

refers to futures contracts and options

on futures contracts covering the same

underlying instrument. In relation to

options on foreign currencies a related

instrument within an option class also

shall include forward contracts on the

same underlying currency.

(4) The term underlying instrument

refers to long and short positions, as

appropriate, covering the same foreign

currency, the same security, or a

security which is exchangeable for or

convertible into the underlying security

within a period of 90 days. If the

exchange or conversion requires the

payment of money or results in a loss

upon conversion at the time when the

security is deemed an underlying

instrument for purposes of this

Appendix A, the broker or dealer will

deduct from net worth the full amount

of the conversion loss. The term

underlying instrument shall not be

deemed to include securities options,

futures contracts, options on futures

contracts, qualified stock baskets, or

unlisted instruments.

(5) The term options class refers to all

options contracts covering the same

underlying instrument.

(6) The term product group refers to

two or more option classes, related

instruments, underlying instruments,

and qualified stock baskets in the same

portfolio type (see paragraph (b)(1)(ii) of

this section) for which it has been

determined that a percentage of

offsetting profits may be applied to

losses at the same valuation point.

(b) The deduction under this

Appendix A to § 240.15c3–1 shall equal

the sum of the deductions specified in

paragraphs (b)(1)(v)(C) or (b)(2) of this

section.

Theoretical Pricing Charges

(1)(i) Definitions.

(A) The terms theoretical gains and

losses shall mean the gain and loss in

the value of individual option series, the

value of underlying instruments, related

instruments, and qualified stock baskets

within that option’s class, at 10

equidistant intervals (valuation points)

ranging from an assumed movement

(both up and down) in the current

market value of the underlying

instrument equal to the percentage

corresponding to the deductions

otherwise required under § 240.15c3–1

for the underlying instrument (See

paragraph (a)(1)(iii) of this section).

Theoretical gains and losses shall be

calculated using a theoretical options

pricing model that satisfies the criteria

set forth in paragraph (a)(1)(i)(B) of this

section.

(B) The term theoretical options

pricing model shall mean any

mathematical model, other than a

broker-dealer proprietary model,

approved by a Designated Examining

Authority. Such Designated Examining

Authority shall submit the model to the

Commission, together with a description

of its methods for approving models.

Any such model shall calculate

theoretical gains and losses as described

in paragraph (a)(1)(i)(A) of this section

for all series and issues of equity, index

and foreign currency options and

related instruments, and shall be made

available equally and on the same terms

to all registered brokers or dealers. Its

procedures shall include the

arrangement of the vendor to supply

accurate and timely data to each brokerdealer with respect to its services, and

the fees for distribution of the services.

The data provided to brokers or dealers

shall also contain the minimum

requirements set forth in paragraphs

(b)(1)(v)(C) of this section and the
6482 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

product group offsets set forth in

paragraphs (b)(1)(v)(B) of this section.

At a minimum, the model shall consider

the following factors in pricing the

option:

(1) The current spot price of the

underlying asset;

(2) The exercise price of the option;

(3) The remaining time until the

option’s expiration;

(4) The volatility of the underlying

asset;

(5) Any cash flows associated with

ownership of the underlying asset

that can reasonably be expected to

occur during the remaining life of

the option; and

(6) The current term structure of interest

rates.

(C) The term major market foreign

currency shall mean the currency of a

sovereign nation whose short-term debt

is rated in one of the two highest

categories by at least two nationally

recognized statistical rating

organizations and for which there is a

substantial inter-bank forward currency

market. For purposes of this section, the

European Currency Unit (ECU) shall be

deemed a major market foreign

currency.

(D) The term qualified stock basket

shall mean a set or basket of stock

positions which represents no less than

50% of the capitalization for a highcapitalization or non-high-capitalization

diversified market index, or, in the case

of a narrow-based index, no less than

95% of the capitalization for such

narrow-based index.

(ii) With respect to positions

involving listed options in a single

specialist’s market-maker account, and,

separately, with respect to positions

involving listed option positions in its

proprietary or other account, the broker

or dealer shall group long and short

positions into the following portfolio

types:

(A) Equity options on the same

underlying instrument and positions in

that underlying instrument;

(B) Options on the same major market

foreign currency, positions in that major

market foreign currency, and related

instruments within those options’

classes;

(C) High-capitalization diversified

market index options, related

instruments within the option’s class,

and qualified stock baskets in the same

index;

(D) Non-high-capitalization

diversified index options, related

instruments within the index option’s

class, and qualified stock baskets in the

same index; and

(E) Narrow-based index options,

related instruments within the index

option’s class, and qualified stock

baskets in the same index.

(iii) Before making the computation,

each broker or dealer shall obtain the

theoretical gains and losses for each

options series and for the related and

underlying instruments within those

options’ class in each specialist’s

market-maker account guaranteed,

endorsed, or carried by a broker or

dealer, or in the proprietary or other

accounts of that broker or dealer. For

each option series, the theoretical

options pricing model shall calculate

theoretical prices at 10 equidistant

valuation points within a range

consisting of an increase or a decrease

of the following percentages of the daily

market price of the underlying

instrument:

(A) +(¥)15% for equity securities with

a ready market, narrow-based

indexes, and non-highcapitalization diversified indexes;

(B) +(¥)6% for major market foreign

currencies;

(C) +(¥) 20% for all other currencies;

and

(D) +(¥)10% for high-capitalization

diversified indexes.

(iv)(A) As to non-clearing option

specialists and market-makers, the

percentages of the daily market price of

the underlying instrument shall be:

(1) +(¥) 41⁄2% for major market foreign

currencies; and

(2) +6(¥)8% for high-capitalization

diversified indexes.

(3) +(¥) 10% for a non-clearing marketmaker, or specialist in non-high

capitalization diversified index

product group.

(B) The provisions of this paragraph

(b)(1)(iv) shall expire two years from

September 1, 1997, unless otherwise

extended by the Commission.

(v)(A) The broker or dealer shall

multiply the corresponding theoretical

gains and losses at each of the 10

equidistant valuation points by the

number of positions held in a particular

options series, the related instruments

and qualified stock baskets within the

option’s class, and the positions in the

same underlying instrument.

(B) In determining the aggregate profit

or loss for each portfolio type, the

broker or dealer will be allowed the

following offsets in the following order,

provided, that in the case of qualified

stock baskets, the broker or dealer may

elect to net individual stocks between

qualified stock baskets and take the

appropriate deduction on the remaining,

if any, securities:

(1) First, a broker or dealer is allowed

the following offsets within an option’s

class:

(i) Between options on the same

underlying instrument, positions

covering the same underlying

instrument, and related instruments

within the option’s class, 100% of a

position’s gain shall offset another

position’s loss at the same valuation

point;

(ii) Between index options, related

instruments within the option’s class,

and qualified stock baskets on the same

index, 95%, or such other amount as

designated by the Commission, of gains

shall offset losses at the same valuation

point;

(2) Second, a broker-dealer is allowed

the following offsets within an index

product group:

(i) Among positions involving

different high-capitalization diversified

index option classes within the same

product group, 90% of the gain in a

high-capitalization diversified market

index option, related instruments, and

qualified stock baskets within that index

option’s class shall offset the loss at the

same valuation point in a different highcapitalization diversified market index

option, related instruments, and

qualified stock baskets within that index

option’s class;

(ii) Among positions involving

different non-high-capitalization

diversified index option classes within

the same product group, 75% of the gain

in a non-high-capitalization diversified

market index option, related

instruments, and qualified stock baskets

within that index option’s class shall

offset the loss at the same valuation

point in another non-high-capitalization

diversified market index option, related

instruments, and qualified stock baskets

within that index option’s class or

product group;

(iii) Among positions involving

different narrow-based index option

classes within the same product group,

90% of the gain in a narrow-based

market index option, related

instruments, and qualified stock baskets

within that index option’s class shall

offset the loss at the same valuation

point in another narrow-based market

index option, related instruments, and

qualified stock baskets within that index

option’s class or product group;

(iv) No qualified stock basket should

offset another qualified stock basket;

and

(3) Third, a broker-dealer is allowed

the following offsets between product

groups: Among positions involving

different diversified index product

groups within the same market group,

50% of the gain in a diversified market

index option, a related instrument, or a

qualified stock basket within that index

option’s product group shall offset the
Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations 6483

loss at the same valuation point in

another product group;

(C) For each portfolio type, the total

deduction shall be the larger of:

(1) The amount for any of the 10

equidistant valuation points

representing the largest theoretical loss

after applying the offsets provided in

paragraph (b)(1)(v)(B) if this section; or

(2) A minimum charge equal to 25%

times the multiplier for each equity and

index option contract and each related

instrument within the option’s class or

product group, or $25 for each option on

a major market foreign currency with

the minimum charge for futures

contracts and options on futures

contracts adjusted for contract size

differentials, not to exceed market value

in the case of long positions in options

and options on futures contracts; plus

(3) In the case of portfolio types

involving index options and related

instruments offset by a qualified stock

basket, there will be a minimum charge

of 5% of the market value of the

qualified stock basket for highcapitalization diversified and narrowbased indexes; and

(4) In the case of portfolio types

involving index options and related

instruments offset by a qualified stock

basket, there will be a minimum charge

of 71⁄2% of the market value of the

qualified stock basket for non-highcapitalization diversified indexes.

Alternative Strategy Based Method

(2) A broker or dealer may elect to

apply the alternative strategy based

method in accordance with the

provisions of this paragraph (b)(2).

(i) Definitions. (A) The term intrinsic

value or in-the-money amount shall

mean the amount by which the exercise

value, in the case of a call, is less than

the current market value of the

underlying instrument, and, in the case

of a put, is greater than the current

market value of the underlying

instrument.

(B) The term out-of-the-money

amount shall mean the amount by

which the exercise value, in the case of

a call, is greater than the current market

value of the underlying instrument, and,

in the case of a put, is less than the

current market value of the underlying

instrument.

(C) The term time value shall mean

the current market value of an option

contract that is in excess of its intrinsic

value.

(ii) Every broker or dealer electing to

calculate adjustments to net worth in

accordance with the provisions of this

paragraph (b)(2) must make the

following adjustments to net worth:

(A) Add the time value of a short

position in a listed option; and

(B) Deduct the time value of a long

position in a listed option, which relates

to a position in the same underlying

instrument or in a related instrument

within the option class or product group

as recognized in the strategies

enumerated in paragraph (b)(2)(iii)(D) of

this section; and

(C) Add the net short market value or

deduct the long market value of listed

options as recognized in the strategies

enumerated in paragraphs

(b)(2)(iii)(E)(1) and (2) of this section.

(iii) In computing net capital after the

adjustments provided for in paragraph

(b)(2)(ii) of this section, every broker or

dealer shall deduct the percentages

specified in this paragraph (b)(2)(iii) for

all listed option positions, positions

covering the same underlying

instrument and related instruments

within the options’ class or product

group.

Uncovered Calls

(A) Where a broker or dealer is short

a call, deducting the percentage

required by paragraphs (c)(2)(vi) (A)

through (K) of § 240.15c3–1 of the

current market value of the underlying

instrument for such option reduced by

its out-of-the-money amount, to the

extent that such reduction does not

operate to increase net capital. In no

event shall this deduction be less than

the greater of $250 for each short call

option contract for 100 shares or 50% of

the aforementioned percentage.

Uncovered Puts

(B) Where a broker or dealer is short

a put, deducting the percentage required

by paragraphs (c)(2)(vi) (A) through (K)

of § 240.15c3–1 of the current market

value of the underlying instrument for

such option reduced by its out-of-themoney amount, to the extent that such

reduction does not operate to increase

net capital. In no event shall the

deduction provided by this paragraph

be less than the greater of $250 for each

short put option contract for 100 shares

or 50% of the aforementioned

percentage.

Long Positions

(C) Where a broker or dealer is long

puts or calls, deducting 50 percent of

the market value of the net long put and

call positions in the same options series.

Certain Security Positions With

Offsetting Options

(D)(1) Where a broker or dealer is long

a put for which it has an offsetting long

position in the same number of units of

the same underlying instrument,

deducting the percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1 of the current market value

of the underlying instrument for the

long offsetting position, not to exceed

the out-of-the-money amount of the

option. In no event shall the deduction

provided by this paragraph be less than

$25 for each option contract for 100

shares, provided that the minimum

charge need not exceed the intrinsic

value of the option.

(2) Where a broker or dealer is long

a call for which it has an offsetting short

position in the same number of units of

the same underlying instrument,

deducting the percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1 of the current market value

of the underlying instrument for the

short offsetting position, not to exceed

the out-of-the-money amount of the

option. In no event shall the deduction

provided by this paragraph be less than

$25 for each option contract for 100

shares, provided that the minimum

charge need not exceed the intrinsic

value of the option.

(3) Where a broker or dealer is short

a call for which it has an offsetting long

position in the same number of units of

the same underlying instrument,

deducting the percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1 of the current market value

of the underlying instrument for the

offsetting long position reduced by the

short call’s intrinsic value. In no event

shall the deduction provided by this

paragraph be less than $25 for each

option contract for 100 shares.

Certain Spread Positions

(E)(1) Where a broker or dealer is

short a listed call and is also long a

listed call in the same class of options

contracts and the long option expires on

the same date as or subsequent to the

short option, the deduction, after

adjustments required in paragraph (b) of

this section, shall be the amount by

which the exercise value of the long call

exceeds the exercise value of the short

call. If the exercise value of the long call

is less than or equal to the exercise

value of the short call, no deduction is

required.

(2) Where a broker or dealer is short

a listed put and is also long a listed put

in the same class of options contracts

and the long option expires on the same

date as or subsequent to the short

option, the deduction, after the

adjustments required in paragraph (b) of

this section, shall be the amount by

which the exercise value of the short

put exceeds the exercise value of the

long put. If the exercise value of the

long put is equal to or greater than the
6484 Federal Register / Vol. 62, No. 29 / Wednesday, February 12, 1997 / Rules and Regulations

exercise value of the short put, no

deduction is required.

(c) With respect to transactions

involving unlisted options, every broker

or dealer shall determine the value of

unlisted option positions in accordance

with the provision of paragraph (c)(2)(i)

of § 240.15c3–1, and shall deduct the

percentages of all securities positions or

unlisted options in the proprietary or

other accounts of the broker or dealer

specified in this paragraph (c). However,

where computing the deduction

required for a security position as if the

security position had no related unlisted

option position and positions in

unlisted options as if uncovered would

result in a lesser deduction from net

worth, the broker or dealer may

compute such deductions separately.

Uncovered Calls

(1) Where a broker or dealer is short

a call, deducting 15 percent (or such

other percentage required by paragraphs

(c)(2)(vi) (A) through (K) of § 240.15c3–

1) of the current market value of the

security underlying such option

reduced by any excess of the exercise

value of the call over the current market

value of the underlying security. In no

event shall the deduction provided by

this paragraph be less than $250 for

each option contract for 100 shares.

Uncovered Puts

(2) Where a broker or dealer is short

a put, deducting 15 percent (or such

other percentage required by paragraphs

(c)(2)(vi) (A) through (K) of § 240.15c3–

1) of the current market value of the

security underlying the option reduced

by any excess of the market value of the

underlying security over the exercise

value of the put. In no event shall the

deduction provided by this paragraph

be less than $250 for each option

contract for 100 shares.

Covered Calls

(3) Where a broker or dealer is short

a call and long equivalent units of the

underlying security, deducting 15

percent (or such other percentage

required by paragraphs (c)(2)(vi) (A)

through (K) of § 240.15c3–1) of the

current market value of the underlying

security reduced by any excess of the

current market value of the underlying

security over the exercise value of the

call. No reduction under this paragraph

shall have the effect of increasing net

capital.

Covered Puts

(4) Where a broker or dealer is short

a put and short equivalent units of the

underlying security, deducting 15

percent (or such other percentage

required by paragraphs (c)(2)(vi) (A)

through (K) of § 240.15c3–1) of the

current market value of the underlying

security reduced by any excess of the

exercise value of the put over the market

value of the underlying security. No

such reduction shall have the effect of

increasing net capital.

Conversion Accounts

(5) Where a broker or dealer is long

equivalent units of the underlying

security, long a put written or endorsed

by a broker or dealer and short a call in

its proprietary or other accounts,

deducting 5 percent (or 50 percent of

such other percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1) of the current market

value of the underlying security.

(6) Where a broker or dealer is short

equivalent units of the underlying

security, long a call written or endorsed

by a broker or dealer and short a put in

his proprietary or other accounts,

deducting 5 percent (or 50 percent of

such other percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1) of the market value of the

underlying security.

Long Options

(7) Where a broker or dealer is long

a put or call endorsed or written by a

broker or dealer, deducting 15 percent

(or such other percentage required by

paragraphs (c)(2)(vi) (A) through (K) of

§ 240.15c3–1) of the market value of the

underlying security, not to exceed any

value attributed to such option in

paragraph (c)(2)(i) of § 240.15c3–1.

By the Commission.

Dated: February 6, 1997.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–3479 Filed 2–11–97; 8:45 am]

BILLING CODE 8010–01–P

DEPARTMENT OF TRANSPORTATION

Coast Guard

33 CFR Part 117

[CGDO1–95–171]

RIN 2115–AE47

Drawbridge Operation Regulations;

Passaic River, New Jersey

AGENCY: Coast Guard, DOT.

ACTION: Final rule.

SUMMARY: The Coast Guard is changing

the regulations governing the Routes 1

& 9 (Lincoln Highway) Bridge, mile 1.8,

the Point-No-Point Railroad Bridge, mile

2.6, both in Newark, New Jersey, and

the Route 7 (Rutgers Street) Bridge, mile

8.9, in Belleville, New Jersey which

cross the Passaic River. The change will

provide openings on signal if at least

four hours notice is given. This change

was requested by the Consolidated Rail

Corporation (CONRAIL) and New Jersey

Department of Transportation (NJDOT)

because of the limited openings of these

bridges. This action will relieve the

bridge owners of the burden of having

personnel constantly available to open

the bridges and should provide for the

reasonable needs of navigation. Other

changes remove redundant

requirements that are included in the

Part 117 general operating regulations,

provide maximum allowable time

delays for specific railroad bridge

openings, remove unnecessary language,

and reorder the paragraphs for clarity

and consistency.

EFFECTIVE DATE: March 14, 1997.

ADDRESSES: Documents referred to in

this preamble are available by writing to

the First Coast Guard District, Bridge

Branch at Bldg. 135A, Governors Island,

New York 10004–5073. The telephone

number is (212) 668–7994.

FOR FURTHER INFORMATION CONTACT: Gary

Kassof, Chief, Bridge Branch, (212) 668–

7021.

SUPPLEMENTARY INFORMATION:

Regulatory History

On June 21, 1996, the Coast Guard

published a notice of proposed

rulemaking entitled ‘‘Drawbridge

Operation Regulations; Passaic River,

New Jersey’’ in the Federal Register (61

FR 31881). The Coast Guard received

three comments on the notice of

proposed rulemaking. No public hearing

was requested, and none was held.

Background and Purpose

The Routes 1 & 9 (Lincoln Highway),

Point-No-Point Railroad, and Route 7

(Rutgers Street) Bridges have respective

vertical clearances, when in the closed

position, of 40′, 16′, and 8′ above mean

high water (MHW). All three bridges

had previously been required to open on

signal. This rule will permit these

bridges to open on signal if at least four

hours notice is given.

Due to the closure of the River Oil

Terminal in August, 1992, requests for

openings of bridges across the Passaic

River have decreased. For the years

1992, 1993, and 1994, the Routes 1 & 9

(Lincoln Highway) Bridge opened 95, 35

and 29 times, respectively, for vessel

transits; the Point-No-Point Bridge

opened 243, 145 and 124 times; the

Route 7 (Rutgers Street) Bridge opened

129, 161 and 169 times. The previous

regulations are being changed to provide