Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules 66569

1Regulation 33.4 in pertinent part states:

Sec. 33.4 Designation as a contract market for the

trading of commodity options.

The Commission may designate any board of

trade * * * as a contract market for the trading of

options on contracts of sale for future delivery

* * * when the applicant complies with and

carries out the requirements of the Act (as provided

in § 33.2), these relations, and the following

conditions and requirements with respect to the

commodity option for which the designation is

sought:

(a) Such board of trade * * *

(2) Provides that the clearing organization must

receive from each of its clearing members, that each

clearing member must receive from each other

person for whom its clears commodity option

transactions, and that each futures commission

merchant must receive from each of its option

customers, the full amount of each option premium

at the time the option is purchased.

or repaired so that the performance of the

requirements of this AD is affected, the

owner/operator must request approval for an

alternative method of compliance in

accordance with paragraph (d) of this AD.

The request should include an assessment of

the effect of the modification, alteration, or

repair on the unsafe condition addressed by

this AD; and, if the unsafe condition has not

been eliminated, the request should include

specific proposed actions to address it.

Compliance: Required as indicated in the

body of this AD, unless already

accomplished.

To prevent failure of the elevator pushrod

caused by corrosion damage, which could

result in loss of control of the sailplane,

accomplish the following:

(a) Within the next 3 calendar months after

the effective date of this AD, drill a drainage

hole in the elevator pushrod in accordance

with Alexander Schleicher Technical Note

No. 26, dated July 1, 1993.

(b) Within the next 3 calendar months after

the effective date of this AD, inspect the

elevator pushrod for corrosion damage in

accordance with Alexander Schleicher

Technical Note No. 26, dated July 1, 1993.

(1) If no corrosion damage is found or

corrosion damage is found that does not

exceed the amount specified in the service

bulletin, prior to further flight after the

inspection required by paragraph (b) of this

AD, apply a corrosion agent as described in

the service bulletin.

(2) If corrosion damage is found that

exceeds the amount specified in the service

bulletin, prior to further flight after the

inspection required by paragraph (b) of this

AD, replace the elevator pushrod in

accordance with the maintenance manual,

and apply a corrosion agent as described in

the service bulletin.

(c) Special flight permits may be issued in

accordance with sections 21.197 and 21.199

of the Federal Aviation Regulations (14 CFR

21.197 and 21.199) to operate the sailplane

to a location where the requirements of this

AD can be accomplished.

(d) An alternative method of compliance or

adjustment of the compliance time that

provides an equivalent level of safety may be

approved by the Manager, Small Airplane

Directorate, FAA, 1201 Walnut, suite 900,

Kansas City, Missouri 64106. The request

shall be forwarded through an appropriate

FAA Maintenance Inspector, who may add

comments and then send it to the Manager,

Small Airplane Directorate.

Note 2: Information concerning the

existence of approved alternative methods of

compliance with this AD, if any, may be

obtained from the Small Airplane

Directorate.

(e) Questions or technical information

related to Alexander Schleicher Technical

Note No. 26, dated July 1, 1993, should be

directed to Alexander Schleicher

Segelflugzeugbau, 6416 Poppenhausen,

Wasserkuppe, Federal Republic of Germany;

telephone: 49.6658.890 or 49.6658.8920;

facsimile: 49.6658.8923 or 49.6658.8940.

This service information may be examined at

the FAA, Central Region, Office of the

Regional Counsel, Room 1558, 601 E. 12th

Street, Kansas City.

Note 3: The subject of this AD is addressed

in German AD No. 93–186, dated September

15, 1993.

Issued in Kansas City, Missouri, on

December 11, 1997.

Michael Gallagher,

Manager, Small Airplane Directorate, Aircraft

Certification Service.

[FR Doc. 97–33147 Filed 12–18–97; 8:45 am]

BILLING CODE 4910–13–U

COMMODITY FUTURES TRADING

COMMISSION

17 CFR Parts 1 and 33

Proposed Rulemaking Permitting

Future-Style Margining of Commodity

Options

AGENCY: Commodity Futures Trading

Commission.

ACTION: Notice of Proposed Rulemaking.

SUMMARY: The Commodity Futures

Trading Commission (‘‘Commission’’) is

proposing the repeal of Commission

Regulation 33.4(a)(2) which requires the

full upfront payment of commodity

option premiums. The effect of the

repeal would be to permit the futuresstyle margining of commodity options

traded on regulated futures exchanges.

Futures-style margining offers several

potential benefits over the current

margining system, including the

possibility for more efficient cash flows

across markets. The Commission is

publishing notice of the proposed

rulemaking and requesting public

comment.

DATES: Comments on the proposed

rulemaking must be received by

February 2, 1998.

ADDRESSES: Comments should be

mailed to Jean A. Webb, Secretary,

Commodity Futures Trading

Commission, Three Lafayette Centre,

1155 21st Street, NW, Washington, D.C.

20581; transmitted by facsimile to (202)

418–5521; or transmitted electronically

to (secretary@cftc.gov).

FOR FURTHER INFORMATION CONTACT:

Thomas Smith, Attorney, Division of

Trading and Markets, Commodity

Futures Trading Commission, Three

Lafayette Centre, 1155 21st Street, NW,

Washington, DC 20581. Telephone (202)

418–5495.

SUPPLEMENTARY INFORMATION:

I. Introduction

The Commission is proposing the

repeal of Commission Regulation

33.4(a)(2). Regulation 33.4(a)(2) requires

that, when a commodity option is

purchased, each clearing member must

pay to the clearinghouse, each member

must pay to the clearing member, and

each option customer must pay to the

futures commission merchant (‘‘FCM’’)

the full option premium.1 The

Commission is considering repealing

this regulation in order to permit the

‘‘futures-style margining’’ of commodity

options.

A futures-style margining system for

options would include two components:

Original margin, set according to the

underlying risk, and variation margin,

reflecting the daily change in the value

of the option premium. Consistent with

the current treatment of futures

positions, long and short option

positions would be marked-to-market,

and gains and losses would be paid and

collected daily. Futures-style margining

may benefit market participants by

improving cash flow in futures and

options markets generally, thereby

increasing liquidity and efficiency.

II. Background

A. Option Pilot Program

In 1981 the Commission instituted a

pilot program for exchange-traded

options on non-agricultural futures

contracts. 46 FR 54500 (November 3,

1981). Concurrently, the Commission

adopted Part 33 of its regulations,

including the full-payment-of-premium

requirement of Regulation 33.4(a)(2).

In approving the pilot program, the

Commission was cognizant of the

history of fraudulent practices

associated with the offer and sale of

commodity options to the general

public. In this connection, the

Commission proceeded cautiously by,

among other things, prohibiting the

margining of option premiums. The

Commission viewed the full payment of

option premiums ‘‘as essential to the

protection of option purchasers who

otherwise could reasonably expect that

an initial payment of margin on an

option contract constituted the full
66570 Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules

2Letter dated July 2, 1982, from Jane K. Stuckey,

Secretary, Commodity Futures Trading

Commission, to Bennett J. Corn, President, CSCE.

3See Report on Volume Investors Corporation,

Division of Trading and Markets, July 1986.

4 Interim Report of the Working Group on

Financial Markets, submitted to the President of the

United States, May 1988.

extent of their obligations on the

option.’’ 46 FR 54504.

The pilot program was made

permanent effective August 1, 1986. 51

FR 17464 (May 13, 1986). Subsequently,

the Commission approved trading of

options involving agricultural futures

contracts and options involving nonagricultural physicals on designated

contract markets. 52 FR 777 (January 9,

1987). The proposed futures-style

margining would apply to each of these

exchange-traded commodity option

categories.

B. Previous Commission Considerations

of Futures-Style Margining of

Commodity Options

In June 1982 the Coffee, Sugar &

Cocoa Exchange, Inc. (‘‘CSCE’’)

petitioned the Commission to repeal

Regulation 33.4(a)(2). The Commission

denied CSCE’s petition, but resolved to

reconsider margining of option

premiums ‘‘after the Commission and

industry ha[d] gained some experience

with the trading of options under the

pilot program.’’ 2

The following year, the Commission

solicited comments concerning ‘‘[t]he

advantages and disadvantages of

permitting margining of option

premiums paid by floor traders.’’ 48 FR

10857, 10858 (March 15, 1983). After

considering comments made in

response to the Federal Register release,

the Commission published a ‘‘Notice of

Proposed Rulemaking’’ in which it

proposed to allow contract markets to

adopt rules permitting their members to

make a deposit with respect to option

premium. 49 FR 8937 (March 9, 1984).

However, the intervening circumstances

of the margin default in the gold futures

option market on the Commodity

Exchange, Inc. raised concerns about

option margining which caused the

Commission to defer further

consideration of futures-style

margining.3

In July 1988 the Chicago Board of

Trade (‘‘CBT’’) and the Chicago

Mercantile Exchange filed separate

petitions with the Commission

requesting repeal of Regulation

33.4(a)(2). The petitioners noted that, as

a result of a study of the October 1987

market break, the President’s Working

Group on Financial Markets

recommended that market participants

and regulators study the potential for

improving liquidity through the use of

futures-style margining of options.4 The

petitions were published, and the public

was invited to file written comments. 54

FR 11233 (March 17, 1989). The

Commission received numerous

comments supporting and opposing the

proposal. Futures exchanges and futures

clearing organizations favored it.

Securities exchanges and securities

clearing organizations opposed it. FCMs

and introducing brokers (‘‘IBs’’)

expressed varying views, with some in

support and some in opposition. With a

few exceptions, commenters from the

agricultural industry generally opposed

the proposal. The Commission took no

further action on the petitions.

Since 1988, a great deal of experience

has been gained with option trading in

numerous products. Industry officials

have continued to indicate to the

Commission that implementation of

futures-style margining might be

beneficial. The Commission notes that

futures-style margining has been in

place at the London International

Financial Futures and Options

Exchange (‘‘LIFFE’’) for over ten years.

Moreover, LIFFE contracts executed in

Chicago pursuant to the CBT/LIFFE link

have been subject to futures-style

margining since May 1997 with no

adverse consequences.

III. Comparison of Option Margining

Systems

Under the current ‘‘stock-style’’

option margining system, the option

buyer or ‘‘long’’ must pay the entire

premium when the transaction is

initiated. No further payments are

required. The premium is credited to

the account of the option seller or

‘‘short,’’ who must keep it posted as

margin. The option seller also must put

up risk margin to cover potential

adverse market moves in his obligation.

If the option increases in value, the

short must deposit additional funds into

the account. These funds, however, are

not transferred to the long, who must

exercise or offset the option in order to

realize any increase in its value. By

contrast, if the option value decreases,

the short may withdraw any excess

funds from its account.

Under the proposed ‘‘futures-style’’

margining system, both the long and

short position holders would post riskbased original margin upon entering

into their option positions. During the

life of the option, the option value

would be marked-to-market daily. Any

increase in value would result in a

credit to the long option holder’s

account and a corresponding debit

against the short’s account. Conversely,

any decrease in value would result in a

credit to the short’s account and a

corresponding debit to the long’s

account. Thus the cash flows in option

contracts would be symmetric, as is the

case for futures. The change in the

margin system, however, would not

alter the fundamental nature of each

party’s overall obligation. A long’s

potential for loss would remain limited

to the full option premium and

transaction costs. As is the case now, a

short’s potential for loss would not be

so limited.

The difference between the current

stock-style margining system and the

proposed futures-style margining system

are illustrated by the following

examples. In each example assume that

an at-the-money call option with an

exercise price of 270 and sixty days to

expiration is purchased for a premium

of $5,000. Further assume that the

minimum price tick in both the futures

and the option is $500.

Example 1: Option Value Decreases

At expiration the futures price has fallen

below the exercise price, and the option

expires out-of-the-money. Under both stockstyle and futures-style margining, the long’s

loss is limited to the $5,000 option premium.

Only the timing of the payments differs.
Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules 66571

Long Short

Stock-Style Margining

Day 1—Pays full premium of $5,000 ....................................................... Day 1—Posts full $5,000 premium received from long plus initial margin.

Day 2–59—Pays no additional funds ....................................................... Day 2–59—May withdraw amount equal to decrease in value of option

position since day of purchase. Total amount withdrawn may not exceed $5,000 premium.

Day 60—Option expires valueless. Nothing is returned .......................... Day 60—Option expires valueless. Initial margin is returned.

Futures-Style Margining

Day 1—Posts initial margin ...................................................................... Day 1—Posts initial margin.

Day 2–59—Pays aggregate variation of $5,000 ...................................... Day 2–59—Collects aggregate settlement variation settlement of

$5,000.

Day 60—Option expires valueless. Initial margin is returned .................. Day 60—Option expires valueless. Initial margin is returned.

Example 2: Option Value Increases

By expiration the futures price has risen above the exercise price to 285. The option is in the money by 15 points, and the

premium is $7,500 ($500 X 15 points) per contract. Under both systems, the long’s profits are the same. Again, only the timing

of the payments differs.

Long Short

Stock-Style Margining

Day 1—Pays full premium of $5,000 ....................................................... Day 1—Posts full $5,000 premium received from long plus initial margin.

Day 2–59—Collects nothing over life of option ........................................ Day 2–59—Posts additional funds equal to the increase in value of option position over the life of the option.

Day 60—Liquidates position by selling the option for $7,500 for a gain

of $2,500.

Day 60—Liquidates position by buying the option for $7,500 for a loss

of $2,500. Total margin payments are returned.

Futures-Style Margining

Day 1—Posts initial margin ...................................................................... Day 1—Posts initial margin.

Day 2–59—Over life of option collects pays aggregate settlement variation of $2,500..Day 2–59—Over life of option pays aggregate settlement variation of

$2,500.

Day 60—Liquidates position. Initial margin is returned. ........................... Day 60—Liquidates position. Initial margin is returned.

The long also may choose to exercise the in-the-money call instead of liquidating the option position. Exercising a futures-style

option is analogous to taking delivery on a futures position. In order to receive a cash commodity by taking delivery on a futures

contract, the long must pay the settlement price of the futures contract prevailing at the time of delivery. Similarly, in order to

obtain a futures position by exercising an option, the long must pay the settlement of the option prevailing at the time of exercise.

In other words, the long must pay the full premium marked-to-market on the day of exercise. Under a futures-style margining system,

this payment is offset by the variation payments received by the long during the life of the option. The difference between this

procedure and the exercise of stock-style options are demonstrated in a final example.

Example 3: Exercise of In-The-Money Option.

As in Example 2, the futures price has risen to 285 by expiration. The long option holder decides to exercise the call.

Long Short

Stock-Style Margining

Exercises option ....................................................................................... Option is exercised.

Receives long futures position at strike price of 270. Futures position is

marked-to-market by the clearinghouse, and the long is credited

$7,500 ((285–270)X $500.

Receives short futures position at strike price of 270. Futures position

is marked-to-market market by the clearinghouse, and short is debited $7,500.

Futures-Style Margining

Exercises option ....................................................................................... Option is exercised.

Clearinghouse debits account for premium settlement price of $7,500 .. Clearinghouse credits short with $7,500 settlement of premium.

Receives long futures position at option strike price of 270. Futures position is marked-to-market by the clearinghouse, and the long is credited with $7,500 ((285–270)X $500.Receives short futures position at option price of 270. Futures position

is marked-to-market by the clearinghouse, and the short is debited

$7,500.

Option position is closed through exercise, but risk margin is retained

until the futures position is offset.

Option position is closed through exercise, but risk marign is retained

until the futures position is offset.

IV. Potential Benefits and Costs of

Futures-Style Margining

A. Potential Benefits

Futures-style margining of options

could enhance financial integrity and

market liquidity by providing for more

efficient cash flows across markets.

Currently, certain spread or risk neutral

positions can give rise to substantial

funds requirements due to asymmetrical

cash flows. The problem arises, for

example, where a short futures position

is hedged with a long call option. If the

price of the futures position increases,

the value of the call also increases.

However, the trader cannot apply the

increased option value toward the
66572 Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules

5Of course, the trader may obtain the excess

funds by exercising or offsetting the option, but this

would eliminate the original hedge strategy or

require reestablishing the option with the potential

for a less favorable price and additional transaction

costs.

6 In May 1996 the Board of Governors of the

Federal Reserve amended Regulation T to allow

securities exchanges to adopt, pursuant to

Securities and Exchange Commission approval,

rules permitting the margining of options on

securities. 61 FR 20386 (May 6, 1996). To date, no

exchange has submitted such a rule.

corresponding loss in the futures

position.5 Instead, the trader must put

up funds to pay the futures variation

requirement. Similar cash flow

shortages can arise for traders holding

arbitrage positions such as conversions,

reverse conversions, and box spreads.

Such problems may be particularly

acute when there are major market

moves.

With futures-style margining of

options, these asymmetrical cash flows

could be reduced. Each increase in an

option position’s value (long or short)

would result in a related variation

payment which would be accessible to

the option trader. The trader could in

turn use the option gains to contribute

to margin payments on other positions

with losses.

Futures-style margining also may

reduce financing requirements for

market participants and, thus, financing

risk for FCMs and clearinghouses.

Under the current margining system,

financing risk is created because long

option equity cannot be used to make

variation margin payments on short

option or futures positions. Moreover,

financing based on option equity may

not be readily available to market

participants because banks may be

reluctant to provide such financing.

Futures-style margining of options, with

its variation pay and collect feature,

would reduce the need for market

participants to borrow against their long

option equity. Thus, FCMs no longer

would be exposed to the resulting credit

risk beyond their control.

Market liquidity may increase under a

futures-style margining system for two

reasons. First, the ability of traders to

participate in option markets could be

less dependent on their ability to obtain

financing. Second, the incentive for

early exercise of options could be

reduced. Under the present system, an

option purchaser can realize increases

in the value of an option only by

offsetting or exercising that option.

Thus, some long option holders may

choose to exercise their options early in

order to obtain the option profits. This

possibility of early exercise may act as

a disincentive to writing options due to

the uncertainty it creates. The daily pay

and collect feature of the futures-style

system could reduce the incentive for

early exercise.

B. Potential Costs

Futures-style margining would

increase leverage in the option markets.

A long would be required to put up a

smaller initial payment to purchase a

given option than he or she would

under the current system. This would

introduce a risk of default that does not

exist today. The Commission notes,

however, that futures and short options

currently may be margined. It is

anomalous that long options, which

entail less risk, are subject to a more

stringent standard. Under futures-style

margining, the total risk of a long option

would still be fixed at the time of

purchase. Moreover, FCMs would

remain free to require an initial payment

equal to the value of the option

premium.

Over the years, the Commission has

brought enforcement actions involving

the fraudulent offer and sale of options

on exchange-traded futures contracts to

unsophisticated retail customers.

Futures-style margining may provide

unscrupulous individuals with an

additional opportunity to mislead

unsophisticated option customers. Such

customers may not fully understand that

they are liable for the full premium

payment if the market moves against

their option position. In addition, less

well-capitalized customers could be

persuaded to invest since the initial

margin would be lower than currently

required. Institution of futures-style

margining would require efforts to

educate market participants. Of course,

consistent with Commission Regulation

1.55, full and accurate disclosure of

potential liability also would be

necessary at the time an option position

was entered in order to ensure investor

protection. The Commission welcomes

comments on what measures might be

appropriate to address these concerns.

Implementation of futures-style

margining would alter option pricing

which could adversely affect certain

market participants. Option premiums

potentially would be higher under a

futures-style margining system because

shorts likely would demand a higher

price to compensate for the loss of

interest income on the full premium and

longs would be willing to pay a higher

price because they would be gaining

such interest income. Some market

participants believe that this could

affect various trading strategies by

potentially diminishing the usefulness

of certain option writing strategies.

Implementation of futures-style

margining might also create issues for

participants in the securities markets.

To the extent the latter retained the

current system, customer confusion

could result.6 In addition, certain

intermarket strategies such as ‘‘buywrite’’ might be less useful because

option grantors would not receive the

full option premium upfront.

Finally, there could be costs to the

industry in making a transition to

futures-style margining. FCMs would

have to adjust their risk management

systems to address the increased

leverage and altered cash flow features.

Moreover, insofar as small retail firms

currently only handle long option

positions, such firms would have to

install risk management systems if they

planned to allow margining of

premiums. In addition, if all exchanges

were not ready or willing to switch from

stock-style option margining to futuresstyle margining at the same time, FCMs

might incur operational costs in order to

maintain multiple option margining

systems and to comply with different

disclosure requirements for different

exchanges. Furthermore, even if all

exchanges introduced futures-style

margining simultaneously, there would

be a necessary transition period during

which exchanges and market

participants would be required to deal

with both margining systems.

In addition, because of the impact of

the futures-style margining on option

pricing, only a newly-issued option

series could be margined in the

proposed manner. Any previously

issued option series would require

margining under the existing stock-style

system. Thus, a change to futures-style

margining would necessitate the

maintenance of a two-tiered margining

system for a period of time.

VI. Proposed Regulatory Changes

A. Repeal of Commission Regulation

33.4(a)(2)

The Commission believes that futuresstyle margining could provide

substantial benefits to the marketplace

and that steps are available to minimize

the potential costs. Accordingly, the

Commission is proposing to delete

Regulation 33.4(a)(2) which requires full

payment of the option premium at the

time of purchase. This would not

impose future-style margining on the

industry but would merely make it

available. Any exchange or

clearinghouse that wished to implement

it would be required to submit

appropriate rule changes to the

Commission pursuant to Section
Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules 66573

7Pub. L. 104–13 (May 13, 1995).

8The Commission will republish the entire

appendix in the final rule.

5a(a)(12)(A) of the Act and Commission

Regulation 1.41. The Commission

would review any such proposal to

ensure that adequate safeguards were in

place. In particular, the Commission

would reemphasize the need to use

systems and procedures that took into

account the unique risk characteristics

of options. Moreover, as previously

mentioned, exchange margin

requirements are minimums. Any FCM

would remain free to collect the full

premium at the time of purchase just as

it is currently free to collect more than

the exchange minimum margin on

futures positions.

B. Amendment of Commission

Regulations 1.55 and 33.7

The Commission is proposing several

amendments to the language of the

generic futures and option risk

disclosure statement set forth in

Appendix A of Commission Regulation

1.55(c) and the more detailed domestic

exchange-traded option disclosure

statement set forth in Regulation 33.7.

The proposed amendments would

inform potential investors that option

transactions may be subject to either a

stock-style or futures-style margining

system. The proposed amendments

would not relieve an FCM or IB from

any other disclosure obligation it may

have under applicable law.

C. Technical Amendments

Implementation of futures-style

margining will require changes to other

Commission requirements to provide for

appropriate accounting treatment of

options. See, Financial and Segregation

Interpretation No. 8, Comm. Fut. L.

Rep., (CCH) ¶ 7118 (August 12, 1982),

relating to the proper accounting,

segregation and net capital treatment of

options, and Commission Regulation

1.17 relating to minimum financial

requirements for FCMs and IBs. The

Commission requests comments on the

appropriate technical amendments to

these provisions. The Commission also

request comments on any other

technical changes to its regulatory

requirements.

VII. Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act

(‘‘RFA’’), 5 U.S.C. 601 et seq., requires

that agencies, in proposing rules,

consider the impact on small

businesses. The rules discussed herein

will affect FCMs and IBs. The

Commission has already established

certain definitions of ‘‘small entities’’ to

be used by the Commission in

evaluating the impact of its rules on

such small entities in accordance with

the RFA. FCMs have been determined

not to be small entities under the RFA.

With respect to IBs, the Commission

has stated that it is appropriate to

evaluate within the context of a

particular rule proposal whether some

or all IBs should be considered to be

small entities and, if so, to analyze that

economic impact on such entities at that

time. The proposed rule amendments

would not require any IB to alter its

current method of doing business as

FCMS have the responsibility of

administering customer funds. Further,

these rule amendments, as proposed

should, impose no additional burden or

requirements on IBs and, thus, if

adopted would not have a significant

economic impact on a substantial

number of IBs.

Therefore, the Chairperson, on behalf

of the Commission, hereby certifies

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

action taken herein would not have a

significant economic impact on a

substantial number of small entities.

The Commission nonetheless invites

comments from any person or entity

which believes that the proposal would

have a significant impact on its

operations.

B. Paperwork Reduction Act

The Paperwork Reduction Act of

1995 7 imposes certain requirements on

federal agencies (including the

Commission) in connection with their

conducting or sponsoring any collection

of information as defined by the

Paperwork Reduction Act.

While proposed Rule 1.55 has no

burden, the group of rules (3038–0024),

which Rule 1.55 is a part, has the

following burden:

Average burden hours per response:

128.

Number of Respondents: 3,148.

Frequency of responses: 36.

While proposed Rule 33.7 has no

burden, the group of rules (3038–0007),

which Rule 33.7 is a part, has the

following burden:

Average burden hours per response:

50.57.

Number of Respondents: 190,422.

Frequency of responses: 1,111.

Copies of the OMB approved

information collection package

associated with these rules may be

obtained from Desk Officer, CFTC,

Office of Management and Budget,

Room 10202, NEOB, Washington DC

20503, (202) 395–7340.

List of Subjects

17 CFR Part 1

Commodity Futures, Domestic

exchange-traded commodity option

transactions.

17 CFR Part 33

Commodity Futures, Domestic

exchange-traded commodity option

transactions.

In consideration of the foregoing, and

pursuant to the authority contained in

the Commodity Exchange Act and, in

particular, sections 2(a)(1), 4b, 4c, and

8a thereof, 7 U.S.C. 2a, 6b, 6c, and 12a,

the Commission hereby proposes to

amend Chapter I of Title 17 of the Code

of Federal Regulations as follows:

PART 1—GENERAL REGULATIONS

UNDER THE COMMODITY EXCHANGE

ACT

1. The authority citation for Part 1

continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 2a 4, 4a, 6, 6a,

6b, 6c, 6d, 6e, 6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m,

6n, 6o, 6p, 7, 7a, 7b, 9, 12, 12a, 12c, 13a, 13a–

-, 16, 16a, 19, 21, 23, 24.

2. Section 1.55(c) is amended by

revising section 3 of Appendix A to read

as follows: 8

Appendix A to CFTC Rule 1.55(c)—

Generic Risk Disclosure Statement

Risk Disclosure Statement for Futures and

Options

* * * * *

Options

3. Variable degree of risk.

Transactions in options carry a high degree

of risk. Purchasers and sellers of options

should familiarize themselves with the type

of option (i.e. put or call) which they

contemplate trading and the associated risks.

You should calculate the extent to which the

value of the options must increase for your

position to become profitable, taking into

account the premium and all transaction

costs.

The purchaser of options may offset or

exercise the options or allow the options to

expire. The exercise of an option results

either in a cash settlement or in the

purchaser acquiring or delivering the

underlying interest. If the option is on a

future, the purchaser will acquire a futures

position with associated liabilities for margin

(see the section on Futures above). If the

purchased options expire worthless, you will

suffer a total loss of your investment which

will consist of the option premium plus

transaction costs. If you are contemplating

purchasing deep-out-of-the-money options,

you should be aware that the chance of such

options becoming profitable ordinarily is

remote.
66574 Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules

Selling (‘‘writing’’ or ‘‘granting’’) an option

generally entails considerably greater risk

than purchasing options. Although the

premium received by the seller is fixed, the

seller may sustain a loss well in excess of

that amount. The seller will be liable for

additional margin to maintain the position if

the market moves unfavorably. The seller

will also be exposed to the risk of the

purchaser exercising the option, and the

seller will be obligated to either settle the

option in cash or to acquire or deliver the

underlying interest. If the option is on a

future, the seller will acquire a position in a

future with associated liabilities for margin

(see the section on Futures above). If the

position is ‘‘covered’’ by the seller holding a

corresponding position in the underlying

interest or a future or another option, the risk

may be reduced. If the option is not covered,

the risk of loss can be unlimited.

Certain exchanges, domestic and foreign,

permit deferred payment of the option

premium, exposing the purchaser to liability

for margin payments not exceeding the

amount of the premium. The purchaser is

still subject to the risk of losing the premium

and transaction costs. When the option is

exercised or expires, the purchaser is

responsible for any unpaid premium

outstanding at that time.

* * * * *

PART 33—REGULATION OF

DOMESTIC EXCHANGE TRADED

COMMODITY OPTION TRANSACTIONS

3. The authority citation for Part 33

continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4, 6, 6a, 6b, 6c,

6d, 6e, 6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o,

7, 7a, 7b, 8, 9, 11, 12a, 12c, 13a, 13a–1, 13b,

19, and 21.

§ 33.4 [Amended]

4. Section 33.4 is amended by

removing and reserving paragraphs

(a)(2).

5. The disclosure statement in

paragraph (b) of § 33.7 is amended by

revising the text preceding paragraph (1)

and paragraph (2)(v), (4) and (5) to read

as follows:

§ 33.7 Disclosure.

* * * * *

(b) The disclosure statement must

read as follows:

OPTION DISCLOSURE STATEMENT

BECAUSE OF THE VOLATILE NATURE

OF THE COMMODITIES MARKETS, THE

PURCHASE AND GRANTING OF

COMMODITY OPTIONS INVOLVE A HIGH

DEGREE OF RISK. COMMODITY OPTION

TRANSACTIONS ARE NOT SUITABLE FOR

MANY MEMBERS OF THE PUBLIC. SUCH

TRANSACTIONS SHOULD BE ENTERED

INTO ONLY BY PERSONS WHO HAVE

READ AND UNDERSTOOD THIS

DISCLOSURE STATEMENT AND WHO

UNDERSTAND THE NATURE AND EXTENT

OF THEIR RIGHTS AND OBLIGATIONS

AND OF THE RISKS INVOLVED IN THE

OPTION TRANSACTIONS COVERED BY

THIS DISCLOSURE STATEMENT.

BOTH THE PURCHASER AND THE

GRANTOR SHOULD KNOW WHETHER THE

PARTICULAR OPTION IN WHICH THEY

CONTEMPLATE TRADING IS AN OPTION

WHICH, IF EXERCISED, RESULTS IN THE

ESTABLISHMENT OF A FUTURES

CONTRACT (AN ‘‘OPTION ON A FUTURES

CONTRACT’’) OR RESULTS IN THE

MAKING OR TAKING OF DELIVERY OF

THE ACTUAL COMMODITY UNDERLYING

THE OPTION (AN ‘‘OPTION ON A

PHYSICAL COMMODITY’’). BOTH THE

PURCHASER AND THE GRANTOR OF AN

OPTION ON A PHYSICAL COMMODITY

SHOULD BE AWARE THAT, IN CERTAIN

CASES, THE DELIVERY OF THE ACTUAL

COMMODITY UNDERLYING THE OPTION

MAY NOT BE REQUIRED AND THAT, IF

THE OPTION IS EXERCISED, THE

OBLIGATIONS OF THE PURCHASER AND

GRANTOR WILL BE SETTLED IN CASH.

BOTH THE PURCHASER AND THE

GRANTOR SHOULD KNOW WHETHER THE

PARTICULAR OPTION IN WHICH THEY

CONTEMPLATE TRADING IS SUBJECT TO

A ‘‘STOCK-STYLE’’ OR ‘‘FUTURES-STYLE’’

SYSTEM OF MARGINING. UNDER A

STOCK-STYLE MARGINING SYSTEM, A

PURCHASER IS REQUIRED TO PAY THE

FULL PURCHASE PRICE OF THE OPTION

AT THE INITIATION OF THE

TRANSACTION. THE PURCHASER HAS NO

FURTHER OBLIGATION ON THE OPTION

POSITION. UNDER A FUTURES-STYLE

MARGINING SYSTEM, THE PURCHASER

DEPOSITS INITIAL MARGIN AND MAY BE

REQUIRED TO DEPOSIT ADDITIONAL

MARGIN IF THE MARKET MOVES

AGAINST THE OPTION POSITION. THE

PURCHASER’S TOTAL MARGIN

OBLIGATION, HOWEVER, WILL NOT

EXCEED THE ORIGINAL OPTION

PREMIUM. IF THE PURCHASER OR

GRANTOR DOES NOT UNDERSTAND HOW

OPTIONS ARE MARGINED UNDER A

STOCK-STYLE OR FUTURES-STYLE

MARGINING SYSTEM, HE OR SHE SHOULD

REQUEST AN EXPLANATION FROM THE

FUTURES COMMISSION MERCHANT

(‘‘FCM’’) OR INTRODUCING BROKER (‘‘IB’’).

A PERSON SHOULD NOT PURCHASE

ANY COMMODITY OPTION UNLESS HE OR

SHE IS ABLE TO SUSTAIN A TOTAL LOSS

OF THE PREMIUM AND TRANSACTION

COSTS OF PURCHASING THE OPTION. A

PERSON SHOULD NOT GRANT ANY

COMMODITY OPTION UNLESS HE OR SHE

IS ABLE TO MEET ADDITIONAL CALLS

FOR MARGIN WHEN THE MARKET MOVES

AGAINST HIS OR HER POSITION AND, IN

SUCH CIRCUMSTANCES, TO SUSTAIN A

VERY LARGE FINANCIAL LOSS.

A PERSON WHO PURCHASES AN

OPTION SUBJECT TO STOCK-STYLE

MARGINING SHOULD BE AWARE THAT,

IN ORDER TO REALIZE ANY VALUE FROM

THE OPTION, IT WILL BE NECESSARY

EITHER TO OFFSET THE OPTION

POSITION OR TO EXERCISE THE OPTION.

OPTIONS SUBJECT TO FUTURES-STYLE

MARGINING ARE MARKED-TO-MARKET,

AND GAINS AND LOSSES ARE PAID AND

COLLECTED DAILY. IF AN OPTION

PURCHASER DOES NOT UNDERSTAND

HOW TO OFFSET OR EXERCISE AN

OPTION, THE PURCHASER SHOULD

REQUEST AN EXPLANATION FROM THE

FCM OR IB. CUSTOMERS SHOULD BE

AWARE THAT IN A NUMBER OF

CIRCUMSTANCES, SOME OF WHICH WILL

BE DESCRIBED IN THIS DISCLOSURE

STATEMENT, IT MAY BE DIFFICULT OR

IMPOSSIBLE TO OFFSET AN EXISTING

OPTION POSITION ON AN EXCHANGE.

THE GRANTOR OF AN OPTION SHOULD

BE AWARE THAT, IN MOST CASES, A

COMMODITY OPTION MAY BE EXERCISED

AT ANY TIME FROM THE TIME IT IS

GRANTED UNTIL IT EXPIRES. THE

PURCHASER OF AN OPTION SHOULD BE

AWARE THAT SOME OPTION CONTRACTS

MAY PROVIDE ONLY A LIMITED PERIOD

OF TIME FOR EXERCISE OF THE OPTION.

THE PURCHASER OF A PUT OR CALL

SUBJECT TO STOCK-STYLE OR FUTURESSTYLE MARGINING IS SUBJECT TO THE

RISK OF LOSING THE ENTIRE PURCHASE

PRICE OF THE OPTION—THAT IS, THE

PREMIUM CHARGED FOR THE OPTION

PLUS ALL TRANSACTION COSTS.

THE COMMODITY FUTURES TRADING

COMMISSION REQUIRES THAT ALL

CUSTOMERS RECEIVE AND

ACKNOWLEDGE RECEIPT OF A COPY OF

THIS DISCLOSURE STATEMENT BUT

DOES NOT INTEND THIS STATEMENT AS

A RECOMMENDATION OR ENDORSEMENT

OF EXCHANGE-TRADED COMMODITY

OPTIONS.

* * * * *

(2) * * *

(v) An explanation and understanding of

the option margining system.

* * * * *

(4) Margin requirements. An individual

should know and understand whether the

option he or she is contemplating trading is

subject to a stock-style or futures-style system

of margining. Stock-style margining requires

the purchaser to pay the full option premium

at the time of purchase. The purchaser has

no further financial obligations, and the risk

of loss is limited to the purchase price and

transaction costs. Futures-style margining

requires the purchaser to pay initial margin

only at the time of purchase. The option

position is marked-to-market, and gains and

losses are collected and paid daily. The

purchaser’s risk of loss is limited to the

initial option premium and transaction costs.

An individual granting options under

either a stock-style or futures-style system of

margining should understand that he or she

may be required to pay additional margin in

the case of adverse market movements.

(5) Profit potential of an option position.

An option customer should carefully

calculate the price which the underlying

futures contract or underlying physical

commodity would have to reach for the

option position to become profitable. Under

a stock-style margining system, this price

would include the amount by which the

underlying futures contract or underlying

physical commodity would have to rise

above or fall below the strike price to cover

the sum of the premium and all other costs

incurred in entering into and exercising or

closing (offsetting) the commodity option

position. Under a future-style margining
Federal Register / Vol. 62, No. 244 / Friday, December 19, 1997 / Proposed Rules 66575

system, option positions would be markedto-market, and gains and losses would be

paid and collected daily, and an option

position would become profitable once the

variation margin collected exceeded the cost

of entering the contract position.

Also, an option customer should be aware

of the risk that the futures price prevailing at

the opening of the next trading day may be

substantially different from the futures price

which prevailed when the option was

exercised. Similarly, for options on physicals

that are cash settled, the physicals price

prevailing at the time the option is exercised

may differ substantially from the cash

settlement price that is determined at a later

time. Thus, if a customer does not cover the

position against the possibility of underlying

commodity price change, the realized price

upon option exercise may differ substantially

from that which existed at the time of

exercise.

* * * * *

Issued in Washington, D.C., on this 15th

day of December, 1997, by the Commodity

Futures Trading Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97–33125 Filed 12–18–97; 8:45 am]

BILLING CODE 6351–01–P

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–105163–97]

RIN 1545–AV15

Certain Investment Income

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations relating to the

treatment of certain investment income

under the qualifying income provisions

of section 7704(d) and the application of

the passive activity loss rules to

publicly traded partnerships. The

regulations would affect the

classification of certain partnerships for

federal tax purposes and would also

affect the passive activity loss

limitations with respect to items

attributable to publicly traded

partnerships. This document also

contains a notice of public hearing on

these proposed regulations.

DATES: Written comments must be

received by March 19, 1998. Requests to

speak (with outlines of oral comments)

at a public hearing scheduled for April

28, 1998, at 10 a.m., must be received

by April 7, 1998.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (REG–105163–97),

room 5228, Internal Revenue Service,

POB 7604, Ben Franklin Station,

Washington, DC 20044. In the

alternative, submissions may be hand

delivered between the hours of 8 a.m.

and 5 p.m. to: CC:DOM:CORP:R (REG–

105163–97), Courier’s Desk, Internal

Revenue Service, 1111 Constitution

Avenue NW., Washington, DC.

Alternatively, taxpayers may submit

comments electronically via the Internet

by selecting the ‘‘Tax Regs’’ option of

the IRS Home Page, or by submitting

comments directly to the IRS Internet

site at: http://www.irs.ustreas.gov/prod/

taxlregs/comments.html. The public

hearing will be held in Room 2615,

Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, Christopher

Kelley, (202) 622–3080; concerning

submissions and the hearing,

Evangelista Lee, (202) 622–7190 (not

toll-free numbers).

SUPPLEMENTARY INFORMATION:

Introduction

This document proposes to add

§ 1.7704–3 to the Income Tax

Regulations (26 CFR part 1) relating to

the definition of qualifying income for

publicly traded partnerships under

section 7704(d) of the Internal Revenue

Code (Code). This document also

proposes to amend § 1.469–10 of the

Income Tax Regulations relating to the

application of section 469 of the Code

to publicly traded partnerships.

Explanation of Provisions

Qualifying Income

Section 7704 of the Code provides

that a publicly traded partnership is

generally treated as a corporation for

federal tax purposes unless 90 percent

or more of the gross income of the

partnership consists of qualifying

income. Section 7704(d) defines

qualifying income to include certain

types of passive investment income,

such as interest, dividends, real

property rents, and income that would

qualify under the regulated investment

company provisions in section 851(b)(2)

or the real estate investment trust

provisions in section 856(c)(2). Since

section 7704 was enacted, however,

several new types of financial

instruments have been developed that

generate passive-type investment

income similar to interest and

dividends. The preamble to the

regulations under § 1.7704–1, issued

December 4, 1995, (regarding the

definition of public trading) requested

comments from the public on the

definition of qualifying income for

investment partnerships and other

partnerships engaged in various types of

securities transactions.

In response to comments received, the

proposed regulations provide that

qualifying income for purposes of

section 7704(c) includes income from

holding annuities, income from notional

principal contracts (as defined in

§ 1.446–3), and other substantially

similar income from ordinary and

routine investments to the extent

determined by the Commissioner.

Qualifying income, however, includes

income from a notional principal

contract only if the property, income, or

cash flow that measures the amounts to

which the partnership is entitled under

the contract would give rise to

qualifying income if held or received

directly by the partnership. The

proposed regulations also confirm that

capital gain from the sale of stock is

qualifying income, regardless of

whether the stock pays dividends. The

proposed regulations also provide that

qualifying income (as defined in the

proposed regulations) does not include

income derived in the ordinary course

of a trade or business by a broker,

dealer, or market maker. Income derived

by traders and investors can be

qualifying income under the proposed

regulations. The proposed regulations,

including the trade or business

restriction, are consistent with the

legislative history of section 7704,

which indicates that the exception for

passive investment income was

intended to distinguish between

partnerships engaged in investment

activities and those partnerships

engaged in active business activities that

are more typically conducted in

corporate form. See H.R. Rep. No. 391

(Part 2), 100th Cong., 1st Sess. 1066–69

(House Report). The IRS also requests

comments on the appropriate way to

determine how gains should be

measured for purposes of determining

whether 90 percent or more of the

partnership’s gross income is qualifying

income when a partnership makes a

mixed straddle account election under

§ 1.1092(b)–4T. The IRS believes that

use of the daily mark-to-market method

provided for by § 1.1092(b)–4T would

be inconsistent with the congressional

purpose behind section 7704.

Passive Activity Loss Rules

Section 469(a) generally provides that

if for any taxable year the taxpayer is an

individual, estate, trust, closely held C

corporation, or personal service

corporation, neither the passive activity

loss nor the passive activity credit for

the taxable year is allowed. Section