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[Federal Register: December 19, 1997 (Volume 62, Number 244)]
[Proposed Rules]
[Page 66569-66575]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr19de97-24]

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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.

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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 futures-style 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 ([email protected]).

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.
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    \1\ Regulation 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 Sec. 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.
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    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

[[Page 66570]]

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 non-agricultural 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\
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    \2\ Letter dated July 2, 1982, from Jane K. Stuckey, Secretary,
Commodity Futures Trading Commission, to Bennett J. Corn, President,
CSCE.
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    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\
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    \3\ See Report on Volume Investors Corporation, Division of
Trading and Markets, July 1986.
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    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.
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    \4\ Interim Report of the Working Group on Financial Markets,
submitted to the President of the United States, May 1988.
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    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 risk-based 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 stock-
style and futures-style margining, the long's loss is limited to the
$5,000 option premium. Only the timing of the payments differs.

[[Page 66571]]



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                          Long                                                    Short
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                                             Stock-Style Margining
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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.
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                                             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      Day 60--Option expires valueless. Initial margin is
 returned.                                                returned.
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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    Day 60--Liquidates position by buying the option for
 $7,500 for a gain of $2,500.                             $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    Day 2-59--Over life of option pays aggregate settlement
 settlement variation of $2,500..                         variation of $2,500.
Day 60--Liquidates position. Initial margin is           Day 60--Liquidates position. Initial margin is
 returned..                                               returned.
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    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.

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                          Long                                                    Short
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                                             Stock-Style Margining
----------------------------------------------------------------------------------------------------------------
Exercises option.......................................  Option is exercised.
Receives long futures position at strike price of 270.   Receives short futures position at strike price of 270.
 Futures position is marked-to-market by the              Futures position is marked-to-market market by the
 clearinghouse, and the long is credited $7,500 ((285-    clearinghouse, and short is debited $7,500.
 270)X $500.
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                                             Futures-Style Margining
----------------------------------------------------------------------------------------------------------------
Exercises option.......................................  Option is exercised.
Clearinghouse debits account for premium settlement      Clearinghouse credits short with $7,500 settlement of
 price of $7,500.                                         premium.
Receives long futures position at option strike price    Receives short futures position at option price of 270.
 of 270. Futures position is marked-to-market by the      Futures position is marked-to-market by the
 clearinghouse, and the long is credited with $7,500      clearinghouse, and the short is debited $7,500.
 ((285-270)X $500.
Option position is closed through exercise, but risk     Option position is closed through exercise, but risk
 margin is retained until the futures position is         marign is retained until the futures position is
 offset.                                                  offset.
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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

[[Page 66572]]

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.
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    \5\ Of 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.
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    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 ``buy-write'' might be
less useful because option grantors would not receive the full option
premium upfront.
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    \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.
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    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 futures-style 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 futures-style 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

[[Page 66573]]

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) para. 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.
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    \7\ Pub. L. 104-13 (May 13, 1995).
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    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\
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    \8\ The Commission will republish the entire appendix in the
final rule.
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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.

[[Page 66574]]

    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.

Sec. 33.4   [Amended]

    4. Section 33.4 is amended by removing and reserving paragraphs
(a)(2).
    5. The disclosure statement in paragraph (b) of Sec. 33.7 is
amended by revising the text preceding paragraph (1) and paragraph
(2)(v), (4) and (5) to read as follows:


Sec. 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
FUTURES-STYLE 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

[[Page 66575]]

system, option positions would be marked-to-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
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