Document ID: SEC-2006-1505-0001
Agency: sec
Document Type: Notice
Title: Self-regulatory organizations; proposed rule changes: National Association of Securities Dealers, Inc.
Posted Date: 2006-11-22T05:00Z

[Federal Register: November 22, 2006 (Volume 71, Number 225)]
[Notices]               
[Page 67675-67678]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr22no06-138]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54755; File No. SR-NASD-2006-007]

 
Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc; Order Approving Proposed Rule Change Relating to Option 
Position and Exercise Limits and Position Reporting Obligations; and 
Notice of Filing and Order Granting Accelerated Approval to Amendment 
No. 1 Thereto

 November 15, 2006.

I. Introduction

    On January 23, 2006, the National Association of Securities 
Dealers, Inc. (``NASD'') filed with the Securities and Exchange 
Commission (``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Exchange Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend NASD Rule 2860, which 
relates to position and exercise limits and position reporting 
obligations for members that hold positions in index and equity options 
or that represent customers holding such positions. The proposed rule 
change was published for comment in the Federal Register on February 6, 
2006.\3\ The Commission received one comment on the proposal.\4\ In its 
comment letter, the Securities Industry Association (``SIA'') 
``endorse[d] the adoption of clear and objective criteria for 
identifying those index options that would be exempt from NASD option 
position and exercise limits.'' \5\ However, the SIA also recommended 
``streamlining the relevant standards and easing the operational steps 
necessary for NASD member firms to verify compliance with the Proposed 
Rule Change.'' \6\ In response to this comment, NASD filed Amendment 
No. 1 to the proposed rule change on September 20, 2006.\7\ This notice 
and order solicits comments from interested persons on Amendment No. 1 
and approves the proposal, as amended by Amendment No. 1, on an 
accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 53189 (January 30, 
2006), 71 FR 6117.
    \4\ See letter from John R. Vitha, Esq., Chairman, Securities 
Industry Association Derivative Product Committee, to Nancy M. 
Morris, Secretary, Commission, dated May 23, 2006 (``SIA Letter'').
    \5\ Id. at 1.
    \6\ Id.
    \7\ The text of Amendment No. 1 is available on the NASD's Web 
site (http://www.nasd.com), at NASD's principal office, and at the 

Commission's Public Reference Room.
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II. Description of the Proposal

A. Position Limits for OTC Index Options

    NASD currently prohibits its members, for their proprietary or 
agency accounts, from holding positions in over-the-counter (``OTC'') 
equity options \8\ that exceed certain position limits.\9\ NASD also 
imposes exercise limits on a member that holds OTC equity options; the 
member may not exercise, within a period of five consecutive business 
days, a number of option contracts that exceeds the same number 
established for the position limit.\10\ The position limits that NASD 
imposes on its members for OTC equity options are based on similar 
standards established by the option exchanges for ``standardized'' 
equity options.\11\ In contrast, NASD rules impose no position limits 
on OTC index options, but do not clarify what constitutes an OTC index 
option for this purpose.
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    \8\ An ``OTC option'' for the purposes of this approval order 
means any option contract not issued or subject to issuance by the 
Options Clearing Corporation (``OCC'').
    \9\ These position limits vary depending on the characteristics 
of the security underlying the OTC option. See NASD Rule 
2860(b)(3)(A)(viii).
    \10\ See NASD Rule 2860(b)(4). NASD's proposal will impact its 
exercise limits in the same way as it will change its position 
limits.
    \11\ The term ``standardized equity option'' means any equity 
options contract issued, or subject to issuance by, The Options 
Clearing Corporation that is not a FLEX Equity Option. See NASD Rule 
2860(b)(2)(UU).
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    NASD believes that some indexes underlying OTC options might have 
economic characteristics more closely resembling single securities than 
broad-based indexes. This could be the case, for example, where the 
index consisted of only a small number of securities or if one or a few 
securities represented a significant percentage of the index's 
weighting. In its initial filing, NASD proposed 11 criteria an index 
would have to meet to be sufficiently broad-based for an option on that 
index to be

[[Page 67676]]

deemed a ``conventional index option'' under proposed NASD Rule 
2860(b)(2)(N).\12\ A position in a ``conventional index option'' would 
continue to be free from any position limits imposed by NASD rules. In 
addition, a position in an OTC option overlying the same index as an 
exchange-traded option would not be subject to position limits. A 
position in an OTC index option that did not either qualify as a 
``conventional index option'' or overlie the same index as an exchange-
traded option would in effect be deconstructed into separate equity 
option components, and NASD position limits would apply with respect to 
each component.\13\
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    \12\ The 11 criteria originally proposed by NASD to define a 
``conventional index option'' were as follows:
    a) The option must be A.M.-settled;
    b) The index must be weighted pursuant to one of a number of 
widely recognized methodologies;
    c) The index must consist of ten or more component securities;
    d) Each component security must be characterized by a minimum 
market capitalization;
    e) Each component security must be characterized by a minimum 
trading volume;
    f) The most highly weighted components of the index must be 
characterized by heightened trading volume, as compared to the 
remaining components;
    g) No single component security or group of five securities may 
represent more than a maximum concentration of the index;
    h) All component securities are ``NMS securities'' as defined in 
Regulation NMS;
    i) Certain non-U.S. component securities may not, in the 
aggregate, represent more than a maximum weight of the index;
    j) An equal dollar-weighted index will be rebalanced once every 
quarter; and
    k) If an underlying index is maintained by a broker-dealer, the 
index must be calculated by a third party that has implemented 
appropriate information barriers around its personnel who have 
access to information about changes to the index.
    \13\ See NASD Rule 2860(b)(2)(JJ).
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    In response to the SIA Comment Letter, NASD in Amendment No. 1 
replaced the 11 originally proposed criteria for a ``conventional index 
option'' with the following criteria:
     An index must contain nine or more equity securities.
     No equity security may comprise more than 30% of the 
equity security component of the index's weighting.
     Each equity security in the index is either:
    1. A component security of the Russell 3000 Index or the FTSE All-
World Index Series; or
    2. Characterized by a minimum market capitalization and minimum 
trading volume.\14\
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    \14\ Specifically, each equity security in the index must: (A) 
Have a market capitalization of at least $75 million, or, in the 
case of the lowest weighted component securities in the basket or 
index in the aggregate account for no more than 10% of the weight of 
the index $50 million; and (B) have a trading volume for each of the 
preceding six months of at least one million shares or, in the case 
of each of the lowest weighted component securities in the basket or 
index that in the aggregate account for no more than 10% of the 
weight of the index, 500,000 shares.
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    The SIA recommended basing the definition of a ``conventional index 
option,'' in part, on the definition under the Exchange Act of what is 
not a ``narrow-based security index.'' \15\ As provided in that 
definition, the SIA recommended replacing the requirement that a 
qualifying index be comprised of ten or more securities with a 
requirement that an index be comprised of nine or more securities. 
Similarly, the SIA also recommended that the NASD amend its proposal to 
conform with the criterion under the Exchange Act definition described 
above, to provide that no equity security in the index represent more 
than 30% of the equity security component of the index. NASD adopted 
both of these recommendations.
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    \15\ See 15 U.S.C. 78c(a)(55)(C).
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    In its original filing, NASD required that the components of an 
index underlying a ``conventional index option'' be characterized by 
certain minimum market capitalization and liquidity standards.\16\ The 
SIA suggested that NASD treat components of the Russell 3000 Index and 
the FTSE All-World Index Series as meeting such quantitative standards 
without measuring the actual market capitalization and trading volume 
of such components.\17\ In Amendment No. 1, NASD retained the 
quantitative standards for market capitalization and trading volume, 
but allowed that condition to be met if an equity security is included 
in the Russell 3000 Index or the FTSE All-World Index Series. NASD 
believes that these indexes are reasonable surrogates for the 
quantitative measurements, and that these alternative criteria would 
reduce the compliance burden for members to monitor capitalization and 
trading volume of the index components.
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    \16\ See supra note 14
    \17\ See SIA Letter at 3.
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    NASD believes that the criteria it proposed in Amendment No. 1 to 
replace the original 11 criteria impose sufficient parameters on the 
components of the index to ensure that a qualifying index would not be 
so narrowly constructed as to have the economic characteristics of a 
single security or small group of securities. Accordingly, NASD in 
Amendment No. 1 eliminated the remaining criteria proposed in the 
original filing.

B. Large Options Position Reporting

    Under existing NASD Rule 2860(b)(5)(A)(i)(a), an NASD member must 
report a position of 200 contracts or more in any OTC option covering 
an ``underlying security or index.'' \18\ On June 30, 2006, the 
Commission approved an NASD rule change that, among other things, 
eliminated the term ``underlying index,'' which was defined to mean 
``an index upon which a Nasdaq index option contract is based.'' \19\ 
Accordingly, NASD rules currently provide no standard for the types of 
OTC index options for which members must report large positions. NASD's 
initial proposal would have clarified this situation by requiring a 
member to report a position of 200 or more contracts in: (1) An OTC 
option on an index underlying an exchange-traded option, or (2) a 
``conventional index option,'' as defined in proposed NASD Rule 
2860(b)(2)(N).
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    \18\ When a member conducts a business in standardized (i.e., 
exchange-traded) options but is not a member of the exchange on 
which the option is traded (i.e. is an ``access firm''), the member 
also must report to NASD a position of 200 contracts or more in a 
standardized option. See NASD Rule 2860(b)(5)(A)(i)(b). Nothing in 
this proposal affects an access firm's obligation to report 
positions in standardized options.
    \19\ The proposed rule change amended various NASD rules in 
anticipation of the Nasdaq Stock Market's separation from NASD. See 
Securities Exchange Act Release No. 54084 (June 30, 2006), 71 FR 
38935 (July 10, 2006) (SR-NASD-2005-087).
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    In its comment letter, the SIA suggested that a position in an OTC 
index option should be exempt from any position reporting requirements 
unless the OTC option overlies the same index as an exchange-traded 
option. NASD generally agrees with the SIA's approach and is proposing 
to revise its Rule 2860(b)(5) to provide that a member must report a 
position in a ``conventional index option'' only when such option is 
based on an index that underlies, or is substantially similar to an 
index that underlies, an exchange-traded option. This approach would 
enable NASD Market Regulation staff to analyze the exchange-traded and 
OTC markets in aggregate for options on the same or substantially 
similar indexes.\20\ NASD believes that position reporting for other 
conventional index options would be of little regulatory interest and 
represents that, to the extent it requires information about a position 
in a conventional index option on a specially negotiated index or group 
of underlying securities, it can obtain such information from a member 
pursuant to

[[Page 67677]]

a request under NASD Rule 8210.\21\ Thus, NASD believes that 
eliminating this position reporting requirement would not prevent it 
from accessing information relating to a conventional index option 
position as needed to carry out its market oversight and enforcement 
responsibilities.
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    \20\ Telephone conversation among Gary Goldsholle, Associate 
General Counsel, NASD, Kathryn Moore, Assistant General Counsel, 
NASD, and Tim Fox, Special Counsel, Commission, on October 31, 2006.
    \21\ However, a position in an OTC index option that did not 
qualify as a ``conventional index option'' would in effect be 
deconstructed into separate equity option components, and the 
position reporting obligation would apply with respect to each 
component. See NASD Rule 2860(b)(2)(JJ).
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    Finally, the SIA urged NASD to revisit the threshold at which 
position reporting applies, for the OTC options where position 
reporting is required.\22\ The SIA suggested raising the threshold from 
the current 200 contracts to 10,000 contracts. NASD stated in Amendment 
No. 1 that it does not believe such a change is appropriate or 
necessary at this time. However, NASD stated that it will consider this 
issue and subject it to further review and discussion with the other 
self-regulatory organizations.
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    \22\ See SIA Letter at 4.
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C. Position Limits for Options on Foreign Equity Securities

    Under existing NASD Rule 2860(b)(3)(A)(viii), the position limits 
for conventional equity options parallel the limits for the 
standardized options on the same security. Therefore, if a standardized 
equity option is subject to a higher tier of position limits because of 
the relatively liquid and deep nature of the market for the underlying 
security, then a conventional option on the same security would be 
subject to a higher tier as well. On the other hand, with respect to an 
OTC option on an equally liquid foreign security, for which no 
exchange-traded equivalent exists, a member is required to limit its 
holdings (or its customer's holdings) to the lowest tier of position 
limits, absent prior approval of NASD staff. To alleviate this 
disparate treatment of OTC options on foreign equities, NASD proposed 
in the original filing to allow the higher tiers of position limits for 
OTC options overlying equity components of the FTSE All-World Index 
Series \23\ meeting the volume and float criteria established by the 
options exchanges for standardized options on domestic equity 
securities.\24\
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    \23\ NASD has represented that, if it designates another index 
in addition to or instead of the FTSE All-World Index Series, NASD 
would publish the designation of the new index in a Notice to 
Members and provide members at least 30 days' written notice of the 
change.
    \24\ See Commentary .07 to American Stock Exchange Rule 904, 
Section 7(c) of Chapter III of the Boston Options Exchange Rules, 
Interpretation .02 to Chicago Board Options Exchange (``CBOE'') Rule 
4.11; International Securities Exchange Rule 412(d); Commentary .06 
to NYSE Arca Rule 6.8; Commentary .05 to Philadelphia Stock Exchange 
Rule 1001.
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    Under the proposed rule change, a member would file a post-trade 
notice--within one business day--with NASD staff providing the 
necessary trade volume data and/or current float data to support the 
member's position limit calculation. NASD staff would review the 
member's notice, and, if the staff determined that a member incorrectly 
assigned a position limit, a staff member would instruct the firm to 
reduce its position below the appropriate limits determined by NASD 
staff. The Commission received no comments on this aspect of the 
proposal.

D. Miscellaneous Issues

    The SIA also suggested revising the definition of ``conventional 
index option'' to permit the inclusion of financial assets other than 
equity securities.\25\ NASD believes that the originally proposed 
definition of ``conventional index option'' permits the inclusion of 
non-equity assets and is not proposing any change to the rule text to 
accommodate SIA's suggestion. According to NASD, financial assets other 
than equity securities could be part of an index and the option thereon 
could still qualify as a ``conventional index option'' if the equity 
security components of the index together met the criteria in the 
definition.
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    \25\ See SIA Letter at 4.
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    In addition to changes in response to the SIA Letter, NASD in 
Amendment No. 1 proposed to clarify the date on which an OTC index 
option would or would not qualify as a ``conventional index option.'' 
The revised rules clarify that the definition's requirements apply as 
of the date the option position is created.\26\ NASD designed this 
approach to clarify that subsequent events that might impact an index's 
components would not change how an option on that index is treated for 
purposes of NASD's position limits and position reporting rules.
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    \26\ Telephone conversation between Gary Goldsholle, Associate 
GeneralCounsel, NASD, and Tim Fox, Division of Market Regulation, 
Commission on October 19, 2006.
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III. Discussion

    The Commission finds that the proposed rule change, as amended, is 
consistent with the requirements of the Exchange Act and the rules and 
regulations thereunder applicable to a national securities association 
and, in particular, the requirements of Section 15A(b)(6) of the 
Exchange Act,\27\ which requires that the rules of the NASD be designed 
to prevent fraudulent and manipulative acts and practices, to promote 
just and equitable principles of trade, to facilitate transactions in 
securities, and to remove impediments to and perfect the mechanism of a 
free and open market and, in general, to protect investors and the 
public interest.\28\ The Commission believes the proposed rule change 
is reasonably designed to enhance the NASD's ability to monitor the 
options positions of members and their customers and to clarify 
applicable position limits. In particular, the Commission believes that 
the NASD rules it is approving today reasonably differentiate between 
broad-based indexes and indexes whose economic characteristics more 
closely approximate those of a single security or a small number of 
securities. The Commission believes that the proposal is designed to 
balance between allowing the NASD to obtain information for surveilling 
the market in OTC index options and limiting the burdens on NASD 
members that hold positions in such options.
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    \27\ 15 U.S.C. 78o-3(b)(6).
    \28\ In approving the proposal, the Commission has considered 
the rule's impact on efficiency, competition, and capital formation. 
See 15 U.S.C. 78c(f).
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    The Commission finds good cause for approving the proposal, as 
amended by Amendment No. 1, prior to the thirtieth day after the 
amended proposal is published for comment in the Federal Register 
pursuant to Section 19(b)(2) of the Exchange Act.\29\ The Commission 
believes that Amendment No. 1 does not make any changes to the proposal 
that would adversely impact investor protection or the public interest. 
The Commission notes that it received only one comment letter in 
response to NASD's original proposal.\30\ Amendment No. 1 is generally 
responsive to the commenter's concerns and does not materially alter 
the proposal. The Commission notes that accelerating approval will 
enable NASD to implement the proposed rule changes without further 
delay.
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    \29\ 15 U.S.C. 78s(b)(2).
    \30\ See SIA Letter, supra note 4.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 1, including whether Amendment No. 1 
is consistent with the Exchange Act. Comments may be submitted by any 
of the following methods:

Electronic comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml
); or

[[Page 67678]]

     Send an e-mail to rule-comments@sec.gov. Please include 
File Number SR-NASD-2006-007 on the subject line.

Paper comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, Station Place, 100 F 
Street, NE., Washington, DC 20549-1090.

All submissions should refer to Amendment No. 1 to File Number SR-NASD-
2006-007. This file number should be included on the subject line if e-
mail is used. To help the Commission process and review your comments 
more efficiently, please use only one method. The Commission will post 
all comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, 

all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Section, Station 
Place, 100 F Street, NE., Washington, DC 20549. Copies of such filing 
also will be available for inspection and copying at the principal 
office of NASD. All comments received will be posted without change; 
the Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to Amendment No. 1 to 
File Number SR-NASD-2006-007 and should be submitted on or before 
December 13, 2006.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\31\ that the proposed rule change (SR-NASD-2006-007) be, 
and hereby is approved, and that Amendment No. 1 is approved on an 
accelerated basis.
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    \31\ Id.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\32\
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    \32\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E6-19732 Filed 11-21-06; 8:45 am]

BILLING CODE 8011-01-P