Document ID: SEC-2007-1127-0001
Agency: sec
Document Type: Notice
Title: Self-regulatory organizations; proposed rule changes: Financial Industry Regulatory Authority, Inc
Posted Date: 2007-08-13T04:00Z

[Federal Register: August 13, 2007 (Volume 72, Number 155)]
[Notices]               
[Page 45284-45287]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13au07-109]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56207; File No. SR-NASD-2007-044]

 
Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc. (n/k/a Financial Industry Regulatory Authority, Inc.); 
Notice of Filing of Proposed Rule Change To Expand the Class of 
Entities Permitted To Use the Delta Hedging Exemption From Equity 
Options Position Limits

August 6, 2007.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on June 29, 2007, the National Association of Securities Dealers, Inc. 
(``NASD'') (n/k/a Financial Industry Regulatory Authority, Inc.) filed 
with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been substantially prepared by FINRA.\3\ The

[[Page 45285]]

Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On July 26, 2007, the Commission approved a proposed rule 
change filed by NASD to amend NASD's Certificate of Incorporation to 
reflect its name change to Financial Industry Regulatory Authority 
Inc., or FINRA, in connection with the consolidation of the member 
firm regulatory functions of NASD and NYSE Regulation, Inc. See 
Securities Exchange Act Release No. 56146 (July 26, 2007), 72 FR 
42190 (August 1, 2007).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA proposes to amend Rule 2860 to expand the class of entities 
permitted to use the delta hedging exemption from equity options 
position limits. The text of the proposed rule change is available on 
FINRA's Web site (http://www.finra.org), at FINRA, and at the Commission's 

Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in Sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
Background
    Over the past several years, FINRA has increased in absolute terms 
the size of the options position and exercise limits as well as the 
size and scope of available exemptions for ``hedged'' positions.\4\ The 
exemptions for hedged positions generally required a one-to-one hedge, 
i.e., one stock option contract must be hedged by the number of shares 
covered by the options contract, typically 100 shares. In practice, 
however, many firms do not hedge their options positions in this way. 
Rather, these firms engage in what is known as ``delta hedging,'' which 
varies the number of shares of stock used to hedge an options position 
based upon the relative sensitivity of the value of the option contract 
to a change in the price of the underlying stock.\5\ FINRA believes 
that delta hedging is widely accepted for net capital and risk 
management purposes.
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    \4\ See Securities Exchange Act Release Nos. 47307 (February 3, 
2003), 68 FR 6977 (February 11, 2003) (SR-NASD-2002-134); 40932 
(January 11, 1999), 64 FR 2930 (January 19, 1999) (SR-NASD-98-92); 
40087 (June 12, 1998), 63 FR 33746 (June 19, 1998) (SR-NASD-98-23); 
and 39771 (March 19, 1998), 63 FR 14743 (March 26, 1998) (SR-NASD-
98-15).
    \5\ For example, an option with a delta of .5 will move $0.50 
for every $1.00 move in the underlying stock.
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    In 2004, the Commission approved amendments to Rule 2860 that 
provide a delta hedging exemption from stock options position and 
exercise limits \6\ for positions held by affiliates of NASD members 
approved by the Commission as ``OTC Derivatives Dealers.'' \7\ At that 
time, the Commission reiterated its ``support for recognizing options 
positions hedged on a delta neutral basis as properly exempted from 
position limits.'' \8\
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    \6\ The proposed rule change does not expressly amend FINRA's 
options exercise limits in Rule 2860(b)(4) because such exercise 
limits apply only to the extent Rule 2860(b)(3) imposes position 
limits. Thus, as delta neutral positions would be exempt from 
position limits under the proposed rule change, such positions also 
would be exempt from exercise limits. See NASD Notice to Members 94-
46 (June 1994) at 2 (``* * * exercise limits correspond to position 
limits, such that investors in options classes on the same side of 
the market are allowed to exercise * * * only the number of options 
contracts set forth as the applicable position limit for those 
options classes.''). Similarly, for positions held that are not 
delta neutral, only the option contract equivalent of the net delta 
of such positions would be subject to exercise limits.
    \7\ See Securities Exchange Act Release No. 50748 (November 29, 
2004), 69 FR 70485 (December 6, 2004) (SR-NASD-2004-153).
    \8\ Id. at 70486.
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Broadening the Scope of FINRA's Delta Hedging Exemption
    In the proposed rule change, FINRA is expanding the delta hedging 
exemption beyond OTC Derivatives Dealers to include broker-dealers and 
certain other financial institutions (``Exemption''). Specifically, the 
proposed rule change would permit any member, or non-member affiliate 
permitted to rely on new proposed subparagraph (B) or (C) of Rule 
2860(b)(3)(A)(vii)b.1. (described below),\9\ to apply the delta model 
developed by the Options Clearing Corporation.
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    \9\ See infra notes 11 and 12 and accompanying text.
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    In addition, certain other broker-dealers and affiliated entities, 
described below, would be permitted to use a proprietary model(s) to 
calculate options position net deltas provided that the use of such 
models were in accordance with the entity's internal risk management 
control systems. The options contract equivalent of the net delta \10\ 
of a hedged options position still would be subject to the position 
limits in Rule 2860 (subject to the availability of any other position 
limit exemptions).
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    \10\ ``Net delta'' would be defined in Rule 2860(b)(2)(GG) to 
mean ``the number of shares that must be maintained (either long or 
short) to offset the risk that the value of an equity options 
position will change with incremental changes in the price of the 
security underlying the options position.''
    Options Contract Equivalent of the Net Delta'' would be defined 
in proposed Rule 2860(b)(2)(LL) to mean the net delta divided by the 
number of shares underlying the options contract.
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    For example, if a member is short 20,000 call contracts (each 
representing 100 shares of stock) with a delta of .5, the member would 
need to be long 1,000,000 shares of stock to hedge that position. 
Assume that the member was long 600,000 shares and had another 
permitted offset (e.g., a swap or futures contract) representing 
another 200,000 shares of stock. In that case, the net delta of that 
position would be 200,000 shares (1,000,000--600,000 long shares--
200,000 swap or future); and the number of contracts attributable to 
that position would be 2,000 contracts (200,000 shares / 100 shares per 
contract) on the short side of the market.
    ``Permitted Pricing Models'' for purposes of the Exemption would be 
pricing models used by: (1) A member or its affiliate subject to 
consolidated supervision by the Commission pursuant to Appendix E of 
Rule 15c3-1 under the Act; \11\ (2) a financial holding company 
(``FHC'') or a company treated as an FHC under the Bank Holding Company 
Act of 1956, or its affiliate subject to consolidated holding company 
group supervision; \12\ (3) an SEC registered OTC derivatives

[[Page 45286]]

dealer; \13\ (4) a national bank under the National Bank Act; \14\ and, 
as previously noted, (5) a member, or non-member affiliate (as 
permitted by subparagraph (B) or (C) of proposed Rule 
2860(b)(3)(A)(vii)b.1.), using a pricing model maintained and operated 
by the Options Clearing Corporation.
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    \11\ Use of such pricing model would be required to be 
consistent with the requirements of Appendices E or G, as 
applicable, to Rules 15c3-1 and 15c3-4 under the Act in connection 
with the calculation of risk-based deductions from capital or 
capital allowances for market risk thereunder. See subparagraph (B) 
of proposed Rule 2860(b)(3)(A)(vii)b.1.
    \12\ An FHC's affiliate that is part of the FHC's consolidated 
supervised holding company group would be eligible to use this part 
of the Exemption. An FHC's (or an affiliate's) use of a proprietary 
model would have to be consistent with either: (i) The requirements 
of the Board of Governors of the Federal Reserve System, as amended 
from time to time, in connection with the calculation of risk-based 
adjustments to capital for market risk under capital requirements of 
the Board of Governors of the Federal Reserve System; or (ii) the 
standards published by the Basel Committee on Banking Supervision, 
as amended from time to time and as implemented by such company's 
principal regulator, in connection with the calculation of risk-
based deductions or adjustments to or allowances for the market risk 
capital requirements of such principal regulator applicable to such 
company--where ``principal regulator'' means a member of the Basel 
Committee on Banking Supervision that is the home country 
consolidated supervisor of such company. See subparagraph (C) of 
proposed Rule 2860(b)(3)(A)(vii)b.1.
    It is important to note that the U.S. activities of entities 
subject to the Basel standards still are overseen by the Federal 
Reserve Board, and FINRA would be relying upon that oversight in 
extending exemptive relief to such entities.
    \13\ This part of the Exemption would replace in its entirety 
current Rule 2860(b)(3)(a)vii.b. An OTC Derivative Dealer's use of a 
proprietary model would be required to be consistent with the 
requirements of Appendix F to Rule 15c3-1 and Rule 15c3-4 under the 
Act, as amended from time to time, in connection with the 
calculation of risk-based deductions from capital for market risk 
thereunder. Only an OTC Derivatives Dealer and no other affiliated 
entity (including a member) would be able to rely upon this 
particular part of the Exemption. See subparagraph (D) of proposed 
new Rule 2860(b)(3)(A)(vii)b.1.
    \14\ The use of a proprietary model by a national bank would be 
required to be consistent with the requirements of the Office of the 
Comptroller of the Currency, as amended from time to time, in 
connection with the calculation of risk-based adjustments to capital 
for market risk under capital requirements of the Office of the 
Comptroller of the Currency. An affiliate of a national bank 
(including a FINRA member) would not be permitted to rely on this 
part of the Exemption. See subparagraph (E) of proposed Rule 
2860(b)(3)(A)(vii)b.1.
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    Irrespective of the features of any proprietary pricing model, only 
financial instruments relating to the security underlying an equity 
options position would be permitted to be included in any determination 
of an equity options position's net delta or whether the options 
position is delta neutral. For example, a short position in XYZ calls 
could be hedged with a long position in XYZ warrants. However, a short 
position in XYZ calls would not be permitted to be hedged with any 
financial instrument relating to a security other than XYZ stock. In 
addition, firms would not be permitted to use the same equity or other 
financial instrument position in connection with more than one hedge 
exemption. Thus, a stock position used as part of a delta hedge would 
not be permitted also to serve as the basis for any other equity option 
hedge exemption.
Obligations of Members and Affiliates
    A member that intends to employ, or whose non-member affiliate 
intends to employ, the Exemption would be required to provide a written 
certification to FINRA stating that the member and/or its affiliate 
will use a Permitted Pricing Model as described above and defined in 
the Rule, and that if an affiliate ceases to hedge stock options 
positions in accordance with such systems and models, it will provide 
immediate written notice to the member.
    In addition, the options positions of a non-member relying on the 
Exemption would be required to be carried by a member with which it is 
affiliated.
    Any options position that is not delta neutral would remain subject 
to position and exercise limits (subject, however, to the availability 
of other exemptions). While delta hedging generally is employed as part 
of an overall risk management program, firms do not necessarily hedge 
every position to be delta neutral, i.e., having a net delta of zero. 
In such cases, only the options contract equivalent of the net delta of 
any such options position would be subject to position limits.
Impact on ``Aggregation'' Guidance
    FINRA recently issued guidance on when certain options accounts may 
be ``disaggregated.'' \15\ The proposed rule change would impact this 
guidance in the following way: Generally, an entity that relies on the 
proposed rule change would be required to ensure that a Permitted 
Pricing Model is applied to all positions in or relating to the 
security underlying the relevant options position that are owned or 
controlled by the entity, or its affiliates. However, the net delta of 
an options position held by an entity entitled to rely on this 
Exemption, or by a separate and distinct trading unit of such entity, 
would be permitted to be calculated without regard to positions in or 
relating to the security underlying the option held by an affiliated 
entity or by another trading unit within the same entity, provided 
that: (1) The entity demonstrates to FINRA's satisfaction that no 
control relationship, as defined in Notice to Members 07-03, exists 
between such affiliates or trading units; and (2) the entity has 
provided FINRA written notice in advance that it intends to be 
considered separate and distinct from any affiliate, or, as applicable, 
which trading units within the entity are to be considered separate and 
distinct from each other for purposes of this Exemption.\16\
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    \15\ See NASD Notice to Members 07-03 (January 2007).
    \16\ See proposed subparagraph (A)(vii)b.2 of Rule 2860(b)(3). 
FINRA has set forth, in Notice to Members 07-03, the conditions 
under which it will deem no control relationship to exist between 
affiliates and between separate and distinct trading units within 
the same entity.
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Position Reporting
    Today, under paragraph (b)(5) of Rule 2860, a broker-dealer must 
report any options position in which the member has an interest, and 
each customer, non-member broker or non-member dealer account, which 
has established an aggregate position of 200 or more options contracts 
(whether long or short) of the put class and the call class on the same 
side of the market. Under the proposed rule change, FINRA would retain 
these reporting thresholds even with respect to options positions of 
any member or designated aggregation unit that are delta neutral. In 
addition, however, each member, or designated aggregation unit pursuant 
to proposed subparagraph (b)(3)(A)(vii)b.2., also shall report the 
options equivalent of the net delta of a position if such position 
represents 200 or more contracts (whether long or short) on the same 
side of the market covering the same underlying stock that are effected 
by the member. Referring to the example above, a member who is short 
20,000 call contracts with a delta of .5 and long 600,000 shares of 
stock and long 200,000 shares through a SWAP or futures contract, would 
report: (a) Its options position as short 20,000 contracts and (b) its 
options equivalent of the net delta as short 2,000 contracts.
    FINRA and other self-regulatory organizations are working on 
modifying the Large Options Position Reporting system and/or the 
Options Clearing Corporation reports to allow a member to indicate that 
an equity options position is being delta hedged.
Reliance on Federal Oversight
    FINRA notes that when it provided exemptive relief for OTC 
Derivatives Dealers in 2004, NASD indicated that it believed that the 
rigor of the Commission's OTC Derivatives Dealer approval process and 
the ongoing oversight by the Commission staff provided an appropriate 
basis for exempting delta neutral positions in options held by such 
entities from position and exercise limits.\17\ The proposed rule 
change's extension of exemptive relief to additional users of 
proprietary models similarly relies upon the rigorous approval 
processes and ongoing oversight of a federal financial regulator.
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    \17\ See Securities Exchange Act Release No. 50539 (October 19, 
2004), 69 FR 61884, 61885 (October 21, 2004)(SR-NASD-2004-153).
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    In an effort to leverage the existing federal oversight in this 
area, FINRA has developed procedures to monitor members' compliance 
with the proposed delta hedging position limit rules. Specifically, 
FINRA would employ a narrowly circumscribed program around the 
employment of delta hedging by eligible broker-dealers. FINRA would 
examine to the extent of: (1) Reviewing that the eligible broker-
dealers have policies and procedures to determine their net positions 
in ascertaining any option holdings in

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respect of position limits including the reduction from any such net 
positions any positions subject to delta hedging or allowable equity 
option hedges; and (2) determining that the eligible broker-dealers 
represent that they have made any reduction from such net option 
positions pursuant to and in accordance with a model, or the processes 
that develop a model, for delta hedging that have been approved by an 
applicable federal regulator. It is important to note that FINRA is not 
under any obligation to test: (1) The integrity of a model, its 
processes or methodology; or (2) the employment of such models by 
eligible broker-dealers as to any data inputs, calculations or any 
other utilization of the model.
    FINRA will announce the effective date of the proposed rule change 
in a Notice to Members to be published no later than 60 days following 
Commission approval. The effective date will be no later than 30 days 
following publication of the Notice to Members announcing Commission 
approval.
2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\18\ which requires, among 
other things, that FINRA rules be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. FINRA believes that it is appropriate, subject to 
certain conditions, to exempt options positions of entities subject to 
an extensive regulatory framework of a federal financial regulator from 
position limits and require that only the option contract equivalent of 
the net delta of a stock options position be subject to position 
limits.
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    \18\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change would result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) As the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the 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     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-NASD-2007-044 on the subject line.

Paper Comments

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

All submissions should refer to File Number SR-NASD-2007-044. 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 Room, on official business 
days between the hours of 10 am and 3 pm. Copies of such filing also 
will be available for inspection and copying at the principal office of 
FINRA. 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 File Number SR-
NASD-2007-044 and should be submitted on or before September 4, 2007.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E7-15723 Filed 8-10-07; 8:45 am]

BILLING CODE 8010-01-P