Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Partial Amendment No. 1 Thereto By the Chicago Board Options Exchange, Incorporated To Amend Rules Relating Margin Treatment on Stock Transactions Effected By an Options Market Maker To Hedge Options Positions, 19536-19538 [05-7375]

Download as PDF 19536 Federal Register / Vol. 70, No. 70 / Wednesday, April 13, 2005 / Notices rules, as well as Commission rules, is a serious matter. However, the Exchange’s Plan provides a reasonable means of addressing rule violations that do not rise to the level of requiring formal disciplinary proceedings, while providing greater flexibility in handling certain violations. The Commission expects that Amex will continue to conduct surveillance with due diligence and make a determination based on its findings, on a case-by-case basis, whether a fine of more or less than the recommended amount is appropriate for a violation under the Plan or whether a violation requires formal disciplinary action. It is therefore ordered, pursuant to Section 19(b)(2) of the Act 9 and Rule 19d–1(c)(2) under the Act,10 that the proposed rule change (SR–Amex–2005– 009) be, and hereby is, approved and declared effective. For the Commission, by the Division of Market Regulation, pursuant to delegated authority.11 Margaret H. McFarland, Deputy Secretary. [FR Doc. E5–1742 Filed 4–12–05; 8:45 am] SECURITIES AND EXCHANGE COMMISSION Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Partial Amendment No. 1 Thereto By the Chicago Board Options Exchange, Incorporated To Amend Rules Relating Margin Treatment on Stock Transactions Effected By an Options Market Maker To Hedge Options Positions April 6, 2005. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (‘‘the Act’’) 1 and Rule 19b–4 2 thereunder, notice is hereby given that on July 30, 2004, the Chicago Board Options Exchange, Incorporated (‘‘CBOE’’ or ‘‘Exchange’’) filed with the Securities and Exchange Commission (‘‘Commission’’ or ‘‘SEC’’) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by the Exchange. On February 22, 2005, the CBOE filed a partial amendment to its proposed rule U.S.C. 78s(b)(2). CFR 240.19d–1(c)(2). 11 17 CFR 200.30–3(a)(12); 17 CFR 200.30– 3(a)(44). 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b–4. VerDate jul<14>2003 19:24 Apr 12, 2005 Jkt 205001 The Chicago Board Options Exchange, Incorporated (the ‘‘CBOE’’ or ‘‘Exchange’’) is proposing to eliminate a rule that essentially disallows favorable margin treatment on stock transactions initiated by options market makers to hedge an option position if the exercise price of the option is more than two standard exercise price intervals above the price of the stock in the case of a call option, or below in the case of a put option. The text of the proposed rule change is available on CBOE’s Web site (https://www.cboe.com), at the CBOE’s Office of the Secretary, 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 1. Purpose [Release No. 51497; File No. SR–CBOE– 2004–54] 10 17 Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change A. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change BILLING CODE 8010–01–P 9 15 change.3 The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons. When options market makers hedge their option positions by taking a long or short position in the underlying security, the underlying security is allowed ‘‘good faith’’ margin treatment,4 provided the underlying security meets the definition of a ‘‘permitted offset.’’ 5 To qualify as a permitted offset, CBOE Rule 12.3(f)(3) requires, among other things, that the transaction price of the underlying security be not more than two standard exercise price intervals below the exercise price of the option being hedged in the case of a call option, or above in the case of a put option. The term ‘‘in-or-at-the-money’’ is used in CBOE Rule 12.3(f)(3) to refer to the two standard strike price interval requirement. Stated another way, ‘‘in-orat-the-money’’ means the option being hedged cannot be ‘‘out-of-the-money’’ 3 SR–CBOE–2004–54: Amendment No. 1. Under the partial amendment, the options market maker must be able to demonstrate that it effected its permitted offset transactions for market-making purposes. 4 Good faith margin is defined in Regulation T of the Board of Governors of the Federal Reserve System (‘‘Regulation T’’), the margin setting authority for the securities industry, as the amount of margin a creditor would require in exercising sound credit judgment. 5 A ‘‘permitted offset’’ is defined in CBOE Rule 12.3(f)(3). PO 00000 Frm 00125 Fmt 4703 Sfmt 4703 by more than two standard exercise price intervals.6 The intent of this requirement was to confine good faith margining of transactions in the underlying security to those that constituted meaningful hedges of an option position. The need to hedge with 100 shares or units of the underlying security diminishes the more the exercise price of a call option is above the price of the underlying security, and the more the exercise price of a put option is below. If these inexpensive, ‘‘out-of-the-money’’ options are offset with a position in the underlying security equivalent in size (that is, units or shares) to that represented by the option, the risk of the combined positions is nearly the same as the underlying security position without the option. The option has very little effect. To prevent inexpensive, ‘‘out-of-the-money’’ options from being used as a means to gain good faith margin for trading in the underlying security, the two standard strike price interval limitation was imposed. The Exchange is proposing to remove the ‘‘in-or-at-the-money’’ requirement.7 The Exchange believes that a hedging transaction in the underlying security by an options market-maker can constitute a reasonable hedge, and is deserving of good faith margin, even if the exercise price of the option is outof-the-money by more than two standard exercise price intervals. The listing of option series is not limited to options that meet the ‘‘in-or-at-themoney’’ requirement and options market-makers are obligated to provide liquidity in such ‘‘out-of-the money’’ options. In today’s listed options market, there can be numerous options series that are out-of-the-money, more so than when the idea of an ‘‘in-or-atthe-money’’ requirement was first conceived. Moreover, in today’s listed options market, smaller standard exercise price intervals have been introduced in some options (for example, 1 point and 21⁄2 points), in contrast to the earlier days of the listed 6 An option is ‘‘out-of-the-money’’ when, based on comparison of the exercise price to the current market price of the underlying security, it makes no economic sense to exercise the option. For example, a call option with the right to purchase the underlying security at $50 per share would not be exercised if the underlying security were trading in the market for $46 per share. 7 The New York Stock Exchange (‘‘NYSE’’) also has filed a proposed rule change to remove the ‘‘inor-at-the-money’’ language from its rules on permitted offsets. Although the language of the NYSE’s proposed rule change differs from the language of the CBOE’s proposed rule change, the proposed changes from the two exchanges are substantively identical. The Commission is publishing a notice to solicit comments on the NYSE’s proposed rule change. E:\FR\FM\13APN1.SGM 13APN1 Federal Register / Vol. 70, No. 70 / Wednesday, April 13, 2005 / Notices options market when the only standard was a five-point interval. The need for relief from the ‘‘in-or-atthe-money’’ constraint has been addressed before. Prior to June 1, 1997, ‘‘in-or-at-the-money’’ was defined in Regulation T to mean the price of the underlying security is not more than one standard exercise price interval below the exercise price of the option being hedged in the case of a call option, or above in the case of a put option. Provisions pertaining to marketmakers and specialists were removed from Regulation T effective June 1, 1997, due to an exemption for marketmakers and specialists that resulted from passage of the National Securities Markets Improvement Act of 1996. The Exchange, as well as the New York Stock Exchange, adopted the provisions of Regulation T applicable to marketmakers and implemented them as exchange rules effective June 1, 1997, except for the definition of ‘‘in-or-at-themoney.’’ The current definition of ‘‘inor-at-the-money,’’ requiring two standard exercise price intervals, was proposed by the exchanges and approved by the Commission at that time.8 This was done based upon the recommendation of an industry committee organized by the New York Stock Exchange to review its margin rules. That committee did consider relief in the form of eliminating the ‘‘inor-at-the-money’’ requirement altogether, but a majority in favor of elimination was not attained at that time. The Exchange also believes that the ‘‘in-or-at-the-money’’ requirement is not in tune with current options marketmaker hedging technique. Options market-makers generally seek to create a risk-neutral hedge when they offset an option with a position in the underlying security. In the case of an ‘‘out-of-themoney’’ option, they cannot create a risk-neutral hedge if they take a full 100 share position per option in the underlying security, because any gain/ loss on the option being hedged would be outweighed by the loss/gain in the underlying security position. Therefore, losses on the underlying security position are not equally hedged and pose a risk. Instead, options marketmakers will take a less than 100 share position in the underlying security per option being hedged so that any gain/ loss on that position in dollar terms closely tracks that of the dollar gain/loss on the option position. When options market-makers hedge in this manner, 8 See Securities Exchange Act Release No. 34– 38709 (June 2, 1997), 62 FR 31643 (approving SR– CBOE–97–17). VerDate jul<14>2003 18:37 Apr 12, 2005 Jkt 205001 known as ‘‘delta neutral hedging,’’ they cannot benefit from any gain on a position in the underlying security because it is equally offset by a loss in the option being hedged. Therefore, there is no need for a rule provision that was originally intended to guard against options market-makers obtaining good faith credit for trading in the underlying security that is unrelated to the options market-making business. It should be noted that internal risk control systems at all of the brokerdealers that clear and carry the accounts of options market-makers impose a delta neutral trading standard on options market-makers, monitor options markermakers’ compliance with the clearing firm’s risk limits, and intervene as necessary to counter any deviation from acceptable risk levels. The internal risk control systems employed by the clearing firms thus provide as good a deterrent against unrelated trading in the underlying security or instrument as the current ‘‘in-or-at-the-money’’ requirement. Another reason why the Exchange deems the ‘‘in-or-at-the-money’’ requirement unnecessary is the fact that, when a clearing firm extends good faith margin on a security underlying an option, it must reduce its net capital by any amount by which the deduction required by Rule 15c3–1 under the Securities Exchange Act of 1934 (the ‘‘haircut’’) exceeds the amount of equity in the options market maker’s account. Thus, the market-maker must post enough margin to cover the haircut requirement or the clearing firm must, in effect, post the margin, or any portion not on deposit in the market-maker’s account, by setting aside its capital. In this way there is a safety cushion to cover the credit risk when good faith margin is extended and the good faith requirement is less than the haircut requirement. Thus, when good faith margin is extended, the haircut requirement is a de facto minimum margin requirement. In further support of eliminating the ‘‘in-or-at-the-money’’ requirement is the fact that, according to each of the options market maker clearing firms, a violation of the ‘‘in-or-at-the-money’’ requirement is very rare. The clearing firms also point out that when the price of an underlying security established for hedging purposes changes in a manner so a to exceed the two standard exercise price interval, the underlying security maintains its permitted offset status, and it becomes impractical to determine which shares are not qualified for permitted offset treatment. PO 00000 Frm 00126 Fmt 4703 Sfmt 4703 19537 2. Statutory Basis The proposed rule is intended to eliminate a requirement that impedes options market makers from hedging, on a good faith margin basis, ‘‘out-of-themoney’’ options having standard exercise price intervals of less than five points. As such, the proposed rule change is consistent with and furthers the objectives of Section 6(b)(5) of the Act, in that it is designated to perfect the mechanisms of a free and open market and to protect investors and the public interest. B. Self-Regulatory Organization’s Statement on Burden on Competition CBOE does not believe that the proposed rule change will impose any burden on competition that is not necessary or appropriate in furtherance of purposes of the Act. C. Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others No written comments were either solicited or received with respect to the proposed rule change. 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 Exchange 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 proposal is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments: • Use the Commission’s Internet comment form (https://www.sec.gov/ rules/sro.shtml); or • Send an e-mail to rulecomments@sec.gov. Please include File Number SR–CBOE–2004–54 on the subject line. E:\FR\FM\13APN1.SGM 13APN1 19538 Federal Register / Vol. 70, No. 70 / Wednesday, April 13, 2005 / Notices Paper Comments: • Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549–0609. All Submissions should refer to File Number SR–CBOE–2004– 54. 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. 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. Copies of such filing will also be available for inspection and copying at the principal office of the CBOE. 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–CBOE–2004–54 and should be submitted on or before May 4, 2005. For the Commission, by the Division of Market Regulation, pursuant to delegated authority.9 Margaret H. McFarland, Deputy Secretary. [FR Doc. 05–7375 Filed 4–12–05; 8:45 am] BILLING CODE 8010–01–M [Release No. 34–51504; File No. SR–NASD– 2004–033] Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amendment Nos. 1, 2, and 3 Thereto by the National Association of Securities Dealers, Inc. Seeking to Modify the Nasdaq Market Center Execution Service to Add an Optional Routing Feature April 7, 2005. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (‘‘Act’’),1 and Rule 19b–4 thereunder,2 CFR 200.30–3(a)(12). U.S.C. 78s(b)(1). 2 17 CFR 240.19b–4. 1 15 VerDate jul<14>2003 19:24 Apr 12, 2005 Jkt 205001 I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change Nasdaq proposes to modify the Nasdaq Market Center execution service (formerly known as SuperMontage or the Nasdaq National Market Execution System) to provide an optional routing feature that will route orders in Nasdaqlisted securities to other markets accessible by the router when these markets are displaying quotes at prices that are superior to those available on Nasdaq. Pending Commission approval, Nasdaq is scheduled to implement the routing feature on or about May 9, 2005. Below is the text of the proposed rule change, as amended. Proposed new language is italicized; proposed deletions are in [brackets]. * * * * * 4700. NASDAQ MARKET CENTER— EXECUTION SERVICES 4701. SECURITIES AND EXCHANGE COMMISSION 9 17 notice is hereby given that on February 25, 2004, the National Association of Securities Dealers, Inc. (‘‘NASD’’), through its subsidiary, The Nasdaq Stock Market, Inc. (‘‘Nasdaq’’), 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 prepared by Nasdaq. On July 15, 2004, Nasdaq submitted Amendment No. 1 to the proposed rule change.3 On February 23, 2005, Nasdaq submitted Amendment No. 2 to the proposed rule change.4 On April 7, 2005, Nasdaq submitted Amendment No. 3 to the proposed rule change.5 The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons. Definitions Unless stated otherwise, the terms described below shall have the following meaning: (a) The term ‘‘active Nasdaq Market Center securities’’ shall mean those Nasdaq Market Center eligible securities in which at least one Nasdaq Market Maker or ITS/CAES Market Maker is currently active in the Nasdaq Market Center, or at least one exchange or the Association’s Alternative Display Facility is actively quoting the security and Nasdaq has access to the quotes of these markets under Rule 4714. A security will not be considered an 3 Amendment No. 1 replaced and superseded the originally filed proposed rule change. 4 Amendment No. 2 replaced and superseded the originally filed proposed rule change, as amended. 5 Amendment No. 3 replaced and superseded the originally filed proposed rule change, as amended. PO 00000 Frm 00127 Fmt 4703 Sfmt 4703 ‘‘active Nasdaq Market Center security’’ when trading on Nasdaq has been halted pursuant to Rule 4120 and the interpretations thereunder. (b)–(z) No change (aa) The term ‘‘Preferenced Order’’ shall mean an order that is entered into the Non-Directed Order Process and is designated to be delivered to or executed against a particular Quoting Market Participant’s Attributable Quote/ Order if the Quoting Market Participant is at the best bid/best offer when the Preferenced Order is the next in line to be executed or delivered. Preferenced Orders shall be executed subject to the conditions set out in Rule 4710(b). Preferenced Orders shall not be eligible for routing as set out in Rule 4714. (bb)–(jj) No change (kk) The term ‘‘Auto-Ex’’ shall mean, for orders in Nasdaq listed securities so designated, an order that (except when it is displayed or interacts with a displayed Discretionary Order at a price in its discretionary price range) will execute solely against the Quotes/ Orders of Nasdaq Market Center Participants that participate in the automatic execution functionality of the Nasdaq Market Center and that do not charge a separate quote access fee to Nasdaq Market Center Participants accessing their Quotes/Orders through the Nasdaq Market Center. An Auto-Ex Order may be designated as ‘‘Immediate or Cancel’’ (an ‘‘IOC Auto-Ex Order’’) or ‘‘Day’’ or ‘‘GTC’’ (a ‘‘Postable Auto-Ex Order’’). A party entering a Postable Auto-Ex Order may (but is not required to) specify that the order will utilize the functionality associated with Discretionary Orders. Auto-Ex orders shall not be eligible for routing as set out in Rule 4714. (ll) The term ‘‘Fill or Return’’ shall mean for orders in ITS Securities so designated, an order that is to be delivered to or executed by Nasdaq Market Center Participants without delivering the order to an ITS Exchange and without trading through the quotations of ITS Exchanges. Fill or Return orders shall not be eligible for routing as set out in Rule 4714. (mm) The term ‘‘Pegged’’ shall mean, for priced limit orders so designated, that after entry into the Nasdaq Market Center, the price of the order is automatically adjusted by the Nasdaq Market Center in response to changes in the Nasdaq Market Center inside bid or offer, as appropriate. The Nasdaq Market Center Participant entering a Pegged Order may specify that the price of the order will either equal the inside quote on the same side of the market (a ‘‘Regular Pegged Order’’) or equal a price that deviates from the inside quote E:\FR\FM\13APN1.SGM 13APN1

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 70, Number 70 (Wednesday, April 13, 2005)]
[Notices]
[Pages 19536-19538]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-7375]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 51497; File No. SR-CBOE-2004-54]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Partial Amendment No. 1 Thereto By the Chicago Board Options 
Exchange, Incorporated To Amend Rules Relating Margin Treatment on 
Stock Transactions Effected By an Options Market Maker To Hedge Options 
Positions

April 6, 2005.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``the Act'') \1\ and Rule 19b-4 \2\ thereunder, notice is hereby given 
that on July 30, 2004, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the Exchange. On February 22, 2005, the CBOE filed a partial 
amendment to its proposed rule change.\3\ The Commission is publishing 
this notice to solicit comments on the proposed rule change, as 
amended, from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ SR-CBOE-2004-54: Amendment No. 1. Under the partial 
amendment, the options market maker must be able to demonstrate that 
it effected its permitted offset transactions for market-making 
purposes.
---------------------------------------------------------------------------

Self-Regulatory Organization's Statement of the Terms of Substance of 
the Proposed Rule Change

    The Chicago Board Options Exchange, Incorporated (the ``CBOE'' or 
``Exchange'') is proposing to eliminate a rule that essentially 
disallows favorable margin treatment on stock transactions initiated by 
options market makers to hedge an option position if the exercise price 
of the option is more than two standard exercise price intervals above 
the price of the stock in the case of a call option, or below in the 
case of a put option. The text of the proposed rule change is available 
on CBOE's Web site (https://www.cboe.com), at the CBOE's Office of the 
Secretary, 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

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

1. Purpose
    When options market makers hedge their option positions by taking a 
long or short position in the underlying security, the underlying 
security is allowed ``good faith'' margin treatment,\4\ provided the 
underlying security meets the definition of a ``permitted offset.'' \5\ 
To qualify as a permitted offset, CBOE Rule 12.3(f)(3) requires, among 
other things, that the transaction price of the underlying security be 
not more than two standard exercise price intervals below the exercise 
price of the option being hedged in the case of a call option, or above 
in the case of a put option. The term ``in-or-at-the-money'' is used in 
CBOE Rule 12.3(f)(3) to refer to the two standard strike price interval 
requirement. Stated another way, ``in-or-at-the-money'' means the 
option being hedged cannot be ``out-of-the-money'' by more than two 
standard exercise price intervals.\6\
---------------------------------------------------------------------------

    \4\ Good faith margin is defined in Regulation T of the Board of 
Governors of the Federal Reserve System (``Regulation T''), the 
margin setting authority for the securities industry, as the amount 
of margin a creditor would require in exercising sound credit 
judgment.
    \5\ A ``permitted offset'' is defined in CBOE Rule 12.3(f)(3).
    \6\ An option is ``out-of-the-money'' when, based on comparison 
of the exercise price to the current market price of the underlying 
security, it makes no economic sense to exercise the option. For 
example, a call option with the right to purchase the underlying 
security at $50 per share would not be exercised if the underlying 
security were trading in the market for $46 per share.
---------------------------------------------------------------------------

    The intent of this requirement was to confine good faith margining 
of transactions in the underlying security to those that constituted 
meaningful hedges of an option position. The need to hedge with 100 
shares or units of the underlying security diminishes the more the 
exercise price of a call option is above the price of the underlying 
security, and the more the exercise price of a put option is below. If 
these inexpensive, ``out-of-the-money'' options are offset with a 
position in the underlying security equivalent in size (that is, units 
or shares) to that represented by the option, the risk of the combined 
positions is nearly the same as the underlying security position 
without the option. The option has very little effect. To prevent 
inexpensive, ``out-of-the-money'' options from being used as a means to 
gain good faith margin for trading in the underlying security, the two 
standard strike price interval limitation was imposed.
    The Exchange is proposing to remove the ``in-or-at-the-money'' 
requirement.\7\ The Exchange believes that a hedging transaction in the 
underlying security by an options market-maker can constitute a 
reasonable hedge, and is deserving of good faith margin, even if the 
exercise price of the option is out-of-the-money by more than two 
standard exercise price intervals. The listing of option series is not 
limited to options that meet the ``in-or-at-the-money'' requirement and 
options market-makers are obligated to provide liquidity in such ``out-
of-the money'' options. In today's listed options market, there can be 
numerous options series that are out-of-the-money, more so than when 
the idea of an ``in-or-at-the-money'' requirement was first conceived. 
Moreover, in today's listed options market, smaller standard exercise 
price intervals have been introduced in some options (for example, 1 
point and 2\1/2\ points), in contrast to the earlier days of the listed

[[Page 19537]]

options market when the only standard was a five-point interval.
---------------------------------------------------------------------------

    \7\ The New York Stock Exchange (``NYSE'') also has filed a 
proposed rule change to remove the ``in-or-at-the-money'' language 
from its rules on permitted offsets. Although the language of the 
NYSE's proposed rule change differs from the language of the CBOE's 
proposed rule change, the proposed changes from the two exchanges 
are substantively identical. The Commission is publishing a notice 
to solicit comments on the NYSE's proposed rule change.
---------------------------------------------------------------------------

    The need for relief from the ``in-or-at-the-money'' constraint has 
been addressed before. Prior to June 1, 1997, ``in-or-at-the-money'' 
was defined in Regulation T to mean the price of the underlying 
security is not more than one standard exercise price interval below 
the exercise price of the option being hedged in the case of a call 
option, or above in the case of a put option. Provisions pertaining to 
market-makers and specialists were removed from Regulation T effective 
June 1, 1997, due to an exemption for market-makers and specialists 
that resulted from passage of the National Securities Markets 
Improvement Act of 1996. The Exchange, as well as the New York Stock 
Exchange, adopted the provisions of Regulation T applicable to market-
makers and implemented them as exchange rules effective June 1, 1997, 
except for the definition of ``in-or-at-the-money.'' The current 
definition of ``in-or-at-the-money,'' requiring two standard exercise 
price intervals, was proposed by the exchanges and approved by the 
Commission at that time.\8\ This was done based upon the recommendation 
of an industry committee organized by the New York Stock Exchange to 
review its margin rules. That committee did consider relief in the form 
of eliminating the ``in-or-at-the-money'' requirement altogether, but a 
majority in favor of elimination was not attained at that time.
---------------------------------------------------------------------------

    \8\ See Securities Exchange Act Release No. 34-38709 (June 2, 
1997), 62 FR 31643 (approving SR-CBOE-97-17).
---------------------------------------------------------------------------

    The Exchange also believes that the ``in-or-at-the-money'' 
requirement is not in tune with current options market-maker hedging 
technique. Options market-makers generally seek to create a risk-
neutral hedge when they offset an option with a position in the 
underlying security. In the case of an ``out-of-the-money'' option, 
they cannot create a risk-neutral hedge if they take a full 100 share 
position per option in the underlying security, because any gain/loss 
on the option being hedged would be outweighed by the loss/gain in the 
underlying security position. Therefore, losses on the underlying 
security position are not equally hedged and pose a risk. Instead, 
options market-makers will take a less than 100 share position in the 
underlying security per option being hedged so that any gain/loss on 
that position in dollar terms closely tracks that of the dollar gain/
loss on the option position. When options market-makers hedge in this 
manner, known as ``delta neutral hedging,'' they cannot benefit from 
any gain on a position in the underlying security because it is equally 
offset by a loss in the option being hedged. Therefore, there is no 
need for a rule provision that was originally intended to guard against 
options market-makers obtaining good faith credit for trading in the 
underlying security that is unrelated to the options market-making 
business.
    It should be noted that internal risk control systems at all of the 
broker-dealers that clear and carry the accounts of options market-
makers impose a delta neutral trading standard on options market-
makers, monitor options marker-makers' compliance with the clearing 
firm's risk limits, and intervene as necessary to counter any deviation 
from acceptable risk levels. The internal risk control systems employed 
by the clearing firms thus provide as good a deterrent against 
unrelated trading in the underlying security or instrument as the 
current ``in-or-at-the-money'' requirement.
    Another reason why the Exchange deems the ``in-or-at-the-money'' 
requirement unnecessary is the fact that, when a clearing firm extends 
good faith margin on a security underlying an option, it must reduce 
its net capital by any amount by which the deduction required by Rule 
15c3-1 under the Securities Exchange Act of 1934 (the ``haircut'') 
exceeds the amount of equity in the options market maker's account. 
Thus, the market-maker must post enough margin to cover the haircut 
requirement or the clearing firm must, in effect, post the margin, or 
any portion not on deposit in the market-maker's account, by setting 
aside its capital. In this way there is a safety cushion to cover the 
credit risk when good faith margin is extended and the good faith 
requirement is less than the haircut requirement. Thus, when good faith 
margin is extended, the haircut requirement is a de facto minimum 
margin requirement.
    In further support of eliminating the ``in-or-at-the-money'' 
requirement is the fact that, according to each of the options market 
maker clearing firms, a violation of the ``in-or-at-the-money'' 
requirement is very rare. The clearing firms also point out that when 
the price of an underlying security established for hedging purposes 
changes in a manner so a to exceed the two standard exercise price 
interval, the underlying security maintains its permitted offset 
status, and it becomes impractical to determine which shares are not 
qualified for permitted offset treatment.
2. Statutory Basis
    The proposed rule is intended to eliminate a requirement that 
impedes options market makers from hedging, on a good faith margin 
basis, ``out-of-the-money'' options having standard exercise price 
intervals of less than five points. As such, the proposed rule change 
is consistent with and furthers the objectives of Section 6(b)(5) of 
the Act, in that it is designated to perfect the mechanisms of a free 
and open market and to protect investors and the public interest.

B. Self-Regulatory Organization's Statement on Burden on Competition

    CBOE does not believe that the proposed rule change will impose any 
burden on competition that is not necessary or appropriate in 
furtherance of purposes of the Act.

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

    No written comments were either solicited or received with respect 
to the proposed rule change.

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 Exchange 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 proposal is 
consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments:

     Use the Commission's Internet comment form (https://
www.sec.gov/rules/sro.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number SR-CBOE-2004-54 on the subject line.

[[Page 19538]]

Paper Comments:

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. All Submissions should refer to File Number 
SR-CBOE-2004-54. 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. 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. Copies of such filing will also be available for 
inspection and copying at the principal office of the CBOE. 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-CBOE-2004-54 and should be 
submitted on or before May 4, 2005.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 05-7375 Filed 4-12-05; 8:45 am]
BILLING CODE 8010-01-M

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