Self-Regulatory Organizations; New York Stock Exchange, Inc.; Order Approving a Proposed Rule Change and Amendment Nos. 1, 2 and 3 Thereto Relating to Customer Portfolio and Cross-Margining Requirements, 42130-42134 [05-14316]

Download as PDF 42130 Federal Register / Vol. 70, No. 139 / Thursday, July 21, 2005 / Notices 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 (https://www.sec.gov/ rules/sro.shtml). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule that are filed with the Commission, and all written communications relating to the proposed rule 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, 100 F Street, NE., Washington, DC 20549–9303. 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 File Number SR–NASD–2004–183 and should be submitted on or before August 11, 2005. V. Conclusion For the Commission, by the Division of Market Regulation, pursuant to delegated authority.21 J. Lynn Taylor, Assistant Secretary. [FR Doc. E5–3903 Filed 7–20–05; 8:45 am] BILLING CODE 8010–01–P SECURITIES AND EXCHANGE COMMISSION [Release No. 34–52031; File No. SR–NYSE– 2002–19] Self-Regulatory Organizations; New York Stock Exchange, Inc.; Order Approving a Proposed Rule Change and Amendment Nos. 1, 2 and 3 Thereto Relating to Customer Portfolio and Cross-Margining Requirements July 14, 2005. I. Introduction On May 13, 2002, the New York Stock Exchange, Inc. (‘‘NYSE’’ or ‘‘Exchange’’ filed with the Securities and Exchange Commission (‘‘Commission’’), pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 (‘‘Act’’) 1 and Rule 21 17 1 15 CFR 200.30–3(a)(12). U.S.C. 78s(b)(1). VerDate jul<14>2003 20:10 Jul 20, 2005 Jkt 205001 19b–4 2 thereunder, a proposed rule change seeking to amend its rules, for certain customer accounts, to allow member organizations to margin listed, broad-based, market index options, index warrants, futures, futures options and related exchange-traded funds according to a portfolio margin methodology. The NYSE seeks to introduce the proposed rule as a twoyear pilot program that would be made available to member organizations on a voluntary basis. On August 21, 2002, the NYSE field Amendment No. 1 to the proposed rule change.3 The Proposed rule change and Amendment No. 1 were published in the Federal Register On October 8, 2002.4 The Commission received three comment letters in response to the October 8, 2002 Federal Register notice.5 On June 21, 2004, the Exchange field Amendment No. 2 to the proposed rule change.6 The proposed rule change and Amendment Nos. 1 and 2 were published in the Federal Register on December 27, 2004.7 The Commission received ten comment letters in response to the December 27, 2004 Federal Register notice.8 CFR 240.19b–4. letter from Mary Yeager, Assistant Secretary, NYSE, to T.R. Lazo, Senior Special Counsel, Division of Market Regulation, Commission, dated August 20, 2002 (‘‘Amendment No. 1’’). In Amendment No. 1, the NYSE made technical corrections to its proposed rule language to eliminate any inconsistencies between its proposal and the CBOE proposal pursuant to the the Rule 431 Committee’s (‘‘Committee’’) recommendations. See Securities Exchange Act Release No. 45630 (March 22, 2002), 67 FR 15263 (March 29, 2002) File No. SR–CBOE–2002–03). 4 See Securities Exchange Act Release No. 46576 (October 1, 2002) 67 FR 62843 (October 8, 2002). 5 See letter from R. Allan Martin, President, Auric Trading Enterprises, Inc., to Secretary, Commission, dated October 9, 2002 (‘‘Martin Letter’’); Phupinder S. Gill, Managing Director and President, Chicago Mercantile Exchange Inc., to Jonathan G. Katz, Secretary, Commission, dated October 21, 2002 (‘‘CME Letter’’); and E-mail from Mike Ianni, Private Investor to rule-comments@sec.gov, dated November 7, 2002 (‘‘Ianni E-mail’’). 6 See letter from Darla C. Stuckey, Corporate Secretary, NYSE, to Michael A. Macchiaroli, Associate Director, Division of Market Regulation (‘‘Division’’), Commission, dated June 17, 2004 (‘‘Amendment No. 2’’). the NYSE filed Amendment No. 2 for the purpose of eliminating inconsistencies between the proposed NYSE and CBOE rules, and to incorporate certain substantive amendments requested by Commission staff. 7 See Securities Exchange Act Release No. 50885 (December 20, 2004) 69 FR 77287 (December 27, 2004); see also Securities Exchange Act Release No. 50886 (December 20, 2004) 69 FR 77275 (December 27, 2004). 8 See letter from Barbara Wierzynski, Executive Vice President and General Counsel, Futures Industry Association (‘‘FIA’’), and Gerard J. Quinn, Vice President and Associate General Counsel, Securities Industry Association (‘‘SIA’’), to Jonathan G. Katz, Secretary, Commission, dated January 14, 2005 (‘‘Wierzynski/Quinn Letter’’); letter from Craig S. Donohue, Chief Executive Officer, Chicago PO 00000 2 17 3 See Frm 00107 Fmt 4703 Sfmt 4703 On March 18, 2005, the Exchange filed Amendment No. 3 9 to the proposed rule change. The proposed rule change and Amendment Nos. 1, 2 and 3 were published in the Federal Register on May 3, 2005.10 The Commission received two comments in response to the May 3, 2005 Federal Register notice.11 The comment letters and the Exchange’s responses to the comments 12 are summarized below. This Order approves the proposed rule, as amended.13 Mercantile Exchange, to Jonathan G. Katz, Secretary, Commission, dated January 18, 2005 (‘‘Donohue Letter’’); letter from Robert C. Sheehan, Chairman, Electronic Brokerages Systems, LLC, to Jonathan G. Katz, Secretary, Commission, dated January 19, 2005 (‘‘Sheehan Letter’’) letter from William O. Melvin, Jr., President, Acorn Derivatives Management, to Jonathan G. Katz, Secretary, Commission, dated January 19, 2005 (‘‘Melvin Letter’’); letter from Margaret Wiermanski, Chief Operating & Compliance Officer, Chicago Trading Company, to Jonathan G. Katz, Secretary, Commission, dated January 20, 2005 (‘‘Wiermanski Letter’’); e-mail from Jeffrey T. Kaufmann, Lakeshore Securities, L.P., to Jonathan G. Katz, Secretary, Commission, dated January 24, 2005 (‘‘Kaufmann Letter’’); letter from J. Todd Weingart, Director of Floor Operations, Mann Securities, to Jonathan G. Katz, Secretary, Commission, dated January 25, 2005 (‘‘Weingart Letter’’); letter from Charles Greiner III, LDB Consulting, Inc., to Jonathan G. Katz, Secretary, Commission, dated January 26, 2005 (‘‘Greiner Letter’’); letter from Jack L. Hansen, Chief Investment Officer and Principal, The Clifton Group, to Jonathan G. Katz, Secretary, Commission, dated February 1, 2005 (‘‘Hansen Letter’’); and letter from Barbara Wierzynski, Executive Vice President and General Counsel, Futures Industry Association, and Ira D. Hammerman, Senior Vice President and General Counsel, Securities Industry Association, to Jonathan G. Katz, Secretary, Commission, dated March 4, 2005 (‘‘Wierzynski/Hammerman Letter’’). 9 See Partial Amendment No. 3 (‘‘Amendment No. 3’’). The Exchange submitted this partial amendment, pursuant to the request of Commission staff, to remove the paragraph under which any affiliate of a self-clearing member organization could participate in portfolio margining, without being subject to the $5 million equity requirement. 10 See Securities Exchange Act Release No. 51615 (April 26, 2005) 70 FR 22953 (May 3, 2005); see also Securities Exchange Act Release No. 51614 (April 26, 2005), 70 FR 22935 (May 3, 2005). 11 See E-mail from Walter Morgenstern, TraditionAsiel Securities, to rule-comments@sec.gov, dated May 16, 2005 (‘‘Morgenstern E-mail’’); and letter from William H. Navin, Executive Vice President, General Counsel, and Secretary, The Options Clearing Corporation, to Jonathan G. Katz, Secretary, Commission, dated May 27, 2005 (‘‘Navin Letter’’). 12 See letter from Grace B. Vogel, Executive Vice President, Member Firm Regulation, NYSE, to Michael A. Macchiaroli, Associate Director, Division of Market Regulation, Commission, dated June 27, 2005 (‘‘NYSE Response’’). 13 By separate orders, the Commission also is approving a parallel rule filing by the CBOE (SR– CBOE–2002–03), and a related rule filing by the Options Clearing Corporation (‘‘OCC’’) (SR–OCC– 2003–04). See Securities Exchange Act Release No. 52030 (July 14, 2005) and Securities Exchange Act Release No. 52032 (July 14, 2005). In addition, the staff of the Division of Market Regulation is issuing certain no-action relief related to the OCC’s rule E:\FR\FM\21JYN1.SGM 21JYN1 Federal Register / Vol. 70, No. 139 / Thursday, July 21, 2005 / Notices II. Description a. Summary of Proposed Rule Change The NYSE has proposed to amend its rules, for certain customer accounts, to allow member organizations to margin listed broad-based securities index options, warrants, futures, futures options and related exchange-traded funds according to a portfolio margin methodology. The NYSE seeks to introduce the proposed rule as a twoyear pilot program that would be made available to member organizations on a voluntary basis. NYSE Rule 431 generally prescribes minimum maintenance margin requirements for customer accounts held at members and member organizations. In April 1996, the Exchange established the Rule 431 Committee to assess the adequacy of NYSE Rule 431 on an ongoing basis, review margin requirements, and make recommendations for change. A number of proposed amendments resulting from the Committee’s recommendations have been approved by the Exchange’s Board of Directors since the Committee was established, including the proposed rule change. b. Overview—Portfolio Margin Computation (1) Portfolio Margin Portfolio margining is a methodology for calculating a customer’s margin requirement by ‘‘shocking’’ a portfolio of financial instruments at different equidistant points along a range representing a potential percentage increase and decrease in the value of the instrument or underlying instrument in the case of a derivative product. For example, the calculation points could be spread equidistantly along a range bounded on one end by a 10% increase in market value of the instrument and at the other end by a 10% decrease in market value. Gains and losses for each instrument in the portfolio are netted at each calculation point along the range to derive a potential portfolio-wide gain or loss for the point. The margin requirement is the amount of the greatest portfolio-wide loss among the calculation points. Under the Exchange’s proposed rule, a portfolio would consist of, and be limited to, financial instruments in the customer’s account within a given broad-based US securities index class filing. See letter from Bonnie Gauch, Attorney, Division of Market Regulation, Commission, to William H. Navin, General Counsel, OCC, dated July 14, 2005. VerDate jul<14>2003 19:42 Jul 20, 2005 Jkt 205001 (e.g., the S&P 500 or S&P 100).14 The gain or loss on each position in the portfolio would be calculated at each of 10 equidistant points (‘‘valuation points’’) set at and between the upper and lower market range points. The range for non-high capitalization indices would be between a market increase of 10% and a decrease of 10%. High capitalization indices would have a range of between a market increase of 6% and a decrease of 8%.15 A theoretical options pricing model would be used to derive position values at each valuation point for the purpose of determining the gain or loss. The amount of margin (initial and maintenance) required with respect to a given portfolio would be the larger of: (1) The greatest loss amount among the valuation point calculations; or (2) the sum of $.375 for each option and future in the portfolio multiplied by the contract’s or instrument’s multiplier. The latter computation establishes a minimum margin requirement to ensure that a certain level of margin is required from the customer. The margin for all other portfolios of broad based US securities index instruments within an account would be calculated in a similar manner. Certain portfolios would be allowed offsets such that, at the same valuation point, for example, 90% of a gain in one portfolio may reduce or offset a loss in another portfolio.16 The amount of offset allowed between portfolios would be the same as permitted under Rule 15c3–1a for computing a broker-dealer’s net capital.17 Under the Exchange’s proposed rule, the theoretical prices used for computing profits and losses must be generated by a theoretical pricing model that meets the requirements in Rule 15c3–1a.18 These requirements include, among other things, that the model be non-proprietary, approved by a Designated Examining Authority 14 A ‘‘portfolio’’ is defined in the rule as ‘‘options of the same options class grouped with their underlying instruments and related instruments.’’ 15 These are the same ranges applied to options market makers under Appendix A to Rule 15c3–1 (17 CFR 240.15c3–1a), which permits a brokerdealer when computing net capital to calculate securities haircuts on options and related positions using a portfolio margin methodology. See 17 CFR 240 15c3–1a(b)(1)(iv)(A); Letter from Michael Macchiaroli, Associate Director, Division of Market Regulation, Commission, to Richard Lewandowski, Vice President, Regulatory Division, The Chicago Board Options Exchange, Inc. (Jan. 13, 2000). 16 These offsets would be allowed between portfolios within the High Capitalization, Broad Based Index Option product group and the NonHigh Capitalization, Board Based Index product group. 17 17 CFR 240.15c3–1a. 18 See 17 CFR 250.15c3–1a(b)(1)(i)(B). PO 00000 Frm 00108 Fmt 4703 Sfmt 4703 42131 (‘‘DEA’’) and available on the same terms to all broker-dealers.19 Currently, the only model that qualifies under Rule 15c3–1a is the OCC’s Theoretical Intermarket Margining System (‘‘TIMS’’). (2) Cross-Margining The Exchange’s proposed rule permits futures and futures options on broadbased US securities indices to be included in the portfolios. Consequently, futures and futures options would be permitted offsets to the securities positions in a given portfolio. Operationally, these offsets would be achieved through crossmargin agreements between the OCC and the futures clearing organizations holding the customer’s futures positions. Cross-margining would operate similar to the cross-margin program that the Commission and the Commodity Futures Trading Commission (‘‘CFTC’’) approved for listed options market-makers and proprietary accounts of clearing members organizations.20 For determining theoretical gains and losses, and resultant margin requirements, the same portfolio margin computation program will be applied to portfolio margin accounts that include futures. Under the proposed rule, a separate cross-margin account must be established for a customer. c. Margin Deficiency Under the Exchange’s proposed rule, account equity would be calculated and maintained separately for each portfolio margin account and a margin call would need to be met by the customer within one business day (T + 1), regardless of whether the deficiency is caused by the addition of new positions, the effect of an unfavorable market movement, or a combination of both. The portfolio margin methodology, therefore, would establish both the customer’s initial and maintenance margin requirement. d. $5.0 Million Equity Requirement The Exchange’s proposed rule would require a customer (other than a brokerdealer or a member of a national futures exchange) to maintain a minimum account equity of not less than $5.0 million. This requirement can be met by combining all securities and futures accounts owned by the customer and carried by the broker-dealer (as brokerdealer and futures commission merchant), provided ownership is identical across all combined accounts. 19 Id. 20 See Securities Exchange Act Release 26153 (Oct. 3, 1988), 53 FR 39567 (Oct. 7, 1988). E:\FR\FM\21JYN1.SGM 21JYN1 42132 Federal Register / Vol. 70, No. 139 / Thursday, July 21, 2005 / Notices The proposed rule would require that, in the event account equity falls below the $5 million minimum, additional equity must be deposited within three business days (T + 3). e. Net Capital The Exchange’s proposed rule would provide that the gross customer portfolio margin requirements of a broker-dealer may at no time exceed 1,000 percent of the broker-dealer’s net capital (a 10:1 ratio), as computed under Rule 15c3–1.21 This requirement is intended to place a ceiling on the amount of portfolio margin a brokerdealer can extend to its customers. f. Internal Risk Monitoring Procedures The Exchange’s proposed rule would require a broker-dealer that carries portfolio margin accounts to establish and maintain written procedures for assessing and monitoring the potential risks to capital arising from portfolio margining. g. Margin at the Clearing House Level The OCC will compute clearing house margin for the broker-dealer using the same portfolio margin methodology applied at the customer level. The OCC will continue to require full payment for all customer long option positions. These positions, however, would be subject to the OCC’s lien. This would permit the long options positions to offset short positions in the customer’s portfolio margin account. In conjunction with the Exchange’s rule proposal, the OCC proposed amending OCC Rule 611 and establishing a new type of omnibus account to be carried at the OCC and known as the ‘‘customer’s lien account.’’ 22 In order to unsegregate the long option positions, the Commission staff would have to grant certain relief from some requirements of Commission Rules 8c–1, 15c2–1, and 15c3–3.23 The OCC requested such relief on behalf of its members.24 21 17 CFR 240.15c3–1. SR–OCC–2033–04, Securities Exchange Act Release No. 51330 (March 8, 2005). As noted above, the Commission is approving the OCC’s rule filing. See Securities Exchange Act Release No. 52030 (July 14, 2005). 23 17 CFR 240.8c–1, 17 CFR 240.15c2–1 and 17 CFR 240.15c3–3, respectively. 24 See Letter from William H. Navin, Executive Vice President, General Counsel, and Secretary, The Options Clearing Corporation, to Michael A. Macchiaroli, Associate Director, Division of Market Regulation, Commission, dated January 13, 2005. As noted above, the staff of the Division of Market Regulation is issuing a no-aciton letter providing such relief. See letter from Bonnie Gauch, Attorney, Division of Market Regulation, Commission, to William H. Navin, General Counsel, OCC, dated July 14, 2005. 22 See VerDate jul<14>2003 19:42 Jul 20, 2005 Jkt 205001 h. Risk Disclosure Statement and Acknowledgement The Exchange’s proposed rule would require a broker-dealer to provide a portfolio margin customer with a written risk disclosure statement at or prior to the initial opening of a portfolio margin account. This disclosure statement would highlight the risks and describe the operation of a portfolio margin account. The disclosure statement would be divided into two sections, one dealing with portfolio margining and the other with crossmargining. The disclosure statement would note that additional leverage is possible in an account margined on a portfolio basis in relation to existing margin requirements. The disclosure statement also would describe, among other things, eligibility requirements for opening a portfolio margin account, the instruments that are allowed in the account, and when deposits to meet margin and minimum equity requirements are but. Further, there would be a summary list of the special risks of a portfolio margin account, including the increased leverage, time frame for meeting margin calls, potential for involuntary liquidation if margin is not received, inability to calculate future margin requirements because of the data and calculations required, and the OCC lien on long option positions. The risks and operation of the crossmargin account are outlined in a separate section of the disclosure statement. Further, at or prior to the time a portfolio margin account is initially opened, the broker-dealer would be required to obtain a signed acknowledgement concerning portfolio margining from the customer. A separate acknowledgement would be required for cross-margining. The acknowledgements would contain statements to the effect that the customer has read the disclosure statement and is aware of the fact that long option positions in a portfolio margin account are not subject to the segregation requirements under the Commission’s customer protection rules, and would be subject to a lien by the OCC. An additional acknowledgement form would be required for a cross-margin account. It would contain similar statements as well as statement to the effect that the customer is aware that futures positions are being carried in a securities account, which would make them subject to the Commission’s customer protection rules, and Securities Investor Protection Act of PO 00000 Frm 00109 Fmt 4703 Sfmt 4703 1970 (‘‘SIPA’’ ) 25 in the event the broker-dealer becomes financially insolvent. The Exchange would prescribe the format of the written disclosure statements and acknowledgements, which would allow a broker-dealer to develop its own format, provided the acknowledgement contains substantially similar information and is approved by the Exchange in advance. i. Rationale for Portfolio Margin Theoretical options pricing models have become widely utilized since Fischer Black and Myron Scholes first introduced a formula for calculating the value of a European style option in 1973.26 Other formulas, such as the CoxRoss-Rubinstein model have since been developed. Option pricing formulas are now used routinely by option market participants to analyze and manage risk. In addition, as noted, a portfolio margin methodology has been used by brokerdealers since 1994 to calculate haircuts on option positions for net capital purposes.27 The Board of Governors of the Federal Reserve System (the ‘‘Federal Reserve Board’’ or ‘‘FRB’’) in its amendments to Regulation T in 1998 permitted SROs to implement portfolio margin rules, provided they are approved by the Commission.28 Portfolio margining brings a more risk sensitive approach to establishing margin requirements. For example, in a diverse portfolio some positions may appreciate and others depreciate in response to a given change in market prices. The portfolio margin methodology recognizes offsetting potential changes among the full portfolio of related instruments. This links the margin required to the risk of the entire portfolio as opposed to the 25 15 U.S.C. 78aaa et seq. Securities Exchange Act Release No. 34– 38248 (Feb. 6, 1997), 62 FR 6474 (Feb. 12, 1997) (discussing the development of the options pricing approach to capital); see also Securities Exchange Act Release No. 33761 (March 15, 1994), 59 FR 13275 (March 21, 1994). 27 See letter from Brandon Becker, Director, Division, Commission, to Mary Bender, First Vice President, Division of Regulatory Services, CBOE, and Timothy Hinkes, Vice President, OCC, dated March 15, 1994; see also ‘‘Net Capital Rule,’’ Securities Exchange Act Release No. 38248 (February 6, 1997), 61 FR 6474 (February 12, 1997). 28 See Federal Reserve System, ‘‘Securities Credit Transactions; Borrowing by Brokers and Dealers’’; Regulations G, T, U and X; Docket Nos. R–0905, R– 0923 and R–0944, 63 FR 2806 (January 16, 1998). More recently, the FRB encouraged the development of a portfolio margin approach in a letter to the Commission and the CFTC delegating authority to the agencies to jointly prescribe margin regulations for security futures products. See letter from the FRB to James E. Newsome, Acting Chairman, CFTC, and Laura S. Unger, Acting Chairman, Commission, dated March 6, 2001. 26 See E:\FR\FM\21JYN1.SGM 21JYN1 Federal Register / Vol. 70, No. 139 / Thursday, July 21, 2005 / Notices individual positions on a position-byposition basis. Professional investors frequently hedge listed index options with futures positions. Cross-margining would better align their margin requirements with the actual risks of these hedged positions. This could reduce the risk of forced liquidations. Currently, an option (securities) account and futures account of the same customer are viewed as separate and unrelated. Moreover, an option account currently must be liquidated if the risk in the positions has increased dramatically or margin calls cannot be met, even if gains in the customer’s futures account offset the losses in the options account. If the accounts are combined (i.e. crossmargined), unnecessary liquidation may be avoided. This could lessen the severity of a period of high volatility in the market by reducing the number of liquidations. III. Summary of Comments Received and NYSE Response The Commission received a total of 15 comment letters to the proposed rule change.29 The comments, in general, were supportive. One commenter stated that ‘‘the NYSE’s efforts to expand the use of portfolio margining systems—as opposed to strategy-based systems— as an enlightened and decidedly forward looking policy.’’ 30 Some commenters, however, recommended changes to specific provisions of the proposed rule change. Seven of the comment letters received specifically objected to the $5.0 million equity requirement.31 Three commenters noted that the requirement blocks certain large institutions from participating in portfolio margining because these institutions hold assets as a custodian bank and would generally not hold $5.0 million in an account with a broker-dealer.32 One commenter recommended reducing the equity requirement to $2.0 million.33 Four commenters raised the issue that securities index options will be at a disadvantage compared with economically similar CFTC regulated index futures and options, because futures accounts have no minimum equity requirement.34 29 See supra notes 5, 8 and 11. Gill CME Letter. 31 See Ianni Letter; Weingart Letter; Wiermanski Letter; Hansen Letter; Greiner Letter; Martin Letter; and Melvin Letter. 32 See Weingart Letter; Wiermanski Letter; and Melvin Letter. 33 See Martin Letter. 34 See Weingart Letter; Wiermanski Letter; Hansen Letter; and Sheehan Letter. The Exchange believes that the comments directed at the $5.0 million have validity, especially with respect to certain types of accounts that must hold assets at a custodial bank. The Exchange intends to further consider this issue, through the Rule 431 Committee, and seek alternative methods for meeting the minimum equity requirement.35 Two commenters stated that other products should be eligible for portfolio margining.36 Two commenters stated that other risk-based algorithms, such as SPAN, that are recognized by other clearing organizations should be permitted for calculating the portfolio margin requirement, in addition to the OCC’s TIMS.37 The Exchange noted that it is working (through the Rule 431 Committee) with an SIA subcommittee to explore the expansion of portfolio margining to additional products and participants. Finally, the NYSE stated that the comments received should not delay implementation of the proposed rule change. IV. Discussion and Commission Findings After careful review, the Commission finds that the proposed rule change, as amended, is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.38 In particular, the Commission believes that the proposed rule change is consistent with Section 6(b)(5) of the Act 39 in particular, in that it is designed to perfect the mechanism of a free and open market and to protect investors and the public interest. The Commission notes that the proposed portfolio margin rule change is intend to promote greater reasonableness, accuracy and efficiency with respect to Exchange margin requirements for complex listed securities index option strategies. The Commission further notes that the cross-margining capability with related index futures positions in eligible accounts may alleviate excessive margin calls, improve cash flows and liquidity, and reduce volatility. Moreover, the Commission notes that approving the proposed rule change would be consistent with the FRB’s 1998 amendments to Regulation T, which sought to advance the use of portfolio margining. 42133 Under the proposed rule changes, the Commission notes that a broker-dealer choosing to offer portfolio margining to its customers must employ a methodology that has been approved by the Commission for use in calculating haircuts under Rule 15c3–1a. As stated above, currently, TIMS is the only approved methodology. While some commenters recommended expanding the choice of models, the Commission believes that requiring a broker-dealer to use a model that qualifies for calculating haircuts under Commission Rule 15c3– 1a maintains a consistency with the Commission’s net capital rule and across potential portfolio margin pricing models. As a result, portfolio margin requirements would vary less from firm to firm. The Commission notes, however, that like Rule 15c3–1a, the proposed rule permits the use of another theoretical pricing model, should one be developed in the future.40 The Commission notes the objections of certain commenters to the $5 million minimum equity requirement. The Commission believes that the requirement circumscribes the number of accounts able to participate and adds safety in that such accounts are more likely to be of significant financial means and investment sophistication. Finally, the Commission notes that several commenters recommended expanding the products eligible for portfolio margining. The Exchange’s proposed rule limits the instruments eligible for portfolio margining to listed products base on broad-based US securities indices, which tend to be less volatile than narrow-based indices and non-index equities. The Commission believes this limitation is appropriate for the pilot program, which should serve as a first step toward the possible expansion of portfolio margining to other classes of securities. V. Conclusion It is therefore ordered, pursuant to seciton 19(b)(2) of the Act,41 that the proposed rule change (File No. SR– NYSE–2002–19), as amended, is approved on a pilot basis to expire on July 31, 2007. 30 See VerDate jul<14>2003 19:42 Jul 20, 2005 Jkt 205001 NYSE Response. Wiermanski Letter and Donohue Letter. 37 See Donohue Letter and Gill CME Letter. 38 In approving this proposed rule change, the Commission notes that it has considered the proposed rule’s impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f). 39 15 U.S.C. 78f(b)(5). PO 00000 35 See 36 See Frm 00110 Fmt 4703 Sfmt 4703 40 See also Securities Exchange Act Release No. 34–38248 (February 6, 1997), 62 FR 6474 (February 12, 1997) (discussing in Part II.A. the use of TIMS versus other pricing models). 41 15 U.S.C. 78s(b)(2). E:\FR\FM\21JYN1.SGM 21JYN1 42134 Federal Register / Vol. 70, No. 139 / Thursday, July 21, 2005 / Notices For the Commission, by the Division of Market Regulation, pursuant to delegated authority.42 J. Lynn Taylor, Assistant Secretary. [FR Doc. 05–14316 Filed 7–20–05; 8:45 am] BILLING CODE 8010–01–M SECURITIES AND EXCHANGE COMMISSION (A) Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change The primary purpose of this rule change is to further reduce OCC’s currently discounted clearing fees for securities option contracts until the Board of Directors determines otherwise.3 Effective July 1, 2005, OCC’s clearing fees for securities options will be: [Release No. 34–52034; File No. SR–OCC– 2005–08] Self-Regulatory Organizations; The Options Clearing Corporation; Notice of Filing and Immediate Effectiveness of a Proposed Rule Change Relating to Reducing Clearing Fees for Securities Option Contracts July 14, 2005. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (‘‘Act’’), 1 notice is hereby given that on June 14, 2005, The Options Clearing Corporation (‘‘OCC’’) 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 primarily by OCC. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change Effective July 1, 2005, OCC will further reduce its discounted fee schedule for securities option contracts until further action by the Board of Directors. II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, OCC 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. OCC has prepared summaries, set forth in sections (A), (B), and (C) below, of the most significant aspects of such statements.2 42 17 CFR 200.30–3(a)(12). 1 15 U.S.C. 78s(b)(1). 2 The Commission has modified parts of these statements. VerDate jul<14>2003 19:42 Jul 20, 2005 Jkt 205001 Discounted fee effective July 1, 2005 Contracts/trade 1–500 ............................ 501–1,000 ..................... 1,001–2,000 .................. >2,000 ........................... $0.05/contract. $0.04/contract. $0.03/contract. $55.00 (capped). The additional fee reduction recognizes the continued strong volume in securities options in 2005. OCC believes that this fee reduction will financially benefit clearing members and other market participants without adversely affecting OCC’s ability to meet its expenses and maintain an acceptable level of retained earnings. The discounted fees for new securities option products will be: Month 1 ............ 2 ............ 3 ............ 4 ............ Contracts/ trade N/A 1–4,400 >4,400 1–2,200 >2,200 N/A Discounted fee effective July 1, 2005 No Fee. $0.01 $40.00 $0.02 $40.00 Regular Schedule. OCC believes that the proposed rule change is consistent with Section 17A of the Act because it benefits clearing members by reducing clearing fees and allocates such fees among clearing members in a fair and equitable manner. The proposed rule change is not inconsistent with the existing rules of OCC, including any other rules proposed to be amended. (B) Self-Regulatory Organization’s Statement on Burden on Competition OCC does not believe that the proposed rule change would impose any burden on competition. (C) Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others Written comments were not and are not intended to be solicited with respect 3 In addition, OCC is deleting charges for 56.0kb lines as they are no longer a supported communications protocol. Other changes made to the Schedule of Fees are of a technical or conforming nature. PO 00000 Frm 00111 Fmt 4703 Sfmt 4703 to the proposed rule change, and none have been received. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action The foregoing proposed rule change has become effective pursuant to Section 19(b)(3)(A)(ii) of the Act 4 and Rule 19b–4(f)(2) 5 thereunder because it establishes or changes a due, fee, or other charge. At any time within 60 days of the filing of the proposed rule change, the Commission may summarily abrogate such rule change if it appears to the Commission that such action is necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Act. 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 (https://www.sec.gov/ rules/sro.shtml) or • Send an e-mail to rulecomments@sec.gov. Please include File Number SR–OCC–2005–08 on the subject line. Paper Comments • Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549–0609. All submissions should refer to File Number SR–OCC–2005–08. 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 (https://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 4 15 5 17 E:\FR\FM\21JYN1.SGM U.S.C. 78(s)(b)(3)(A)(ii). CFR 240.19b–4(f)(2). 21JYN1

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 70, Number 139 (Thursday, July 21, 2005)]
[Notices]
[Pages 42130-42134]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-14316]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52031; File No. SR-NYSE-2002-19]


Self-Regulatory Organizations; New York Stock Exchange, Inc.; 
Order Approving a Proposed Rule Change and Amendment Nos. 1, 2 and 3 
Thereto Relating to Customer Portfolio and Cross-Margining Requirements

July 14, 2005.

I. Introduction

    On May 13, 2002, the New York Stock Exchange, Inc. (``NYSE'' or 
``Exchange'' filed with the Securities and Exchange Commission 
(``Commission''), pursuant to section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 \2\ thereunder, a 
proposed rule change seeking to amend its rules, for certain customer 
accounts, to allow member organizations to margin listed, broad-based, 
market index options, index warrants, futures, futures options and 
related exchange-traded funds according to a portfolio margin 
methodology. The NYSE seeks to introduce the proposed rule as a two-
year pilot program that would be made available to member organizations 
on a voluntary basis.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    On August 21, 2002, the NYSE field Amendment No. 1 to the proposed 
rule change.\3\ The Proposed rule change and Amendment No. 1 were 
published in the Federal Register On October 8, 2002.\4\ The Commission 
received three comment letters in response to the October 8, 2002 
Federal Register notice.\5\ On June 21, 2004, the Exchange field 
Amendment No. 2 to the proposed rule change.\6\ The proposed rule 
change and Amendment Nos. 1 and 2 were published in the Federal 
Register on December 27, 2004.\7\ The Commission received ten comment 
letters in response to the December 27, 2004 Federal Register 
notice.\8\
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    \3\ See letter from Mary Yeager, Assistant Secretary, NYSE, to 
T.R. Lazo, Senior Special Counsel, Division of Market Regulation, 
Commission, dated August 20, 2002 (``Amendment No. 1''). In 
Amendment No. 1, the NYSE made technical corrections to its proposed 
rule language to eliminate any inconsistencies between its proposal 
and the CBOE proposal pursuant to the the Rule 431 Committee's 
(``Committee'') recommendations. See Securities Exchange Act Release 
No. 45630 (March 22, 2002), 67 FR 15263 (March 29, 2002) File No. 
SR-CBOE-2002-03).
    \4\ See Securities Exchange Act Release No. 46576 (October 1, 
2002) 67 FR 62843 (October 8, 2002).
    \5\ See letter from R. Allan Martin, President, Auric Trading 
Enterprises, Inc., to Secretary, Commission, dated October 9, 2002 
(``Martin Letter''); Phupinder S. Gill, Managing Director and 
President, Chicago Mercantile Exchange Inc., to Jonathan G. Katz, 
Secretary, Commission, dated October 21, 2002 (``CME Letter''); and 
E-mail from Mike Ianni, Private Investor to rule-comments@sec.gov, 
dated November 7, 2002 (``Ianni E-mail'').
    \6\ See letter from Darla C. Stuckey, Corporate Secretary, NYSE, 
to Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation (``Division''), Commission, dated June 17, 2004 
(``Amendment No. 2''). the NYSE filed Amendment No. 2 for the 
purpose of eliminating inconsistencies between the proposed NYSE and 
CBOE rules, and to incorporate certain substantive amendments 
requested by Commission staff.
    \7\ See Securities Exchange Act Release No. 50885 (December 20, 
2004) 69 FR 77287 (December 27, 2004); see also Securities Exchange 
Act Release No. 50886 (December 20, 2004) 69 FR 77275 (December 27, 
2004).
    \8\ See letter from Barbara Wierzynski, Executive Vice President 
and General Counsel, Futures Industry Association (``FIA''), and 
Gerard J. Quinn, Vice President and Associate General Counsel, 
Securities Industry Association (``SIA''), to Jonathan G. Katz, 
Secretary, Commission, dated January 14, 2005 (``Wierzynski/Quinn 
Letter''); letter from Craig S. Donohue, Chief Executive Officer, 
Chicago Mercantile Exchange, to Jonathan G. Katz, Secretary, 
Commission, dated January 18, 2005 (``Donohue Letter''); letter from 
Robert C. Sheehan, Chairman, Electronic Brokerages Systems, LLC, to 
Jonathan G. Katz, Secretary, Commission, dated January 19, 2005 
(``Sheehan Letter'') letter from William O. Melvin, Jr., President, 
Acorn Derivatives Management, to Jonathan G. Katz, Secretary, 
Commission, dated January 19, 2005 (``Melvin Letter''); letter from 
Margaret Wiermanski, Chief Operating & Compliance Officer, Chicago 
Trading Company, to Jonathan G. Katz, Secretary, Commission, dated 
January 20, 2005 (``Wiermanski Letter''); e-mail from Jeffrey T. 
Kaufmann, Lakeshore Securities, L.P., to Jonathan G. Katz, 
Secretary, Commission, dated January 24, 2005 (``Kaufmann Letter''); 
letter from J. Todd Weingart, Director of Floor Operations, Mann 
Securities, to Jonathan G. Katz, Secretary, Commission, dated 
January 25, 2005 (``Weingart Letter''); letter from Charles Greiner 
III, LDB Consulting, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated January 26, 2005 (``Greiner Letter''); letter from 
Jack L. Hansen, Chief Investment Officer and Principal, The Clifton 
Group, to Jonathan G. Katz, Secretary, Commission, dated February 1, 
2005 (``Hansen Letter''); and letter from Barbara Wierzynski, 
Executive Vice President and General Counsel, Futures Industry 
Association, and Ira D. Hammerman, Senior Vice President and General 
Counsel, Securities Industry Association, to Jonathan G. Katz, 
Secretary, Commission, dated March 4, 2005 (``Wierzynski/Hammerman 
Letter'').
---------------------------------------------------------------------------

    On March 18, 2005, the Exchange filed Amendment No. 3 \9\ to the 
proposed rule change. The proposed rule change and Amendment Nos. 1, 2 
and 3 were published in the Federal Register on May 3, 2005.\10\ The 
Commission received two comments in response to the May 3, 2005 Federal 
Register notice.\11\
---------------------------------------------------------------------------

    \9\ See Partial Amendment No. 3 (``Amendment No. 3''). The 
Exchange submitted this partial amendment, pursuant to the request 
of Commission staff, to remove the paragraph under which any 
affiliate of a self-clearing member organization could participate 
in portfolio margining, without being subject to the $5 million 
equity requirement.
    \10\ See Securities Exchange Act Release No. 51615 (April 26, 
2005) 70 FR 22953 (May 3, 2005); see also Securities Exchange Act 
Release No. 51614 (April 26, 2005), 70 FR 22935 (May 3, 2005).
    \11\ See E-mail from Walter Morgenstern, Tradition-Asiel 
Securities, to rule-comments@sec.gov, dated May 16, 2005 
(``Morgenstern E-mail''); and letter from William H. Navin, 
Executive Vice President, General Counsel, and Secretary, The 
Options Clearing Corporation, to Jonathan G. Katz, Secretary, 
Commission, dated May 27, 2005 (``Navin Letter'').
---------------------------------------------------------------------------

    The comment letters and the Exchange's responses to the comments 
\12\ are summarized below. This Order approves the proposed rule, as 
amended.\13\
---------------------------------------------------------------------------

    \12\ See letter from Grace B. Vogel, Executive Vice President, 
Member Firm Regulation, NYSE, to Michael A. Macchiaroli, Associate 
Director, Division of Market Regulation, Commission, dated June 27, 
2005 (``NYSE Response'').
    \13\ By separate orders, the Commission also is approving a 
parallel rule filing by the CBOE (SR-CBOE-2002-03), and a related 
rule filing by the Options Clearing Corporation (``OCC'') (SR-OCC-
2003-04). See Securities Exchange Act Release No. 52030 (July 14, 
2005) and Securities Exchange Act Release No. 52032 (July 14, 2005). 
In addition, the staff of the Division of Market Regulation is 
issuing certain no-action relief related to the OCC's rule filing. 
See letter from Bonnie Gauch, Attorney, Division of Market 
Regulation, Commission, to William H. Navin, General Counsel, OCC, 
dated July 14, 2005.

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[[Page 42131]]

II. Description

a. Summary of Proposed Rule Change

    The NYSE has proposed to amend its rules, for certain customer 
accounts, to allow member organizations to margin listed broad-based 
securities index options, warrants, futures, futures options and 
related exchange-traded funds according to a portfolio margin 
methodology. The NYSE seeks to introduce the proposed rule as a two-
year pilot program that would be made available to member organizations 
on a voluntary basis.
    NYSE Rule 431 generally prescribes minimum maintenance margin 
requirements for customer accounts held at members and member 
organizations. In April 1996, the Exchange established the Rule 431 
Committee to assess the adequacy of NYSE Rule 431 on an ongoing basis, 
review margin requirements, and make recommendations for change. A 
number of proposed amendments resulting from the Committee's 
recommendations have been approved by the Exchange's Board of Directors 
since the Committee was established, including the proposed rule 
change.

b. Overview--Portfolio Margin Computation

(1) Portfolio Margin
    Portfolio margining is a methodology for calculating a customer's 
margin requirement by ``shocking'' a portfolio of financial instruments 
at different equidistant points along a range representing a potential 
percentage increase and decrease in the value of the instrument or 
underlying instrument in the case of a derivative product. For example, 
the calculation points could be spread equidistantly along a range 
bounded on one end by a 10% increase in market value of the instrument 
and at the other end by a 10% decrease in market value. Gains and 
losses for each instrument in the portfolio are netted at each 
calculation point along the range to derive a potential portfolio-wide 
gain or loss for the point. The margin requirement is the amount of the 
greatest portfolio-wide loss among the calculation points.
    Under the Exchange's proposed rule, a portfolio would consist of, 
and be limited to, financial instruments in the customer's account 
within a given broad-based US securities index class (e.g., the S&P 500 
or S&P 100).\14\ The gain or loss on each position in the portfolio 
would be calculated at each of 10 equidistant points (``valuation 
points'') set at and between the upper and lower market range points. 
The range for non-high capitalization indices would be between a market 
increase of 10% and a decrease of 10%. High capitalization indices 
would have a range of between a market increase of 6% and a decrease of 
8%.\15\ A theoretical options pricing model would be used to derive 
position values at each valuation point for the purpose of determining 
the gain or loss. The amount of margin (initial and maintenance) 
required with respect to a given portfolio would be the larger of: (1) 
The greatest loss amount among the valuation point calculations; or (2) 
the sum of $.375 for each option and future in the portfolio multiplied 
by the contract's or instrument's multiplier. The latter computation 
establishes a minimum margin requirement to ensure that a certain level 
of margin is required from the customer. The margin for all other 
portfolios of broad based US securities index instruments within an 
account would be calculated in a similar manner.
    Certain portfolios would be allowed offsets such that, at the same 
valuation point, for example, 90% of a gain in one portfolio may reduce 
or offset a loss in another portfolio.\16\ The amount of offset allowed 
between portfolios would be the same as permitted under Rule 15c3-1a 
for computing a broker-dealer's net capital.\17\
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    \14\ A ``portfolio'' is defined in the rule as ``options of the 
same options class grouped with their underlying instruments and 
related instruments.''
    \15\ These are the same ranges applied to options market makers 
under Appendix A to Rule 15c3-1 (17 CFR 240.15c3-1a), which permits 
a broker-dealer when computing net capital to calculate securities 
haircuts on options and related positions using a portfolio margin 
methodology. See 17 CFR 240 15c3-1a(b)(1)(iv)(A); Letter from 
Michael Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, to Richard Lewandowski, Vice President, 
Regulatory Division, The Chicago Board Options Exchange, Inc. (Jan. 
13, 2000).
    \16\ These offsets would be allowed between portfolios within 
the High Capitalization, Broad Based Index Option product group and 
the Non-High Capitalization, Board Based Index product group.
    \17\ 17 CFR 240.15c3-1a.
---------------------------------------------------------------------------

    Under the Exchange's proposed rule, the theoretical prices used for 
computing profits and losses must be generated by a theoretical pricing 
model that meets the requirements in Rule 15c3-1a.\18\ These 
requirements include, among other things, that the model be non-
proprietary, approved by a Designated Examining Authority (``DEA'') and 
available on the same terms to all broker-dealers.\19\ Currently, the 
only model that qualifies under Rule 15c3-1a is the OCC's Theoretical 
Intermarket Margining System (``TIMS'').
---------------------------------------------------------------------------

    \18\ See 17 CFR 250.15c3-1a(b)(1)(i)(B).
    \19\ Id.
---------------------------------------------------------------------------

(2) Cross-Margining
    The Exchange's proposed rule permits futures and futures options on 
broad-based US securities indices to be included in the portfolios. 
Consequently, futures and futures options would be permitted offsets to 
the securities positions in a given portfolio. Operationally, these 
offsets would be achieved through cross-margin agreements between the 
OCC and the futures clearing organizations holding the customer's 
futures positions. Cross-margining would operate similar to the cross-
margin program that the Commission and the Commodity Futures Trading 
Commission (``CFTC'') approved for listed options market-makers and 
proprietary accounts of clearing members organizations.\20\ For 
determining theoretical gains and losses, and resultant margin 
requirements, the same portfolio margin computation program will be 
applied to portfolio margin accounts that include futures. Under the 
proposed rule, a separate cross-margin account must be established for 
a customer.
---------------------------------------------------------------------------

    \20\ See Securities Exchange Act Release 26153 (Oct. 3, 1988), 
53 FR 39567 (Oct. 7, 1988).
---------------------------------------------------------------------------

c. Margin Deficiency

    Under the Exchange's proposed rule, account equity would be 
calculated and maintained separately for each portfolio margin account 
and a margin call would need to be met by the customer within one 
business day (T + 1), regardless of whether the deficiency is caused by 
the addition of new positions, the effect of an unfavorable market 
movement, or a combination of both. The portfolio margin methodology, 
therefore, would establish both the customer's initial and maintenance 
margin requirement.

d. $5.0 Million Equity Requirement

    The Exchange's proposed rule would require a customer (other than a 
broker-dealer or a member of a national futures exchange) to maintain a 
minimum account equity of not less than $5.0 million. This requirement 
can be met by combining all securities and futures accounts owned by 
the customer and carried by the broker-dealer (as broker-dealer and 
futures commission merchant), provided ownership is identical across 
all combined accounts.

[[Page 42132]]

The proposed rule would require that, in the event account equity falls 
below the $5 million minimum, additional equity must be deposited 
within three business days (T + 3).

e. Net Capital

    The Exchange's proposed rule would provide that the gross customer 
portfolio margin requirements of a broker-dealer may at no time exceed 
1,000 percent of the broker-dealer's net capital (a 10:1 ratio), as 
computed under Rule 15c3-1.\21\ This requirement is intended to place a 
ceiling on the amount of portfolio margin a broker-dealer can extend to 
its customers.
---------------------------------------------------------------------------

    \21\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

f. Internal Risk Monitoring Procedures

    The Exchange's proposed rule would require a broker-dealer that 
carries portfolio margin accounts to establish and maintain written 
procedures for assessing and monitoring the potential risks to capital 
arising from portfolio margining.

g. Margin at the Clearing House Level

    The OCC will compute clearing house margin for the broker-dealer 
using the same portfolio margin methodology applied at the customer 
level. The OCC will continue to require full payment for all customer 
long option positions. These positions, however, would be subject to 
the OCC's lien. This would permit the long options positions to offset 
short positions in the customer's portfolio margin account. In 
conjunction with the Exchange's rule proposal, the OCC proposed 
amending OCC Rule 611 and establishing a new type of omnibus account to 
be carried at the OCC and known as the ``customer's lien account.'' 
\22\ In order to unsegregate the long option positions, the Commission 
staff would have to grant certain relief from some requirements of 
Commission Rules 8c-1, 15c2-1, and 15c3-3.\23\ The OCC requested such 
relief on behalf of its members.\24\
---------------------------------------------------------------------------

    \22\ See SR-OCC-2033-04, Securities Exchange Act Release No. 
51330 (March 8, 2005). As noted above, the Commission is approving 
the OCC's rule filing. See Securities Exchange Act Release No. 52030 
(July 14, 2005).
    \23\ 17 CFR 240.8c-1, 17 CFR 240.15c2-1 and 17 CFR 240.15c3-3, 
respectively.
    \24\ See Letter from William H. Navin, Executive Vice President, 
General Counsel, and Secretary, The Options Clearing Corporation, to 
Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, dated January 13, 2005. As noted above, the 
staff of the Division of Market Regulation is issuing a no-aciton 
letter providing such relief. See letter from Bonnie Gauch, 
Attorney, Division of Market Regulation, Commission, to William H. 
Navin, General Counsel, OCC, dated July 14, 2005.
---------------------------------------------------------------------------

h. Risk Disclosure Statement and Acknowledgement

    The Exchange's proposed rule would require a broker-dealer to 
provide a portfolio margin customer with a written risk disclosure 
statement at or prior to the initial opening of a portfolio margin 
account. This disclosure statement would highlight the risks and 
describe the operation of a portfolio margin account. The disclosure 
statement would be divided into two sections, one dealing with 
portfolio margining and the other with cross-margining. The disclosure 
statement would note that additional leverage is possible in an account 
margined on a portfolio basis in relation to existing margin 
requirements. The disclosure statement also would describe, among other 
things, eligibility requirements for opening a portfolio margin 
account, the instruments that are allowed in the account, and when 
deposits to meet margin and minimum equity requirements are but. 
Further, there would be a summary list of the special risks of a 
portfolio margin account, including the increased leverage, time frame 
for meeting margin calls, potential for involuntary liquidation if 
margin is not received, inability to calculate future margin 
requirements because of the data and calculations required, and the OCC 
lien on long option positions. The risks and operation of the cross-
margin account are outlined in a separate section of the disclosure 
statement.
    Further, at or prior to the time a portfolio margin account is 
initially opened, the broker-dealer would be required to obtain a 
signed acknowledgement concerning portfolio margining from the 
customer. A separate acknowledgement would be required for cross-
margining. The acknowledgements would contain statements to the effect 
that the customer has read the disclosure statement and is aware of the 
fact that long option positions in a portfolio margin account are not 
subject to the segregation requirements under the Commission's customer 
protection rules, and would be subject to a lien by the OCC.
    An additional acknowledgement form would be required for a cross-
margin account. It would contain similar statements as well as 
statement to the effect that the customer is aware that futures 
positions are being carried in a securities account, which would make 
them subject to the Commission's customer protection rules, and 
Securities Investor Protection Act of 1970 (``SIPA'' ) \25\ in the 
event the broker-dealer becomes financially insolvent. The Exchange 
would prescribe the format of the written disclosure statements and 
acknowledgements, which would allow a broker-dealer to develop its own 
format, provided the acknowledgement contains substantially similar 
information and is approved by the Exchange in advance.
---------------------------------------------------------------------------

    \25\ 15 U.S.C. 78aaa et seq.
---------------------------------------------------------------------------

i. Rationale for Portfolio Margin

    Theoretical options pricing models have become widely utilized 
since Fischer Black and Myron Scholes first introduced a formula for 
calculating the value of a European style option in 1973.\26\ Other 
formulas, such as the Cox-Ross-Rubinstein model have since been 
developed. Option pricing formulas are now used routinely by option 
market participants to analyze and manage risk. In addition, as noted, 
a portfolio margin methodology has been used by broker-dealers since 
1994 to calculate haircuts on option positions for net capital 
purposes.\27\
---------------------------------------------------------------------------

    \26\ See Securities Exchange Act Release No. 34-38248 (Feb. 6, 
1997), 62 FR 6474 (Feb. 12, 1997) (discussing the development of the 
options pricing approach to capital); see also Securities Exchange 
Act Release No. 33761 (March 15, 1994), 59 FR 13275 (March 21, 
1994).
    \27\ See letter from Brandon Becker, Director, Division, 
Commission, to Mary Bender, First Vice President, Division of 
Regulatory Services, CBOE, and Timothy Hinkes, Vice President, OCC, 
dated March 15, 1994; see also ``Net Capital Rule,'' Securities 
Exchange Act Release No. 38248 (February 6, 1997), 61 FR 6474 
(February 12, 1997).
---------------------------------------------------------------------------

    The Board of Governors of the Federal Reserve System (the ``Federal 
Reserve Board'' or ``FRB'') in its amendments to Regulation T in 1998 
permitted SROs to implement portfolio margin rules, provided they are 
approved by the Commission.\28\
---------------------------------------------------------------------------

    \28\ See Federal Reserve System, ``Securities Credit 
Transactions; Borrowing by Brokers and Dealers''; Regulations G, T, 
U and X; Docket Nos. R-0905, R-0923 and R-0944, 63 FR 2806 (January 
16, 1998). More recently, the FRB encouraged the development of a 
portfolio margin approach in a letter to the Commission and the CFTC 
delegating authority to the agencies to jointly prescribe margin 
regulations for security futures products. See letter from the FRB 
to James E. Newsome, Acting Chairman, CFTC, and Laura S. Unger, 
Acting Chairman, Commission, dated March 6, 2001.
---------------------------------------------------------------------------

    Portfolio margining brings a more risk sensitive approach to 
establishing margin requirements. For example, in a diverse portfolio 
some positions may appreciate and others depreciate in response to a 
given change in market prices. The portfolio margin methodology 
recognizes offsetting potential changes among the full portfolio of 
related instruments. This links the margin required to the risk of the 
entire portfolio as opposed to the

[[Page 42133]]

individual positions on a position-by-position basis.
    Professional investors frequently hedge listed index options with 
futures positions. Cross-margining would better align their margin 
requirements with the actual risks of these hedged positions. This 
could reduce the risk of forced liquidations. Currently, an option 
(securities) account and futures account of the same customer are 
viewed as separate and unrelated. Moreover, an option account currently 
must be liquidated if the risk in the positions has increased 
dramatically or margin calls cannot be met, even if gains in the 
customer's futures account offset the losses in the options account. If 
the accounts are combined (i.e. cross-margined), unnecessary 
liquidation may be avoided. This could lessen the severity of a period 
of high volatility in the market by reducing the number of 
liquidations.

III. Summary of Comments Received and NYSE Response

    The Commission received a total of 15 comment letters to the 
proposed rule change.\29\ The comments, in general, were supportive. 
One commenter stated that ``the NYSE's efforts to expand the use of 
portfolio margining systems--as opposed to strategy-based systems-- as 
an enlightened and decidedly forward looking policy.'' \30\ Some 
commenters, however, recommended changes to specific provisions of the 
proposed rule change.
---------------------------------------------------------------------------

    \29\ See supra notes 5, 8 and 11.
    \30\ See Gill CME Letter.
---------------------------------------------------------------------------

    Seven of the comment letters received specifically objected to the 
$5.0 million equity requirement.\31\ Three commenters noted that the 
requirement blocks certain large institutions from participating in 
portfolio margining because these institutions hold assets as a 
custodian bank and would generally not hold $5.0 million in an account 
with a broker-dealer.\32\ One commenter recommended reducing the equity 
requirement to $2.0 million.\33\ Four commenters raised the issue that 
securities index options will be at a disadvantage compared with 
economically similar CFTC regulated index futures and options, because 
futures accounts have no minimum equity requirement.\34\
---------------------------------------------------------------------------

    \31\ See Ianni Letter; Weingart Letter; Wiermanski Letter; 
Hansen Letter; Greiner Letter; Martin Letter; and Melvin Letter.
    \32\ See Weingart Letter; Wiermanski Letter; and Melvin Letter.
    \33\ See Martin Letter.
    \34\ See Weingart Letter; Wiermanski Letter; Hansen Letter; and 
Sheehan Letter.
---------------------------------------------------------------------------

    The Exchange believes that the comments directed at the $5.0 
million have validity, especially with respect to certain types of 
accounts that must hold assets at a custodial bank. The Exchange 
intends to further consider this issue, through the Rule 431 Committee, 
and seek alternative methods for meeting the minimum equity 
requirement.\35\
---------------------------------------------------------------------------

    \35\ See NYSE Response.
---------------------------------------------------------------------------

    Two commenters stated that other products should be eligible for 
portfolio margining.\36\ Two commenters stated that other risk-based 
algorithms, such as SPAN, that are recognized by other clearing 
organizations should be permitted for calculating the portfolio margin 
requirement, in addition to the OCC's TIMS.\37\ The Exchange noted that 
it is working (through the Rule 431 Committee) with an SIA subcommittee 
to explore the expansion of portfolio margining to additional products 
and participants. Finally, the NYSE stated that the comments received 
should not delay implementation of the proposed rule change.
---------------------------------------------------------------------------

    \36\ See Wiermanski Letter and Donohue Letter.
    \37\ See Donohue Letter and Gill CME Letter.
---------------------------------------------------------------------------

IV. Discussion and Commission Findings

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\38\ In particular, the Commission believes that 
the proposed rule change is consistent with Section 6(b)(5) of the Act 
\39\ in particular, in that it is designed to perfect the mechanism of 
a free and open market and to protect investors and the public 
interest. The Commission notes that the proposed portfolio margin rule 
change is intend to promote greater reasonableness, accuracy and 
efficiency with respect to Exchange margin requirements for complex 
listed securities index option strategies. The Commission further notes 
that the cross-margining capability with related index futures 
positions in eligible accounts may alleviate excessive margin calls, 
improve cash flows and liquidity, and reduce volatility. Moreover, the 
Commission notes that approving the proposed rule change would be 
consistent with the FRB's 1998 amendments to Regulation T, which sought 
to advance the use of portfolio margining.
---------------------------------------------------------------------------

    \38\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \39\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    Under the proposed rule changes, the Commission notes that a 
broker-dealer choosing to offer portfolio margining to its customers 
must employ a methodology that has been approved by the Commission for 
use in calculating haircuts under Rule 15c3-1a. As stated above, 
currently, TIMS is the only approved methodology. While some commenters 
recommended expanding the choice of models, the Commission believes 
that requiring a broker-dealer to use a model that qualifies for 
calculating haircuts under Commission Rule 15c3-1a maintains a 
consistency with the Commission's net capital rule and across potential 
portfolio margin pricing models. As a result, portfolio margin 
requirements would vary less from firm to firm. The Commission notes, 
however, that like Rule 15c3-1a, the proposed rule permits the use of 
another theoretical pricing model, should one be developed in the 
future.\40\
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    \40\ See also Securities Exchange Act Release No. 34-38248 
(February 6, 1997), 62 FR 6474 (February 12, 1997) (discussing in 
Part II.A. the use of TIMS versus other pricing models).
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    The Commission notes the objections of certain commenters to the $5 
million minimum equity requirement. The Commission believes that the 
requirement circumscribes the number of accounts able to participate 
and adds safety in that such accounts are more likely to be of 
significant financial means and investment sophistication.
    Finally, the Commission notes that several commenters recommended 
expanding the products eligible for portfolio margining. The Exchange's 
proposed rule limits the instruments eligible for portfolio margining 
to listed products base on broad-based US securities indices, which 
tend to be less volatile than narrow-based indices and non-index 
equities. The Commission believes this limitation is appropriate for 
the pilot program, which should serve as a first step toward the 
possible expansion of portfolio margining to other classes of 
securities.

V. Conclusion

    It is therefore ordered, pursuant to seciton 19(b)(2) of the 
Act,\41\ that the proposed rule change (File No. SR-NYSE-2002-19), as 
amended, is approved on a pilot basis to expire on July 31, 2007.
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    \41\ 15 U.S.C. 78s(b)(2).


[[Page 42134]]


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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\42\
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    \42\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 05-14316 Filed 7-20-05; 8:45 am]
BILLING CODE 8010-01-M

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