Self-Regulatory Organizations; Chicago Board Options Exchange, Incorporated; Order Granting Approval of a Proposed Rule Change To List and Trade Credit Default Basket Options, as Modified by Amendment No. 3, and Designating Credit Default Basket Options as Standardized Options Under Rule 9b-1 of the Securities Exchange Act of 1934, 47097-47102 [E7-16587]
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Federal Register / Vol. 72, No. 162 / Wednesday, August 22, 2007 / Notices
CBOE anticipates that its reports will
assess the impact of the changes to the
minimum increments during the
specific time period being analyzed,
including, among other things, effects
on (i) Market participants and
customers; (ii) market performance and
quality, such as quoted spreads,
effective spreads, and the displayed size
in the Pilot classes; and (iii) OPRA,
vendor and exchange capacity. CBOE’s
reports should be submitted within one
month following the end of the period
being analyzed.
2. Statutory Basis
The Exchange believes that the
proposed rule change is consistent with
Section 6(b) of the Act,6 in general, and
furthers the objectives of Section 6(b)(5)
of the Act,7 in particular, in that the
proposed rule change is designed to
promote just and equitable principles of
trade, serve to remove impediments to
and perfect the mechanism of a free and
open market and a national market
system, and, in general, to protect
investors and the public interest.
B. Self-Regulatory Organization’s
Statement on Burden on Competition
The Exchange does not believe that
the proposed rule change will result in
any burden on competition that is not
necessary or appropriate in furtherance
of the purposes of the Act.
C. Self-Regulatory Organization’s
Statement on Comments on the
Proposed Rule Change Received From
Members, Participants, or Others
Written comments on the proposed
rule change were neither solicited nor
received.
III. Date of Effectiveness of the
Proposed Rule Change and Timing for
Commission Action
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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
6 15
7 15
U.S.C. 78f(b).
U.S.C. 78f(b)(5).
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47097
arguments concerning the foregoing,
including whether the proposed rule
change is consistent with the Act. The
Commission also requests and
encourages interested persons to submit
comments on the following specific
questions:
• Whether there are circumstances
under which options classes included in
the Penny Pilot should be removed from
the Pilot?
• If so, what factors should be
considered in making the determination
to remove an option class from the
Penny Pilot?
Æ Should an objective standard be
used? For instance, should an option
class come out of the Penny Pilot if its
trading volume drops below a threshold
amount? If so, what should that
threshold be? Or, should an option class
come out of the Penny Pilot if it is no
longer among the most actively-traded
options? If so, what should be
considered the most-actively traded
options? What statistics or analysis
should be used to support a
determination to remove an options
class?
Æ Should a more subjective analysis
be allowed? If so, what factors should be
taken into account?
• What concerns might arise by
removing an option from the Penny
Pilot? How could such concerns be
ameliorated?
• How frequently should the analysis
be undertaken (e.g., annually, biannually, quarterly), or should the
evaluation be an automated process?
• If a determination is made that an
option should be removed from the
Penny Pilot, how much notice should be
given to market participants that the
quoting increment will change?
Comments may be submitted by any
of the following methods:
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
available for inspection and copying in
the Commission’s Public Reference
Room, 100 F Street, NE., Washington,
DC 20549, on official business days
between the hours of 10 a.m. and 3 p.m.
Copies of such filing also will 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–2007–98 and should
be submitted on or before September 12,
2007.
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–2007–98 on the
subject line.
Self-Regulatory Organizations;
Chicago Board Options Exchange,
Incorporated; Order Granting Approval
of a Proposed Rule Change To List and
Trade Credit Default Basket Options,
as Modified by Amendment No. 3, and
Designating Credit Default Basket
Options as Standardized Options
Under Rule 9b–1 of the Securities
Exchange Act of 1934
Paper Comments
• Send paper comments in triplicate
to Nancy M. Morris, Secretary,
Securities and Exchange Commission,
100 F Street, NE., Washington, DC
20549–1090.
All submissions should refer to File
Number SR–CBOE–2007–98. 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
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For the Commission, by the Division of
Market Regulation, pursuant to delegated
authority.8
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7–16582 Filed 8–21–07; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–56275; File No. SR–CBOE–
2007–26]
August 17, 2007.
I. Introduction
On April 5, 2007, the Chicago Board
Options Exchange, Incorporated
(‘‘CBOE’’ or ‘‘Exchange’’) filed with the
Securities and Exchange Commission
(‘‘Commission’’) a proposed rule
change, pursuant to section 19(b)(1) of
8 17
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Federal Register / Vol. 72, No. 162 / Wednesday, August 22, 2007 / Notices
the Securities Exchange Act of 1934
(‘‘Act’’) 1 and Rule 19b–4 thereunder,2 to
permit CBOE to list and trade cashsettled, binary options 3 based on the
occurrence of credit events in the debt
securities of one or more issuers,
referred to as credit default basket
options. On June 15, 2007, CBOE filed
Amendment No. 1 to the proposed rule
change; on June 19, 2007, CBOE
withdrew Amendment No. 1 and filed
Amendment No. 2 to the proposed rule
change; and on June 21, 2007, CBOE
withdrew Amendment No. 2 and filed
Amendment No. 3 to the proposed rule
change.4 The proposed rule change, as
modified by Amendment No. 3, was
published for comment in the Federal
Register on June 28, 2007 for a 15-day
comment period.5 The Commission
received no comments on the proposal.
This order approves the proposed rule
change, as modified by Amendment No.
3, and designates credit default basket
options as ‘‘standardized options’’
pursuant to Rule 9b–1 under the Act.6
II. Description of the CBOE Proposal
A. Generally
On June 6, 2007, the Commission
approved a proposal by CBOE to list and
trade credit default options, which are
cash-settled binary options that are
automatically exercised upon the
occurrence of specified credit events or
expire worthless. 7 CBOE now proposes
to list and trade credit default basket
options, which are cash-settled binary
options based on a basket of at least two
Reference Entities (described below).
This proposal would add new rules
1 15
U.S.C. 78s(b)(1).
CFR 240.19b–4.
3 A binary option is a style of option having only
two possible payoff outcomes: either a fixed amount
or nothing at all.
4 Amendment No. 3 replaced the original filing in
its entirety.
5 See Securities Exchange Act Release No. 55938
(June 21, 2007), 72 FR 35523 (‘‘CBOE Proposal’’).
6 See 17 CFR 240.9b–1. Pursuant to Rule 9b–
1(a)(4) under the Act, the Commission may, by
order, designate as ‘‘standardized options’’
securities that do not otherwise meet the definition
of ‘‘standardized options.’’ Standardized options are
defined in Rule 9b–1(a)(4) as: ‘‘[O]ptions contracts
trading on a national securities exchange, an
automated quotations system of a registered
securities association, or a foreign securities
exchange which relate to options classes the terms
of which are limited to specific expiration dates and
exercise prices, or such other securities as the
Commission may, by order, designate.’’ 17 CFR
240.9b–1(a)(4).
7 See Securities Exchange Act Release No. 55871,
72 FR 32372 (June 12, 2007) (SR–CBOE–2006–84)
(approving CBOE’s proposal to list and trade credit
default options) (‘‘Credit Default Option Approval
Order’’). See also Securities Exchange Act Release
No. 55919 (June 18, 2007), 72 FR 34498 (June 22,
2007) (SR–CBOE–2007–62) (making various
technical changes to CBOE’s credit default option
rules).
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applicable to credit default basket
options and amend certain existing
rules applicable to credit default options
to make them applicable to credit
default basket options.
Credit default options are referenced
to debt securities issued by a specified
public company (‘‘Reference Entity’’) 8
and either have a fixed payout or expire
worthless, depending upon whether a
credit event occurs during the life of the
option. Upon confirmation of a credit
event prior to the last day of trading of
a credit default option series,9 the
options positions existing as of that time
are automatically exercised and the
holders of long options positions receive
a fixed cash payment of $100,000 per
contract.10 If no credit event is
confirmed during the life of the option,
the final settlement price is $0.
Credit default basket options are like
credit default options, but instead of
being based on the debt securities of one
Reference Entity, they are based on the
debt securities of two or more Reference
Entities, or Basket Components. There
would be two types of credit default
basket options: (i) Multiple payout
credit default basket options that
automatically pay holders a cash
settlement amount each time a credit
event is confirmed in a Basket
Component during the life of the option,
after which the applicable Basket
Component would be removed from the
basket, or expire worthless if no credit
events are confirmed during the life of
the option; and (ii) single payout credit
default basket options that
automatically pay holders a single cash
settlement amount when the first credit
event is confirmed in any Basket
Component, or expire worthless if no
credit event for any Basket Component
is confirmed during the life of the
option.11 Unlike a multiple payout
8 Proposed CBOE Rule 29.1(f) also includes as a
‘‘Reference Entity’’ the guarantor of the debt
security underlying the credit default option. For
purposes of credit default basket options, Reference
Entities are referred to as ‘‘Basket Components.’’
See proposed CBOE Rule 29.1(h).
9 CBOE Rule 29.9(c) (to be relettered CBOE Rule
29.9(d)) requires that CBOE confirm the occurrence
of a credit event through at least two sources, which
may include announcements published via
newswire services or information service
companies, the names of which would be
announced to the membership via a CBOE
regulatory circular, or information contained in any
order, decree, or notice of filing, however described,
of or filed with the courts, the Commission, an
exchange, an association, the Options Clearing
Corporation (‘‘OCC’’), or another regulatory agency
or similar authority.
10 However, the settlement amount could be
adjusted pursuant to proposed CBOE Rule 29.4.
11 Credit events that trigger an automatic pay out
include a failure to make payment pursuant to the
terms of an underlying debt security and any other
event of default specified by CBOE at the time it
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credit default basket option, a single
payout credit default basket option
ceases trading after confirmation of the
first credit event.
The cash payout for credit default
basket options is calculated differently
than for credit default options. For both
types of credit default basket options,
each time a credit event is confirmed
during the life of the option, the holder
of the option would receive a cash
payment per contract that is equal to
one minus the Basket Component
recovery rate specified by the Exchange
at listing, multiplied by the notional
face value of the applicable Basket
Component.12 For example, if there is a
credit event in a Basket Component
with notional face value of $10,000 and
a recovery rate of 40%, the cash
payment per contract would be
$6,000.13 As with credit default options,
if no credit event is confirmed during
the life of the option, the final
settlement price would be $0.
B. Listing Standards
Like credit default options, credit
default basket options must conform to
the initial and continued listing
standards under proposed CBOE
Chapter XXIX.14 CBOE is proposing to
list and trade only credit default basket
options overlying debt securities of
multiple Reference Entities each having
at least one class of securities that is
registered under the Act and is an
‘‘NMS stock’’ 15 as defined in Rule 600
of Regulation NMS under the Act.16 Any
registered equity security issued by the
Reference Entity also would have to
satisfy the requirements of CBOE Rule
initially lists a particular class of credit default
basket options. For each Basket Component, the
events of default that CBOE may specify must be
defined in accordance with the terms of the specific
debt security underlying the Basket Component
(each a ‘‘Reference Obligation’’) or any other debt
securities of the Basket Component other than nonrecourse indebtedness (collectively with the
Reference Obligation, ‘‘Relevant Obligations’’). See
proposed CBOE Rules 29.1(c) and 29.2A.
12 At the time of listing, the Exchange will
designate the notional face value and recovery rate
of each Basket Component. See proposed CBOE
Rule 29.2A (setting forth the requirements for the
designation and terms of credit default basket
options); and proposed CBOE Rules 29.1(a)(ii) and
(j) (setting forth the definitions for ‘‘cash settlement
amount’’ for credit default basket options and
‘‘Notional Face Value of Basket Component,’’
respectively).
13 $10,000 × (1 ¥ 0.40) = $6,000.
14 CBOE is amending Chapter XXIX to make it
applicable to all ‘‘Credit Options,’’ which would
include credit default options and credit default
basket options.
15 ‘‘NMS stock’’ means any security, or class of
securities, other than an option for which
transaction reports are collected, processed, and
made available pursuant to an effective transaction
reporting plan. See 17 CFR 242.600(b)(46) and (47).
16 See proposed CBOE Rule 5.3.11.
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5.4, which requires, among other things,
that an equity security underlying an
option be itself widely held and actively
traded.17 This requirement is designed
to ensure that the issuer’s securities
enjoy widespread investor interest. The
requirement that each Reference Entity
be an issuer or guarantor of registered
NMS stock will help ensure that
investors have access to comprehensive
public information about the Reference
Entity, including the registration
statement filed under the Securities Act
of 1933 (‘‘Securities Act’’) and other
periodic reports.18
Also, as with credit default options, a
credit default basket option could not be
exercised at the discretion of the
investor, but instead would have an
automatic payout only upon the
occurrence of a credit event. The
expiration date would be the fourth
business day after the last day of trading
of the series, which would be the third
Friday of the expiration month.19 The
Exchange usually would open one to
four series for each year up to 10.25
years from the current expiration.20
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C. Trading
The trading rules for credit default
basket options would be consistent with
those applicable to credit default
options. Specifically, credit default
basket options would trade on CBOE’s
17 CBOE Rule 5.4 provides that, absent
exceptional circumstances, an underlying security
will not be deemed to meet the Exchange’s
requirements for continued approval when: (i)
There are fewer than 6,300,000 shares of the
underlying security held by persons other than
those who are required to report their security
holdings under Section 16(a) of the Act (15 U.S.C.
78p); (ii) there are fewer than 1,600 holders of the
underlying security; (iii) the trading volume (in all
markets in which the underlying security is traded)
was less than 1,800,000 shares in the preceding 12
months; (iv) the market price per share of the
underlying security closed below $3 on the
previous trading day, as measured by the closing
price reported in the primary market in which the
underlying security traded; or (v) the underlying
security ceases to be an NMS stock.
18 Section 13 of the Act, 15 U.S.C. 78m, provides
that any issuer of a security registered pursuant to
Section 12 of the Act, 15 U.S.C. 78l, must file with
the Commission annual reports and information
and documents necessary to keep reasonably
current the information in its Section 12 registration
statement.
19 For a single payout credit default basket option,
if a credit event is confirmed, the expiration date
would be the second business day after the
confirmation of the first credit event. For a multiple
payout credit default basket option, if a credit event
is confirmed in every Basket Component, the
expiration date would be the second business day
after the confirmation of the last credit event. For
either type of credit default basket options, if a
Redemption Event is confirmed in all Basket
Components, the expiration date would be the
second business day after the last confirmation
date. See proposed CBOE Rules 29.1(d)(ii) and
(e)(ii). See also proposed CBOE Rule 29.4.
20 See proposed CBOE Rule 29.2A(b)(1) and (2).
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Hybrid Trading System from 8:30 a.m.
to 3 p.m. (Central Time) 21 in a manner
similar to the trading of equity options.
With limited distinctions, as described
more fully in the proposal, CBOE’s
equity option trading rules would apply
to credit default options.22 Also, credit
default basket options would be eligible
for trading as Flexible Exchange Options
(‘‘FLEX Options’’). A FLEX Option that
is a credit default basket option would
be cash-settled and the exercise-byexception provisions of OCC Rule 805 23
would not apply. Market-makers would
be appointed to credit default options
pursuant to CBOE’s existing
requirements,24 as supplemented by
proposed CBOE Rule 29.17.
Additionally, CBOE represents that it,
and the Options Price Reporting
Authority (‘‘OPRA’’), have the necessary
systems capacity to handle the
additional quote volume anticipated to
be associated with credit default basket
options.
Once a particular credit default basket
option class has been approved for
listing and trading, the Exchange would,
from time to time, open for trading a
series of that class. If a credit default
option class initially approved for
trading no longer meets the Exchange’s
requirements for continued approval,
the Exchange would not open for
trading any additional series of options
and, as provided in CBOE Rule 5.4,
could prohibit any opening purchase
transactions in such class. The proposed
trading rules for credit default basket
options are designed to create an
environment that takes into account the
small number of transactions likely to
occur, while providing price
improvement and the transparency
benefits of competitive floor bidding, as
compared to the over-the-counter
(‘‘OTC’’) market.
Upon the confirmation of the first
credit event (in the case of a single
payout credit default basket option), a
credit event in every Basket Component
(in the case of a multiple payout credit
default basket option), or the
redemption of all Relevant Obligations
(in the case of either type of credit
default basket option), the applicable
credit default basket option class would
cease trading. In addition, CBOE’s
trading halt procedures applicable to
equity options would apply to credit
21 See
proposed CBOE Rule 29.11.
proposed CBOE Rules 29.11–29.15, 29.16,
and 29.19.
23 OCC Rule 805 sets forth the expiration date
exercise procedures for options cleared and settled
by the OCC.
24 See Chapter VIII of CBOE’s rules.
22 See
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47099
default basket options.25 When
determining whether to institute a
trading halt in credit default basket
options, CBOE floor officials would
consider whether current quotations for
a Relevant Obligation or other securities
of a Reference Entity are unavailable or
have become unreliable.26 The
Exchange’s board of directors would
also have the power to impose
restrictions on transactions or exercises
in one or more series of credit default
basket options as the board, in its
judgment, determines advisable in the
interests of maintaining a fair and
orderly market or otherwise deems
advisable in the public interest or for
the protection of investors.27
D. Clearance and Settlement
Like credit default options, credit
default basket options do not have an
exercise price, and thus by their terms,
do not meet the definition of
‘‘standardized options’’ for purposes of
Rule 9b–1 under the Act.28 However, as
discussed herein, the Commission today
is using its authority pursuant to Rule
9b–1 to designate credit default basket
options as ‘‘standardized options’’
under Rule 9b–1. Consequently, credit
default basket option transactions will
be eligible for clearance and settlement
by the OCC in accordance with
procedures that are substantially similar
to existing systems and procedures for
the clearance and settlement of
exchange-traded options.29
E. Adjustments
Like credit default options, both types
of credit default basket options would
be subject to adjustments in two
circumstances.30 First, if a Basket
Component is succeeded by another
entity in accordance with the terms of
the underlying debt securities, the
Exchange will specify a new recovery
25 See CBOE Rules 6.3 and 6.3B; proposed CBOE
Rule 29.13.
26 See id.
27 See proposed CBOE Rule 29.8.
28 17 CFR 240.9b–1.
29 On April 20, 2007, the OCC filed with the
Commission, a proposed rule change to enable it to
clear and settle credit default basket options
proposed to be listed by CBOE. On June 14, 2007,
the OCC filed Amendment No. 1 to the proposal.
The proposed rule change, as amended, was
published for comment in the Federal Register on
June 27, 2007. Securities Exchange Act Release No.
55939 (June 21, 2007), 72 FR 35291 (SR–OCC–
2007–06) (the ‘‘OCC Proposal’’). The Commission
has not yet taken action on the OCC proposal. The
Commission also notes that the Options Disclosure
Document (‘‘ODD’’) was recently amended to
incorporate disclosure related to both credit default
options and credit default basket options. See
Securities Exchange Act Release No. 55921 (June
18, 2007), 72 FR 34495 (June 22, 2007) (SR–ODD–
2007–03).
30 See CBOE proposed Rule 29.4.
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rate and basket weight for each
successor Basket Component. The
newly specified weights would equal
the weight of the original Basket
Component. To the extent necessary and
appropriate for the protection of
investors and the public interest, all
other terms and conditions of the
options would be the same as the
original credit default basket options.
Second, if the Reference Obligation of
a Basket Component is redeemed or
matures during the life of the credit
default basket option, the Exchange
would specify another debt security of
the Reference Entity as the new
Reference Obligation for that Basket
Component. If all debt securities of a
Basket Component (i.e., all Relevant
Obligations) are redeemed during the
life of the credit default basket option,
that Basket Component would be
removed from the basket.
F. Position Limits
Pursuant to proposed CBOE Rule
29.5, credit default basket options
would be subject to a position limit
equal to 50,000 contracts on the same
side of the market. Credit default basket
options would not be aggregated with
option contracts on the same underlying
security and would not be subject to the
hedge exemption to CBOE’s standard
position limits. Instead, the following
hedge strategies and positions would be
exempt from CBOE’s position limits: (i)
A credit default basket option position
‘‘hedged’’ or ‘‘covered’’ by an
appropriate amount of cash to meet the
cash settlement amount obligation; and
(ii) a credit default basket option
position ‘‘hedged’’ or ‘‘covered’’ by an
amount of any of the Basket
Component’s debt securities,
instruments, or interests sufficient to
meet: (A) In the case of a single payout
credit default option, the cash
settlement amount obligation that
would be the greatest if any of the
Basket Components of that option were
to experience a credit event; or (B) in
the case of a multiple payout credit
default option, the sum of the sum of
each Basket Component’s cash
settlement amount.31 Also, CBOE’s
market-maker and firm facilitation
exemptions to position limits would
apply.32
31 See
proposed CBOE Rule 29.5.
CBOE Rule 29.5 would require that
for purposes of its market-maker hedge exemption
(CBOE Rule 4.11.05) the position must be within
20% of the applicable limit before an exemption
would be granted. With respect to CBOE’s firm
facilitation exemption (CBOE Rule 4.11.06),
proposed CBOE Rule 29.5 would provide that the
aggregate exemption position could not exceed
three times the standard limit of 50,000 contracts.
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G. Margin
The margin (both initial and
maintenance) required for writing short
and long positions in credit default
basket options would be as follows:
• For a qualified customer carrying a
long position in a credit default basket
option, the margin requirement would
be 15% of the current market value of
the credit default basket option.
• For a non-qualified customer
carrying a long position in a credit
default basket option, the margin
requirement would be 100% of the
current market value of the credit
default basket option.
• For a qualified customer carrying a
short position in a multiple payout
credit default basket option, the margin
requirement would be the lesser of the
current market value of the credit
default basket option plus 15% of the
sum of each Basket Component’s cash
settlement amount, or the sum of each
Basket Component’s cash settlement
amount.
• For a non-qualified customer
carrying a short position in a multiple
payout credit default basket option, the
margin requirement would be the sum
of each Basket Component’s cash
settlement amount.
• For a qualified customer carrying a
short position in a single payout credit
default basket option, the margin
requirement would be the lesser of the
current market value of the credit
default basket option plus 15% of the
cash settlement amount of the Basket
Component that would be the greatest if
any of the Basket Components were to
experience a credit event, or the cash
settlement amount of the Basket
Component that would be the greatest if
any of the Basket Components were to
experience a credit event.
• For a non-qualified customer
carrying a short position in a single
payout credit default basket option, the
margin requirement would be the cash
settlement amount of the Basket
Component that would be the greatest if
any of the Basket Components were to
experience a credit event.
These requirements may be satisfied
by a deposit of cash or marginable
securities.
A credit default option carried short
in a customer’s account would be
deemed a covered position, and eligible
for the cash account, provided any one
of the following is held in the account
at the time the option is written or is
received into the account promptly
thereafter: (i) For multiple payout credit
default basket options, cash or cash
equivalents equal to 100% of the sum of
each Basket Component’s cash
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settlement amount; (ii) for single payout
credit default basket options, cash or
cash equivalents equal to 100% of the
cash settlement amount of the Basket
Component that would be the greatest if
any of the Basket Components were to
experience a credit event; or (iii) an
escrow agreement. The Exchange
believes that these requirements strike
the appropriate balance and adequately
address concerns that a member or its
customer may try to maintain an
inordinately large unhedged position in
credit default options. The Exchange
represents that, in accordance with
proposed CBOE Rule 12.3(a)(4), an
escrow agreement must be issued in a
form acceptable to the Exchange, and
that it has traditionally recognized as
acceptable the escrow agreement forms
of the OCC and the New York Stock
Exchange.
Lastly, pursuant to proposed CBOE
Rule 12.5, a credit default basket option
that is carried for the account of a
qualified customer may be deemed to
have market value for the purposes of
CBOE Rule 12.3(c).
H. Surveillance
The Exchange has represented that it
will have in place adequate surveillance
procedures to monitor trading in credit
default basket options prior to listing
and trading such options.
III. Discussion
The Commission finds that the
proposed rule change is consistent with
the requirements of the Act and the
rules and regulations thereunder
applicable to a national securities
exchange.33 In particular, the
Commission finds that the proposal is
consistent with section 6(b)(5) of the
Act,34 which requires, among other
things, that the rules of an exchange be
designed to prevent fraudulent and
manipulative acts and practices; to
promote just and equitable principles of
trade; to foster cooperation and
coordination with persons engaged in
regulating, clearing, processing
information with respect to, and
facilitating transactions in securities; to
remove impediments to and perfect the
mechanism of a free and open market
and a national market system; and, in
general to protect investors and the
public interest. CBOE’s proposal, by
enabling it to list and trade securities
heretofore existing only in the OTC
market, would extend to investors the
benefits of a listed exchange market,
33 In approving this proposed rule change, the
Commission notes that it has considered the
proposed rule’s impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f).
34 15 U.S.C. 78f(b)(5).
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which include: a centralized market
center; an auction market with posted,
transparent market quotations and
transaction reporting; standardized
contract specifications; and the
guarantee of the OCC.
In connection with its earlier approval
of credit default options, the
Commission found that the credit
default options proposed by CBOE are
securities because they are options
based on the value of a security or
securities and because they are options
on an interest in, or based on the value
of an interest in, a security or
securities.35 Under an analysis similar
to that applied to credit default options,
and after careful consideration of the
terms of the two types of credit default
basket options, the Commission finds
that the credit default basket options
proposed by CBOE are securities.
Specifically, the Commission finds that
credit default basket options are options
based on the value of securities or a
group or index of securities and are
options on an interest in or based on the
value of an interest in, securities or a
group or index of securities and,
therefore, are securities under section
3(a)(10) of the Act.36
As a threshold matter, the
Commission finds that credit default
basket options are options, not futures
contracts. Generally speaking an option
grants the holder the right, but not the
obligation, to buy or sell a specific
quantity, at a specific price, on or before
a specified future date.37 Courts have
highlighted three characteristics in
particular that distinguish options from
futures contracts: (i) An options-buyer
pays to the seller a nonrefundable
premium; (ii) an options-buyer has
rights but no further obligations under
the contract; and (iii) an options-seller
bears all the risk exposure.38 Examining
credit default basket options in light of
these characteristics, it is clear that
credit default basket options are
options. First, the buyer of a credit
default basket option pays to the seller
a nonrefundable premium. Second, the
buyer of a credit default basket option
has rights but no further obligations
under the contract. Third, the buyer of
a credit default basket option has no
further risk exposure under the contract
and the seller bears all the risk of the
credit event occurring.
35 See Credit Default Option Approval Order,
supra note 7.
36 15 U.S.C. 78c(a)(10).
37 See British American Commodity Options v.
Bagley, 552 F.2d 482, 484–85 (2d Cir. 1977).
38 See CFTC v. U.S. Metals Depository Co., 468
F.Supp. 1149, 1154 (S.D.N.Y. 1979); and United
States v. Bein, 728 F.2d 107, 112 (2d Cir. 1984).
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Although credit default basket options
differ from classic options in certain
respects, these differences do not affect
the economic substance of the contract.
First, credit default basket options are
cash-settled and do not allow for
physical delivery. It is well established,
however, that cash-settled options based
on prices of securities are options ‘‘on’’
such securities.39 Second, credit default
basket options are automatically
exercised, unlike a classic option that
generally gives the option-holder the
right but not the obligation to exercise
if the option is in the money. In the case
of cash-settled options, such as credit
default basket options, however, giving
the option-holder the right to decline to
accept the cash upon the occurrence of
an event of default would be
economically meaningless.40 For this
reason, under OCC rules, index option
contracts are automatically exercised if
they are in-the-money at expiration, and
equity options contracts are
automatically exercised if they are inthe-money by specified amounts. Third,
the payout for a credit default basket
option is fixed in advance and binary in
nature, while in a classic option the
payout can increase or decrease
continuously in direct correlation with
the price movement of the underlying
instrument. The same is true, of course,
of the payout of a futures contract. Thus,
the fixed payout of credit default basket
options does not weigh in favor of
classifying them as either futures or
options.
In short, even though the potential
payout of a credit default basket option
is cash-settled, automatically exercised,
and fixed in advance, the buyer of a
credit default basket option still pays a
fixed premium for the possibility of
receiving a greater amount—which is
the essence of optionality.41
Furthermore, the Commission finds
that credit default basket options are
securities under section 3(a)(10) of the
Act.42 Specifically, credit default basket
39 See Caiola v. Citibank, N.A., New York, 295
F.3d 312, 326 (2d Cir. 2002).
40 See Stechler v. Sidley, Austin Brown & Wood,
L.L.P., 382 F.Supp.2d 580, 595–97 (S.D.N.Y. 2005).
41 See Brief of Amicus Curiae The Securities and
Exchange Commission, at 24, Caiola v. Citibank,
N.A., New York, 295 F.3d 312 (2d Cir. 2002) (01–
7545) (‘‘Simply put, Caiola paid a little for the
chance to get a lot’’).
42 The Commission wishes to make clear that
because credit default basket options will be
exchange-traded and not individually negotiated
(and not necessarily between eligible contract
participants), they are not qualifying swap
agreements under Section 206A of the GrammLeach-Bliley Act (‘‘GLBA’’), 15 U.S.C. 78c note,
and, therefore, not excluded from the definition of
security by Section 3A of the Act, 15 U.S.C. 78c–
1. Also, certain OTC credit default swaps (whether
single-name or basket) are not securities. The
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Fmt 4703
Sfmt 4703
47101
options are options based on the value
of securities or a group or index of
securities and are options on an interest
in, or based on the value of an interest
in, securities or a group or index of
securities. In coming to these
conclusions, the Commission carefully
considered the terms of the credit
default basket options, using an
analytical approach similar to that
which the Commission applied to credit
default options.
The Commission also believes that the
listing and trading rules proposed by
CBOE for credit default basket options
are substantially similar to the listing
and trading rules for credit default
options, and are likewise reasonable and
consistent with the Act. As with a credit
default option, a credit default basket
option must be based on Reference
Obligations issued by entities that issue
or guarantee registered equity securities
that are NMS stocks and that meet the
Exchange’s standards for listing an
equity option. These requirements are
reasonably designed to facilitate
investors’ access to information about
the Reference Entities that may be
necessary to price a credit default basket
option appropriately.
The Commission believes that the
proposed position limits and margin
rules for credit default basket options
are reasonable and consistent with the
Act. The proposed position limit of
50,000 contracts in any credit default
basket option class appears to
reasonably balance the promotion of a
free and open market for these securities
with minimization of incentives for
market manipulation and insider
trading. The proposed margin rules
finding that credit default basket options are
securities because they are options based on the
value of securities or a group or index of securities
might suggest that single-name or basket OTC credit
default swaps are also options based on the value
of a security or group or index of securities and,
therefore, excluded from the definition of swap
agreement because Section 206A(b)(1) of the GLBA,
15 U.S.C. 78c note, excludes from the definition of
swap agreement ‘‘any put, call, straddle, option, or
privilege on any security, certificate of deposit, or
group or index of securities, including any interest
therein or based on the value thereof.’’ However,
Congress specifically enumerated ‘‘credit default
swaps’’ (without defining the term) as one example
of a qualifying swap agreement. See Section
206A(a)(3) of the GLBA, 15 U.S.C. 78c note. The
Commission views the specific enumeration of
‘‘credit default swaps’’ as reflecting the intention of
Congress to exclude certain OTC credit default
swaps from the definition of security pursuant to
Sections 206B & C of the GLBA, 15 U.S.C. 78c note.
Of course, OTC credit default swaps that involve
terms similar to credit default basket options, but
that are otherwise excluded from the definition of
security because they are qualifying swap
agreements, remain subject to the Commission’s
antifraud jurisdiction (including authority over
insider trading) as ‘‘security-based swap
agreements’’ under Section 206B of the GLBA, 15
U.S.C. 78c note.
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Federal Register / Vol. 72, No. 162 / Wednesday, August 22, 2007 / Notices
appear reasonably designed to deter a
member or its customer from assuming
an imprudent position in credit default
options.
In support of this proposal, the
Exchange made the following
representations:
• The Exchange will have in place
adequate surveillance procedures to
monitor trading in credit default basket
options prior to listing and trading such
options, thereby helping to ensure the
maintenance of a fair and orderly
market for trading in credit default
options.
• The Exchange and the OPRA will
have the necessary systems capacity to
accommodate the additional volume
associated with credit default basket
options as proposed.
This approval order is based on
CBOE’s representations.
For the foregoing reasons, the
Commission finds that the proposed
rule is consistent with the Act.
IV. Designation of Credit Default Basket
Options Pursuant to Rule 9b–1
Rule 9b–1 establishes a disclosure
framework for standardized options that
are traded on a national securities
exchange and cleared through a
registered clearing agency. Under this
framework, the exchange on which a
standardized option is listed and traded
must prepare an ODD that, among other
things, identifies the issuer and
describes the uses, mechanics, and risks
of options trading, in language that can
be easily understood by the general
investing public. The ODD is treated as
a substitute for the traditional
prospectus. A broker-dealer must
provide a copy of the ODD to each
customer at or before approving of the
customer’s account for trading any
standardized option.43 Any amendment
to the ODD must be distributed to each
customer whose account is approved for
trading the options class for which the
ODD relates.44
Under Rule 9b–1, use of the ODD is
limited to ‘‘standardized options’’ for
which there is an effective registration
statement on Form S–20 under the
Securities Act or that are exempt from
registration.45 The Commission
43 See
17 CFR 240.9b–1(d)(1).
17 CFR 240.9b–1(d)(2).
45 See 17 CFR 240.9b–1(b)(1) and (c)(8). See also
17 CFR 230.238. Rule 238 under the Securities Act
provides an exemption from the Securities Act for
any standardized option, as defined by Rule 9b–
1(a)(4) under the Act, with limited exceptions. Rule
238 does not exempt standardized options from the
antifraud provisions of Section 17 of the Securities
Act, 15 U.S.C. 77q. Also, offers and sales of
standardized options by or on behalf of the issuer
of the underlying security or securities, an affiliate
of the issuer, or an underwriter, will constitute an
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44 See
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specifically reserved in Rule 9b–1 the
ability to designate as standardized
options other securities ‘‘that the
Commission believes should be
included within the options disclosure
framework.’’ 46
The Commission hereby designates
credit default basket options, as defined
in the OCC Proposal,47 as standardized
options for purposes of Rule 9b–1 under
the Act. Like credit default options,
credit default basket options do not
meet the definition of ‘‘standardized
options,’’ because they do not have an
exercise price.48 However, they
resemble standardized options in other
significant respects. Credit default
basket options have underlying
securities and an expiration date. Like
other standardized options, credit
default basket options have
standardized terms relating to exercise
procedures, contract adjustments, time
of issuance, effect of closing
transactions, restrictions, and other
matters pertaining to the rights and
obligations of holders and writers.
Further, credit default basket options
offer or sale of the underlying security or securities
as defined in Section 2(a)(3) of the Securities Act,
15 U.S.C. 77b(a)(3). See also Securities Act Release
No. 8171 (December 23, 2002), 68 FR 188 (January
2, 2003) (Exemption for Standardized Options From
Provisions of the Securities Act of 1933 and From
Registration Requirements of the Exchange Act of
1934).
46 See Securities Exchange Act Release No. 19055
and Securities Act Release No. 6426 (September 16,
1982), 47 FR 41950, 41954 (September 23, 1982).
47 For purposes of its proposal, OCC would define
the term ‘‘credit default basket option’’ as an option
that is based on a basket comprised of at least two
reference entities and that is either a ‘‘multiple
payout credit default basket option’’ or a ‘‘single
payout credit default basket option.’’ A ‘‘multiple
payout credit default basket option’’ would mean a
credit default basket option that automatically pays
an exercise settlement amount each time a credit
event is confirmed with respect to any one of the
reference entities prior to expiration of the option.
A ‘‘single payout credit default basket option’’
would be automatically exercised and pay a single
exercise settlement amount only when the first
credit event is confirmed with respect to a reference
entity prior to expiration of the option. See
proposed Section 1.C.(2) of Article XIV of the OCC
By-Laws.
‘‘Credit event’’ would be as defined in the rules
of the exchange on which the credit default basket
options are listed, with respect to a reference
obligation for such option. See proposed Section
1.C.(3) of Article XIV of the OCC By-Laws.
‘‘Reference entity’’ would mean any one of the
issuers or guarantors of the reference obligation(s)
that underlie a credit default basket option. See
proposed Section 1.R.(1) of Article XIV of the OCC
By-Laws.
‘‘Reference obligation’’ would mean any debt
security the terms of which are used to define the
occurrence of a credit event with respect to the
reference entity that is its issuer or guarantor for a
class of credit default basket options, as provided
in the rules of the listing exchange. See id.
48 See Credit Default Options Approval Order at
Section VI (designating credit default options as
standardized options for purposes of Rule 9b–1
under the Act).
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are designed to provide market
participants with the ability to hedge
their exposure to underlying securities.
The fact that credit default basket
options lack a specified exercise price
does not detract from this option-like
benefit. The Commission believes that
the fact that the OCC, the clearing
agency for all standardized options, is
willing to serve as issuer of credit
default basket options supports the view
that adding credit default basket options
to the standardized option disclosure
framework is reasonable.
Therefore, the Commission hereby
designates credit default basket options,
such as those proposed by CBOE, as
standardized options for purposes of
Rule 9b–1 under the Act.
V. Conclusion
It is therefore ordered, pursuant to
section 19(b)(2) of the Act,49 that the
proposed rule change (SR–CBOE–2007–
26), as modified by Amendment No. 3,
be and hereby is approved.
It is further ordered, pursuant to Rule
9b–1(a)(4) under the Act, that credit
default basket options, as defined in
proposed rule change SR–OCC–2007–
06, are designated as standardized
options.
By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7–16587 Filed 8–21–07; 8:45 am]
BILLING CODE 8010–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–56265; File No. SR–FINRA–
2007–002]
Self-Regulatory Organizations;
Financial Industry Regulatory
Authority, Inc.; Notice of Filing and
Immediate Effectiveness of Proposed
Rule Change To Extend a Pilot
Program That Increases Position and
Exercise Limits for Certain Equity
Options
August 15, 2007.
Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934
(‘‘Act’’) 1 and Rule 19b–4 thereunder,2
notice is hereby given that on July 31,
2007, the Financial Industry Regulatory
Authority, Inc. (‘‘FINRA’’) (f/k/a the
National Association of Securities
Dealers, Inc. (‘‘NASD’’)) filed with the
Securities and Exchange Commission
(‘‘Commission’’) the proposed rule
change as described in Items I, II, and
49 15
U.S.C. 78s(b)(2).
U.S.C. 78s(b)(1).
2 17 CFR 240.19b–4.
1 15
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]]>Agencies
[Federal Register Volume 72, Number 162 (Wednesday, August 22, 2007)]
[Notices]
[Pages 47097-47102]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-16587]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-56275; File No. SR-CBOE-2007-26]
Self-Regulatory Organizations; Chicago Board Options Exchange,
Incorporated; Order Granting Approval of a Proposed Rule Change To List
and Trade Credit Default Basket Options, as Modified by Amendment No.
3, and Designating Credit Default Basket Options as Standardized
Options Under Rule 9b-1 of the Securities Exchange Act of 1934
August 17, 2007.
I. Introduction
On April 5, 2007, the Chicago Board Options Exchange, Incorporated
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange
Commission (``Commission'') a proposed rule change, pursuant to section
19(b)(1) of
[[Page 47098]]
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ to permit CBOE to list and trade cash-settled, binary
options \3\ based on the occurrence of credit events in the debt
securities of one or more issuers, referred to as credit default basket
options. On June 15, 2007, CBOE filed Amendment No. 1 to the proposed
rule change; on June 19, 2007, CBOE withdrew Amendment No. 1 and filed
Amendment No. 2 to the proposed rule change; and on June 21, 2007, CBOE
withdrew Amendment No. 2 and filed Amendment No. 3 to the proposed rule
change.\4\ The proposed rule change, as modified by Amendment No. 3,
was published for comment in the Federal Register on June 28, 2007 for
a 15-day comment period.\5\ The Commission received no comments on the
proposal. This order approves the proposed rule change, as modified by
Amendment No. 3, and designates credit default basket options as
``standardized options'' pursuant to Rule 9b-1 under the Act.\6\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ A binary option is a style of option having only two
possible payoff outcomes: either a fixed amount or nothing at all.
\4\ Amendment No. 3 replaced the original filing in its
entirety.
\5\ See Securities Exchange Act Release No. 55938 (June 21,
2007), 72 FR 35523 (``CBOE Proposal'').
\6\ See 17 CFR 240.9b-1. Pursuant to Rule 9b-1(a)(4) under the
Act, the Commission may, by order, designate as ``standardized
options'' securities that do not otherwise meet the definition of
``standardized options.'' Standardized options are defined in Rule
9b-1(a)(4) as: ``[O]ptions contracts trading on a national
securities exchange, an automated quotations system of a registered
securities association, or a foreign securities exchange which
relate to options classes the terms of which are limited to specific
expiration dates and exercise prices, or such other securities as
the Commission may, by order, designate.'' 17 CFR 240.9b-1(a)(4).
---------------------------------------------------------------------------
II. Description of the CBOE Proposal
A. Generally
On June 6, 2007, the Commission approved a proposal by CBOE to list
and trade credit default options, which are cash-settled binary options
that are automatically exercised upon the occurrence of specified
credit events or expire worthless. \7\ CBOE now proposes to list and
trade credit default basket options, which are cash-settled binary
options based on a basket of at least two Reference Entities (described
below). This proposal would add new rules applicable to credit default
basket options and amend certain existing rules applicable to credit
default options to make them applicable to credit default basket
options.
Credit default options are referenced to debt securities issued by
a specified public company (``Reference Entity'') \8\ and either have a
fixed payout or expire worthless, depending upon whether a credit event
occurs during the life of the option. Upon confirmation of a credit
event prior to the last day of trading of a credit default option
series,\9\ the options positions existing as of that time are
automatically exercised and the holders of long options positions
receive a fixed cash payment of $100,000 per contract.\10\ If no credit
event is confirmed during the life of the option, the final settlement
price is $0.
---------------------------------------------------------------------------
\7\ See Securities Exchange Act Release No. 55871, 72 FR 32372
(June 12, 2007) (SR-CBOE-2006-84) (approving CBOE's proposal to list
and trade credit default options) (``Credit Default Option Approval
Order''). See also Securities Exchange Act Release No. 55919 (June
18, 2007), 72 FR 34498 (June 22, 2007) (SR-CBOE-2007-62) (making
various technical changes to CBOE's credit default option rules).
\8\ Proposed CBOE Rule 29.1(f) also includes as a ``Reference
Entity'' the guarantor of the debt security underlying the credit
default option. For purposes of credit default basket options,
Reference Entities are referred to as ``Basket Components.'' See
proposed CBOE Rule 29.1(h).
\9\ CBOE Rule 29.9(c) (to be relettered CBOE Rule 29.9(d))
requires that CBOE confirm the occurrence of a credit event through
at least two sources, which may include announcements published via
newswire services or information service companies, the names of
which would be announced to the membership via a CBOE regulatory
circular, or information contained in any order, decree, or notice
of filing, however described, of or filed with the courts, the
Commission, an exchange, an association, the Options Clearing
Corporation (``OCC''), or another regulatory agency or similar
authority.
\10\ However, the settlement amount could be adjusted pursuant
to proposed CBOE Rule 29.4.
---------------------------------------------------------------------------
Credit default basket options are like credit default options, but
instead of being based on the debt securities of one Reference Entity,
they are based on the debt securities of two or more Reference
Entities, or Basket Components. There would be two types of credit
default basket options: (i) Multiple payout credit default basket
options that automatically pay holders a cash settlement amount each
time a credit event is confirmed in a Basket Component during the life
of the option, after which the applicable Basket Component would be
removed from the basket, or expire worthless if no credit events are
confirmed during the life of the option; and (ii) single payout credit
default basket options that automatically pay holders a single cash
settlement amount when the first credit event is confirmed in any
Basket Component, or expire worthless if no credit event for any Basket
Component is confirmed during the life of the option.\11\ Unlike a
multiple payout credit default basket option, a single payout credit
default basket option ceases trading after confirmation of the first
credit event.
---------------------------------------------------------------------------
\11\ Credit events that trigger an automatic pay out include a
failure to make payment pursuant to the terms of an underlying debt
security and any other event of default specified by CBOE at the
time it initially lists a particular class of credit default basket
options. For each Basket Component, the events of default that CBOE
may specify must be defined in accordance with the terms of the
specific debt security underlying the Basket Component (each a
``Reference Obligation'') or any other debt securities of the Basket
Component other than non-recourse indebtedness (collectively with
the Reference Obligation, ``Relevant Obligations''). See proposed
CBOE Rules 29.1(c) and 29.2A.
---------------------------------------------------------------------------
The cash payout for credit default basket options is calculated
differently than for credit default options. For both types of credit
default basket options, each time a credit event is confirmed during
the life of the option, the holder of the option would receive a cash
payment per contract that is equal to one minus the Basket Component
recovery rate specified by the Exchange at listing, multiplied by the
notional face value of the applicable Basket Component.\12\ For
example, if there is a credit event in a Basket Component with notional
face value of $10,000 and a recovery rate of 40%, the cash payment per
contract would be $6,000.\13\ As with credit default options, if no
credit event is confirmed during the life of the option, the final
settlement price would be $0.
---------------------------------------------------------------------------
\12\ At the time of listing, the Exchange will designate the
notional face value and recovery rate of each Basket Component. See
proposed CBOE Rule 29.2A (setting forth the requirements for the
designation and terms of credit default basket options); and
proposed CBOE Rules 29.1(a)(ii) and (j) (setting forth the
definitions for ``cash settlement amount'' for credit default basket
options and ``Notional Face Value of Basket Component,''
respectively).
\13\ $10,000 x (1 - 0.40) = $6,000.
---------------------------------------------------------------------------
B. Listing Standards
Like credit default options, credit default basket options must
conform to the initial and continued listing standards under proposed
CBOE Chapter XXIX.\14\ CBOE is proposing to list and trade only credit
default basket options overlying debt securities of multiple Reference
Entities each having at least one class of securities that is
registered under the Act and is an ``NMS stock'' \15\ as defined in
Rule 600 of Regulation NMS under the Act.\16\ Any registered equity
security issued by the Reference Entity also would have to satisfy the
requirements of CBOE Rule
[[Page 47099]]
5.4, which requires, among other things, that an equity security
underlying an option be itself widely held and actively traded.\17\
This requirement is designed to ensure that the issuer's securities
enjoy widespread investor interest. The requirement that each Reference
Entity be an issuer or guarantor of registered NMS stock will help
ensure that investors have access to comprehensive public information
about the Reference Entity, including the registration statement filed
under the Securities Act of 1933 (``Securities Act'') and other
periodic reports.\18\
---------------------------------------------------------------------------
\14\ CBOE is amending Chapter XXIX to make it applicable to all
``Credit Options,'' which would include credit default options and
credit default basket options.
\15\ ``NMS stock'' means any security, or class of securities,
other than an option for which transaction reports are collected,
processed, and made available pursuant to an effective transaction
reporting plan. See 17 CFR 242.600(b)(46) and (47).
\16\ See proposed CBOE Rule 5.3.11.
\17\ CBOE Rule 5.4 provides that, absent exceptional
circumstances, an underlying security will not be deemed to meet the
Exchange's requirements for continued approval when: (i) There are
fewer than 6,300,000 shares of the underlying security held by
persons other than those who are required to report their security
holdings under Section 16(a) of the Act (15 U.S.C. 78p); (ii) there
are fewer than 1,600 holders of the underlying security; (iii) the
trading volume (in all markets in which the underlying security is
traded) was less than 1,800,000 shares in the preceding 12 months;
(iv) the market price per share of the underlying security closed
below $3 on the previous trading day, as measured by the closing
price reported in the primary market in which the underlying
security traded; or (v) the underlying security ceases to be an NMS
stock.
\18\ Section 13 of the Act, 15 U.S.C. 78m, provides that any
issuer of a security registered pursuant to Section 12 of the Act,
15 U.S.C. 78l, must file with the Commission annual reports and
information and documents necessary to keep reasonably current the
information in its Section 12 registration statement.
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Also, as with credit default options, a credit default basket
option could not be exercised at the discretion of the investor, but
instead would have an automatic payout only upon the occurrence of a
credit event. The expiration date would be the fourth business day
after the last day of trading of the series, which would be the third
Friday of the expiration month.\19\ The Exchange usually would open one
to four series for each year up to 10.25 years from the current
expiration.\20\
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\19\ For a single payout credit default basket option, if a
credit event is confirmed, the expiration date would be the second
business day after the confirmation of the first credit event. For a
multiple payout credit default basket option, if a credit event is
confirmed in every Basket Component, the expiration date would be
the second business day after the confirmation of the last credit
event. For either type of credit default basket options, if a
Redemption Event is confirmed in all Basket Components, the
expiration date would be the second business day after the last
confirmation date. See proposed CBOE Rules 29.1(d)(ii) and (e)(ii).
See also proposed CBOE Rule 29.4.
\20\ See proposed CBOE Rule 29.2A(b)(1) and (2).
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C. Trading
The trading rules for credit default basket options would be
consistent with those applicable to credit default options.
Specifically, credit default basket options would trade on CBOE's
Hybrid Trading System from 8:30 a.m. to 3 p.m. (Central Time) \21\ in a
manner similar to the trading of equity options. With limited
distinctions, as described more fully in the proposal, CBOE's equity
option trading rules would apply to credit default options.\22\ Also,
credit default basket options would be eligible for trading as Flexible
Exchange Options (``FLEX Options''). A FLEX Option that is a credit
default basket option would be cash-settled and the exercise-by-
exception provisions of OCC Rule 805 \23\ would not apply. Market-
makers would be appointed to credit default options pursuant to CBOE's
existing requirements,\24\ as supplemented by proposed CBOE Rule 29.17.
Additionally, CBOE represents that it, and the Options Price Reporting
Authority (``OPRA''), have the necessary systems capacity to handle the
additional quote volume anticipated to be associated with credit
default basket options.
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\21\ See proposed CBOE Rule 29.11.
\22\ See proposed CBOE Rules 29.11-29.15, 29.16, and 29.19.
\23\ OCC Rule 805 sets forth the expiration date exercise
procedures for options cleared and settled by the OCC.
\24\ See Chapter VIII of CBOE's rules.
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Once a particular credit default basket option class has been
approved for listing and trading, the Exchange would, from time to
time, open for trading a series of that class. If a credit default
option class initially approved for trading no longer meets the
Exchange's requirements for continued approval, the Exchange would not
open for trading any additional series of options and, as provided in
CBOE Rule 5.4, could prohibit any opening purchase transactions in such
class. The proposed trading rules for credit default basket options are
designed to create an environment that takes into account the small
number of transactions likely to occur, while providing price
improvement and the transparency benefits of competitive floor bidding,
as compared to the over-the-counter (``OTC'') market.
Upon the confirmation of the first credit event (in the case of a
single payout credit default basket option), a credit event in every
Basket Component (in the case of a multiple payout credit default
basket option), or the redemption of all Relevant Obligations (in the
case of either type of credit default basket option), the applicable
credit default basket option class would cease trading. In addition,
CBOE's trading halt procedures applicable to equity options would apply
to credit default basket options.\25\ When determining whether to
institute a trading halt in credit default basket options, CBOE floor
officials would consider whether current quotations for a Relevant
Obligation or other securities of a Reference Entity are unavailable or
have become unreliable.\26\ The Exchange's board of directors would
also have the power to impose restrictions on transactions or exercises
in one or more series of credit default basket options as the board, in
its judgment, determines advisable in the interests of maintaining a
fair and orderly market or otherwise deems advisable in the public
interest or for the protection of investors.\27\
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\25\ See CBOE Rules 6.3 and 6.3B; proposed CBOE Rule 29.13.
\26\ See id.
\27\ See proposed CBOE Rule 29.8.
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D. Clearance and Settlement
Like credit default options, credit default basket options do not
have an exercise price, and thus by their terms, do not meet the
definition of ``standardized options'' for purposes of Rule 9b-1 under
the Act.\28\ However, as discussed herein, the Commission today is
using its authority pursuant to Rule 9b-1 to designate credit default
basket options as ``standardized options'' under Rule 9b-1.
Consequently, credit default basket option transactions will be
eligible for clearance and settlement by the OCC in accordance with
procedures that are substantially similar to existing systems and
procedures for the clearance and settlement of exchange-traded
options.\29\
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\28\ 17 CFR 240.9b-1.
\29\ On April 20, 2007, the OCC filed with the Commission, a
proposed rule change to enable it to clear and settle credit default
basket options proposed to be listed by CBOE. On June 14, 2007, the
OCC filed Amendment No. 1 to the proposal. The proposed rule change,
as amended, was published for comment in the Federal Register on
June 27, 2007. Securities Exchange Act Release No. 55939 (June 21,
2007), 72 FR 35291 (SR-OCC-2007-06) (the ``OCC Proposal''). The
Commission has not yet taken action on the OCC proposal. The
Commission also notes that the Options Disclosure Document (``ODD'')
was recently amended to incorporate disclosure related to both
credit default options and credit default basket options. See
Securities Exchange Act Release No. 55921 (June 18, 2007), 72 FR
34495 (June 22, 2007) (SR-ODD-2007-03).
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E. Adjustments
Like credit default options, both types of credit default basket
options would be subject to adjustments in two circumstances.\30\
First, if a Basket Component is succeeded by another entity in
accordance with the terms of the underlying debt securities, the
Exchange will specify a new recovery
[[Page 47100]]
rate and basket weight for each successor Basket Component. The newly
specified weights would equal the weight of the original Basket
Component. To the extent necessary and appropriate for the protection
of investors and the public interest, all other terms and conditions of
the options would be the same as the original credit default basket
options.
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\30\ See CBOE proposed Rule 29.4.
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Second, if the Reference Obligation of a Basket Component is
redeemed or matures during the life of the credit default basket
option, the Exchange would specify another debt security of the
Reference Entity as the new Reference Obligation for that Basket
Component. If all debt securities of a Basket Component (i.e., all
Relevant Obligations) are redeemed during the life of the credit
default basket option, that Basket Component would be removed from the
basket.
F. Position Limits
Pursuant to proposed CBOE Rule 29.5, credit default basket options
would be subject to a position limit equal to 50,000 contracts on the
same side of the market. Credit default basket options would not be
aggregated with option contracts on the same underlying security and
would not be subject to the hedge exemption to CBOE's standard position
limits. Instead, the following hedge strategies and positions would be
exempt from CBOE's position limits: (i) A credit default basket option
position ``hedged'' or ``covered'' by an appropriate amount of cash to
meet the cash settlement amount obligation; and (ii) a credit default
basket option position ``hedged'' or ``covered'' by an amount of any of
the Basket Component's debt securities, instruments, or interests
sufficient to meet: (A) In the case of a single payout credit default
option, the cash settlement amount obligation that would be the
greatest if any of the Basket Components of that option were to
experience a credit event; or (B) in the case of a multiple payout
credit default option, the sum of the sum of each Basket Component's
cash settlement amount.\31\ Also, CBOE's market-maker and firm
facilitation exemptions to position limits would apply.\32 \
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\31\ See proposed CBOE Rule 29.5.
\32\ Proposed CBOE Rule 29.5 would require that for purposes of
its market-maker hedge exemption (CBOE Rule 4.11.05) the position
must be within 20% of the applicable limit before an exemption would
be granted. With respect to CBOE's firm facilitation exemption (CBOE
Rule 4.11.06), proposed CBOE Rule 29.5 would provide that the
aggregate exemption position could not exceed three times the
standard limit of 50,000 contracts.
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G. Margin
The margin (both initial and maintenance) required for writing
short and long positions in credit default basket options would be as
follows:
For a qualified customer carrying a long position in a
credit default basket option, the margin requirement would be 15% of
the current market value of the credit default basket option.
For a non-qualified customer carrying a long position in a
credit default basket option, the margin requirement would be 100% of
the current market value of the credit default basket option.
For a qualified customer carrying a short position in a
multiple payout credit default basket option, the margin requirement
would be the lesser of the current market value of the credit default
basket option plus 15% of the sum of each Basket Component's cash
settlement amount, or the sum of each Basket Component's cash
settlement amount.
For a non-qualified customer carrying a short position in
a multiple payout credit default basket option, the margin requirement
would be the sum of each Basket Component's cash settlement amount.
For a qualified customer carrying a short position in a
single payout credit default basket option, the margin requirement
would be the lesser of the current market value of the credit default
basket option plus 15% of the cash settlement amount of the Basket
Component that would be the greatest if any of the Basket Components
were to experience a credit event, or the cash settlement amount of the
Basket Component that would be the greatest if any of the Basket
Components were to experience a credit event.
For a non-qualified customer carrying a short position in
a single payout credit default basket option, the margin requirement
would be the cash settlement amount of the Basket Component that would
be the greatest if any of the Basket Components were to experience a
credit event.
These requirements may be satisfied by a deposit of cash or
marginable securities.
A credit default option carried short in a customer's account would
be deemed a covered position, and eligible for the cash account,
provided any one of the following is held in the account at the time
the option is written or is received into the account promptly
thereafter: (i) For multiple payout credit default basket options, cash
or cash equivalents equal to 100% of the sum of each Basket Component's
cash settlement amount; (ii) for single payout credit default basket
options, cash or cash equivalents equal to 100% of the cash settlement
amount of the Basket Component that would be the greatest if any of the
Basket Components were to experience a credit event; or (iii) an escrow
agreement. The Exchange believes that these requirements strike the
appropriate balance and adequately address concerns that a member or
its customer may try to maintain an inordinately large unhedged
position in credit default options. The Exchange represents that, in
accordance with proposed CBOE Rule 12.3(a)(4), an escrow agreement must
be issued in a form acceptable to the Exchange, and that it has
traditionally recognized as acceptable the escrow agreement forms of
the OCC and the New York Stock Exchange.
Lastly, pursuant to proposed CBOE Rule 12.5, a credit default
basket option that is carried for the account of a qualified customer
may be deemed to have market value for the purposes of CBOE Rule
12.3(c).
H. Surveillance
The Exchange has represented that it will have in place adequate
surveillance procedures to monitor trading in credit default basket
options prior to listing and trading such options.
III. Discussion
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to a national securities exchange.\33\ In
particular, the Commission finds that the proposal is consistent with
section 6(b)(5) of the Act,\34\ which requires, among other things,
that the rules of an exchange be designed to prevent fraudulent and
manipulative acts and practices; to promote just and equitable
principles of trade; to foster cooperation and coordination with
persons engaged in regulating, clearing, processing information with
respect to, and facilitating transactions in securities; to remove
impediments to and perfect the mechanism of a free and open market and
a national market system; and, in general to protect investors and the
public interest. CBOE's proposal, by enabling it to list and trade
securities heretofore existing only in the OTC market, would extend to
investors the benefits of a listed exchange market,
[[Page 47101]]
which include: a centralized market center; an auction market with
posted, transparent market quotations and transaction reporting;
standardized contract specifications; and the guarantee of the OCC.
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\33\ In approving this proposed rule change, the Commission
notes that it has considered the proposed rule's impact on
efficiency, competition, and capital formation. See 15 U.S.C.
78c(f).
\34\ 15 U.S.C. 78f(b)(5).
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In connection with its earlier approval of credit default options,
the Commission found that the credit default options proposed by CBOE
are securities because they are options based on the value of a
security or securities and because they are options on an interest in,
or based on the value of an interest in, a security or securities.\35\
Under an analysis similar to that applied to credit default options,
and after careful consideration of the terms of the two types of credit
default basket options, the Commission finds that the credit default
basket options proposed by CBOE are securities. Specifically, the
Commission finds that credit default basket options are options based
on the value of securities or a group or index of securities and are
options on an interest in or based on the value of an interest in,
securities or a group or index of securities and, therefore, are
securities under section 3(a)(10) of the Act.\36\
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\35\ See Credit Default Option Approval Order, supra note 7.
\36\ 15 U.S.C. 78c(a)(10).
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As a threshold matter, the Commission finds that credit default
basket options are options, not futures contracts. Generally speaking
an option grants the holder the right, but not the obligation, to buy
or sell a specific quantity, at a specific price, on or before a
specified future date.\37\ Courts have highlighted three
characteristics in particular that distinguish options from futures
contracts: (i) An options-buyer pays to the seller a nonrefundable
premium; (ii) an options-buyer has rights but no further obligations
under the contract; and (iii) an options-seller bears all the risk
exposure.\38\ Examining credit default basket options in light of these
characteristics, it is clear that credit default basket options are
options. First, the buyer of a credit default basket option pays to the
seller a nonrefundable premium. Second, the buyer of a credit default
basket option has rights but no further obligations under the contract.
Third, the buyer of a credit default basket option has no further risk
exposure under the contract and the seller bears all the risk of the
credit event occurring.
---------------------------------------------------------------------------
\37\ See British American Commodity Options v. Bagley, 552 F.2d
482, 484-85 (2d Cir. 1977).
\38\ See CFTC v. U.S. Metals Depository Co., 468 F.Supp. 1149,
1154 (S.D.N.Y. 1979); and United States v. Bein, 728 F.2d 107, 112
(2d Cir. 1984).
---------------------------------------------------------------------------
Although credit default basket options differ from classic options
in certain respects, these differences do not affect the economic
substance of the contract. First, credit default basket options are
cash-settled and do not allow for physical delivery. It is well
established, however, that cash-settled options based on prices of
securities are options ``on'' such securities.\39\ Second, credit
default basket options are automatically exercised, unlike a classic
option that generally gives the option-holder the right but not the
obligation to exercise if the option is in the money. In the case of
cash-settled options, such as credit default basket options, however,
giving the option-holder the right to decline to accept the cash upon
the occurrence of an event of default would be economically
meaningless.\40\ For this reason, under OCC rules, index option
contracts are automatically exercised if they are in-the-money at
expiration, and equity options contracts are automatically exercised if
they are in-the-money by specified amounts. Third, the payout for a
credit default basket option is fixed in advance and binary in nature,
while in a classic option the payout can increase or decrease
continuously in direct correlation with the price movement of the
underlying instrument. The same is true, of course, of the payout of a
futures contract. Thus, the fixed payout of credit default basket
options does not weigh in favor of classifying them as either futures
or options.
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\39\ See Caiola v. Citibank, N.A., New York, 295 F.3d 312, 326
(2d Cir. 2002).
\40\ See Stechler v. Sidley, Austin Brown & Wood, L.L.P., 382
F.Supp.2d 580, 595-97 (S.D.N.Y. 2005).
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In short, even though the potential payout of a credit default
basket option is cash-settled, automatically exercised, and fixed in
advance, the buyer of a credit default basket option still pays a fixed
premium for the possibility of receiving a greater amount--which is the
essence of optionality.\41\
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\41\ See Brief of Amicus Curiae The Securities and Exchange
Commission, at 24, Caiola v. Citibank, N.A., New York, 295 F.3d 312
(2d Cir. 2002) (01-7545) (``Simply put, Caiola paid a little for the
chance to get a lot'').
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Furthermore, the Commission finds that credit default basket
options are securities under section 3(a)(10) of the Act.\42\
Specifically, credit default basket options are options based on the
value of securities or a group or index of securities and are options
on an interest in, or based on the value of an interest in, securities
or a group or index of securities. In coming to these conclusions, the
Commission carefully considered the terms of the credit default basket
options, using an analytical approach similar to that which the
Commission applied to credit default options.
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\42\ The Commission wishes to make clear that because credit
default basket options will be exchange-traded and not individually
negotiated (and not necessarily between eligible contract
participants), they are not qualifying swap agreements under Section
206A of the Gramm-Leach-Bliley Act (``GLBA''), 15 U.S.C. 78c note,
and, therefore, not excluded from the definition of security by
Section 3A of the Act, 15 U.S.C. 78c-1. Also, certain OTC credit
default swaps (whether single-name or basket) are not securities.
The finding that credit default basket options are securities
because they are options based on the value of securities or a group
or index of securities might suggest that single-name or basket OTC
credit default swaps are also options based on the value of a
security or group or index of securities and, therefore, excluded
from the definition of swap agreement because Section 206A(b)(1) of
the GLBA, 15 U.S.C. 78c note, excludes from the definition of swap
agreement ``any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities,
including any interest therein or based on the value thereof.''
However, Congress specifically enumerated ``credit default swaps''
(without defining the term) as one example of a qualifying swap
agreement. See Section 206A(a)(3) of the GLBA, 15 U.S.C. 78c note.
The Commission views the specific enumeration of ``credit default
swaps'' as reflecting the intention of Congress to exclude certain
OTC credit default swaps from the definition of security pursuant to
Sections 206B & C of the GLBA, 15 U.S.C. 78c note. Of course, OTC
credit default swaps that involve terms similar to credit default
basket options, but that are otherwise excluded from the definition
of security because they are qualifying swap agreements, remain
subject to the Commission's antifraud jurisdiction (including
authority over insider trading) as ``security-based swap
agreements'' under Section 206B of the GLBA, 15 U.S.C. 78c note.
---------------------------------------------------------------------------
The Commission also believes that the listing and trading rules
proposed by CBOE for credit default basket options are substantially
similar to the listing and trading rules for credit default options,
and are likewise reasonable and consistent with the Act. As with a
credit default option, a credit default basket option must be based on
Reference Obligations issued by entities that issue or guarantee
registered equity securities that are NMS stocks and that meet the
Exchange's standards for listing an equity option. These requirements
are reasonably designed to facilitate investors' access to information
about the Reference Entities that may be necessary to price a credit
default basket option appropriately.
The Commission believes that the proposed position limits and
margin rules for credit default basket options are reasonable and
consistent with the Act. The proposed position limit of 50,000
contracts in any credit default basket option class appears to
reasonably balance the promotion of a free and open market for these
securities with minimization of incentives for market manipulation and
insider trading. The proposed margin rules
[[Page 47102]]
appear reasonably designed to deter a member or its customer from
assuming an imprudent position in credit default options.
In support of this proposal, the Exchange made the following
representations:
The Exchange will have in place adequate surveillance
procedures to monitor trading in credit default basket options prior to
listing and trading such options, thereby helping to ensure the
maintenance of a fair and orderly market for trading in credit default
options.
The Exchange and the OPRA will have the necessary systems
capacity to accommodate the additional volume associated with credit
default basket options as proposed.
This approval order is based on CBOE's representations.
For the foregoing reasons, the Commission finds that the proposed
rule is consistent with the Act.
IV. Designation of Credit Default Basket Options Pursuant to Rule 9b-1
Rule 9b-1 establishes a disclosure framework for standardized
options that are traded on a national securities exchange and cleared
through a registered clearing agency. Under this framework, the
exchange on which a standardized option is listed and traded must
prepare an ODD that, among other things, identifies the issuer and
describes the uses, mechanics, and risks of options trading, in
language that can be easily understood by the general investing public.
The ODD is treated as a substitute for the traditional prospectus. A
broker-dealer must provide a copy of the ODD to each customer at or
before approving of the customer's account for trading any standardized
option.\43\ Any amendment to the ODD must be distributed to each
customer whose account is approved for trading the options class for
which the ODD relates.\44\
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\43\ See 17 CFR 240.9b-1(d)(1).
\44\ See 17 CFR 240.9b-1(d)(2).
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Under Rule 9b-1, use of the ODD is limited to ``standardized
options'' for which there is an effective registration statement on
Form S-20 under the Securities Act or that are exempt from
registration.\45\ The Commission specifically reserved in Rule 9b-1 the
ability to designate as standardized options other securities ``that
the Commission believes should be included within the options
disclosure framework.'' \46\
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\45\ See 17 CFR 240.9b-1(b)(1) and (c)(8). See also 17 CFR
230.238. Rule 238 under the Securities Act provides an exemption
from the Securities Act for any standardized option, as defined by
Rule 9b-1(a)(4) under the Act, with limited exceptions. Rule 238
does not exempt standardized options from the antifraud provisions
of Section 17 of the Securities Act, 15 U.S.C. 77q. Also, offers and
sales of standardized options by or on behalf of the issuer of the
underlying security or securities, an affiliate of the issuer, or an
underwriter, will constitute an offer or sale of the underlying
security or securities as defined in Section 2(a)(3) of the
Securities Act, 15 U.S.C. 77b(a)(3). See also Securities Act Release
No. 8171 (December 23, 2002), 68 FR 188 (January 2, 2003) (Exemption
for Standardized Options From Provisions of the Securities Act of
1933 and From Registration Requirements of the Exchange Act of
1934).
\46\ See Securities Exchange Act Release No. 19055 and
Securities Act Release No. 6426 (September 16, 1982), 47 FR 41950,
41954 (September 23, 1982).
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The Commission hereby designates credit default basket options, as
defined in the OCC Proposal,\47\ as standardized options for purposes
of Rule 9b-1 under the Act. Like credit default options, credit default
basket options do not meet the definition of ``standardized options,''
because they do not have an exercise price.\48\ However, they resemble
standardized options in other significant respects. Credit default
basket options have underlying securities and an expiration date. Like
other standardized options, credit default basket options have
standardized terms relating to exercise procedures, contract
adjustments, time of issuance, effect of closing transactions,
restrictions, and other matters pertaining to the rights and
obligations of holders and writers. Further, credit default basket
options are designed to provide market participants with the ability to
hedge their exposure to underlying securities. The fact that credit
default basket options lack a specified exercise price does not detract
from this option-like benefit. The Commission believes that the fact
that the OCC, the clearing agency for all standardized options, is
willing to serve as issuer of credit default basket options supports
the view that adding credit default basket options to the standardized
option disclosure framework is reasonable.
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\47\ For purposes of its proposal, OCC would define the term
``credit default basket option'' as an option that is based on a
basket comprised of at least two reference entities and that is
either a ``multiple payout credit default basket option'' or a
``single payout credit default basket option.'' A ``multiple payout
credit default basket option'' would mean a credit default basket
option that automatically pays an exercise settlement amount each
time a credit event is confirmed with respect to any one of the
reference entities prior to expiration of the option. A ``single
payout credit default basket option'' would be automatically
exercised and pay a single exercise settlement amount only when the
first credit event is confirmed with respect to a reference entity
prior to expiration of the option. See proposed Section 1.C.(2) of
Article XIV of the OCC By-Laws.
``Credit event'' would be as defined in the rules of the
exchange on which the credit default basket options are listed, with
respect to a reference obligation for such option. See proposed
Section 1.C.(3) of Article XIV of the OCC By-Laws.
``Reference entity'' would mean any one of the issuers or
guarantors of the reference obligation(s) that underlie a credit
default basket option. See proposed Section 1.R.(1) of Article XIV
of the OCC By-Laws.
``Reference obligation'' would mean any debt security the terms
of which are used to define the occurrence of a credit event with
respect to the reference entity that is its issuer or guarantor for
a class of credit default basket options, as provided in the rules
of the listing exchange. See id.
\48\ See Credit Default Options Approval Order at Section VI
(designating credit default options as standardized options for
purposes of Rule 9b-1 under the Act).
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Therefore, the Commission hereby designates credit default basket
options, such as those proposed by CBOE, as standardized options for
purposes of Rule 9b-1 under the Act.
V. Conclusion
It is therefore ordered, pursuant to section 19(b)(2) of the
Act,\49\ that the proposed rule change (SR-CBOE-2007-26), as modified
by Amendment No. 3, be and hereby is approved.
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\49\ 15 U.S.C. 78s(b)(2).
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It is further ordered, pursuant to Rule 9b-1(a)(4) under the Act,
that credit default basket options, as defined in proposed rule change
SR-OCC-2007-06, are designated as standardized options.
By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-16587 Filed 8-21-07; 8:45 am]
BILLING CODE 8010-01-P
