

[Federal Register: February 14, 2007 (Volume 72, Number 30)]
[Notices]               
[Page 7091-7099]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14fe07-137]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55251; File No. SR-CBOE-2006-84]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of a Proposed Rule Change and Amendment 
Nos. 1, 2, 3, and 4 Thereto To List and Trade Credit Default Options

February 7, 2007.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(the ``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given 
that on October 26, 2006, the Chicago Board Options Exchange, 
Incorporated (``Exchange'' or ``CBOE'') filed with the Securities and 
Exchange Commission (``Commission'') a proposed rule change to list and 
trade credit default options (``Credit Default Options''). On December 
21, 2006, CBOE filed Amendment No. 1 to the proposed rule change; on 
January 16, 2007, CBOE filed Amendment No. 2 to the proposed rule 
change; on February 2, 2007, CBOE filed Amendment No. 3, to the 
proposed rule change; and on February 7, 2007, CBOE filed Amendment 
No.4 to the proposed rule change. The proposed rule change is described 
in Items I, II, and III below, which Items have been prepared 
substantially by the Exchange. The

[[Page 7092]]

Commission is publishing this notice to solicit comments on the 
proposed rule change, as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to amend its rules to provide for the listing 
and trading of cash-settled, binary call options based on credit events 
in one or more debt securities of an issuer or guarantor. The text of 
the proposed rule change is available at (http://www.cboe.org/legal), 

CBOE, and the Commission's Public Reference Room.

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

    In its filing with the Commission, the Exchange 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 those statements may be examined at the places specified in 
Item IV below. The Exchange has prepared summaries, set forth in 
Sections A, B, and C below, of the most significant aspects of such 
statements.

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

1. Purpose
    Amendment No. 4 deleted the text of proposed Rule 29.16 and made 
typographical and clarifying corrections to the discussion sections of 
the Form 19b-4 and the Exhibit 1 Federal Register notice, and the 
product description contained in Exhibit 3 to the Form 19b-4.
    Amendment 3 replaced Amendment 2 it its entirety. The purpose of 
Amendment 3 was to: (i) Eliminate the term ``event-style option'' from 
the proposed rule text; (ii) amend the definition of a ``Credit Event'' 
in the proposed rule text to explicitly include references to 
restructuring of the Relevant Obligation(s) as an underlying Credit 
Event in a Credit Default Option class; (iii) revise the cutoff times 
applicable to the occurrence of Credit Events, Redemption Events, and 
related confirmation periods; (iv) expand the definition of ``Reference 
Entity'' to include guarantors in addition to issuers; and (v) make 
conforming changes and clarifications to this ``Purpose'' section, as 
well as various typographical corrections to the proposed rule text.
    Amendment 2 replaced Amendment 1 in its entirety. The purpose of 
Amendment 2 was to: (i) Modify the proposed margin requirements for 
Credit Default Options, (ii) modify the proposed definitions of the 
``last trading day'' and the ``expiration date,'' (iii) modify the 
proposed definition of the ``Relevant Obligations,'' and (iv) make 
various conforming changes and clarifications to this ``Purpose'' 
section.
    The purpose of Amendment 1, which replaced the original filing in 
its entirety, was to revise the rule text and related discussion in 
this ``Purpose'' section to make various changes and clarifications.
    The purpose of the proposed rule change is to enable CBOE to list 
and trade Credit Default Options. With the introduction of Credit 
Default Options, as described more fully below, investors would be able 
to trade cash-settled options based on particular credit-related events 
that are confirmed to have occurred based on a particular debt security 
obligation or related debt security obligations of an issuer. Credit 
Default Options should provide investors with hedging and risk-shifting 
vehicles that correlate with the creditworthiness of the Reference 
Entity and its debt security obligations. Indeed, creditworthiness is 
viewed as a key component of the valuation of a debt security. 
Investors with substantial investments in debt securities would be able 
to use CBOE Credit Default Options to hedge their exposure and risk, or 
to supplement income by writing Credit Default Option calls. CBOE 
asserts that, as a result, these products would be useful to those with 
investments in debt securities, including institutional investors such 
as credit market participants and fixed income traders, as well as 
individual investors.
    Credit Default Options would be structured as binary call options 
\3\ that settle in cash based on confirmation of a Credit Event in a 
Reference Entity. A ``Reference Entity'' would be the issuer or 
guarantor \4\ of the debt security underlying the Credit Default Option 
(referred to as the ``Reference Obligation'').
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    \3\ A ``binary call option'' is an option contract that will pay 
the holder of the option contract a fixed amount upon exercise.
    \4\ The Exchange has included ``guarantor'' within the proposed 
definition of ``Reference Entity'' in the event a succession occurs 
and the original issuer remains a guarantor of the debt security. 
Alternatively, the situation may arise in which the Reference Entity 
may not be the original issuer, but is a guarantor of the debt 
security.
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    A ``Credit Event'' would occur:
    (i) When the Reference Entity has a Failure-to-Pay Default on the 
Reference Obligation or any other debt security obligation(s) (the set 
of these obligations and the Reference Obligation are referred to as 
the ``Relevant Obligations''). A ``Failure-to-Pay Default'' would be 
defined in accordance with the terms of the Relevant Obligation(s); 
and/or
    (ii) When the Reference Entity has any other Event of Default on 
the Relevant Obligation(s). Any applicable ``Event(s) of Default'' 
would be specified by the Exchange at the time the option class is 
initially listed in accordance with the procedures of proposed Rule 
29.2 (described below) and, for each such Event(s) of Default 
specified, would be defined in accordance with the terms of the 
Relevant Obligation(s); and/or
    (iii) When the Reference Entity has a change in the terms of the 
Relevant Obligation(s) (a ``Restructuring''). The terms of such a 
Restructuring would be specified by the Exchange in accordance with 
Rule 29.2 and, if so specified, would be defined in accordance with the 
terms of the Relevant Obligation(s).
    To confirm, the particular Credit Events applicable to a Credit 
Default Option would be designated by the Exchange on a class-by-class 
basis. And, when designating the applicable Credit Events for a given 
Credit Default Option class, the Exchange would select from among the 
terms in the underlying instruments of the Relevant Obligation(s) of 
the particular Reference Entity.
    The Exchange would confirm a Credit Event through at least two 
sources, which may include announcements published via newswire 
services or information services companies, the names of which would be 
announced to the membership via Regulatory Circular, and/or information 
contained in any order, decree, or notice of filing, however described, 
of or filed with the courts, the Commission, an exchange, or 
association, the Options Clearing Corporation (``OCC''), or another 
regulatory agency or similar authority. Every determination of a Credit 
Event would be within the Exchange's sole discretion and would be 
conclusive and binding on all holders and sellers of the Credit Default 
Option and not subject to review.
    For a Credit Default Option to be automatically exercised, a Credit 
Event would need to have: (i) Occurred between the option's listing 
date and 10:59 p.m. (CT) on the option's last trading day which, 
subject to certain exceptions, would generally be the third Friday of 
the expiration month; and (ii) been confirmed by the Exchange no

[[Page 7093]]

later than the option's expiration date which, subject to certain 
exceptions, would generally be the fourth business day after the third 
Friday of the expiration month. If the Exchange confirms a Credit 
Event, the Credit Default Options class would be subject to an 
automatic exercise and the holders of long options positions would 
receive a fixed cash settlement amount payment equal to $100,000 per 
contract. Otherwise, if there is no Credit Event confirmed prior to the 
expiration date, the cash settlement amount would be $0. The last 
trading day, expiration day, and automatic exercise procedures are 
described in more detail below.
    Given the binary nature of the product, a benefit of Credit Default 
Options is that the purchaser and writer of the options would know the 
expected return at the time the contract is entered. Further, since the 
payment is fixed, the risk (return) to the writer (purchaser) would be 
limited. CBOE believes that there are several other benefits to be 
realized by providing for the trading of Credit Default Options on its 
exchange marketplace. Among these benefits are the following: (i) By 
trading Credit Default Options in the CBOE's centralized, open-outcry 
auction market, with designated members having market-making 
responsibilities, investors would be better able to initiate and close 
out positions efficiently and at the best available prices; (ii) unlike 
the existing over-the-counter (``OTC'') market, CBOE's market would 
provide transparency as the result of the real-time dissemination of 
best bids and offers and reports of completed transactions in Credit 
Default Options; (iii) the role of the OCC as issuer and guarantor of 
Credit Default Options would eliminate concern over contra-party 
creditworthiness and assure performance upon automatic exercise of 
Credit Default Options; and (iv) subjecting Credit Default Options to 
CBOE's rules, regulations, and oversight would provide enhanced 
investor protection and market surveillance.
    To accommodate the introduction of these new Credit Default 
Options, CBOE proposes to adopt new Chapter XXIX to its rules and to 
make corresponding amendments to CBOE's initial and maintenance listing 
rules and margin rules. An introductory section to Chapter XXIX would 
explain that the proposed rules in the Chapter are applicable only to 
Credit Default Options. The introductory section would further explain 
that the existing rules in Chapters I through XIX, XXIVA, and XXIVB are 
also applicable to Credit Default Options and, in some cases, are 
supplemented by the proposed rules in the Chapter, except for existing 
rules that would be replaced in respect of Credit Default Options in 
the Chapter and except where the context otherwise requires. Whenever a 
proposed rule in the Chapter supplements or, for purposes of the 
Chapter, replaces rules in Chapter I through XIX, XXIVA, and XXIVB, 
that fact would be indicated following the rule text. Each of the 
proposed rules and amendments to the existing rules are described 
below.
a. Definitions (Proposed Rule 29.1)
    New Chapter XXIX would include definitions applicable to Credit 
Default Options in proposed Rule 29.1. In particular, the terms 
``Credit Default Option,'' ``Credit Event,'' and ``Reference Entity'' 
are defined as described above. In addition, the term ``cash settlement 
amount,'' which is the amount of cash that a holder would receive upon 
automatic exercise, if the Exchange has confirmed the occurrence of a 
Credit Event in a Reference Entity between the listing date and the 
last trading day, is proposed to be a fixed amount of $100,000. The 
$100,000 amount is equal to an exercise settlement value of $100 
multiplied by the contract multiplier of 1,000. If no Credit Event is 
confirmed, the cash settlement amount would be $0. As described in more 
detail below, the $100,000 cash settlement amount may be subject to 
adjustment if certain adjustment-related events are confirmed to have 
occurred.
    Also included within the proposed definitions, the term ``last 
trading day'' would be defined as the third Friday of the expiration 
month (or, if that day is not a business day, the last trading day 
would be the preceding business day); provided, however, if a Credit 
Event is confirmed prior to that day, the series would cease trading at 
the time of the confirmation of the Credit Event and the last trading 
day would be accelerated to the confirmation date. In addition, within 
the proposed definitions, the term ``expiration date'' would be defined 
as the fourth business day after the third Friday of the expiration 
month (or, if that day is not a business day, the expiration date would 
be the fourth business day after the preceding business day); provided, 
however, if a Credit Event is confirmed by the Exchange to members and 
the OCC before the third Friday of the expiration month, the expiration 
date would be accelerated to the second business day immediately 
following the confirmation date.\5\
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    \5\ The Exchange understands, based on discussions with the OCC, 
that the final settlement would occur on the first business day 
following the expiration date.
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b. Designation, Withdrawal & Adjustment (Proposed Rules 29.2-29.4; 
Revised Rules 5.3 and 5.4)
    Proposed Interpretation and Policy .11 to existing Rule 5.3, 
Criteria for Underlying Securities, would be added to provide the 
listing criteria for Credit Default Options. Under the proposed 
criteria, the Exchange could list and trade a Credit Default Option 
that overlies a Reference Obligation of a Reference Entity, provided 
that the Reference Entity satisfies the following: (i) the Reference 
Entity or the Reference Entity's parent, if the Reference Entity is a 
wholly-owned subsidiary, must have at least one class of securities 
that is duly registered and is an ``NMS stock'' as defined in Rule 600 
of Regulation NMS under the Act; \6\ and (ii) the registered equity 
securities issued by the Reference Entity must also satisfy the 
requirements for continued options trading on CBOE pursuant to existing 
Exchange Rule 5.4.\7\
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    \6\ This criterion is designed to ensure that there is adequate 
information publicly available regarding the issuer of a debt 
security that serves as a Reference Obligation underlying a Credit 
Default Option. The market for debt securities that would serve as 
Reference Obligations is largely an OTC market, and many debt 
securities, including those among the most actively traded, are not 
themselves registered under Section 12 of the Act, 15 U.S.C. 78l. 
The issuers of many unregistered debt securities, however, have 
equity securities that are duly registered and are ``NMS stocks'' as 
defined in Rule 600 of Regulation NMS, 17 CFR 242.600. These issuers 
are required to provide periodic reports to the public due to the 
equity registration, and the fact that their debt securities are 
unregistered does not diminish in practical terms the information 
provided by their periodic reports. Thus, the requirements, would 
enable a wide array of credit Default Options to be listed while 
ensuring sufficient public disclosure of information about any debt 
securities that serve as Reference Obligations underlying the 
exchange-traded Credit Default Options.
    \7\ The provisions of existing Rule 5.4.01 require that an 
equity security underlying an option be itself widely held and 
actively traded. The requirement that the securities of an issuer of 
a debt security meet the criterion of Rule 5.4.01 provides an 
additional assurance that such issuer's securities enjoy widespread 
investor interest.
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    Proposed Interpretation and Policy .15 to existing Rule 5.4, 
Withdrawal of Approval of Underlying Securities, would similarly 
provide that a Credit Default Option initially approved for trading 
shall be deemed not to meet the Exchange's requirements for continued 
approval, and the Exchange would not open for trading any additional 
series of options contracts of the class covering such options and may 
prohibit any opening purchases transactions in such series as provided 
in existing Rule 5.4, at any time the Exchange determines on the basis 
of information made publicly available that any of the listing

[[Page 7094]]

requirements identified above are not satisfied.
    Proposed Rule 29.2, Designation of Credit Default Option Contracts, 
would supplement existing Rules 5.1, Designation of Securities, 5.3, 
5.5, Series of Option Contracts Open for Trading, and 5.8, Long-Term 
Equity Option Series (LEAPS [reg]). The text of proposed Rule 29.2 
references the applicable listing requirements in proposed Rule 5.3.11 
and also provides that each Credit Default Options class would be 
designated by reference to the Reference Entity, Reference Obligation, 
and the applicable Credit Event(s). The applicable Credit Event(s) 
would include a Failure-to-Pay Default and might also include any other 
Event of Default or Restructuring, if any, specified by the Exchange.
    After a particular Credit Default Option class has been approved 
for listing and trading on the Exchange, the Exchange would from time 
to time open for trading series of options on that class. Only Credit 
Default Option contracts approved by the Exchange and currently open 
for trading on the Exchange would be eligible to be purchased or 
written on the Exchange. Prior to the opening of trading in a 
particular Credit Default Options series in a given class, the Exchange 
would fix the expiration month and year. To the extent possible, CBOE 
intends to have Credit Default Options recognized and treated like 
existing standardized options. Standardized systems for listing, 
trading, transmitting, clearing, and settling options, including 
systems used by OCC, would be employed in connection with Credit 
Default Options. Credit Default Options would also have a symbology 
based on the current system. For example, the ABC Dec-07 Calls would 
designate a Credit Default Option on Reference Entity ABC, which option 
would expire in December 2007 and would cease trading on the third 
Friday of that month (assuming that date is an Exchange business day 
and assuming no Credit Event has been determined by the Exchange before 
that date).
    A Credit Default Option series would generally be listed up to 123 
months ahead of its expiration date and could expire in the months of 
March, June, September, or December. The last trading day would be the 
close of business on the third Friday of the expiration month. However, 
if that day is not a business day, the series would cease trading at 
the close of business on the preceding business day. The Exchange 
usually would open one to four series for each year up to 10.25 years 
from the current expiration. For example, in December 2006, the 
Exchange would open the Jun-07 and Dec-07 series, as well as the Dec-
08, Dec-09, Dec-10, and Dec-11 series. Additional series of options on 
the same Credit Default Option class could be opened for trading on the 
Exchange when the Exchange deems it necessary to maintain an orderly 
market or to meet customer demand. The opening of a new series of 
Credit Default Options on the Exchange would not affect any other 
series of options of the same class previously opened.
    Proposed Rule 29.3, Withdrawal of Approval of Underlying Reference 
Entity, would provide that the requirements for continuance of approval 
of Credit Default Options would be in accordance with proposed Rule 
5.4.15.
    Proposed Rule 29.4, Adjustments, which for purposes of Credit 
Default Options would replace existing Rule 5.7, Adjustments, would 
contain information about adjustments due to succession or redemption 
events in the Reference Entity.
    With respect to adjustments related to a succession, the proposed 
rule provides that each Credit Default Option would be replaced by one 
or more Credit Default Options derived from Reference Entities that 
have succeeded the original Reference Entity as a result of the 
Succession Event based on the applicable share of each Successor 
Reference Entity. For purposes of the proposed rule, a ``Successor 
Reference Entity'' and a ``Succession Event'' would be defined in 
accordance with the terms of the Relevant Obligation(s). In respect of 
each successor Credit Default Option, the cash settlement amount and 
contract multiplier would be based on the applicable share of each 
Successor Reference Entity. For example, if there are two Successor 
Reference Entities that each has an applicable share of 50%, the cash 
settlement for each replacement Credit Default Option would be $50,000 
(equal to an exercise settlement value of $100 multiplied by the 
revised contract multiplier of 500). All other terms and conditions of 
each successor Credit Default Option would be the same as the original 
Credit Default Option unless the Exchange determines, in its sole 
discretion, that a change is necessary and appropriate for the 
protection of investors and the public interest, including but not 
limited to the maintenance of fair and orderly markets, consistency of 
interpretation and practice, and the efficiency of settlement 
procedures.
    With respect to adjustments related to a redemption, the proposed 
rule provides that, once the Exchange has confirmed a Redemption Event, 
the Credit Default Option contract would cease trading on the 
confirmation date. If no Credit Event has been confirmed to have 
occurred prior to the effective date of the Redemption, the contract 
payout would be $0. If a Credit Event has occurred prior to the 
effective date of the Redemption, the cash settlement amount would be 
$100,000 per contract (or the applicable adjusted amount). The Credit 
Event confirmation period would begin when the Credit Default Option 
contact is listed and would extend to 3 p.m. (CT) on the fourth 
Exchange business day after the effective date of the Redemption. A 
``Redemption Event'' would be defined in accordance with the terms of 
the Relevant Obligation(s) and would include the redemption of the 
Reference Obligation and of all other Relevant Obligations. However, if 
the Reference Obligation is redeemed but other Relevant Obligation(s) 
remain, a new Reference Obligation would be specified from among the 
remaining Relevant Obligation(s).
    The Exchange would confirm adjustment events based on at least two 
sources, which could include announcements published via newswire 
services or information services companies, the names of which would be 
announced to the membership via Regulatory Circular, and/or information 
submitted to or filed with the courts, the Commission, an exchange or 
association, the OCC, or another regulatory agency or similar 
authority.
    Proposed Rule 29.4 also would provide that every such determination 
made pursuant to the proposed rule would be within the Exchange's sole 
discretion and be conclusive and binding on all holders and sellers and 
not subject to review.
c. Determination of Credit Events, Automatic Exercise, and Settlement 
(Proposed Rules 29.9-29.10)
    A Credit Default Option would be subject to automatic exercise upon 
the Exchange confirming that a Credit Event has occurred in a Reference 
Entity between the listing date and the last trading day. Under 
proposed Rule 29.9, the Credit Event confirmation period would begin 
when the Credit Default Option contract is listed and would extend to 3 
p.m. (CT) on the expiration date.
    The Exchange would confirm a Credit Event based on at least two 
sources, which could include announcements published via newswire 
services or information services companies, the names of which would be 
announced to the membership via Regulatory Circular,

[[Page 7095]]

or information submitted to or filed with the courts, the Commission, 
an exchange or association, the OCC, or another regulatory agency or 
similar authority. Proposed Rule 29.9 would also provide that every 
determination made pursuant to the proposed rule would be within the 
Exchange's sole discretion and be conclusive and binding on all holders 
and sellers and not subject to review.
    Proposed Rule 29.10 would provide that the Exchange shall have no 
liability for damages, claims, losses, or expenses caused by any 
errors, omissions, or delays in confirming or disseminating notice of 
any Credit Event resulting from a negligent act or omission by the 
Exchange or any act, condition, or cause beyond the reasonable control 
of the Exchange, including, but not limited to, an act of God; fire; 
flood; extraordinary weather conditions; war; insurrection; riot; 
strike; accident; action of government; communications or power 
failure; equipment or software malfunction; or any error, omission, or 
delay in the reports of transactions in one or more underlying 
securities.
    If the Exchange determines that a Credit Event in the underlying 
Reference Entity has occurred prior to 10:59 p.m. (CT) on the last 
trading day, the final cash settlement amount would be $100,000 per 
contract (or the applicable adjusted amount). Otherwise the final 
settlement price would be $0. As indicated above, if a Credit Event has 
been confirmed by the Exchange to have occurred prior to the last 
trading day, the Credit Default Option would cease trading upon 
confirmation of the Credit Event. Once a Credit Event is confirmed, the 
Exchange would also provide the OCC with notice of the Credit Event and 
notice of the applicable cash settlement value, similar to the 
notification procedures that are currently in place for existing index 
products trading on the Exchange. The rights and obligations of holders 
and sellers of Credit Default Options dealt in on the Exchange shall be 
set forth in the By-Laws and Rules of OCC.
d. Position Limits, Reporting Requirements, Exercise Limits, and Other 
Restrictions (Proposed Rules 29.5-29.8)
    The Exchange is proposing that the position limits for Credit 
Default Option contracts be equal to 5,000 contracts on the same side 
of the market. The Exchange believes this amount is sufficiently low 
enough to minimize potential risks on firms as Credit Default Options 
are first introduced. However, over time and based on the Exchange's 
experience in trading Credit Default Options, CBOE anticipates these 
limits would be increased. Any such increase would be reflected through 
a rule filing submitted pursuant to Section 19(b) of the Act.\8\
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    \8\ 15 U.S.C. 78s(b).
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    In determining compliance with the Exchange's position limit 
requirements, proposed Rule 29.5 would provide that Credit Default 
Options shall not be aggregated with option contracts on the same or 
similar underlying security. CBOE believes that the ``all-or-none'' 
nature of Credit Default Options as well as the risk/return profile of 
these options provides significant differences to existing standardized 
options that render aggregation of such positions unnecessary. In 
addition, Credit Default Options shall not be subject to the hedge 
exemption to the standard position limits found in existing Rule 
4.11.04. Instead, the following qualified hedge exemption strategies 
and positions shall be exempt from the established position limits: (i) 
A Credit Default Option position ``hedged'' or ``covered'' by an 
appropriate amount of cash to meet the cash settlement amount 
obligation (e.g., $100,000 for a Credit Default Option with an exercise 
settlement value of $100 multiplied by a contract multiplier of 1,000); 
and (ii) a Credit Default Option position ``hedged'' or ``covered'' by 
an amount of an underlying debt security(ies) that serves as a Relevant 
Obligation(s) and/or other securities, instruments, or interests 
related to the Reference Entity that is sufficient to meet the cash 
settlement amount obligation. For example, a long Credit Default Option 
position could be offset by a long position in a debt security of the 
Reference Entity that is worth $100,000 per contract (or the applicable 
adjusted amount) and a short Credit Default Option position could be 
offset by a short position in a debt security of the Reference Entity 
that is worth $100,000 per contract (or the applicable adjusted 
amount).
    The existing Market-Maker and firm facilitation exemptions to 
position limits currently available to members under existing Rules 
4.11.05 and 4.11.06, respectively, would also apply. With respect to 
the Market-Maker hedge exemption, the Exchange is proposing that the 
positions must generally be within 20% of the applicable limits of the 
Credit Default Option before an exemption would be granted. With 
respect to the firm facilitation exemption, the Exchange is proposing 
that the aggregate exemption position could not exceed three times the 
standard limit of $5,000 and be applied consistent with the procedures 
described in existing Rule 4.11.06.
    Under proposed Rule 29.6, Reports Related to Position Limits and 
Liquidation of Positions, the standard equity reporting requirements 
described in existing Rule 4.13, Reports Related to Position Limits, 
would be applicable to Credit Default Options. As such, in accordance 
with Rule 4.13(a), positions in Credit Default Options would be 
reported to the Exchange via the Large Option Positions Report when an 
account establishes an aggregate same side of the market position of 
200 or more Credit Default Options. In computing reportable Credit 
Default Options under existing Rule 4.13, Credit Default Options could 
not be aggregated with non-Credit Default contracts. In addition, 
Credit Default Options on a given class shall not be aggregated with 
any other class of Credit Default Options. The applicable position 
reporting requirements described in existing Rule 4.13(b) would also 
apply, except that the reporting requirement would be triggered for a 
Credit Default Option position on behalf of a member's account or for 
the account of a customer in excess of 1,000 contracts on the same side 
of the market, instead of the normal 10,000 contract trigger amount. 
The data to be reported would include, but would not be limited to, the 
Credit Default Option positions, whether such positions are hedged, and 
documentation as to how such contracts are hedged. The Exchange 
believes that the reporting requirements and the surveillance 
procedures for hedged positions would enable the Exchange to closely 
monitor sizable positions and corresponding hedges.
    Upon determination of a Credit Event, the Credit Default Option 
class would cease trading and all outstanding Credit Default Option 
contracts would be subject to automatic exercise. As a result and given 
the fixed payout nature of these options, there shall be no exercise 
limits for Credit Default Options. Proposed Rule 29.7 confirms this.
    Proposed Rule 29.8 provides that Credit Default Options shall also 
be subject to existing Rule 4.16, Other Restrictions on Options 
Transactions and Exercises, which provides the Exchange's Board with 
the power to impose restrictions on transactions or exercises in one or 
more series of options of any class dealt in on the Exchange 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

[[Page 7096]]

interest or for the protection of investors.\9\
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    \9\ For example, it is possible that the Exchange would prohibit 
exercises in a Credit Default Option if a court, the Commission, or 
another regulatory agency having jurisdiction would impose a 
restriction which would have the effect of restricting the exercise 
of an option.
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    CBOE believes the proposed safeguards would serve sufficiently to 
help monitor open interest in Credit Default Option series and 
significantly reduce any risks.
e. Margin Requirements (Amendment to Rules 12.3 and 12.5)
    The Exchange is proposing to supplement its existing Rule 12.3, 
Margin Requirements, to include requirements applicable to the initial 
and maintenance margin required on any Credit Default Options carried 
in a customer's account. The requirements would be as follows: The 
initial and maintenance margin required on any Credit Default Option 
carried long in a customer's account would be 100% of the current 
market value of the Credit Default Option; provided, however, for the 
account of a qualified customer, the margin would be 20% of the current 
market value of the Credit Default Option. The initial and maintenance 
margin required on any Credit Default Option carried short in a 
customer's account would be the cash settlement amount, i.e., $100,000 
per contract; provided, however, for the account of a qualified 
customer, the margin would be the lesser of the current market value 
plus 20% of the cash settlement amount defined in proposed Rule 29.1 or 
the cash settlement amount.
    The Exchange is also proposing to amend its existing Rule 12.5, 
Determination of Value for Margin Purposes, to provide that Credit 
Default Options carried for the account of a qualified investor that 
are listed or guaranteed by the carrying broker-dealer may be deemed to 
have market value for the purposes of the customer margin account 
provisions provided in existing Rule 12.3(c). For purposes of these 
proposed provisions, the term ``qualified customer'' would be defined a 
person or entity that owns and invests on a discretionary basis no less 
than $5,000,000 in investments.
    Under the proposal, Credit Default Option margin requirements could 
be satisfied by a deposit of cash or marginable securities or by 
presentation to the member organization carrying such customer's 
account of a letter of credit in a form satisfactory to the Exchange 
and issued by a bank. Such a letter of credit would be required to: (i) 
Contain the unqualified commitment of the issuer to pay to the member 
or participant organization a specified sum of money equal to or 
greater than the amount of margin due with respect to such option 
position, immediately upon demand at any time prior to the expiration 
of such letter of credit; (ii) be irrevocable; and (iii) expire no 
earlier than the expiration of such option. Such a letter of credit 
would be permitted to serve as margin for more than one Credit Default 
Option position written by the customer for whose account the letter of 
credit is issued, provided that the margin due with respect to each 
such option position does not, in the aggregate, exceed the sum 
specified in such letter of credit and provided that such letter 
expires no sooner than the most distant expiration date of any of the 
options with respect to which it is designed to serve as margin.
    The proposed margin provisions also would provide that a Credit 
Default Option carried short in a customer's account be deemed a 
covered position, and eligible for the cash account, provided any one 
of the following either is held in the account at the time the option 
is written or is received into the account promptly thereafter: (i) 
Cash or cash equivalents equal to 100% of the cash settlement amount as 
defined in Rule 29.1; or (ii) an escrow agreement. Under the proposal, 
the escrow agreement must certify that the bank holds for the account 
of the customer as security for the agreement: (i) Cash, (ii) cash 
equivalents, (iii) one or more qualified equity securities, or (iv) a 
combination thereof having an aggregate market value of not less than 
100% of the cash settlement amount (e.g., $100,000 in the case of an 
unadjusted Credit Default Option) and that the bank would promptly pay 
the member organization the cash settlement amount in the event of a 
Credit Event.
    The Exchange notes that, in accordance with Rule 12.10, Margin 
Required is Minimum, the Exchange would also have the ability to 
determine at any time to impose higher margin requirements than those 
described above in respect of any Credit Default Option position(s) 
when it deems such higher margin requirements appropriate.
    In setting the proposed margin requirements, particularly those 
with respect to qualified customers, and the proposed position limit 
and reporting requirements described above, the Exchange has been 
cognizant of the sophistication and capitalization of the particular 
market participants and their need for substantial options transaction 
capacity to hedge their substantial investment portfolios, on the one 
hand, and the potential for untoward effects on the market and on firms 
that might be attributable to excessive Credit Default Option 
positions, on the other. The Exchange has also been cognizant of the 
existence of the competitive OTC market, in which similar restrictions 
do not apply. For these reasons, the Exchange believes that the 
requirements set forth in the proposed rules strike a necessary and 
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.
f. Letter of Guarantee or Authorization (Proposed Rule 29.18)
    Proposed Rule 29.18 would extend the general letter of guarantee 
requirement under existing Rule 8.5, Letters of Guarantee, to Market-
Makers with appointments in Credit Default Options, thereby subjecting 
such Market-Makers to a focused creditworthiness review by their 
clearing members. Similarly, proposed Rule 29.18 would extend the 
general letter of authorization requirement under existing Rule 6.72, 
Letters of Authorization, to floor brokers that would represent orders 
in Credit Default Option contracts.
g. Trading Mechanics for Credit Default Options (Proposed Rules 29.11-
29.17 and 29.19)
    The Exchange intends to trade Credit Default Options similar to the 
manner in which it trades equity options on its Hybrid Trading System 
(``Hybrid''). The existing Hybrid equity option trading rules would 
apply largely unchanged to Credit Default Options, with a few 
distinctions noted below. Under the proposed rules, trading in Credit 
Default Options would be conducted in the following manner:
     Days and Hours of Business (Proposed Rule 29.11 and 
Revised Rule 6.1): Proposed Rule 29.11 would provide that, except under 
unusual conditions as may be determined by the Exchange, the hours 
during which Credit Default Options transactions could be made on the 
Exchange would be from 8:30 a.m. to 3 p.m. (CT). The Exchange is also 
proposing to include a cross-reference to proposed Rule 29.11 in 
existing Rule 6.1, Days and Hours of Business, to reflect that existing 
Rule 6.1 would be supplemented by proposed Rule 29.11.
     Trading Rotations (Proposed Rule 29.12): Trading rotations 
would generally be conducted through use of the Hybrid Opening System 
(``HOSS''), which is described in existing Rule 6.2B. Normally equity 
options open at a

[[Page 7097]]

randomly selected time following the opening of the underlying 
security. Because Credit Default Options would not have a traditional 
underlying security, the opening rotation process would begin at a 
randomly selected time within a number of seconds after 8:30 a.m. (CT), 
unless unusual circumstances exist.
     Trading Halts and Suspension of Trading (Proposed Rule 
29.13): The trading halt procedures contained in existing Rules 6.3 and 
6.3B that are applicable to equity options shall also be applicable to 
Credit Default Options. In addition, proposed Rule 29.13 provides that 
another factor that may be considered by Floor Officials in connection 
with the institution of a trading halt under existing Rule 6.3 in 
Credit Default Options is that current quotations for the Relevant 
Obligation(s) or other securities of the Reference Entity are 
unavailable or have become unreliable.
     Premium Bids and Offers & Minimum Increments, Priority and 
Allocation (Proposed Rule 29.14): Bids and offers would have to be 
expressed in terms of dollars per the contract multiplier unit (e.g., a 
bid of ``7'' shall represent a bid of $7,000 for a Credit Default 
Option with a contract multiplier of 1,000). In addition, the minimum 
price variation (``MPV'') for bids and offers would be $0.05 ($50 per 
contract) on both simple orders and multi-part complex orders. All bids 
or offers made for Credit Default Option contracts would be deemed to 
be for one contract unless a specific number of option contracts is 
expressed in the bid or offer. A bid or offer for more than one option 
contract would be deemed to be for the amount thereof or a smaller 
number of option contracts. The rules of priority and order allocation 
procedures set forth in Rule 6.45A, Priority and Allocation of Equity 
Option Trades on the CBOE Hybrid System, would apply to Credit Default 
Options.
     Nullification and Adjustment of Credit Default Option 
Transactions (Proposed Rule 29.15): The provisions in existing Rule 
6.25, which pertain to the nullification and adjustment of equity 
option transactions, would be generally applicable to Credit Default 
Options. However, the conditions for determining an obvious error in a 
Credit Default Option would differ. For Credit Default Options, there 
would be two categories of errors. The first type of error pertains to 
an obvious pricing error, which occurs when the execution price of an 
electronic transaction is below or above the theoretical price range 
(i.e., $0-$100) for the series by an amount equal to at least 5% per 
contract. Trading Officials would adjust such transactions to a price 
within 5% of the theoretical price range (i.e., to -$5 or $105), unless 
both parties agree to a nullification. The second type of error 
pertains to electronic or open outcry transactions arising out of a 
verifiable disruption or malfunction in the use or operation of any 
Exchange automated quotation, dissemination, execution, or 
communication system. Trading Officials would nullify such 
transactions, unless both parties agree to an adjustment. All other 
provisions of existing Rule 6.25 related to procedures for review, and 
obvious error panel and appeals committee reviews, would apply 
unchanged.
     Market-Maker Appointments & Obligations (Proposed Rule 
29.17): Proposed Rule 29.17 provides that the Market-Maker appointment 
process for Credit Default Option classes would be the same as the 
appointments for other options, as set out in existing Rules 8.3, 
Appointment of Market-Makers; 8.4, Remote Market-Makers, 8.15A; Lead 
Market-Makers in Hybrid Classes; and 8.95, Allocation of Securities and 
Location of Trading Crowds and DPMs. This proposed rule would further 
provide that an appointed Market-Maker could, but would not be 
obligated to, enter a response to a request for quotes in an appointed 
Credit Default Option class and need not provide continuous quotes or 
quote a minimum bid-offer spread. However, when quoting, the Market-
Maker's minimum value size would have to be at least one contract. With 
respect to an appointed DPM or LMM, as applicable, there would be 
additional obligations to enter opening quotes in accordance with 
existing Rule 6.2B, Hybrid Opening System (``HOSS''), in 100% of the 
series in the appointed class and to enter a quote in response to any 
open-outcry request for quotes on any appointed Credit Default Option 
class. The Exchange also could establish permissible price differences 
for one or more series of classes of Credit Default Options as 
warranted by market conditions. These quoting mechanics would be 
similar to the mechanics that exist today for trading Flexible Exchange 
Options (``FLEX Options'') on the Exchange.
     FLEX Trading Rules (Proposed Rule 29.19): In addition to 
Hybrid, Credit Default Options also would be eligible for trading as 
FLEX Options. For proposes of existing Chapter XXIVA and proposed 
Chapter XXIVB, which chapters contain the Exchange's rules pertaining 
to FLEX Options, references to the term ``FLEX Equity Options'' would 
include a Credit Default Option and references to the ``underlying 
security'' or ``underlying equity security'' in respect of a Credit 
Default Option would mean the Reference Obligation as defined in 
proposed Rule 29.1. For purposes of existing Rule 24A.4 and Rule 
24B.4,\10\ a FLEX Equity Option that is a Credit Default Option would 
be cash-settled and the exercise-by-exception provisions of OCC Rule 
805 would not apply.
---------------------------------------------------------------------------

    \10\ Chapter XXIVB and Rule 24B.4 are proposed to be adopted 
through a separate rule filing, SR-CBOE-2006-99.
---------------------------------------------------------------------------

    These trading mechanics are designed to create a modified trading 
environment that takes into account the relatively small number of 
transactions that are likely to occur in this sophisticated, large-size 
market, while at the same time providing the Credit Default Options 
market with the price improvement and transparency benefits of 
competitive Exchange floor bidding, as compared to the OTC market. The 
Exchange believes that the resulting market environment would be fair, 
efficient, and creditworthy and, as such, would prove to be 
particularly suitable to the large sophisticated trades and investors 
that now resort to the OTC market to effect these types of options 
transactions.
h. Options Disclosure Document
    To accommodate the listing and trading of Credit Default Options, 
it is expected that the OCC would amend its By-Laws and Rules to 
reflect the different structure of Credit Default Options. In addition, 
it is expected that OCC would seek a revision to the Options Disclosure 
Document (``ODD'') to incorporate Credit Default Options.
i. Systems Capacity
    CBOE represents that it believes the Exchange and the Options Price 
Reporting Authority have the necessary systems capacity to handle the 
additional traffic associated with the listing and trading of Credit 
Default Options as proposed herein. Further, in light of the above-
described proposed trading, quoting, and product structures, including 
that there would be a maximum of one series per quarterly expiration in 
a given Credit Default Option class, CBOE does not anticipate that 
there would be any additional quote mitigation strategy necessary to 
accommodate the trading of Credit Default Options.
j. Applicability of Rule 9b-1 Under the Act
    The Exchange asks the Commission to clarify that Credit Default 
Options are standardized options under Rule 9b-1

[[Page 7098]]

under the Act.\11\ Subsection (a)(4) of Rule 9b-1 \12\ defines 
``standardized options'' as ``options 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.'' Credit Default Options are like 
existing standardized options trading on CBOE in every respect except 
for the exercise price. Credit Default Options: (i) Trade on a national 
securities exchange, (ii) have a specific expiration date, (iii) have 
fixed terms, (iv) have a specific exercise style,\13\ and (v) would be 
issued and cleared by the OCC. All of these are attributes of 
``standardized options'' as defined in Rule 9b-1. The one respect with 
which Credit Default Options differ from existing standardized options 
is in the exercise price.
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    \11\ 17 CFR 240.9b-1.
    \12\ 17 CFR 240.9b-1(a)(4).
    \13\ Credit Default Options would be automatically exercised at 
any time before expiration upon confirmation of a Credit Event. In 
this regard, the proposed exercise style of Credit Default Options 
is similar to capped-styled options, which are automatically 
exercised when the cap price is reached prior to expiration. The 
distinction between a Credit Default Option and a capped-styled 
option is that at expiration a capped-styled option is exercisable 
whereas a Credit Default Option is not (unless a Credit Event 
happens to occur and is confirmed at the same time as expiration). 
See existing CBOE Rule 1.1(ww) (which provides that, if the cap 
price is not reached prior to expiration, a capped-styled option can 
be exercised, subject to the provisions of rule 11.1 and to the 
Rules of the OCC, only on its expiration date).
---------------------------------------------------------------------------

    ``Exercise price'' is not a defined term in Rule 9b-1. However, the 
significance of having a specific exercise price term in a standardized 
option is that traditionally it, in conjunction with the specific 
exercise style (e.g., American-, European-, or capped-style), 
symbolizes the formula for calculating the exercise settlement of the 
option that is publicly known and announced, objectively determined, 
and unalterable. For example, in the case of a physical delivery 
option, the exercise price (which is sometimes called the ``strike 
price'') is the price at which the option holder has the right either 
to purchase (in the case of a call) or to sell (in the case of a put) 
the underlying interest upon exercise.\14\ In the case of a cash-
settled option, the exercise price is the base used for determining the 
amount of cash, if any, that the option holder is entitled to receive 
upon exercise (referred to as the ``cash settlement amount'').\15\ 
Traditionally, the cash settlement amount is the amount by which the 
exercise settlement value of the underlying interest of a cash-settled 
call exceeds the exercise price, or the amount by which the exercise 
price of a cash-settled put exceeds the exercise settlement value of 
the underlying interest, multiplied by the multiplier for the 
option.\16\
---------------------------------------------------------------------------

    \14\ See ODD at 6-7.
    \15\ See id.
    \16\ Currently, instead of a variable amount, the cash 
settlement amount may instead be ``capped.'' A capped option will be 
automatically exercised prior to expiration if the options market on 
which the option is trading determines that the value of the 
underlying interest at a specified time on a trading day ``hits the 
cap price'' for the option. Capped options may also be exercised, 
like European-style options, during a specified period before 
expiration. Cash-settled options having a binary cash settlement 
amount based upon the price of the underlying security may be 
introduced for trading in the future.
---------------------------------------------------------------------------

    Whereas for traditional cash-settled options the cash settlement 
amount is determined by reference to the particular price of the 
underlying interest, the cash settlement amount for a Credit Default 
Option would be a fixed sum of $100,000 payable upon automatic exercise 
if a Credit Event in the underlying Relevant Obligation(s) is 
confirmed. As with traditional cash-settled options, the calculation of 
the cash settlement amount of a Credit Default Option would be 
established prior to the commencement of trading according to a formula 
that is publicly known and announced, objectively determined, and 
unalterable. Thus, as with a traditional cash-settled option, a party 
entering into a Credit Default Option would know exactly the terms 
under which a Credit Default Option would be automatically exercised 
and the option's cash settlement value, which would be an exercise 
settlement value of $100 multiplied by the contract multiplier of 
1,000. In this regard, the Exchange believes that Credit Default 
Options, by their proposed terms, are standardized options within the 
meaning of Rule 9b-1.
    If the Commission cannot determine that Credit Default Options are, 
by their proposed terms, standardized options, then the Exchange 
requests that the Commission use its authority under Rule 9b-1(a)(4) to 
otherwise designate options, such as Credit Default Options, as 
standardized options. The Commission used this authority in 1993 to 
designate ``FLEX Options'' as standardized options.\17\ In making this 
designation, the Commission found that, ``[a]part from the flexibility 
with respect to strike prices, settlement, expiration dates, and 
exercise style, all of the other terms of [FLEX] Options are 
standardized.'' The Commission observed that standardized terms include 
matters such as ``exercise procedures, contract adjustments, time of 
issuance, effect of closing transactions, restrictions on exercise 
under OCC rules [and] margin requirements * * * .'' Credit Default 
Options share all of these characteristics and, in fact, are more 
standardized than FLEX Options in that the exercise settlement 
calculation, settlement, expiration dates, and exercise style of a 
given class may not vary.
---------------------------------------------------------------------------

    \17\ See Securities Exchange Act Release No. 31910 (February 23, 
1993), 58 FR 12056 (March 2, 1993).
---------------------------------------------------------------------------

k. Surveillance Program
    The Exchange represents that it would have in place adequate 
surveillance procedures to monitor trading in Credit Default 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.
2. Statutory Basis
    The Exchange believes the proposed rule change is consistent with 
the Act and the rules and regulations under the Exchange Act applicable 
to national securities exchanges and, in particular, the requirements 
of Section 6(b) of the Act.\18\ Specifically, the Exchange believes the 
proposed rule change is consistent with the Section 6(b)(5) \19\ 
requirements that the rules of an exchange be designed to promote just 
and equitable principles of trade, to prevent fraudulent and 
manipulative acts, to remove impediments to and to perfect the 
mechanism for a free and open market and a national market system, and, 
in general, to protect investors and the public interest.
---------------------------------------------------------------------------

    \18\ 15 U.S.C. 78f(b).
    \19\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

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

    CBOE does not believe that the proposed rule change would impose 
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

    No written comments were solicited or received on the proposed rule 
change.

[[Page 7099]]

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

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-CBOE-2006-84 on the subject line.

Paper Comments

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

All submissions should refer to File Number SR-CBOE-2006-84. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, all 

written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection and 
copying in the Commission's Public Reference Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of 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-2006-84 and should be submitted on or before March 7, 2007.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\20\
---------------------------------------------------------------------------

    \20\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E7-2477 Filed 2-13-07; 8:45 am]

BILLING CODE 8010-01-P
