

[Federal Register: June 12, 2007 (Volume 72, Number 112)]
[Notices]               
[Page 32372-32378]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr12jn07-79]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55871; File No. SR-CBOE-2006-84]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Amendment No. 5 to a Proposed Rule 
Change To List and Trade Credit Default Options; and Order Granting 
Accelerated Approval of the Proposed Rule Change, as Modified by 
Amendment Nos. 3, 4, and 5, and Designating Credit Default Options as 
Standardized Options Under Rule 9b-1 of the Securities Exchange Act of 
1934

June 6, 2007.

I. Introduction

    On October 26, 2006, 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 the Securities Exchange Act of 1934 (``Act'') 
\1\ and Rule 19b-4 thereunder,\2\ to permit CBOE to list and trade 
cash-settled, binary call options based on credit events in one or more 
debt securities of an issuer, referred to as 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; \3\ and on February 7, 2007, CBOE filed Amendment 
No. 4 to the proposed rule change. The proposed rule change, as 
amended, was published for comment in the Federal Register on February 
14, 2007.\4\ The Commission received no comments on the proposal. On 
March 28, 2007, CBOE filed Amendment No. 5 to the proposed rule change 
(``Amendment No. 5''). This notice and order notices Amendment No. 5; 
solicits comments from interested persons on Amendment No. 5; approves 
the proposed rule change, as amended, on an accelerated basis; and 
designates credit default options as ``standardized options'' pursuant 
to Rule 9b-1 under the Act.\5\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 3 replaced the original filing, as modified by 
Amendment Nos. 1 and 2, in its entirety.
    \4\ See Securities Exchange Act Release No. 55251 (February 7, 
2007) (SR-CBOE-2006-84), 72 FR 7091 (``CBOE Proposal'').
    \5\ 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 for 
``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).
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II. Description of the CBOE Proposal

A. Generally

    CBOE proposes to list and trade credit default options, which are 
cash-settled, binary options \6\ that are automatically exercised upon 
the occurrence of specified credit events or expire worthless. A credit 
default option would be referenced to the debt securities issued by a 
specified public company (``Reference Entity'') \7\ and would either 
have a fixed payout or expire worthless, depending upon whether or not 
a credit event (as described below) occurs during the life of the 
option. Upon confirmation of a credit event prior to the last day of

[[Page 32373]]

trading of a credit default option series,\8\ the options positions 
existing as of that time would be automatically exercised and the 
holders of long options positions would receive a fixed cash payment of 
$100,000 per contract.\9\ If no credit event is confirmed during the 
life of the option, the final settlement price would be $0.
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    \6\ A binary option is a style of option having only two 
possible payoff outcomes: Either a fixed amount or nothing at all.
    \7\ Proposed CBOE Rule 29.1(f) also includes as a ``Reference 
Entity'' the guarantor of the debt security underlying the credit 
default option.
    \8\ Proposed CBOE Rule 29.9 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.
    \9\ The settlement amount would be $100,000 per contract unless 
adjusted pursuant to proposed CBOE Rule 29.4, as discussed below.
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    Credit events that would trigger automatic exercise include a 
failure to make payment pursuant to the terms of the underlying debt 
security and any other event of default specified by CBOE at the time 
the Exchange initially lists a particular class of credit default 
options. The events of default that CBOE may specify must be defined in 
accordance with the terms of the debt security underlying the credit 
default option (``Reference Obligation'') or any other debt security of 
the Reference Entity (collectively with the Reference Obligation, 
``Relevant Obligations'').\10\
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    \10\ See proposed CBOE Rule 29.1(c).
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B. Listing Standards

    A credit default option must conform to the initial and continued 
listing standards under proposed CBOE Chapter XXIX. CBOE may list and 
trade a credit default option that overlies a debt security of a 
Reference Entity, provided that such issuer or guarantor, or its parent 
if a wholly owned subsidiary, has at least one class of securities that 
is registered under the Act and is an ``NMS stock'' \11\ as defined in 
Rule 600 of Regulation NMS under the Act.\12\ The registered equity 
securities issued by the Reference Entity also would have to satisfy 
the requirements of CBOE Rule 5.4 for continued options trading, which 
requires, among other things, that an equity security underlying an 
option be itself widely held and actively traded.\13\ The requirement 
that the equity securities of an issuer of a debt security underlying a 
credit default option meet the criteria of Rule 5.4 is designed to 
ensure that the issuer's securities enjoy widespread investor interest. 
The requirement that the Reference Entity be an issuer of a registered 
NMS stock will help ensure that investors have access to comprehensive 
public information about the issuer, including the registration 
statement filed under the Securities Act of 1933 (``Securities Act'') 
and other periodic reports.\14\
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    \11\ ``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, or an effective national market system plan for 
reporting transaction in listed options. See 17 CFR 242.600(b)(46) 
and (47).
    \12\ See proposed CBOE Rule 5.3.11.
    \13\ 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: (a) 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); (b) there 
are fewer than 1,600 holders of the underlying security; (c) the 
trading volume (in all markets in which the underlying security is 
traded) was less than 1,800,000 shares in the preceding twelve 
months; (d) 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 (e) the underlying security ceases to be an NMS 
stock.
    \14\ Section 13 of the Act, 15 U.S.C. 78m, requires that any 
issuer of a security registered pursuant to Section 12 of the Act, 
15 U.S.C. 78l, would 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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    A credit default 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.\15\ A credit default 
option generally would expire up to 123 months from the time it is 
listed, and the Exchange usually would open one to four series for each 
year up to 10.25 years from the current expiration.\16\
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    \15\ If a credit event is confirmed, the expiration date would 
be the second business day after the confirmation of a credit event. 
See proposed CBOE Rule 29.1(d) and (e).
    \16\ See proposed CBOE Rule 29.2(b)(1) and (2).
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C. Trading

    Credit default options will trade on CBOE's Hybrid Trading System 
from 8:30 a.m. to 3 p.m. (Central Time) \17\ 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 will apply to 
credit default options.\18\ Also, credit default options will be 
eligible for trading as Flexible Exchange Options (``FLEX Options''). A 
FLEX Option that is a credit default option would be cash-settled and 
the exercise-by-exception provisions of OCC Rule 805 \19\ would not 
apply. Market-makers shall be appointed to credit default options 
pursuant to CBOE's existing requirements,\20\ as supplemented by 
proposed CBOE Rule 29.17. Additionally, CBOE represents that there will 
be a maximum of one series per quarterly expiration in a given credit 
default option class, and 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 options.
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    \17\ See proposed CBOE Rule 29.11.
    \18\ See proposed CBOE Rules 29.11-29.17 and 29.19.
    \19\ OCC Rule 805 sets forth the expiration date exercise 
procedures for options cleared and settled by the OCC.
    \20\ See Chapter VIII of CBOE's Rules.
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    Once a particular credit default 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 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 series. The proposed 
trading rules for credit default 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 Exchange floor bidding, as compared to the 
over-the-counter (``OTC'') market.
    Upon the confirmation of a credit event or the redemption of all 
Relevant Obligations, the applicable credit default option class would 
cease trading and all outstanding contracts in that class would be 
subject to automatic exercise. In addition, the CBOE's trading halt 
procedures applicable to equity options shall apply to credit default 
options.\21\ When determining whether to institute a trading halt in 
credit default options, CBOE floor officials would consider whether 
current quotations for the Relevant Obligation(s) or other securities 
of the Reference Entity are unavailable or have become unreliable. The 
Exchange's board of directors shall also have the power to impose 
restrictions on transactions or exercises in one or more series of 
credit default options as the board, in its judgment, determines 
advisable in the interests of maintaining a fair and orderly market or 
otherwise deems

[[Page 32374]]

advisable in the public interest or for the protection of 
investors.\22\
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    \21\ See CBOE Rules 6.3 and 6.3B; proposed CBOE Rule 29.13.
    \22\ See proposed CBOE Rule 29.8.
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D. Clearance and Settlement

    Because credit default options do not have an exercise price, they 
do not, by their terms, meet the definition of ``standardized options'' 
for purposes of Rule 9b-1 under the Act.\23\ However, as discussed 
herein, the Commission today is using its authority pursuant to Rule 
9b-1 to designate credit default options as ``standardized options'' 
under Rule 9b-1. Consequently, credit default option transactions would 
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.\24\
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    \23\ See 17 CFR 240.9b-1.
    \24\ On February 13, 2007, the OCC filed with the Commission 
pursuant to Section 19(b)(1) of the Act, 15 U.S.C. 78s(b)(1), and 
Rule 19b-4 thereunder, 17 CFR 240.19b-4, a proposed rule change to 
enable it to clear and settle credit default options proposed to be 
listed by CBOE. The proposed rule change was published for comment 
in the Federal Register on February 27, 2007. Securities Exchange 
Act Release No. 55362, 72 FR 9826 (March 5, 2007). On March 7, 2007, 
the OCC filed Amendment No. 1 to the proposed rule change. See SR-
OCC-2007-01 (as amended, the ``OCC Proposal''). The Commission has 
not yet taken action on the OCC proposal.
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E. Adjustments

    Credit default options will be subject to adjustments in two 
circumstances.\25\ First, if the original Reference Entity is succeeded 
by another entity in accordance with the terms of the underlying debt 
security, the related credit default options would be replaced by one 
or more credit default options derived from the debt securities of the 
successor entity or entities. To the extent necessary and appropriate 
for the protection of investors and the public interest, all other 
terms and conditions of the successor options would be the same as the 
original credit default options.
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    \25\ See CBOE Proposed Rule 29.4.
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    Second, if the specific debt security (the Reference Obligation) is 
redeemed during the life of the credit default option, another debt 
security of the Reference Entity would be specified as the new 
Reference Obligation. In the event that all debt securities of the 
Reference Entity (i.e., all Relevant Obligations) are redeemed during 
the life of the credit default option, the option would cease trading 
and, assuming that CBOE has not confirmed a credit event, the contract 
payout would be $0.

F. Position Limits

    Pursuant to proposed CBOE Rule 29.5, credit default options will be 
subject to a position limit equal to 5,000 contracts on the same side 
of the market. Credit default options shall not be aggregated with 
option contracts on the same underlying security and will not be 
subject to the hedge exemption to CBOE's standard position limits. 
Instead, the following hedge exemption strategies and positions shall 
be exempt from CBOE's 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) or other 
securities, instruments, or interests related to the Reference Entity 
that is sufficient to meet the cash settlement amount obligation.\26\ 
Also, CBOE's market-maker and firm facilitation exemptions to position 
limits will apply.\27\
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    \26\ See proposed CBOE Rule 29.5.
    \27\ Proposed CBOE Rule 29.5 requires 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 provides that the aggregate 
exemption position could not exceed three times the standard limit 
of 5,000 contracts.
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G. Margin

    The margin (both initial and maintenance) required for writing 
short and long positions in credit default options will be as follows: 
\28\
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    \28\ See proposed CBOE Rule 12.3(l); Amendment No. 5.
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     For a qualified customer \29\ carrying a long position in 
credit default options, the margin requirement will be 20% of the 
current market value of the credit default option.
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    \29\ Proposed CBOE Rule 12.3(l)(1)(i) defines ``qualified 
customer'' as a person or entity that owns and invests on a 
discretionary basis no less than $5,000,000 in investments.
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     For a non-qualified customer carrying a long position in a 
credit default option, the margin requirement will be 100% of the 
current market value of the credit default option.
     For a non-qualified customer carrying a short position in 
a credit default option, the margin requirement will be the cash 
settlement amount, i.e., $100,000 per contract.
     For a qualified customer carrying a short position in a 
credit default option, the margin requirement will be the lesser of the 
current market value plus 20% of the cash settlement amount or the cash 
settlement amount.

These requirements may be satisfied by a deposit of cash or marginable 
securities. These requirements may not be satisfied by presentation to 
the member organization carrying the customer's account of a letter of 
credit meeting the requirements of proposed CBOE Rule 
12.3(l)(1)(iii).\30\
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    \30\ In Amendment No. 5, CBOE deletes from proposed rule 
12.3(l)(1)(iii) the option of using a letter of credit to satisfy 
margin requirements applicable to credit default options and makes 
non-substantive corrections to the formatting of proposed CBOE Rule 
12.3(l)(1)(iii) and the ``Interpretations and Policies'' heading 
that accompanies CBOE Rule 12.3.
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    A credit default option carried short in a customer's account will 
be deemed a covered position, and eligible for the cash account, 
provided any one of the following is either 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 or (ii) 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. In 
addition, in Amendment No. 5, the Exchange notes that, in accordance 
with CBOE Rule 12.3(a)(3), 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.
    In Amendment No. 5, the Exchange also represents the following:

    ``As part of its regulatory oversight of member organizations, 
the Exchange generally reviews member organizations' compliance with 
margin requirements applicable to customer accounts. In the future, 
the Exchange will include [c]redit [d]efault [o]ption margin 
requirements as part of this review. Additionally, the Exchange will 
review member organizations' internal procedures for managing credit 
risk associated with extending margin to customers trading [c]redit 
[d]efault [o]ptions. The Exchange also notes that, pursuant to CBOE 
Rule 12.10, the Exchange may at any time impose higher margin 
requirements when it deems such higher margin requirements 
advisable.''

    Lastly, in Amendment No. 5, the Exchange makes non-substantive 
changes to the text of CBOE Rule 12.5, to clarify that a credit default 
option that is carried for the account of a qualified investor may be 
deemed to

[[Page 32375]]

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 options 
prior to listing and trading such options.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 5, including whether Amendment No. 5 
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, Station Place, 100 F 
Street, NE., Washington, DC 20549-1090.

All submissions should refer to Amendment No. 5 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 the Exchange. 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 
Amendment No. 5 of File Number SR-CBOE-2006-84 and should be submitted 
on or before July 3, 2007.

IV. 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.\31\ In 
particular, the Commission finds that the proposal is consistent with 
Section 6(b)(5) of the Act,\32\ 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. The CBOE's proposal, by enabling CBOE to offer a 
security that will be listed and traded on the Exchange, as opposed to 
the OTC market, would extend to investors the benefits of a listed 
exchange market, 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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    \31\ 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).
    \32\ 15 U.S.C. 78f(b)(5).
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    As a threshold matter, the Commission finds that the credit default 
options proposed by CBOE are securities. Section 3(a)(10) of the Act 
\33\ defines security to include, in part, ``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).'' After careful analysis, the Commission finds that 
credit default options are options \34\ based on the value of a 
security or securities and, therefore, securities under Section 
3(a)(10) of the Act; \35\ in addition, the Commission finds that credit 
default options are options on an interest in, or based on the value of 
an interest in, a security or securities and, therefore, are securities 
under Section 3(a)(10) of the Act.\36\
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    \33\ 15 U.S.C. 78c(a)(10).
    \34\ Although credit default options do not share every feature 
of a classic option, the Commission nonetheless finds that credit 
default options are option contracts. In particular, the Commission 
notes that the buyer of a credit default option pays to the seller a 
nonrefundable premium, has rights but no further obligations under 
the contract, and has no further risk exposure because the seller 
bears all the risk of the credit event occurring. See United States 
v. Bein, 728 F.2d 107, 112 (2d Cir. 1984) (highlighting 
characteristics that distinguish options from futures contracts).
    \35\ 15 U.S.C. 78c(a)(10).
    \36\ 15 U.S.C. 78c(a)(10). In determining whether a derivative 
is a security, the Commission and the courts have looked to the 
economic reality of the product. See Caiola v. Citibank, N.A., New 
York, 295 F.3d 312, 325 (2d Cir. 2002), quoting United Housing 
Foundation v. Foreman, 421 U.S. 837, 848 (1975) (``In searching for 
the meaning and scope of the word `security' * * * the emphasis 
should be on economic reality''). Construing the definition of a 
security in this manner permits the Commission and the courts 
``sufficient flexibility to ensure that those who market investments 
are not able to escape the coverage of the Securities Acts by 
creating new instruments that would not be covered by a more 
determinate definition.'' Reves v. Ernst & Young, 494 U.S. 56, 63 
n.2 (1990).
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    The Commission interprets ``based on the value [of a security or 
securities]'' in Section 3(a)(10) of the Act \37\ to include options 
whose pricing in the secondary market moves in relation to the value of 
the underlying security or securities of the option in question. Thus 
the fact that the payout of a cash-settled option will not increase or 
decrease based on the price movement of the underlying security of that 
option is not dispositive.\38\
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    \37\ Id.
    \38\ In addressing whether a ``digital option'' or a ``binary 
option'' with a fixed payout is an option based on the value of a 
security or securities, the court in Stechler v. Sidley, Austin 
Brown & Wood, L.L.P., 382 F.Supp.2d 580, 596-97 (S.D.N.Y. 2005), 
held that the issue ultimately turned on questions of fact and 
declined to decide the issue on a motion to dismiss. However, the 
court's analysis made clear that the existence of a fixed payout 
that is not tied in a proportionate manner to the price of an 
underlying security is not a determining factor in deciding whether 
an instrument is an option on a security. Rather, the court accepted 
that, in evaluating the economic reality of an instrument, it is 
appropriate to consider whether the resale value of the instrument 
moves in relation to the movement of an underlying reference.
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    Because credit default options are not currently traded, there is 
no empirical data regarding their pricing in the secondary market. 
However, credit default options are essentially exchange-traded 
equivalents of single-name, OTC credit default swaps.\39\ A single-name

[[Page 32376]]

credit default swap is an agreement between a protection buyer and a 
protection seller whereby the buyer pays a periodic fee in return for a 
contingent payment by the seller upon the occurrence of a credit event 
with respect to one or more reference obligations of a reference 
entity. Credit events typically include one or more of the following: 
(1) Bankruptcy, (2) obligation acceleration, (3) obligation default, 
(4) a failure to pay, (5) repudiation or moratorium, or (6) 
restructuring. Similarly, as explained above, each credit default 
option shall specify (a) the Reference Entity, (b) the specific debt 
security or securities that serve as its Reference Obligation or other 
Relevant Obligations, and (c) the applicable events of default that 
trigger payout (as determined in accordance with the terms of the 
Reference Obligation or other Relevant Obligations), which could 
include such events as a failure to pay, obligation acceleration or 
default, and restructuring. Hence, credit default options have 
essentially the same structure as credit default swaps.
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    \39\ Despite the similarities between credit default options and 
OTC credit default swaps, the Commission wishes to make two things 
clear. First, because credit default 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. Second, certain OTC credit default swaps are not securities. The 
finding that credit default options are securities because they are 
options based on the value of a security might suggest that OTC 
credit default swaps are also options based on the value of a 
security or 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. Credit default swaps that involve terms 
similar to credit default 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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    In the case of a credit default swap, the amount the buyer pays for 
protection is based on a quoted spread expressed in basis points on a 
notional amount specified in the swap agreement. This quoted spread is 
often referred to as a ``CDS spread'' and is principally based on the 
probability that the Reference Entity will default (i.e., its 
creditworthiness). More specifically, the CDS spread represents the 
price required by a swap counterparty to compensate it for the credit 
risk associated with the potential default on a particular reference 
obligation or obligations of an issuer. Similarly, the value of a debt 
security is a function of the issuer's creditworthiness, which is 
expressed in terms of a ``yield spread'' (sometimes called ``credit 
spread''). The yield (or credit) spread is the difference between the 
yield on the debt instrument and the yield on a debt security of 
similar maturity whose yield represents pure interest rate risk, such 
as U.S. Treasuries,\40\ and represents the additional yield required by 
an investor to compensate it for the credit risk associated with the 
potential default on the particular debt instrument of an issuer.\41\ 
As a consequence of this relationship between debt securities and 
credit default swaps, the credit default swap market enables more 
widespread trading in an issuer's creditworthiness than was previously 
possible.
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    \40\ Some academics have hypothesized that there may be some 
deviation between the yield on U.S. Treasuries and pure interest 
rate risk because bond interest is subject to state tax but U.S. 
Treasuries are not. See, e.g., Haibin Zhu, An Empirical Comparison 
of Credit Spreads between the Bond Market and the Credit Default 
Swap Market, BIS Working Papers No. 160 (August 2004) (also noting 
that transparency and the widespread use of U.S. Treasuries as 
collateral could explain apparent deviations).
    \41\ While the terms of both corporate securities and credit 
default swaps are established when parties enter into the respective 
contracts, the fair market value of these contracts can vary over 
the life of the contracts in response to changing perceptions of the 
creditworthiness of an issuer.
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    There is a close empirical correlation between the price of a 
credit default swap (as expressed in the CDS spread) and the yield (or 
credit) spread of the specific reference obligation or obligations of 
that credit default swap.\42\ This correlation is to be expected 
because the valuation of credit default swaps and debt securities are 
each based on credit risk, and because of the potential for arbitrage 
between the secondary bond market and the credit default swap 
market.\43\ Similarly, because credit default options are exchange-
traded equivalents of credit default swaps, the Commission expects that 
there will be a close empirical correlation between the pricing of a 
specific credit default option during the life of the contract and the 
yield spread of the Reference Obligation or other Relevant Obligations 
of that credit default option.
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    \42\ See, e.g., Roberto Blanco, Simon Brennan, and Ian W. Marsh, 
An Empirical Analysis of the Dynamic Relation between Investment-
Grade Bonds and Credit Default Swaps, The Journal of Economics, 
Volume LX, No. 5 (Oct. 2005) (finding credit default swap spreads to 
be quite close to bond yield spreads).
    \43\ See Zhu, An Empirical Comparison of Credit Spreads between 
the Bond Market and the Credit Default Swap Market, supra note 40.
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    We further note, more generally, that credit default options 
expressly reference in their payout conditions a term of an underlying 
security that is material to the value of that security. A credit 
default option will pay out if there is a failure to pay or other 
default event under the terms of the underlying debt security.
    For these reasons, credit default options are options ``based on 
the value [of a security or securities]'' and, therefore, securities.
    In addition, the Commission has determined that credit default 
options are options on an ``interest in,'' or based on the value of an 
interest in, a security or securities within the meaning of Section 
3(a)(10) of the Act.\44\ A security is a collection of rights (and 
obligations) running between the issuer and the holder of the security. 
The concept of an ``interest in'' a security plainly includes rights 
generating a pecuniary interest in a security, such as the right to a 
dividend payment or bond (coupon) payment. One relevant ``interest in'' 
a debt security underlying a credit default option is the right to 
receive (coupon) payments under the terms of that debt security. When a 
(coupon) payment is not made, impairing the value of that interest, the 
protection seller must make a payment to the protection buyer. 
Similarly, a specified default event may trigger other rights of a 
holder of the debt security. The default events that trigger exercise 
and payment under the credit default option are meaningful only because 
they are material terms of a security, essential to the debt holder's 
rights and interests in that security.\45\ The credit default option 
payout is contingent on these security-dependent events. For these 
reasons, credit default options are options on an interest in, or based 
on the value of an interest in, a security or securities.\46\
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    \44\ 15 U.S.C. 78c(a)(10).
    \45\ Although certain default events trigger the exercise and 
payment of a credit default option, it would not be accurate to 
describe these options as options on ``an event''. There is no event 
delivered upon exercise of the option, rather a payment is 
delivered. The crucial question is what causes the option to be in-
the-money and pay out. In the case of credit default options, it is 
an event that is created by a security.
    \46\ It is important to note that merely because the option does 
not transfer ownership of the interest or right in a security--but 
instead becomes in-the-money and provides a cash payment if certain 
security rights are triggered--does not mean the option is not on an 
interest in a security. Cf. Caiola, 295 F.3d 312 (2d Cir. 2002) 
(including within the definition of ``security'' an option that did 
not deliver an actual security or interest in a security, but merely 
a cash payment).
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    Moreover, the economic reality of credit default options supports 
the conclusion that credit default options are securities. Taking a 
short position (i.e., taking on the role of a protection seller) via 
credit default options would be akin to purchasing the corporate bond 
that is the Reference Obligation or other Relevant Obligations of that 
credit

[[Page 32377]]

default option with the interest rate risk fully hedged. Both give the 
investor the same risk exposure to creditworthiness of an issuer. 
Indeed, credit default options may even more closely reflect the 
financial condition of an SEC-registered issuer because, unlike 
corporate bonds, which reflect both an issuer's creditworthiness and 
general interest rate risk, credit default options would only reflect 
an issuer's creditworthiness. That ability to isolate and transfer 
credit risk, backed by the guarantee of a central counterparty and the 
transparency of an exchange, should provide investors with additional 
opportunities to gain exposure to the public debt market.
    For these reasons, the Commission finds that credit default options 
are options based on the value of, and options on interests in or based 
on the value of interests in, a security or securities of the Reference 
Entity and, therefore, securities under Section 3(a)(10) of the 
Act.\47\
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    \47\ 15 U.S.C. 78c(a)(10).
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    Further, the Commission believes that the listing rules proposed by 
CBOE for credit default options are reasonable and consistent with the 
Act. The Commission notes in particular that a credit default option 
must be based on a Reference Obligation issued by an entity that issues 
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 Entity that may be necessary to price a credit 
default option appropriately.
    The Commission believes that the proposed position limits and 
margin rules for credit default options are reasonable and consistent 
with the Act. The proposed position limit of 5,000 contracts in any 
credit default 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 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 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 options as proposed.

This approval order is conditioned on CBOE's adherence to these 
representations.
    For the foregoing reasons, the Commission finds that the proposed 
rule is consistent with the Act.

V. Accelerated Approval

    The Commission finds good cause for approving the proposed rule 
change, as modified by Amendment No. 5, prior to the thirtieth day 
after publishing notice of Amendment No. 5 in the Federal Register 
pursuant to Section 19(b)(2) of the Act.\48\ In Amendment No. 5, CBOE: 
(1) Modified the text of the proposed margin requirements applicable to 
credit default options contained in proposed Rules 12.3 and 12.5; (2) 
made corresponding changes to the discussion sections of the Form 19b-4 
and the Exhibit 1 thereto; and (3) inserted information in the 
discussion sections of the Form 19b-4 and the Exhibit 1 thereto 
regarding the form of escrow agreements and the Exchange's supervision 
of member organizations that extend margin to customers trading Credit 
Default Options.\49\ The Commission believes that Amendment No. 5 
raises no significant regulatory issues. The Commission therefore finds 
good cause exists to accelerate approval of the proposed change, as 
modified by Amendment No. 5, pursuant to Section 19(b)(2) of the Act.
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    \48\ 15 U.S.C. 78s(b)(2). Pursuant to Section 19(b)(2) of the 
Act, the Commission may not approve any proposed rule change, or 
amendment thereto, prior to the thirtieth day after the date of 
publication of the notice thereof, unless the Commission finds good 
cause for so doing.
    \49\ The changes pursuant to Amendment No. 5 are discussed more 
fully in Section II.G, supra.
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VI. Designation of Credit Default 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 Options Disclosure Document (``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.\50\ 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.\51\
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    \50\ See 17 CFR 240.9b-1(d)(1).
    \51\ 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.\52\ 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.'' \53\
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    \52\ 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).
    \53\ 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 options, as defined 
in the OCC Proposal,\54\ as standardized options for purposes of Rule 
9b-1 under the Act. Credit default options do not meet the definition 
of ``standardized options,'' because they do not have an exercise 
price. However, they resemble

[[Page 32378]]

standardized options in other significant respects. Credit default 
options have an underlying security and an expiration date. Like other 
standardized options, credit default 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 options are designed to provide market 
participants with the ability to hedge their exposure to an underlying 
security. The fact that credit default 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 options supports the view that adding credit default options to 
the standardized option disclosure framework is reasonable.
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    \54\ For purposes of its proposal, OCC would define the term 
``credit default option'' as an option that is automatically 
exercised upon receipt by the OCC of a credit event confirmation 
with respect to the reference obligation(s) of a reference entity. 
Credit default options have only two possible payoff outcomes: 
Either a fixed automatic exercise settlement amount or nothing at 
all. See proposed Section 1.C.(2) of Article XIV of the OCC By-Laws.
     I11``Credit event'' would be as defined in the rules of 
the exchange on which the credit default 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.
     I11``Reference entity'' would mean the issuer or 
guarantor of the reference obligation(s). See proposed Section 
1.R.(1) of Article XIV of the OCC By-Laws.
     I11``Reference obligations'' would mean one or more 
debt securities the terms of which define a credit event for a class 
of credit default options, as provided in the rules of the listing 
exchange. See id.
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    Therefore, the Commission hereby designates credit default options, 
such as those proposed by CBOE, as standardized options for purposes of 
Rule 9b-1 under the Act.

VII. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\55\ that the proposed rule change (SR-CBOE-2006-84) as modified by 
Amendment Nos. 3, 4, and 5, be, and hereby is approved on an 
accelerated basis.
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    \55\ 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, 
the credit default options, as defined in proposed rule change (SR-OCC-
2007-01) are designated as standardized options.

    By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-11273 Filed 6-11-07; 8:45 am]

BILLING CODE 8010-01-P
