

[Federal Register: July 10, 2007 (Volume 72, Number 131)]
[Notices]               
[Page 37551-37554]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10jy07-93]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-55976; File No. SR-CBOE-2003-41]

 
Self-Regulatory Organizations; Chicago Board Options Exchange 
Incorporated; Order Granting Approval of Proposed Rule Change as 
Modified by Amendment No. 4 To List and Trade Options on Corporate Debt 
Securities

June 28, 2007.

I. Introduction

    On September 22, 2003, the Chicago Board Options Exchange 
Incorporated (``CBOE'' or ``Exchange'') filed with the Securities and 
Exchange Commission (``Commission'' or ``SEC''), pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 
19b-4 thereunder,\2\ a proposed rule change to list and trade options 
on corporate debt securities (``CDSOs''). On March 1, 2003, CBOE filed 
Amendment No. 1 to the proposed rule change. CBOE filed Amendment No. 2 
to the proposed rule change on August 24, 2005. CBOE filed Amendment 
No. 3 to the proposed rule change on May 26, 2006. On June 13, 2006, 
the proposed rule change, as amended by Amendment Nos. 1, 2, and 3, was 
published in the Federal Register.\3\ CBOE filed Amendment No. 4 on 
July 14, 2006.\4\ The Commission received one comment letter on the 
proposal.\5\ On October 31, 2006, CBOE filed a response to the 
comment.\6\ This order approves the proposed rule change, as amended.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 53935 (June 2, 
2006), 71 FR 34174.
    \4\ In Amendment No. 4, CBOE made minor technical changes to the 
proposed rule text.
    \5\ See Letter from Mary C.M. Kuan, Vice President and Assistant 
General Counsel, The Bond Market Association (``TBMA''), to Nancy M. 
Morris, Secretary, Commission, dated August 25, 2006 (``TBMA 
Letter'').
    \6 \ See Letter from Angelo Evangelou, Assistant Secretary, 
CBOE, to Ronesha Butler, Special Counsel, Commission, dated October 
25, 2006 (``Response'').
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II. Description of the Proposed Rule Change

(a) Background

    Over-the-counter (``OTC'') transactions in corporate debt 
securities are publicly reported through the NASD's Trade Reporting and 
Compliance Engine (``TRACE'') system. CBOE believes that the enhanced 
transparency created by TRACE has given rise to an OTC market in CDSOs, 
and that an exchange-traded alternative for such products may provide a 
useful risk management and trading vehicle for member firms and their 
customers.
    CBOE believes that exchange-listed CDSOs would have three important 
advantages over similar options traded in the OTC market. First, as a 
result of greater standardization of contract terms, exchange-listed 
contracts should develop more liquidity. Second, counterparty credit 
risk would be mitigated because the contracts would be issued and 
guaranteed by The Options Clearing Corporation (``OCC''). Finally, the 
quotation and last-sale data provided by CBOE and its members would 
lead to more transparent markets. CBOE believes that offering CDSOs 
would create competition with the OTC market and expand the universe of 
listed products available to interested market participants.

(b) Listing Standards

    The Exchange has proposed CBOE Rules 5.3.10 and 5.4.14 for the 
initial listing and continued maintenance standards, respectively, for 
CDSOs. The Exchange proposes that for initial listing, a CDSO must 
satisfy the following criteria:
     The original public sale of a corporate debt security on 
which options transactions will be effected on the Exchange shall be at 
least a $250,000,000 principal amount.
     Trading volume (in all markets in which the underlying 
corporate debt security is traded) has been at least $100,000,000 in 
notional value over the preceding six months.
     The corporate debt security has a minimum aggregate par 
value or ``float'' of $200,000,000.

[[Page 37552]]

     The corporate debt security has at least 320 holders.
     The issuer of the corporate debt security or the issuer's 
parent, if the issuer is a wholly-owned subsidiary, has at least one 
class of common or preferred equity securities registered under Section 
12(b) of the Act.
     The equity securities issued by the corporate debt 
security issuer are ``covered securities'' as defined under Section 
18(b)(1)(A) of the Securities Act of 1933 (``1933 Act'').
     The corporate debt security on which options transactions 
will be effected on the Exchange has a credit rating issued by Moody's 
Investors Service that is Caa or higher and a credit rating issued by 
Standard and Poor's that is CC or higher.
     The issuer of the corporate debt security has registered 
the offer and sale of such securities under the 1933 Act.
     The transfer agent of the corporate debt security is 
registered under Section 17A of the Act.
     The trust indenture for the corporate debt security is 
qualified under the Trust Indenture Act of 1939.

(c) Settlement

    CDSOs will be physically settled, European-style options that may 
be exercised only on the last day of expiration. Trading in CDSOs 
ordinarily will cease on the business day (usually a Friday) preceding 
the expiration date and the trading hours will be 8:30 a.m. to 3:02 
p.m. Chicago time. The expiration date will be the Saturday immediately 
following the third Friday of the expiration month. CBOE Rule 28.7 
provides that there will be up to five expiration months, none further 
out than 15 months, but the Exchange can list additional options 
expiration further out than 15 months where a reasonably active 
secondary market exists.
    The settlement process for CDSOs will be the same as the settlement 
process for equity options under CBOE rules, with the exception of the 
delivery process.\7\ Payment of a CDSO's exercise price will be 
accompanied by payment of accrued interest on the underlying corporate 
debt security from, but not including, the last interest payment date 
to, and including, the exercise settlement date, as specified in OCC 
rules. The Exchange will notify OCC of the accrued interest calculation 
methodology that applies to each corporate debt security prior to the 
listing of the particular CDSO.
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    \7\ If the outstanding debt issuance amount of an underlying 
corporate debt security is insufficient to satisfy the delivery 
requirements under CBOE Rule 11.3, OCC rules provide for special 
settlement exercise procedures.
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(d) Minimum Price Variation and Strike Price Intervals

    The option premium will be quoted in points where each point equals 
$1,000. The minimum tick will be 0.05 ($50.00). Series with strike 
prices in, at, and out of the money initially will be listed (up to ten 
per month initially). In addition, CBOE proposes to limit the strike 
price intervals that can be used for CDSOs, which will be fixed at a 
percentage of principal amounts (based on a par quote basis of $100) as 
follows:
     0.5% ($0.50) or greater, provided that the series to be 
listed is no more than 5% above or below the current market price of a 
corporate debt security reported on TRACE during TRACE system hours or 
effected on or through the facilities of a national securities 
exchange, as applicable, on the day prior to the day the series is 
first listed for trading;
     1.0% ($1.00) or greater, provided that the series to be 
listed is no more than 10% above or below the current market price of a 
corporate debt security reported on TRACE during TRACE system hours or 
effected on or through the facilities of a national securities 
exchange, as applicable, on the day prior to the day the series is 
first listed for trading; and
     2.5% ($2.50) or greater, provided that the series to be 
listed is greater than 10% above or below the current market price of a 
corporate debt security reported on TRACE during TRACE system hours or 
effected on or through facilities of a national securities exchange, as 
applicable, on the day prior to the day the series is first listed for 
trading.
    These increments are designed to allow the Exchange flexibility to 
list options with strike increments at appropriate levels, while 
diminishing any potential adverse effect on the Exchange's quote 
capacity thresholds. CBOE believes that the operational capacity used 
to accommodate the trading of CDSOs on the Exchange will have a 
negligible effect on the total capacity used by the Exchange to trade 
its products on a daily basis. The Exchange has represented that it 
will delist a CDSO series for which there is no open interest.

(e) Position Limits

    CBOE proposes to establish tiered position limits for CDSOs based 
on a policy to limit positions in such options to a quantity that, if 
exercised, would not exceed 10% of the total float of the underlying 
bond. CBOE believes the 10% level is sufficient to inhibit market 
manipulation or to mitigate other possible disruptions in the market. 
CBOE's lowest position limit for equity options is 13,500 contracts, 
which, if exercised, would represent approximately 19.28% of the 
minimum float of an equity security eligible to underlie a CBOE equity 
option (seven million shares).\8\ Moreover, CBOE's 13,500 equity option 
contract limit applies to those options having an underlying security 
that does not meet the requirements for a higher option contract limit. 
CBOE believes the 10% position limit for CDSOs, which is significantly 
less than that for equity options, is sufficiently high to account for 
the differences in liquidity between the equity and debt markets and 
would consist of the following tiers:
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    \8\ See CBOE Rule 4.11 (Position Limits).

------------------------------------------------------------------------
                                                               Position
                                                              limit for
               Float of underlying debt issue                    CDSO
                                                             (contracts)
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$200,000,000-$499,999,000..................................          200
500,000,000-749,999,000....................................          500
750,000,000-999,999,000....................................          750
1,000,000,000-2,499,999,000................................        1,000
2,500,000,000 and greater..................................        2,500
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    If a person holds more than 10% of a particular corporate debt 
security, the amount held by such person would not be included in the 
``total float'' for purposes of determining the applicable position 
(and exercise) limits.\9\
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    \9\ For example, if a person holds 14% of the total outstanding 
issuance of a corporate debt security, the applicable position (and 
exercise) limits would be based only on the remaining 86% of the 
issuance that is not held by such person.
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(f) Margin

    The margin (both initial and maintenance) for writing uncovered 
puts or calls will be as follows:
     An option writer will be required to deposit and maintain 
100% of the current market value of the option plus 10% of the 
aggregate contract value minus the amount, if any, by which the option 
is out of the money, subject to a minimum for calls equal to 100% of 
the current market value of the option plus 5% of the aggregate 
contract value for any options on corporate debt securities that are 
rated investment-grade.\10\
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    \10\ The definition of an investment-grade corporate debt 
security is set forth in CBOE Rule 12.3(a)(15). The definition 
mirrors the definition set forth in NASD rules pertaining to TRACE.
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     For options on non-investment-grade \11\ corporate debt 
securities, the margin requirement will be 100% of the

[[Page 37553]]

current market value of the option plus 15% of the aggregate contract 
value minus the amount, if any, by which the option is out of the 
money, subject to a minimum for calls equal to 100% of the current 
market value of the option plus 10% of the aggregate contract value.
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    \11\ The definition of a non-investment-grade corporate debt 
security is set forth in CBOE Rule 12.3(a)(16). The definition 
mirrors the definition set forth in the NASD rules pertaining to 
TRACE.
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     Writers of options on convertible corporate debt 
securities will be required to deposit and maintain 100% of the current 
market value of the option plus 20% of the aggregate contract value 
minus the amount, if any, by which the option is out of the money, 
subject to a minimum for calls equal to 100% of the current market 
value of the option plus 10% of the aggregate contract value.
     In the case of puts for each of investment-grade, non-
investment-grade, and convertible corporate debt securities, the 
minimum margin required will be 100% of the current market value of the 
option plus 5%, 10%, and 10%, respectively, of the put exercise price.
    This methodology incorporates the same formula that the Exchange 
applies to all other option classes in Chapter 12 of CBOE rules, but 
with percentages that consider the specific market factors pertaining 
to the debt rating and type of corporate debt security. For example, 
the Exchange requires a deposit of 100% of the current market value of 
the option plus a 20% initial/maintenance margin and a 10% minimum 
margin. The Exchange would apply these initial/maintenance margin and 
minimum margin requirements if a convertible debt security underlies a 
CDSO. If an investment-grade corporate debt security underlies an 
option, the Exchange would impose a 10% initial/maintenance margin and 
a 5% minimum margin on the CDSO position because an investment-grade 
corporate debt security generally experiences lower price movements and 
lower volatility levels than stocks. CBOE proposes a 15% initial/
maintenance margin and a 5% minimum margin for CDSOs based on non-
investment-grade corporate debt securities because these securities 
exhibit more price movements than investment-grade corporate debt 
securities. The Exchange believes that these margin levels are 
consistent with the Commission's Net Capital Rule \12\ for the 
underlying corporate debt securities.
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    \12\ 17 CFR 240.15c3-1.
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(g) Surveillance

    CBOE will implement a surveillance plan to monitor trading in 
CDSOs. The surveillance plan will include, but not be limited to, 
monitoring for insider trading, mini-manipulation, manipulation, 
frontrunning, and capping and pegging. The Exchange will also monitor 
the media for rating downgrades and other corporate actions to ensure 
the Exchange's maintenance standards are fulfilled, and monitor for any 
corporate actions that may influence the pricing of corporate debt 
securities and options thereon.

(h) Information Bulletin

    CBOE will issue a circular to its members before the initiation of 
trading in CDSOs that will describe the special characteristics of 
CDSOs. This circular will highlight the exercise methodology of the 
series, explain the cash adjustment procedures, identify the new 
symbols for the CDSO series, and identify the initial expiration months 
and strike prices available for trading.

(i) Trading Halts

    The Exchange proposes CBOE Rule 28.10 which would allow floor 
officials to consider the following factors, in addition to those set 
forth in CBOE Rule 6.3, in determining whether to halt trading in a 
CDSO:
     Whether TRACE is inoperative; and
     whether the issuer or trustee, as applicable under the 
agreements governing the underlying corporate debt security, provides 
notification to holders of the corporate debt security that the 
corporate debt security is to be redeemed in whole or part.

III. Summary of Comments and CBOE Response

    The Commission received one comment on the proposal. The commenter, 
TBMA, generally supported the proposed rule change, but suggested 
modifying it in certain respects. TBMA noted that the initial principal 
amount for bonds underlying an option is typically $500 million in the 
OTC market, and suggested that CBOE raise its threshold. CBOE responded 
that the $250 million issue threshold gave the Exchange the flexibility 
to list options on smaller issues that CBOE believed were actively 
traded.
    Furthermore, TBMA believed that the float and trading volume 
requirements may not be sufficiently high. TBMA also requested 
additional information on how the initial and ongoing trading volume 
and float would be determined by the Exchange. CBOE responded that the 
float and trading volume requirements for its CDSOs should not be 
significantly higher than for equities. Setting the listing criteria 
too high for CDSOs could prevent the listing of options on corporate 
debt securities where options could be listed on equities of the same 
issuer. CBOE also stated that it will determine the initial $200 
million float by looking at public information submitted by investors 
who are required to report their holdings.
    TBMA claimed that differences exist between CBOE's proposed margin 
requirements and other self-regulatory organizations (``SROs''). 
Specifically, TBMA notes the differences in the definition of 
``investment grade'' and the range of products eligible for portfolio 
margining. CBOE, however, believed that its proposed margin levels are 
appropriate. CBOE asserted that the definition of investment grade is 
consistent with the definition of that term as used by other SROs, and 
that CBOE's definition is more comprehensive. With respect to the range 
of equity products available for portfolio margining, CBOE stated that 
it supports the inclusion of fixed income products within the portfolio 
margining regime and expects that CDSOs will be incorporated at a later 
stage. CBOE noted that it would consider amending its margin rules at 
that time.
    TBMA requested information on how CBOE would exclude 10% holders in 
determining the total float amount. CBOE stated that the Exchange 
anticipates using Bloomberg's ``HDS'' function to obtain this 
information in a timely manner. CBOE added that the Exchange intends to 
implement monitoring procedures to identify corporate actions on an 
ongoing basis.
    TBMA claimed that the expiration date of CBOE's CDSOs differed from 
the general practice of OTC options on corporate bonds, which typically 
expire on the 20th of the relevant month. TBMA believed that this 
difference could affect how CBOE's options were used to hedge OTC 
options. CBOE stated that final trading on third Fridays allows 
settlement on Saturdays and allows dovetailing of processing of equity 
and bond options. CBOE noted that, while the 20th of the month may be 
the standard settlement date for credit index derivatives, it is not 
clear that this settlement date has been adopted for the less active 
market for CDSOs. CBOE added that it would nevertheless consider 
amending its rule to adopt this standard at a later time.
    TBMA suggested that CBOE work with the OCC to revise the Options 
Disclosure Document (``ODD'') to accommodate CDSOs, and that the ODD be 
made available for review and comment before approval of the proposal. 
In order to accommodate the listing and trading of CDSOs, CBOE expects 
that the OCC would amend its By-Laws and Rules to reflect CDSOs, which 
would be subject to public

[[Page 37554]]

comment.\13\ In addition, the Exchange believes that the OCC would seek 
to revise the ODD to incorporate CDSOs.\14\ Further, CBOE clarified 
that the Exchange is working with OCC to develop procedures to address 
actions including full and partial redemptions, conversions to 
equities, bankruptcies, conversion to new series, and other actions. 
According to CBOE, the OCC intends to use a major data vendor to 
determine the market value of the underlying corporate debt securities 
of CDSOs. The data vendor will view TRACE and several other price 
reporting services to derive a composite price for each underlying 
security on a daily basis.
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    \13\ Telephone conversation between Jennifer L. Klebes, Senior 
Attorney, CBOE and Marc McKayle, Special Counsel, Division of Market 
Regulation, Commission, on June 28, 2007.
    \14\ See also Exchange Act Rule 9b-1(b)(2)(i) which requires the 
relevant option market to file material changes to the ODD with the 
Commission, if the ODD without such changes would become inaccurate, 
incomplete, or misleading.
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IV. Discussion and Commission's Findings

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\15\ In particular, the Commission believes that 
the proposed rule change is consistent with Section 6(b)(5) of the 
Act,\16\ which requires 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 remove impediments to and perfect 
the mechanism for a free and open market and a national market system, 
and, in general, to protect investors and the public interest.
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    \15\ 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).
    \16\ 15 U.S.C. 78s(b)(5).
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    The Commission believes that the listing rules proposed by CBOE for 
CDSOs are reasonable and consistent with the Act. The Commission notes 
that, for a CDSO to be listed, the underlying corporate debt security 
must, among other things, have substantial trading volume, initial 
principal amount, and outstanding float; the issuer of the corporate 
debt security must have at least one class of equity security 
registered under Section 12(b) of the Act; and such equity securities 
must satisfy the requirements for options trading on CBOE. These 
requirements are reasonably designed to facilitate investors' access to 
information that may be necessary to price a CDSO appropriately.
    The Commission believes that the proposed position limits and 
margin rules for CDSOs are reasonable and consistent with the Act. The 
proposed position limits 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 are 
reasonably designed to deter a member or its customer from assuming an 
imprudent position in CDSOs.
    In support of the proposed rule change, the Exchange has made the 
following representations:
    1. The Exchange has sufficient operational capacity to accommodate 
the listing and trading of CDSOs.
    2. The Exchange's surveillance procedures are adequate to properly 
monitor the trading of the CDSOs.
    3. The Exchange will inform its members in an Information Circular 
of the special characteristics and risks associated with trading the 
CDSOs.
    4. The Exchange will delist CDSO series for which there is no open 
interest.
    This approval order is conditioned on the Exchange's adherence to 
these representations.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\17\ that the proposed rule change (SR-CBOE-2003-41), as modified 
by Amendment No. 4, be, and hereby is, approved.
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    \17\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\18\
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    \18\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-13275 Filed 7-9-07; 8:45 am]

BILLING CODE 8010-01-P
