

[Federal Register: August 27, 2007 (Volume 72, Number 165)]
[Notices]               
[Page 49034-49036]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr27au07-93]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56288; File No. SR-OCC-2007-06]

 
Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Granting Approval of a Proposed Rule Change Relating to Credit 
Default Basket Options

August 20, 2007.

I. Introduction

    On April 20, 2007, The Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') a

[[Page 49035]]

proposed rule change pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and on June 16, 2007, amended the 
proposed rule change. Notice of the proposal was published in the 
Federal Register on June 27, 2007 for a 15-day comment period.\2\ No 
comment letters were received. This order approves the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 55939 (June 21, 2007), 
72 FR 35291.
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II. Description

    The purpose of the proposed rule change is to permit OCC to clear 
and settle credit default basket options (``CDBOs''), which are options 
related to the creditworthiness of an issuer or guarantor (``reference 
entity'') of one or more specified debt securities (``reference 
obligations''). CDBOs are proposed to be traded by the Chicago Board 
Options Exchange (``CBOE'').\3\ Characteristics of CDBOs are described 
below, followed by an explanation of the specific rule changes being 
implemented by OCC in order that it may clear and settle them.
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    \3\ Securities Exchange Act Release Nos. 55938 (June 21, 2007), 
72 FR 35523 (June 28, 2007) (notice of filing of proposed rule 
change); 56275 (August 17, 2007) (order approving proposed rule 
change) [File No. SR-CBOE-2007-26].
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Description of Credit Default Basket Options

    CDBOs are structured as binary options with an automatic exercise 
feature.\4\ They are very similar to Credit Default Options (``CDOs'') 
that were recently approved for trading by CBOE and for clearing by OCC 
except that CDBOs are based upon multiple reference entities instead of 
a single reference entity.\5\ A CDBO will be automatically exercised 
and an exercise settlement amount will be payable if a ``credit event'' 
occurs with respect to any one of the reference entities at any time 
prior to the last day of trading. As in the case of a CDO, a ``credit 
event'' is generally defined as any failure to pay on any of the 
reference obligations or any other occurrence that constitutes an 
``event of default'' or a ``restructuring'' under the terms of any of 
the reference obligations of a particular reference entity and that the 
listing exchange has determined is a credit event for purposes of the 
CDBO.
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    \4\ ``Binary'' options (also sometimes referred to as 
``digital'' options) are ``all-or-nothing'' options that pay a fixed 
amount if automatically exercised and otherwise pay nothing.
    \5\ Securities Exchange Act Release No. 55871 (June 6, 2007), 72 
FR 32372 (June 12, 2007) [File No. SR-CBOE-2006-84]. See also 
Securities Exchange Act Release No. 55872 (June 6, 2007), 72 FR 
32693 (June 13, 2007) [File No. SR-OCC-2007-01].
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    CDBOs may be thought of as a bundle of CDOs in that there is a 
fixed exercise settlement amount that is determined for each of the 
reference entities included in the basket of reference entities 
underlying the CDBO. The exercise settlement amount may be the same for 
all of the reference entities or it may be different for each one.
    CDBOs come in two types: multiple payout CDBOs and single payout 
CDBOs. A multiple payout CDBO is automatically exercised each time 
there is a credit event affecting any one of the reference entities. 
Once the CDBO has been exercised with respect to that reference entity 
such reference entity is removed from the basket. In the unlikely event 
that a CDBO is exercised with respect to all of the reference entities 
in the basket, the expiration of the CDBO would be accelerated. A 
single payout CDBO, on the other hand, is automatically exercised only 
the first time that a credit event is confirmed with respect to any one 
of the reference entities. A single payout CDBO cannot be exercised 
again with respect to any other reference entity, and its expiration 
date would be accelerated. With either a multiple payout CDBO or a 
single payout CDBO, the exercise settlement amount will be the exercise 
settlement amount that is assigned by the listing exchange to the 
reference entity affected by the credit event.

By-Law and Rule Amendments Applicable to CDOs

    In order to accommodate trading in CDBOs, OCC is amending the By-
Law Article and Rule Chapter that it adopted for the clearance and 
settlement of CDOs.
1. Terminology--Article I, Section 1 and Article XIV, Section 1 of the 
By-Laws
    The definition of ``option contract'' in Article I of the By-Laws 
is amended to include CDBOs. ``Adjustment event'' and ``credit event'' 
are defined in Article XIV by reference to the rules of the listing 
exchange. The terms ``credit event confirmation'' and ``credit event 
confirmation deadline'' are used, respectively, to refer to the notice 
that must be provided by the listing exchange or other reporting 
authority to OCC that a credit event has occurred (and that a CDBO will 
therefore automatically be exercised) and to the deadline for receipt 
of such notice if it is to be treated as having been received on the 
business day on which it is submitted. Credit event confirmations 
received after the credit event confirmation deadline on the expiration 
date but before the expiration time will be given effect but may result 
in delayed exercise settlement.
    OCC is also defining the term ``exercise settlement amount'' in 
Article XIV for purposes of CDBOs. The exercise settlement amount of a 
CDBO is the amount specified by the listing exchange that will be paid 
in settlement when a CDBO is automatically exercised as a result of a 
credit event affecting a particular reference entity. The exercise 
settlement amount for each reference entity will be determined by the 
exchange at the time of listing when the exchange fixes the other 
variable terms for the options of a particular class or series.
    OCC is replacing the definitions of ``variable terms,'' 
``premium,'' and ``multiplier'' in Article I of the By-Laws with 
revised definitions in Article XIV, Section 1 that are applicable to 
CDBOs. The term ``class'' is also redefined in Article XIV, Section 1. 
To be within the same class, CDBOs must have the same reporting 
authority, which OCC anticipates will ordinarily be the listing 
exchange. This is necessary because of the degree of discretion that 
the reporting authority will have in determining whether a credit event 
has occurred.
    Other terms that were created or amended for CDOs will be modified 
to apply to CDBOs as well.
2. Terms of Cleared Contracts--Article VI, Section 10(e)
    A new paragraph (e) is added to Article VI, Section 10 so that an 
exchange is required to designate the exercise settlement amount and 
expiration date for a series of CDBOs at the time the series is opened 
for trading. Section 10(e) also reminds the reader that CDBOs are 
subject to adjustment under Article XIV.
3. Rights and Obligations--Article XIV, Section 2
    Article XIV, Section 2A defines the general rights and obligations 
of holders and writers of CDBOs. As noted above, the holder of a CDBO 
that is automatically exercised has the right to receive the fixed 
exercise settlement amount from OCC, and the assigned writer has the 
obligation to pay that amount to OCC.
4. Adjustments of Credit Default Basket Options--Article XIV, Section 
3; Determination of Occurrence of Credit Event--Article XIV, Section 4
    Article XIV, Section 3 provides for adjustment of CDBOs in 
accordance with the rules of the listing exchange. CBOE's rules provide 
for adjustment of

[[Page 49036]]

CDBOs in the case of certain corporate events affecting the reference 
obligations, and OCC proposes simply to defer to the rules and to the 
determinations of the listing exchange pursuant to its rules. 
Accordingly, as in the case of CDOs, OCC will have no responsibility 
for adjustment determinations with respect to CDBOs.
    Similarly, Section 4 provides that the listing exchange for a class 
of CDBOs will have responsibility for determining the occurrence of a 
credit event that will result in the automatic exercise of the CDBOs of 
that class with respect to a particular reference entity. The listing 
exchange has the obligation to provide a credit event confirmation to 
OCC in order to trigger the automatic exercise.
5. Exercise and Settlement--Chapter XV of the Rules and Rule 801
    CDBOs will not be subject to the exercise-by-exception procedures 
applicable to most other options under OCC's Rules but instead will be 
automatically exercised prior to or at expiration if the specified 
criterion for exercise is met. The procedures for the automatic 
exercise of CDBOs, as well as their assignment and settlement 
(including during periods when a clearing member is suspended), are set 
forth in Rules 1501 through 1505 of new Chapter XV and in revised Rule 
801(b).
6. Special Margin Requirements--Rule 601; Deposits in Lieu of Margin--
Rule 1506
    As in the case of CDOs, OCC will not initially margin CDBOs through 
its ``STANS'' system in the same way that other options are margined. 
Because of the fixed payout feature of CDOs and CDBOs, further systems 
development is needed to accommodate these options in STANS on a 
portfolio basis. Until such development is completed, elements of STANS 
will be used to determine the expected liquidating value of each class 
of CDBOs and CDOs by extracting certain information regarding the 
default probability from the listed equity options on the common stock 
of the reference entity and the market price of the CDBOs and CDOs. 
Expected liquidating values can then be derived from simulated price 
movements in the stock over a range of values. Thus, general principles 
of STANS will be applied, but each class of CDBOs and CDOs will be 
treated as a separate portfolio and will not be included within the 
entire portfolio of a particular account. An exception to this will be 
in the case where a firm has a net long position in CDBO or CDO 
contracts that is not required to be segregated and the risk computed 
under this methodology is less than 100% of the premium value of the 
net long position. In such a situation, the excess long value will be 
used to cover requirements associated with other cleared contracts. 
This margin methodology will result in a more conservative risk 
estimate than if the contracts were fully integrated in STANS since 
offsets in the risk calculation between these products and others will 
not be recognized except to the extent of any excess long value. 
Ultimately, CDBOs will be incorporated into the STANS system and will 
be valued and margined on a risk basis.
    OCC does not propose to accept escrow deposits in lieu of clearing 
margin for CDBOs. Therefore, Rule 1506 states that Rule 610, which 
otherwise would permit such deposits, does not apply to CDBOs.
7. Acceleration of Expiration Date--Rule 1507
    This provision permits OCC to accelerate the expiration date of a 
single payout CDBO when the option is deemed to have been automatically 
exercised on any day prior to the expiration date and to accelerate the 
expiration date of a multiple payout CDBO when the option is deemed to 
have been automatically exercised with respect to every reference 
entity underlying such option prior to the expiration date.

III. Discussion

    Section 17A(b)(3)(F) of the Act requires that the rules of a 
clearing agency be designed to promote the prompt and accurate 
clearance and settlement of securities transactions.\6\ The Commission 
finds the proposed rule change to be consistent with Section 
17A(b)(3)(F) of the Act because it is designed to promote the prompt 
and accurate clearance and settlement of transactions in, including 
exercises of, credit default basket options. The proposed rule change 
is also consistent with Section 17A(b)(3)(F) of the Act because it is 
designed to remove impediments to and perfect the mechanism of a 
national system for the prompt and accurate clearance and settlement of 
such transactions.\7\ These purposes are accomplished by having the 
clearance and settlement of CDBOs take place at OCC with OCC applying 
substantially the same rules and procedures to CDBOs as it applies to 
similar transactions in other cash-settled options.
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    \6\ 15 U.S.C. 78q-1(b)(3)(F).
    \7\ In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular Section 17A of the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-2007-06) be and hereby 
is approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\8\
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    \8\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-16839 Filed 8-24-07; 8:45 am]

BILLING CODE 8010-01-P
