

[Federal Register: October 15, 2007 (Volume 72, Number 198)]
[Notices]               
[Page 58341-58344]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr15oc07-79]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56631; File No. CBOE-2007-99]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Notice of Filing of Proposed Rule Change, as Modified by 
Amendment No. 1, Relating to a Delta Hedging Exemption From Equity 
Options Position Limits

October 9, 2007.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on August 21, 2007, the Chicago Board Options Exchange, Incorporated 
(``CBOE'' or ``Exchange'') filed with the Securities and Exchange 
Commission (``Commission'') a proposed rule change as described in 
Items I, II, and III below, which Items have been prepared 
substantially by the CBOE. The Exchange filed Amendment No. 1 to the 
proposal on October 4, 2007.\3\ The Commission is publishing this 
notice to solicit comments on the proposed rule change, as modified by 
Amendment No. 1, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 replaces and supersedes the previously filed 
proposed rule change in its entirety.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to create a delta hedging exemption from 
equity options position limits. The text of the proposed rule change is 
available at CBOE, the Commission's Public Reference Room, and http://www.cboe.com/legal
.


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

    In its filing with the Commission, CBOE 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 these statements may be examined at the places specified in 
Item IV below. CBOE 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
    All options traded on the Exchange are subject to position and 
exercise limits, as provided under CBOE Rules 4.11 and 4.12.\4\ 
Position limits are imposed, generally, to maintain fair and orderly 
markets for options and other securities by limiting the amount of 
control one or more affiliated persons or entities may have over one 
particular options class or the security or securities that underlie 
that options class. Exchange rules also contain various hedge 
exemptions to allow certain hedged positions in excess of the 
applicable standard position limit.\5\
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    \4\ Position limits for index options are provided separately 
under CBOE Rules 24.4, 24.4A, and 24.4B.
    \5\ See Interpretation and Policy .04 to Rule 4.11.
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    Over the years, CBOE has increased the size of options position and 
exercise limits, as well as the size and scope of available hedge 
exemptions to the applicable position limits.\6\ These hedge exemptions 
generally require a one-to-one hedge (i.e., one stock option contract 
must be hedged by the number of shares underlying the options contract, 
typically 100 shares). In practice, however, many firms do not hedge 
their options positions in this manner. Instead, these firms engage in 
what is commonly known as ``delta hedging.'' Delta hedging varies the 
number of shares of the underlying security used to hedge an options 
position based upon the relative sensitivity of the value of the option 
contract to a change in the price of the underlying security.\7\ Delta 
hedging is a widely accepted method for risk management.
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    \6\ See, e.g., Securities Exchange Act Release No. 55176 
(January 25, 2007), 72 FR 4741 (February 1, 2007) (SR-CBOE-2007-08); 
Securities Exchange Act Release No. 51244 (February 23, 2005), 70 FR 
10010 (March 1, 2005) (SR-CBOE-2003-30); and Securities Exchange Act 
Release No. 45603 (March 20, 2002), 67 FR 14751 (March 27, 2002) 
(SR-CBOE-00-12).
    \7\ To illustrate, a stock option contract with a delta of .5 
will move $0.50 for every $1.00 move in the underlying stock.
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    Delta Neutral-Based Equity Hedge Exemption. The Exchange proposes 
to adopt a new exemption from equity options position and exercise 
limits \8\ for positions held by CBOE members and certain of their 
affiliates that are ``delta

[[Page 58342]]

neutral'' \9\ under a ``permitted pricing model'' (as defined below), 
subject to certain conditions (``Exemption''). The proposed Exemption 
would apply only to equity options (stock options and options on 
exchange-traded funds (``ETFs'')).\10\
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    \8\ Rule 4.12 establishes exercise limits for an option at the 
same level as the option's position limit under Rule 4.11; 
therefore, no changes are proposed to Rule 4.12.
    \9\ The term ``delta neutral'' is defined in proposed Rule 
4.11.04(c)(A) as referring to an equity option position that is 
hedged, in accordance with a permitted pricing model, by a position 
in the underlying security or one or more instruments relating to 
the underlying security, for the purpose of offsetting the risk that 
the value of the option position will change with incremental 
changes in the price of the security underlying the option position.
    \10\ The Exchange intends to submit a separate proposed rule 
change to adopt a delta neutral-based hedge exemption for certain 
index options and to expand the delta neutral-based hedge exemption 
for ETF options to allow highly correlated instruments to be 
included in any ETF option net delta calculation.
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    Any equity option position that is not delta neutral would be 
subject to position and exercise limits, subject to the availability of 
other exemptions. Only the ``option contract equivalent of the net 
delta'' of such position would be subject to the appropriate position 
limit.\11\
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    \11\ Under proposed Rule 4.11.04(c)(B), the term ``options 
contract equivalent of the net delta'' is defined as the net delta 
divided by the number of shares underlying the option contract, and 
the term ``net delta'' is defined as, at any time, the number of 
shares (either long or short) required to offset the risk that the 
value of an equity option position will change with incremental 
changes in the price of the security underlying the option position, 
as determined in accordance with a permitted pricing model.
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    Only financial instruments relating to the security underlying an 
equity options position could be included in any determination of an 
equity options position's net delta or whether the options position is 
delta neutral. In addition, members could not use the same equity or 
other financial instrument position in connection with more than one 
hedge exemption. Therefore, a stock position used as part of a delta 
hedging strategy could not also serve as the basis for any other equity 
hedge exemption.
    Permitted Pricing Model. Under the proposed rule, the calculation 
of the delta for any equity option position, and the determination of 
whether a particular equity option position is delta neutral, must be 
made using a permitted pricing model. A ``permitted pricing model'' is 
defined in proposed Rule 4.11.04(c)(C) to mean the pricing model 
maintained and operated by The Options Clearing Corporation (``OCC'') 
and the pricing models used by (i) A member or its affiliate subject to 
consolidated supervision by the Commission pursuant to Appendix E of 
Rule 15c3-1 under the Act; (ii) a financial holding company (``FHC'') 
or a company treated as an FHC under the Bank Holding Company Act of 
1956, or its affiliate subject to consolidated holding company group 
supervision; \12\ (iii) a Commission-registered OTC derivatives dealer; 
\13\ and (iv) a national bank.\14\
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    \12\ The pricing model of an FHC or of an affiliate of an FHC 
would have to be consistent with: (i) The requirements of the Board 
of Governors of the Federal Reserve System (``FRB''), as amended 
from time to time, in connection with the calculation of risk-based 
adjustments to capital for market risk under capital requirements of 
the FRB, provided that the member or affiliate of a member relying 
on this exemption in connection with the use of such model is an 
entity that is part of such company's consolidated supervised 
holding company group; or (ii) the standards published by the Basel 
Committee on Banking Supervision, as amended from time to time and 
as implemented by such company's principal regulator, in connection 
with the calculation of risk-based deductions or adjustments to or 
allowances for the market risk capital requirements of such 
principal regulator applicable to such company--where ``principal 
regulator'' means a member of the Basel Committee on Banking 
Supervision that is the home country consolidated supervisor of such 
company--provided that the member or affiliate of a member relying 
on this exemption in connection with the use of such model is an 
entity that is part of such company's consolidated supervised 
holding company group. See subparagraph (C)(3) of proposed Rule 
4.11.04(c).
    \13\ The pricing model of a Commission-registered OTC 
derivatives dealer would have to be consistent with the requirements 
of Appendix F to Rules 15c3-1 and 15c3-4 under the Act, as amended 
from time to time, in connection with the calculation of risk-based 
deductions from capital for market risk thereunder. Only an OTC 
derivatives dealer and no other affiliated entity (including a 
member) would be able to rely on this part of the Exemption. See 
subparagraph (C)(4) of proposed Rule 4.11.04(c).
    \14\ The pricing model of a national bank would have to be 
consistent with the requirements of the Office of the Comptroller of 
the Currency, as amended from time to time, in connection with the 
calculation of risk-based adjustments to capital for market risk 
under capital requirements of the Office of the Comptroller of the 
Currency. Only a national bank and no other affiliated entity 
(including a member) would be able to rely on this part of the 
Exemption. See subparagraph (C)(5) of proposed Rule 4.11.04(c).
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    Aggregation of Accounts. Members and non-member affiliates relying 
on the Exemption would be required to ensure that the permitted pricing 
model is applied to all positions in or relating to the security 
underlying the relevant options position that are owned or controlled 
by the member, or its affiliates.
    However, the net delta of an options position held by an entity 
entitled to rely on the Exemption, or by a separate and distinct 
trading unit of such entity, may be calculated without regard to 
positions in or relating to the security underlying the option position 
held by an affiliated entity or by another trading unit within the same 
entity, provided that: (i) The entity demonstrates to the Exchange's 
satisfaction that no control relationship, as defined in Rule 4.11.03, 
exists between such affiliates or trading units, and (ii) the entity 
has provided the Exchange written notice in advance that it intends to 
be considered separate and distinct from any affiliate, or, as 
applicable, which trading units within the entity are to be considered 
separate and distinct from each other for purposes of the 
Exemption.\15\
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    \15\ See subparagraph (D) of proposed Rule 4.11.04(c).
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    The Exchange has set forth in Regulatory Circular RG04-45 
(``Aggregation Circular'') the conditions under which it will deem no 
control relationship to exist between affiliated broker-dealers and 
between separate and distinct trading units within the same broker-
dealer. The Exchange proposes to amend the Aggregation Circular to 
include affiliated entities, not only affiliated broker-dealers as in 
the current version.
    Any member or non-member affiliate relying on the Exemption must 
designate, by prior written notice to the Exchange, each trading unit 
or entity whose options positions are required by Exchange rules to be 
aggregated with the options positions of such member or non-member 
affiliate relying on the Exemption for purposes of compliance with 
Exchange position or exercise limits.\16\
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    \16\ See proposed Rule 4.11.04(c)(D)(3).
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    Obligations of Members and Affiliates. Any member relying on the 
Exemption would be required to provide a written certification to the 
Exchange that it is using a permitted pricing model as defined in the 
rule for purposes of the Exemption. In addition, by such reliance, such 
member would authorize any other person carrying for such member an 
account including, or with whom such member has entered into, a 
position in or relating to a security underlying the relevant option 
position to provide to the Exchange or OCC such information regarding 
such account or position as the Exchange or OCC may request as part of 
the Exchange's confirmation or verification of the accuracy of any net 
delta calculation under this Exemption.\17\
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    \17\ See subparagraph (E) of proposed Rule 4.11.04(c).
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    The options positions of a non-member affiliate relying on the 
Exemption must be carried by a member with which it is affiliated. A 
member carrying an account that includes an equity option position for 
a non-member affiliate that intends to rely on the Exemption would be 
required to obtain from such non-member affiliate a written 
certification that it is using a

[[Page 58343]]

permitted pricing model as defined in the rule for purposes of the 
Exemption.\18\
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    \18\ In addition, the member would be required to obtain from 
such non-member affiliate a written statement confirming that such 
non-member affiliate: (a) Is relying on the Exemption; (b) will use 
only a permitted pricing model for purposes of calculating the net 
delta of its option positions for purposes of the Exemption; (c) 
will promptly notify the member if it ceases to rely on the 
Exemption; (d) authorizes the member to provide to the Exchange or 
the OCC such information regarding positions of the non-member 
affiliate as the Exchange or OCC may request as part of the 
Exchange's confirmation or verification of the accuracy of any net 
delta calculation under the Exemption; and (e) if the non-member 
affiliate is using the OCC Model, has duly executed and delivered to 
the Exchange such documents as the Exchange may require to be 
executed and delivered to the Exchange as a condition to reliance on 
the Exemption. See subparagraph (E)(3) of proposed Rule 4.11.04(c).
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    Reporting. Under proposed Rule 4.11.04(c)(F), each member relying 
on the Exemption would be required to report, in accordance with Rule 
4.13,\19\ (i) All equity option positions (including those that are 
delta neutral) that are reportable thereunder, and (ii) on its own 
behalf or on behalf of a designated aggregation unit pursuant to Rule 
4.11.04(c)(D), for each such account that holds an equity option 
position subject to the Exemption in excess of the levels specified in 
Rule 4.11, the net delta and the options contract equivalent of the net 
delta of such position.
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    \19\ Exchange Rule 4.13 requires, among other things, that 
members report to the Exchange aggregate long or short positions on 
the same side of the market of 200 or more contracts of any single 
class of options contracts dealt in on the Exchange.
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    The Exchange and other self-regulatory organizations are working on 
modifying the Large Options Position Report system and/or OCC reports 
to allow a member to indicate that an equity options position is delta 
neutral.
    Records. Under proposed Rule 4.11.04(c)(G), each member relying on 
the Exemption would be required to (i) Retain, and would be required to 
undertake reasonable efforts to ensure that any non-member affiliate of 
the member relying on the exemption retains, a list of the options, 
securities and other instruments underlying each options position net 
delta calculation reported to the Exchange hereunder, and (ii) produce 
such information to the Exchange upon request.\20\
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    \20\ A member would be authorized to report position information 
of its non-member affiliate pursuant to the written statement 
required under proposed Rule 4.11.04(c)(E)(3)(ii)(d).
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    Reliance on Federal Oversight. As provided under proposed Rule 
4.11.04(c)(C), a permitted pricing model includes proprietary pricing 
models used by members and affiliates that have been approved by the 
Commission, the FRB or another federal financial regulator. In adopting 
the proposed Exemption the Exchange would be relying upon the rigorous 
approval processes and ongoing oversight of a federal financial 
regulator. The Exchange notes that it would not be under any obligation 
to verify whether a member's or its affiliate's use of a proprietary 
pricing model is appropriate or yielding accurate results.
    CBOE will announce the effective date of the proposed rule change 
in a regulatory circular to be published no later than 60 days after 
Commission approval. The effective date shall be no later than 30 days 
after publication of the regulatory circular.
2. Statutory Basis
    The Exchange believes that its proposal is consistent with section 
6(b) of the Act,\21\ in general, and furthers the objectives of section 
6(b)(5) of the Act,\22\ in particular, in that it is designed in 
particular, in that it is designed to prevent fraudulent and 
manipulative acts and practices, promote just and equitable principles 
of trade, 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 Exchange believes the proposed 
delta neutral-based hedge exemption from equity options position and 
exercise limits is appropriate in that it is based on a widely accepted 
risk management method used in options trading. Also, the Commission 
has previously stated its support for recognizing options positions 
hedged on a delta neutral basis as properly exempted from position 
limits.\23\
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    \21\ 15 U.S.C. 78f(b).
    \22\ 15 U.S.C. 78f(b)(5).
    \23\ See Securities Exchange Act Release No. 40594 (October 23, 
1998), 63 FR 59362, 59380 (November 3, 1998) (S7-30-97) (adopting 
rules relating to OTC Derivatives Dealers).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange believes that the proposed rule change will not impose 
any burden on competition 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 either solicited or received.

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 CBOE 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-2007-99 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-2007-99. 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, 100 F Street, NE., 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m.

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Copies of the filing also will be available for inspection and copying 
at the principal office of the CBOE. All comments received will be 
posted without change; the Commission does not edit personal 
identifying information from submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-CBOE-2007-99 and should be submitted on 
or before November 5, 2007.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\24\
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    \24\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
 [FR Doc. E7-20216 Filed 10-12-07; 8:45 am]

BILLING CODE 8011-01-P
