

[Federal Register: December 7, 2007 (Volume 72, Number 235)]
[Notices]               
[Page 69274-69276]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07de07-95]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-56875; File No. SR-OCC-2007-08]

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

November 30, 2007.

I. Introduction

    On June 28, 2007, The Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') proposed 
rule change SR-OCC-2007-08 pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act'').\1\ Notice of the proposal 
was published in the Federal Register on September 26, 2007.\2\ No 
comment letters were received. For the reasons discussed below, the 
Commission is granting approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 56471 (September 19, 
2007), 72 FR 54705.
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II. Description

    The proposed rule change permits OCC to clear and settle binary 
options, including fixed return options (``FROs'') to be listed and 
traded by Amex \3\ and binary options on broad-based indexes proposed 
to be listed and traded by CBOE.\4\ Binary options (sometimes referred 
to as ``digital'' options) are all-or-nothing options that pay a fixed 
amount if exercised in the money and otherwise pay nothing. Until 
recently, OCC did not clear any binary options other than credit 
default options (``CDOs'') traded on CBOE. The Commission recently 
granted approval of proposed rule changes filed by OCC and CBOE so that 
CBOE could trade and OCC could clear related products called credit 
default basket options (``CDBOs'').\5\ General characteristics of 
binary options, excluding features unique to CDOs and/or CDBOs that 
were already described in OCC's prior rule filings, are described below 
followed by an explanation of the specific rule changes now being made 
by OCC.
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    \3\ Securities Exchange Act Release No. 56251 (August 14, 2007), 
72 FR 46523 (August 20, 2007) (File No. SR-Amex-2004-27).
    \4\ File No. SR-CBOE-2006-105.
    \5\ Securities Exchange Act Release Nos. 56275 (August 17, 
2007), 72 FR 47097 (August 22, 2007) (File No. SR-CBOE-2007-026) and 
56288 (August 20, 2007), 72 FR 49034 (August 27, 2007) (File No. SR-
OCC-2007-06).
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    Description of Binary Options. Binary options are cash-settled 
options that have only two possible payoff outcomes, either a fixed 
exercise settlement amount or nothing at all. They are subject to 
automatic exercise. The underlying interest of a binary option may be 
one or more securities, an index of securities, or some other measure; 
however, OCC presently intends to clear only binary options that are 
within the definition of a ``security'' as determined by the 
Commission. In its capacity as a ``derivatives clearing organization'' 
regulated by the Commodity Futures Trading Commission (``CFTC''), OCC 
may in the future propose to clear binary options that are commodity 
options subject to the jurisdiction of the CFTC.
    A binary option, other than a CDO or CDBO, is in the money and will 
be automatically exercised if its underlying interest value as measured 
against its exercise price is determined to meet the criteria for 
automatic exercise as specified in the Exchange Rules of the listing 
Exchange.\6\ For example, in the case of a ``finish high fixed return 
option,'' such option will be automatically exercised and settled for a 
fixed amount of cash if its underlying interest value is above its 
exercise price at expiration. In the case of a ``finish low fixed 
return option,'' such option will be automatically exercised and 
settled for a fixed amount of cash if its underlying interest value is 
below its exercise price at expiration. The rule changes in this 
current filing for binary options are intended to be sufficiently 
generic to be the basis for clearing binary options to be listed by 
Amex and proposed to be listed by CBOE as well as other binary options 
in the future.
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    \6\ CDOs and CDBOs, on the other hand, do not have exercise 
prices. A CDO or CDBO is deemed to be in the money and is 
automatically exercised if a ``credit event'' occurs at any time 
prior to the last day of trading.
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    By-Law and Rule Amendments Applicable to Binary Options. In order 
to provide a framework of rules that can accommodate the clearance and 
settlement of various kinds of binary option products, OCC is 
broadening the By-Law Article and Rule Chapter covering CDOs and CDBOs.
    (1) Terminology--Article I, Section 1 and Article XIV, Section 1
    ``Binary option'' is defined in Article XIV, Section 1 of the By-
Laws, and the definition is cross-referenced in Article I of the By-
Laws.
    The definitions of ``option contract'' and ``type of option'' in 
Article I of the By-Laws is amended to include a binary option.
    OCC is redefining the term ``class'' in Article XIV, Section 1 so 
that it will apply to binary options generally. To be within the same 
class, binary options

[[Page 69275]]

other than CDOs or CDBOs must cover the same underlying interest and 
have otherwise identical terms except for exercise price (if any) and 
expiration date.
    The definition of ``exercise price'' in Article I is replaced with 
respect to binary options with a revised definition in Article XIV, 
Section 1 that will recognize that binary options will be settled by a 
fixed cash payment. The exercise price of a binary option neither is an 
amount that is paid in exchange for an underlying interest nor is used 
to determine the exercise settlement amount as in the case of other 
cash-settled options. In the case of a binary option other than a CDO 
or CDBO, the exercise price of a binary option is simply a defined 
value or range of values for the underlying interest. If the underlying 
interest value falls within the defined range at expiration of such 
binary option, the option will be automatically exercised; otherwise, 
the option will expire unexercised. A CDO or CDBO is said to have no 
exercise price.
    OCC is redefining the term ``underlying interest'' in Article XIV, 
Section 1 so that it will apply to binary options generally. In the 
case of a binary option other than a CDO or CDBO, the underlying 
interest is the underlying security, securities, index, basket, or 
measure whose value is compared to such option's exercise price to 
determine whether the option is in the money and will be automatically 
exercised. In conjunction with the revised definitions of ``exercise 
price'' and ``underlying interest,'' OCC is also adding a new defined 
term, ``underlying interest value,'' to Article XIV, Section 1. When 
used with respect to a binary option other than a CDO or CDBO, 
underlying interest value means the value or level of the unit of 
trading of the underlying interest at any point in time as reported by 
the reporting authority. A new definition for the term ``unit of 
trading'' states ``unit of trading'' when used with respect to a binary 
option means the quantity of the underlying interest on which the 
underlying interest value is based and is ordinarily a single share in 
the case of binary options on individual equity securities or one (1) 
in the case of binary index options. The terms ``unit of trading'' and 
``underlying interest value'' will not be applicable to CDOs and CDBOs.
    Other terms that were created or amended for CDOs and CDBOs are 
modified to apply to binary options generally.
    (2) Terms of Cleared Contracts--Article VI, Section 10(e)
    Paragraph (e) of Article VI, Section 10 are further amended to 
apply to binary options generally.
    (3) General Rights and Obligations--Article XIV, Section 2B
    Article XIV, Section 2B defines the general rights and obligations 
of holders and writers of binary options other than CDOs or CDBOs. As 
noted above, the holder of a binary option that is automatically 
exercised will have the right to receive the fixed exercise settlement 
amount from OCC, and the assigned writer will have the obligation to 
pay that amount to OCC.
    (4) Adjustments of Binary Options Other Than CDOs or CDBOs--Article 
XIV, Section 3A; Unavailability or Inaccuracy of Final Underlying 
Interest Value--Article XIV, Section 5; Determination of Final 
Underlying Interest Value--Article XIV, Section 6
    Article XIV, Section 3A describes the methods by which binary 
options other than CDOs or CDBOs generally will be adjusted if 
adjustments are deemed to be necessary. Special adjustment rules are 
needed because of the fixed, cash-settlement feature of binary options. 
For instance, under Article VI, Section 11A(d), which governs 
adjustment of other equity options, if there is a stock dividend, 
distribution, or split whereby a whole number of shares of the 
underlying security is issued for each outstanding share, the exercise 
price is proportionately reduced, and the number of option contracts is 
increased by the number of shares issued with respect to each share of 
the underlying security. This adjustment would be inappropriate for 
binary options where the underlying interest is an equity security. For 
example, an XYZ option with an exercise price of $50 would be adjusted 
to become two XYZ options, each with an exercise price of $25. While 
the fixed exercise settlement amount of such binary option would be 
intended to remain at $100, such an adjustment would increase the total 
payout upon exercise to $200. To avoid this result, Article XIV, 
Section 3A(a)(4) will provide that the number of option contracts will 
not proportionally increase and only the exercise price will be 
adjusted. The other provisions of Article XIV, Section 3A are similar 
to Article VI, Section 11A with appropriate modifications for binary 
options. In order to maintain consistency with adjustment policies for 
physically settled stock options where such consistency is appropriate, 
certain changes in the treatment of dividends that were approved in SR-
OCC-2006-01 and were to become effective at a future date will become 
effective on the same date for binary options on single stocks.
    Article XIV, Section 3A(b) will govern adjustments of binary 
options for which the underlying interest is an index of equity 
securities and will be similar to Article XVII, Section 3, which 
governs index options, with appropriate modifications to reflect unique 
features of binary options. For instance, because binary options do not 
have an index multiplier, the Securities Committee will generally 
adjust the exercise price of a binary option of which the underlying 
interest is an index of equity securities to get the appropriate 
result.
    Article XIV, Section 5, will give OCC the authority to fix the 
underlying interest value for a binary option other than a CDO or CDBO 
and to rely on that value for determining whether such binary option 
will be exercised under circumstances similar to those in which OCC may 
currently fix the exercise settlement amount for index options.
    Article XIV, Section 6 will provide, in essence, that the 
underlying interest value of a series of binary options at expiration, 
other than CDOs or CDBOs, will be determined by the Exchange or 
Exchanges on which such series is traded subject to any overriding 
provision of OCC's By-Laws and Rules. If a series of options is traded 
on more than one Exchange, OCC could use the underlying interest value 
received from the Exchange deemed by OCC to be the principal Exchange, 
or OCC could employ a procedure to derive a single value based on some 
or all of the values received.
    (5) Exercise and Settlement--Chapter XV of the Rules and Rule 801
    Binary options will not be subject to the exercise-by-exception 
procedures applicable to most other options under OCC's Rules but will 
instead be automatically exercised prior to or at expiration if the 
specified criterion for exercise is met. The procedures for the 
automatic exercise of binary options, as well as assignment and 
settlement of exercises (including provisions applicable to a suspended 
Clearing Member), will be set forth in Rules 1501 through 1505 of new 
Chapter XV and in revised Rule 801(b).
    (6) Margin Requirements--Rule 601; Deposits in Lieu of Margin--Rule 
1506
    OCC will margin binary options through its usual ``STANS'' system. 
STANS has been modified to accommodate the particular binary options to 
be traded by Amex and the binary index product currently proposed by 
CBOE. CDOs and CDBOs will be margined as described in the applicable 
rule filings cited above.

[[Page 69276]]

    OCC is not proposing to accept escrow deposits in lieu of clearing 
margin for binary options. Therefore, Rule 1506 will state that Rule 
610, which otherwise would permit such deposits, does not apply to 
binary options.
    (7) Acceleration of Expiration Date--Rule 1507(d)
    This new provision will accelerate the expiration date of a binary 
option other than a CDO or CDBO when OCC determines in its discretion 
that the underlying interest value of such option has become fixed 
prior to the expiration of the option (e.g., where the equity security 
underlying a binary option has been converted by a merger into the 
right to receive a fixed amount of cash). If the option is out of the 
money, it will expire unexercised. Otherwise, it will be automatically 
exercised.

III. Discussion

    Section 17A(b)(3)(F) of the Act requires, among other things, that 
the rules of a clearing agency be designed to promote the prompt and 
accurate clearance and settlement of securities transactions.\7\ After 
careful review the Commission finds that the proposed rule change meets 
the requirements of Section 17A(b)(3)(F) of the Act because, by 
amending OCC's By-Laws so that OCC may clear and settle options on 
binary options that have been approved to be listed and traded on Amex 
and that have been proposed to be listed and traded on CBOE, it should 
help promote the prompt and accurate clearance and settlement of such 
securities transactions.
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    \7\ 15 U.S.C. 78q-1(b)(3)(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.\8\
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    \8\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition and 
capital formation. 15 U.S.C. 78c(f).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-2007-08) be and hereby 
is approved.

    For the Commission by the Division of Trading and Markets, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. E7-23768 Filed 12-6-07; 8:45 am]

BILLING CODE 8011-01-P
