
[Federal Register: February 29, 2008 (Volume 73, Number 41)]
[Notices]               
[Page 11170-11173]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr29fe08-128]                         

-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-57360; File No. SR-ISE-2008-06]

 
Self-Regulatory Organizations; International Securities Exchange, 
LLC; Notice of Filing and Immediate Effectiveness of Proposed Rule 
Change To Create a Delta Hedging Exemption from Equity Options Position 
Limits

February 20, 2008.
    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 February 1, 2008, the International Securities

[[Page 11171]]

Exchange, LLC (``ISE'' or ``Exchange'') filed with the Securities and 
Exchange Commission (``Commission'') the proposed rule change as 
described in Items I and II below, which Items have been substantially 
prepared by ISE. The Exchange has filed the proposal as a ``non-
controversial'' rule change pursuant to Section 19(b)(3)(A) of the Act 
\3\ and Rule 19b-4(f)(6) thereunder,\4\ which renders it effective upon 
filing with the Commission. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ 15 U.S.C. 78s(b)(3)(A).
    \4\ 17 CFR 240.19b-4(f)(6).
---------------------------------------------------------------------------

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 pursuant to ISE Rule 413 (Exemptions 
from Position Limits). The text of the proposed rule change is 
available at ISE, the Commission's Public Reference Room, and http://
www.ise.com.

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

    In its filing with the Commission, ISE 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. ISE 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 ISE Rules 412 and 413.\5\ 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.\6\
---------------------------------------------------------------------------

    \5\ Position limits for index options are provided separately 
under Rules 2004, 2005, and 2006.
    \6\ See Rule 413.
---------------------------------------------------------------------------

    Over the years, ISE 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.\7\ 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.\8\ Delta 
hedging is a widely accepted method for risk management.
---------------------------------------------------------------------------

    \7\ See, e.g., Securities Exchange Act Release Nos. 56493 
(September 21, 2007), 72 FR 55266 (September 28, 2007); 56263 
(August 15, 2007), 72 FR 47105 (August 22, 2007); and 56020 (July 6, 
2007), 72 FR 38109 (July 12, 2007).
    \8\ To illustrate, a stock option contract with a delta of .5 
will move $0.50 for every $1.00 move in the underlying stock.
---------------------------------------------------------------------------

    Delta Neutral-Based Equity Hedge Exemption. The Exchange proposes 
to adopt a new exemption from equity options position and exercise 
limits \9\ for positions held by ISE members and certain of their 
affiliates that are ``delta neutral'' \10\ 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'')).\11\
---------------------------------------------------------------------------

    \9\ Rule 414 establishes exercise limits for an option at the 
same level as the option's position limit under Rule 412; therefore, 
no changes are proposed to Rule 414.
    \10\ The term ``delta neutral'' is defined in proposed Rule 
413(a)(7)(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.
    \11\ 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.
---------------------------------------------------------------------------

    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.\12\
---------------------------------------------------------------------------

    \12\ Under proposed Rule 413(a)(7)(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.
---------------------------------------------------------------------------

    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 413(a)(7)(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; (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; 
\13\ (iii) an

[[Page 11172]]

SEC registered OTC derivatives dealer; \14\ and (iv) a national 
bank.\15\
---------------------------------------------------------------------------

    \13\ 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 proposed Rule 413(a)(7)(C)(3).
    \14\ 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 
proposed Rule 413(a)(7)(C)(4).
    \15\ 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 proposed Rule 413(a)(7)(C)(5).
---------------------------------------------------------------------------

    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 412(f), 
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.\16\
---------------------------------------------------------------------------

    \16\ See proposed Rule 413(a)(7)(D)(2).
---------------------------------------------------------------------------

    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.\17\
---------------------------------------------------------------------------

    \17\ See proposed Rule 413(a)(7)(D)(3).
---------------------------------------------------------------------------

    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.\18\
---------------------------------------------------------------------------

    \18\ See proposed Rule 413(a)(7)(E).
---------------------------------------------------------------------------

    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 permitted pricing model as defined in 
the rule for purposes of the Exemption.\19\
---------------------------------------------------------------------------

    \19\ 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 413(a)(7).
---------------------------------------------------------------------------

    Reporting. Under proposed Rule 413(a)(7)(F), each member relying on 
the Exemption would be required to report, in accordance with Rule 
415\20\ (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 
413(a)(7)(F), for each such account that holds an equity option 
position subject to the Exemption in excess of the levels specified in 
Rule 413, the net delta and the options contract equivalent of the net 
delta of such position.
---------------------------------------------------------------------------

    \20\ Rule 415 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.
---------------------------------------------------------------------------

    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 413(a)(7)(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.\21\
---------------------------------------------------------------------------

    \21\ A member would be authorized to report position information 
of its non-member affiliate pursuant to the written statement 
required under proposed Rule 413(a)(7)(E)(3)(ii)(d).
---------------------------------------------------------------------------

    Reliance on Federal Oversight. As provided under proposed Rule 413, 
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.
    The Exchange will issue a regulatory circular stating the operative 
date and describing the substantive terms of the proposed rule change 
no later than 60 days after the Commission issues notice of the 
proposed rule change. The operative date shall be such date as may be 
necessary to ensure that necessary technology changes to The Options 
Clearing Corporation and the Securities Industry Automation Corporation 
reports used for position limit surveillance have been completed.\22\
---------------------------------------------------------------------------

    \22\ Telephone conversation between John Rademacher, Assistant 
General Counsel, ISE, and Ira Brandriss, Special Counsel, Division 
of Trading and Markets, Commission, on February 19, 2008.
---------------------------------------------------------------------------

2. Statutory Basis
    The Exchange believes the rule proposal is consistent with the Act 
and the rules and regulations thereunder applicable to a national 
securities exchange and, in particular, the requirements of Section 
6(b) of the Act.\23\ Specifically, the Exchange believes that the 
proposed rule change is consistent with the Section 6(b)(5)\24\ Act 
requirements that the rules of an exchange be designed to promote just

[[Page 11173]]

and equitable principles of trade, to prevent fraudulent and 
manipulative acts 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.\25\
---------------------------------------------------------------------------

    \23\ 15 U.S.C. 78f(b).
    \24\ 15 U.S.C. 78f(b)(5).
    \25\ See Securities Exchange Act Release No. 40594 (October 23, 
1998), 63 FR 59362, 59380 (November 3, 1998) (adopting rules 
relating to OTC Derivatives Dealers).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition that is 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

    The Exchange has not solicited, and does no intend to solicit, 
comments on this proposed rule change. The Exchange has not received 
any unsolicited written comments from members or other interested 
parties.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Because the foregoing rule change does not: (1) Significantly 
affect the protection of investors or the public interest; (2) impose 
any significant burden on competition; and (3) become operative for 30 
days after the date of this filing, or such shorter time as the 
Commission may designate, it has become effective pursuant to Section 
19(b)(3)(A) of the Act\26\ and Rule 19b-4(f)(6) thereunder.\27\
---------------------------------------------------------------------------

    \26\ 15 U.S.C. 78s(b)(3)(A).
    \27\ CFR 240.19b-4(f)(6).
---------------------------------------------------------------------------

    A proposed rule change filed under 19b-4(f)(6) normally may not 
become operative prior to 30 days after the date of filing.\28\ 
However, Rule 19b-4(f)(6)(iii)\29\ permits the Commission to designate 
a shorter time if such action is consistent with the protection of 
investors and the public interest. The Exchange has requested that the 
Commission waive the 30-day operative delay. The Commission believes 
that waiving the 30-day operative delay is consistent with the 
protection of investors and the public interest because such waiver 
would allow the Exchange to implement the delta hedging exemption from 
equity options position limits without needless delay. The Commission 
notes that it recently approved a substantially similar proposal filed 
by the Chicago Board Options Exchange, Incorporated.\30\ The Commission 
believes that ISE's proposal to create a delta hedging exemption from 
equity options position limits raises no new issues. For these reasons, 
the Commission designates the proposed rule change to be operative upon 
filing with the Commission.\31\
---------------------------------------------------------------------------

    \28\ 17 CFR 240.19b-4(f)(6)(iii). In addition, Rule 19b-
4(f)(6)(iii) requires that a self-regulatory organization submit to 
the Commission written notice of its intent to file the proposed 
rule change, along with a brief description and text of the proposed 
rule change, at least five business days prior to the date of filing 
of the proposed rule change, or such shorter time as designated by 
the Commission. The Exchange has satisfied the five-day pre-filing 
notice requirement.
    \29\ Id.
    \30\ See Securities Exchange Act Release No. 56970 (December 14, 
2007), 72 FR 72428 (December 20, 2007) (SR-CBOE-2007-99).
    \31\ For the purposes only of waiving the 30-day operative 
delay, the Commission has considered the proposed rule's impact on 
efficiency, competition, and capital formation. See 15 U.S.C. 
78c(f).
---------------------------------------------------------------------------

    At any time within 60 days of the filing of such proposed rule 
change the Commission may summarily abrogate such rule change if it 
appears to the Commission that such action is necessary or appropriate 
in the public interest, for the protection of investors or otherwise in 
furtherance of the purposes of the Act.

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-ISE-2008-06 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-ISE-2008-06. 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. Copies of the filing also will be available for 
inspection and copying at the principal office of ISE. 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-ISE-2008-06 and should be 
submitted on or before March 21, 2008.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\32\
---------------------------------------------------------------------------

    \32\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Florence E. Harmon,
Deputy Secretary.
 [FR Doc. E8-3842 Filed 2-28-08; 8:45 am]

BILLING CODE 8011-01-P
