
[Federal Register: February 4, 2010 (Volume 75, Number 23)]
[Notices]               
[Page 5831-5832]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr04fe10-87]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-61439; File No. SR-CBOE-2009-087]

 
Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Approving Proposed Rule Change To Establish a Pilot 
Program To Modify FLEX Option Exercise Settlement Values and Minimum 
Value Sizes

January 28, 2010.
    On December 3, 2009, Chicago Board Options Exchange, Incorporated 
(``CBOE'') filed with the Securities and Exchange Commission 
(``Commission''), 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 establish a pilot program to modify exercise 
settlement values and minimum value sizes for Flexible Exchange Options 
(``FLEX Options'').\3\ The proposed rule change was published for 
comment in the Federal Register on December 24, 2009.\4\ The Commission 
received six comments regarding the proposal. One commenter provided 
background information about financial derivatives as they related to 
variable annuity products,\5\ and five commenters supported the 
proposed rule change.\6\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ A FLEX option is a customized option that provides parties 
to the transaction with the ability to fix terms including the 
exercise style, expiration date, and certain exercise prices. See 
CBOE Rule 24A.4(a). A FLEX Option may be either a FLEX Index Option 
or a FLEX Equity Option.
    \4\ See Securities Exchange Act Release No. 61183 (December 16, 
2009), 74 FR 68435 (``Notice'').
    \5\ See Letter to Elizabeth M. Murphy, Secretary, Commission, 
from Mark E. White, Assistant Superintendent, Regulation Sector, 
Office of the Superintendent of Financial Institutions Canada, dated 
January 7, 2010 (noting that the Office did ``not feel comfortable 
making comments on the particular proposal,'' but wanted to 
``provide some information related to variable annuity products that 
the SEC may find helpful when considering the CBOE's submission.'').
    \6\ See Submissions via SEC WebForm from Miller Blew, CEO, Safe 
Haven Advisors, LLC, dated January 12, 2010 (supporting proposal to 
eliminate minimum size requirements); Charles L. Gilbert, President, 
Nexus Risk Management, dated January 8, 2010 (supporting the 
elimination of the p.m. settlement restriction and minimum size 
requirements as a means to enable insurers to more effectively hedge 
their risks); Ram Kelkar, Capital Markets and Trading, Milliman, 
Inc., dated January 8, 2010 (the ability to use FLEX Options as a 
hedging tool for life insurers ``should be enhanced by reducing the 
minimum size requirements and by allowing p.m. settlements for all 
days of the month''); Kannoo Ravindran, dated January 14, 2010 
(stating that the elimination of the p.m. settlement restriction and 
minimum size requirements will contribute to more effective risk 
management by institutions); Donald C. Smyth, dated January 12, 2010 
(noting that ``the more flexibility/granulatity we have in terms of 
FLEX option dates with p.m. expirations and small minimum notionals 
(preferably $0), the more effectively we can [tailor] and use FLEX 
options for our [equity indexed annuity] hedging needs.'').
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    The Exchange is proposing two pilots with this proposed rule 
change. First, CBOE is proposing to implement a fourteen-month pilot 
program to permit p.m. and specified average price settlements of FLEX 
Index Options that expire on, or within two business days of, a third-
Friday-of-the-month expiration (``Blackout Period'').\7\ Under current 
FLEX Option rules, only a.m. settlements based on opening prices of the 
underlying components of an index can be used to settle a FLEX Index 
Option if it expires within the Blackout Period. In its proposal, CBOE 
has stated that, at least two months prior to the expiration of the 
pilot program, it will provide the Commission with an annual report 
analyzing volume and open interest for each broad-based FLEX Index 
Options class overlying an Expiration Friday, p.m.-settled FLEX Index 
Options series.\8\ The annual report will also contain information and 
analysis of FLEX Options trading patterns, and index price volatility 
and underlying share trading activity for each broad-based index class 
overlying an Expiration Friday, p.m.-settled FLEX Index Option that 
exceeds certain minimum open interest parameters.\9\ The Exchange will 
also provide to the Commission, on a periodic basis, interim reports of 
volume and open interest.
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    \7\ A third-Friday-of-the-month expiration is generally referred 
to as ``Expiration Friday''.
    \8\ The annual report would also contain analyses of volume and 
open interest for Expiration Friday Non-FLEX Index series, where a 
broad-based Non-FLEX Index class overlies the same index as an 
Expiration Friday, p.m.-settled FLEX Index option. See Notice, supra 
note 4, 74 FR at 68436.
    \9\ See Notice, supra note 4, 74 FR at 68437. Any positions 
established under the pilot would not be impacted by the expiration 
of the pilot. For example, a position in a p.m.-settled FLEX Index 
Option series that expires on Expiration Friday in January 2015 
could be established during the 14-month pilot. If the pilot program 
were not extended, then the position could continue to exist. 
However, any further trading in the series would be restricted to 
transactions where at least one side of the trade is a closing 
transaction. The Exchange stated that it would notify members of 
this restriction in a circular to members. See Notice, supra note 4, 
74 FR at 68436.
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    CBOE also proposes to eliminate the minimum value size requirements 
for all FLEX Options on a fourteen-month pilot basis. CBOE will submit 
a pilot program report if it elects to extend or expand the pilot 
program, or to make the program permanent. The pilot program report 
would include data and analysis of open interest and trading volume, 
and analysis of the types of investors that initiated opening FLEX

[[Page 5832]]

Equity and Index Options transactions.\10\
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    \10\ Any positions established under this pilot would not be 
impacted by the expiration of the pilot. For example, a 10-contract 
FLEX Equity Option opening position that overlies less than $1 
million in the underlying security and expires in January 2015 could 
be established during the 14-month pilot. If the pilot program were 
not extended, then the position could continue to exist and any 
further trading in the series would be subject to the minimum value 
size requirements for continued trading in that series. See Notice, 
supra note 4, 74 FR at 68437.
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    The Commission has carefully reviewed CBOE's proposed rule change 
and finds that it is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange \11\ and, in particular, Section 6(b)(5) of the 
Act,\12\ which requires that an exchange have rules designed to 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 to protect investors and the public interest, to allow CBOE 
to conduct limited, and carefully monitored, pilots as proposed.
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    \11\ 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).
    \12\ 15 U.S.C. 78f(b)(5).
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    Since the Commission approved the initial listing and trading of 
FLEX Options in 1993,\13\ it has been concerned about the adverse 
effects and impact of p.m. settlements upon market volatility and the 
operation of fair and orderly markets on the underlying cash market at 
or near the close of trading. For example, FLEX Index Options were 
initially approved by the Commission with the restriction that they 
could not expire during the Blackout Period, which the Commission 
believed would ``diminish the impact that FLEX Options could have on 
the market.'' \14\ When the Commission approved a proposed rule change 
allowing a.m.-settled FLEX Options to expire during the Blackout 
Period, it noted that requiring FLEX Index Options expiring during the 
Blackout Period to be a.m.-settled would ``reduce the potential for 
adverse effects on the underlying component securities.'' \15\
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    \13\ See Securities Exchange Act Release No. 31920 (February 24, 
1993), 58 FR 12280 (March 3, 1993) (SR-CBOE-92-17).
    \14\ Id.
    \15\ See Securities Exchange Act Release No. 59417 (February 18, 
2009), 74 FR 8591 (February 25, 2009) (SR-CBOE-2008-115).
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    The Commission's concern about the effect upon market volatility of 
p.m. settlements for FLEX Index Options during the Blackout Period 
remains. Nevertheless, the Commission agrees with the Exchange that 
allowing p.m. and averaged price settlements for FLEX Index Options 
during the Blackout Period may allow more market participants to 
benefit from trading customized-type options in the Exchange's FLEX 
Options market rather than the OTC market.
    Moreover, the Commission believes that CBOE's proposed fourteen-
month pilot will allow for the CBOE and the Commission to monitor the 
potential for adverse market effects. In particular, the Commission 
notes that CBOE will provide the Commission with both annual and 
interim reports analyzing volume and open interest for each broad-based 
FLEX Index Options class overlying an Expiration Friday, p.m.-settled 
FLEX Index Options series. The annual report will also contain 
information and analysis of FLEX Options trading patterns, and index 
price volatility and underlying share trading activity for series that 
exceed certain minimum interest parameters. This information will 
enable the Commission to evaluate whether allowing p.m. settlements for 
FLEX Index Options during the Blackout Period has resulted in increased 
market and price volatility in the underlying component stocks. 
Further, the Exchange's position reporting requirements,\16\ along with 
the ongoing analysis of the pilot, should help the Exchange to monitor 
any potential risk from large p.m.-settled positions and take 
appropriate action if warranted.\17\
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    \16\ See CBOE Rule 24A.7; CBOE Rule 24B.7; see also CBOE Rule 
4.13.
    \17\ As to the changes allowing settlement values to be a 
specified average price, the Commission notes that when it 
originally allowed for FLEX Options to expire with a.m. settlements 
in the Blackout Period, it was unsure what potential market impact 
specified averages would have because CBOE had not established any 
average price parameters. In the current proposal, CBOE states that 
average parameters would be limited to three alternatives.
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    The Commission also believes that CBOE's proposal to eliminate 
minimum size requirements for all FLEX Options on a pilot basis is 
consistent with the Act. Historically, the intended customers of FLEX 
Options were institutional and high net worth customers, rather than 
retail customers.\18\ Although eliminating minimum size requirements 
raises the possibility that retail customers will access the FLEX 
Options market, the Commission received several comment letters noting 
that this proposal would assist institutional customers, such as 
insurance companies.\19\
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    \18\ See Securities Exchange Act Release No. 57429 (March 4, 
2008), 73 FR 13058 (March 11, 2008) (SR-CBOE-2006-36).
    \19\ See, e.g., Submission via SEC WebForm from Ram Kelkar, 
Capital Markets and Trading, Milliman, Inc., dated January 8, 2010 
(supporting the reduction of minimum size requirements and noting 
that ``[t]he ability to hedge the risk for smaller notional amounts 
is vital for small and medium-size insurance companies and for 
smaller sized liability portfolios for large insurers.'').
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    As noted above, the Exchange will be monitoring the type of 
customers initiating opening FLEX Options transactions as part of the 
minimum size pilot over its fourteen-month period. In the event the 
Exchange elects to extend, expand or make the minimum-size pilot 
permanent, this information will enable the Commission to evaluate how 
market participants have responded to this proposal, and what types of 
customers are using the FLEX Options market.
    Finally, we note that the combination of eliminating restrictions 
on settlement values during the Blackout Period, together with reducing 
the minimum size, increases the potential for the FLEX Options market 
to act as a surrogate for the non-FLEX Options market. The Commission 
has previously expressed concern that the FLEX Options market not act 
as a surrogate for trading in standardized options, especially because 
the standardized options market contains certain protections for 
investors. For example, because the FLEX Options market is designed to 
contain the benefits of an auction market with the features of 
negotiated transactions, continuous quotes may not always be 
available.\20\ In addition, due to their customized nature, FLEX 
Options do not have trading rotations at either the opening or closing 
of trading.\21\ The p.m. settlement and minimum size pilot information 
should help the Commission assess the impact on these markets as well 
as on the standardized market and determine whether other changes are 
necessary.
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    \20\ See Securities Exchange Act Release No. 59417 (February 18, 
2009), 74 FR 8591 (February 25, 2009) (SR-CBOE-2008-115).
    \21\ See Securities Exchange Act Release No. 31920 (February 24, 
1993), 58 FR 12280 (March 3, 1993) (SR-CBOE-92-17).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change (SR-CBOE-2009-087) be, and it hereby is, 
approved.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Florence E. Harmon,
Deputy Secretary.
[FR Doc. 2010-2336 Filed 2-3-10; 8:45 am]
BILLING CODE 8011-01-P

