
[Federal Register Volume 77, Number 22 (Thursday, February 2, 2012)]
[Notices]
[Pages 5286-5289]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-2237]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-66265; File No. SR-CBOE-2011-007]


Self-Regulatory Organizations; Chicago Board Options Exchange, 
Incorporated; Order Approving a Proposed Rule Change To Adopt Rules 
Governing S&P 500 Option Variance Basket Trades

January 27, 2012.

I. Introduction

    On October 26, 2011, Chicago Board Options Exchange, Incorporated 
(``Exchange'' or ``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 adopt rules in connection with 
a mechanism to quote for, and trade, at a single aggregate price, a 
basket of S&P 500 Index Options comprising a pre-specified series of 
listed calls and puts that are constructed to assist market 
participants who use such baskets of options as part of a trading 
strategy to obtain or hedge variance exposure on the S&P 500 Index. The 
proposed rule change was published for comment in the Federal Register 
on November 16, 2011.\3\ The Commission received one comment letter on 
the proposed rule change.\4\ This order approves the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 65725 (November 10, 
2011), 76 FR 71092 (``Notice'').
    \4\ See Letter dated December 14, 2011, from Angelo Evangelou, 
Assistant General Counsel, Legal Division, CBOE, to Elizabeth M. 
Murphy, Secretary, Commission (``CBOE Letter'').
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II. Description of the Proposed Rule Change

    The Exchange is proposing a new offering, called S&P 500 Variance 
Trades (``Variance Trades''), which will allow market participants to 
trade a basket of pre-specified series of S&P 500 Index options (``SPX 
options'') in a single transaction. Each pre-specified basket of series 
of options offered by the Exchange will be constructed using a 
methodology designed to produce options baskets that can be used by 
market participants as part of a trading strategy to obtain or hedge 
variance exposure on the S&P 500 Index.\5\ Currently, a trader would 
need to separately purchase or sell each of the options in a pre-
specified Variance Trade basket to acquire this type of options 
exposure. In its filing, the Exchange notes that demand for volatility 
products has increased in recent years, and believes that the proposed 
Variance Trades would provide investors with an additional way to 
efficiently trade S&P 500 volatility.\6\
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    \5\ The Exchange notes that Variance Trades do not replicate 
variance swaps. See Notice, supra note 3, 76 FR 71092, n.4. The 
Commission understands that Variance Trades could be useful to 
market participants who employ trading strategies to hedge or 
replicate variance swaps on the S&P 500 Index. A variance swap is a 
derivative in which two counterparties agree to exchange future cash 
flows based on the realized level of volatility of a tradable 
financial instrument over a pre-specified, future period of time.
    \6\ See Notice, supra note 3, 76 FR 71092, text accompanying 
n.4. See also CBOE Letter, supra note 4, at 3.
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    A Variance Trade consists of a basket of SPX options across 
different series, where the constituent options of the basket are put 
and call options with the same expiration date that are centered around 
an at-the-money strike price.\7\ The Exchange will make one or more 
Variance Trade baskets available for trading each day. Each basket will 
consist of a portfolio of SPX options defined by the Exchange the day 
before it is available for trading. Each basket will have a unique 
ticker symbol.
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    \7\ Detailed examples of how Variance Trades would be 
constructed and executed on the Exchange are provided in the Notice. 
See Notice, supra note 3.
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    Unlike a typical multi-legged option transaction whose price is 
expressed as a net dollar price, the price of a Variance Trade will be 
quoted in ``volatility terms'' (i.e., a single number that reflects an 
aggregate implied volatility for the entire options basket). Trade 
quantities will be expressed in contracts, and each contract will have 
a multiplier of $10,000 or more, as determined and announced by the 
Exchange in advance.\8\ The Exchange expects typically to specify a 
higher multiplier than $10,000, but has proposed to establish a $10,000 
minimum to allow greater flexibility for short-dated options and low 
volatility levels.\9\
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    \8\ The multiplier for Variance Trades represents the aggregate 
``vega'' exposure of the SPX option series that comprise the 
Variance Trade portfolio. Vega describes the change in value of a 
contract corresponding to a one-point change in volatility.
    \9\ See Notice, supra note 3, at n.6.
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    A participant will submit a Variance Trade order with a limit price 
expressed in terms of volatility (market orders would not be permitted) 
and a contract size.\10\ Market makers also will be allowed to provide 
quotes for Variance Trade baskets. Orders and quotes will be ranked 
pursuant to one of the matching algorithms set forth in CBOE Rule 
6.45A, which may be different from the matching algorithm in place for 
other option products, including SPX. Once a Variance Trade match 
occurs, the Exchange will use a formula to deconstruct the trade into 
individual trades in the constituent SPX options that compose the 
basket, and those individual trades each will be sent to OPRA as 
separate trades.\11\
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    \10\ Variance Trades will trade only electronically.
    \11\ See Notice, supra note 3, 76 FR 71093 (setting forth the 
formula).
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    The algorithm that deconstructs a Variance Trade into its 
constituent SPX option legs uses a two step process. First, based on 
the matched implied volatility (i.e., the price of the trade), the 
system will calculate the exact number of contracts for each SPX option 
series composing the Variance Trade.\12\ Second, the system will 
calculate resulting trade prices for each SPX option series through an 
iterative process in which current implied volatilities for each option 
series are collectively adjusted upwards or downwards until the 
aggregate implied volatility of the overall basket equals the matched 
implied volatility as quoted. The individual price of any given option 
series in the basket generally would not be the same as (or directly 
related to) the prevailing market price for that series because the 
entire basket will be priced in the aggregate in order to reflect the 
desired volatility level.
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    \12\ Unlike a typical complex order, the terms of a Variance 
Trade order would not pre-specify the number of contracts for each 
individual series composing the trade. These quantities instead 
depend on the implied volatility of the options basket itself, which 
is not known until a matched implied volatility for a trade has been 
determined.
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    The Exchange's proposal will allow the constituent SPX option 
trades of a Variance Trade to be executed and reported without regard 
to existing bids and offers on the Exchange in the individual SPX 
options series at the time of the transaction.\13\ Once prices are 
determined for a trade in each constituent series, the system will 
execute and report the constituent trades to OPRA.\14\ In addition, the 
executions in the individual constituent series will be sent to the 
Options

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Clearing Corporation (``OCC'') for clearing.
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    \13\ See Notice, supra note 3, 76 FR 71093.
    \14\ To highlight that executions of Variance Trades are not 
associated with the quoted prices in the respective SPX series at 
the time of execution, each constituent SPX option execution will be 
reported to OPRA with the ``benchmark'' indicator. The benchmark 
indicator was created to facilitate the execution of benchmark 
orders as contemplated by the Options Order Protection and Locked/
Crossed Market Plan (the ``Linkage Plan''). A benchmark order is an 
order for which the price is not based, directly or indirectly, on 
the quoted price of the option at the time of the order's execution 
and for which the material terms were not reasonably determinable at 
the time a commitment to trade the order was made.
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    As there are no position limits for SPX options, the Exchange did 
not propose any position limits for executions associated with Variance 
Trades. Reporting limits applicable to SPX options will apply pursuant 
to CBOE Rule 24.4, Interpretation and Policy .03.
    The Exchange expects Variance Trades to appeal to institutional 
users and not to retail customers.\15\ Because of the complex nature of 
Variance Trades, the Exchange will only allow orders in Variance Trades 
to be submitted by members who have affirmatively communicated to the 
Exchange a desire to submit orders in Variance Trades. Thus, retail 
brokerage firms (or any other firms) that have not specifically opted 
to submit orders in Variance Trades will not be allowed to send such 
orders to CBOE (any such orders from such firms will be rejected).
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    \15\ See id. at 71101.
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    The Exchange represents that appropriate surveillance will be in 
place in connection with Variance Trades.\16\ Further, the Exchange 
states that it has analyzed its capacity and represents that it and the 
Options Price Reporting Authority have the necessary systems capacity 
to handle the additional traffic that it expects will be associated 
with Variance Trades.\17\
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    \16\ See id.
    \17\ See id.
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III. Discussion and Commission's Findings

    After careful review, the Commission finds that the proposed rule 
change is consistent with the requirements of Section 6 of the Act \18\ 
and the rules and regulations thereunder applicable to a national 
securities exchange.\19\ In particular, the Commission finds that the 
proposed rule change is consistent with Section 6(b)(5) of the Act,\20\ 
which requires, among other things, that the Exchange's rules be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in facilitating transactions in 
securities, to 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.
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    \18\ 15 U.S.C. 78f.
    \19\ 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).
    \20\ 15 U.S.C. 78f(b)(5).
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    The introduction of Variance Trades is designed to allow 
professional market participants to more efficiently trade an entire 
option portfolio to obtain or hedge variance exposure on the S&P 500 
Index. Such traders otherwise would need to purchase or sell each 
option individually to acquire exposure to such a basket of options in 
a complex web of simultaneously-executed transactions that is very 
difficult to reproduce as a series of individual trades. To the extent 
that traders currently seek out similar products offered on the over-
the-counter securities markets, the proposed rule change will permit 
them to trade Variance Trades on a registered national securities 
exchange. The Commission believes that the proposal will benefit 
participants by providing an alternative to the over-the-counter market 
through the functionality to trade these baskets of exchange-listed 
options in a national securities exchange environment that offers the 
potential of enhanced liquidity, transparency, and oversight, and where 
counterparty risk can be mitigated through the role of OCC. Moreover, 
the requirement that permit holders affirmatively indicate to the 
Exchange a desire to transact in Variance Trades before the Exchange 
accepts and processes orders from such firms will serve as an 
additional safeguard to protect against the inadvertent submission of 
Variance Trade orders.
    In the Notice, the Commission sought comment on two particular 
issues relating to the proposed Variance Trades: (1) Allowing the 
constituent SPX option trades of a Variance Trade to be executed and 
reported without regard to existing bids and offers on the Exchange in 
SPX at the time of the transaction; and (2) use of the benchmark 
indicator when reporting the constituent legs of a Variance Trade.\21\ 
CBOE submitted a letter in response to the Commission's request for 
comments, urging the Commission to approve its proposal.\22\ The 
Commission did not receive any other comments.
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    \21\ See Notice, supra note 3, 76 FR 71102.
    \22\ See CBOE Letter, supra note 4.
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    On the first point, the Commission requested commenters' opinions 
on whether allowing the constituent SPX option legs of a Variance Trade 
to be executed and reported without regard for existing bids and offers 
on the Exchange in SPX at the time of the transaction would be 
consistent with the Exchange Act and what, if any, potential impact 
this proposal might have on market participants.\23\ As noted above, 
the Commission received no comments except from CBOE.
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    \23\ See Notice, supra note 3, 76 FR 71102.
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    While multi-leg complex orders can trade on CBOE at the same price 
as existing booked interest on CBOE for one or more legs only if they 
improve the price on another leg,\24\ Variance Trades will have no 
similar restrictions, and the constituent legs could thus trade without 
regard to quotes and orders with priority on CBOE's book.\25\ 
Exceptions from intra-market priority can raise concerns relating to 
the protection of resting quotes and orders on an exchange's book and 
the potential impact on the price discovery process.\26\
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    \24\ See CBOE Rule 6.45(B)(b)(ii).
    \25\ Because SPX options are singly-listed on CBOE, and because 
the only components of a Variance Trade will be SPX options, CBOE's 
proposal does not implicate inter-market order protection concerns.
    \26\ See e.g.,Securities Exchange Act Release No. 63955 
(February 24, 2011), 76 FR 11533, at 11540 (March 2, 2011) (SR-ISE-
2010-73).
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    In its letter, the Exchange argues that orders and quotes in 
individual SPX options series would not be disadvantaged when the 
various legs of a deconstructed Variance Trade execute, because traders 
in the individual SPX option series are not bidding for or offering the 
entire Variance Trade, which is the relevant order being executed.\27\ 
While true, that argument is inconsistent with the treatment of other 
complex orders, noted above, which are required to interact with 
resting orders with priority except under limited circumstances.
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    \27\ See CBOE Letter, supra note 4, at 2.
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    In addition, CBOE believes that requiring the deconstructed 
components of a Variance Trade to interact with orders resting on the 
CBOE's SPX book would impede and frustrate traders' desire to enter 
into Variance Trades and achieve their investment objectives.\28\ 
Rather, CBOE argues that introducing an exchange-traded functionality 
that allows investors to place a single order expressed in volatility 
terms and that permits those investors to establish a specific 
volatility profile is consistent with Section 6(b)(5) of the Act in 
that it removes impediments to, and perfects the mechanism for, a free 
and open market.\29\ The Exchange asserts that if some constituent 
trades were required to be executed separately from the Variance Trade 
it would materially alter the pricing of the Variance Trade as well as 
its variance exposure, and would require the investor to execute 
separate trades in one or more constituent SPX options in an attempt to 
achieve the

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objective variance exposure.\30\ The Exchange also states that 
requiring that positions in the individual constituent series be 
assigned different prices than those assigned by the algorithm would 
mean that either the Variance Trade execution price must be modified or 
a different and less efficient algorithm would be required to assign 
prices to certain constituent SPX options to reach the trade's stated 
execution price.\31\ The Exchange believes both alternatives would 
destroy the appeal of the Variance Trade process.\32\ According to the 
Exchange, its proposal is narrowly crafted to prevent abuse and would 
facilitate beneficial volatility trading and hedging activity that 
would serve the needs of the marketplace.\33\
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    \28\ See id. at 3.
    \29\ See id.
    \30\ See id. at 4.
    \31\ See id.
    \32\ See id.
    \33\ See id.
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    Further, CBOE argues that the prices of the constituent option 
series are unrelated to quotes and orders on CBOE's book and that 
requiring the constituent legs of a Variance Trade to interact with the 
book could introduce inefficiencies in the pricing of Variance 
Trades.\34\ The Commission notes that the fact that a given trade in a 
constituent option series may trade through the price of resting 
interest is a consequence of the Variance Trade methodology and the 
fact that a Variance Trade is priced not in net dollar terms but in 
volatility terms. Unlike complex orders (as defined in CBOE's 
rules),\35\ the terms of a Variance Trade order would not pre-specify a 
quantity for each individual series. Rather, since the exact size 
(number of contracts) in each constituent series is a function of the 
matched implied volatility, it can only be computed once a match has 
occurred. In addition, the trade prices of the individual legs are 
derived simultaneously using a complex iterative process that is 
conducted after a match has occurred.
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    \34\ See id. The Commission notes that despite CBOE's assertion 
that the prices of the constituent option series of a Variance Trade 
would be unrelated to quotes and orders on CBOE's book, the proposed 
methodology CBOE would use for determining option prices in 
connection with Variance Trades starts with the actual quoted option 
prices themselves and then adjusts them upwards or downwards as 
needed. Thus, the price of each option leg of a Variance Trade 
actually would take into account the market price of each series.
    \35\ See CBOE Rule 6.53C.
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    Requiring the component legs of a Variance Trade basket to interact 
with resting orders in CBOE's SPX book would materially alter the 
computed prices for each component leg and therein would frustrate the 
ability of participants to consummate such transactions and undermine 
the objective of the trade. Specifically, the Variance Trade algorithm 
calculates a series of contract sizes and prices that span a 
considerable number of series and the interaction of these trades with 
resting orders would impact that process to an extent that could make 
it difficult, if not impossible, to consummate a Variance Trade 
transaction. Accordingly, in light of the unique structure and 
calculation methodology of the Variance Trade, as discussed more fully 
above, the Commission believes that allowing Variance Trades to execute 
without interacting with pre-existing interest on CBOE is appropriate 
and consistent with the Act.
    The second point on which the Commission requested comment in the 
Notice relates to the use of the benchmark trade reporting indicator 
when reporting the constituent legs of a Variance Trade. The Exchange's 
proposal seeks to use the ``benchmark'' indicator for informational 
purposes when reporting executions of the constituent legs of a 
Variance Trade transaction, even though such trades would not be 
``benchmark'' trades pursuant to Section 5(b)(xi) of the Linkage Plan, 
which by its terms applies only to inter-market (not intra-market) 
order protection.\36\ The Commission received no comments except from 
CBOE.
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    \36\ A benchmark order is an order for which the price is not 
based, directly or indirectly, on the quoted price of the option at 
the time of the order's execution and for which the material terms 
were not reasonably determinable at the time a commitment to trade 
the order was made. See CBOE Rule 6.81(b)(10) and Section 5(b)(xi) 
of the Linkage Plan.
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    The Exchange believes that the benchmark indicator, while it was 
created for the reporting of multiply-listed option executions, 
nevertheless would be useful to append to the execution of constituent 
series of a Variance Trade so SPX traders know that the executions were 
not related to the quoted price at the time of the print.\37\ In its 
letter, the Exchange argues that the rationale behind the benchmark 
indicator also applies to Variance Trades.\38\ Specifically, the 
Exchange believes that the constituent SPX options executions clearly 
fall within the definition of a benchmark trade in that they are not 
related to the quoted SPX prices at the time of execution, which is how 
the benchmark indicator would be used in the context of multiply-listed 
options.\39\ Further, CBOE believes that the fact that SPX options only 
trade on CBOE should not alter the conclusion that benchmark trades be 
exempt from certain priority considerations because they utilize 
transparent pricing methods that do not take into account the quoted 
market in the applicable security.\40\ The Exchange believes that the 
proposed use of the benchmark trade indicator would appropriately alert 
SPX market participants that the prices of the executed SPX constituent 
trades were not related to the quoted SPX prices at the time of the 
execution, in a way that would avoid any market confusion. The Exchange 
also believes that it would facilitate its surveillance of the 
constituent trades.\41\
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    \37\ Currently, CBOE does not offer functionality or order types 
that utilize the benchmark exception to the Linkage Plan. See 
Notice, supra note 3, 76 FR 71093, n.7.
    \38\ CBOE Letter, supra note 4, at 3.
    \39\ CBOE Letter, supra note 4, at 5.
    \40\ See id. at 3. See also supra note 34.
    \41\ See CBOE Letter, supra note 4, at 5.
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    The Commission believes that the use of an indicator for the trades 
in the constituent series of a Variance Trade is appropriate to alert 
market participants that the executions are not regular market 
transactions in order to guard against investor confusion in seeing 
individual options trade at prices that may be above or below 
prevailing market prices.
    CBOE has informed the Commission that, at the present time, the 
benchmark indicator is not used in the options markets.\42\ In reliance 
on this representation, the Commission believes the potential for 
investor confusion by marking the constituent trades as benchmark 
trades would be minimal, and that the use of the benchmark indicator 
for these purposes is reasonable at this time. The Commission notes, 
however, that use of another indicator may be preferable given that the 
benchmark indicator was intended for use in the context of inter-market 
order protection and therefore was not necessarily contemplated for use 
in the context of singly-listed SPX options that only trade on CBOE. 
Further, as noted above, a benchmark trade is defined as an order for 
which the price is not based, directly or indirectly, on the quoted 
price of the option at the time of the order's execution and for which 
the material terms were not reasonably determinable at the time a 
commitment to trade the order was made. As also noted above, however, 
the price of each leg of a Variance Trade actually would take into 
account the market price of each series as part of the proposed

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methodology in which the quoted price for a series is adjusted upwards 
or downwards as necessary.\43\ CBOE should monitor for the future use 
of the benchmark indicator in the options markets, and if CBOE or any 
other options market begins to use the benchmark indicator pursuant to 
the Linkage Plan, then CBOE should consider the impact of the potential 
for investor confusion, and whether to seek approval for use of a 
different indicator for Variance Trades to avoid investor confusion.
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    \42\ See email from Angelo Evangelo, CBOE, to Richard Holley, 
Assistant Director, Commission, dated January 26, 2012.
    \43\ See supra note 34.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\44\ that the proposed rule change (SR-CBOE-2011-007) be, and 
hereby is, approved.

    \44\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\45\
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    \45\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2012-2237 Filed 2-1-12; 8:45 am]
BILLING CODE 8011-01-P


