regulatory organizations; proposed rule changes: National Association of Securities Dealers, Inc.,

[Federal Register: December 28, 1998 (Volume 63, Number 248)]

[Notices]

[Page 71534-71535]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr28de98-128]

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40814; File No. SR-NASD-98-78]

Self-Regulatory Organizations; Order Granting Approval to Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to the Equity Option Hedge Exemption

December 21, 1998.

1. Introduction

   On October 15, 1998, the National Association of Securities Dealers, Inc. (``NASD'' or ``Association''), through its wholly owned subsidiary NASD Regulation (``NASD Regulation''), filedwith the Securities and Exchange Commission (``Commission'') a proposed rule change pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Exchange Act''),\1\ and Rule 19b-4 thereunder.\2\ In its proposal, NASD Regulation seeks to make permanent the Equity Option Hedge Exemption, which has been operating as a pilot program since 1990. Notice of the proposal was published in the Federal Register on November 16, 1998 (``Notice'').\3\ No comments were received. This order approves the proposal.

   \1\ 15 U.S.C. 78s(b)(1).

   \2\ 17 CFR 240.19b-4.

   \3\ See Exchange Act Release No. 40652 (Nov. 9, 1998), 63 FR 63764 (Nov. 16, 1998) (File No. SR-NASD-98-78).

2. Description of the Proposal

   The purpose of the proposed rule change is to make permanent the NASD's Equity Option Hedge Exemption program (``Hedge Exemption''), which has been operating on a pilot basis since 1990. NASD Rule 2860(b)(3) provides that the position limits for equity options are determined according to a five-tiered system in which more actively traded stocks with larger public floats are subject to higher position limits. Under the NASD rules, the current basic position limits are as follows. For standardized equity options,\4\ the current basic position limits are: 4,500, 7,500, 10,500, 20,000 and 25,000 contracts. For conventional equity options,\5\ the current basic position limits are three times the standardized equity options position limits, i.e., 13,500, 22,500, 31,500, 60,000 and 75,000 contracts. NASD rules do not specifically govern how a particular equity option falls within one of the five position limit tiers. Rather, the NASD's position limit rule provides that the position limit established by an options exchange for a particular equity option is the applicable position limit for purposes of the NASD's rule.\6\

   \4\ Standardized equity options are exchange-traded options issued by the Options Clearing Corporation (``OCC'') that have standard terms with respect to strike prices, expiration dates and the amount of the underlying security.

   \5\ A conventional option is any option contract not issued, or subject to issuance by, the OCC.

   \6\ For equity options that do not trade on an options exchange, the NASD's position limit rule provides that the limit for conventional equity options shall be three times the basic limit of 4,500 contracts, such as 13,500 contracts, unless the member can demonstrate to the Association that the underlying security meets the standards for higher limits and the initial listing standards for standardized options trading.

   The Hedge Exemption provides for an automatic, limited exemption from position limits \7\ and exercise limits \8\ for equity options that are hedged using one of the four most commonly used hedge positions: (1) Long stock and short call; (2) long stock and long put; (3) short stock and long call; and (4) short stock and short put. The NASD rules also specify how an options contract must be hedged. To be properly hedged, the options contract must be: (i) hedged by 100 shares of stock, (ii) hedged by securities that are readily convertible into, or economically equivalent to, such stock,\9\ or (iii) in the case of an adjusted options contract, hedged by the number of shares represented by the adjusted contract. Under the Hedge Exemption, the maximum standardized equity option position (combining hedged and unhedged positions) is three times the basic position limit level for standardized options, i.e., 13,500, 22,500, 31,500, 60,000 or 75,000 contracts. Additionally, the maximum conventional equity option position (combining hedged and unhedged positions) is three times the basic position level for conventional equity options, i.e., 40,500, 67,500, 94,500, 180,000 or 225,000 contracts.

   \7\ Position limits impose a ceiling on the number of options contracts of each options class on the same side of the market that can be held or written by an investor or group of investors acting in concert.

   \8\ Exercise limits restrict the number of options contracts that an investor or group of investors acting in concert can exercise within five consecutive business days. Under NASD Rules, exercise limits correspond to position limits, such that investors in options classes on the same side of the market are allowed to exercise, during any five consecutive business days, only the number of options contracts set forth as the applicable position limits for those options classes.

   \9\ The Commission notes that the NASD determines on a case-by- case basis whether an instrument that is being used as the basis for an underlying hedged position is readily and immediately convertible into the security underlying the corresponding option position. In this regard, the NASD generally finds that an instrument which will become convertible into a security at a future date, but which is not presently convertible, is not a ``convertible'' security for purpose of the equity option position limit hedge exemption until the date it becomes convertible. In addition, if the convertible security used to hedge an options position is called for redemption by the issuer, the security would have to be converted into the underlying security immediately or the corresponding options position reduced accordingly.

3. Discussion

   The Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities association, and, in particular, the requirements of Section 15A.\10\ Specifically, the Commission believes that the NASD's equity options position limit hedge exemption will accommodate the needs of investors and market participants while at the same time furthering investor protection and the public interest.\11\

   \10\ 15 U.S.C. 78o-3(b)(6).

   \11\ In approving the proposal, the Commission has considered its impact on efficiency, competition, and capital formation. 15 U.S.C. 78c(f).

   The Commission believes that the Hedge Exemption is an important component of the options position limit rules and should be continued on a permanent basis. The Hedge Exemption is a necessary tool for market participants to manage their market exposure by allowing them the flexibility to hold larger options positions in cases where such positions are hedged. The Commission further believes that the Hedge Exemption provides depth and liquidity to the market and will allow investors to hedge their stock portfolios more effectively, without significantly increasing concerns regarding intermarket manipulations or disruptions of either the options market or the underlying stock market.

   The Commission notes that the Hedge Exemption has been operating on a pilot basis since 1990. NASD Regulation has had eight years of experience administering and monitoring the program. The Commission believes that NASD Regulation has adequate rules in place to surveil the proposed hedge exemption. Specifically, NASD rules require each member to report options positions of any account which has established an aggregate position of 200

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   or more option contracts of the put class and the call class on the same side of the market covering the same underlying security.\12\ Finally, the Commission believes that approval of the NASD's Hedge Exemption on a permanent basis is appropriate in order to achieve parity with the exchange-trade options markets.\13\

   \12\ See Rule 2860(b)(5).

   \13\ See, e.g., American Stock Exchange Rule 904; Chicago Board Options Exchange Rule 4.11.

4. Conclusion

   It is therefore ordered, pursuant to Section 19(b)(2) of the Act,\14\ that the proposed rule change (SR-NASD-98-78) is approved.

   \14\ 15 U.S.C. 78s(b)(2).

   For the Commission, by the Division of Market Regulation, pursuant to delegated authority.\15\

   \15\ 17 CFR 200.30-3(a)(12).

   Margaret H. McFarland, Deputy Secretary.

   [FR Doc. 98-34253Filed12-24-98; 8:45 am]

   BILLING CODE 8010-01-M