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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-38248; File No. S7-7-94]
RIN 3235-AG14
Net Capital Rule
AGENCY: Securities and Exchange Commission
ACTION: Final Rule.
SUMMARY: The Securities and Exchange Commission ("Commission")
is amending Rule 15c3-1 under the Securities Exchange Act of 1934
("Exchange Act"), the net capital rule, to permit broker-dealers
to employ theoretical option pricing models in determining net
capital requirements for listed options and related positions.
Alternatively, broker-dealers may elect a strategy-based
methodology. The amendments are intended to simplify the net
capital rule's treatment of options for capital purposes and more
accurately reflect the risk inherent in broker-dealer options
positions.
EFFECTIVE DATE: The amendments become effective September 1,
1997.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli,
Associate Director (202) 942-0131, Peter R. Geraghty, Assistant
Director (202) 942-0177, or Louis A. Randazzo, Special Counsel
(202) 942-0191, Division of Market Regulation, Securities and
Exchange Commission, 450 Fifth Street, N.W., Mail Stop 5-1,
Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
I. INTRODUCTION
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The Commission is adopting amendments to Rule 15c3-1 under
the Exchange Act to permit broker-dealers to employ theoretical
option pricing models to calculate required net capital for
listed options and the related positions that hedge those
options. In adopting these amendments, the Commission is
continuing its process of revising the net capital rule that was
contemplated when the Commission solicited comments on a range of
capital related issues in 1993.-[1]- The amendments being
adopted today were proposed in initial form in March of 1994 and
would allow broker-dealers to use an options pricing model to
determine capital charges for listed options and related
positions.-[2]- Simultaneously with the Commission's
proposal, the Division of Market Regulation ("Division") issued a
no-action letter allowing broker-dealers to utilize the options
pricing approach immediately.-[3]- Based on the experience
gained by the Commission under the no-action letter, and the
nature of the comments received during the public comment period,
the Commission is adopting the proposed amendments with certain
---------FOOTNOTES----------
-[1]- Securities Exchange Act Release No. 32256 (May 4,
1993), 58 FR 27486 (May 10, 1993) ("Concept
Release").
-[2]- Securities Exchange Act Release No. 33761 (March
15, 1994), 59 FR 13275 (March 21, 1994)
("Proposing Release").
-[3]- Letter from Brandon Becker, Division of Market
Regulation, SEC to Mary L. Bender, First Vice
President, CBOE and Timothy Hinkas, Vice
President, The Options Clearing Corporation
("OCC") (March 15, 1994) ("1994 No-Action
Letter").
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changes discussed herein. The rules will become effective on
September 1, 1997; however, broker-dealers that desire to apply
the rule before the effective date may do so.
A. The Net Capital Rule Generally
The Commission adopted its first net capital rule in
1942.-[4]- The rule requires that every registered broker-
dealer maintain certain specified minimum levels of net capital.
The primary purpose of the rule is to protect the customers of a
broker-dealer from losses that can be incurred upon the broker-
dealer's failure. Rule 15c3-1 requires registered broker-dealers
to maintain sufficient liquid assets to enable those firms that
fall below the minimum net capital requirements to liquidate in
an orderly fashion without the need for a formal legal
proceeding. The rule prescribes different required minimum
levels based upon both the method a firm adopts in computing its
net capital and the type of securities business it conducts. A
firm engaging in a general securities business (which would allow
the firm to clear and carry customer accounts) must maintain a
minimum net capital level of the greater of $250,000 or 6 2/3
percent of its liabilities (with certain exclusions), or if the
---------FOOTNOTES----------
-[4]- The section 8(b) of the Securities Exchange Act
that was adopted in 1934 contained a rudimentary
net capital ratio requirement for members of
national securities exchanges and broker-dealers
conducting business through members. In 1942, the
Commission adopted its first net capital rule.
Section 8(b) was repealed by section 5(2) of the
Securities Act Amendments of 1975, which also
required the adoption of the uniform net capital
rule applicable to all broker-dealers.
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firm chooses the alternative method, the greater of $250,000 or 2
percent of its customer-related receivables. The different
minimum levels of net capital for firms based on categories of
business activity are designed to address the perceived risk in
the broker-dealers' business. For example, if a broker-dealer
carries no customer accounts and does not engage in certain
specified activities, it can maintain as little as $5,000 in net
capital.
Under the net capital rule, a broker-dealer takes its net
worth, computed in accordance with generally accepted accounting
principles, deducts certain illiquid assets (such as goodwill),
certain percentages from its proprietary securities or
commodities inventory, and adds back certain liabilities to
arrive at net capital. This number is then compared to its
requirement to determine compliance. Much of the rule itself is
comprised of the haircut deductions which account for the market
and other risks inherent in a trading business. The Commission
believes the net capital rule has performed its customer
protection function well over the years, has enabled the
Commission and the self-regulatory organizations ("SROs") to
identify financial problems at early stages, and has allowed the
Commission and the SROs to perform self-liquidations of failing
securities firms without both customer loss and the need for
proceedings under the Securities Investor Protection Act of
1970.-[5]-
---------FOOTNOTES----------
-[5]- 15 U.S.C. 78aaa et seq.
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Currently, the net capital rule provides two basic capital
treatments for option positions held by broker-dealers. The
first approach, which is set forth in Appendix A to Rule 15c3-1,
was designed for firms clearing their proprietary listed option
and related positions, and assumes that the option will be
exercised or held to expiration. The second approach, which is
set forth in Rule 15c3-1(c)(2)(x), is a premium-based approach.
Both methodologies of computing charges provide for lower
haircuts for certain risk offsetting positions held by broker-
dealers, although the premium-based approach recognizes more
types of offsetting positions and gives value for the portion of
the premium which is related to time.
B. The Development of the Options Pricing Approach to
Capital
In 1973, Fischer Black and Myron Scholes introduced a
formula to calculate the value of European style options. The
Black-Scholes formula assumes that the primary factors affecting
the price of an option are: the value of the underlying asset,
the exercise price of the option, the volatility of the
underlying asset, the risk-free rate of interest, and the
remaining time to expiration. Subsequent to the development of
the Black-Scholes formula, the Cox-Ross-Rubinstein binomial
pricing formula was developed. By calculating different probable
option values at various intervals, the formula is able to more
easily incorporate dividends, the term structure of the yield
curve, and the early exercise feature of American style options.
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Other models which are based on the Cox-Ross-Rubinstein formula
have since been developed, including OCC's Theoretical
Intermarket Margining System ("TIMS"), which is used to measure
the market risk associated with participants' positions and to
establish clearing house margin requirements.
The sharp market breaks in 1987 and 1989 made it imperative
for the Commission to review the adequacy of the current options
haircut methodology. The Chicago Board Options Exchange ("CBOE")
and OCC formed a task force to determine whether a more rigorous
and predictive approach to haircuts could be developed. As
noted, the current methodology requires that positions be
allocated to specific recognized strategies which are then
haircut at the prescribed levels. The aggregate haircut for a
class, or product group in the case of indexes, is the sum of the
haircuts calculated for each individually identified strategy.
CBOE and OCC believed that the current strategy-based approach
did not effectively recognize the risk reduction of offsetting
positions within a class or product group, and therefore such
approach required excessive amounts of capital to maintain such
offsetting positions. In addition, CBOE and OCC maintained that
the haircuts associated with short, unhedged, out-of-the-money
options were an insufficient measure of capital adequacy with
respect to rapid, material changes in market prices. At that
time, OCC had been utilizing an options pricing model to
establish clearing house margin requirements. In addition,
traders and risk managers had been using options pricing models
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in the development of trading strategies and the management of
market risk. Thus, the task force determined to explore the
impact of haircuts calculated through the use of an options
pricing model.
CBOE and OCC conducted a preliminary study which compared
haircut and account equity data obtained from three options
market-maker clearing firms with position risk calculated using a
derivation of TIMS for a three month time frame in late 1990.
Current haircuts and equity were compared to the maximum loss
under TIMS per class or product group for each market-maker
account. The preliminary study disclosed that haircuts would be
reduced for well-hedged, strategy-diverse positions, and
increased for unhedged positions. The study further disclosed
that the subject clearing firms maintained sufficient capital to
continue in capital compliance under the new approach. Based
upon the results of this study, the Division invited CBOE and OCC
to propose a formal pilot program specifically designed for
calculating haircuts for listed options on currencies, equities,
and securities and futures indexes.
The Division, CBOE, and OCC agreed upon the criteria to be
used in the pilot program, and OCC staff developed the software
and performed the operations to calculate the risk-based
haircuts. TIMS was used to project prices. Projected price
moves were calculated based upon the closing underlying asset
price for each day plus and minus moves at ten equidistant data
points over a range of market movements. The greatest loss at
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any one of these points would become the haircut. The volatility
implied from the closing price of the options series was used for
the calculation of each projected price for that series. To
account for liquidation risk, a minimum charge of 1/8 point per
option contract was applied when the haircut for the class or
product group reflected little or no market exposure.
The results of the pilot program were consistent with
earlier findings in that accounts having primarily hedged
positions reflected significant haircut reductions; unhedged
portfolios received higher capital charges. Based in part on
this experience, the Commission issued the Proposing Release for
comment.
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C. The Commission's Proposal
The proposed amendments provided that, with respect to each
option series-[6]- it clears, OCC would collect certain
information on a daily basis.-[7]- Using this information
and TIMS, OCC would measure the implied volatility for each
option series. After measuring the implied volatility for each
option series, OCC would input to the model the resulting implied
volatility for each option series. For each option series, the
model would calculate theoretical prices at 10 equidistant
valuation points within a range consisting of an increase or a
decrease of the following percentages of the daily market price
of the underlying instrument:
(i) +(-) 15% for equity securities with
a ready market, narrow-based
indexes, and non-high-
capitalization diversified
---------FOOTNOTES----------
-[6]- An option series includes option contracts of the
same type (either a call or a put) and exercise
style covering the same underlying instrument with
the same exercise price, expiration date, and
number of underlying units. The Commission notes
that for the purposes of the final amendments, the
term listed option includes listed warrants.
-[7]- Under the proposed rule, OCC would collect the
following information: (1) the dividend streams
for the underlying securities, (2) interest rates
(either the current call rate or the Eurodollar
rate for the maturity date which approximates the
expiration date of the option), (3) days to
expiration, and (4) closing underlying security
and option prices from various vendors.
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indexes,-[8]-
(ii) +(-) 6% for major market
currencies,-[9]-
(iii) +(-) 10% for high-
capitalization diversified
indexes,-[10]- and
(iv) +(-) 20% for currencies other than major
market currencies.
After the model calculated the theoretical gain/loss
valuations, OCC would provide the valuations to broker-dealers.
Broker-dealers would download this information into a spreadsheet
from which the broker-dealer would calculate the profit/loss for
each of its proprietary and market-maker options
positions.-[11]- The greatest loss at any one valuation
---------FOOTNOTES----------
-[8]- In order to avoid confusion with the designation
of indexes for margin or futures eligibility, the
final amendments and the remainder of this release
refer to "broad-based" indexes as "diversified"
indexes.
-[9]- The major market currencies are: Deutsche Mark,
British Pound, Swiss Franc, French Franc, Canadian
Dollar, Japanese Yen and European Currency Unit.
-[10]- The Commission indicated in the Proposing Release
that underlying price movement assumptions for the
proposed theoretical pricing model should be
consistent with the volatility assumptions
currently incorporated in the net capital rule.
-[11]- For those broker-dealers which choose to use TIMS
but do not obtain a computer interface with OCC,
OCC has developed a dial-up service by which such
broker-dealers may obtain, on a daily basis,
theoretical gains and losses. Other third-party
vendors would presumably offer a similar service.
Any such dial-up service may be a more practical
option for those broker-dealers that do not find
it economically feasible to maintain a
computerized interface with a third-party source,
(continued...)
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point would be the haircut.-[12]-
Depending upon the type of positions a broker-dealer sought
to offset, a percentage of a position's gain at any one valuation
point would offset another position's loss at the same valuation
point. The proposed amendments allowed the following offsets:
(1) within any portfolio type involving the same underlying
stock, index, or currency, 100% of a position's gain at any one
valuation point would offset another position's loss at the same
valuation point; (2) between qualified stock baskets (provided
the stock basket represented no less than 90% of a high-
capitalization diversified index's capitalization or 100% of the
capitalization of a narrow diversified index) offset by index
options, or futures, or futures options on the same underlying
index, 95% of gains would offset losses at the same valuation
point; (3) among high-capitalization diversified index options,
futures, and futures options, 90% of the gain on one high-
capitalization index position in the same product group would
---------FOOTNOTES----------
-[11]-(...continued)
but that do not wish to apply the alternative
strategy-based methodology, as discussed below.
-[12]- The spreadsheet would be programmed to compute a
minimum haircut charge and identify the greater of
the computed or minimum charge as the haircut.
For example, assume a portfolio consisting of IBM
common stock and various puts and calls on IBM
common stock with different strikes and expiration
dates. OCC would re-price each option position
assuming that the price of the IBM common stock
had moved up or down by a maximum of 15%, at 10
valuation points (i.e., -15%, -12%, -9%, -6%, -3%,
+3%, +6%, +9%, +12%, +15%). The single, maximum
net loss amount at any one of the 10 valuation
points would become the haircut for the portfolio.
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offset the loss on a position on a different high-capitalization
diversified index at the same valuation point; and (4) among non-
high-capitalization diversified index options, futures, and
futures options, 75% of the gain on one non-high-capitalization
diversified index position would offset the loss on a different
non-high-capitalization diversified index at the same valuation
point.
Under the proposed amendments, required deductions were: (1)
the amount of losses at any of the 10 equidistant valuation
points representing the largest theoretical loss after applying
the permissible offsets; or (2) a minimum charge equal to 1/4 of
a point-[13]- times the multiplier for each options
contract (or $25.00 per option contract assuming that option
contract covers 100 shares) and each related instrument within
the option's class or product group, or $25 for each option on a
major market foreign currency; plus (3) in the case of portfolio
types involving index options and related instruments offset by a
qualified stock basket, a minimum charge of 5% of the market
value of the qualified stock basket for high-capitalization
indexes, whether diversified or narrow-based; or (4) in the case
of portfolio types involving index options and related
---------FOOTNOTES----------
-[13]- As noted earlier, the pilot program applied a
minimum haircut of 1/8 of a point. Pursuant to a
recommendation by CBOE and OCC, the Proposing
Release increased the minimum charge to 1/4 of a
point per option contract. The Commission
believed this increase was appropriate to account
for liquidation and decay risk in options prices
in situations where application of the proposed
amendments resulted in little or no charge.
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instruments offset by a qualified stock basket, a minimum charge
of 10% of the market value of the qualified stock basket for
diversified non-high-capitalization indexes.
In proposing the amendments, the Commission recognized that
certain broker-dealers may not want to, or may not find it cost
effective to use an options pricing methodology because of their
limited dealings in options. Accordingly, the proposed
amendments also included an alternative strategy-based haircut
methodology that generally followed, but was more limited than,
the haircut approach embodied in the current rule.
Under the current rule, a broker-dealer that carries
accounts of listed options specialists must take a charge against
capital as of the close of business each day even though the
broker-dealer does not know the level of the charges until the
following day. The proposed amendments provided broker-dealers
with additional time by which to take the capital charge.
Specifically, the proposed amendments provided that broker-
dealers could adjust their net worth by deducting as of noon of
the next business day the charges computed as of the prior
business day. In addition, the proposed amendments provided that
the required deductions could be reduced by the deposit of funds
or securities by noon of the next business day.
D. Summary of Comments
The Commission received ten comment letters in response to
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the Proposing Release.-[14]- The comments, in general,
were supportive of the Commission's proposal. Most commenters,
however, suggested that, in addition to TIMS, the Commission
permit the use of other pricing models.-[15]- In addition,
some commenters suggested that the Commission allow the use of
theoretical pricing models in connection with over-the-counter
("OTC") options and positions in U.S. Treasury securities.
The commenters also suggested that the underlying price
assumption for high-capitalization diversified indexes be reduced
and that the rule permit implied volatility inputs to fluctuate
within certain parameters. In addition, a few commenters
suggested that the minimum charge of 1/4 of a point per option
contract be reduced. These issues, as well as others, are
discussed below.
II. DESCRIPTION OF RULE AMENDMENTS
A. Use of TIMS Versus Other Pricing Models
In the Proposing Release and under the 1994 No-Action
---------FOOTNOTES----------
-[14]- The comment letters are available for public
inspection and copying in the Commission's public
reference room located at 450 Fifth Street, N.W.,
Washington, D.C. 20549 (File No. S7-7-94).
-[15]- Some commenters suggested the use of broker-dealer
proprietary models or the Chicago Mercantile
Exchange's Standard Portfolio Analysis System
("SPAN") which is used by many futures exchanges
to calculate margin requirements. Letter from
Jeffrey Bernstein, Chairman, Capital Committee of
the Securities Industry Association ("SIA") to
Jonathan G. Katz, Secretary, SEC (September 16,
1994), and Letter from Thomas R. Donovan,
President and Chief Executive Officer, Chicago
Board of Trade to Jonathan G. Katz, Secretary, SEC
(May 13, 1994).
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Letter, broker-dealers were required to use the OCC TIMS system
as the exclusive means of determining theoretical options prices.
While TIMS is a theoretically sound options pricing methodology,
it is not the only recognized methodology in the marketplace.
Other models, using different formulae, are also capable of
arriving at legitimate results. In response to the comments and
based on additional experience with models, the Commission is
removing the requirement that TIMS be used. The final rule
permits the use of a model (other than a proprietary model)
maintained and operated by any third-party source and approved by
an examining authority designated pursuant to Section 17(d) of
the Exchange Act ("DEA"). The DEA shall submit to the Commission
for consideration a description of its methods for approving
models.-[16]- The model must consider at a minimum the
following factors in pricing the option: (1) the current spot
price of the underlying asset; (2) the exercise price of the
option; (3) the remaining time until the option's expiration; (4)
the volatility of the underlying asset; (5) any cash flows
associated with ownership of the underlying asset that can
reasonably be expected to occur during the remaining life of the
option; and (6) current information about interest rates. Any
such approval of a model by a DEA must include appropriate
provisions relating to the obligations of the third-party vendor
---------FOOTNOTES----------
-[16]- The Commission notes that any such third-party
source, including OCC, may charge broker-dealers a
fee for the services they provide in connection
with these amendments.
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to supply timely and accurate information to the broker-dealers.
Once a model has been approved by a DEA, broker-dealers may use
the model in order to calculate haircuts. For purposes of this
rule, the TIMS system as operated by OCC will be deemed to be an
approved model for a period of two years from the effective date
of these amendments. OCC, however, should clarify its vendor
status by appropriate DEA approval.
In addition to the commenters' suggestions that the final
amendments permit broker-dealers to utilize theoretical pricing
systems other than TIMS, certain commenters argued that the
Commission should permit the use of internal proprietary models
for both listed products and OTC options. The staff of the
Division is preparing a separate release which will propose for
comment further amendments to the net capital rule to permit the
use of proprietary models to value listed options.
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B. Implied Volatilities
The TIMS model uses implied options volatilities to
calculate theoretical prices of options. It was suggested that
because TIMS does not alter implied volatilities as the
theoretical price of the option changes, the model overlooks an
important element that could have a major effect on capital
requirements. In fact, requiring alteration of the implied
volatilities would cause numerous additional computations without
substantial benefits given the wide range in assumed underlying
price movements. The Commission notes, however, that the
amendments have been liberalized and permit the use of differing
options pricing models. The properties of each model can then be
evaluated during the model approval process established in the
amendments.
C. Underlying Price Movement Assumptions
The proposed amendments included underlying price movement
assumptions for the theoretical pricing model that are consistent
with the volatility assumptions currently incorporated in the net
capital rule. The Commission believes that requiring the model
to "shock" the portfolio in the amounts currently incorporated
into the net capital rule is necessary to ensure consistent
treatment of options and the underlying positions. Since the
amendments permit broker-dealers to take haircuts on equities
after taking into consideration options on those equities,
broker-dealers with limited options positions might seek to apply
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the assumptions to all of their positions (both equities and
options) if the options pricing amendments utilized assumptions
that were less robust than those currently in the net capital
rule for the underlying positions. If this were the case, broker-
dealers could potentially obtain more favorable treatment on
their equity positions than currently contemplated by the net
capital rule.
The Commission notes that the 1994 No-Action Letter
contained a reduction in the underlying price movements for non-
clearing specialists and market-makers to +(-)4«% for major
market foreign currency positions, +(-)10% for non-high-
capitalization diversified indexes, and +6(-8)% for high-
capitalization diversified indexes. In that letter, the Division
expressly declined to extend this position to other broker-
dealers.-[17]- The concession for market-makers and non-
clearing specialists was based upon the important role that non-
clearing specialists and market-makers perform in maintaining
fair and orderly markets. The Commission is incorporating the
reduced requirements for market-makers into the final rule in
light of these considerations, however, this concession expires
two years from the effective date of the amendments unless it can
be demonstrated by the non-clearing specialists and market-makers
that retention of reduced capital requirements is in the public
interest. Therefore, the Commission is adopting the minimum
---------FOOTNOTES----------
-[17]- See 1994 No-Action Letter, supra note 3, at note
5.
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price movements substantially as proposed.
Similarly, some commenters suggested that the +(-)10% price
move assumption for high-capitalization diversified indexes (such
as the S&P 500) was too high and should be reduced. During the
time the 1994 No-Action Letter has been in effect using a +(-)10%
assumption, there does not appear to have been any evidence of
liquidity or execution problems in the option markets from
application of this assumption. The Commission notes that this
assumption is intended to cover the risks of uncovered, out-of-
the-money option positions. Accordingly, the amendment retains
the +(-)10% underlying assumption for high-capitalization
diversified indexes.
D. Permissible Offsets
The proposed amendments permitted specified offsets between
differing categories of instruments. The rule being adopted
today maintains the concept of specifying offsets, but with a few
significant changes. With respect to the offset between
qualified stock baskets, the Commission received one comment
which contended that rather than requiring that a basket contain
a certain minimum amount of stock to be considered a qualified
stock basket, the rule should permit a broker-dealer to convert
every basket into a qualified stock basket by taking a haircut on
the missing or excess stocks, depending on whether too little or
too much of a stock was in the basket.
The Commission believes that the better approach is to
maintain the stock basket capitalization requirement. The
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purpose of the minimum capitalization requirement is to ensure
that a broker-dealer has a sufficient number of stocks that match
those in the index so that the stocks correlate with the index.
The Commission, however, believes that a decrease in the
capitalization requirement is appropriate. Accordingly, under
the rule amendment, to be a qualified stock basket, the basket
must represent no less than 50% of a diversified index's
capitalization and, for a narrow-based index, the basket must
represent no less than 95% capitalization. The proposed
amendments allowed offsets only between the same type of indexes
and related positions. Commenters suggested that offsets be
allowed between different diversified index product groups, and
the Commission agrees it is appropriate to permit offsets for
positions among different diversified index product groups. The
groupings and netting allowances are set forth below.
In addition, questions have arisen regarding the methodology
that should be used to designate indexes as high-capitalization
diversified or non-high capitalization diversified for purposes
of the rule. Set forth below is a list of those indexes which
are to be treated as high capitalization diversified or non-high
capitalization diversified, and the appropriate offsets. The
offsets designated in the groupings are based on historical
correlations. The Commission recognizes that this approach does
not provide for the treatment of new indexes, however, the
Commission intends to issue a release which will set forth
generic guidelines for adding and deleting indexes (and
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designating appropriate offsets) for purposes of the net capital
rule.
ù U.S. Market Group A (i) Institutional Index ("XII"),
(ii) Major Market Index ("XMI"), (iii) S&P 100 Index
("OEX"), (iv) S&P 500 Index ("SPX"), (v) New York Stock
Exchange Composite Index ("NYA"), (vi) Big-Cap Sector
Index ("MKT"), and (vii) PHLX US Top 100 Index ("TPX").
A 90% offset is permitted between classes within this
product group, an 85% offset with U.S. Market Group B,
and a 50% offset with the non-high capitalization
diversified U.S. Market Product Group and the U.S. NASD
Market Group.
ù U.S. Market Group B (i) S&P Barra Growth Index, and
(ii) S&P Barra Value Index. An 80% offset is permitted
within this product group, an 85% offset with U.S.
Market Group A, and a 50% offset with the non-high
capitalization diversified U.S. Market Product Group
and the U.S. NASD Market Group.
ù Japan Market Group A (i) Japan Index ("JPN"), (ii) CBOE
Nikkei 300 Index ("NIK"), and (iii) the Nikkei 225
Index ("NK"). A 90% offset is permitted within this
product group.
ù Japan Market Group B consists of the CBOE Japanese
Export Warrant Index. ù European Market Product
Group consists of the
EuroTop 100 Index ("TOP").
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ù United Kingdom Market Product Group consists of the
Financial Times Exchange Index ("FT-SE").
The following indexes are designated non high-capitalization
diversified market indexes:
ù U.S. Market Product Group (i) MidCap Index ("MID"),
(ii) Russell 2000 Index ("RUT"), (iii) Value Line Index
("VLE"), (iv) Wilshire 250 Index ("WSX"), and (v) the
S&P 600 Smallcap Index ("SML"). A 75% offset is
permitted within this product group, and a 50% offset
with the U.S. NASD Market Group and with high-
capitalization diversified U.S. Market Groups A and B.
ù U.S. NASD Market Group (i) NASDAQ 100 Index ("NDX"),
and (ii) National OTC Index ("XOC"). A 75% offset is
permitted within this product group and a 50% offset
with the U.S. Market Product Group and with high-
capitalization diversified U.S. Market Groups A and B.
ù Mexican Market Product Group consists of the Index of
Prices and Quotations ("IPC").
The following indexes are designated narrow-based index
options within the following sector product groups.
ù Bank Sector Product Group (i) S&P Banking Index
("BIX"), and (ii) PHLX KBW Bank Index ("BKX"). A 90%
offset is permitted within this product group.
ù Technology Sector Product Group (i) Morgan Stanley
High Tech 35 Index ("MSH"), (ii) PSE Technology Index
("PSE"), (iii) CBOE Technology Index ("TXX"), (iv) AMEX
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Computer Technology Index ("XCI"), (v) Goldman Sachs
Technology Index ("GSTI") Composit Index ("GTC"), (vi)
GSTI Hardware Index ("GHA"), (vii) GSTI Multimedia
Network Index ("GIP"), and (viii) GSTI Software Index
("GSO"). A 75% offset is permitted within this group.
In addition, the PSE may be offset 75% with the U.S.
NASD Market Group.
ù Internet Product Group (i) CBOE Internet Index, (ii)
AMEX Internet Index, and (iii) GSTI Internet Index
("GIN"). A 75% offset is permitted within this group.
ù Oil Product Group (i) CBOE Oil Index ("OIX"), and (ii)
AMEX Oil and Gas Index ("XOI"). A 90% offset is
permitted within this product group.
ù Gold Product Group (i) CBOE Gold Index ("GOX"), and
(ii) PHLX Gold/Silver Index ("XAU"). A 90% offset is
permitted within this product group.
ù Semiconductor Product Group (i) PHLX Semiconductor
Index ("SOX"), and (ii) GSTI Semiconductor Index
("GSM"). A 90% offset is permitted within this product
group.
ù Semiconductor Product Group (General) All remaining
narrow-based indexes. No offset is permitted within
this product group.
E. Minimum Charges
The minimum charge specified in the rule is designed to
account for liquidation and decay risk in the prices of long and
==========================================START OF PAGE 24======
short options in those instances in which applications of the
theoretical pricing methodology results in little or no capital
requirement. One commenter noted that the use of a minimum
charge of a 1/4 of a point was a fair method of estimating the
liquidation risk of out-of-the-money options. Another commenter
indicated that the impact of the minimum charge was to cause
spreads for out-of-the-money calls and puts to expand because
market-makers are reluctant to sell these options.
Thus far, there is no evidence that these concerns have been
borne out, however, the Commission intends to monitor the impact
of the amendments and whether these concerns arise in fact. In
the meantime, the Commission believes that the minimum charge
should be retained as proposed. The rule as adopted, therefore,
requires a minimum charge of 1/4 of a point or $25.00 per option
contract assuming that the basic equity option contract covers
100 shares. To the extent that an option or futures contract
exceeds the size of a basic option contract, the minimum charge
will be increased by the additional percentage amount of
underlying units. For example, an option or a futures contract on
the S&P 500 Index covers 500 shares (rather than 100 shares for a
basic equity option contract) and therefore the minimum charge
would be $125.00 (5 x $25.00).
In addition to the 1/4 of a point minimum charge, the
proposed amendments required an additional deduction of 10% for
each qualified stock basket of non-high-capitalization
diversified indexes, and 5% for each qualified stock basket of
==========================================START OF PAGE 25======
high-capitalization diversified and narrow-based indexes for
those positions hedging an options or futures contract subject to
the minimum charge. In response to concerns that, in the case of
non-high-capitalization indexes, the 10% charge was excessive,
the Commission believes it is appropriate to decrease this charge
to 7.5%. For high-capitalization indexes, the proposed 5%
charge will be adopted.
F. Alternative Strategy-Based Methodology
The proposed amendments provided that broker-dealers could
elect to use the alternative strategy-based method for
calculating haircuts. One commenter contended that the
alternative strategy-based methodology contained in the proposal,
because it contained very few simple strategies, would impose
haircuts on a trading book which are larger than the haircuts in
the current rule. The commenter recommended that the Commission
explore the possibility of adopting a strategy-based calculation
that would include common strategies currently used by firms.
The Commission notes that the new rule is designed in part
to eliminate the complicated overlay of strategies and
interpretations that developed out of the necessity to
accommodate all dealer options strategies. To attempt to
recognize many classes of strategies in the alternative section
would result in a return to the system the Commission is revising
today. Hence, the Commission believes that a simple strategy-
based alternative should be retained in the rule. Limiting the
alternative to simple strategies will tend to encourage firms
==========================================START OF PAGE 26======
with any options positions of substance to utilize the pricing
model methodology. Because the recognized strategies in the
alternative section are minimal, limited hedges will be
recognized with the result that a book of any significance will
incur larger charges under the strategy-based method than the
options pricing methodology. This will provide an economic
incentive for firms active in options to develop the capability
to use up-to-date modelling techniques.
G. Clearing Firm Capital Deposits
The net capital rule requires broker-dealers carrying the
accounts of listed options specialists to take capital charges
reflecting haircuts required due to specialists' trading
activity. The capital rule historically has required the
clearing firm to take the required charge as of the close of
business each day to ensure it has sufficient capital to open the
next morning. However, the carrying firm generally will not
know the full extent of its requirements as to its specialists
until that next morning. Generally, clearing firms will seek to
bring in money, either from the specialist or from elsewhere
during the morning. This is a conservative charge considering
the rule's usual acceptance of allowing time for margin calls.
To remedy this, the proposal allowed the clearing firm until noon
to obtain funds or arrange financing. All of the commenters who
addressed the issue supported it; accordingly, the Commission is
adopting the provision with the clarification that "noon" is
determined according to the local time where the carrying firm
==========================================START OF PAGE 27======
has its headquarters. In any event, this provision will not be
available for a market-maker account in deficit.
III. TECHNICAL AMENDMENTS TO THE RULE
As noted in the Proposing Release, in connection with the
adoption of the amendments, the Commission is making the
following technical amendments to the net capital rule
necessitated by the new amendments and to codify a long-standing
staff interpretation:
A. Deletion of Paragraph (a)(7) of the Net Capital Rule
As previously stated, the net capital rule, as it currently
is written, contains two haircut methodologies, the premium-based
approach set forth in Rule 15c3-1(c)(2)(x) and the approach
embodied in Appendix A to Rule 15c3-1. Currently, pursuant to
the provisions of paragraph (a)(7) of the net capital rule, the
premium-based approach is available to a clearing firm if its
business is limited almost exclusively to effecting (either
directly or as agent) and clearing market-making transactions in
listed options.
The final rule deletes paragraph (a)(7) of the net capital
rule. The Commission believes that this provision is no longer
necessary because the final rule eliminates the distinction
between the premium-based approach set forth in 15c3-1(c)(2)(x)
and the approach set forth in Appendix A to 17 CFR 240.15c3-1.
==========================================START OF PAGE 28======
B. Steps to be Taken by a Broker-Dealer Carrying the
Account of an Option Market-Maker When Equity in That
Account is Insufficient to Cover Haircuts
Pursuant to an interpretation letter,-[18]- carrying
broker-dealers may extend credit in a market-maker account even
when haircuts for that account exceed the equity in the
account.-[19]- This interpretation is conditioned upon the
carrying broker-dealer taking a charge against its capital to the
extent that the equity in the market-maker's account is
insufficient to cover the haircuts. The amendments incorporate
this interpretation into the net capital rule.
IV. SUMMARY OF THE FINAL REGULATORY FLEXIBILITY ANALYSIS
The Regulatory Flexibility Act, which became effective on
January 1, 1981, imposes procedural steps applicable to agency
rule making which has a "significant economic impact on a
substantial number of small entities."-[20]- The
---------FOOTNOTES----------
-[18]- Letter from Lee A. Pickard, Director, Division of
Market Regulation, SEC, to Joseph W. Sullivan,
President, CBOE (April 8, 1977).
-[19]- Currently, paragraph (c)(2)(x)(F) of Rule 15c3-1
provides that, if the haircuts for a particular
market-maker's account exceed the equity in the
account, the carrying broker-dealer may not extend
further credit to the market-maker unless the
carrying broker-dealer requires the additional
deposit of sufficient equity to eliminate the net
capital charge.
-[20]- Although Section 601(b) of the Regulatory
Flexibility Act defines the term "small entity,"
the statute permits agencies to formulate their
own definitions. The Commission has adopted
definitions of the term "small entity" for
purposes of Commission rulemaking in accordance
(continued...)
==========================================START OF PAGE 29======
Commission has prepared a Final Regulatory Flexibility Analysis
("Analysis") in accordance with 5 U.S.C. 604 regarding the
amendments. The Analysis states that the Commission did not
receive any comments concerning the Initial Regulatory
Flexibility Analysis.
The Analysis notes that the amendments implement a haircut
methodology which employs a mathematical formula to determine the
theoretical value of options. The purpose of the amendments is
to make haircuts more accurately reflect the risks associated
with dealer option positions than is possible under the current
rule and to simplify the net capital rule's treatment of options
for capital purposes. The amendments permit the use of a model
(other than a proprietary model) maintained and operated by a
third-party source, including OCC, and approved according to the
terms of the amendments. The amendments will impact
---------FOOTNOTES----------
-[20]-(...continued)
with the Regulatory Flexibility Act. Those
definitions are set forth in Rule 0-10, 17 CFR
240.0-10. See Securities Exchange Act Release No.
18452 (January 28, 1982), 47 FR 5215 (February 4,
1982). A broker-dealer is a "small business" or
"small organization" under Rule 0-10, if the
broker-dealer (i) had total capital (net worth
plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as
of which its audited financial statements were
prepared pursuant to 17 CFR 240.17-5(d) or, if not
required to file such statements, a broker-dealer
that had total net capital (net worth plus
subordinated liabilities) of less than $500,000 on
the last business day of the preceding fiscal year
(or in the time that it has been in business, if
shorter); and (ii) is not affiliated with any
person (other than a natural person) that is not a
small business or small organization as defined in
17 CFR 240.0-10.
==========================================START OF PAGE 30======
approximately 247 "small entities" which are subject to the
provisions of Rule 15c3-1 and have listed options positions
insofar as they would be required to implement a computer
interface with a third-party vendor in order to receive reliable
data to calculate haircuts. The Commission recognizes, however,
that some broker-dealers with very limited options positions
might find it cost prohibitive to install such computerized
interface with a model provider. In order to reduce the economic
impact on these broker-dealers, the amendments include an
alternative haircut methodology that is based on the basic
options strategies used by broker-dealers, and is similar to the
approach used in the current rule.
The Analysis also states that no federal securities laws
duplicate, overlap, or conflict with the amendments, and adds
that the Commission does not believe any less burdensome
alternatives are available to accomplish the objectives of the
amendments. In addition, the Analysis notes that the staff
carefully considered the possibility that smaller broker-dealers
who elect the strategy-based approach may receive more severe
haircut treatment than under the current rule because the
strategy-based approach under the amendments is limited to a few
very simple strategies. Because the Commission intended to
eliminate the complicated overlay of strategies and
interpretations that developed under the former rule to
accommodate all dealer options strategies, and because smaller
broker-dealers which elect the alternate approach will not be
==========================================START OF PAGE 31======
required to incur the costs associated with adopting a new system
to employ models, the Commission believes the amendments should
have a minimal adverse impact on small businesses or small
organizations. As such, the amendments contain no additional
reporting, recordkeeping, or other compliance requirements. For
additional information, a copy of the Analysis may be obtained by
contacting Peter Geraghty (202/942-0177) or Louis A. Randazzo
(202/942-0191), Division of Market Regulation, Securities and
Exchange Commission, Washington, D.C. 20549.
V. Paperwork Reduction Act
The text of the amendments contain "collection of
information" requirements within the meaning of the Paperwork
Reduction Act of 1995 ("PRA").-[21]- Broker-dealers
subject to the rule are required to notify the Commission and the
appropriate designated examining authority whenever their level
of net capital falls below a prescribed level for any period
exceeding three business days, and whenever there is a
liquidating deficit in a specialist's market-maker account. These
same notification obligations exist under the present rule before
adoption of the amendments.-[22]- Consequently, the
amendment does not change the PRA collection of information
requirements or burden under Rule 15c3-1. The Commission
recently received an extension from the Office of Management and
Budget ("OMB") for the collection of information requirements
---------FOOTNOTES----------
-[21]- 44 U.S.C. 3501 et seq.
-[22]- See Rule 15c3-1(c)(2)(x).
==========================================START OF PAGE 32======
contained in Rule 15c3-1. The title of the collection of
information is "Net Capital Requirements for Brokers and Dealers,
Rule 15c3-1." The OMB control number is 3235-0200. The
Commission also reminds brokers and dealers subject to the
amendments about their related recordkeeping obligations under
Rule 17a-4.
VI. STATUTORY ANALYSIS
Pursuant to the Securities Exchange Act of 1934 and
particularly Section 15(c)(3), (15 U.S.C. 78o(c)(3)) thereof, the
Commission is adopting amendments to 240.15c3-1 of Title 17 of
the Code of Federal Regulations in the manner set forth below.
LIST OF SUBJECTS IN 17 CFR PART 240
Brokers, Reporting and recordkeeping requirements,
Securities.
TEXT OF FINAL RULE
In accordance with the foregoing, Title 17, chapter II, part
240 of the Code of Federal Regulations is amended as follows:
Part 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT
OF 1934.
1. The authority citation for Part 240 continues to read in
part as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78k, 78k-1, 78l,
78m, 78n, 78o, 78p, 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-
20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless
otherwise noted.
==========================================START OF PAGE 33======
* * * * *
2. Section 240.15c3-1 is amended by removing and reserving
paragraph (a)(7).
3. Section 240.15c3-1 is amended by adding an undesignated
center heading before paragraph (c)(2)(x) and revising paragraph
(c)(2)(x) to read as follows:
240.15c3-1 Net capital requirements for brokers or
dealers.
* * * * *
(c) * * *
(2) * * *
Brokers or Dealers Carrying Accounts of Listed Options
Specialists
(x)(A) With respect to any transaction of a specialist in
listed options, who is either not otherwise subject to the
provisions of this section or is described in paragraph
(c)(2)(vi)(N) of this section, for whose specialist account a
broker or dealer acts as a guarantor, endorser, or carrying
broker or dealer, such broker or dealer shall adjust its net
worth by deducting as of noon of each business day the amounts
computed as of the prior business day pursuant to 240.15c3-1a.
The required deductions may be reduced by any liquidating equity
that exists in such specialist's market-maker account as of that
time and shall be increased to the extent of any liquidating
deficit in such account. Noon shall be determined according to
the local time where the broker or dealer is headquartered. In
==========================================START OF PAGE 34======
no event shall excess equity in the specialist's market-maker
account result in an increase of the net capital of any such
guarantor, endorser, or carrying broker or dealer.
(B) Definitions.
(1) The term listed option shall mean any option traded on a
registered national securities exchange or automated facility of
a registered national securities association.
(2) For purposes of this provision, the equity in an
individual specialist's market-maker account shall be computed
by:
(i) Marking all securities positions long or short in
the account to their respective current market values;
(ii) Adding (deducting in the case of a debit balance)
the credit balance carried in such specialist's market-maker
account; and
(iii) Adding (deducting in the case of short positions)
the market value of positions long in such account.
(C) No guarantor, endorser, or carrying broker or dealer
shall permit the sum of the deductions required pursuant to
240.15c3-1a in respect of all transactions in specialists'
market-maker accounts guaranteed, endorsed, or carried by such
broker or dealer to exceed 1,000 percent of such broker's or
dealer's net capital as defined in 240.15c3-1(c)(2) for any
period exceeding three business days. If at any time such sum
exceeds 1,000 percent of such broker's or dealer's net capital,
then the broker or dealer shall:
==========================================START OF PAGE 35======
(1) Immediately transmit telegraphic or facsimile notice of
such event to the Division of Market Regulation in the
headquarters office of the Commission in Washington, D.C., to the
district or regional office of the Commission for the district or
region in which the broker or dealer maintains its principal
place of business, and to its examining authority designated
pursuant to section 17(d) of the Act (15 U.S.C. 78q(d))
("Designated Examining Authority"); and
(2) Be subject to the prohibitions against withdrawal of
equity capital set forth in 240.15c3-1(e) and to the
prohibitions against reduction, prepayment, and repayment of
subordination agreements set forth in paragraph (b)(11) of
240.15c3-1d, as if such broker or dealer's net capital were below
the minimum standards specified by each of those paragraphs.
(D) If at any time there is a liquidating deficit in a
specialist's market-maker account, then the broker or dealer
guaranteeing, endorsing, or carrying listed options transactions
in such specialist's market-maker account may not extend any
further credit in that account, and shall take steps to liquidate
promptly existing positions in the account. This provision shall
not prevent the broker or dealer from, upon approval by the
broker's or dealer's Designated Examining Authority, entering
into hedging positions in the specialist's market-maker account.
The broker or dealer also shall transmit telegraphic or facsimile
notice of the deficit and its amount by the close of business of
the following business day to its Designated Examining Authority
==========================================START OF PAGE 36======
and the Designated Examining Authority of the specialist, if
different from its own.
(E) Upon written application to the Commission by the
specialist and the broker or dealer guaranteeing, endorsing, or
carrying options transactions in such specialist's market-maker
account, the Commission may approve upon specified terms and
conditions lesser adjustments to net worth than those specified
in 240.15c3-1a.
* * * * *
4. Section 240.15c3-1a is revised to read as follows:
240.15c3-1a Options (Appendix A to 17 CFR 240.15c3-1).
(a) Definitions.
(1) The term unlisted option shall mean any option not
included in the definition of listed option provided in paragraph
(c)(2)(x) of 240.15c3-1.
(2) The term option series refers to listed option contracts
of the same type (either a call or a put) and exercise style,
covering the same underlying security with the same exercise
price, expiration date, and number of underlying units.
(3) The term related instrument within an option class or
product group refers to futures contracts and options on futures
contracts covering the same underlying instrument. In relation
to options on foreign currencies a related instrument within an
option class also shall include forward contracts on the same
underlying currency.
(4) The term underlying instrument refers to long and short
==========================================START OF PAGE 37======
positions, as appropriate, covering the same foreign currency,
the same security, or a security which is exchangeable for or
convertible into the underlying security within a period of 90
days. If the exchange or conversion requires the payment of
money or results in a loss upon conversion at the time when the
security is deemed an underlying instrument for purposes of this
Appendix A, the broker or dealer will deduct from net worth the
full amount of the conversion loss. The term underlying
instrument shall not be deemed to include securities options,
futures contracts, options on futures contracts, qualified stock
baskets, or unlisted instruments.
(5) The term options class refers to all options contracts
covering the same underlying instrument.
(6) The term product group refers to two or more option
classes, related instruments, underlying instruments, and
qualified stock baskets in the same portfolio type (see paragraph
(b)(1)(ii) of this section) for which it has been determined that
a percentage of offsetting profits may be applied to losses at
the same valuation point.
(b) The deduction under this Appendix A to 240.15c3-1
shall equal the sum of the deductions specified in paragraphs
(b)(1)(v)(C) or (b)(2) of this section.
Theoretical Pricing Charges
(1)(i) Definitions.
(A) The terms theoretical gains and losses shall mean the
gain and loss in the value of individual option series, the value
==========================================START OF PAGE 38======
of underlying instruments, related instruments, and qualified
stock baskets within that option's class, at 10 equidistant
intervals (valuation points) ranging from an assumed movement
(both up and down) in the current market value of the underlying
instrument equal to the percentage corresponding to the
deductions otherwise required under 240.15c3-1 for the
underlying instrument (See paragraph (a)(1)(iii) below).
Theoretical gains and losses shall be calculated using a
theoretical options pricing model that satisfies the criteria set
forth in paragraph (a)(1)(i)(B) of this section.
(B) The term theoretical options pricing model shall mean
any mathematical model, other than a broker-dealer proprietary
model, approved by a Designated Examining Authority. Such
Designated Examining Authority shall submit the model to the
Commission, together with a description of its methods for
approving models. Any such model shall calculate theoretical
gains and losses as described in paragraph (a)(1)(i)(A) of this
section for all series and issues of equity, index and foreign
currency options and related instruments, and shall be made
available equally and on the same terms to all registered brokers
or dealers. Its procedures shall include the arrangement of the
vendor to supply accurate and timely data to each broker-dealer
with respect to its services, and the fees for distribution of
the services. The data provided to brokers or dealers shall also
contain the minimum requirements set forth in paragraphs
(b)(1)(v)(C) of this section and the product group offsets set
==========================================START OF PAGE 39======
forth in paragraphs (b)(1)(v)(B) of this section. At a minimum,
the model shall consider the following factors in pricing the
option:
(1) The current spot price of the underlying asset;
(2) The exercise price of the option;
(3) The remaining time until the option's expiration;
(4) The volatility of the underlying asset;
(5) Any cash flows associated with ownership of the
underlying asset that can reasonably be expected to occur during
the remaining life of the option; and
(6) The current term structure of interest rates.
(C) The term major market foreign currency shall mean the
currency of a sovereign nation whose short-term debt is rated in
one of the two highest categories by at least two nationally
recognized statistical rating organizations and for which there
is a substantial inter-bank forward currency market. For
purposes of this section, the European Currency Unit (ECU) shall
be deemed a major market foreign currency.
(D) The term qualified stock basket shall mean a set or
basket of stock positions which represents no less than 50% of
the capitalization for a high-capitalization or non-high-
capitalization diversified market index, or, in the case of a
narrow-based index, no less than 95% of the capitalization for
such narrow-based index.
(ii) With respect to positions involving listed options in a
single specialist's market-maker account, and, separately, with
==========================================START OF PAGE 40======
respect to positions involving listed option positions in its
proprietary or other account, the broker or dealer shall group
long and short positions into the following portfolio types:
(A) Equity options on the same underlying instrument and
positions in that underlying instrument;
(B) Options on the same major market foreign currency,
positions in that major market foreign currency, and related
instruments within those options' classes;
(C) High-capitalization diversified market index options,
related instruments within the option's class, and qualified
stock baskets in the same index;
(D) Non-high-capitalization diversified index options,
related instruments within the index option's class, and
qualified stock baskets in the same index; and
(E) Narrow-based index options, related instruments within
the index option's class, and qualified stock baskets in the same
index.
(iii) Before making the computation, each broker or dealer
shall obtain the theoretical gains and losses for each options
series and for the related and underlying instruments within
those options' class in each specialist's market-maker account
guaranteed, endorsed, or carried by a broker or dealer, or in the
proprietary or other accounts of that broker or dealer. For each
option series, the theoretical options pricing model shall
calculate theoretical prices at 10 equidistant valuation points
within a range consisting of an increase or a decrease of the
==========================================START OF PAGE 41======
following percentages of the daily market price of the underlying
instrument:
(1) +(-)15% for equity securities with a ready market,
narrow-based indexes, and non-high-capitalization diversified
indexes;
(2) +(-)6% for major market foreign currencies;
(3) +(-) 20% for all other currencies; and
(4) +(-)10% for high-capitalization diversified indexes.
(iv)(A) As to non-clearing option specialists and market-
makers, the percentages of the daily market price of the
underlying instrument shall be:
(1) +(-) 4«% for major market foreign currencies; and
(2) +6(-)8% for high-capitalization diversified indexes.
(3) +(-) 10% for a non-clearing market-maker, or specialist
in non-high capitalization diversified index product group.
(B) The provisions of this paragraph (b)(1)(iv) shall expire
two years from the effective date of this paragraph, unless
otherwise extended by the Commission.
(v)(A) The broker or dealer shall multiply the corresponding
theoretical gains and losses at each of the 10 equidistant
valuation points by the number of positions held in a particular
options series, the related instruments and qualified stock
baskets within the option's class, and the positions in the same
underlying instrument.
(B) In determining the aggregate profit or loss for each
portfolio type, the broker or dealer will be allowed the
==========================================START OF PAGE 42======
following offsets in the following order, provided, that in the
case of qualified stock baskets, the broker or dealer may elect
to net individual stocks between qualified stock baskets and take
the appropriate deduction on the remaining, if any, securities:
(1) First, a broker or dealer is allowed the following
offsets within an option's class:
(i) Between options on the same underlying instrument,
positions covering the same underlying instrument, and related
instruments within the option's class, 100% of a position's gain
shall offset another position's loss at the same valuation point;
(ii) Between index options, related instruments within the
option's class, and qualified stock baskets on the same index,
95%, or such other amount as designated by the Commission, of
gains shall offset losses at the same valuation point;
(2) Second, a broker-dealer is allowed the following
offsets within an index product group:
(i) Among positions involving different high-capitalization
diversified index option classes within the same product group,
90% of the gain in a high-capitalization diversified market index
option, related instruments, and qualified stock baskets within
that index option's class shall offset the loss at the same
valuation point in a different high-capitalization diversified
market index option, related instruments, and qualified stock
baskets within that index option's class;
(ii) Among positions involving different non-high-
capitalization diversified index option classes within the same
==========================================START OF PAGE 43======
product group, 75% of the gain in a non-high-capitalization
diversified market index option, related instruments, and
qualified stock baskets within that index option's class shall
offset the loss at the same valuation point in another non-high-
capitalization diversified market index option, related
instruments, and qualified stock baskets within that index
option's class or product group;
(iii) Among positions involving different narrow-based index
option classes within the same product group, 90% of the gain in
a narrow-based market index option, related instruments, and
qualified stock baskets within that index option's class shall
offset the loss at the same valuation point in another narrow-
based market index option, related instruments, and qualified
stock baskets within that index option's class or product group;
(iv) No qualified stock basket should offset another
qualified stock basket; and
(3) Third, a broker-dealer is allowed the following offsets
between product groups:
Among positions involving different diversified index product
groups within the same market group, 50% of the gain in a
diversified market index option, a related instrument, or a
qualified stock basket within that index option's product group
shall offset the loss at the same valuation point in another
product group;
(C) For each portfolio type, the total deduction shall be
the larger of:
==========================================START OF PAGE 44======
(1) The amount for any of the 10 equidistant valuation
points representing the largest theoretical loss after applying
the offsets provided in paragraph (b)(1)(v)(B) if this section;
or
(2) A minimum charge equal to 25% times the multiplier for
each equity and index option contract and each related instrument
within the option's class or product group, or $25 for each
option on a major market foreign currency with the minimum charge
for futures contracts and options on futures contracts adjusted
for contract size differentials, not to exceed market value in
the case of long positions in options and options on futures
contracts; plus
(3) In the case of portfolio types involving index options
and related instruments offset by a qualified stock basket, there
will be a minimum charge of 5% of the market value of the
qualified stock basket for high-capitalization diversified and
narrow-based indexes; and
(4) In the case of portfolio types involving index options
and related instruments offset by a qualified stock basket, there
will be a minimum charge of 7«% of the market value of the
qualified stock basket for non-high-capitalization diversified
indexes.
Alternative Strategy Based Method
(2) A broker or dealer may elect to apply the alternative
strategy based method in accordance with the provisions of this
paragraph (b)(2).
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(i) Definitions.
(A) The term intrinsic value or in-the-money amount shall
mean the amount by which the exercise value, in the case of a
call, is less than the current market value of the underlying
instrument, and, in the case of a put, is greater than the
current market value of the underlying instrument.
(B) The term out-of-the-money amount shall mean the amount
by which the exercise value, in the case of a call, is greater
than the current market value of the underlying instrument, and,
in the case of a put, is less than the current market value of
the underlying instrument.
(C) The term time value shall mean the current market value
of an option contract that is in excess of its intrinsic value.
(ii) Every broker or dealer electing to calculate
adjustments to net worth in accordance with the provisions of
this paragraph (b)(2) must make the following adjustments to net
worth:
(A) Add the time value of a short position in a listed
option; and
(B) Deduct the time value of a long position in a listed
option, which relates to a position in the same underlying
instrument or in a related instrument within the option class or
product group as recognized in the strategies enumerated in
paragraph (b)(2)(iii)(D) of this section; and
(C) Add the net short market value or deduct the long
market value of listed options as recognized in the strategies
==========================================START OF PAGE 46======
enumerated in paragraphs (b)(2)(iii)(E)(1) and (2) of this
section.
(iii) In computing net capital after the adjustments
provided for in paragraph (b)(2)(ii) of this section, every
broker or dealer shall deduct the percentages specified in this
paragraph (b)(2)(iii) for all listed option positions, positions
covering the same underlying instrument and related instruments
within the options' class or product group.
Uncovered Calls
(A) Where a broker or dealer is short a call, deducting the
percentage required by paragraphs (c)(2)(vi)(A) through (K) of
240.15c3-1 of the current market value of the underlying
instrument for such option reduced by its out-of-the-money
amount, to the extent that such reduction does not operate to
increase net capital. In no event shall this deduction be less
than the greater of $250 for each short call option contract for
100 shares or 50% of the aforementioned percentage.
Uncovered Puts
(B) Where a broker or dealer is short a put, deducting the
percentage required by paragraphs (c)(2)(vi)(A) through (K) of
240.15c3-1 of the current market value of the underlying
instrument for such option reduced by its out-of-the-money
amount, to the extent that such reduction does not operate to
increase net capital. In no event shall the deduction provided
by this paragraph be less than the greater of $250 for each short
put option contract for 100 shares or 50% of the aforementioned
==========================================START OF PAGE 47======
percentage.
Long Positions
(C) Where a broker or dealer is long puts or calls,
deducting 50 percent of the market value of the net long put and
call positions in the same options series.
Certain Security Positions With Offsetting Options
(D)(1) Where a broker or dealer is long a put for which it
has an offsetting long position in the same number of units of
the same underlying instrument, deducting the percentage required
by paragraphs (c)(2)(vi)(A) through (K) of 240.15c3-1 of the
current market value of the underlying instrument for the long
offsetting position, not to exceed the out-of-the-money amount of
the option. In no event shall the deduction provided by this
paragraph be less than $25 for each option contract for 100
shares, provided that the minimum charge need not exceed the
intrinsic value of the option.
(2) Where a broker or dealer is long a call for which it has
an offsetting short position in the same number of units of the
same underlying instrument, deducting the percentage required by
paragraphs (c)(2)(vi)(A) through (K) of 240.15c3-1 of the
current market value of the underlying instrument for the short
offsetting position, not to exceed the out-of-the-money amount of
the option. In no event shall the deduction provided by this
paragraph be less than $25 for each option contract for 100
shares, provided that the minimum charge need not exceed the
intrinsic value of the option.
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(3) Where a broker or dealer is short a call for which it
has an offsetting long position in the same number of units of
the same underlying instrument, deducting the percentage required
by paragraphs (c)(2)(vi)(A) through (K) of 240.15c3-1 of the
current market value of the underlying instrument for the
offsetting long position reduced by the short call's intrinsic
value. In no event shall the deduction provided by this
paragraph be less than $25 for each option contract for 100
shares.
Certain Spread Positions
(E)(1) Where a broker or dealer is short a listed call and
is also long a listed call in the same class of options contracts
and the long option expires on the same date as or subsequent to
the short option, the deduction, after adjustments required in
paragraph (b) of this section, shall be the amount by which the
exercise value of the long call exceeds the exercise value of the
short call. If the exercise value of the long call is less than
or equal to the exercise value of the short call, no deduction is
required.
(2) Where a broker or dealer is short a listed put and is
also long a listed put in the same class of options contracts and
the long option expires on the same date as or subsequent to the
short option, the deduction, after the adjustments required in
paragraph (b) of this section, shall be the amount by which the
exercise value of the short put exceeds the exercise value of the
long put. If the exercise value of the long put is equal to or
==========================================START OF PAGE 49======
greater than the exercise value of the short put, no deduction is
required.
(c) With respect to transactions involving unlisted options,
every broker or dealer shall determine the value of unlisted
option positions in accordance with the provision of paragraph
(c)(2)(i) of 240.15c3-1, and shall deduct the percentages of
all securities positions or unlisted options in the proprietary
or other accounts of the broker or dealer specified in this
paragraph (c). However, where computing the deduction required
for a security position as if the security position had no
related unlisted option position and positions in unlisted
options as if uncovered would result in a lesser deduction from
net worth, the broker or dealer may compute such deductions
separately.
Uncovered Calls
(1) Where a broker or dealer is short a call, deducting 15
percent (or such other percentage required by paragraphs
(c)(2)(vi)(A) through (K) of 240.15c3-1) of the current market
value of the security underlying such option reduced by any
excess of the exercise value of the call over the current market
value of the underlying security. In no event shall the
deduction provided by this paragraph be less than $250 for each
option contract for 100 shares.
Uncovered Puts
(2) Where a broker or dealer is short a put, deducting 15
percent (or such other percentage required by paragraphs
==========================================START OF PAGE 50======
(c)(2)(vi)(A) through (K) of 240.15c3-1) of the current market
value of the security underlying the option reduced by any excess
of the market value of the underlying security over the exercise
value of the put. In no event shall the deduction provided by
this paragraph be less than $250 for each option contract for 100
shares.
Covered Calls
(3) Where a broker or dealer is short a call and long
equivalent units of the underlying security, deducting 15 percent
(or such other percentage required by paragraphs (c)(2)(vi)(A)
through (K) of 240.15c3-1) of the current market value of the
underlying security reduced by any excess of the current market
value of the underlying security over the exercise value of the
call. No reduction under this paragraph shall have the effect of
increasing net capital.
Covered Puts
(4) Where a broker or dealer is short a put and short
equivalent units of the underlying security, deducting 15 percent
(or such other percentage required by paragraphs (c)(2)(vi)(A)
through (K) of 240.15c3-1) of the current market value of the
underlying security reduced by any excess of the exercise value
of the put over the market value of the underlying security. No
such reduction shall have the effect of increasing net capital.
Conversion Accounts
(5) Where a broker or dealer is long equivalent units of the
underlying security, long a put written or endorsed by a broker
==========================================START OF PAGE 51======
or dealer and short a call in its proprietary or other accounts,
deducting 5 percent (or 50 percent of such other percentage
required by paragraphs (c)(2)(vi)(A) through (K) of 240.15c3-1)
of the current market value of the underlying security.
(6) Where a broker or dealer is short equivalent units of
the underlying security, long a call written or endorsed by a
broker or dealer and short a put in his proprietary or other
accounts, deducting 5 percent (or 50 percent of such other
percentage required by paragraphs (c)(2)(vi)(A) through (K) of
240.15c3-1) of the market value of the underlying security.
Long Options
(7) Where a broker or dealer is long a put or call endorsed
or written by a broker or dealer, deducting 15 percent (or such
other percentage required by paragraphs (c)(2)(vi)(A) through (K)
of 240.15c3-1) of the market value of the underlying security,
not to exceed any value attributed to such option in paragraph
(c)(2)(i) of 240.15c3-1.
By the Commission.
Jonathan G. Katz
Secretary
Dated: February 6, 1997