I. Introduction
On August 5, 1999, the Philadelphia Stock Exchange, Inc. (“Phlx” or “Exchange”) filed with the Securities and Exchange Commission (“SEC” or “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) and Rule 19b-4 thereunder, a proposed rule change to amend its method of calculating initial and maintenance customer margin requirements for non-customized cross-rate foreign currency options (“Cross-Rate FCOs”). The Exchange amended the proposal on October 26, 1999.
15 U.S.C. 8s(b)(1).
17 CFR 240.19b-4.
In Amendment No. 1, the Exchange requested that the Commission approve the existing 4% add-on margin for all non-customized cross-rate foreign currency options until February 4, 2000, prior to the thirtieth day after the publication of the notice thereof in the Federal Register; provided statistical data to substantiate the proposed rule change; and made substantive changes to the proposed rule text. See Letter from Nandita Yagnik, Counsel, Phlx, to Hong-anh Tran, Attorney, Division of Market Regulation (“Division”), Commission, dated October 25, 1999 (“amendment No. 1”).
The Commission published notice of the proposed rule change in the Federal Register on November 12, 1999. The Exchange filed a second amendment to the proposal on January 19, 2000. The Commission received no comments on the proposal. This order approves the proposed rule change, as amended.
Securities Exchange Act Release No. 42093 (November 3, 1999), 64 FR 61682 (November 12, 1999) (File No. SR-Phlx-99-30).
In Amendment No. 2, the Exchange made technical changes to the proposed rule text. Specifically, the Exchange proposes to modify the introductory portion of Commentary .16 to Phlx Rule 722 to clarify that the Commentary .16 methodology applies to non-customized Cross-Rate FCOs, but not to customized Cross-Rate FCOs. The Exchange also proposes replacing the word “currency” with the term “currency pair” throughout Paragraph (c) of Commentary .16, and adding the word “the” before the word “base currency” in Paragraph (a) of the same commentary. See Letter from Nadita Yagnik, Counsel, Phlx, to Hong-anh Tran, Attorney, Division of Market Regulation (“Division”), Commission, dated January 18, 2000 (“Amendment No. 2”).
II. Description of the Proposal
The Exchange proposes to determine the add-on margin levels for all non-customized Cross-Rate FCOs using the methodology outlined in Commentary .16 to Phlx Rule 722, in lieu of the fixed four percent rate that the Exchange currently uses.
In 1991, the Commission approved the Exchange's proposal to list and trade three non-customized Cross-Rate FCOs—German mark/Japanese yen, British pound/German mark and British pound/Japanese yen options. The Commission's 1991 order approved a four percent add-on margin level for the non-customized Cross-Rate FCOs for a one-year period only, because these products were new products and the Commission was concerned that the volatility in the underlying currencies could change significantly. Accordingly, the Commission stated that the Exchange should further analyze the add-on margin adequacy, and, within nine months, submit the analysis along with a proposed rule change to retain the margin level or establish a new level.
See Securities Exchange Act Release No. 29919 (November 7, 1991), 56 FR 58109 (November 15, 1991) (“1991 Order“). Although the Exchange received approval for the British pound/Japanese yen Cross-rate FCO, the Exchange has not listed such a contract.
Based on the 1991 Order, the Exchange's customer margin requirements for short positions for non-customized Cross-Rate FCOs equaled the add-on margin of four percent of the current market value of the foreign currency underlying the FCO contract, plus 100 percent of the market value of the FCO contract, reduced by any “out-of-the-money amounts” but in no event be less than 100 percent of the market value of the FCO contract plus a “minimum add-on margin amount” The Exchange represented that this add-on margin level was sufficient to cover each non-customized cross-rate product's historical price volatility over seven-day intervals (for the July 30, 1990 to July 30, 1991 time period) with a confidence level of at least 96 percent.
For foreign currency put options, “out-of-the-money-amounts” equal the aggregate exercise price of the option minus the product of units per foreign currency contract and the closing spot price. See Phlx Rule 722(d).
For foreign currency call options, “out-of-the-money-amounts” equal the product of units per foreign currency contract and the closing spot price minus the aggregate exercise price of the option. See id.
The minimum add-on margin on any call carried “short” in a customer's account is equal to 3/4% of the current market value of the underlying FCO contract; the minimum add-on margin on any such put option contract is equal to 3/4% of the option's aggregate exercise price amount. See id.
Due to an oversight, the Exchange did not file the required analysis of the adequacy of the add-on margin nor the proposed rule change within nine months of the 1991 Order. Following this discovery, the Exchange in 1999 filed a proposed rule change to temporarily codify the four percent add-on margin level while it considered a method of determining add-on margin, on a permanent basis, for all non-customized Cross-Rate FCOs.9 The Commission's order approving that proposed rule change permitted the Exchange to apply a four percent add-on margin level for all non-customized Cross-Rate FCOs for a six-month period until November 4, 1999.
On August 5, 1999, the Exchange filed the current proposed rule change to determine the add-on margin levels for non-customized Cross-Rate FCOs using the methodology outlined in Commentary .16 to Phlx Rule 722, in lieu of the four percent rate that the Exchange currently uses.
The Exchange currently uses the Commentary .16 methodology to calculate the add-on margin for standardized FCOs (where the base currency is denominated in U.S. dollars). The Commentary .16 methodology bases the add-on margin percentage for a foreign currency option on the volatility of the foreign currency underlying the option (the “underlying currency”) relative to the “trading currency.” To implement this change, the Exchange proposes to amend the text of Commentary .16, and the chart in Rule 722, to clarify that the Exchange will set the add-on margin for Cross-Rate FCOs based on all five-day price movements of the base currency vis-a-vis the underlying currency for the contract.
In particular, the Exchange proposes to review five day price movements of the base currency relative to the underlying currency over the most recent three year period and would set the add-on margin level at a level sufficient to cover those price changes at least 97.5 percent of the time. If subsequent quarterly reviews show that the existing add-on margin level for any non-customized cross-rate FCO currency pair provides a confidence level below 97 percent, the Exchange would increase the add-on margin requirement for that currency pair to a level that would have covered those price movements at a 98 percent confidence level. If a subsequent quarterly review shows a confidence level between 97 percent and 97.5 percent, the add-on margin level would remain the same but would be subject to monthly follow-up reviews until the confidence level exceeds 97.5 percent for two consecutive months (then the Exchange would put it back on the quarterly review cycle). If a monthly follow-up review showed that the confidence level dropped below 97 percent, the Exchange would increase the add-on margin level to a 98 percent confidence level. Generally, if any review shows that the confidence level exceeds 98.5 percent, the Exchange would reduce the add-on margin level to a 98 percent confidence level. But to account for the possibility of unexpectedly large price movements, if any review show that a Cross-Rate FCO currency paid had a five-day price movement, either positive or negative, greater than two times the existing add-on margin level, the Exchange would set the add-on margin requirement for that currency pair to a 99 percent confidence level (“Extreme Outlier Test”). In addition to the routine reviews described above, the Exchange would continue to have authority to impose a higher margin level at any time, if market conditions so warrant.
The Exchange filed an amendment to the proposed rule change on October 26, 1999. The amendment requested that the Commission grant accelerated approval to the amendment so that the Exchange could continue to apply the four percent add-on margin for all Cross-Rate FCO products until February 4, 2000. This would provide additional time for the Commission to consider the proposed rule change, while ensuring that trading of these products would continue following November 4, 1999, when the existing four percent add-on margin would have expired.
Based on the data supplied by the Exchange on October 26, 1999 for the three-year period of July 16, 1996 through July 15, 1999, the Commentary .16 methodology would produce add-on margins for British pound/Deutsche mark and Deutsche mark/Japanese yen non-customized Cross-Rates (which are currently listed on the Exchange) of 3.5 percent and 4 percent, respectively, covering 99 percent and 97.5 percent confidence level, respectively. The British pound/Deutsche mark FCO contract would have been margined at a 99 percent confidence level because the extreme outlier test would have applied. The British pound/Japanese yen Cross-Rate contract, which is currently not listed on the Exchange, would have an add-on margin of 5 percent, covering 97.5 percent confidence level.
III. Discussion
Upon careful review, 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 exchange.11 The Commission finds that the proposed rule change is consistent with Section 6(b)(5) of the Act, which requires, inter alia, that the rules of an exchange promote just and equitable principles of trade and facilitate transactions in securities.12 In particular, the proposed rule change will make the required margin on non-customized Cross-Rate FCOs better reflect existing economic circumstances and therefore will better correlate the margin requirement with the risk associated with holding a short position in a non-customized Cross-Rate FCO.
The Exchange proposes to set the add-on margin based on the five-day price movements (excluding weekends) of the underlying currency relative to the base currency over the most recent three-year period, by setting the add-on margin percentage at a level that would cover those price movements at a specified confidence level, typically 97.5 percent.
The Commission finds that the use of the Commentary .16 methodology to set add-on margins for non-customized Cross-Rate FCOs, in lieu of the fixed four percent requirement the Exchange currently uses, potentially provides a more economically meaningful margin. The currencies involved in the non-customized Cross-Rate FCOs that the Exchange is authorized to list and trade—the British pound, Deutsche mark, and Japanese yen—are all relatively stable currencies and it is reasonable to assume that those currencies' future volatility will be linked to their past volatility. Also, the Exchange has the authority to apply a higher add-on margin than required by the Commentary .16 methodology, when appropriate. Use of the Commentary .16 methodology further would promote efficiency because the Exchange will not have to file a proposed rule change with the Commission each time Commentary .16 methodology changes the add-on margin levels.
The Commission finds good cause for approving Amendment No. 2 to the proposed rule change prior to the thirtieth day after the date of publication of notice of filing thereof in the Federal Register. In Amendment No. 2, the Exchange made two general technical changes to Commentary .16 to Phlx Rule 722, by clarifying that Commentary .16 was applicable to non-customized Cross-Rate FCOs but not to customized Cross-Rate FCSs, and by clarifying that paragraph (c) of Commentary .16 focuses on currency pairs, i.e., movements of currencies vis-a-vis each other. The amendment did not raise any new regulatory issues. Accordingly, the Commission believes that there is good cause to approve Amendment No. 2 to the proposal on an accelerated basis.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and arguments concerning Amendment No. 2, including whether the amendment is consistent with the Act. Persons making written submissions should file six copies thereof with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Room. Copies of the filing will also be available for inspection and copying at the principal office of the Exchange. All submissions should refer to File No. SR-Phlx-99-30 and should be submitted by March 2, 2000.
V. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-Phlx-99-30) is approved, as amended.
For the Commission, by the Division of Market Regulation, pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-3089 Filed 2-9-00; 8:45 am]
BILLING CODE 8010-01-M