Self-Regulatory Organizations; Proposed Rule Change and Amendment No. 1 to Proposed Rule Change; National Association of Securities Dealers, Inc.

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-35134; File No. SR-NASD-94-60]

Self-Regulatory Organizations; Proposed Rule Change and Amendment

No. 1 to Proposed Rule Change; National Association of Securities

Dealers, Inc.

December 21, 1994.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on October

27, 1994, the National Association of Securities Dealers, Inc.

(``NASD'' or ``Association'') filed with the Securities and Exchange

Commission (``Commission'' or ``SEC'') the proposed rule change as

described in Items I, II, and III below, which Items have been prepared

by the NASD. The Commission is publishing this notice to solicit

comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule

The NASD proposes to amend Section 33 of the NASD Rules of Fair

Practice, the NASD's position limit rule for standardized and

conventional options, to add a new subsection governing the application

of the NASD's aggregation rules for options positions to certain ``OTC

collar'' transactions involving conventional equity options (``OTC

Collar Aggregation Exemption'').

Section 33 of the NASD By-Laws

* * * * *

Section (b)(3) Position Limits

(a)(1)-(5) No change.

(a)(6) OTC Collar Aggregation Exemption.

(a) For purposes of this subsection, the term OTC collar shall mean

a conventional equity option position comprised of short (long) calls

and long (short) puts overlying the same security that hedge a

corresponding long (short) position in that security.

(b) Notwithstanding the aggregation provisions for short (long)

call positions and long (short) put positions contained in subsections

(A)(1)-(A)(3) above, the conventional options positions involved in a

particular OTC collar transaction need not be aggregated for position

limit purposes, provided the following conditions are satisfied:

1. the conventional options can only be exercised if they are in-

the-money;

2. neither conventional option can be sold, assigned, or

transferred by the holder without the prior written consent of the

writer;

3. the conventional options must be European-style (i.e., only

exercisable upon expiration) and expire on the same date;

4. the strike price of the short call can never be less than the

strike price of the long put; and

5. no more than one side of the transaction can be in-the-money

when the color is established.

6. the size of the conventional options in excess of the applicable

basic position limit for the options established pursuant to

subsections (A) (1)--(3) above must be hedged on a one-to-one basis

with the requisite long or short stock position for the duration of the

collar, although the same long or short stock position can be used to

hedge both legs of the collar. (c) For multiple OTC collars on the same

security meeting the conditions set forth in subsection (b) above, all

of the short (long) call options that are part of such collars must be

aggregated and all of the long (short) put options that are part of

such collars must be aggregated, but the short (long) calls need not be

aggregated with the long (short) puts.

(d) Except as provided above in subsections (b) and (c), in no

event may a member fail to aggregate any conventional or standardized

options contract of the put class and the call class overlying the same

equity security on the same side of the market with conventional option

positions established in connection with an OTC collar.

(e) Nothing in this subsection (6) changes the applicable position

limit for a particular equity security.

On December 14, 1994, the NASD amended the proposal (``Amendment

No. 1'') to require that neither side of a particular OTC collar be in-

the-money at the time the collar is established.\1\

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\1\Letter from Thomas R. Gira, Assistant General Counsel, NASD,

to Stephen M. Youhn, Derivative Products Regulation, SEC, dated Dec.

14, 1994.

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II. Self-Regulatory Organizations's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the NASD included statements

concerning the purpose of and basis for the proposed rule change and

discussed any comments it received on the proposed rule change. The

text of these statements may be examined at the places specified in

Item IV below. The NASD has prepared summaries, set forth in Sections

(A), (B), and (C) below, of the most significant aspects of such

statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

The NASD is proposing to amend its options position limit rule to

provide that positions in conventional put and call options

establishing OTC collars meeting certain qualifications need not be

aggregated for position limit purposes.\2\ An OTC collar transaction

involves the purchase (sale) of a long put and the sale (purchase) of a

short call on the same underlying security to hedge a long (short)

stock position. Market participants typically establish OTC collars to

hedge price exposure to long stock positions. Because of the NASD's

aggregation rules for options positions on the same side of the market,

however, members have represented that they have been constrained when

seeking to establish OTC collar positions for their customers. For

example, if a customer wanted to hedge 900,000 shares in XYZ with an

OTC collar (assuming XYZ is subject to a position limit of 4,500

contracts), and if the calls and puts associated with the collar must

be aggregated, the customer could only establish the collar for 450,000

shares (i.e., 4500 short calls and 4,500 long puts).\3\ As a result,

the remaining 450,000 shares of XYZ would remain unhedged.

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\2\Section 33(b)(3) of the NASD Rules of Fair Practice provides

that ``options contracts of the put and call class on the same side

of the market covering the same underlying security'' are aggregated

for position limit purposes. Accordingly, long calls and short puts

are aggregated and short calls and long puts are aggregated.

\3\In this instance, 4,500 of the 9,000 contracts are

permissible under the basic position limit contained in Section

33(b)(3) (A)(1) of the NASD Rules of Fair Practice and the remaining

4,500 contracts are permissible because they are hedged by the

900,000 shares of XYZ and, therefore, fall within the NASD's hedge

exemption contained in Section 33(b)(3) (A)(5).

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Accordingly in order to facilitate the needs of market participants

seeking to hedge their long stock positions with OTC collars, while not

compromising the market integrity and anti-manipulation concerns

underlying the NASD's options position limit rule, the NASD proposes to

waive the aggregation rules for certain OTC collar transactions meeting

specific criteria. Specifically, under the proposal, puts and calls on

the same side of the market would not have to be aggregated for

position limit purposes if they are part of an OTC collar transaction

meeting the following characteristics: (1) the options can only be

exercised if they are in-the-money; (2) neither option can be sold,

assigned, or transferred by the holder without the prior written

consent of the writer; (3) the options must be European-style (i.e.,

only exercisable upon expiration) and expire on the same date; (4) the

strike price of the short call can never be less than the strike price

of the long put; and (5) neither side of the transaction can be in-the-

money when the collar is established.\4\

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\4\See Amendment No. 1.

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In addition, consistent with the NASD'S position limit hedge

exemption rule, to the extent that the size of the conventional options

involved in an OTC collar exceed the size of the applicable basic

position limit for that option, the OTC Collar Aggregation Exemption

provides that such options positions must be hedged on a one-for-one

basis with the corresponding long/short stock position for the duration

of the collar. The NASD also notes that the OTC Collar Aggregation

Exemption will not affect the NASD's other aggregation rules for

options positions on the same side of the market. Thus, the NASD will

aggregate all standardized an conventional options positions with

options positions established pursuant to the OTC Collar Aggregation

Exemption, as well as options positions established in multiple OTC

collars on the same security. For example, if an investor establishes a

short position in 1,000 standardized call options on XYZ, a long

position in 1,000 standardized put options on XYZ, a short position in

1,000 conventional call options on XYZ (not established as part of an

OTC collar), a long position in 1,000 conventional put options on XYZ

(not established as part of an OTC collar), and an OTC collar meeting

the standards set forth above covering 500,000 shares of XYZ, the total

options position for position limit purposes would be 9,000

contracts.\5\ The proposal also contains provisions governing the

aggregation of conventional options positions establishing multiple OTC

collars. Specifically, for multiple OTC collars on the same security

meeting the conditions for the OTC Collar Aggregation Exemption, all of

the short (long) call options that are part of such collars must be

aggregated and all of the long (short) put options that are part of

such collars must be aggregated, but the short (long) calls need not be

aggregated with the long (short) puts.

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\5\See Amendment No. 1. This sentence was amended to correct a

typographical error.

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The NASD believes the conditions and limitations contained in the

OTC Collar Aggregation Exemption proposal strike a reasonable balance

between the need to facilitate legitimate hedging needs of market

participants and the need to have rules in place that do not compromise

the regulatory purposes served by equity option position limits. In

particular, because the conditions and limitations for the OTC Collar

Aggregation Exemption effectively provide that no more than one leg of

the OTC collar can ever be in-the-money at any time during the term of

the collar and no more than one leg of the collar can ever be exercised

throughout the term of the collar, the NASD believes that the potential

for market manipulation or disruption will not be increased by not

requiring the aggregation of the short (long) calls and long (short)

puts established pursuant to the OTC Collar Aggregation Exemption. In

addition, even though the legs of an OTC collar do not have to be

aggregated if the collar meets the standards for the aggregation

exemption, the NASD notes that these positions must be aggregated with

all other standardized and conventional options on the same side of the

market overlying the same security.\6\ Accordingly, the NASD believes

the proposal will not undermine the regulatory purposes served by

equity option position limits.

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\6\However, as noted above, if there are multiple OTC collars on

the same security meeting the conditions for the aggregation

exemption, then all of the short (long) call options that are part

of the collars must be aggregated and all of the long (short) put

options that are part of the collars must be aggregated, but the

short (long) calls need not be aggregated with the long (short)

puts.

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The NASD believes the proposed rule change is consistent with

Section 15A(b)(6) of the Act. Section 15A(b)(6) requires that the rules

of a national securities association be designed to prevent fraudulent

and manipulative acts and practices, to promote just and equitable

principles of trade, to foster cooperation and coordination with

persons engaged in regulating, clearing, settling, processing

information with respect to, and facilitating transactions in

securities, to remove impediments to and perfect the mechanism of a

free and open market and a national market system and, in general, to

protect investors and the public interest. Specifically, the NASD

believes that the OTC Collar Aggregation Exemption may increase the

depth and liquidity of the options markets by permitting investors to

hedge greater amounts of stock than would otherwise be the case without

the exemption. In addition, to the extent that investors have greater

assurance that they can hedge larger stock positions through the use of

OTC collars, the NASD believes liquidity in the underlying cash market

may be enhanced by the proposal. At the same time, the NASD believes

that the larger options positions available by virtue of the proposal

will not result in disruptions to the underlying stock market due to

the conditions and limitations that must be met to be eligible for the

aggregation exemption, and the NASD's surveillance program. In this

connection, the NASD will monitor the use of the OTC Collar Aggregation

Exemption to ensure that NASD members are complying with the

requirements of the exemption.

B. Self-Regulatory Organization's Statement on Burden on Competition

The NASD believes that the proposed rule change will not result in

any burden on competition that is not necessary or appropriate in

furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for

Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the NASD consents, the Commission will:

A. by order approve such proposed rule change, or

B. institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

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 Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

NASD. All submissions should refer to the file number in the caption

above and should be submitted by January 19, 1995.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\7\

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\7\17 CFR 200.30-3(a)(12) (1993).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-31996 Filed 12-28-94; 8:45 am]

BILLING CODE 8010-01-M