Capital Requirements for Brokers or Dealers Under the Securities Exchange Act of 1934

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-33761; File No. S7-7-94]

RIN 3235-AG14

Capital Requirements for Brokers or Dealers Under the Securities

Exchange Act of 1934

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Proposed rule amendments.

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SUMMARY: The Commission is proposing for comment amendments that would

allow broker-dealers to use a theoretical pricing model when

calculating capital charges for listed options and related positions.

Haircuts for options and related positions, when computed using this

model, would more accurately reflect the risk inherent in broker-

dealers' option positions. The proposed amendments are intended to

provide capital charges that better protect broker-dealers against

market risk.

DATES: The requested written data, views, arguments or comments must be

received on or before May 16, 1994.

ADDRESSES: People wishing to submit written data, views, arguments, or

comments should file three copies with Jonathan G. Katz, Secretary,

Securities and Exchange Commission, 450 Fifth Street, NW., Stop 6-9,

Washington, DC 20549. All written data, views, arguments, or comments

should refer to File No. S7-7-94. All comments received will be

available for public inspection and copying in the Commission's Public

Reference Room, 450 Fifth Street, NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate

Director, (202) 272-2904; Roger G. Coffin, Branch Chief, (202) 272-

7375; Timothy H. Thompson, Branch Chief, (202) 272-2372; or Bradley W.

Paulson, Staff Attorney (202) 272-2396; Office of Capital Markets and

Financial Responsibility, Division of Market Regulation, Securities and

Exchange Commission.

SUPPLEMENTARY INFORMATION:

I. Introduction

In May 1993, the Commission issued a concept release soliciting

public comment on issues relating to the standards imposed on

derivative products by the net capital rule (``Concept

Release'').1 The Concept Release noted that, at the time, the

Commission's staff was studying a recommendation to adopt a theoretical

pricing model developed by The Options Clearing Corporation (``OCC'')

to determine haircuts for broker-dealers' option positions under the

net capital rule. The Concept Release specifically asked questions on

the use of theoretical pricing formulas to determine haircuts for over-

the-counter (``OTC'') options. The Commission is now proposing for

comment amendments to the net capital rule, that would allow broker-

dealers to use data derived from OCC's theoretical pricing model to

determine haircuts for listed options and related positions.2

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\1\Securities Exchange Act Rel. No. 32256 (May 4, 1993), 58 FR

27486 (May 10, 1993).

\2\Simultaneous with this release, the Division of Market

Regulation (``Division'') is issuing a letter stating that it will

recommend no enforcement action to the Commission if, pursuant to

the terms of that letter, broker-dealers use theoretical pricing

data provided by OCC to calculate haircuts for listed options and

related positions.

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The proposed amendments will not change the current strategy-based

haircut methodology for OTC options. As noted in the Concept Release,

before adequate charges for OTC options can be determined, it will be

necessary to ascertain the manner in which the credit risk associated

with these positions can be adequately measured. The Commission,

however, continues to be interested in studying the applicability of

the proposed theoretical pricing haircut methodology to assess the

market risk for OTC options and currently is evaluating, among other

things, the comment letters addressing the questions for comment set

forth in the Concept Release.

II. Historical and Technical Background

A. Current Net Capital Treatment of Options

The Commission's net capital rule requires that every registered

broker-dealer 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 proceeding. Generally,

net capital, as defined by Rule 15c3-1, is a broker-dealer's net worth

plus liabilities subordinated in accordance with Appendix D of the net

capital rule, minus assets not readily convertible into cash and

certain percentages, or haircuts, of a firm's proprietary securities

positions, including option positions.

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, assumes that

the option will be exercised or held to expiration. The second

approach, a premium-based approach, assumes that options are used as

trading positions. This approach is contained in paragraph (c)(2)(x) of

Rule 15c3-1. 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 offset

positions. The provisions of Appendix A were designed for firms

clearing their proprietary listed option and related positions.3

While market-makers on the floors of the option exchanges are exempt

from the net capital rule,4 a clearing firm endorsing or

guaranteeing the listed option positions of non-clearing market-makers

is required to charge the premium-based haircuts to its capital. The

premium-based approach also can be used by 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.5

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\3\In a letter dated October 23, 1985, the Commission's staff

issued no-action relief allowing broker-dealers clearing their

proprietary listed option and related positions to apply a premium-

based haircut methodology. Letter from Michael A. Macchiaroli,

Assistant Director, to Michael Minikes, Chairman, Capital Committee,

Securities Industry Association, (October 23, 1985).

\4\17 CFR 240.15c3-1(b)(1).

\5\17 CFR 240.15c3-1(a)(7).

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As currently drafted, 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. However, the Division, in an

interpretive letter approved by the Commission, has allowed the

carrying broker-dealer to forego this requirement if it takes a charge

against its capital to the extent that the equity in the market-maker's

account is insufficient to cover the haircuts.6

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\6\Letter from Lee A. Pickard, Director, Division, Commission,

to Joseph W. Sullivan, President, Chicago Board Options Exchange

(April 8, 1977).

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B. Development of Option Pricing Models

Over the last 30 years, several models have been developed to

determine the value of an option.7 Initially, these models were

applied to warrants, because, at the time, that market was more

active.8 Option pricing formulas have been refined and are now

widely used to calculate option prices by assigning pre-determined

values to the factors that are known to affect their prices.

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\7\An option gives the holder the right to buy (i.e., a call) or

sell (i.e., a put) a particular underlying instrument at a certain

price for a limited period of time. An option's price, or

``premium,'' has two components, the option's intrinsic value and

the ``time value.'' An option's intrinsic value is the difference

between the price of the underlying instrument and the strike price.

The time value is the amount by which the premium exceeds the

option's intrinsic value.

\8\Fischer Black, ``How We Came Up With the Formula'' in The

Financial Derivatives Reader 176 (Kolb ed. 1992).

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In 1973, Fischer Black and Myron Scholes introduced a formula to

calculate European call option prices.9 The primary factors

affecting the price of an option are: The value of the underlying

asset, the exercise price of the option, the price volatility of the

underlying asset, the risk-free rate of interest and the remaining time

to expiration. The payment of dividends on the stock, as well as the

exercise timing of the option (i.e., American or European), also can be

factors in the pricing of an option.

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\9\Fischer Black & Myron Scholes, The Pricing of Options and

Corporate Liabilities 3 J. Polit. Econ. 637 (May-June 1973).

A European option can be exercised only on the expiration date,

while an American option can be exercised at any time prior to

expiration date.

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Subsequent to the development of the Black-Scholes formula, John

Cox, Stephen Ross and Mark Rubinstein developed a binomial pricing

model to determine the value of options.10 Unlike the Black-

Scholes formula, which employs ``mathematical tools * * * [that] are

quite advanced'' to determine the probable value of the underlying

instrument at the time of expiration, the Cox-Ross Rubinstein model

replicates periodical upward and downward movements in the value of an

option until the option's expiration date.11 By determining

different probable option values at various periods during the life of

an option, the Cox-Ross-Rubinstein model is able to incorporate

dividend yields, and American option prices can be determined.

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\1\0John Cox, Mark Rubinstein & Stephen Ross, Option Pricing: A

Simplified Approach 7 J. Fin. Econ. 229 (1979).

\1\1Id. at 230.

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Based on the Cox-Ross-Rubinstein model, OCC has developed the

Theoretical Intermarket Margining System (``TIMS'') to measure the

market risk associated with participants' positions and establish

clearing house margin requirements.12 Likewise, for the last

several years, option pricing models, including the Cox-Ross-Rubinstein

model, have been commonly used by market professionals to develop

trading strategies and to manage market risk. In light of such

industry-wide usage, recommendations have been made urging the

Commission to adopt option pricing models to set capital charges.

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\1\2Securities Exchange Act Rel. No. 23167 (April 22, 1986), 51

FR 16127 (April 30, 1986).

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The proposed amendments to Rule 15c3-1 would establish a haircut

methodology based on the Cox-Ross-Rubinstein binomial model. This model

would be used to determine an option's theoretical gains and losses

after re-pricing the option in relation to assumed changes in the value

of the underlying instrument. At least initially, OCC would run the

model as explained below and deliver to interested broker-dealers the

gains and losses from each option positions which would be downloaded

by the broker-dealer into a spreadsheet provided by OCC. The

spreadsheet would contain all of the broker-dealer's relevant

positions.

III. Description of the Proposed Rule Amendment

With respect to each option series13 it clears, OCC would

collect the following information on a daily basis:

\1\3An 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

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and number of underlying units.

(i) The dividend streams for the underlying securities,

(ii) Interest rates (either the current call rate or the

Eurodollar rate for the maturity date which approximates the

expiration date of the option),

(iii) Days to expiration, and

(iv) Closing underlying security and option prices from various

vendors.

Using these values and the binomial model, OCC would measure the

implied volatility for each option series.

OCC then would input to the model the resulting implied volatility

for each option series and other data, except the underlying value,

used in the calculation of the implied volatility. For each option

series, the model would calculate theoretical prices at ten 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-cap, broad- based indexes,

(ii) +(-)6% for major market currencies,14 and

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\1\4Deutsche Mark, British Pound, Swiss Franc, French Franc,

Canadian Dollar, Japanese Yen and European Currency Unit.

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(iii) +(-)10% for high-cap, broad-based indexes.

On a daily basis, OCC would use the model to determine the

theoretical gains/losses between the option's closing price and the

theoretical price at each one of the ten equidistant valuation points.

OCC would provide daily these theoretical gain/loss amounts to broker-

dealers.

Upon receipt of the theoretical gain/loss amounts, the broker-

dealer would download the information to a theoretical pricing haircut

spreadsheet. The broker-dealer must add to the spreadsheet all

proprietary or market-maker positions to be haircut. The spreadsheet

generates a profit/loss amount at each valuation point for each option

series and related positions covering the same underlying asset. The

greatest loss at any of the valuation points becomes the haircut for

those positions. The spreadsheet has been 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 ten 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 ten valuation points would become the haircut for the portfolio.

Within any portfolio type involving the same underlying stock,

index or currency, 100% of a position's gain at any one valuation point

will be allowed to offset another position's loss at the same valuation

point. Between qualified stock baskets (provided that the stock basket

represents no less than 90% of a high-cap, broad-based index's

capitalization or 100% of the capitalization of a narrow-based

index)15 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. Among high-cap, broad-based index options, futures and

futures options, 90% of the gain on one high-cap, broad-based index

position in the same market group, e.g. U.S. or Japan, would offset the

loss on a position on a different high-cap, broad-based index at the

same valuation point. Among non-high-cap, broad-based index options,

futures and futures options, 75% of the gain on one non-high-cap,

broad-based index position shall offset the loss on a position on a

different non-high-cap, broad-based index at the same valuation point.

The difference in offsets are designed to take into account liquidity

and execution risk in different markets.

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\1\5The proposed amendments would not recognize stock basket

offsets for non-high-cap, broad-based indexes.

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IV. Discussion of Issues Pertaining to the Proposed Theoretical Pricing

Haircut Methodology

A. Pilot Program

At the request of the Commission's staff, The Chicago Board Options

Exchange, Inc. (``CBOE'') and OCC established a pilot program to

compare the results achieved under the current haircut methodology and

the theoretical pricing approach. The pilot study was conducted from

April 22, 1992, through July 31, 1992, and included twelve firms

clearing either independent or proprietary market-maker accounts. The

pilot program included approximately 1,400 market-maker accounts.

The study employed the methodology that is now being proposed to

replace the current treatment for options and related positions set

forth in the net capital rule. As part of the pilot study, a minimum

charge of \1/8\ of a point per option contract was applied when the

theoretical pricing haircut for the class or product group reflected

little or no market exposure. This minimum charge (raised to \1/4\ of a

point in the current proposal), was assessed to account for liquidation

risk.

During the pilot study period, the proposed haircut methodology

resulted in an average haircut level reduction of 38% for self-clearing

market-maker firms. This average remained generally constant throughout

the pilot study period. This reduction in haircut levels seemed to have

resulted from the fact that, while these firms take large positions,

they tend to be more active in covering their market risk.

The results of the pilot study revealed that haircut charges for

non-clearing market-maker firms increased by an average of 3%. Of the

non-clearing market-maker accounts, 70% reflected a haircut change of

less than +(-) $50,000. At the same time, however, total deductions for

those firms (reflecting an increase in haircuts above the equity levels

kept in the market-maker accounts) increased by an average of 59%. The

decrease or minor increase in haircut levels, accompanied by a

substantial increase in deductions, seemed to have been the result of a

redistribution of haircuts to accounts containing positions with

greater market exposure but with less equity to cover the haircut

increase.

This conclusion appeared to be further confirmed by the fact that,

under the proposed methodology, haircut charges for accounts with short

positions appeared to increase.16 During the pilot study, CBOE and

OCC selected ten accounts that reflected significant differences

between the current haircut methodology and theoretical pricing

haircuts. Five of these accounts consisted of index option positions,

while the rest consisted of equity options. As a general rule, when

using theoretical prices to calculate haircuts, excess short positions

resulted in a substantial haircut increase. This also was true in the

case of index option accounts, where, assuming a +(-) 10% underlying

movement, accounts with excess short positions endured an increase in

haircut levels, unless the risk associated with the short positions was

offset by the profit in another position.

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\1\6Past market experiences have shown that short option

positions tend to be particularly risky. In relation to the Market

Break of 1987, the Division noted the link between substantial

market-maker losses and short option positions. At the time, the

Division concluded that ``* * * the present net capital treatment

accorded to short options positions is inadequate to insure against

the risks of major market movements.'' Division, The October 1987

Market Break 5-46 (February 1988).

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To further test the level of market protection provided by the

proposed underlying price movement assumptions, the Commission's staff

required CBOE and OCC to compare haircuts under the proposed

theoretical price-based methodology and under the current methodology,

assuming a 22% daily downward market move for two days. In addition,

given the magnitude of this market move, implied volatilities were

assumed to double in size. The results of this test seemed to be

consistent with the general conclusions of the pilot study.

B. Underlying Price Movement Assumption for Certain Index and Currency

Options

One of the principal variables affecting the value of an option is

the price of the underlying instrument. The Commission, therefore,

believes 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. These

assumptions are: 6% for major market foreign currencies, 15% for

equities with a ready market, narrow-based indexes and 10% for high-

cap, broad-based indexes and non-high-cap broad-based indexes. These

underlying price movement assumptions reflect the risk stemming from

major movements in the value of the option's underlying instrument.

While CBOE and OCC agree with the Commission with regard to the

underlying price movement assumptions for equities with a ready

market,17 they believe that, with respect to high-cap, broad-based

index options, a +(-)10% underlying price movement assumption for all

broker-dealers may be too large. Similarly, the Philadelphia Stock

Exchange (``Phlx'') believes that an underlying price movement

assumption of +(-)6% for major market foreign currency options may be

too large for non-clearing market-makers. CBOE, OCC and Phlx,

therefore, have recommended the following underlying price movement

assumptions: (i) +6%, (-)8% for high-cap, broad-based index positions

of non-clearing option market-makers and a +(-)10% underlying

volatility assumption for all other broker-dealers, and (ii) +(-)4\1/

2\% for the major market foreign currency positions of non-clearing

option market-makers and a +(-)6% for all other broker-dealers.

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\1\7Letter from Mary L. Bender, First Vice President, CBOE &

John C. Hiatt, Executive Vice President, OCC to Michael A.

Macchiaroli, Associate Director, Division, Commission (May 7, 1993)

at 7.

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CBOE and OCC note that during the pilot study, haircuts for non-

clearing index market-makers increased by an average of approximately

27% and deductions increased by 121%. The data, however, provides very

little information indicating whether this percentage is entirely due

to the application of a +(-)10%, rather than if the proposed +6%, (-)8%

underlying price movement assumption, or whether the increase was the

result of account positions reflecting a larger market exposure. The

data provided, however, shows that during the course of the study there

were days when the application of a +(-)10% underlying price movement

assumption resulted in haircut reductions. Moreover, in one case for

which detailed account information was provided, the data showed that,

in the absence of excess naked short positions, theoretical pricing

haircuts assuming a +(-)10% underlying price movement resulted in an

81% reduction in haircut levels.

In light of the concerns raised and the lack of sufficient data,

the Commission is requesting comments on the recommendation set forth

by CBOE, OCC and Phlx. In particular, the Commission would like to

receive information on the impact upon traders, their clearing firms

and the pricing and liquidity of the index and currency markets

resulting from the implementation of a +(-)10% underlying volatility

assumption for high-cap, broad-based index options and a +(-)6% for

major market currency options and related positions. The Commission

also would welcome information regarding the cost of keeping the

underlying price movement assumptions at the proposed levels, rather

than at the levels recommended by CBOE, OCC and Phlx.18 In this

regard, the Commission invites commentators to discuss the extent to

which foregoing the added protection afforded by a +(-)10% underlying

price movement for high-cap, broad-based index options and a +(-)6% for

major market currency options and related positions is justified in

light of the possibility of sudden market movements such as those

experienced in 1987 and 1989.

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\1\8In this regard, the Commission encourages commentators to

consider, in particular, the impact that the marginal cost of

capital will have on the proposed rule amendment.

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C. Series Specific Volatilities and Constant Short-term Interest Rates

Prices derived from theoretical pricing models are a function of

the variables inputted. In computing the theoretical price of an

option, the Cox-Ross-Rubinstein model, like the Black-Scholes formula,

assumes that the implied volatility will remain constant over the life

of the option. Accordingly, the underlying instrument's price is

expected to change smoothly, never reflecting a sudden large movement.

Likewise, in computing theoretical prices it is assumed that the short-

term interest rate never changes.

(1) Series Specific Volatilities

Failure to take into account abrupt changes in an option's implied

volatility could result in unrealistic theoretical prices and less than

adequate capital requirements.19 The proposed rule amendment

requires the use of daily calculated series specific implied

volatilities. It has been suggested, however, that implied volatility

inputs should be allowed to fluctuate within chosen parameters.

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\1\9See generally Fischer Black, ``How to use the Holes in Black

Scholes'' in The Financial Derivatives Reader 198 (Kolb ed. 1992).

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There seems to be, however, little market consensus as to the

manner in which such adjustment can be implemented. Although it appears

that the underlying price movement assumptions embodied in the proposed

rule amendment are sufficiently large to adequately address any

concerns raised by the use of a constant implied volatility measure,

the Commission solicits comments on this issue.

(2) Constant Short-Term Interest Rates

Some commentators have suggested that interest rate variables

should be allowed to fluctuate within chosen parameters when computing

theoretical pricing haircuts. Aside from the computational burden

associated with allowing interest rates to fluctuate within chosen

parameters,20 it is generally believed that option prices are not

so sensitive to changes in interest rates so as to warrant changes in

the model's interest rate factor. Moreover, as previously noted, it

would seem that the substantial proposed underlying price movement

assumptions should compensate for any pricing problem associated with a

constant interest rate input.

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\2\0Altering the interest rate assumption would result in a

substantial increase in the number of computer calculations

necessary to determine theoretical pricing haircuts.

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D. Minimum Charges

During the pilot program, a minimum haircut of \1/8\ of a point per

option contract was applied. Pursuant to a recommendation by OCC and

CBOE, the proposed amendments would increase the minimum charge to \1/

4\ of a point per contract. The Commission believes that this increase

is appropriate to account for liquidation and decay risk in the prices

of long and short options in those instances in which application of

the theoretical pricing haircut methodology results in little or no

charge.

The proposed minimum charge presumes that a 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

would have to be increased by the additional percentage amount of

underlying units. For example, if an IBM option contract covered 500

shares instead of the usual 100, the minimum charge would be $125

((i.e., 5 x 25).

E. Distribution of Theoretical Pricing Data

The theoretical pricing haircut methodology set forth in the

proposed rule amendment seems to provide appropriate capital levels for

broker-dealers. While the securities industry generally supports the

proposal and its immediate implementation, the Commission believes that

there are several details in the proposed rule that should be observed

closely, and continued to be discussed in light of the public comment

received in response to this proposal.

In this regard, particular concerns have been raised respecting the

use of proprietary versions of option pricing models to calculate

haircuts. During the pilot study, OCC calculated the theoretical value

for each option series. Accordingly, the values inputted to determine

the theoretical pricing haircuts and, consequently, the resulting

haircuts were consistent among broker-dealers with the same positions.

In order to secure reliable results during the pilot study, moreover,

OCC applied editing procedures to ensure the accuracy of the resulting

values.21

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\2\1Prices for options and underlying assets were supplied by at

least two sources, private vendors and the exchanges where the

products were traded. OCC would perform a direct comparison of the

supplied price data. Subsequently, OCC would subject option prices

to a reasonableness check by calculating theoretical prices for

every option series. Ranges based on the option's theoretical price

were then set. An option's price was verified if a market price fell

outside its designated range. OCC would use a theoretical price in

place of a market price that fell outside its designated range.

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In light of the reliance on the choices made concerning the model's

variables, the use of proprietary models could result in significantly

different theoretical prices given the same assumed underlying price

movement. The Commission believes, therefore that there is a need for a

controlled environment that ensures the integrity of the haircut

results for all broker-dealers using the proposed methodology. Allowing

broker-dealers to employ any proprietary model and/or failing to

control the sources of the various values inputted to the model would

substantially hinder the ability to examine the accuracy of option

haircuts and their effectiveness as a way of ensuring adequate capital

levels. For this reason, the proposed amendments to Rule 15c3-1 would

require broker-dealers to use exclusively the theoretical pricing

values produced and distributed nightly by OCC (or such other entity as

the Commission may designate).

While the proposed amendments provide authority for the Commission

to designate other providers of theoretical option prices, OCC is

designated in the rule as a provider because it is presently in a

unique position with respect to the listed securities option positions

in that it is the issuer of the options, the clearing agent of the

options, and the entity that currently sets margin requirements for its

clearing members by use of a theoretical pricing model. The Commission

also considers it critical that OCC is subject to Commission inspection

and regulation.

The Commission solicits comment on whether it is preferable to

continue to use a single theoretical pricing model or whether, and

subject to what conditions, the Commission should consider allowing the

use of alternative models. The Commission also requests comments on

whether limitations should be imposed on fees charged by entities

providing theoretical prices.

F. Alternative Strategy-Based Methodology

As a practical matter, to be able to implement the proposed haircut

methodology, broker-dealers will be required to have a computerized

interface with OCC's system.22 This linkage would allow broker-

dealers to receive timely the theoretical gain/loss amounts provided by

OCC. In addition, the computer system would enable broker-dealers to

make the multiple calculations that are necessary in order to apply

such data to their option positions.

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\2\2For broker-dealers requiring theoretical gains/losses data,

OCC is considering a menu approach to select the classes of options

for which values are needed. This approach is intended to reduce the

expense and transmission time of providing values which are not

needed.

For broker-dealers who are not participants, OCC is considering

the possibility of establishing a dial-up facility to provide

theoretical gain/loss amounts. The particular characteristics of

this facility would be determined in conjunction with the potential

users.

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The Commission realizes that broker-dealers with limited option

positions might find it not cost effective to implement a computerized

interface with OCC. In order to address this concern, the proposed

amendments contain an alternative strategy-based haircut methodology.

This alternative methodology generally follows the conservative

approach currently embodied in Appendix A to the net capital rule.

Broker-dealers employing the proposed strategy-based methodology

would be required to eliminate from net worth the time value associated

with long or short option positions. In addition, this alternative

haircut methodology will allow only certain basic strategies used by

broker-dealers to offset market risk. In particular, broker-dealers

would be allowed to take a reduced charge for hedged positions

consisting of a long underlying position and an offsetting short call,

a short underlying position and an offsetting long call, and a long

underlying position and an offsetting long put. The Commission believes

that these strategies will allow broker-dealers who do not want to use

the theoretical price-based methodology to maintain lower haircut

requirements that are consistent with the market risk associated with

their option positions.

V. Discussion of Related Issues

In connection with the adoption of a theoretical pricing haircut

methodology, the Commission believes it is necessary to make the

following changes to the net capital rule:

A. Deletion of Paragraph (a)(7) of the Net Capital Rule

As previously stated, the net capital rule contains two haircut

methodologies, the premium-based approach 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 proposed amendments would delete paragraph (a)(7) of the net

capital rule. The Commission believes that this provision is no longer

necessary, because the proposed amendments would eliminate the

distinction between the premium-based approach and the approach set

forth in Appendix A.

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 the provisions of a 1977 interpretive letter, carrying

broker-dealers are not required to refrain from extending credit in a

market-maker account when haircuts for that account exceed the equity

in the account.23 This interpretation is conditioned on the

carrying broker-dealer taking a charge against capital to the extent

that the equity is insufficient to cover the haircuts. The proposed

amendments would incorporate this interpretation into the net capital

rule.

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\2\3Supra note 7.

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VI. Request for Comments

The Commission invites interested persons to submit written data,

views, arguments and/or comments on the proposed amendments. The

Commission is particularly interested in receiving comments from

broker-dealers on how these proposed rule amendments would affect their

required capital levels. Also, the Commission is interested in analyses

from broker-dealers on the ability of the theoretical pricing models to

accurately predict the risks in trading these instruments.

VII. Effects on Competition and Summary of Initial Regulatory

Flexibility Analysis

Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a)(2), requires

the Commission, in adopting rules under the Exchange Act, to consider

the anti-competitive effect of the rule, if any, and to balance any

impact against the regulatory benefits to be gained. The Commission has

considered the proposed amendments in light of this standard and

believes, preliminarily, that if adopted they would not likely impose

any significant burden on competition that is not necessary or

appropriate in furtherance of the Exchange Act. The Commission solicits

comment on this preliminary view.

In accordance with 5 U.S.C. 603, the Commission has prepared an

Initial Regulatory Flexibility Analysis (``IRFA'') concerning the

proposed amendments. The analysis notes that the proposed amendments

would implement a haircut methodology that employs a mathematical

formula to determine the theoretical value of options. The purpose of

these amendments is to make haircuts reflect more accurately the risks

associated with option positions.

Because of the complexity of the formula used to compute

theoretical prices, and in order to ensure the integrity of the

resulting haircuts, the Commission is proposing that only the OCC

theoretical pricing haircut program be utilized. Accordingly, to be

able to use this system it will be necessary for a broker-dealer to

have an automate interface with OCC's computer system. This would

enable broker-dealers to receive reliable, nightly data necessary to

calculate haircuts.

The proposed amendments will impact ``small business[es]'' or

``small organization[s],'' as those terms are defined in 17 CFR 240.0-

10(c), subject to Rule 15c3-1, insofar as they would be required to

implement a computer interface with OCC to be able to comply with the

requirements of the proposed rule amendment. In order to reduce the

impact on these broker-dealers, the proposed amendments set forth an

alternative haircut methodology that is based on the basic option

strategies used by broker-dealers.

A copy of the IRFA may be obtained by contacting Timothy H.

Thompson, Division of Market Regulation, Securities and Exchange

Commission, 450 Fifth Street NW., Washington, DC 20549, tel: (202) 272-

2372.

VIII. Statutory Analysis

The amendments are proposed pursuant to the authority conferred on

the Commission by section 15(c)(3) of the Act.

List of Subjects in 17 CFR Part 240

Brokers, Reporting and recordkeeping requirements, Securities.

For the reasons set forth in the preamble, Title 17 Chapter II of

the Code of Federal Regulation is proposed to be 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, 78i, 78j, 78l, 78m, 78n, 78o, 78p,

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.

* * * * *

Sec. 240.15c3-1 [Amended]

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:

Sec. 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 in listed options for which

a broker or dealer acts as a guarantor, endorser or carrying broker or

dealer for listed options purchased or written by a specialist that is

either not otherwise subject to the provisions of this section or is

described in paragraph (c)(2)(vi)(N) of this section, such broker or

dealer shall adjust its net worth by deducting as of noon of the next

business day the amounts computed as of the prior business day pursuant

to Sec. 240.15c3-1a. The required deductions may be reduced by any

liquidating equity that exists in such specialist's market maker

account as of the close of the prior business day or by the deposit of

additional funds or securities in the account by noon of the next

business day, and shall be increased to the extent of any liquidating

deficit in such account. In 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 a

standardized option as defined in Sec. 240.9b-1 that is traded on a

registered national securities exchange or the automated facilities of

a registered national securities association and is subject to the

transaction reporting requirements of the registered entity where it

trades.

(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 Sec. 240.15c3-1

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

Sec. 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:

(1) Immediately transmit telegraphic or telephone facsimile notice

of such event to the Division of Market Regulation in the headquarter's

office of the Commission in Washington, DC, 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

Securities Exchange Act of 1934 Act (``Designated Examining

Authority''); and

(2) Be subject to the prohibitions against withdrawal of equity

capital set forth in Sec. 240.15c3-1(e), and to the prohibitions

against reduction, prepayment and repayment of subordination agreements

set forth in paragraph (b)(11) of Sec. 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. The broker or dealer also shall transmit by the close of

business of the following business day telegraphic or telephone

facsimile notice to its Designated Examining Authority and the

Designated Examining Authority of the specialist, if different from its

own.

* * * * *

4. Section 240.15c3-1a is revised to read as follows:

Sec. 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 Sec. 240.15c3-1.

(2) For purposes of this section, the term option series includes

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) For purposes of this Appendix A to Sec. 240.15c3-1, the term

related instrument within an option class or product group includes

futures contracts and options on futures contracts covering the same

underlying instrument. In relation to options on major market foreign

currencies a related instrument within an option class also shall

include forward contracts on the same underlying currency.

(4) For purposes of this Appendix A to Sec. 240.15c3-1, the term

underlying instrument includes long and short positions, as

appropriate, covering the same major market foreign currency, the same

security, other than an option contract (underlying security), or a

security which is exchangeable for or convertible into the underlying

security within a period of 90 days. If the conversion or exchange

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 to Sec. 240.15c3-1, the broker or dealer

will deduct from net worth the full amount of the conversion loss or

the amount required for the conversion or exchange. The term underlying

security shall not be deemed to include futures contracts, options on

futures contracts or unlisted products.

(5) For the purposes of this Appendix A to Sec. 240.15c3-1, the

term product group is two or more option classes, related instruments

and underlying instruments in the same portfolio type for which it has

determined a percentage of offsetting profits may be applied to losses

at the same valuation point.

(b) Every broker or dealer shall deduct from net worth, in

calculating net capital, the amount resulting from the computation

required under the provisions of paragraph (b)(1) of this section,

unless it elects to calculate the required deductions in accordance

with the provisions of paragraph (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

and the value of related instruments within that option's class, at ten

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 Sec. 240.15c3-1 for the underlying

instrument. Theoretical gains and losses shall be calculated by The

Options Clearing Corporation, or such other entity as the Commission

may designate, using an approved theoretical options pricing model.

(B) The term approved theoretical options pricing model shall mean

a mathematical model, previously provided in writing to the Commission,

which is used by The Options Clearing Corporation to calculate

theoretical gains and losses.

(C) The term major market foreign currency shall mean the currency

of a sovereign nation whose short-term debt is rated in the highest

category by at least two nationally recognized statistical rating

organizations 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 with an aggregate market value at least equal to the

aggregate underlying value of a particular index option and related

instrument within that index option's class, provided that the set or

basket of stock represents no less than 90% of the capitalization for a

high-cap or non-high-cap broad-based market index, or, in the case of a

narrow-based index, no less than 100% 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 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' class;

(C) High-cap broad-based market index options, related instruments

within an option class and qualified stock baskets on the same index;

(D) All other high-cap broad-based market index options and related

instruments within the index option's class or product group;

(E) Non-high-cap broad based index options on the same index and

related instruments within that index option's class and qualified

stock baskets in the same index;

(F) All other non-high-cap broad-based market index options and

related instruments within that index option's class or product group,

and

(G) Narrow-based index options, related instruments within the

index option's class and qualified stock baskets on the same index.

(iii) Before making the computation, each broker or dealer shall

obtain from The Options Clearing Corporation the theoretical gains and

losses for each options series and for the related 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.

(A) Upon receipt of the theoretical gains and losses, for each one

of the portfolio types described above, the broker or dealer shall

multiply the corresponding theoretical gains and losses at each of the

ten equidistant valuation points by the number of positions held in a

particular options series, the related instruments within those options

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 following offsets:

(1) Between options on the same underlying instrument, positions

covering the same underlying instrument and related instruments within

the options' class, 100% of a position's gain shall offset another

position's loss at the same valuation point;

(2) Between high-cap broad-based market index options or related

instruments within the option class and qualified stock baskets on the

same index, 95% of gains shall offset losses at the same valuation

point;

(3) Between narrow-based market index options or related

instruments within the option class and qualified stock baskets on the

same index, 95% of gains shall offset losses at the same valuation

point;

(4) Among positions involving options series covering different

high-cap broad-based index options within the same product group, 90%

of the gain in a high-cap broad-based market index option and related

instruments within that index option's class shall offset the loss at

the same valuation point in a different high-cap broad-based market

index option and related instruments within that index option's class;

(5) Among positions involving options series covering different

non-high-cap broad-based index options within the same product group,

75% of the gain in a non-high-cap broad-based market index option and

related instruments within that index option's class shall offset the

loss at the same valuation point in another non-high-cap broad-based

market index option and related instruments within that index option's

class or product group; and

(6) Between non-high-cap broad-based market index options or

related instruments within the same options class and qualified stock

baskets on the same index, 95% of the gains shall offset losses at the

same valuation point.

(C) For each portfolio type, the total deduction shall be the

larger of:

(1) The amount for any of the ten equidistant valuation points

representing the largest theoretical loss after applying the offsets

provided above; or

(2) A minimum charge equal to one quarter (\1/4\) point 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; or

(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-cap broad-based and narrow-based indexes; or

(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 10% of the market value of the qualified stock basket

for non-high-cap broad-based indexes.

Alternative Strategy Based Charges

(2) A broker or dealer may elect not to apply the method described

in paragraph (b)(1) of this section and, instead, calculate adjustments

to net worth in accordance with the provisions of this paragraph

(b)(2).

(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.

(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. However, where computing the deductions required for commodity

or securities positions, other than a listed option position, if said

positions have no related listed option position the broker or dealer

shall compute the required deductions for such commodity or securities

positions separately.

Uncovered Short Calls

(A) Where a broker or dealer is short a call, deducting the

percentage required by paragraphs (c)(2)(vi) (A) through (K) of

Sec. 240.15c3-1 of the current market value of the underlying

instrument for such option reduced by the 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 Short Puts

(B) Where a broker or dealer is short a put, deducting the

percentage required by paragraphs (c)(2)(vi) (A) through (K) of

Sec. 240.15c3-1 of the current market value of the underlying

instrument for such option reduced by the 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 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, or in a related instrument within the option

class or product group covering the same number of units of the same

underlying instrument, deducting the percentage required by paragraphs

(c)(2)(vi) (A) through (K) of Sec. 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. 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, or in a related instrument within the option

class or product group covering the same number of units of the same

underlying instrument, deducting the percentage required by paragraphs

(c)(2)(vi) (A) through (K) of Sec. 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. 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.

(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, or in a related instrument within the option

class or product group covering the same number of units of the same

underlying instrument, deducting, the percentage required by paragraphs

(c)(2)(vi) (A) through (K) of Sec. 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.

(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

Sec. 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 Sec. 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 (c)(2)(vi) (A) through

(K) of Sec. 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

Sec. 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

Sec. 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 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 Sec. 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 Sec. 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

Sec. 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

Sec. 240.15c3-1.

Dated: March 15, 1994.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-6413 Filed 3-18-94; 8:45 am]

BILLING CODE 8010-01-P