Petition of the Philadelphia Stock Exchange, Inc. for Exemptive Relief To Permit United States Customers To Establish or Offset Positions in Certain Foreign Currency Options on the Hong Kong Futures Exchange Ltd. Through Registered Broker-Dealers

COMMODITY FUTURES TRADING COMMISSION

Petition of the Philadelphia Stock Exchange, Inc. for Exemptive

Relief To Permit United States Customers To Establish or Offset

Positions in Certain Foreign Currency Options on the Hong Kong Futures

Exchange Ltd. Through Registered Broker-Dealers

AGENCY: Commodity Futures Trading Commission.

ACTION: Notice of final order.

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SUMMARY: In response to a petition by the Philadelphia Stock Exchange,

Inc. (``PHLX''), the Commodity Futures Trading Commission

(``Commission'' or ``CFTC'') has issued an Order (the ``Order'')

exempting from regulation under the Commodity Exchange Act (``Act'' or

``CEA'') \1\ transactions in which United States (``U.S.'') customers

establish or offset positions in Philadelphia Stock Exchange, Inc.

(``PHLX'') foreign currency options on the Hong Kong Futures Exchange

Ltd. (``HKFE'') through registered broker-dealers pursuant to

regulation by the Securities and Exchange Commission (``SEC'') under

the federal securities laws and subject to specified conditions as set

forth herein. The Order grants the requested relief pursuant to section

4c(b) of the Act.

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\1\ 7 U.S.C. 1 et seq.

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EFFECTIVE DATE: March 28, 1997.

FOR FURTHER INFORMATION CONTACT: Susan C. Ervin, Deputy Director/Chief

Counsel or Christopher W. Cummings, Attorney/Advisor, Division of

Trading and Markets, Commodity Futures Trading Commission, 1155 21st

Street, NW., Washington, DC. 20581. Telephone number: (202) 418-5450.

Facsimile number: (202) 418-5536. Electronic mail: [email protected].

[[Page 15660]]

SUPPLEMENTARY INFORMATION: On October 9, 1996, the Commission published

a Notice of Proposed Order and Request for Comment (the ``Proposing

Release'') \2\ in connection with the petition of PHLX (the ``PHLX

Petition'') for exemptive relief under sections 4(c) and 4c(b) of the

Act.\3\ In its Petition, PHLX requested that, to the extent pertinent,

the Commission exempt from its regulatory framework certain

transactions by U.S. customers in PHLX foreign currency options

(``FCOs'') effected on HKFE pursuant to a cross-listing and clearing

linkage arrangement between PHLX and HKFE.

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\2\ 61 FR 52921 (October 9, 1996).

\3\ 7 U.S.C. 6(c) and 6c(b) (1994), respectively. The intial

thirty-day period specified in the Proposing Release for public

comment on the PHLX Petition would have expired on November 8, 1996

but was extended to December 11, 1996. 61 FR 59089 (November 20,

1996). The PHLX Petition (dated August 15, 1996) is described in

detail in the Proposing Release.

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I. Background

PHLX and HKFE have entered into a licensing agreement pursuant to

which FCOs traded on PHLX may also be traded and offset on HKFE (the

``Linkage''). The Linkage is intended to permit U.S. customers, acting

through U.S.-registered broker-dealers, to establish FCO positions on

PHLX and offset such positions on HKFE or to establish FCO positions on

HKFE and offset the positions on PHLX.\4\ PHLX petitioned the

Commission for exemptive relief in order to assure that: (1) PHLX FCOs

may be cross-listed on HKFE, treated as fungible with PHLX-traded FCOs

and cleared through a securities-regulated clearing organization

pursuant to the federal securities laws and SEC oversight; and (2) the

PHLX and HKFE cross-listed FCOs would not be dually regulated under the

securities laws and the CEA, taking cognizance of the policies inherent

in Section 4c(f) of the Act, which provides that within the U.S.

options on foreign currencies may be traded on both futures and

securities exchanges.\5\

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\4\ Non-U.S. customers will also be able to use the Linkage to

trade PHLX FCOs. Although a non-U.S. customer will be able to

establish a position on HKFE through an HKFE broker that need not be

a clearing member of PHLX, if that customer wishes to offset or add

to that position on PHLX, the customer (or his HKFE broker) must

ultimately do so through a broker that is a PHLX member clearing

through The Options Clearing Corporation (``OCC'').

\5\ 7 U.S.C. 6c(f) (1994) provides that nothing in the CEA

``shall be deemed to govern or in any way be applicable to any

transaction in an option on foreign currency traded on a national

securities exchange.'' The parallel securities law provision is

Section 9(g) of the Securities Exchange Act of 1934 (the ``Exchange

Act''), 15 U.S.C. 78i(g) (1994), which provides, in relevant part,

that:

Notwithstanding any other provision of law, the [Securities and

Exchange] Commission shall have the authority to regulate the

trading of * * * any put, call, straddle, option, or privilege

entered into on a national securities exchange relating to foreign

currency * * *.

An option on foreign currency is within the securities law

definition of a ``security'' when it is ``entered into on a national

securities exchange.'' Exchange Act section 2(a)(1), 15 U.S.C.

77b(a)(1) (1994).

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A. PHLX Foreign Currency Options Trading

PHLX is a national securities exchange which has been registered

with the SEC since 1934. Equity securities, equity and index options,

and FCOs are listed for trading on the PHLX. PHLX commenced trading

FCOs on December 10, 1982. FCOs currently listed on PHLX include

dollar-denominated options on foreign currencies, cross-rate currency

options, cash/spot FCOs (which permit the holder to receive the

difference between the current foreign exchange spot price and the

exercise price of the particular contract) and customized currency

options.\6\

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\6\ The Proposing Release more fully describes the FCOs listed

for trading on PHLX and cross-references the relevant SEC releases

approving PHLX's proposed listing and trading of such FCOs. See 61

FR 52921 at 52922 (October 9, 1996).

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As discussed in the PHLX Petition,\7\ trading of options on PHLX is

governed by PHLX rules that require, inter alia, that a customer's

account be specifically approved for options trading before any option

transactions may be effected by a PHLX member for that customer. Such

approval must be in writing, may be made only by a person registered

with (and approved by) PHLX as a ``Registered Options Principal,'' \8\

and may occur only after the PHLX member ``exercise[s] due diligence to

learn the essential facts as to the customer and his investment

objectives and financial situation.'' \9\ PHLX rules additionally

require that a customer's account be specifically approved, in writing,

for transactions in foreign currency options by a ``Foreign Currency

Options Principal,'' \10\ before transactions in foreign currency

options are effected.

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\7\ PHLX Petition at 7-11.

\8\ A ``Registered Options Principal'' must pass a proficiency

examination demonstrating knowledge of the self-regulatory

organization requirements applicable to options transactions,

including the rules of PHLX and OCC, and also must demonstrate an

understanding of options trading. PHLX Rule 1024(a). Both the

National Association of Securities Dealers (``NASD'') and PHLX

require that persons selling FCOs pass a proficiency examination.

\9\ PHLX Petition at 7, quoting from PHLX Rule 1024(b)(ii). As

used herein, ``PHLX member'' means a broker-dealer that is either a

full member of PHLX or a non-member that has been admitted to PHLX

as a ``Foreign Currency Options Participant.'' A Foreign Currency

Options Participant must meet the same financial and fitness

requirements as a full member of PHLX (including registration with

the SEC and compliance with SEC net capital requirements), but

avoids paying the full price of a PHLX seat.

\10\ A ``Foreign Currency Options Principal'' of a PHLX member

must be a general partner, officer or person or appropriate

supervisory or managerial rank who has successfully completed a

registered options principal examination, allied member's

examination or other principal's examination (or equivalent

demonstration of knowledge) and who has also successfully completed

an examination prescribed by PHLX to demonstrate adequate knowledge

of foreign currency options and foreign currency markets. PHLX Rule

1025(c).

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PHLX also has a customer suitability rule, which prohibits a member

firm from recommending any option transaction to a customer unless the

firm ``has reasonable grounds to believe that the entire recommended

transaction is not unsuitable'' for the customer.\11\ Before a broker

may permit a customer to begin trading options, SEC and PHLX rules

require the broker to provide to the customer an SEC-mandated

disclosure document specific to the particular type of option order the

customer seeks to enter.\12\ PHLX and NASD rules also regulate the

content and presentation of advertisements, sales literature, and other

options-related communications in connection with sales of PHLX-offered

options to the public. Each foreign currency option contract on PHLX is

issued and marketed by prospectus pursuant to a registration statement

filed with the SEC under the Securities Act of 1933 (the ``Securities

Act'').\13\

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\11\ PHLX Petition at 8, quoting from PHLX Rule 1026(a).

\12\ Exchange Act Rule 9b-1 provides that an options disclosure

document must include information delineating the mechanics of

options trading, options trading risks, the uses of options,

transaction costs, margin requirements, and relevant tax issues. 17

CFR 240.9b-1(1996). PHLX Rule 1029 also requires delivery of the

Rule 9b-1 options disclosure document.

\13\ The prospectus prepared and delivered pursuant to the

Securities Act is a separate document from the options disclosure

document required to be furnished to customers under Exchange Act

Rule 9b-1.

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PHLX rules require member firms to establish written procedures

concerning supervision of customer option accounts and of all option

orders in such accounts and to maintain a special supervisory structure

for foreign currency options.\14\ Consistent with SEC regulations, PHLX

requires that all order tickets be time-stamped immediately upon

execution, and floor brokers and traders are required to report

relevant information regarding each option transaction. With the

exception of specialists, PHLX floor traders are prohibited from dual

trading, that is, trading a particular options class for their own

account on the day of

[[Page 15661]]

execution of a customer order in the same options class.\15\

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\14\ PHLX Petition at 9.

\15\ PHLX Petition at 11.

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PHLX has represented that HKFE has agreed to adopt rules similar to

certain of PHLX's rules and requirements applicable to cross-listed

PHLX FCOs in order assure fungibility.\16\ HKFE has further agreed not

to adopt any rules that conflict with PHLX's options rules.\17\

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\16\ Such rules include those regarding margin levels and

changes thereof, position and exercise limits, reporting and

liquidation of positions, quote spread parameters, minimum

fractional changes, allocation of exercise notices, series of

options open for trading, customized FCOs and settlement of dollar-

denominated FCOs.

\17\ PHLX Petition at 11.

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B. Proposed PHLX-HKFE Linkage

Incorporated in 1976, HKFE is licensed as an exchange company by

the Governor in Council of Hong Kong and is governed by a board of

directors consisting of both HKFE members and non-members from the Hong

Kong financial and business community. In addition, the operations of

the HKFE and the HKFE Clearing Corporation Limited (``HCC''), HKFE's

subsidiary, are under the jurisdiction of and are regulated by Hong

Kong's independent financial regulatory body, the Securities and

Futures Commission (``SFC'') pursuant to the Commodities Trading

Ordinance, which treats options on foreign currencies similarly to

securities options for such purposes, and which regulates fitness and

qualifications of persons involved in customer order solicitation and

acceptance, imposes minimum financial requirements upon persons

accepting customer funds, and establishes requirements for the

protection of customer funds from misapplication, recordkeeping and

reporting, sales practices and risk disclosure, and procedures to

ensure compliance with such regulatory requirements. It currently is

expected that the existing regulatory structure will continue beyond

July 1997, notwithstanding the changeover to mainland Chinese rule.

Currently, no FCOs are listed for trading on HKFE. The Linkage

provides for cross-listing of PHLX FCOs, permitting U.S. customers and

non-U.S. customers to establish positions in PHLX FCOs on HKFE and

offset them on PHLX or to establish PHLX FCO positions on PHLX and

offset them on HKFE. Only registered broker-dealers would be permitted

to carry the account of FCOs traded through the Linkage on behalf of

U.S. persons (and to clear FCOs on the PHLX side of the Linkage for

non-U.S. customers). The Linkage will be applicable to all foreign

currency option contracts for which PHLX has received SEC approval.

Pursuant to the Linkage, trading in PHLX FCOs will be permitted on HKFE

during Asian business hours in the same manner as such FCOs are

currently traded on PHLX.\18\ In general, auction trading of PHLX's

FCOs occurs between 2:30 a.m. and 2:30 p.m. Eastern Time each business

day. The Linkage thus effectively extends the trading hours for PHLX

foreign currency option contracts. FCOs, regardless of where

originated, will be marketed by means of the same prospectus and

subject to the same securities margin requirements.

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\18\ The licensing agreement between PHLX and HKFE provides that

PHLX FCOs may not be traded on HKFE between the hours of 2:00 a.m.

and 3:00 p.m. Eastern Time, Monday through Friday.

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The Commission has permitted appropriately designed linkages

between exchanges in different time zones as a means of lengthening

trading hours, broadening distribution of products, enhancing trading

volume and open interest, and increasing the capacity to offset risk or

adjust portfolios in a timely manner without incurring excessive

transaction costs.\19\ In its Petition, PHLX states that it expects

that the proposed Linkage will stimulate trading interest in PHLX's

FCOs in the Far East. The PHLX agreement with HKFE does not preclude

similar agreements between HKFE and U.S. futures exchanges with respect

to foreign currency options. Consequently, a similar linkage agreement

between HKFE and a futures exchange potentially could permit such an

exchange to extend its hours and allow registered futures commission

merchants (``FCMs'') to offset currency options undertaken there on

HKFE.

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\19\ The Commission has approved linkage arrangements between

the Singapore International Monetary Exchange, Ltd. (``SIMEX'') and

CME (approved August 28, 1984); between the Commodity Exchange, Inc.

(``COMEX'') and the Sydney Futures Exchange, Ltd. (``SFE'')

(approved August 1, 1986); between Marche a Terme International de

France (``MATIF'') and the CME (approved September 24, 1992); and

between the New York Merchantile Exchange and SFE (approved

September 1, 1995).

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OCC, owned equally by the five national securities exchanges that

list options, functions as the issuer and clearing organization for all

options traded on national securities exchanges, including the FCOs

traded on PHLX. OCC is regulated as a clearing agency by the SEC under

section 17A of the Exchange Act \20\ and the Standards for the

Registration of Clearing Agencies issued thereunder.\21\ OCC will

issue, clear and settle PHLX FCOs that are cross-listed on HKFE.\22\

Subject to SEC approval, PHLX, HKFE, and OCC expect to enter into an

International Market Agreement (the ``IMA''), which will govern the

trading and clearance of transactions in FCOs cross-listed on HKFE. The

IMA will address issues relevant to the trading and clearance of the

PHLX contracts, including issuance, disclosure, expiration months,

exercise prices, units of trading, margin, trade information

comparison, clearing and settlement of PHLX FCOs traded on HKFE, and

the respective rights and obligations of the parties with respect to

such options.

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\20\ 15 U.S.C. 78q-1 (1994).

\21\ Exchange Act Release No. 34-16900 (June 17, 1980) 45 FR

41920.

\22\ PHLX Petition at 5. However, as noted below, OCC expects

that FCO transactions for HKFE members that are not clearing members

of OCC will be cleared through HKFE or an affiliate of HKFE.

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Subject to SEC approval, OCC expects to execute an ``Associate

Clearinghouse Agreement'' with HCC (or another affiliate of HKFE)

organized for the purpose of acting as a clearing organization for the

PHLX foreign currency option contracts traded on HKFE, under which HCC

(or such affiliate) will act as an ``associate clearinghouse'' of OCC.

The Associate Clearinghouse Agreement will provide that HCC (or other

HKFE affiliate) will be treated in all material respects as an OCC

clearing member for purposes of clearing trades in PHLX foreign

currency options for HKFE members that are not clearing members of OCC,

whether such trades are effected on HKFE or (through PHLX members) on

PHLX.\23\ As such, HCC (or other HKFE affiliate) will be subject to SEC

oversight, albeit indirectly through the SEC's oversight of OCC.

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\23\ Provision will be made, however, for matters such as

reconciling non-U.S. accounting principles.

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C. Request for Comments

In the Proposing Release, the Commission sought comments on any

aspect of the Petition that commenters believed might raise issues

under the CEA or Commission regulations. In particular, the Commission

invited comments regarding: (1) The appropriateness of addressing the

transactions specified in the Proposing Release pursuant to the

Commission's exemptive authority under section 4(c) and/or pursuant to

the Commission's plenary authority under section 4c(b); (2) whether the

proposed exemption is consistent with the standards set forth in

section 4(c) of the CEA; (3) whether there is sufficient authority

under existing law for the SEC to exercise its regulatory and

supervisory authority over transactions effected pursuant to the

Linkage; (4) any material adverse

[[Page 15662]]

effects that granting the PHLX petition would have upon other

securities exchanges, futures exchanges, or Commission registrants,

such as FCMs, from a competitive or other perspective; (5) the type of

risk assessment information that should be available to the Commission

regarding FCO transactions by FCM affiliates; (6) whether the

Commission should attach any conditions to any exemptive relief that

may be granted; and (7) any other issues relevant to the PHLX Petition.

Five comment letters were received: one from OCC, one each from the

Chicago Board of Trade (``CBOT'') and the Chicago Mercantile Exchange

(``CME''), both designated contract markets, one from the SEC, and one

from the Futures Industry Association Inc. (``FIA''), a futures

industry trade organization. The comments of the SEC, FIA and OCC

generally supported granting the relief sought by the PHLX Petition;

the CBOT and CME comment letters offered conditional or qualified

support and identified various concerns for future consideration by the

Commission.

II. The Order

Based upon its consideration of the PHLX Petition and the comments

received, and subject to SEC approval of the relevant rules and

agreements establishing and governing operation of the Linkage, the

Commission has determined to issue an order, pursuant to its authority

under Section 4c(b) of the Act, granting an exemption from Commission

regulation consistent with certain conditions more particularly set

forth herein, for Linkage transactions. As discussed below, the

Commission has considered the public comments received in response to

the Proposing Release in connection with issuing this Order.

A. Statutory and Regulatory Basis of the Order

1. The Commission's Authority To Grant the Requested Relief

Section 4c(b) of the Act prohibits persons from entering into any

transaction involving any commodity regulated under the CEA which is of

the character of or is commonly known ``as an option * * * contrary to

any rule, regulation or order of the Commission * * *.'' Section 4c(b)

vests the Commission with the authority to adopt orders, rules or

regulations to prohibit or allow commodity option transactions, upon

notice and opportunity for hearing. Section 4c(b) of the Act,

therefore, affords the Commission plenary authority to permit the

trading of commodity options outside of designated futures

exchanges.\24\

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\24\ Section 4c(b) provides, in relevant part:

No person shall offer to enter into, enter into or confirm the

execution of, any transaction involving any commodity regulated

under this Act which is of the character of, or is commonly known to

the trade as, an ``option'' [or] ``privilege'', * * * contrary to

any rule, regulation, or order of the commission prohibiting any

such transaction or allowing any such transaction under such terms

and conditions as the Commission shall prescribe. Any such order,

rule, or regulation may be made only after notice and opportunity

for hearing, and the Commission may set different terms and

conditions for different markets.

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CME and OCC commented that in order to permit the Linkage the

Commission would be required to grant particularized relief and that a

new rule, order or regulation must be adopted under section 4c(b) for

this purpose. The commenters generally concurred that the appropriate

basis for granting the relief requested would be pursuant to an order

issued under section 4c(b). Several commenters nonetheless urged the

Commission to apply the standards required for exercising its exemptive

authority under section 4(c) of the Act in determining whether to grant

relief under section 4c(b). The SEC stated that the CFTC could

appropriately address Linkage transactions under either section 4(c) or

section 4c(b), as both sections provide the CFTC with broad flexibility

to address the transactions encompassed by the PHLX Petition. FIA and

the CBOT, however, commented that basing an exemptive order solely on

section 4c(b) would be more consistent with the CEA than an order based

upon sections 4c(b) and 4(c).

2. Consistency with Section 4c(f)

The Commission believes that while section 4c(f) may not itself

confer authority to grant the requested relief to the Linkage, such

relief would be consistent with the policy of section 4c(f) of the CEA,

which provides that nothing in the CEA ``shall be deemed to govern or

in any way be applicable to any transaction in an option on foreign

currency traded on a national securities exchange.'' \25\ In its

petition, PHLX contended that a PHLX FCO would remain ``an option on

foreign currency traded on a national securities exchange,'' despite

being cross-listed on HKFE, which is not so registered.\26\ PHLX urged

that ``[f]or this purpose, cross-listing of PHLX foreign currency

options on the HKFE may be viewed as adding another PHLX trading floor,

or as lengthening the trading day for PHLX foreign currency options.''

\27\ Thus, PHLX contended that section 4c(f) should remove the Linkage

from CFTC jurisdiction, while requesting exemptive relief under

sections 4(c) and 4c(b) ``to eliminate any potential uncertainty as to

the status of these transactions.'' \28\

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\25\ Section 4c(f) is part of the jurisdictional accord between

the SEC and the CFTC that was codified in the Futures Trading Act of

1982. Public Law 97-444, Act of January 11, 1983, effective January

11, 1983, sec. 102, 96 Stat. 2294, 2296. The effect of the provision

was that the SEC would have jurisdiction over FCOs that trade on

national securities exchanges, while the CFTC continued to have

jurisdiction to regulate other trading of FCOs. H.R. Rep. No. 97-

565, 97th Cong., 2d Sess. 82 (1982).

\26\ The SEC and OCC comments agreed with this characterization.

The SEC stated that it would treat the Linkage as an operating

extension of the trading of FCOs on PHLX and therefore as being

subject to the full scope of the federal securities laws (noting

that the FCOs traded on PHLX and HKFE would be identical, would be

cleared and settled through OCC, and would be traded pursuant to an

agreement between PHLX and HKFE, as are other linked securities

contracts). The CBOT and the CME, however, disputed that the Linkage

should be treated as an extension of the PHLX trading floor and

questioned the validity of any assertion of SEC jurisdiction over

the establishment or offsetting of FCO positions on HKFE.

\27\ PHLX Petition at 2.

\28\ Id. In its comment letter, OCC supported PHLX's request

that the CFTC issue an exemption to eliminate potential uncertainty.

CME and CBOT disputed PHLX's assertion that transactions in the

cross-listed FCOs are excluded from the CFTC's jurisdiction,

contending that HKFE is not a national securities exchange and

should not be characterized as an additional PHLX trading floor.

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3. Consistency with Section 4(c)

Section 4(c) provides, in relevant part, that the Commission may

exempt, ``by rule, regulation, or order, after notice and opportunity

for hearing, * * * any agreement, contract, or transaction * * * that

is otherwise subject to'' the exchange-trading requirement of section

4(a) from all provisions of the CEA except section 2(a)(1)(B).\29\ Such

exemption may be granted upon a determination by the Commission that:

(1) The exemption is in the public interest;\30\ (2) the requirements

from

[[Page 15663]]

which exemption is sought should not be applied to the agreement,

contract, or transaction at issue and the exemption would be consistent

with the purposes of the CEA; (3) the agreement, contract or

transaction will be entered into solely between ``appropriate

persons;'' \31\ and (4) the agreement, contract or transaction will not

have a material adverse effect upon the ability of the Commission or

any contract market to discharge its regulatory or self-regulatory

duties under the CEA.

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\29\ 7 U.S.C. 6(c)(1) (1994). In particular, section 4(c)(1)

provides:

In order to promote responsible economic or financial innovation

and fair competition, the Commission by rule, regulation, or order,

after notice and opportunity for hearing, may (on its own initiative

or on application of any person, including any board of trade

designated as a contract market for transactions for future delivery

in any commodity under section 5 of this Act) exempt any agreement,

contract or transaction (or class thereof) that is otherwise subject

to subsection (a) (the exchange-trading requirement) (including any

person or class of persons offering, entering into, rendering advice

or rendering other services with respect to, the agreement,

contract, or transaction), either unconditionally or on stated terms

or conditions or for stated periods and either retroactively or

prospectively, or both, from any of the requirements of subsection

(a), or from any other provision of this Act (except section

2(a)(1)(B)), if the Commission determines that the exemption would

be consistent with the public interest.

\30\ As the Commission noted in the Proposing Release, the

Conference Committee Report on the legislation enacting section 4(c)

indicated that the ``public interest'' includes ``the national

public interests noted in the (CEA), the prevention of fraud and the

preservation of the financial integrity of markets, as well as the

promotion of responsible economic or financial innovation and fair

competition,'' and that the Commission should ``assess the impact of

a proposed exemption on the maintenance of the integrity and

soundness of markets and market participants'' and that an exemption

should not be denied ``solely on grounds that it may compete with or

draw market share away from the existing market.'' H.R. Rep. No.

978, 102d Cong., 2d Sess. 78-79 (1992).

\31\ ``Appropriate person'' is defined in section 4(c)(3) (A)-

(K) of the Act to include, generally, a bank or trust company, a

savings association, an insurance company, a registered investment

company, a commodity pool operated by a Commission registrant,

certain business entities and employee benefit plans, governmental

entities, registered broker-dealers, registered futures commission

merchants, floor brokers and floor traders and ``[s]uch other

persons that the Commission determines to be appropriate in light of

their financial or other qualifications or the applicability of

appropriate regulatory protections.'' 7 U.S.C. 6(c)(3) (A)-

(K)(1994).

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Several commenters expressed the view that, because section 4(c)

provides the Commission with authority to exempt from CEA regulation

transactions in futures contracts on or subject to the rules of a U.S.

exchange, it is not the appropriate basis for an exemptive order with

respect to the PHLX/HKFE Linkage. However, although CBOT, CME and OCC

argued against reliance by the Commission upon section 4(c) as the

basis for granting an exemption for Linkage transactions, CBOT and FIA

urged the Commission to consider the merits of the PHLX Petition in

light of the standards set forth in section 4(c).\32\ The Commission

concurs that the standards for exemption established by section 4(c)

are relevant in determining whether an order of relief should be issued

under section 4c(b). Accordingly, the Commission has considered the

PHLX Petition in light of the criteria of section 4(c) and believes,

for the reasons discussed below, that granting the Petition is

consistent with such criteria.

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\32\ OCC stated that ``the Commission may of course choose as a

policy matter to consider the standards of section 4(c).'' CME

stated that even if the Commission had authority under section 4(c)

to grant the requested relief, the proposed exemption is not

consistent with (and does not meet the standards set forth in)

section 4(c).

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a. Consistency with the Public Interest and Purposes of the Act.

With respect to the public interest standard of section 4(c), the CBOT

commented that ``(w)hen the retail public is involved, it would seem

that the only way an exemption from CEA regulation could be consistent

with the public interest is if another comparable regulatory scheme

also applies.'' The CBOT expressed the view that before deciding to

grant exemptive relief, the Commission should carefully examine ``the

nature and reach'' of the SEC's regulation of broker-dealers, including

the scope of the SEC's authority to regulate ``broker-dealers'

activities with respect to foreign currency options traded on the HKFE,

given that such instruments are technically not securities.''

The Commission believes that based upon the SEC's analysis of its

regulatory authority with respect to Linkage transactions and the other

materials of record, the concerns voiced by the CBOT are adequately

addressed. Under the linkage, FCOs may be traded for U.S. customers on

a foreign futures exchange. The Commission does not and, indeed, cannot

directly regulate foreign boards of trade, under section 4(b) of the

Act.\33\ Under that section, however, the Commission has authority to

adopt regulations prohibiting fraud, setting financial standards, and

imposing registration, recordkeeping, reporting and other obligations

on persons trading futures contracts for U.S. customers on non-U.S.

exchanges. Pursuant to part 30 of its regulations, the Commission

regulates the offer and sale to U.S. persons of commodity option

contracts made on or subject to the rules of foreign boards of trade.

However, the Commission's rules no longer require prior authorization

by the Commission before a foreign commodity option may be offered or

sold to U.S. customers, and therefore, U.S. customers could trade

foreign currency options on HKFE without further action by the

Commission.

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\33\ 7 U.S.C. 6(b) (1994). Section 4(b) provides that the

Commission may not adopt any rule that requires Commission approval

of a foreign board of trade's contracts or rules, or that governs in

any way any rule or contract term or action of a foreign board of

trade.

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Moreover, irrespective of the characterization of HKFE FCOs cross-

listed with PHLX FCOs, the Commission believes that the SEC has

authority to exercise regulatory functions comparable to those that the

CFTC would be able to exercise with respect to transactions to be

established or offset on HKFE through the Linkage. The CFTC itself

could not directly regulate the HKFE market and would be limited to

regulating sales to U.S. persons from locations outside the U.S. in

accordance with section 4(b) of the Act. The SEC regulates broker-

dealer fitness, capital requirements, sales practices and protection of

customer funds. In the limited circumstances of the PHLX-HKFE Linkage,

therefore, based upon the SEC's regulatory authority and program

applicable to registered broker-dealers, and subject to the conditions

discussed below, the Commission believes that its deference to SEC

regulation over the Linkage as a whole to facilitate the Linkage

arrangement is warranted, especially as such deference is without

prejudice to a similar arrangement for linking a U.S. futures market to

HKFE or the regulatory characterization of foreign currency options in

that context.

Although it acknowledged that it does not have express authority

over activities occurring on HKFE, the SEC cited its authority under

the Exchange Act to condition approval of the PHLX rules necessary to

implement the Linkage upon establishment of adequate safeguards

addressing surveillance-sharing between PHLX and HKFE, as well as

between the SEC and Hong Kong regulators; provisions for trading and

clearing the FCOs (on PHLX and on HKFE); and the requirement that the

FCOs be registered under the Securities Act. The SEC has authority over

OCC (and indirectly over HCC or other HKFE affiliate) and the broker-

dealers who will effect Linkage transactions for U.S. customers and

offset on PHLX linked transactions undertaken for U.S. customers. It

therefore can require meaningful safeguards as a condition for approval

of the implementing PHLX and OCC rule changes for the Linkage.\34\

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\34\ CBOT urged the Commission to consider carefully the nature

and scope of SEC and NASD regulation (including whether SEC and NASD

are willing or prepared to accept this jurisdiction, whether

safeguards exist equivalent to the Commission's segregation

requirements, and whether the requested relief amounts to a transfer

to the SEC of Commission jurisdiction over foreign currency

options). The SEC has indicated in its comment letter that it is

prepared to exercise regulatory oversight with respect to

transactions over the Linkage. Moreover, PHLX FCOs are already

subject to SEC and PHLX regulation, and broker-dealer practices are

subject to NASD regulation.

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The FIA, OCC and SEC urged that the Commission find that the

requested exemption would be consistent with the public interest and

the purposes of the Act. To this end, FIA commented that the requested

exemption would not be contrary to the essential purposes of the Act

(customer protection, financial integrity and market integrity)

because: (1) FCOs executed on HKFE may be offered and sold in the U.S.

only

[[Page 15664]]

through registered broker-dealers in accordance with sales practice and

related customer protection rules of PHLX and the NASD;

(2) the financial integrity of the transactions will be assured

because they will be settled and cleared by OCC (and trades on HKFE for

non-OCC clearing members will be carried out pursuant to an agreement

with OCC); and (3) market integrity is assured by the Intermarket

Surveillance Group Surveillance Sharing Agreement between PHLX and

HKFE. The SEC stated that FCOs cross-listed on HKFE ``would be subject

to full SEC regulation'' and that ``subjecting such trading to a single

regulatory regime is appropriate and might additionally facilitate

efficiencies in the trading, clearance and settlement of such

transactions.''

OCC expressed the view that the proposed relief would be consistent

with the public interest because it is an essential precondition to the

Linkage, and the Linkage itself is in the public interest because it

would ``contribute to greater depth and liquidity in the market for

PHLX FX Options'' and ``foster global market efficiency and reduce

systemic risk by standardizing the currency options traded on PHLX and

HKFE and centralizing the clearance and settlement process for trades

in such options.'' The currency cash market is a 24-hour market.

Establishing an Asia time zone link extends the liquidity and the

hedging usefulness of the PHLX foreign currency options market and

renders it more competitive with the larger over-the-counter market,

subject to significant regulatory safeguards for participants. Pursuant

to part 30 of its regulations, the Commission routinely evaluates the

comparability of other regulatory regimes. In this case, without ceding

authority or characterizing the jurisdictional status of the HKFE FCOs,

the Commission concludes that sufficient grounds exist for deference to

the SEC regulatory regime, especially in light of the policies

underlying section 4c(f), which supports trading in foreign currency

options in both domestic securities and futures exchanges, subject to

either securities or futures laws and the attendant regulatory

frameworks, respectively.

b. The ``Appropriate Person'' Criterion. Section 4(c) of the Act

defines the term ``appropriate person'' to include various categories

of business and corporate entities, including banks and trust

companies, savings associations; insurance companies, registered

investment companies, CEA-regulated commodity pools, corporations or

other business entities with net worth of $1 million or total assets of

$5 million, and ``[s]uch other persons that the Commission determines

to be appropriate in light of their financial or other qualifications

or the applicability of appropriate regulatory protections.'' \35\ In

its Petition, PHLX urges that because PHLX FCOs ``are subject to the

full panoply of SEC regulation under the securities laws,'' appropriate

regulatory protections apply to the Linkage, and the Commission

therefore should be able to determine that any person eligible to

purchase or sell such options under the SEC regulatory scheme is an

``appropriate person'' within the meaning of section 4(c)(3)(K).\36\ In

its comment letter, the SEC agreed that the class of permissible FCO

participants proposed by PHLX may not be identical to those designated

in the enumerated categories of section 4(c)(3) (A)-(J) but concluded

that ``it is appropriate for the CFTC to determine, pursuant to

4(c)(3)(K), that such persons are appropriate persons because they meet

the requirements set forth by PHLX and approved by the SEC for persons

engaged in exchange-traded options transactions.''

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\35\ 7 U.S.C. 6(c)(3) (1994).

\36\ PHLX Petition at 16.

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Section 4(c)(3)(K) permits the Commission to determine that persons

engaging in transactions that are otherwise regulated by another

governmental agency qualify as ``appropriate persons.'' In adopting

rules exempting from CFTC regulation certain hybrid instruments, the

Commission stated that ``appropriate persons'' eligible for that

exemption would include ``person[s] permitted by applicable securities

or banking requirements to purchase or enter into the security

(component) of the hybrid instrument * * *.'' 58 FR 5580 (January 22,

1993) (release adopting final rules regarding the regulation of hybrid

instruments). As discussed above, the SEC, PHLX and NASD requirements

applicable to U.S. customers in FCO transactions conducted on PHLX will

apply equally to cross-linked FCO transactions on HKFE. Based upon the

restrictions imposed by these requirements upon participation in FCOs

cross-linked on HKFE and the other regulatory safeguards applicable to

such transactions, the Commission believes that the ``appropriate

persons'' criterion is satisfied with respect to U.S. persons engaging

in FCO transactions pursuant to the Linkage.\37\

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\37\ However, an ``appropriate person'' for purposes of Linkage

transactions in accordance with this Order may not be an

``appropriate person'' in other contexts.

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c. No Material Adverse Effect on Regulatory or Self-Regulatory

Responsibilities. Commenters differed in their assessment as to whether

granting the PHLX Petition would have a material adverse effect on the

ability of the Commission or any contract market to discharge its

regulatory or self-regulatory duties under the CEA. The Commission

believes that with appropriate risk assessment information sharing, and

retention of its own ability to terminate relief, granting the

requested relief will not interfere with the Commission's regulatory

program or adversely affect the ability of any U.S. contract market to

discharge its regulatory duties.

B. Risk Assessment

The Commission requested comments regarding the type of risk

assessment information that should be available to it concerning FCO

transactions effected by FCM affiliates. The two commenters who

addressed this issue. The SEC noted that all PHLX/HKFE cross-listed FCO

transactions involving U.S. customers must be effected through U.S.-

registered broker-dealers and that the SEC's risk assessment rules

would thus be applicable and would result in the provision of important

risk assessment data to the SEC. The SEC has confirmed that it would

coordinate information-sharing with the CFTC in the event that problems

developed warranting CFTC review. Similarly, the OCC stated that there

was no need for risk assessment information in addition to that which

the Commission currently obtains regarding FCM affiliate transactions

on PHLX, since PHLX and HKFE FCO transactions pose the same risks. The

Commission nonetheless has conditioned this relief on its access to

information on transactions through the Linkage relevant to exercise of

its and its markets' supervisory duties with respect to FCMs or other

relevant futures market participants engaged in Linkage transactions.

C. Conditions

The Commission also invited comment concerning whether conditions

should be attached to any exemptive relief granted in response to the

PHLX Petition. Several commenters addressed this subject. The SEC

recommended that the Commission condition exemptive relief on assured

availability to the Commission of information exchanged pursuant to the

terms of the Intermarket Surveillance Group Surveillance Sharing

Agreement

[[Page 15665]]

between PHLX and HKFE and suggested that the Commission consider

conditioning relief upon the SEC's approval of a PHLX implementing rule

submission under section 19(b) of the Exchange Act. The CME urged the

Commission to ensure that adequate regulatory protections exist with

respect to any trading activities that take place in Hong Kong,

suggesting, by way of example, that the Commission consider whether the

policies underlying Rule 30.7 \38\ require that the foreign futures and

options secured amount for HKFE positions be separately accounted for

and segregated from customer funds used to margin PHLX positions. OCC

commented that it saw no need for any conditions other than that the

Linkage be operated substantially as described in the PHLX Petition.

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\38\ Rule 30.7 sets forth an FCM's duty to maintain in a

segregated account at an appropriate depository sufficient money or

other property to cover all of its current obligations to foreign

futures and options customers and to keep records and make daily

computations with respect to such obligations.

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D. Other Issues Raised by Commenters

The FIA urged the Commission to consider granting relief for

registered broker-dealers that are also registered as FCMs from the

restrictions on options transactions applicable to FCMs set forth in

Commission Rule 1.19 and to consider whether any relief with respect to

the provisions of subchapter IV of Chapter 7 of the Bankruptcy Code

\39\ and part 190 of the Commission's rules may be necessary. CME

commented that granting the requested relief would amount to

sanctioning the cross-margining of securities options and futures

positions at the customer level and that if the Commission grants the

PHLX Petition, CME expects to be permitted to expand its cross-

margining program with OCC to include retail customer accounts. Because

the PHLX FCOs are functionally identical, whether traded on PHLX or

HKFE, and because offsetting positions will cancel, rather than hedge

each other, the Commission believes that cross-margining arrangements

raise different issues from the cross-listing of FCOs. In any event,

the Commission will address any such request on its individual merits

and believes that a response to CME is outside the scope of this

proceeding.

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\39\ 11 U.S.C. 761-766 (1994).

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E. Conclusion

Regulatory authority over trading activity in FCOs is divided

between the SEC and the CFTC, and absent a grant of exemptive relief by

the CFTC, participation by U.S. customers in the HKFE side of the

proposed Linkage would be subject to regulation under the CEA.

Nonetheless, upon consideration of the PHLX Petition and the comments

received and for the reasons stated above, the Commission has

determined to exercise its authority under Section 4c(b) of the Act by

issuing the attached Order granting the Petition, provided that certain

conditions are met. The Commission believes that under the specific

circumstances of the Linkage, and subject to certain conditions,

deference to the SEC to provide regulatory oversight for the Linkage is

appropriate.

The Commission believes that the SEC's existing regulation of

registered broker-dealers and clearing organizations, combined with its

ability to condition approval of the PHLX and OCC rule changes

necessary to implement the Linkage upon incorporation of appropriate

safeguards will enable the SEC to exercise regulatory authority over

the HKFE side of the Linkage comparable to that which the Commission

would be able to exercise. Neither agency is empowered directly to

regulate HKFE, but each has statutory authority to regulate assigned

classes of market participants, and thereby, activities on HKFE of such

persons. The Commission believes that the existing regulatory framework

applicable to HKFE in Hong Kong, combined with the SEC's regulation of

U.S. broker-dealers effecting transactions over the Linkage and

regulation of OCC, will be adequate in the absence of direct regulation

of trading on HKFE by U.S. regulatory agencies. Additionally, the SEC

has authority over the design of relevant clearing arrangements and the

rules of PHLX establishing the operating agreement between the markets

for the Linkage. The Commission further believes that the risk

assessment information provided to the SEC will be adequate but that it

should likewise be provided to the Commission upon request or as

otherwise appropriate in light of market conditions.

The Commission also believes that the standards set forth in

section 4(c) will be met by the Linkage, in that: (1) Granting the

requested relief is in the public interest, because due to the

applicability of a regulatory scheme comparable to the Commission's,

the Linkage can operate to expand the availability and usefulness of

PHLX FCOs, while maintaining regulatory protections for customers and

markets; (2) granting the requested relief will neither interfere with

the Commission's ability to carry out its regulatory program nor

adversely affect the ability of any contract market to carry out its

self-regulatory duties; and (3) in view of the regulatory and self-

regulatory requirements regarding eligibility of customers to effect

transactions over the Linkage, it is appropriate to determine pursuant

to section 4(c)(3)(K) that participation in the Linkage will be limited

to appropriate persons.

Several commenters raised related issues which the Commission does

not believe affect the appropriateness of granting the PHLX Petition.

In response to concerns that broker-dealers that are also registered as

FCMs may be considered to be in violation of Rule 1.19 as a result of

transactions in FCOs on the HKFE, the Commission hereby confirms that

PHLX FCOs traded on the Linkage may be considered exchange-traded

``commodity options'' for purposes of Rule 1.19(a) such that an FCM

would not be precluded from taking a position in such FCOs. With

respect to FIA's concern as to the applicability of Subchapter IV of

Chapter 7 of the Bankruptcy Code, the Commission has conditioned its

exemptive order upon the applicability of the SEC's segregation

requirements for securities,\40\ and Subchapter III of Chapter 7 of the

Bankruptcy Code \41\ to securities broker-dealers. Consequently, PHLX

represents that it will take whatever contractual or regulatory actions

may be necessary to cause the cross-listed FCOs to be treated as

securities for purposes of the Bankruptcy Code and for purposes of the

segregation requirements under Exchange Act Rule 15c3-3.

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\40\ Exchange Act Rule 15c3-3, 17 CFR 240.15c3-3 (1996).

\41\ 11 U.S.C. 741-752 (1994).

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The Commission thus has determined that an exemption with respect

to the Linkage should be conditioned upon implementation of the Linkage

pursuant to PHLX and OCC rules approved by the SEC, operation of the

Linkage (including restrictions on participation by U.S. customers)

substantially as described in the PHLX Petition, availability to the

Commission of adequate risk assessment information, availability to the

Commission of surveillance information required to be exchanged

pursuant to the Surveillance Sharing Agreement between PHLX and HKFE

and the completion of any necessary contractual or other measures to

cause FCOs traded over the Linkage to be treated as securities for

purposes of securities segregation requirements and under the

Bankruptcy Code.

[[Page 15666]]

Order of the Commodity Futures Trading Commission Exempting From

Regulation Certain Foreign Currency Option Transactions

Whereas, it is the Commission's understanding, based upon

representations made by the Philadelphia Stock Exchange, Inc.

(``PHLX'') as set forth in a Request for Exemptive Relief from

regulation under the Commodity Exchange Act (7 U.S.C. 1 et seq.), dated

August 15, 1996, that PHLX and the Hong Kong Futures Exchange Ltd.

(``HKFE'') have entered into a licensing agreement (the ``Linkage'')

pursuant to which foreign currency options (``FCOs'') listed and traded

on PHLX will be cross-listed and traded on HKFE. The Linkage will

permit PHLX FCOs to be traded on HKFE during Asian business hours.

Transactions for U.S. customers will be effected only through brokers

or dealers registered as such with the Securities and Exchange

Commission (``SEC'') on behalf of persons meeting the PHLX customer

options account approval and suitability standards (approved by the

SEC) for persons engaging in options transactions. Transactions on PHLX

for non-U.S. customers, whether or not initiated through a non-PHLX

member, must ultimately be effected through a member of PHLX that is a

clearing member of The Options Clearing Corporation (``OCC'').

Whereas, transactions effected through the Linkage will be issued,

cleared and settled by OCC pursuant to the terms of an International

Market Agreement (``IMA'') among PHLX, HKFE and OCC. Clearing of trades

in PHLX FCOs for HKFE members that are not clearing members of OCC

(whether such trades are effected on PHLX or on HKFE) will be made by

an OCC clearing member or an affiliate of HKFE (as an ``associate

clearinghouse'' of OCC) pursuant to an Associate Clearinghouse

Agreement between OCC and such affiliate of HKFE, and such associate

clearinghouse will be treated in all material respects as a clearing

member of OCC for purposes of Linkage transactions.

Whereas, PHLX and HKFE have entered into an Intermarket

Surveillance Group Surveillance Sharing Agreement obligating each to

use its best efforts to obtain and provide information required by the

other to fulfill its self-regulatory responsibilities.

Whereas, PHLX will submit for SEC approval an amendment to PHLX's

rules, permitting the establishment and operation of the Linkage, and

that OCC will likewise submit a rule amendment to accommodate clearing

and settlement functions with respect to the Linkage.

And Whereas, PHLX represents that the licensing agreement and other

relevant documentation, including the Surveillance Sharing Agreement,

the IMA and the Associate Clearinghouse Agreement, are consistent with

the aforesaid understanding of the Linkage arrangement and will be

submitted to the SEC for its review in conjunction with the SEC's

review of PHLX and OCC rule changes to implement the Linkage.

It is therefore ordered, pursuant to section 4c(b) of the Commodity

Exchange Act (the ``Act'') and based upon the Commission's

consideration of the representations set forth in the PHLX Petition and

the comments received pursuant to the Notice of Proposed Order and

Request for Comments, that transactions in FCOs listed for trading on

HKFE as described in the PHLX Petition are exempt from all provisions

of the Act and the Commission's rules promulgated thereunder subject to

the following conditions:

1. That the Linkage is operated substantially as described in the

PHLX Petition;

2. That FCO transactions effected pursuant to the Linkage on behalf

of U.S. customers are undertaken through broker-dealers registered as

such with the SEC, cleared through clearing facilities subject to SEC

oversight, and restricted to customers who satisfy the customer options

account approval and suitability standards set forth in PHLX rules

approved by the SEC;

3. That the Linkage is implemented pursuant to rules of PHLX and

OCC approved by the SEC pursuant to section 19(b) of the Securities

Exchange Act of 1934 (the ``Exchange Act''), 15 U.S.C. 78s;

4. That HKFE and PHLX will make available to the Commission upon

request all information required to be exchanged under the terms of the

Intermarket Surveillance Group Surveillance Sharing Agreement between

PHLX and HKFE;

5. That HKFE is subject to rules which establish fitness and

qualifications of persons through whom customer orders are solicited or

accepted, minimum financial requirements for persons that accept

customer funds, measures for protection of customer funds from

misapplication, recordkeeping and reporting requirements, minimum sales

practice and risk disclosure standards, and procedures to ensure and to

audit for compliance with regulatory requirements;

6. That all risk assessment information pertinent to the Linkage

provided to the SEC by broker-dealers participating in the Linkage (and

that is not otherwise available to the CFTC pursuant to its risk

assessment rules) is made available to the Commission by the SEC and/or

PHLX upon request and as otherwise appropriate; and

7. That the FCO positions, regardless of where established, will be

treated as securities for purposes of required segregation pursuant to

Exchange Act Rule 15c3-3 and for application of the relevant insolvency

laws, including the Bankruptcy Code and rules, and Securities Investor

Protection Act of 1970.

By issuing this Order, the Commission does not intend to prohibit

or restrict the ability of any futures exchange to establish a similar

linkage arrangement with HKFE.

By issuing this Order, the Commission takes notice of its

surveillance and enforcement information sharing arrangements with the

appropriate Hong Kong regulatory authorities.

The Commission retains the authority to terminate or otherwise to

modify this relief at such time as it determines that exemption of

transactions through the Linkage is no longer in the public interest.

Issued in Washington, DC on March 28, 1997, by the Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97-8365 Filed 4-1-97; 8:45 am]

BILLING CODE 6351-01-P