COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 1

Commodity Options; Prohibited Trading

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rules.

SUMMARY: The Commodity Futures Trading Commission ("Commission'') is amending
Rule 1.19, 17 CFR 1.19 (1992), by including an additional exception from the
prohibition on futures commission merchants ("FCMs'') from assuming any
financial responsibility for the fulfillment of commodity options. To help
ensure the financial integrity of FCMs undertaking such transactions, the
Commission also is amending Rule 1.17, the Commission's rule regarding
required regulatory capital for FCMs, to provide an appropriate capital
treatment.

EFFECTIVE DATE: January 27, 1994.

FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Deputy Director, Division
of Trading and Markets, or Paul M. Architzel, Chief Counsel, Division of
Economic Analysis, Commodity Futures Trading Commission, 2033 K Street NW.,
Washington, DC 20581, (202) 254Ä8955, 254Ä6990, respectively.

SUPPLEMENTARY INFORMATION: Commission Rule 1.19 prohibits futures commission
merchants ("FCMs'') and introducing brokers ("IBs'') from assuming any
financial responsibility for the fulfillment of any commodity option, with two
exceptions. These exceptions are for options traded on or subject to the rules
of a designated option contract market or on or subject to the rules of a
foreign board of trade, in accordance with the requirements of part 30 of the
Commission's rules.1

®1¯ Commission Rule 1.19 provides that: No futures commission merchant or
introducing broker may make, underwrite, issue, or otherwise assume any
financial responsibility for the fulfillment of, any commodity option except:

(a) Commodity options traded on or subject to the rules of a contract market
in accordance with the requirements of part 33 of this chapter; or (b)
Commodity options traded on or subject to the rules of a foreign board of
trade in accordance with the requirements of part 30 of this chapter.

The Commission, on August 13, 1993, published a further proposed exception
from the Rule 1.19 prohibition on FCMs from assuming any "financial
responsibility for the fulfillment of any commodity option.'' 58 FR 43087. The
effect of this proposed revision would have been to permit FCMs to grant
certain off-exchange trade options which are permitted under Commission Rule
32.4, 17 CFR 32.4.2

®2¯ Rule 32.4 provides, in part, that: the provisions of this part shall not
apply to a commodity option offered by a person which has a reasonable basis
to believe that the option is offered to a producer, processor, or commercial
user of, or a merchant handling, the commodity which is the subject of the
commodity option transaction, or the products or byproducts thereof, and that
such producer, processor, commercial user or merchant is offered or enters
into the commodity option transaction solely for purposes related to its
business as such.

By proposing to amend the prohibition of Rule 1.19 that FCMs not assume
financial responsibility for the fulfillment of any commodity option, the
Commission was not also proposing to expand the scope of options which can be
traded legally. Accordingly, in light of the existing general suspension for
off-exchange trading of commodity options under Commission Rule 32.11, the
proposed amendment to Rule 1.19 only would have permitted FCMs to grant
options, pursuant to Commission Rule 32.4, where the offeree is a producer,
processor, or commercial user of, or a merchant handling, the underlying
commodity in its business.

Commission Rule 1.19 was first promulgated by the Commission's predecessor
agency, the Commodity Exchange Authority, in 1973, prior to the adoption of
Commission rules relating to regulatory capital.3

®3¯ A fuller explanation of the history of Commission Rule 1.19 is provided in
the Notice of Proposed Rulemaking, 58 FR 43087Ä88.

      In proposing an additional exception from this prohibition for any
option permitted under  32.4 for which a capital treatment is specified in 
1.17, the Commission reasoned that:

The Commission, upon further experience over the years, is convinced that its
previously stated intent to delete the prohibition in Rule 1.19 as it applies
to FCMs, subject to a capital treatment, is appropriate. In this regard, the
Commission notes that Rule 1.19 already excepts FCMs from its prohibitions for
options traded on exchanges. The prohibition of Rule 1.19 therefore, currently
applies to off-exchange options permitted under Part 32 of the Commission's
rules. Although concern over the risk to FCMs from dealing in certain
over-the-counter options previously may have supported the prohibition, the
Commission believes that FCMs generally have had a sufficient opportunity
during the intervening years to become sufficiently familiar with option
trading and theory, so that they can institute appropriate internal controls
to address their risk from such positions provided that the Commission has
articulated a capital treatment for such positions.

58 FR at 43088.

The risk to the FCM of assuming the positions permitted under this exception
must be reflected fully by FCMs in the computation of their adjusted net
capital under Commission Rule 1.17. Accordingly, the Commission proposed to
extend the capital treatment provided under Rule 1.17 that certain "haircuts''
be taken in computing net capital for "securities options,'' 17 CFR
1.17(c)(5)(vi),4 to over-the-counter options on foreign currencies, security
indices and options on government debt.''5 Moreover, the Commission proposed
to apply the same capital treatment to granted over-the-counter options or
options on such "securities,'' applying the charges to capital specified in 
1.17(c)(5)(vi) for those positions.

®4¯ 17 CFR 1.17(c)(5)(vi) incorporates by reference the net capital rules of
the Securities and Exchange Commission (SEC), which contains a generic
treatment for options positions, as interpreted, stating that in computing net
capital, the calculation should use: In the case of securities options used by
the applicant or registrant in computing net capital, the deductions
specified, in  240.15c3Ä1 appendix A of this title, after effecting certain
adjustments to net capital for listed and unlisted options as set forth in
such appendix:

An SEC interpretative letter, covering the net capital treatment of baskets of
securities offset by securities options on broad based security indices was
issued to Mr. David Marcus, New York Stock Exchange, Inc., on February 27,
1986. SEC interpretative letters covering foreign currency option spreads and
forwards offset by foreign currency options were issued to Ms. Susan R. Mann
and Mr. Robert B. Gilmore, of the Philadelphia Stock Exchange, Inc., dated
January 15, 1985 and February 14, 1986, respectively. The SEC interpretative
letter covering the treatment of government debt options was issued to Mr.
Salvatore Pallante, New York Stock Exchange, Inc., on January 31, 1990.
Commission Rule 1.17 currently incorporates by reference securities haircuts,
and is intended to automatically incorporate any amendments or adjustments to
those haircuts permitted by the SEC.

®5¯ By extending the capital treatment of such instruments under SEC
regulations to certain instruments, which are regulated by the Commission
under the CEA, see, section 2(a)(1)(B) of the Act, the Commission does not
intend to affect jurisdictional boundaries, but rather, merely to treat
equally, for regulatory capital purposes, economically similar instruments.

As noted in the Notice of Proposed Rulemaking, option positions for which Rule
1.17(c)(5)(vi) fails to specify a method of computation are excluded from the
relief available under this exception until such time as Rule 1.17 is amended
to reflect the risk of such positions or the Commission addresses applications
on a case-by-case basis. See e.g., CFTC Interpretative Letter 91Ä1, (1991Ä1992
Transfer Binder) Comm. Fut. L. Rep., (CCH) 25,065 (May 29, 1991).6 In this
regard, the Commission sought comment regarding the issue of the appropriate
methodology for potentially computing haircuts for those options for which no
capital treatment was proposed and consequently which were not included within
the proposed exception. Specifically, the Commission asked seven questions
concerning this, and related, issues.

®6¯ As noted therein, Rule 1.17(c)(5)(vi) currently does not explicitly
specify the net capital treatment for all option positions which otherwise
could be included under the exception, nor has the SEC rule been interpreted
to reference a particular treatment for commodity options, except that the
treatment of forex options, government debt securities and stock indices is
separately identified by SEC interpretation. The CFTC adopts this treatment,
to the extent that FCM positions can be characterized as commodity options
under the Act. 58 FR 43089.

      Two comments were submitted. One commenter is an industry association
representing FCMs and other segments of the futures industry. This commenter:

Strongly endorses the amendments to Commission rules 1.17 and 1.19 as proposed
and urges their prompt promulgation. In this connection, it is important that
the adoption of final rules as they relate to options on foreign currencies,
stock indices and government debt should not be delayed pending resolution of
those issues with respect to which the Commission has requested additional
comment.

[The commenter] is particularly pleased that the Commission has proposed to
coordinate its capital requirements with those prescribed by the SEC. For
purposes of both regulatory efficiency and competitive balance, it is
essential that FCMs, many of which are also registered as broker-dealers, be
subject to uniform capital treatment.

The commenter also supported the further extension of the proposed exception
to over-the-counter trade options other than those specified in the proposed
rule. It noted that "participation of FCMs in OTC trade options may benefit
both commercial participants and the regulated markets.'' They reasoned that
FCMs had the necessary knowledge to hedge their resulting financial exposure,
and that appropriate changes to Commission and self-regulatory oversight
systems could be made to accommodate this change. Finally, although noting
with approval the coordination of capital rules by the Commission and the SEC,
and advocating the use of capital charges that are risk-based in nature, the
commenter nevertheless did not offer recommendations regarding the appropriate
level of capital charges for such positions.7

®7¯ The second commenter was a law firm inquiring about the application of the
proposed exception from Rule 1.19 to instruments offered under parts 34 and 35
of the Commission's rules (Regulation of Hybrid Instruments and Exemption for
Certain Swap Agreements, respectively.) In this regard, the Commission notes
that to the extent an instrument has option-like features, and would be
otherwise eligible for exemption under Rule 32.4 as a trade option, and an
appropriate capital treatment has been specified, as discussed above, then
this exception from Rule 1.19 would apply to FCM counterparties. However, the
swaps portion of any such instrument would be treated consistent with the
capital treatment specified in the concept release issued by the SEC, 58 FR
27486 at 27490, which requires treatment of the unrealized profit as an
unsecured receivable and specifies a haircut on the notional amount plus an
options charge pursuant to appendix A, cited above.

The Commission is adopting, as final, the rules as proposed. In light of the
significant issues regarding the appropriate methodology for computing net
capital for option positions for which a capital treatment was not proposed in
the release, the Commission believes that it is premature to extend the
proposed exception to all options which are exempt under Commission Rule 32.4.
Nevertheless, the Commission believes that it should proceed immediately in
granting this exception for those types of options for which there is ready
agreement and general acceptance of an appropriate capital treatment. The
Commission is of the view that proceeding with this exception, though limited,
will remove from U.S. FCMs a potential competitive disadvantage without
adversely affecting the integrity of the regulated futures markets. The
Commission will consider further expansions of this exception in connection
with its ongoing consideration of revisions to the capital requirements.

Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (RFA), 5 U.S.C 601 et seq., requires that
agencies, in proposing rules, consider the impact of these rules on small
entities. The Commission has previously determined that "FCMs'' and similar
entities are not "small entities'' for purposes of the RFA. 47 FR 18618 (April
30, 1982). These rules modify certain minimum capital requirements for FCMs.
The amendments also permit FCMs to undertake additional option strategies and
do not otherwise impose any additional burdens, but rather, alleviate an
already existing prohibition. Accordingly, if promulgated, this rule would
have no significant impact on a substantial number of small entities. For the
above reasons, and pursuant to section 3(a) of the RFA, 5 U.S.C. 605(b), the
Acting Chairman, on behalf of the Commission, hereby certifies that these
regulations will not have a significant economic impact on a substantial
number of small entities.

In this regard, the Commission invited comments from any firms or other
persons which believe that the promulgation of the proposed rule amendments
might have a significant impact upon their activities. None were received.

B. Paperwork Reduction Act

The Paperwork Reduction Act of 1980, 44 U.S.C. 3501 et seq., ("PRA'') imposes
certain requirements on Federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of information
as defined by the PRA. In compliance with the Act the Commission has submitted
these amended rules and their associated information collection requirements
to the Office of Management and Budget ("OMB''). Rule 1.19, including its
proposed revision, has no burden associated with it and is not part of a group
of rules having a burden.

With respect to the proposed amendments to Rule 1.17, OMB approved the
collection of information associated with these rules on January 25, 1993, and
assigned OMB control number 3038Ä0024. The burden associated with this
specific final rule is as follows:

Average burden hours per response 0.50

Number of respondents 100 (FCMs); 15 (IBs)

Frequency of response Annually

Copies of the OMB approved information collection package associated with this
rule may be obtained from Gary Waxman, Office of Management and Budget, room
3220, NEOB, Washington, DC 20503, (202) 395Ä7340.

List of Subjects in 17 CFR Part 1

Commodity options, Financial requirements, Reporting and record keeping
requirements.

In consideration of the foregoing, and pursuant to the authority contained in
the Commodity Exchange Act and, in particular, sections 4c, 4f, 4g, and 8a of
the Act, 7 U.S.C. 6c, 6f, 6g, and 12a (1988), the Commission hereby amends
Chapter I of Title 17 of the Code of Federal Regulations as follows:

PART 1 GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

1. The authority citation for part 1 continues to read as follows:

Authority: 7 U.S.C. 2, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h, 6i, 6j, 6k,
6l, 6m, 6n, 6o, 7, 7a, 9, 12, 12a, 12c, 13a-1, 13a-2, 16, 19, 21, 23 and 24,
unless otherwise noted.

2. Section 1.17 is amended by revising paragraph (c)(5)(vi) to read as
follows:

 1.17 Minimum financial requirements for futures commission merchants and
introducing brokers.

                                  * * * * *

(c) * * *

(5) * * *

(vi) In the case of securities options and/or other options for which a
haircut has been specified for the option or for the underlying instrument in
 240.15c3Ä1 appendix A of this title, the treatment specified in, or under, 
240.15c3Ä1 appendix A, after effecting certain adjustments to net capital for
listed and unlisted options as set forth in such appendix;

                                  * * * * *

3. Section 1.19 is amended by revising paragraphs (a) and (b) and adding
paragraph (c) to read as follows:

 1.19 Prohibited trading in certain "puts'' and "calls''.

                                  * * * * *

(a) Commodity options traded on or subject to the rules of a contract market
in accordance with the requirements of part 33 of this chapter;

(b) Commodity options traded on or subject to the rules of a foreign board of
trade in accordance with the requirements of part 30 of this chapter; or

(c) For futures commission merchants, any option permitted under  32.4 of
this chapter, provided however, that a capital treatment for such options is
referenced in  1.17(c)(5)(vi).

Issued in Washington, DC, this 21st day of December, 1993, by the Commodity
Futures Trading Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 93Ä31557 Filed 12Ä27Ä93; 8:45 am]

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