[Federal Register Volume 63, Number 118 (Friday, June 19, 1998)]
[Notices]
[Pages 33746-33750]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16351]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40087; File No. SR-NASD-98-23]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc; Order Granting Approval and Notice of Filing and Order
Granting Accelerated Approval to Amendment No. 1 and Amendment No. 2 to
Proposed Rule Change Relating to an Amendment to the NASD's Options
Position Limit Rule
June 12, 1998.
I. Introduction
On March 10, 1998, NASD Regulation, Inc. (``NASD Regulation'')
submitted to the Securities and Exchange Commission (``SEC'' or
``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to amend Rule 2860(b) of the
National Association of Securities Dealers, Inc. (``NASD'') or
``Association'') to: (1) increase the position limits on conventional
equity options to three times the basic position limits for
standardized equity options on the same security; (2) disaggregate
conventional equity options from standardized equity options and FLEX
Equity Options for position limit purposes; and (3) provide that the
OTC Collar Aggregation Exemption shall be available with respect to an
entire conventional equity options position, not just that portion of
the position that is established pursuant to the NASD's Equity Option
Hedge Exemption.
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\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1994).
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The proposed rule change was published for comment in Exchange Act
Release No. 39893 (April 21, 1998), 63 FR 23317 (April 28, 1998) NASD
Regulations submitted an amendment to the proposed rule change on April
29, 1998.\3\ A second amendment to the
[[Page 33747]]
proposed rule change was submitted on June 3, 1998.\4\ One comment
letter was received on the proposal \5\ This order approves the
proposed rule change, as amended.
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\3\ See Letter to Katherine A. England, Assistant Director,
Division of Market Regulation, Commission, from John M. Ramsay, Vice
President and Deputy General Counsel, NASD Regulation, dated April
29, 1998 (``Amendment No. 1''). Amendment No. 1 makes certain
technical corrections to the text of the proposed rule change.
\4\ See Letter to Katherine A. England, Assistant Director,
Division of Market Regulation, Commission, from Gary L. Goldsholle,
Assistant General Counsel, NASD Regulation, dated June 2, 1998
(``Amendment No. 2''). Amendment No. 2 corrects a deficiency in the
language of the proposed rule change by clarifying that the tripling
aspect of the proposal will apply to all conventional equity
options. Under the current rules, the position limits for
conventional equity options overlying a security for which there is
no standardize equity options contract is set at 4,500 contracts, or
such higher limit for which the underlying security would qualify.
As now written, the proposed rule language establishes position
limits for conventional equity options at ``three times the
applicable position limit established for standardized equity
options overlying the security,'' but does not take into account the
circumstance where there is no standardized equity option contract
overlying the security. Amendment No. 2 proposes language that
triples the position limits for all conventional equity options,
including those for which there is no standardize equity option
contract overlying the security.
\5\ See Letter to Jonathan G. Katz, Secretary, Commission, from
Deutsche Bank Securities, Inc., Merrill Lynch, Pierce Fenner &
Smith, Inc., Morgan Stanley & Co., Inc., Salomon Brothers Inc./Smith
Barney, Inc., and SBC Warburg Dillon Read, Inc., dated June 2, 1998
(``Firms' Letter''). The letter supports the approval of SR-NASD-98-
23, as amended.
The Commission notes that it received a comment letter on a
separate NASD rule filing (SR-NASD-97-80) on January 23, 1998, that
is relevant to present filing. The letter supported the approval of
SR-NASD-97-80, as well a SR-NASD-97-67, which was substantively very
similar to the present filing. SR-NASD-97-67, was withdrawn and
replaced by the present filing. See Letter to Jonathan G. Katz,
Secretary, Commission, from Bear, Stearns & Co., Deutsche Morgan
Grenfell, Inc., Goldman, Sachs & Co., Lehman Brothers, Inc., Merrill
Lynch, Pierce Fenner & Smith, Inc., Morgan Stanley & Co., Inc.,
Natwest Securities Corporation, Salomon Brothers, Inc., SBC Warburg
Dillon Read, Inc., and Smith Barney, Inc., dated January 23, 1998.
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II. Description
NASD Rule 2860(b)(3) provided that the position limit \6\ for each
equity option is determined according to a five-tiered system whereby
more actively traded securities with larger public floats are subject
to higher position limits and less actively traded stocks are subject
to lower limits.\7\ Presently, conventional and standardized equity
options are subject to the same position limits, and all equity options
overlying a particular equity security on the same side of the market
are aggregated for position limit purposes, regardless of whether the
option is a conventional, standardized or FLEX Equity Option.\8\ On
September 9, 1997, the Commission approved a two-year pilot program
(``Pilot Program'') to eliminate position and exercise limits for FLEX
Equity Options, which are traded on the American Stock Exchange, Inc.
(``AMEX''), the Chicago Board Options Exchange, Inc. (``CBOE''), and
the Pacific Exchange, Inc. (``PCX'') (collectively ``Options
Exchange'').\9\ In light of the Pilot Program, NASD Regulation is
proposing to amend its rules governing position and exercise limits for
conventional equity options. NASD Regulation previously has filed a
proposed rule change to eliminate position and exercise limits on FLEX
Equity Options to make its rules consistent with the Pilot Program.\10\
NASD Regulation believes the proposed rule change herein is necessary
to foster competition between the over-the-counter (``OTC'') market and
the Options Exchanges.
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\6\ Position limits impose a ceiling on the number of option
contracts in each class on the same side of the market (i.e.,
aggregating long calls and short puts or long puts and short calls)
that can be held or written by an investor or group of investors
acting in concert. Exercise limits restrict the number of options
contracts that an investor or group of investors acting in concert
can exercise within five consecutive business days. Under NASD
Rules, exercise limits correspond to position limits, such that
investors in options classes on the same side of the market are
allowed to exercise, during any five consecutive business days, only
the number of options contracts set forth as the applicable position
limit for those options classes. See NASD Rules 2860(b) (3) and (4).
\7\ Currently, the five tiers are for 4,500, 7,500, 10,500,
20,000, and 25,000 contracts NASD rules do not specifically govern
how a specific equity option falls within one of the five position
limit tiers. Rather, the NASD's position limit established by an
options exchange(s) for a particular equity option is the applicable
position limit for purpose of the Government's rule.
\8\ Standardized options are exchange-traded options issued by
the Options Clearing Corporation (``OCC'') that have standard terms
with respect to strike prices, expiration dates, and the amount of
the underlying security. A conventional option is any other option
contract not issued, or subject to issuance by, OCC.
\9\ See Exchange Act Release No. 39032 (September 9, 1997) 62 FR
48683 (September 16, 1997).
\10\ SR-NASD-98-15. The Commission notes that SR-NASD-98-15 was
approved on March 19, 1998. See Exchange Act Release No. 39771
(March 19, 1998), 63 FR 14743 (March 26, 1998).
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FLEX Equity Options are exchange-traded options issued by the OCC
that give investors the ability, within specified limits, to designate
certain terms of the option (i.e., the exercise price, exercise style,
expiration date, and option type). Because they are non-uniform and
individually negotiated, FLEX Equity Options closely resemble and are
economically equivalent to conventional equity options. Accordingly, to
align more closely the NASD's position limit rules for conventional
equity options with the rules for FLEX Equity Options, NASD Regulation
proposes to amend Rule 2860(b)(3) to provide that: (1) position limits
on conventional equity options shall be increased to three times the
basic position limits for standardized equity options on the same
security, (2) conventional equity options shall be disaggregated from
standardized equity options FLEX Equity Options for position limit
purposes; and (3) the OTC Collar Aggregation Exemption shall be
available with respect to an entire conventional equity options
position, not just that portion of the position that is established
pursuant to the NASD's Equity Option Hedge Exemption.
The NASD's Equity Option Hedge Exemption \11\ provides for an
automatic exemption from equity option limits for accounts that have
established hedged positions on a limited one-for-one basis (i.e., 100
shares of stock for one option contract). Under the Equity Option Hedge
Exemption, the largest options position that may be established
(combining hedged and unhedged positions) may not exceed three times
the basic position limit. The OTC Collar Aggregation Exemption \12\
provides that positions in conventional put and call options
establishing OTC collars need not be aggregated for position limit
purposes. An OTC collar transaction involves the purchase (sale) of a
put and the sale (purchase) of a call on the same underlying security
to hedge a long (short) stock position.
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\11\ Rule 2860(b)(3)(A)(vii).
\12\ 2860(b)(3)(A)(viii).
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At the present time, NASD Regulation believes that the prudent
regulatory approach is to increase position limits on conventional
equity options in conjunction with continued availability of the Equity
Option Hedge Exemption and OTC Collar Aggregation Exemption. NASD
Regulation proposes an incremental approach and in this case believes
increasing position limits for conventional equity options to three
times the position limits for standardized equity options is
appropriate. These proposed limits correspond to the position limits in
effect for FLEX Equity Options prior to the Pilot Program.
NASD Regulation also believes that conventional equity options
positions should not be aggregated with standardized and FLEX Equity
Options on the same securities for position limit purposes. It believes
that disaggregation of conventional and other options is necessary to
give full effect to the proposed increase in position limits for
conventional equity options. Without disaggregation, positions in FLEX
Equity Option or standardized option positions would reduce or
potentially even eliminate (in the case of FLEX
[[Page 33748]]
Equity Options) the available position limits for conventional equity
options.
To illustrate how these proposed amendments would work, consider
the following example of stock ABCD, which is subject to a position
limit of 25,000 standardized equity option contracts. In this example,
a market participant could establish a position of 25,000 standardized
option contracts on ABCD and an additional 75,000 conventional option
contracts on ABCD on the same side of the market, since conventional
and standardized option positions would be disaggregated. In addition,
the market participant also may have a position of any size in FLEX
Equity Options overlying ABCD, since such FLEX Equity Options would not
be aggregated with either the conventional equity options or
standardized equity options overlying ABCD. Further, by taking
advantage of the Equity Option Hedge Exemption, which permits a market
participant to assume a hedged options position that is three times the
otherwise applicable position limit, a market participant could
increase the number of conventional equity options to 225,000
contracts.
NASD Regulation proposes to modify the terms of the OTC Collar
Aggregation Exemption to apply to an entire conventional equity option
position, not just the portion that is established pursuant to the
Equity Option Hedge Exemption. NASD Regulation believes such an
amendment is consistent with the economic logic underlying the OTC
Collar Aggregation Exemption, i.e., that if the terms of the exemption
are met, the segments of an OTC collar will never both be in-the-money
at the same time or exercised. Under current rules, assuming that stock
ABCD is subject to a basic position limit of 25,000 contracts, a market
participant taking advantage of the Equity Option Hedge Exemption could
establish a hedged position on ABCD involving a total of 75,000
conventional equity option contracts (three times the basic limit),
including 50,000 contracts that are established under the Equity Option
Hedge Exemption. A market participant using the OTC Collar Aggregation
Exemption could then establish a conventional position of 50,000 long
(short) calls and 50,000 short (long) puts, for a total of 125,000
contracts overlying ABCD. The proposed rule change to the OTC Collar
Aggregation Exemption would allow a market participant to establish a
collar consisting of two segments, each of which involves a position
three times greater than the basic position limit. Consequently, using
the example above, a market participant could establish an OTC collar
on ABCD involving 75,000 long (short) calls and 75,000 short (long)
puts, for a total of 150,000 contracts.\13\
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\13\ While the OTC Collar Aggregation Exemption is self-
effectuating with respect to the hedged components of conventional
options positions, NASD Regulation has also permitted members to
include non-hedged positions within OTC collars under the terms of
the OTC Collar Aggregation Exemption on a pre-approval basis.
Accordingly, the instant rule change would turn this pre-approval
process for non-hedged components of OTC collars into a self-
effectuating process.
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If, however, the basic position limits for conventional options
were tripled, as proposed above, the permissible options position
established under the OTC Collar Aggregation Exemption would be
correspondingly increased. For example, if the market participate in
the above example had increased the size of its conventional options
position to 225,000 contracts pursuant to the Equity Option Hedge
Exemption as proposed above (based upon a limit of three times the
75,000 conventional equity options position limit), the market
participant could establish an OTC collar on ABCD involving 225,000
long (short) calls and 225,000 short (long) puts, for a total of
450,000 contracts.
Finally, in addition to the proposed rule changes discussed above,
the NASD is proposing to clarify and update the examples contained in
IM-2860-1 so that they are consistent with the instant proposal and
prior increases in the hedge exemption.
III. Discussion
The Commission finds that the proposed rule change is consistent
with the requirements of the Act and the rules and regulations
thereunder applicable to the Association, and, in particular, with the
requirements of Section 15A(b)(6).\14\ Specifically, the Commission
believes that the proposed rule change is designed to prevent
fraudulent and manipulative acts and practices, to promote just and
equitable principles of trade, and is not designed to permit unfair
discrimination between customers, issuers, brokers, or dealers.
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\14\ 15 U.S.C. 78o-3(b)(6).
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The Commission also believes that the proposed rule changes is
consistent with Section 11A of the Act in that it will increase the
position limits on conventional equity options, disaggregate
conventional equity options from exchange-traded equity options for
position limit purposes, and provide that the OTC Collar Aggregation
Exemption may be utilized with respect to any conventional equity
options position, not just that part of the position that is
established pursuant to the NASD's Equity Option Hedge Exemption, and
thereby allow market participants in the OTC options market to compete
effectively with the participants using standardized options or with
entities not subject to position limit rules.
Since the inception of conventional equity options trading, the
NASD has had rules imposing limits on the aggregate number of options
contracts that a member or customer could hold or exercise.\15\ These
rules are intended to prevent the establishment of options positions
that can be used or might create incentives to manipulate or disrupt
the underlying market so as to benefit the options position. In
particular, position and exercise limits are designed to minimize the
potential for mini-manipulation \16\ and for corners or squeezes of the
underlying market. In addition, they serve to reduce the possibility
for disruption of the options market itself, especially in illiquid
options classes.
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\15\ As stated earlier, under NASD rules conventional and
standardized equity options currently are subject to the same
position limits, and all equity options overlying a particular
equity security on the same side of the market are aggregated for
position limit purposes, regardless of whether the option is a
conventional, standardized of FLEX Equity Option.
\16\ Mini-manipulation is an attempt to influence, over a
relatively small range, the price movement in a stock to benefit a
previously established derivatives position.
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The Commission has been careful to balance two competing concerns
when considering a self-regulatory organization's position and exercise
limits. The Commission has recognized that the limits must be
sufficient to prevent investors from disrupting the market for the
underlying security by acquiring and exercising a number of options
contracts disproportionate to the deliverable supply and average
trading volume of the underlying security. At the same time, the
Commission has realized that limits must not be established at levels
that are so low as to discourage participation in the options market by
institutions and other investors with substantial hedging needs or to
prevent specialists and market makers from adequately meeting their
obligations to maintain a fair and orderly market.\17\
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\17\ See H.R. Rep. No. IFC-3, 96th Cong., 1st Sess. at 189-91
(Comm. Print 1978) (``Options Study'').
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The Commission believes that the proposed rule change will improve
the conventional equity options market for several reasons. First, the
Commission notes that the NASD's current reporting requirements for all
conventional equity options transactions establishing large options
positions will apply to such transactions effectuated under the new
rule. Rule 2860(b)(5)(ii) imposes
[[Page 33749]]
reporting obligations on ``each account in which the member has an
interest * * * and each customer account, which has established an
aggregate position of 200 or more option contracts * * *.'' Information
reported to the NASD is used by the NASD Regulation Market Regulation
staff as part of their ongoing market surveillance operations and helps
to minimize the risk of any market manipulation or disruption related
to the accumulation or disposition of large options positions. It also
enables NASD Regulation to identify large positions held or written by
a member that could pose a financial risk to the member or its clearing
firm.
Second, the tripling of the position limits on conventional equity
options will help those investors who utilize conventional equity
options, typically large, sophisticated institutional investors, or
persons of extremely high net worth, with their extensive hedging
needs.\18\
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\18\ In the Firms' Letter, the commenters indicate that they
``have experienced an overwhelming interest by institutional and
other accredited investors to enter into collar transactions and
other hedging transactions involving conventional options.'' On
several occasions they have been unable ``to meet the demand for
this hedging activity due to the relatively low [applicable]
conventional option position limits.'' See Firms' Letter, supra,
note 5.
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Third, the Commission also believes that the proposed tripling of
position limits for conventional equity options will expand the depth
and competitiveness of the conventional equity option market without
significantly increasing concerns regarding intermarket manipulations
or disruptions of the options or the underlying securities. Broker-
dealers and banks act as dealers in the OTC derivatives market, and
compete with each other for counterparty business. The proposal will
enable broker-dealers to compete more effectively with banks that are
not subject to NASD rules for OTC options transactions. It will also
enable NASD members to accommodate better their clients' risk
management strategies. The Commission recognizes, however, that the
proposal presents substantial increases in OTC options transactions. It
will also enable NASD members to accommodate better their clients' risk
management strategies. The Commission recognizes, however, that the
proposal present substantial increases in OTVC options positions.
Although the proposed rule change increases threefold the position
limits for conventional equity options, those markets that are
relatively less active and not as deep in trading interest will remain
subject to the lowest existing position limit, i.e., 4,500 x 3, or
13,500 option contracts. Moreover, as noted above, the large positions
will be reported to the NASD for monitoring. Finally, the Commission
notes that the proposed positions for conventional equity options are
still capped at a fixed level, whereas there are no position limits for
FLEX Equity options.
Fourth, the Commission believes that the disaggregation of
conventional equity options from standardized equity options is
warranted given that the tripling provision will otherwise be of
limited effect. That is, if an investor has reached the limit for
standardized equity options and is required to aggregate those options
with his conventional equity options, he will reach the total position
limit for conventional equity options sooner than if the standardized
and conventional equity options were not aggregated. The Commission
also notes that, under the rules of the Options Exchanges, FLEX Equity
Options, which are very similar to conventional equity options, are not
aggregated with standardized equity options for position limit
purposes.\19\
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\19\ Positions in FLEX Index Options generally are also not
aggregated with options on any stocks included in the index or with
FLEX Index Option positions on another index. See, e.g., CBOE Rule
24A.7(c).
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Fifth, the Commission notes that in September 1997, it approved the
elimination of position and exercise limits for FLEX Equity Options on
a two year pilot basis.\20\ As stated above, FLEX Equity Options are
exchange-traded options issued by the OCC that give investors the
ability, within specified limits, to designate certain terms of the
option (i.e., the exercise price, exercise style, expiration date, and
option type). Conventional equity options are very similar to FLEX
Equity Options given that they are also non-uniform and individually
negotiated.\21\ Traditionally, the Commission has taken a gradual,
evolutionary approach toward expansion of position and exercise limits.
The Commission believes that increasing position limits for
conventional equity options to three times the position limits for
standardized equity options is appropriate given the Commission's
previous approach to the expansion of position and exercise limits. The
Commission also believes that the proposed rule change will help to
foster competition between the OTC market and the Options Exchanges, as
well as ensure that OTC market participants are not placed at a
competitive disadvantage vis-a-vis the Options Exchanges.
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\20\ See supra note 9.
\21\ Conventional equity options are not, however, issued or
subject to issuance by OCC.
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The Commission finds good cause to approve Amendment No. 1 to the
proposed rule change prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Amendment No. 1 makes minor technical changes to the text of the
proposed rule. Specifically, Amendment No. 1 clarifies in the rule
language that the Equity Option Hedge Exemption program was approved by
the Commission on a pilot basis only until December 31, 1998. Amendment
No. 1 also makes certain clerical corrections. Accordingly, the
Commission believes that it is consistent with Section 15A(b)(6) of the
Act to approve Amendment No. 1 to the proposed rule change on an
accelerated basis.
The Commission finds good cause to approve Amendment No. 2 to the
proposed rule change prior to the thirtieth day after the date of
publication of notice of filing thereof in the Federal Register.
Amendment No 2 corrects a deficiency in the text of the proposed rule.
Specifically, Amendment No. 2 clarifies in the rule language that
position limits for conventional equity for which there is not
standardized equity option contract overlying the security are also to
be tripled. Under the current rules, the position limits for
conventional equity options overlying a security for which there is no
standardized equity options contract is set at 4,500 contracts, or such
higher limit for which the underlying security would qualify. As now
written, the proposed rule language establishes position limits for
conventional equity options at ``three times the applicable position
limit established for standardized equity options overlying the
security,'' but does not take into account the circumstance where there
is no standardized equity option contract overlying the security.
Amendment No. 2 proposes language that triples these limits. The
Commission believes that accelerated approval of Amendment No. 2 is
appropriate given that it clarifies the application of the new position
limits in a manner that is consistent with the approach established in
the original rule filing. Accordingly, the Commission believes that it
is consistent with Section 15A(b)(6) of the Act to approve Amendment
No. 2 to the proposed rule change on an accelerated basis.
Interested persons are invited to submit written data, views and
arguments concerning Amendment No. 1 and Amendment No. 2 to the
proposed rule change, including whether the amendments are consistent
[[Page 33750]]
with the Act. Persons making written submissions should file six copies
thereof with the Secretary, Securities and Exchange Commission, 450
Fifth Street, N.W., Washington, D.C. 20549. Copies of the submission,
all subsequent amendments, all written statements with respect to the
proposed rule change that are filed with the Commission, and all
written communications relating to the proposed rule change between the
Commission and any person, other than those that may be withheld from
the public in accordance with the provisions of 5 U.S.C. Sec. 552, will
be available for inspection and copying at the Commission's Public
Reference Room. Copies of such filing will also be available for
inspection and copying at the principal office of the Exchange. All
submissions should refer to File No. SR-NASD-98-23 and should be
submitted July 10, 1998.
IV. Conclusion
For the foregoing reasons, the Commission finds that NASD
Regulation's proposal, as amended, is consistent with the requirements
of the Act and the rules and regulations thereunder.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\22\ that the proposed rule change (SR-NASD-98-23) is approved, as
amended.
\22\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\23\
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\23\ 17 CFR 200.30-3(a)(12) (1994).
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Jonathan G. Katz,
Secretary.
[FR Doc. 98-16351 Filed 6-18-98; 8:45 am]
BILLING CODE 8010-01-M