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F e d er a l R e se r v e Ba n k DALLAS, TEX A S of D allas 75222 Circular No. 73-1+9 March 5? 1973 PROPOSED AMENDMENTS TO REGULATIONS G, T AND U (Treatment of Puts, Calls and combinations thereof) INTERPRETATIONS OF REGULATIONS T AND U (Treatment of Put and Call Options as securities) To All Banks, Broker/Dealers, and Others Concerned in the Eleventh Federal Reserve District: The Board of Governors of the Federal Reserve System proposes to amend Regulations G, T and U to indicate that certain Puts, Calls or combin ations thereof are to be given no loan value as collateral, even if such options themselves are registered as securities on a national securities exchange. Changes are also proposed to indicate in Regulation T that the adjusted debit balance in a general account must include the amount of any margin required in connection with the issuance, endorsement or guarantee of any Put, Call or combination thereof, and in Regulation U to conform the definition of "stock" to the statutory definition of "equity securities1. ' Copies of the proposed amendments are attached. Interested persons should submit relevant data, views or arguments to the Secretary, Board of Governors of the Federal Reserve System, Washington, D. C. 20551? to be received no later than March l6, 1973. Also attached are interpretations by the Board, effective February 20, 1973? relating to the treatment of Puts, Calls and combinations thereof as securities for the purposes of Regulations T and U. Very truly yours, P. E. Coldwell, President Attachment This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) TITLE 12 -- BANKS AND BANKING CHAPTER II -- FEDERAL RESERVE SYSTEM SUBCHAPTER A -- BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM [Regs. G, T and U] PARTS 207, 220, 221 -- SECURITIES CREDIT TRANSACTIONS Treatment of Puts, Calls and Combinations thereof The Board of Governors proposes to amend Parts 207, 220 and 221 (Regulations G, T and U) in order to provide that any put, call or combination thereof which is written on an equity security, even if such option is itself registered as a security on a national secu rities exchange, shall have no loan value for the purposes of § 207.1, § 220.3 and § 221.1 (Regulations G, T and U ) ; to clarify that the cus tomer's adjusted debit balance in a general account under Regulation T must include the amount of margin required in connection with the issuance, endorsement or guarantee of any put, call or combination thereof whether or not such obligations are assumed by the creditor; and to conform the definition of "stock" in Regulation U to the statu tory definition of "equity security." PART 207 -- SECURITIES CREDIT BY PERSONS OTHER THAN BANKS, BROKERS OR DEALERS 1. Section 207.5(a) (the Supplement to Regulation G) would be amended as set forth below: - 2 - Section 207.5 SUPPLEMENT (a) Maximum loan value of margin securities. For the purpose of § 207.1, the maximum loan value of any margin security, except convertible securities subject to § 207.1(d) and any put, call or combination thereof, shall be 35 per cent of its current m a r ket value, as determined by any reasonable method. No put, call or combination thereof shall have any loan value for the purposes of this part. PART 220 -- CREDIT BY BROKERS AND DEALERS 2a. Section 220.3(d)(5) would be amended as set forth below: Section 220.3 GENERAL A C C O U N T S * (d) * * Adjusted debit balance. * * For the purpose of this part, the adjusted debit balance of a general account, special bond account, or special convertible debt security account shall be calculated hy taking the sum of the following items: * * * (5) the amount of any margin required in connection with the issuance, endorsement or guarantee of any put, call or combination thereof. (b) Section 220.8(a)(1) and (f) (the Supplement to R eg u l a tion T) is amended to read as follows: - 3 Section 220.8 SUPPLEMENT (a) Maximum loan value for general acco u n ts . The maximum loan value of securities in a -general account subject to § 220.3 shall be (1) of a registered non-equity security held in the account on March 11, 1968, and continuously thereafter, and of a margin equity security (except as provided in § 220.3(c) and paragraphs (b), (c) and (f) of this section), 35 per cent of the current market value of such securities. * (f) * * * * Securities having no loan value in a general a c count. N o securities other than an exempted security or registered non-equity security held in the account on March 11, 1968, and continuously thereafter, and a margin security,shall have any loan value in a general account except that a margin security eligible for the special convertible debt security account pursuant to § 220.4( j) shall have loan value only if held in the account on March 11, 1968, tinuously thereafter; and no put, call or and combination thereof con shall have loan value in a general account. PART OF 3a. 221 -- CREDIT BY BANKS FOR THE PURPOSE PURCHASING OR CARRYING MARGIN STOCKS Section 221.3(_1) would be amended as set forth below: Section 221.3 MISCELLANEOUS PROVISIONS * (1) * * * * S t oc k . The term stock includes any security commonly known as a stock; any voting trust certificate or other instrument representing such a security; and any security convertible, with or - 4 - without consideration, presently or in the future, into such secu rity, certificate, or other instrument, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Securities and Exchange Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security such as any certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so. (b) Section 221.4(a) (the Supplement to Regulation U) would be amended to read as follows: Section 221.4 SUPPLEMENT (a) Maximum loan value of stocks. For the purpose of § 221.1, the maximum loan value of any stock except puts, calls and combinations thereof, whether or not registered on a national securities exchange shall be 35 per cent of its current market value, as determined by any reasonable method. loan value. Puts, calls and combinations thereof shall have no - 5 - The purpose of the proposed changes in Regulations G, T and U is to Indicate that puts, calls and combinations thereof are to be given no loan value as collateral even if they become regis tered as securities on a national securities exchange. Clarifying changes are proposed in § 220.3(d)(5) to indicate that any margin required in connection with the issuance, endorsement or guarantee of any put, call or combination thereof must be added to the adjusted debit balance of a general account and in § 221.1(3)(J.) to designate specific securities which are to be treated as stock. Because of the limited life of puts and calls and the avail ability of credit if they are exercised the Board deems it necessary, in order to prevent the excessive use of credit to finance transactions in securities, t o propose these amendments to Regulations G, T and U under the authority of section 7(b) of the Securities Exchange Act of 1934 (15 U.S.C. 7 8 g ) . 4a. The Board is affording interested persons an opportunity to submit relevant data, views, or arguments concerning the proposed amendment. Any such material should be submitted in writing to the Secretary, Board of Governors of the Federal Reserve System, Washington, D. C. 20551, to be received not later than inarch 16,1973. Such material will be made available for inspection and copying upon request, except as provided in § 261.6(a) of the Board's Rules Regarding Availability of Information. - 6 - b. This notice is published pursuant to section 553(b) of Title 5, United States Code, and § 262.2(a) of the Rules of Procedure of the Board of Governors of the Federal Reserve System (12 C.F.R. 262.2(a)). By order of the Board of Governors, February 20, 1973. (signed) Michael A. Greenspan Michael A. Greenspan Assistant Secretary of the Board (SEAL) BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM CREDIT BY BROKERS AND DEALERS IN T E R P R E T A T IO N O F R E G U L A T IO N T T R E A T M E N T OF P U T A N D C A L L O P T IO N S A N D C O M B IN A T IO N S T H E R E O F A S SE C U R IT IE S § 2 2 0 .1 2 6 Certain transactions in put and call op tions and combinations thereof m ay be effected in the special cash account; a put, call or combination thereof is not considered an “unissued” security or a security “exchangeable or convertible” into the underlying security. (a ) The Board has been asked several questions about the treatment o f put and call options and combinations thereof ( “puts and calls” ) under Regulation T (Part 2 2 0 ) . These questions involve § 2 2 0 .3 (d ) Adjusted debit balance, § 2 2 0 .3 (h ) Unissued securities, § 2 2 0 .4 ( c ) Special cash ac count and § 2 2 0 .4 ( d ) Special arbitrage account. (b ) The special cash account under § 2 2 0 .4 ( c ) may be used only for those bona fide transactions in securities in which the creditor accepts in good faith the customer’s agreement, if he is a pur chaser, that (if he does not already have sufficient funds in the account) he will promptly make full cash payment for the security and does not con template selling it prior to making such payment, and if he is a seller, that he or his principal owns the security and (if it is not already held in the account) it will be promptly deposited therein. It is the Board’s view that subject to these require ments, a creditor may effect in a special cash ac count ( 1 ) the purchase or sale for cash o f a put or call; ( 2 ) the exercise o f a call, provided that full cash payment for the purchased stock is depos ited in the account promptly and in any event prior to the release o f the proceeds o f any resale o f such security; and ( 3 ) the endorsement, guarantee or issuance o f a put or call if (in the case o f a put) sufficient funds to purchase the underlying stock or (in the case o f a call) the underlying stock itself are held in the account. (c ) Generally a put or call option refers to an agreement to sell a security or to purchase a secur ity, at som e future time. A lthough the agreement may itself be deemed to be a security, it cannot be an “ u n is s u e d ” s e c u r ity , u n d er § 2 2 0 . 3 ( h ) or § 2 2 0 . 4 ( c ) ( 3 ) , for the reasons set forth by the Board in discussing a similar question in regard to mutual funds shares (1 9 6 2 Bulletin 1427; 12 C.F.R. 2 2 0 .1 1 8 ). Accordingly, in respect o f a transaction involving puts or calls, payment is required within the period o f time provided by § 2 2 0 . 3 ( b ) ( 1 ) if the transaction occurs in the general account (or if the transaction occurs in a special cash account, by § 2 2 0 . 4 ( c ) ( 2 ) ) without regard to whether there has been a delay in obtain ing the endorsement, or for any other reason the option has not yet technically been issued. (d ) A question has been asked whether puts and calls may be considered to be securities which are exchangeable or convertible into other secur ities, within 90 calendar days, without restriction other than the payment o f money. If held in a gen eral account, such exchangeable or convertible securities are acceptable in lieu o f the margin r e q u ir ed in r e s p e c t o f a sh o rt s a le u n d er § 2 2 0 . 3 ( d ) ( 3 ) . If held in a special arbitrage ac count under § 2 2 0 .4 ( d ) , exchangeable or convert ible securities will support the sale, for purposes of bona fide arbitrage, of the security into which they are so exchangeable or convertible. The board con cludes that puts and calls m ay not be considered, for either purpose, as securities that are exchangeable or convertible into other securities. The Board’s view stems from the policies underlying the sec tions in question. (e ) T he margin restrictions in respect of short sales were im posed in order that “. . . traders on the short side o f the market should not be in a position, with a given amount o f funds, to exert a greater influence on the market than they could with the same amount o f funds if they were trading on the long side.” (A nnual Report, Board o f G over nors, 1937, p. 20 8 ) (O V ER ) not likely that true arbitrage w ould take place between an option and an underlying security. Such options w oud be used, rather, for purposes of “hedging,” that is to say, to protect an investor against loss while he holds a security in the hope (f) The use o f the special arbitrage account o f profiting by changes in its price. Such market under § 2 2 0 .4 ( d ) is limited to the simultaneous strategies may be beneficial to individual investors. purchase and sale o f the same or equivalent secur However, they do not perform a comparable ities for the purpose o f taking advantage o f a dif market function. ference in price. Arbitrage is permitted to be carried on without additional deposit o f margin because it tends to equalize prices between markets and between equivalent securities. Because the rela 2 /2 0 /7 3 tively high initial cost o f a put or call option must be deducted from the potential profit due to the disparity in price between the tw o securities, it is * * * * * Permitting call options to be used in lieu o f the margin required in respect o f a short sale would be inconsistent with that general policy (parallel considerations would apply in the case o f puts.) BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM CREDIT BY BANKS FOR THE PURPOSE OF PURCHASING OR CARRYING MARGIN STOCKS IN TER PR ETA TIO N OF R EG U LA TIO N U SE C T IO N 2 21 .1 2 2 B O N A F ID E A R B IT R A G E T R A N S A C T IO N S . purchase of a security which is, without restric tion other than the payment of m oney exchange able or con v ertib le. . . into a second security” so (g ) Section 221.2 o f this chapter provides that as to qualify such purchase, w hen effected together with an offsetting sale o f the second security, as a “a bank may extend and may maintain any credit bona fide arbitrage transaction, and the Board’s for the purpose specified in § 221.1, without re conclusion is also applicable to subsection (j) o f gard to the limitations prescribed therein, or in § 221 . 2. § 221.3 ( t ) , if the credit com es within any o f the follow ing descriptions.” Subsection (j) contains the follow ing description: “ (j) A n y credit extended to a member o f a national securities exchange for 2 /2 0 /7 3 the purpose o f financing his or his customers’ bona fide arbitrage transactions in securities.” The Board has: concluded that a purchase o f a put or call is not embraced within the term in § 2 2 0 .4 (d ) “a * * * * *