CBOE Recommends Criteria for Securities Futures Contracts Dealer Qualification

[1] The Chicago Board Options Exchange ("CBOE") is pleased to offer these comments in response to the notice soliciting comments from the IRS and Treasury Department that was published in 66 Federal Register 13836 (March 7, 2001). The notice invited comments on the criteria that should be used to determine whether a taxpayer is a "dealer" in securities futures contracts for purposes of Section 1256 of the Internal Revenue Code ("Code").

[2] This issue arises because of the recent enactment of the Commodity Futures Modernization Act of 2000 ("CFMA"). Among other things, the CFMA will allow the trading of security futures contracts ("SFCs") -- futures contracts on individual stocks and narrow-based stock indexes. SFCs are to be regulated as both securities and futures, subject to joint regulation by the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC").

[3] The tax treatment of SFCs was prescribed in companion legislation that was enacted as part of the Community Renewal Tax Relief Act of 2000. Prior to this legislation, all futures contracts were subject to mark-to-market treatment, with capital gains or losses treated as 60% long-term and 40% short-term ("60/40 tax treatment"). In contrast, taxpayers who buy and sell securities options receive favorable 60/40 tax treatment only for broad-based index options. When trading stock options and narrow-based index options, most taxpayers are taxed 100% at short-term capital gain rates unless they held a long option position for more than one year, in which case long-term capital gain rates apply. Only persons who qualify as an "options dealer" receive 60/40 tax treatment for their transactions in stock options and narrow-based index options. The term "options dealer" is defined in Section 1256(g)(8) of the Code to mean any person registered with an appropriate national securities exchange as a market-maker or specialist in listed options.

[4] The legislative history of the CFMA and the companion tax provisions for SFCs makes clear that the tax treatment for SFCs is intended to be comparable to the tax treatment for equity options in order to avoid giving transactions in SFCs a tax advantage over transactions in equity options. ¹ Accordingly, transactions in SFCs will not receive 60/40 tax treatment unless they are entered into by a person treated as a "dealer" in SFCs pursuant to Section 1256(g)(9) of the Code. Under that section, a person is treated as a "dealer" in SFCs if the Secretary of the Treasury determines that the person performs functions with respect to such contracts similar to the functions performed with respect to equity options by a market-maker or specialist.

[5] The Federal Register notice invited comments on "administrable and economically meaningful criteria for identifying any traders that should be treated as dealers in securities futures contracts." Such criteria must satisfy the statutory mandate of identifying persons who perform functions similar to registered market-makers or specialists in listed options. In CBOE's view, the appropriate criteria include a combination of regulatory and market participation criteria.

REGULATORY CRITERIA

[6] We believe that a person or entity must satisfy all three of the regulatory criteria described below in order to qualify as a "dealer" in SFCs. Each of these criteria is a critical component of the regulatory scheme applicable to options market-makers. These criteria would apply both to open outcry markets and to markets using screen-based trading.

1. EXCHANGE MEMBER. The person or entity must be a member of an exchange that lists SFCs for trading, must have trading privileges in SFCs as an exchange member, and must be subject to the rules of the exchange. All of these factors exist for market-makers and specialists in listed options. Under this criterion, non-members, even those with direct electronic access to a market trading SFCs, would not qualify as a "dealer" in SFCs.

2. REGISTRATION STATUS. The person or entity must be registered as a broker-dealer under the Securities Exchange Act of 1934, or as a futures commission merchant ("FCM"), introducing broker, floor broker or floor trader under the Commodity Exchange Act. Registration is one way to distinguish market professionals from casual traders. All market-makers and specialists in listed options must be registered as broker-dealers.

3. SUBJECT TO APPROPRIATE NET CAPITAL REQUIREMENT. In order to qualify as a "dealer" in SFCs, the person or entity must be subject to an appropriate net capital requirement applicable to such person or entity or to the clearing member firm that clears the trades of such person or entity. For example, under the capital requirement currently applicable to options market-makers, the market-maker is exempted from the SEC's net capital rule, provided that his clearing firm takes an immediate capital haircut for the positions held in the market-maker's account. As explained in Exhibit A attached hereto, the requirement in the CFTC's net capital rule for an FCM that clears the trades of a floor trader at a futures exchange is significantly more relaxed. We believe that all dealers in SFCS must have an equivalent capital requirement in order to prevent those dealers regulated by the CFTC from obtaining an unfair competitive advantage over those dealers regulated by the SEC.

MARKET PARTICIPATION CRITERIA

[7] In addition to the regulatory criteria discussed above, a person or entity must also satisfy ONE of the market performance criteria set forth below. Although these criteria are intended to apply both to open outcry markets and to markets with screen-based trading, the way in which the criteria can be satisfied will differ depending on the type of market.

1. AFFIRMATIVE OBLIGATIONS. A person or entity that has an affirmative obligation to make a two-sided market in SFCs would qualify as a "dealer" in SFCs. However, the legislative history of the SFC tax provisions quoted in the Federal Register notice makes clear that the absence of affirmative obligations does not necessarily preclude a trader from qualifying as a "dealer" in SFCs. ²

2. PRINCIPAL BUSINESS ACTIVITY. Alternatively, someone could qualify as a "dealer" in SFCs by being a regular participant in the market for SFCs such that trading in SFCs is part of his principal business. In an open outcry market, this criterion would be satisfied by someone who is physically present on the trading floor at the pit or station where the SFC is traded and who regularly trades the contract for his own account. Regular participation in a screen-based market is more difficult to measure. We propose that, for screen- based traders, this criterion would require that 75% of the trader's revenue be derived from trading listed equity-based derivatives (i.e., SFCs, index futures, equity options and index options). We would not limit this test to trading SFCs only because we believe that a dealer who adds liquidity to the SFC market is likely to trade in related equity derivatives markets for spreading and arbitrage.

[8] CBOE believes that using a combination of regulatory and market participation criteria, as described above, is consistent with both the statutory language and the legislative intent. From an administrative standpoint, these criteria draw a clear line that distinguishes between professional dealers with an established regulatory status from persons trading SFCs on a casual basis. It will be obvious to the taxpayer in almost every case whether or not he satisfies the criteria described above to qualify as a "dealer" in SFCs.

[9] We appreciate this opportunity to submit comments on a subject that is of great importance to our market.

Sincerely,

EXHIBIT A

[11] Market intermediaries also must register with both agencies. Firms registered with the CFTC as a futures commission merchant ("FCM") or introducing broker must register as a broker- dealer with the SEC if they effect transactions in SFCs. An FCM that is notice registered with the SEC is exempted from specified sections of the securities laws and certain SEC rules thereunder, including the SEC's net capital rule. Floor brokers and floor traders at futures exchanges are exempted from the requirement to register as a broker-dealer. Similarly, securities broker-dealer firms must register with the CFTC as an FCM or introducing broker if they act as intermediaries with respect to transactions in SFCs. A securities broker-dealer that is notice registered with the CFTC is exempted from specified sections of the Commodity Exchange Act and certain CFTC rules thereunder, including the CFTC's net capital rule. Broker- dealers who act solely as a floor broker or floor trader in SFCs are exempted from registering as such with the CFTC.

[12] Accordingly, a firm that clears a market-maker's SFC transactions executed on a securities exchange will be subject to the SEC's net capital rule, but may be exempted from the CFTC's net capital rule if it has no involvement in futures other than SFCs. By the same token, a firm that clears a floor trader's SFC transactions executed on a futures exchange will be subject to the CFTC's net capital rule, but may be exempted from the SEC's net capital rule if it has no involvement in securities other than SFCs. As described below, a firm that is subject only to the CFTC's net capital rule has a significant advantage over a firm that is subject to the SEC's net capital rule.

CAPITAL REQUIREMENTS FOR FIRMS CLEARING THE TRANSACTIONS OF OPTIONS MARKET-MAKERS

[13] Options market-makers are required to register as broker- dealers and are thus subject to the SEC's net capital rule, unless subject to an applicable exemption. SEC Rule 15c3-1(b)(1) provides an exemption to any person or entity whose securities business is limited to acting as an options market-maker ³ on a national securities exchange; that is a member in good standing and subject to the capital requirements of a national securities exchange; that transacts business in securities only with registered broker-dealers; and that is not a clearing member of The Options Clearing Corporation and whose securities transactions are cleared by another registered broker-dealer.

[14] Although options market-makers are exempted from the SEC's net capital rule if they meet all of the conditions set forth in the (b)(1) exemption, the clearing firms that carry their accounts are subject to additional capital haircuts as specified in SEC Rule 15c3- 1(c)(2)(x). That section requires the clearing firm to deduct from its net worth, as of noon of each business day, the amounts computed as of the prior business day pursuant to Appendix A to the net capital rule. (The Appendix A deductions are calculated by using either a portfolio-based approach or a strategy-based approach.) The required deductions are reduced by any liquidating equity that exists in the market-maker's account, and they are increased to the extent of any liquidating deficit in such account.

[15] The operation of the SEC's net capital rule is illustrated in the following example. Assume that an options market-maker acquired a long option position by executing transactions at his exchange on a Monday. Assume further, for the sake of simplicity, that the long option position is the only position in his account. As of noon on Tuesday, his clearing firm must calculate the appropriate haircut pursuant to Appendix A and, if the equity in the market- maker's account is less than that haircut, the clearing firm must deduct the difference from its net worth. This will cause the clearing firm either to require the market-maker to deposit more funds into his account or to compensate the clearing firm for tying up its capital. It is important to note that this capital haircut will be charged even if the market-maker liquidates his position the day after he acquired it.

CAPITAL REQUIREMENTS FOR FIRMS CLEARING THE TRANSACTIONS OF FUTURES FLOOR TRADERS

[16] The CFTC's net capital rule applies to FCMs and non- guaranteed introducing brokers; it does not apply to floor traders. Under CFTC Rule 1.17(c)(5)(viii), an FCM that carries an undermargined customer account must deduct from its adjusted net capital the amount of funds required in order to meet the maintenance margin requirements of the futures exchange that lists the contract contained in the account. This deduction does not apply until a margin call has been outstanding and unsatisfied for three business days. In other words, if a floor trader acquires a futures position on Monday and does not have sufficient equity in his account to cover the margin requirement, the FCM would call for margin on Tuesday. If the margin call is not satisfied by Friday, the FCM would be required to deduct the margin deficit from its adjusted net capital.

[17] As a practical matter, this means that the FCM that clears the transactions of a futures floor trader can avoid any capital charge for the floor trader's transactions simply by having the floor trader liquidate the positions that gave rise to a margin call during the three-day grace period. The floor trader can then establish another position, liquidate that position within four days, and repeat the process again and again, without ever creating a capital charge for himself or his FCM clearing firm. This capital treatment is much more favorable than the treatment discussed above for an options market-maker and his broker-dealer/clearing firm, where the firm must take a capital haircut for the positions in the market-maker's account as of the close of the previous day, even if the market-maker liquidates the position the next day.

[18] Net capital requirements are a critical element of the regulatory scheme applicable to options market-makers and their clearing firms. If persons deemed to be "dealers" in SFCs can trade SFCs at a futures exchange without either themselves or their clearing firms being subject to comparable capital requirements, they would have a substantial competitive advantage over their counterparts at securities exchanges. As a matter of regulatory policy, it would be unfair and unwise to give floor traders at futures exchanges the advantages of being treated like options market-makers in order to obtain favorable margin and tax treatment when trading SFCs without also subjecting them to comparable net capital requirements.

² See H.R.Conf. Pep. No.106-1033,106th Cong.,2d Sess. 1036 (2000).

³ CBOE intends to request the SEC to broaden the scope of this (b)(1) exemption to include transactions in SFCs. If such request is not approved, market-makers at securities exchanges would be at an even greater competitive disadvantage to futures floor traders.