PORTFOLIO MARGIN and CROSS-MARGIN

1. PORTFOLIO MARGIN and CROSS-MARGIN AN OVERVIEW OF THE BROAD BASED INDEX OPTION PILOT PROGRAMS FOR CUSTOMERS Richard Lewandowski - Chicago Board Options Exchange

2. Portfolio Margin and Cross-Margin Pilot Plan Proposal • History • Past and current margining of listed options and securities underlying listed options . • Studies of the 1987 market crash advocate cross-margining. • “Report of the Presidential Task Force on Market Mechanisms” (the “Brady Commission”) • “The October 1987 Market Break” (SEC) • “Working Group on Financial Markets” (Dept. of the Treasury, FRB, SEC and CFTC) • Net Capital - haircuts on options strategy based prior to April 1994. • SEC no-action letter in April 1994 allows portfolio methodology. • SEC changes Net Capital Rule in Sept. 1997 to formally allow portfolio methodology as an alternative to strategy based requirements. • Proposed customer program will parallel haircut methodology.

3. Portfolio Margin and Cross-Margin Pilot Plan Proposal History • Since April 1986, OCC has utilized portfolio margin. • Since 1988, Futures Commission Merchants (“FCM”) have applied a portfolio (SPAN) margin requirement. • Final changes to Reg. T (effective April 1, 1998) • Permit portfolio margining as an alternative to Reg. T. • Self-regulatory organization (“SRO”) rules needed to implement portfolio margining • SEC approval required. • Portfolio Margin Committee formed - recommendations made.

4. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Joint effort by CBOE, OCC, NYSE, AMEX, CME and CBOT to implement portfolio margin system for customers. • An alternative to the current “position” or “strategy” based margin. • Pilot program initially. • Limits a firm’s gross portfolio margin requirements to 1,000 percent of its net capital. • Firms can select accounts as they deem appropriate. • Participant criteria may be modified based on the pilot experience. • Plan also provides for cross-margin - margin requirement determined using the same portfolio margin facility. • Pilot will only permit portfolio margining of: • Broad based U.S. listed securities index options • Related exchange traded funds (i.e., SPDRS, DIAMONDS) • Related index futures and options on those futures. • No stock baskets permitted at this time.

5. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Portfolio margining objective - determine margin based on potential risk in a portfolio as a whole. • Margin required is derived based on the greatest projected net loss in an account given various scenarios of underlying price increases and decreases and implied volatility changes. • Positions grouped by class. • Gain or loss on each position is calculated for assumed moves in the underlying, both up and down. • Theoretical pricing formula is employed for options gains / losses. • Netting of gains / losses within class groups. • Offsets (gains) applied between classes, if eligible. • Greatest loss is the portfolio margin requirement for that class. • Total of class requirements is overall portfolio margin requirement. • Per contract minimum of $37.50 (.375 X $100 multiplier). • Firms can impose an “add-on” (house) requirement if desired.

6. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Option theoretical values supplied by The Options Clearing Corporation. • Provides for uniform margin requirements across broker-dealers. • Broker-dealers organize customer positions into a firm or vendor supplied spreadsheet. • Portfolio margin requirement calculated within the spreadsheet application using option theoretical values obtained from the OCC. • Process is the same as is currently in place for computing haircuts under the Securities & Exchange Commission’s capital rule. • Market ranges for computing gains and losses: • high-cap broad based indexes --- +6% / -8% of the closing price of the index • non-high- cap broad based indexes --- +/- 10% of the closing price of the index

7. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Portfolio margin computation done at close of each business day. • Portfolio margin requirement is both the initial and maintenance margin requirement - not necessary to determine whether an increase in the requirement is due to a new commitment or adverse market moves. • Margin call arises if requirement greater than net liquidating equity in the portfolio margin account (cross-margin account). • Margin call must be met by the end of business on T+1 (one day settlement).

8. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Liquidating or hedging to meet a margin call is allowed. • Minimum Equity Requirement. • Account equity of at least five million dollars. • Accounts may be aggregated if same owner. • Not applicable to a broker-dealer, an affiliate of the clearing broker-dealer, or to the cross-margining activity of a member of a national futures exchange. • Firms may impose a higher minimum equity (house) requirement if desired. • Equity call must be met by T+3 (three business day settlement). • If equity call not met, no new orders may be accepted (except opening orders that reduce margin requirement). • Account guarantees prohibited (for equity or margin).

9. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • Required Disclosure • Firm must provide customer with a standard disclosure statement prior to opening a portfolio margin and/or cross-margin account. • Customers must sign an attestation acknowledging that they have received the disclosure document and are aware of the risks involved. • Not applicable to broker-dealers, affiliates of the clearing broker-dealer, and members of futures exchanges. • To offer cross-margining, a broker-dealer must: • also be an FCM and • either be a clearing FCM or have an affiliate that is a clearing FCM. • Cross-margin account would be a securities account. • SEC customer protection rules and SIPC coverage apply. • Internal risk analysis procedures required of each firm.

10. Portfolio Margin and Cross-Margin Pilot Plan Proposal Plan Overview • CBOE filed a rule change with the SEC in January 2002 to go forward with the pilot. • NYSE filed a similar rule change with the SEC in May 2002. • Final work to be completed before the pilot can begin: • Customer Protection changes at the SEC and CFTC concerning cross-margin account • SIPC protection for non-securities products and balances in a cross-margin account • Hypothecation of customers’ long options positions at the clearing house level (SEC)