Episode 36

Expanding Your Options with Nasdaq Derivatives

By:

Chief Strategist at Interactive Brokers

Kevin Davitt, Head of Index Options Content at Nasdaq, joins Steve Sosnick, Chief Strategist at Interactive Brokers, for a wide-ranging discussion about options, Nasdaq’s derivatives offerings and the key differences between index and equity/ETF products.

Note: Any performance figures mentioned in this podcast are as of the date of recording (September 7, 2022).

Summary – IBKR Podcasts Ep. 36

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steve Sosnick

Hi everybody, welcome to IBKR Podcasts. My name is Steve Sosnick. I’m your host and the chief strategist at Interactive Brokers. With me today as my guest, Kevin Davitt, Head of Index Options Content at Nasdaq.  It’s a real pleasure to have Kevin joining me today. He and I have interacted via e-mail, via Twitter, or via social media several times, but it’s actually the first time I’m meeting you — well, not exactly in person, we’re remote but as it were meeting you face to face somewhat. Before we launch into the program, Kevin, why don’t you introduce yourself to the audience?

Kevin Davitt

Sure. I’d love to and I appreciate this opportunity to be in 2D with you. So, as you mentioned in my current role, I am Head of Index Options Content at Nasdaq. Prior to this, I spent years doing fairly similar work at Cboe. So, a different exchange, but in the industry. And I started in this business many moons ago out of college. I started with a proprietary trading firm based in Chicago, but with a presence on all four exchanges at that point in time. I was a market maker and made markets in equity options, index options, commodity futures and options. So, I’ve seen this business from a variety of different ways, but in my current situation, I focus on business development and obviously content creation with an emphasis on Nasdaq products. Thank you very much for having me.

Steve Sosnick

My pleasure. And if nothing else, it’s nice to get a reminder of the quaint days of four exchanges. Now we’ve squared that. I guess what I wanted to start with was an overview of the options industry from your point of view, particularly, having spent considerable time at, two of the biggest exchange families that we have. How do you view the state of the options industry right now?

Kevin Davitt

Sure, I’d love to expound on that a little bit. And there certainly has been a lot of hoopla around or surrounding options over the past couple of years — and do not misconstrue this, it is super exciting, and we’ll touch on that a bit. But what I find, at least here and now, most compelling is that volume numbers remain very high despite the fact that U.S. equity markets have reversed course in a meaningful way, which historically is somewhat unusual. So, if you look back there have been spikes in volume, tied to what I would call significant market events. Like I’m old enough to remember the dotcom bust, global financial crisis and more recently the early stages of the COVID pandemic. But typically, the tide goes out after a couple months of big volumes. But that’s not been the case this year and so I’m going to give that a little bit more color hopefully.

So Steve, as you know like any metric, it’s going to depend on where you measure from … so, your base. Now on a year over year basis, option volumes increased 50% in 2020, so that’s relative to 2019. There was another 30% year over year growth between 2020 and 2021.  And this year, so through August we are on pace to be roughly in line with 2021 numbers this year. So the growth, particularly for a fairly mature industry is pretty, pretty outstanding. Now going back to 2019-2020, the tide was rising across the exchange landscape, and in the early stages of the pandemic there was a big pickup in primarily institutional volume, and that volume was centered in large part on index options. So, let’s understand a little bit why that might be, and then move toward a very, very much present day.

As you know, and many of your audience likely knows, institutions generally manage huge sums of money. Most of them, most of those institutions now have managers that understand options, that includes index options, and they use them typically to reduce risk, potentially increase yield or create some desired range of potential outcomes. So, when you have a situation like market movement in February and March of 2020, correlations increase. This is something you’ve written well about in the past. Now, in more typical markets, correlations will vary depending on your sector and a variety of other influencing factors. But when you get those what I would term “baby out with the bathwater” type markets like we saw in early 2020, money managers typically look to the most efficient way to insulate themselves in deep liquid, typically broad-based index products. So, you saw a big pickup in NDX volume or XND, which is a smaller notional tracker for the Nasdaq 100, as opposed to Apple options or Microsoft options or Tesla. Does that make sense?

Steve Sosnick

Yeah, absolutely. If I’m trying to manage a big institutional exposure, I would much rather try to do it using a handful of products, a handful of trades rather than, 50 or 100 or whatever is necessary. So clearly you get much more — I hate to say bang for the buck ’cause, that’s not the right way of putting it– but if you’re hedging an event for a large portfolio, it’s just simply easier to use either your major indices or your ETFs that replicate them.

Kevin Davitt

That’s absolutely correct. That’s a type of behavior that we have noticed throughout these sort of very high correlation markets where index options become that go-to hedging or exposure vehicle. Now, after that we had a confluence of events that have been well covered that bolstered the individual equity option volume. So, you had a huge portion of the public working from home, you had unprecedented monetary and fiscal stimulus; another thing that you’ve written about.

So on the monetary side, I’m referencing the Federal Reserve lowering the Fed funds rate so they were effectively making money and leverage cheaper. They went so far as to expand their balance sheet by going into the public markets and buying assets. That almost certainly helps stabilize markets during a time of considerable uncertainty.  As a by-product, it also kind of incentivized risk taking. Now if return on debt instruments like US Treasuries are less than 1% — just picking kind of a low number — capital is likely going to flow to areas where there’s the potential for better return. Then on the government side, there was huge fiscal stimulus in the form of direct payments, again stabilizing from an employment standpoint, from an income standpoint, but risk-taking incentive was incentivized, and higher levels of disposable income arguably led to some of the surge in individual equity options. That much has been made about, and I’m not going to rehash that.

Steve Sosnick

Sorry, one thing I was going to add here is — I hate to say it because as someone who’s been a long-time advocate of options as a hedging vehicle, as a strategic investment, as an income stream — they were adopted by gamblers with a gambling mentality. There were no sports for a while, this was the only game in town. The payoff is very similar to a sports bet where you put out a fixed amount of money for a leveraged return and on top of it, to some people they were playing with what I would call “house money” after the government sent you a check. Let me be very clear, if you were in poor financial straits and hindered by COVID, et cetera, that money was a lifeline. If you continued to be gainfully employed except working from home under less supervision, well, that could be somewhat … that could be kind of a little bit of mad money. And I think that mentality not only helped the rise in options but brought along the flood into cryptocurrencies, brought along the flood into meme stocks. I’m not going to say it encouraged the most extreme risk-taking behavior, but it certainly enabled it. Sorry, I didn’t mean to interrupt.

Kevin Davitt

No! I think that point of clarification really shines a light on a period that was unprecedented. I like thinking about historical analogs and trying to put these things in context but quite frankly, it would be impossible to draw an appropriate analogy for what we saw in terms of market behavior, government interventions and the employment situation for the better part of the past 2 to 2 1/2 years and that has impacted the options industry across the board. It arguably continues to.  But you pointed out a handful of, I’m going to call them “niche markets” or “markets within the overall capital market and umbrella.” So cryptos, or your meme names, generally higher volatility assets.

What’s interesting to me is the fact that you continue to see relatively strong volumes. Now they’ll ebb and flow to different corners of the market, particularly in 2022, but the overall volume numbers have not through eight months of the year dropped off in 2022. I think that’s a testament to broader understanding of how these tools work, right? That’s very different than back in 2000 or even in 2008 where there were huge swings. I think people genuinely understand like the risk reward dynamic, when you’re buying options, your risk is limited to what you’ve paid for it and you’re getting leveraged exposure And I think there’s a much greater understanding of the risk mitigation approaches that have been in some cases rewarded this year. And that’s exciting, not just because to a certain extent, I work and advocate for the responsible use of these tools but because —

Steve Sosnick

Me too, by the way.

Kevin Davitt

I know, it’s music to our ears. But, you have tools. Generally, and there is risk associated with any tool, whether it’s a power saw, an automobile, what have you.  A fire is hugely powerful, but when domesticated it can do amazing things. And so, I do think that we have seen a much broader portion of the population educated on the risks as well as the potential rewards associated with these tools and that’s super exciting as I look out further into the future.

Steve Sosnick

Oh, me too as well. I think that I fully agree with the idea that people have moved away from options strictly as a vehicle for speculation and realize the ancillary uses which arguably are why they exist. They didn’t come into existence as a means of speculation. They came in as a means of hedging and or income, et cetera. And so, it’s nice to see that it’s not only institutions using those strategies, it is retail — well individuals — as well and smaller institutions. I think that’s wonderful, the fact that we’re running at levels comparable to last year which were 50% and then 30% sequentially higher. To maintain that here is… I agree I think we all get a little bit of a pat on the back here. I’d like to think that you and I individually and our organizations collectively played some role in educating users about the benefits.

So moving on a little bit, to the extent you can, compare and contrast the offerings of the Cboe versus Nasdaq.  I mean the simplest thing is that Cboe is the home of the S&P complex and Nasdaq of course is the home of the, I’m going to call it the NDX complex, but you could flesh that out a bit more than I can certainly.

Kevin Davitt

Yeah, I think it’s an interesting question and I look forward to kind of addressing that, but just to be clear here, I think I have perhaps a unique perspective because I traded on both the Cboe floor as well as the PHLX options floor, which is now part of the Nasdaq family of exchanges. So, I’ve been a member of both exchanges, and I’m also fortunate to have worked for both exchanges over the past decade or so. So, I just want to be clear that this is just my perspective and it’s more rooted in the evolution of the broader industry. To give that a little context, Cboe, as you kind of alluded to, developed as a floor-based options exchange. They were the first options exchange that that was launched in 1973 as part of the Chicago Board of Trade. Cboe gained a foothold in the equities business with their BATS merger about six years ago. That also changed Cboe’s emphasis on technology and the underlying platform that matches buyers to sellers, which to this day is the primary exchange function.

Now contrasting that, Nasdaq developed as a kind of technology first equities exchange.  It’s always been electronic, Nasdaq, and that was revolutionary at the time. Nasdaq moved into the options market in a big way with their acquisition of the ISE and the PHLX at two different points in time. Now as I kind of alluded to, the PHLX was and is a huge player in the options business with both a trading floor in an electronic marketplace. The ISE was the first fully electronic options marketplace. I remember very much how in the early 2000s, as we mentioned at the outset, there were four floor-based exchanges. ISE came along and changed the game right away.

Now Nasdaq and Cboe were launched at essentially, if you’re given a long-time frame here, essentially the same time. So Nasdaq, 1971, first electronic stock market, Cboe, 1973. Early 70s, but in very different markets with a different focus, electronic trading versus floor trading. Now in time they have come to resemble one another through acquisitions and the evolution that’s transpired in both the equities and US option market. They both now have global reach. Nasdaq for example is the dominant marketplace in the Nordics. I visited there this year, and it was absolutely amazing.

Steve Sosnick

Nice.

Kevin Davitt

And now just kind of wrapping up in my current role, Nasdaq is and is clearly invested in growing in their index options offering. Historically, Cboe has been the leader in index options, but Nasdaq is in an enviable position because they control the IP, the intellectual property for the Nasdaq indices and the index options on them. Cboe works with Dow Jones S&P on the index side, and then they control that options business. So that’s kind of idiosyncratic and nuanced, but I think it’s worth pointing out. So, I will work in a capacity that you do to educate clients on understanding use cases, the nuances associated with index options, are more recent VOLQ offering. And just as a final kind of editorial point, when I joined the Nasdaq Index options team earlier this year, it was explained to me that this smaller group operates like a like a startup or with a startup mentality that’s part of a much larger technology company and I have very much found that to be the case, and it’s a dynamic that works well for me. Now, we all have our focus, but there’s also an opportunity in in this index options group to do nearly anything if you can make a business case for it. And I really, really love that as opposed to kind of being expected to stay in your lane in more mature situations. Does that make sense?

Steve Sosnick

Yeah, yeah, quite a bit. I’ve dealt with several of your colleagues over the past few years, in various educational settings and TradeTalks, where we’ve talked about VOLQ and the other intellectual property that you guys are working on.  It’s fascinating that Nasdaq kept that software first mentality; the Cboe I think had to learn it. I’ll date myself a bit here and say that I remember making markets on Nasdaq back in the day when people would yell at you over the phone. So it was electronic quoting, but it was still trading very old school.  I do also remember sneaking into the Cboe sort of undercover, as they were trying to get their hybrid system up and running. Which ended up — they realized perhaps BATS had a better thing going. But that was their catch-up to ISE, so it’s interesting to have all that perspective and it’s very useful to keep that in mind. I think that when you put it that way, I hadn’t realized how much the DNA of the original old exchange families still pervade their way of doing business.

Kevin Davitt

And how would it not, right? That’s no knock on either strands of DNA, right? But it does to this day influence the business, the way they operate. Despite the sort of aggregation that we’ve seen and the parallels as far as being technology driven in both the equities and options markets.  It’s super interesting.

Steve Sosnick

So, I guess now that you’ve mentioned the sort of the proprietary stuff, tell us a little bit about why someone should be utilizing Nasdaq suite of products? We referenced VOLQ, but you could do better than I can. Another thing that that I’ve been working on is I recently did a TradeTalk based on some of the work I do. Did you know that, effectively, if you’re a speculator — and I know this is completely the opposite of what we talked about with education — but if you’re a speculator, QQQ is generally the better way to speculate, or in many ways the better way to hedge because it correlates — depending on how you want to look at … there’s so many different ways you can look at correlation — but almost any way you slice it, the R-squared is roughly 0.9 or more. Which is very high.  Except, NDX is more volatile than SPX.  I’d like your take on some of these themes ’cause while I know I’ve talked about them with your people. I want you to talk about them with me.

Kevin Davitt

Sure. I’d love to.  Just to make sure that we’re talking about the same thing, when you run those correlation numbers, you’re talking about correlation between the Nasdaq 100 and the S&P 500, correct?

Steve Sosnick

Correct, correct. Yes, I use the shorthand, but thank you for clarifying.

Kevin Davitt

Yeah, sure. One of the things that I point out often in client facing situations and to a certain extent with the written word is the fact that I think increasingly about portfolios, whether they’re institutional or individual investors managing their retirement or discretionary income. Those portfolios more often resemble the Nasdaq 100 or the QQQs than the S&P 500. Now don’t get me wrong, if you have big interest in financials or real estate or energy or something like that, then the S&P is probably going to have a higher degree of correlation, but like you pointed out in your research, the correlation between the two indices is quite high and as such there can be compelling reasons to choose Nasdaq index options as your hedging vehicle or as your tool for exposure. So, my team obviously works to increase awareness and understanding around those. I’d point out that you have the NDX, which with a Nasdaq 100 around 12,000 right now, the notional value of one option is $1.2 million. That’s significant and it prices out a huge swath of the investing public, one of the trends that we’ve seen —

Steve Sosnick

On the on the other hand, if I can interrupt for one second. On the other hand, that is why large institutions gravitate toward big index options, because if I’m talking about hundreds of millions under management, if I want to hedge that index options become an efficient tool for doing so. Sorry, but just wanted to bring that back in.

Kevin Davitt

Don’t be sorry, that’s really important to understand. You go back historically, and derivatives were created to be used as tools for commercials on the commodity side and institutions to manage risk but as the industry’s grown, the use cases for smaller products has grown, and that’s a trend that continues to this day. I sometimes make the analogy of the NDX product is like an offering at Costco, right? Like not everybody needs that huge thing of pretzels but if you’re putting it in the office or whatever, there’s a use case for it and that’s kind of like the institutional use of a big product. But like if I’m getting a snack for my soon-to-be 8-year-old, we’re going to a convenience store and getting the appropriate size, right? Not that he would take any issue with the big one, he’d probably crush that too. So, there are there are those kind of convenience store size products, particularly in the form of XND, which is one 100th the size of the full Nasdaq [Index].

Now the notional value: there is a difference between QQQ and XND; QQQ is actually a little bit bigger. So, this is a trend that we see going on, but pointing out that index options — and I’m sure a huge percentage of your audience knows this already — but index options there are idiosyncratic differences between an index option like XND and QQQ. I’ll point them out really briefly for those this might be new to. Index options cash settlement expiration, whereas those ETF options physically deliver. What does that mean? Well, at expiration, an XND or an NDX option will simply settle to cash in your account based on the value of that option at expiration whereas, if I have an in the money QQQ call option, let’s say, I need to have sufficient funds in my account to cover the purchase of 100 shares of QQQ at the strike price at expiration, and that can be a big difference. Now some people like to focus their attention on options, they want to manage an options portfolio. Other people look to mix underlyings and options and so the breadth of offerings is appropriate and there’s huge volume in all the products as a result of that. So, understanding that difference in settlement is key, second —

Steve Sosnick

Let me, just — sorry before I interrupt your second point, let me finish this part.

Kevin Davitt

Don’t be sorry.

Steve Sosnick

The difference with index options are when they expire, you’re done. You either made, you lost, you owe the money, you receive the money. Those by the way, typically expire on Friday morning, not Friday afternoon. They’re AM expiration, not PM expiration typically. But the key is you don’t find yourself needing either to hedge or to manage a position Monday morning. I’m talking Friday expirations here, so that’s it, you’re done. That’s another reason why cash settled index options are very popular as a hedging tool with institutions, because they don’t have to change their portfolio as a result. The cash goes in and out but while those are very important for institutions who may not want to actually deal with moving around positions.  Individuals should be thinking of those the same way, and I think people don’t necessarily think of that, when they think of, let’s say, an XND as opposed to a QQQ.

Kevin Davitt

So let me make it a little bit personal and be vulnerable here. So, I can think of a handful of occasions where I have say, sold a put with the hopes that that thing is expiring out of the money and collecting the premium right? And drawing the distinction here between an ETF and an index option is important. Say ultimately that put ends up in the money. If I have an ETF option, I’m going to end up long [the ETF] and, in my mind, I have done this countless times. I tell myself I’m going to trade around this long position in the underlying, this residual long position as opposed to being absolved of it had I sold an index option. And while it’s not always going to be the case, say you have a gap between — over the weekend, right — between the Friday closed settle price and Mondays open, which seems to be happening with greater frequency over the past few years. And all of a sudden, the management of that residual position becomes kind of an albatross, right. So that inherent discipline, if you will, of being done with it at expiration is something that I appreciate. It’s not for everybody, but it’s an element that I like.

Steve Sosnick

Well, if you’re doing, for example, cash secured puts you don’t mind having the stock put to you. That can be a feature.  That could be your way of entering a position. On the other hand, if you’re speculating by shorting puts, as you say, it can be a huge albatross. You didn’t want to be long this [stock or ETF], but you go in there, particularly if you’ve got some pin risk … if you’re very close to a pin, it can be nasty.

Sorry, so let’s get to #2, I interrupted. #2 ’cause I really wanted to flesh out #1 ’cause I thought that was very important.

Kevin Davitt

 I appreciate the clarification and I think you did so really well. So, the last two sort of points of distinction, index options are European styled, so what does that mean? Well, there’s no risk of early exercise or assignment. ETF options like QQQ, any equity option is American style, so there is the potential which I don’t want to inflate, of early assignment. Now generally speaking, that would happen in an index product in an effort to collect a dividend, so ahead of the underlying going ex-dividend. So, we’re talking about a quarterly risk typically, but it’s one of those things where if it happens to you once and you’re responsible for a quarterly dividend that you didn’t sort of bank on, you’re probably not going to want that to happen again.

Then the final point of distinction, and one that is hopefully getting more and more awareness, is the generally favored tax treatment in the eyes of the IRS. Now, I am not looking to negatively impact your podcast ratings so there’s going to be no deep dive on tax law here. But there is kind of like a story behind this that I think is interesting, but I’m kind of a history fan generally. So how the heck did this 1256 tax treatment for index options as opposed to equity options come to be? You got to go back to the —

Steve Sosnick

Please explain 1256 ’cause you threw out a term there that not everyone is familiar with, so please, just what is it in a nutshell?

Kevin Davitt

This one makes it stick, the 1256 is a thank you to Dan Rostenkowski.  You gotta go back to the early 80s. This guy Dan Rostenkowski that’s got an awesome, totally Chicago name, he’s a Chicago native, was head of the Ways and Means Committee, a very powerful position in Congress. So back then, his district encompassed these new derivative exchanges in downtown Chicago — the CME, the Board of Trade and the Cboe. So, there was this big tax provision being worked on in the early years of the Reagan administration and Rostenkowski managed to carve out this favorable provision for broad based index products. So what does that mean? In most situations they would be taxed at 40% short term rates and 60% long term rates, no matter the holding period. Now that compares to ETF and equity options where that rate is flipped. They are generally taxed at 60% short term, which is the higher rate and 40% long term if held for less than one year. Now maybe that doesn’t sound meaningful, but I can tell you from lived experience that it matters. So anecdotally, I grew up in a kind of old fashioned Irish Catholic household. It was really typical to have a picture of like John F. Kennedy or the Pope in your home, maybe the Sacred Heart. Many of those same Irish Catholics went to work on Chicago exchanges back in the day, and when they understood the implications of those tax benefits and index products, a picture of Dan Rostenkowski in some situations went up on the wall alongside JFK and the Pope, because that’s how much it mattered to some of those early index options traders.

So just to recap, you know there’s three basic distinctions between the two types of option vehicles for gaining exposure, hedging exposure to index products. There’s differences that need to be understood. There’s differences between your Costco size that I referenced and your convenience size. And then the one last thing that I mentioned but didn’t expound upon at all was that we support VOLQ. VOLQ is something you’ve written about, and it is an index. There is an index and there’s also a tradeable product. So, the index tracks at the money 30 day forward, Nasdaq 100 volatility. So, the inputs here are at the money index options that expire in roughly one month, and that output is an annualized volatility assumption. Your audience is likely familiar to some degree with the VIX index. It is similar but different in kind of two key ways.

So, the primary one, the inputs are different in that we’re using NDX options, Nasdaq 100 options as opposed to S&P 500 options. And the inputs for VOLQ are those at the money options as opposed to a wide strip of options or the variance swap methodology that’s employed in the case of VIX. So VOLQ, if you kind of distill it, negates the impact of index options skew on that reading on that output. Now VOLQ the index could be used for information purposes. So, in other words, what are Nasdaq 100 index options forecasting in terms of volatility here and now and then put that in context. So how does it compare to history? What is that saying about the market that we’re in right now? So yesterday VOLQ, was measuring right around 32 and that means that one month at the money and the X options are forecasting roughly 2% daily moves for the Nasdaq 100.  [Note: The conversion from annualized to daily volatility measures is done with the “Rule of 16”, explained here]

A little context, you look back a couple weeks ago, that measure was in the low 20s. Back in May when energy prices were soaring and kind of inflation concerns arguably peaked or hopefully, knock on wood, peaked, VOLQ was around 40. Now that information is valuable for whatever it’s worth.  I was doing some data wrangling for a piece I’ll write shortly about intraday volatility for the Nasdaq 100 this year. Average intraday vol in the Nasdaq 100 has been 2.44% of spot, which you have to go back to 2008 for anything comparable. We have seen persistently high volatility and I would argue that volatility is ultimately what drives interest in capital markets across the board. No matter the tool you use, it’s the fact that prices change. That can be beneficial, it can also be a risk, but these tools and having alternatives and in some cases the appropriate vega or vol. exposure that you’re looking to offset or gain exposure to. If Nasdaq 100 forward volatility is your interest you have VOLQ futures. There are spreading opportunities there, and more recently we’ve introduced VOLQ options, so there’s going to need to be education and growth around that.  But I appreciate opportunities like this to sort of raise awareness and make it known that if there are questions about these newer tools to please relate them to me and I will do my job and explain how and why they work.

Steve Sosnick

Wow, you know what? I just kind of looked at the time now and I realize we’re over budget, which means we’ve been having a great conversation. I hope the listeners agree. By the way, just going back to the tax thing, we don’t offer tax advice, neither Nasdaq nor Interactive Brokers does. And also, the second part of that is never underestimate the power of Chicago machine politics. But I think we’re going to have to wrap it up here because … I’m looking at the time and realize we blew through the normal ending time of one of these podcasts. So, I’m going to say here, I’m just going to thank my guest, Kevin Davitt, who’s been a wonderful, wonderful speaker. I’ve learned a lot. You know, here’s the thing. I’ve been doing dealing with this stuff for decades now, but the way that it was portrayed in terms of — I know those are the differences, but 1, 2, 3, you’re laying it out nicely for everybody. This is why you should be following his work and getting the clarity that comes from someone who really knows how to educate about the pros and cons and use cases of options and for that I really thank you for being my guest here today.

Kevin Davitt

Well, thank you. That means a lot coming from you. I genuinely appreciate the opportunity.

Steve Sosnick

So, I’m going to wrap it up here. I’m going to thank my guest, Kevin Davitt once again for joining us from Nasdaq. And once again, thank you very much. This has been IBKR Podcasts, and we look forward to speaking with you again soon. Take care, everybody.

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