[Federal Register Volume 59, Number 18 (Thursday, January 27, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-1676]
[[Page Unknown]]
[Federal Register: January 27, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-33492; File No. SR-OCC-90-11]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Approving a Proposed Rule Change Revising Its Market-Maker
Account Structure
January 19, 1994.
I. Introduction
On September 11, 1990, The Options Clearing Corporation (``OCC'')
filed a proposed rule change (File No. SR-OCC-90-11) with the
Securities and Exchange Commission (``Commission'') pursuant to Section
19(b) of the Securities Exchange Act of 1934\1\ to revise OCC's market-
maker account structure. Notice of OCC's proposal was published in the
Federal Register on December 12, 1990.\2\ On July 10, 1991, and on
March 13, 1992, OCC filed Amendment No. 1 and Amendment No. 2,
respectively.\3\ Both amendments were technical in nature and did not
require republication of notice of filing. No written comments were
received. As discussed below, the Commission is approving OCC's
proposal.
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\1\15 U.S.C. 78s(b).
\2\Securities Exchange Act Release No. 28676 (December 4, 1990),
55 FR 51365.
\3\Amendment No. 1 modified the filing by separately defining
the term ``related person'' to simplify the definition of
``associated market-maker.'' Amendment No. 1 also added to the
proposal and defined the term ``proprietary market professional.''
Amendment No. 2 modified the filing by amending the Associated
Market-Maker Consent agreement, which an associated market-maker
uses to elect to have its account treated as a proprietary market-
maker's account. The agreement was amended in connection with the
Commission's no-action letter from Michael A. Macchiaroli, Assistant
Director, Division, Commission, to James R. McDaniel, Schiff Hardin
& Waite [Counsel to OCC] (March 27, 1992) in response to a letter
from James R. McDaniel, Shiff Hardin & Waite [Counsel to OCC], to
Michael A. Macchiaroli, Assistant Director, Division, Commission
(May 21, 1990).
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II. Description
A. In General
The proposed rule change authorizes OCC to exclude from a clearing
member's combined market-makers' account the exchange transactions and
positions of market-makers, specialists, or registered traders that are
directly or indirectly related to or associated with the carrying
clearing member (``associated market-makers'').\4\ Positions excluded
from the combined market-makers' account as a result of this proposal
can be maintained by the clearing member either in a separate market-
maker's account (that is specifically limited to the positions of the
clearing member) or in a proprietary market-maker account under certain
circumstances as described below.
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\4\The term associated market-maker is defined as a person
maintaining an account with a clearing member as a market-maker,
specialist, stock market-maker, stock specialist, or registered
trader that is a ``related person'' of the clearing member and
includes any participant in an account of which 10% or more is owned
by an associated market-maker or an aggregate of 10% or more is
owned by one or more associated market-makers. OCC By-Laws, Article
I, Section 1.A(10).
A person is a related person of the clearing member if such
person (1) is a business affiliate that controls, is controlled by,
or is under common control with the clearing member or any officer,
director, or general or special partner of the clearing member, (2)
is a spouse or minor living in the same household as the related
person or any non-customer of the clearing member, or (3) is an
employee who manages the business or funds of the clearing member.
The term related person does not include a non-customer of the
clearing member. Direct or indirect control of 10% or more of the
equity of any entity is deemed to confer control of that entity. OCC
By-Laws, Article I, Section 1.R(3).
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B. Exclusion of Associated Market-Makers From the Combined Market-
Makers' Account
Section 3(c) of Article VI of OCC's By-Laws permits a clearing
member to maintain a combined market-makers' account. A combined
market-makers' account is confined to the exchange transactions and
positions of market-makers who have consented to the commingling of
their positions with those of other market-makers. Currently, section
3(c) specifically prohibits the carrying clearing member from
participating in its combined market-makers' account, and OCC's market-
makers' account agreement prohibits non-customers of the carrying
clearing member from participating in the carrying clearing member's
combined market-makers' account.
``Non-customer'' is defined in Article I, Section N(1) of OCC's By-
Laws to include the clearing member, any general or special partner of
the clearing member, any officer or director of the clearing member, or
any participant, as such, in any joint, group, or syndicate account
with the clearing member or with any partner, officer, or director of
the clearing member. This definition was drafted to encompass, in
addition to the clearing member itself, only those categories of
persons who are specifically excluded from the definition of customer
in the Commission's hypothecation rules.\5\ Because OCC's definition of
non-customer is so narrowly drafted, OCC's rules currently permit a
market-maker that is closely related to its carrying clearing member to
commingle its positions with the positions of market-makers that are
unrelated to the carrying clearing member in the carrying clearing
member's combined market makers' account.
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\5\Commission Rules 8c-1 and 15c2-1 [17 CFR 240.8c-1 and
240.15c2-1]. Hypothecation is the pledging of securities as
collateral for loans made to purchase securities or to cover short
sells. Generally, the Commission's hypothecation rules prohibit
hypothecating or arranging for the hypothecation of securities
carried for the account of a customer under circumstances that
permit:
(1) the commingling without written consent of a customer's
securities with the securities of any other customer;
(2) the commingling of a customer's securities with the
securities of any person other than a bona fide customer; or
(3) the hypothecation of customers' securities for a sum in
excess of the aggregate indebtedness of all such customers with
respect to such securities.
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In light of its experience during the 1989 market break, OCC
believes that the commingling of positions of associated market-makers
with those of unrelated market-makers significantly increases the risks
to unrelated market-makers, OCC, and the options markets.\6\ Such
associated market-makers may be financially dependent upon the carrying
clearing member or may be under common direction with respect to
trading strategies and risk management. In the event of the failure of
the clearing member, the conditions which led to such failure may also
lead to the insolvency of the associated market-maker. If the
associated market-maker's positions are carried in a combined market-
makers' account, OCC may be unable to separate the collateral
supporting the positions in the combined market-makers' account from
the collateral supporting the carrying clearing member's proprietary
positions. As a result, OCC may have difficulty in transferring the
unrelated market-makers' positions and supporting collateral even
though those positions continue to be viable. OCC believes that
prohibiting the commingling of the positions of associated market-
makers with the positions of unrelated market-makers will facilitate
OCC's ability to transfer expeditiously viable accounts of the
unrelated market-makers to other clearing members in the event of a
failure of the carrying clearing member. Consequently, OCC's and the
unrelated market-makers' risk of loss should be decreased.
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\6\See supra note 17 and accompanying text.
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Accordingly, OCC is amending its By-Laws by adding definitions of
``associated market-maker''\7\ and ``proprietary market-maker''\8\ and
by including language to prohibit associated market-makers and
proprietary market-makers from participating in the combined market-
makers' account.\9\ An associated market-maker so excluded can maintain
its positions in a separate market-maker's account.\10\ Because each
separate market-maker's account is restricted to the transactions of a
single market-maker, the positions of an associated market-maker that
are maintained in such an account will not be commingled with the
positions of other market-makers or with the positions of the clearing
firm.\11\ Under OCC rules, a clearing member that maintains a separate
market-maker's account for its proprietary market-maker positions
(``proprietary market-maker account'') may elect to have the positions
in that account combined with the positions in its firm account for
purposes of margin calculations\12\ as a clearing member may elect to
have its associated market-makers' positions treated as proprietary
positions so that the associated market-makers' positions are combined
with firm positions for purposes of margin calculation.
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\7\OCC By-laws, Article I, Section 1.A(10).
\8\Under the proposal, Article I, Section 1.P(5) of OCC By-Laws
defines proprietary market-maker as a market-maker, specialist,
stock market-maker, stock specialist, or registered trader that is
(A) a non-customer of the carrying clearing member or (B) a related
person of the clearing member that (1) is not a customer of the
clearing member for purposes of Commission Rule 15c3-3 [17 CFR
240.15c3-3], (2) does not carry the accounts of persons who are
customers for purposes of Commission Rule 15c3-3, and (3) has
consented to be treated as a proprietary market-maker. Thus, a
proprietary market-maker account can be maintained by not only the
clearing member itself but also by any non-customer of the clearing
member. See also OCC's Amendment No. 2, discussed supra note 3.
\9\OCC By-laws, Article VI, Section 3(c). A parallel change is
made to Article VI, Section 3(e) with respect to combined registered
traders' accounts.
\10\OCC By-Laws, Article VI, Section 3(b). In the case of a
registered trader, positions can be maintained in a separate
registered trader's account established under paragraph (e).
\11\It is generally advantageous to a clearing member to
maintain positions in a combined market-makers' account rather than
in a separate market-maker's account. Market-makers' positions in
the combined market makers' account can be used as offsets or hedges
against each other which may result in a lower margin requirement
for the clearing member.
\12\OCC Rules 601(c)(3) and 602(c)(4).
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III. Discussion
Section 17A of the Act provides that a clearing agency must be
organized and its rules designed to assure the safeguarding of funds
and securities which are in the custody or control of the clearing
agency or for which it is responsible.\13\ As discussed below, the
Commission believes that OCC's proposal is consistent with these
objectives.
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\13\15 U.S.C. 78q-1(b)(3) (A) and (F).
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OCC's proposal responds to the events surrounding the default of an
OCC clearing member on October 13, 1989.\14\ The defaulting clearing
member carried in a combined market-makers' account the positions of an
associated market-maker and the positions of approximately 160
unaffiliated market-makers. One person owned 100% of both the
defaulting clearing member and the associated market-maker.
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\14\For a detailed discussion of the events surrounding the
clearing member default, refer to Market Analysis of October 13 and
16, 1989, A Report by the Division of Market Regulation, U.S.
Securities and Exchange Commission (December 1990), 158-60 and 164-
66.
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Because of the precipitous decline in the markets on Friday,
October 13, 1987, OCC issued an intraday margin call to the defaulting
clearing member whose settlement bank informed OCC that it would
neither honor OCC's intraday margin call nor extend further credit to
the defaulting clearing member. In an effort to cure the default, OCC
directed the defaulting clearing member to transfer the positions in
its accounts, particularly positions that were carried for unaffiliated
market-makers and customers, to another OCC clearing member. Because
the associated market-maker's positions were commingled with those of
unaffiliated market-makers in a combined market-makers' account, OCC
was unable to distinguish the collateral relating to the associated
market-maker's positions from the collateral relating to the
unaffiliated market-makers' positions in the account. Consequently, OCC
was required to direct the defaulting clearing member to transfer all
of the positions in its combined market-makers' account. Although this
did not preclude the transfer, it did make the transfer of the non-
proprietary positions more difficult.
The Commission believes that OCC's proposal will enhance OCC's
clearing member monitoring and risk management capabilities in several
respects. As an initial matter, the Commission notes that OCC's current
market-maker account structure permits clearing members to mask
proprietary activity by forming associated market-makers and combining
the positions of such market-makers with those of unaffiliated market-
makers in a combined market-makers' account. Although OCC can separate
the positions of the associated market-makers from those of
unaffiliated market-makers, the present account structure can
complicate OCC's monitoring of clearing member positions. Currently,
before OCC can assess the positions under a clearing member's control,
OCC must separate associated market-makers' positions from unaffiliated
market-makers' positions and then must combine the associated market-
makers' positions with the clearing member's positions. By requiring
the associated market-makers' positions to be maintained apart from the
unaffiliated market-makers' positions, OCC's proposal should enhance
its ability to monitor the positions of its clearing members.
The proposal also should enhance OCC's risk management capabilities
by providing OCC with a more accurate representation of clearing
members' financial condition. Generally, there are two levels of
capital supporting the trading and positions of a clearing member's
market-maker.\15\ However, as the above-described clearing member
default illustrates, this may not be the case when a clearing member
carriers the account of an associated market-maker because the clearing
member and the associated market-maker may be relying on the same
sources of financing to support their trading activities. Thus, by
requiring that associated market-maker hold their positions either in a
separate account or is a proprietary market-maker's account, OCC's
proposal should provide OCC with a more accurate picture of its sources
of exposure and the financial ability of a particular firm to cover
such exposure in the event of a clearing member default.
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\15\I.e., the capital of the clearing member and the capital of
the market-makers.
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The proposal also should enhance OCC's ability to administer a
clearing member's account in the event of the clearing member's
default. If the financial or operational condition of a clearing member
makes it necessary or advisable for the protection of OCC or other
clearing members, OCC has the authority to direct a clearing member to
transfer some or all of its accounts to another clearing member.\16\
However, if associated market-maker's positions are held with the
positions of unaffiliated market-makers in a combined market-makers'
account, as in the situation described above, OCC may experience
difficulty in separating the collateral supporting the associated
market-maker's positions from the collateral supporting the positions
of the unaffiliated market-makers' positions thereby making the
transfer of unaffiliated market-makers' positions difficult if not
impossible.
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\16\OCC Rule 305.
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IV. Conclusion
For the reasons stated above, the Commission finds that the
proposed rule change is consistent with Section 17A.
It is therefore ordered, pursuant to Section 19(b) (2) of the Act,
that the proposed rule change (File No. SR-OCC-90-11) be, and hereby
is, approved.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\17\
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\17\17 CFR 200.30-3(a)(12) (1992).
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[FR Doc. 94-1676 Filed 1-26-94; 8:45 am]
BILLING CODE 8010-01-M