[Federal Register Volume 63, Number 50 (Monday, March 16, 1998)]
[Proposed Rules]
[Pages 12713-12717]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-6580]



17 CFR Part 1

Amendments to Minimum Financial Requirements for Futures 
Commission Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.


SUMMARY: The Commodity Futures Trading Commission (``Commission'' or 
``CFTC'') proposes to amend its minimum financial requirements for 
futures commission merchants (``FCMs''). The proposed amendment would 
eliminate the charge against the net capital of an FCM, presently 
required by rule 1.17(c)(5)(iii). The charge is four percent of the 
market value of options sold by customers trading on contract markets 
or foreign boards of trade. It is generally referred to as the ``short 
option value charge'' or ``SOV charge''. The original intent in 
adopting this rule was to require FCMs to provide additional capital to 
offset the risk of short options positions carried on behalf of 
customers. The Commission is proposing to rescind this rule because it 
has determined that the charge is not closely correlated to the actual 
risk of the options carried on behalf of customers and, in any event, 
there are adequate other protections in place to address the risk of 
short options. In particular, the Standard Portfolio Analysis of Risk 
(``SPAN'') margining system has been effectively used to set 
appropriate levels of risk margin and there are many other non-capital 
protections. These protections include effective self-regulatory 
organization (``SRO'') audit and financial surveillance programs and 
modern risk management and control systems at FCMs. Because of the 
demonstrated effectiveness of these programs, the Commission believes 
it may now be appropriate to rescind the SOV charge.
    The Commission wishes to receive comments on this proposal. 
Comments are desired not only on the specific proposal itself, but also 
on all of the components of the system of protections that are designed 
to address the risk of short options, which are described below.

DATES: Comments must be received on or before May 15, 1998. Any 
requests for an extension of the comment period must be made in writing 
to the Commission within the comment period.

ADDRESSES: Comments may be sent to: Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington, 
D.C. 20581. Attn.: Secretariat with a reference to the Minimum 
Financial Requirement Rule--SOV Charge. Also, comments may be E-mailed 
to ``[email protected]''.

Accountant, 202-418-5459 or ``[email protected]''; or Lawrence B. Patent, 
Associate Chief Counsel, 202-418-5439 or ``[email protected]''. Mailing 
address: Division of Trading and Markets, Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington, 
D.C. 20581.


I. Background

    On July 7, 1982,1 the Commission proposed amendments to 
the rule governing the computation of net capital for FCMs to recognize 
the difference in risk between the purchase and sale of commodity 
options. The sale of an option (``short option'') poses a greater risk 
to an FCM than does the purchase of an option (``long option'') because 
the risk of a short option is unlimited. In contrast, long options pose 
a risk to the carrying FCM which is limited to the premium on the 
option. Once the premium is collected from the customer who purchased 
the option, there is no further risk of financial loss to the FCM or 
the customer. In this connection, the Commission has proposed the 
repeal of Commission Regulation 33.4(a)(2) which requires the full 
payment of a commodity option premium at the time the option is 
purchased. The proposal was initially published for comment on December 
19, 1997. The comment period was extended to March 4, 1998. The effect 
of the repeal would be to permit the futures-style margining of 
commodity options traded on regulated futures exchanges and is 
discussed in the initial notice of proposed rulemaking.2

    \1\ 47 FR 30261 (July 13, 1982).
    \2\ 63 FR 6112 (February 6, 1998), Extension of comment period 
to March 4, 1998; See also 62 FR 66569 (December 19, 1997), Initial 
request for comment.

    To recognize the risk of carrying short options, the Commission 
adopted, effective September 21, 1982,3 a safety factor 
charge of four percent of the market value of exchange-traded (domestic 
and foreign) options granted or sold by an FCM's customers--the short 
option value charge (``SOV charge''), as set forth in Regulation 
1.17(c)(5)(iii).4 However, over the years since its 
adoption, there have been complaints that the charge was not 
proportional to the risk of the options and was excessive in its 
financial burden upon the FCMs in terms of the cost of the capital 
required to carry the positions.

    \3\ 47 FR 41513 (September 21, 1982).
    \4\ Commission rules referred to herein can be found at 17 CFR 
Ch. I (1997).

    In June 1995, both the Chicago Board of Trade (``CBOT'') and the 
Chicago Mercantile Exchange (``CME'') urged the Commission to rescind 
the SOV charge. In the alternative, the two exchanges asked for some 
degree of relief from the SOV charge in the event that the Commission 
felt that complete rescission of the charge was not possible. Their 
letters cited, among other reasons for rescission or the requested 
relief, that: (a) Short options positions may serve to reduce the risk 
of a portfolio that would carry greater risk absent the short options 
positions, and (b) the risks of short option positions are already 
adequately addressed by the risk-based margining system currently being 
used by all commodity exchanges in the U.S. and many abroad.
    They pointed out that the charge was adopted in 1982, prior to the 
development of risk-based margining systems. While the charge was 
intended to serve as an additional regulatory capital safety factor for 
option positions, they contended that it is now excessive and no longer 
justified because of the use of margining systems that

[[Page 12714]]

adequately measure portfolio risk and, therefore, assess appropriate 
margins on the entire portfolio.
    The Commission staff felt that there was some merit to the position 
of the exchanges and others who had criticized the efficacy of the SOV 
charge. Therefore, to temper the impact of the charge, while the matter 
was studied further, on July 26, 1995, the Division of Trading and 
Markets (``Division'') issued Interpretative Letter No. 95-
65.5 That letter provided partial relief through a ``no 
action'' position that would allow FCMs to reduce the four percent SOV 
charge applicable to short options positions carried by professional 
traders and market makers.6 An FCM that wished to avail 
itself of the relief under the ``no action'' position was required to 
prepare certain supporting calculations and obtain approval from its 
designated self-regulatory organization (``DSRO'') to take the relief. 
The Division subsequently expanded this relief to include any customer 
account carried by an FCM, in Interpretative Letter No. 97-46, dated 
June 12, 1997, provided the same conditions could be met by the 
additional accounts.7

    \5\ CFTC Interpretative Letter No. 95-65, [1994-1996 Transfer 
Binder] Comm. Fut. L. Rep. (CCH) para. 26,495 (July 26,1995).
    \6\ The reduction in the charge cannot exceed 50 percent of the 
pre-relief charge calculated for all SOV on a firm-wide basis.
    \7\ CFTC Interpretative Letter No. 97-46, [Current Binder] Comm. 
Fut. L. Rep. (CCH) para. 27,086 (June 12,1997). This letter also 
provided some relief pertaining to the required supporting 

    However, only five FCMs have taken advantage of the relief. This 
small number resulted from the fact that the relief required what were 
viewed as burdensome calculations and, in any event, the relief was 
limited to fifty percent of the total charge. The FCM community also 
communicated to the Commission that the relief provided by the Division 
failed to address the theoretical deficiencies of the rule. In a letter 
dated September 26, 1997, the Joint Audit Committee (``JAC'') 
8 formally suggested that the net capital charge on SOV be 
eliminated. The JAC letter stated the following:

    \8\  JAC is comprised of representatives from each commodity 
exchange and National Futures Association who coordinate the 
industry's audit and ongoing surveillance activities to promote a 
uniform framework of self-regulation.

    * * * Since the limited relief was granted, the JAC has closely 
monitored the application of the relief. From JAC's experience and 
from discussions with FCMs, many firms feel that the conditions for 
relief are too restrictive and complicated. Thus, they are not able 
to expend their resources to take advantage of the relief. In fact, 
there are only five FCMs which have applied for such relief.
    During periods of high volatility, the capital charge will 
increase as the value of the applicable short option increases. 
However, this charge does not necessarily relate to the risk 
applicable to a particular options portfolio. Selling options may 
actually serve to reduce risk in a portfolio. As a result, some 
firms have made a business decision to refuse large, lucrative 
customer accounts due to an unwillingness to absorb the charge. The 
fact that this decision is made for cost rather than risk reasons is 
clearly not in the best interest of any participant in the U.S. 
futures industry. This outdated regulation forces the concentration 
of exchange traded short options in a few firms.
    In general, FCMs have little control over reducing the charge. 
Requiring additional collateral has no impact on the charge itself 
and will instead increase the FCM's capital requirements. We believe 
the SPAN 9 performance bond system adequately captures 
the risk in options portfolios and the undermargined charge to 
capital appropriately reflects risk in an FCM's capital computation.

    \9\ SPAN is an acronym for Standard Portfolio Analysis of Risk.

    The charge has a significant impact on the viability of the 
exchange traded options markets. When market users can not find an 
FCM willing to absorb the charge, the liquidity of our markets is 
directly impacted. For all the reasons stated above, we again 
request the CFTC eliminate this charge in its entirety . . .

II. Discussion

    As stated above, the Commission proposes that the SOV charge be 
rescinded for two reasons: (1) The rule has not resulted in capital 
charges proportionate to risk; and (2) the SPAN margining system and 
other non-capital components of the system of protections are much 
better developed and executed than they were when the SOV charge was 
first adopted. These factors are discussed below in two sections. The 
first section addresses the theoretical deficiencies of the SOV charge, 
and the second section is a summary of non-capital protections.

A. Theoretical Deficiencies of the SOV Charge

    The current charge based on four percent of SOV has not, in 
practice, resulted in capital charges which are proportionate to risk. 
The following situations are illustrative:
    Multiple Strikes--Exchanges typically list multiple strikes with 
the same underlying futures contract in a given option contract month. 
Option premium typically increases across strikes, moving from out-of-
the-money strikes to in-the-money strikes. Moving to deep-in-the-money 
strikes increases the option intrinsic value and the resulting premium. 
At some deep-in-the-money point the deltas of the different strikes 
will be the same. Therefore, while two deep-in-the-money strikes may 
have very similar or even identical risk profiles, the deeper-in strike 
will have a higher intrinsic value and a higher premium, yielding a 
higher SOV charge. The SOV charges for the two options can differ 200 
percent or more, even though those options have the same underlying 
futures, the same time to expiration, and the same risk profiles.
    Risk-Reducing Strategies--Short options positions are often used as 
one component of a trading strategy. The other positions used in the 
strategy could be futures, other derivatives, or cash instruments. In 
such strategies, the short options positions may be intended as a risk-
reducing position, as demonstrated by the fact that the introduction of 
the short options positions into the portfolio results in a reduction 
in the SPAN-based margin requirement for the portfolio. Despite the 
fact that these positions are risk-reducing, the short option values 
for these portfolios increase markedly in trending markets. In 
practice, the Commission notes that some FCMs which have carried the 
accounts of traders who do a great deal of these kinds of strategies 
have faced large capital charges in trending markets. Because the short 
options component of such strategies is actually risk-reducing, the SOV 
charge has not served its intended purpose in these cases.
    The following examples will illustrate the problem with short 
calls. (Also, the same problem applies to short puts.)
    Deep-In-The-Money Short Dated Short Call--A deep-in-the-money short 
dated short call has a risk profile essentially like a short futures 
position. The one major difference between the short call and the 
futures contract is that the call has a large intrinsic value which 
translates into a large premium and a corresponding large SOV charge. 
Therefore, FCMs incur a significant extra capital requirement for the 
short call even though there is no extra capital requirement to carry 
essentially the same risk with equivalent short futures contracts. In 
this case, the capital requirement is excessive compared to the risk, 
as indicated by the margin requirement on the futures contract.
    Deep-Out-Of-The-Money Short Dated Call--A deep-out-of-the-money 
short dated call displays more of the unique risk characteristics 
associated with options. While initially it has a low

[[Page 12715]]

delta 10 this short call has a high gamma 11 as 
it approaches the money, introducing the potential for significant 
losses from extreme underlying moves. For normal underlying moves, this 
deep-out short call has little risk. Only extreme moves far beyond the 
normal performance bond coverage levels would cause significant losses 
for this option. However, because this deep-out short call has no 
intrinsic value and little time value, it typically has very low 
premium and therefore has a correspondingly low capital charge. Because 
this kind of risk rarely materializes into actual losses, it is best 
addressed by the non-capital protections. These protections are 
described below.

    \10\ Delta measures the amount an option price changes for a 
one-point change in the price of the underlying product.
    \11\ Gamma is a risk variable that measures the amount that the 
delta of an option changes given a one-point change in the price of 
the underlying product.

    As discussed below, the Commission believes that the SPAN margining 
system, since its introduction in December 1988, appears to have 
provided adequate margins. Also, SPAN is being refined on an ongoing 
basis by the CME, the CBOT, and the other SROs which use it. Finally, 
the Commission has previously reported to the Federal Reserve Board 
that the SPAN margining system has met its performance goals for many 
years, with respect to futures margins on stock index futures 

B. Summary of Non-Capital Protections

    There are protections against the risk of short options other than 
net capital charges. In this connection, the Commission believes that 
the non-capital components of the system of protections in place are 
now stronger than they were when the SOV charge was put into place. 
Risk management models have been refined over the years; there have 
been enhancements in Commission and SRO audit and surveillance 
programs; FCM risk management systems and controls have improved 
significantly compared to what was available and in place at many firms 
when the SOV charge was first adopted; and technological advancements 
have improved communication among clearing organizations, FCMs and 
their customers. Therefore, the Commission has preliminarily concluded 
not only that the SOV charge has not worked to provide a risk-based 
protection, as hoped, but also that these other non-net capital 
protections have been improved over the years and have resulted in an 
overall strengthening of the system, well beyond what was in place when 
the SOV charge was adopted. The primary non-capital protections are 
described below.
Portfolio Margining System
    Performance bond requirements are referred to commonly as 
``margin'' requirements. Margin requirements typically are set at 
levels which cover 95 to 99 percent of a product's expected daily price 
change over a period of time. To ensure that margin requirements are 
set at appropriate levels, historical volatility price charts are 
reviewed by product and spreads between products. SPAN is a risk-
measuring margin methodology adopted by all U.S. and numerous foreign 
futures exchanges. SPAN uses option pricing models to calculate the 
theoretical gains and losses on options under various market situations 
(e.g., prices up, prices down, volatility up, volatility down, and 
extreme price movements). As noted above, the Commission has reported 
to the Federal Reserve Board on the effectiveness of SPAN in setting 
margins in equities-related futures contracts.
Financial Surveillance and Position Reporting Systems
    Generally, it is the large traders which pose the greatest risk to 
FCMs. To deal with this risk, the U.S. futures industry has a very 
complete and current system of position reporting. This permits close 
monitoring of the positions of large traders and is the foundation of 
an effective program of financial surveillance conducted by the SROs. 
As explained below, current positions are assessed prospectively--what 
financial effect would such positions have if the market moved 
significantly one way or the other. The advanced reporting systems in 
place permit assessments to be done at the account level, which is 
where risk to the firms must be evaluated. Using account level data 
along with other information, the SROs' sophisticated programs are 
designed to identify risks to the clearing system, including 
financially troubled FCMs or FCMs that carry high-risk positions.
    To accomplish this goal, SROs monitor market developments 
throughout the day, make intra-day variation margin calls on clearing 
members, and follow up with individual FCMs regarding potential 
problems. There have been occasions in the past when customers holding 
very large or concentrated positions have caused financial problems for 
their carrying FCMs. Large trader monitoring systems are designed to 
identify such traders before losses occur. Although it is not possible 
to obviate the possibility of an FCM failure due to the default of a 
large trader, the systems operated by the SROs improve the control of 
this risk by permitting scrutiny of large trader positions by the SROs. 
Scrutiny is carried out by the SROs on a systematic basis.
    Using the large trader information, SROs perform stress testing of 
positions using ``what if'' price simulations based on open positions 
carried by clearing member FCMs in order to determine an FCM's 
potential risk in relation to its excess net capital. Daily pay/collect 
variation margin is aggregated for periods of time to monitor losses 
compared to the excess capital of the firm. Potential losses revealed 
by the stress testing, which are determined to be large in relation to 
an FCM's most recently reported capital, will indicate that the firm 
should be contacted by SRO surveillance staff to obtain assurances that 
the FCM has properly evaluated the creditworthiness of its customers 
and the adequacy of collateral in place.
    As noted elsewhere, as a part of its oversight program, the 
Division regularly reviews the procedures used by the SROs to conduct 
financial surveillance over member-FCMs. The Division's reviews, as 
well as experience over many years working with the SROs in identified 
problem situations, reveal that the systems generally have been 
effective. The systems also have improved over time, because the SROs 
have shown a willingness to learn from experience. However, it should 
be noted that financial surveillance at the SRO level, including any 
review work done at an FCM during an in-field examination, is not a 
substitute for an effective risk management and control system operated 
by the FCM itself. The Commission believes that the audit and financial 
surveillance programs operated by the SROs have been effective in 
encouraging the development of equally good risk management and control 
systems at FCMs. In this connection, as explained below, the SROs 
ensure that FCMs have appropriate risk management and control systems 
in place and make recommendations when their in-field audits reveal 
inadequate systems.
Capital and Segregation Requirements for FCMs
    The Commission's capital and segregation requirements are part of 
the protections built into the system against the risk of short options 
positions. All FCMs must meet the Commission's net capital and 
segregation requirements, as

[[Page 12716]]

well as SRO requirements. An FCM which is a clearing member also must 
have capital requirements which are higher than those set by the 
Commission. Commission regulations require firms to keep current books 
and records, prepare a daily segregation calculation and a formal, 
monthly capital calculation, among other things. FCMs must be in 
compliance with the net capital and segregation rules at all times. 
Material inadequacies in internal control must be reported. The demands 
of these recordkeeping and reporting requirements serve as an element 
of the overall system of internal controls. The daily segregation 
calculation, especially, will reveal problems in customers' accounts 
very quickly, when and if they occur.
    The basic capital requirement is set at four percent of an FCM's 
liabilities to its customers. The segregation rule requires an FCM to 
have sufficient funds in segregation to meet its liabilities to its 
customers. The underlying concept of segregation is that by separating, 
i.e., segregating, the funds of customers from the proprietary funds of 
the FCM, there will be sufficient funds available to pay off the FCM's 
liabilities to its customers in the event of the FCM's failure due to 
proprietary losses. As already stated, in order to demonstrate to 
itself and regulators that it is in compliance with the segregation 
requirements, an FCM is required to prepare a daily computation of the 
status of the segregated accounts, which shows that there are 
sufficient funds in segregation. One of the elements of the computation 
is to ascertain the status of deficits in the accounts of customers. 
Any deficit which is not covered by appropriate collateral must be made 
up by the firm with funds of its own. Deficits outstanding for more 
than one day have a direct and immediate impact upon firm capital and 
may cause a firm to be undercapitalized. An FCM must report to the 
Commission in the event its capital falls below the early warning 
level, which is 150 percent of required capital. Although the capital 
rule provides some discretion to the Commission in allowing an FCM to 
come back into capital compliance, with respect to undersegregation, 
there is no grace period.12 Therefore, it is prudent for an 
FCM to carry excess net capital and funds in segregation in amounts 
commensurate with the type of business it handles.

    \12\ The Commission has proposed to amend Regulation 1.12, its 
early warning notification rule, to add a requirement that an FCM 
promptly report to the Commission and the FCM's DSRO whenever it 
knows or should have known that it does not have sufficient funds in 
segregated accounts to meet its obligations to customers who are 
trading on U.S. markets or set aside in special accounts to meet its 
obligations to customers who are trading on non-U.S. markets. 63 FR 
2188 (January 14, 1998).

SRO Programs of In-Field Audits of FCMs
    The Commission believes that the in-field audit program conducted 
by the SROs over their member-FCMs has resulted in a high level of 
compliance with the Commission's and the SROs' financial rules. 
Commission rules require SROs to have these programs in place. To this 
end, each FCM's DSRO conducts an annual audit of each FCM assigned to 
it under the Joint Audit Plan. Under the plan, a full-scope audit is 
conducted every other year, and a limited-scope records review is 
conducted in the alternate year. The audits are conducted according to 
the Joint Audit Program, which is designed and regularly updated for 
new developments by the JAC. The Commission reviews the Joint Audit 
Program each time it is updated.
    The full-scope audit, conducted using the Joint Audit Program, 
includes a review of the systems and controls that the FCM has in 
place. In this connection, members of JAC complete a Financial and Risk 
Management Internal Controls questionnaire for each FCM audit. The 
questionnaire covers the firm's procedures for: opening new accounts, 
monitoring non-customer trading, assessing the impact of potential 
market movements on customer and non-customer trading, and ensuring 
that the segregation of duties is appropriate. Furthermore, during the 
course of the audit, a review is made of account documentation, margin 
procedures, undermargined account net capital charges, debit/deficit 
accounts and sales practices. Such reviews provide information to 
assess the firm's overall internal control and risk management 
    The JAC has initiated a project to revise its in-field audit 
approach to be more explicitly risk-based. That is, in planning and 
performing in-field audits, the DSRO will place a greater emphasis upon 
review and identification of potentially high risk areas at an FCM at 
the outset of an audit. The results of this early audit survey and 
planning work will translate into a more focused targeting by the DSRO 
of the total available audit resources upon the areas of highest risk 
at an FCM.

III. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') 5 U.S.C. 601 et seq., 
requires that agencies, in proposing rules, consider the impact of 
those rules on small businesses. The Commission has previously 
determined that FCMs are not ``small entities'' for purposes of the 
Regulatory Flexibility Act.13 Therefore, the Chairperson, on 
behalf of the Commission, hereby certifies, pursuant to 5 U.S.C. 
605(b), that the action taken herein will not have a significant 
economic impact on a substantial number of small entities.

    \13\ 47 FR 18619-18620.

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 14 imposes certain 
requirements on federal agencies (including the Commission) in 
connection with their conducting or sponsoring any collection of 
information as defined by the Paperwork Reduction Act. While this 
proposed rule has no burden, the group of rules (3038-0024) of which 
this is a part has the following burden:

    \14\ Pub. L. 104-13 (May 13, 1995).

Average burden hours per response: 128.
Number of Respondents: 3143.
Frequency of response: On occasion.

    Copies of the OMB-approved information collection package 
associated with this rule may be obtained from Desk Officer, CFTC, 
Office of Management and Budget, Room 10202, NEOB Washington, DC 20503, 
(202) 395-7340.

List of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and 
recordkeeping requirements, Net capital requirements.

    In consideration of the foregoing and pursuant to the authority 
contained in the Commodity Exchange Act and, in particular, Sections 
4f, 4g and 8a (5) thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission 
hereby proposes to amend Chapter I of Title 17 of the Code of Federal 
Regulations as follows:


    1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f, 
6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 
12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24.

Sec. 1.17  [Amended]

    2. Section 1.17(c)(5)(iii) is removed and reserved.

[[Page 12717]]

    Issued in Washington, DC on March 9, 1998, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 98-6580 Filed 3-13-98; 8:45 am]