[Federal Register Volume 63, Number 158 (Monday, August 17, 1998)]
[Notices]
[Pages 43980-43982]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-21958]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40317; File No. SR-OCC-98-07]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change Regarding the Short Option 
Adjustment as Applied to Non-Equity Options

August 11, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on July 10, 1998, The Options 
Clearing Corp. (``OCC'') filed with the Securities and Exchange 
Commission (``Commission'') the proposed rule change as described in 
Items I, II, and III below, which items have been prepared primarily by 
OCC. The Commission is publishing this notice to solicit comments from 
interested persons on the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The purpose of the proposed rule change is to amend OCC's Rule 602 
to modify the ``short option adjustment'' as it applies to non-equity 
options in OCC's margin system, the theoretical intermarket margin 
system (``TIMS'' or ``NEO TIMS'').\2\
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    \2\ ``TIMS'' refers to OCC's margin system as it applies to 
stock options and ``NEO TIMS'' refers to OCC's margin system as it 
applies to non-equity options.
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II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, OCC included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. OCC has prepared summaries, set forth in sections (A), 
(B), and (C) below, of the most significant aspects of such 
statements.\3\
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    \3\ The Commission has modified the text of the summaries 
prepared by OCC.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    OCC requires its clearing members to adjust their margin deposits 
with OCC in the morning on every business day based on OCC's overnight 
calculations. OCC imposes a margin requirement on short positions in 
each clearing member account and gives margin credit for unsegregated 
long positions.\4\ Under TIMS, positions in a class group are margined 
based on premium levels at the close of trading on the preceding day 
which are then increased or decreased by the additional margin amount 
for that class group.\5\
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    \4\ A long position is unsegregated for OCC's purposes if OCC 
has a lien on the position (i.e., it has recourse to the value of 
the position in the event that the clearing member does not perform 
an obligation to OCC). Long positions in firm accounts and market-
maker accounts are unsegregated. Long positions in the clearing 
member's customers' accounts are unsegregated only if the clearing 
member submits instructions to that effect in accordance with Rule 
611.
    \5\ For purposes of NEO TIMS, a class group consists of all put 
and call options, certain market baskets, and commodity options and 
futures that are subject to margin at OCC because of a cross-
margining program with a commodity clearing organization. A class 
group may also contain stock loan baskets and stock borrow baskets.
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    TIMS calculates additional margin amounts using options price 
theory. TIMS first calculates the theoretical liquidating value for the 
positions in each class group by assuming either an increase or 
decrease in the market value of the underlying asset in an amount equal 
to the applicable margin interval. The margin interval is the maximum 
one price movement that OCC wants to protect against in the price of 
the underlying asset.\6\ Margin intervals are determined separately for 
each underlying interest to reflect the volatility in the price of the 
underlying interest.
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    \6\ Some combinations of positions can present a greater net 
theoretical liquidating value at an intermediate value than at 
either of the endpoint values. As a result, TIMS also calculates the 
theoretical liquidating value for the positions in each class group 
assuming intermediate market values of the underlying asset.
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    TIMS then selects the theoretical liquidating value that represents 
the greatest decrease (where the actual liquidating value is positive) 
or increase (where the actual liquidating value is negative) in 
liquidating value compared with the actual liquidating value based on 
the premium levels at the close of trading on the preceding day. The 
difference between that theoretical

[[Page 43981]]

liquidating value and the actual liquidating value is the additional 
margin amount for that class group unless the class group is subject to 
the short option adjustment.
    For net short positions \7\ in deep out of the money options, 
little or no change in value would be predicted given a change in value 
of the underlying interest equal to the applicable margin interval. As 
a result, TIMS would calculate additional margin amounts of zero or 
close to zero for deep out of the money options. However, volatile 
markets could cause such positions to become near to or in the money 
and thereby could create increased risk to OCC. OCC protects against 
this risk with an adjustment to the additional margin calculation known 
as the short options adjustment.\8\
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    \7\ A net position in an option series in an account is the 
position resulting from offsetting the gross unsegregated long 
position in that series against the gross short position in that 
series. After netting, an account will reflect a net short position 
or a net long position for each series of options held in the 
account.
    \8\ The short option adjustment for non-equity options is 
described in OCC Rule 602(c)(1)(ii)(C)(1).
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    Originally, the short option adjustment calculated a minimum 
additional margin amount for all net short positions in an options 
series for which the ordinary calculation of the additional margin 
requirement was less than twenty-five percent of the applicable margin 
interval. The original methodology applied the short option adjustment 
to all such short option positions and did not attempt to match or pair 
net short positions with net long positions which would substantially 
reduce or eliminate the risk of such net short positions.\9\ OCC 
concluded several years ago that this method required clearing members 
to deposit margin in excess of the risk presented by certain net short 
positions in deep out of the money options.
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    \9\ The term unpaired is defined in Interpretation .04 to Rule 
601 for equity options and Interpretation .06 to Rule 602 for non-
equity options.
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    As a result, OCC modified the short option adjustment so that it 
applied only to unpaired net short positions in deep out of the money 
options.\10\ Currently, the term unpaired is defined to mean that a net 
short position is not offset by a net long position on the same 
underlying interest. By excluding paired net short positions from the 
short option adjustment, OCC no longer needs to collect margin 
calculated pursuant to the short option adjustment for many short 
option positions which in fact pose little or no risk to OCC under 
OCC's ordinary additional margin methodology.\11\
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    \10\ Securities Exchange Act Release No. 31682 (December 31, 
1992), 58 FR 3318 [File No. SR-OCC-91-12].
    \11\ A pair consisting of a net short position and a net long 
position on the same underlying interest (i.e., in the same class 
group) will pose no risk to OCC if the exercise price of the short 
position is higher (in the case of calls) or lower (in the case of 
puts) than the exercise price of the long position. A pair 
consisting of a net short position and a net long position will pose 
a risk to OCC consisting of the difference between the exercise 
prices of the short position and long position if the exercise price 
of the short position is lower (in the case of calls) or higher (in 
the case of puts) than the exercise price of the long position. 
However, this risk is relatively small and is not open-ended (i.e., 
the risk cannot be greater than the difference between the two 
exercise prices times the applicable unit of trading or index 
multiplier and the number of contracts).
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    Excluding paired net short positions from the short option 
adjustment reduced the overcollateralization caused by the short option 
adjustment. However, OCC believes that the short option adjustment 
still requires members to deposit margin in excess of the risk created 
by certain net short positions. This remaining overcollateralization 
occurs because Interpretation .06 to OCC Rule 602 currently provides 
that a net short position is unpaired unless the position is offset by 
a net long position in the same class group (i.e., the net short and 
long positions have the same underlying interest). Therefore, 
Interpretation .06 treats a net short position as unpaired even if the 
net short position is offset by a net long position in a highly 
correlated class group. In other words, Interpretation .06 treats a net 
short position on an index options that is offset by a net long 
position on a highly correlated index option as unpaired for purposes 
of the short option adjustment.
    To reduce this remaining overcollateralization, OCC will refine the 
short option adjustment logic of NEO TIMS so that it recognizes spreads 
between net long and short positions on underlying interests that 
exhibit price correlation of seventy percent or greater in addition to 
spreads between net long and short positions on the same underlying 
interests.\12\ Under the proposed rule change, OCC will modify Rule 602 
to provide that NEO TIMS (1) will continue to pair all net short 
contracts on a particular underlying interest against all net long 
contracts on the same underlying interest and (2) will then pair any 
remaining net short positions against any net long positions that 
remain in other class groups that exhibit seventy percent or greater 
price correlation.\13\ Any short contracts remaining unpaired after 
this pairing process will be subject to the short option 
adjustment.\14\
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    \12\ OCC is not proposing to refine the short option adjustment 
in TIMS for equity options. OCC attributes a thirty percent price 
correlation to the class groups in the equity option product group, 
and the modified short option adjustment would therefore have no 
effect on equity options even if Interpretation .04 to Rule 601 were 
revised.
    \13\ The class groups in OCC's stock index and currency option 
product groups satisfy the requirement for seventy percent or 
greater price correlation.
    \14\ Commodity options and futures held in cross-margin 
accounts, market baskets, and stock loan and borrow baskets also 
will be included in the pairing process. Long calls, futures, 
commodity calls, market baskets, and stock loan baskets will be 
netted against short calls and commodity calls. Long puts, commodity 
puts, short futures, market baskets, and stock borrow baskets will 
be netted against short puts and commodity puts.
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    Interpretation .06 currently states that those short contracts 
having the lowest premium margin values will be deemed to be unpaired. 
Premium margin value is an important criterion used by OCC to identify 
the excess short contracts that OCC will deem unpaired, but is not the 
only criterion.\15\
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    \15\ Other criteria may include identifying contracts that are 
furthest from expiration, those that have the highest exercise price 
(in the case of calls) or the lowest exercise price (in the case of 
puts), or those that have been assigned the largest margin interval.
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    Under the proposed rule change, Interpretation .06 will be modified 
to provide that OCC will identify which of the excess short contracts 
will be deemed unpaired and therefore be subject to margin requirements 
using the short option adjustment.
    OCC believes that pairing net short positions with net long 
positions that do not exhibit one hundred percent price correlation 
will create some incremental risk to OCC. However, OCC believes that 
this incremental risk is relatively small and that OCC's ordinary 
additional margin calculations should generate margin requirements 
sufficient to protect OCC.
    OCC believes that the proposed rule change is consistent with the 
requirements of Section 17A of the Act \16\ and the rules and 
regulations thereunder because it should further the public interest by 
eliminating overcollateralization of certain short positions in deep 
out of the money options where the risk of such positions is offset by 
long positions on a highly correlated underlying interest. OCC believes 
further that the proposed rule change will remove an impediment to 
market liquidity without reducing OCC's protection with respect to 
truly uncovered short positions in deep out of the money options.
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    \16\ 15 U.S.C. 78q-1(b)(3)(A).

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[[Page 43982]]

(B) Self-Regulatory Organization's Statement on Burden on Competition

    OCC does not believe that the proposed rule change will have any 
material impact on competition.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants or Others

    Written comments were not and are not intended to be solicited by 
OCC with respect to the proposed rule change, and none have been 
received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within thirty-five days of the date of publication of this notice 
in the Federal Register or within such longer period (i) as the 
Commission may designate up to ninety days of such date if it finds 
such longer period to be appropriate and publishes its reasons for no 
finding or (ii) as to which OCC consents, the Commission will:
    (A) By order approve such proposed rule change or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Section, 450 Fifth Street, NW., 
Washington, DC 20549.
    Copies of such filing also will be available for inspection and 
copying at the principal office of OCC. All submissions should refer to 
File No. SR-OCC-98-07 and should be submitted by September 8, 1998.

    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).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-21958 Filed 8-14-98; 8:45 am]
BILLING CODE 8010-01-M