[Federal Register Volume 63, Number 246 (Wednesday, December 23, 1998)]
[Notices]
[Pages 71179-71181]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-33911]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40800; File No. SR-OCC-98-11]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change Regarding the Calculation of 
the Short Option Adjustment

December 16, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on September 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

    Under the proposed rule change, OCC will amend the short option 
adjustment contained in OCC's Theoretical Intermarket Margin System 
(``TIMS'') to enable OCC to use a ``sliding scale'' to calculate short 
option adjustment amounts.

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.\2\
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    \2\ 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

    Under the proposed rule change, OCC will amend Rules 601 and 602 to

[[Page 71180]]

provide OCC with more flexibility in calculating the amount of the 
short option adjustment.\3\
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    \3\ OCC Rule 601 describes TIMS as it applies to equity options 
(``equity TIMS'') and OCC Rule 602 describes TIMS as it applies to 
non-equity options (``non-equity TIMS'').
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    OCC requires its clearing members to adjust their margin deposits 
with OCC in the morning of 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, the margin for positions in a class 
group is based on premium levels at the close of trading on the 
preceding day and is 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., 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' account are unsegregated only if the clearing member 
submits instructions to that effect in accordance with Rule 611.
    \5\ For purposes of equity TIMS, a class group consists of all 
put and call options, all BOUNDS, and all stock loan and borrow 
positions relating to the same underlying security. For purposes of 
non-equity 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) that relate to the same underlying 
asset. A NEO TIMS 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 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 day 
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 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 
such risk by incorporating into the additional margin calculation a 
margin cushion known as the short option 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 is described in Rule 
601(c)(1)(C)(1) for equity options and Rule 602 (c)(1)(ii)(C)(1) for 
non-equity options. OCC recently amended Interpretation .06 to Rule 
602 so that net short non-equity option positions can be paired off 
against net long non-equity positions whose underlying interests 
exhibit price correlation of at least seventy percent. Securities 
Exchange Act Release No. 40515 (September 30, 1988), 63 FR 53970.
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    Currently, the short option adjustment requires a minimum 
additional margin amount equal to twenty-five percent of the applicable 
margin interval for all unpaired\9\ net short positions in options 
series for which the ordinary calculation of the additional margin 
requirement would be less than twenty-five percent of the applicable 
margin interval. OCC believes that this methodology requires clearing 
members to deposit margin in excess of the risk presented by some 
unpaired net short positions in 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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    OCC believes that this excess margin requirement can be attributed 
essentially to two causes. First, some short positions are so far out 
of the money that even an extreme market move would not cause them to 
prevent risk to OCC commensurate with a short option adjustment 
equivalent to twenty-five percent of the applicable margin interval. To 
illustrate, on October 27, 1997, the S&P 500 Index fell 6.9% to 876.98 
from its closing value of 941.64 on October 24, 1997.\10\ There was a 
series of SPX 11/97 put options with an exercise price of 700 open on 
that date. At the close of October 24, 1997, that series was 25.7% out 
of the money and had a closing premium of $25.00. At the close on 
October 27, 1997, that series was 20.2% out of the money and had a 
closing premium of $56.25. The increase in the closing premium from 
October 24 to October 27 was $31.25. In the absence of the short option 
adjustment, TIMS would have required additional margin of $23.25. With 
the short option adjustment, TIMS required additional margin of $875.00 
(equal to the margin interval, which was 35 points, times the index 
multiplier of 100, times 25%). Even in this extreme market move the 
short option adjustment required far more collateral than OCC needed to 
hedge the risk presented to it by unpaired short positions in this 
series.
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    \10\ This market decline of 64.66 points was the 14th largest 
one day percentage decline in the period from January 1930 through 
June 1998, and it constituted a more extreme daily move than 99.9% 
of the daily moves during this period. The decline on October 27, 
1997, actually represents a more rigorous test of the short option 
adjustment methodology than the market move on October 19, 1987. 
There are several reasons for this, such as the option implied 
volatility was so high on October 19, 1987, and the theoretical 
additional margin levels calculated by TIMS generally exceeded the 
alternative short option adjustment calculations.
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    Second, out of the money short call positions present less risk to 
OCC than short put positions that are equally out of the money. This is 
essentially because a market that moves sharply down (presenting risk 
to OCC from short put positions) is generally associated with an 
increase in option implied volatility whereas a market that moves 
sharply up (presenting risk to OCC from short call positions) is 
generally associated with a decrease in option implied volatility. 
Other things being equal, an upward move in the market of a given size 
creates less risk for OCC from short call positions than a downward 
move in the market of the same size from short put positions. 
Therefore, because TIMS employs a twenty-five percent short option 
adjustment for both puts and calls, it tends to require excessive 
additional margin particularly with respect to short call positions.
    To address these situations, the proposed rule change will 
establish a sliding scale short option adjustment methodology. Using 
the sliding scale, the short option adjustment percentage will be 
applied to a particular series according to the extent to which the 
series is out of the money. In addition, OCC will use different sliding 
scales for put options and for call options.
    OCC believes that the margin required by these sliding scales 
should be sufficient to protect it against the risks

[[Page 71181]]

presented by out of the money short positions even in extreme market 
conditions. For example, in the illustration described above, the 
sliding scale short option adjustment would still have required 
additional margin of $350.00 (equal to the margin interval of 35 
points, times the index multiplier of 100, times 10%, the applicable 
percentage for a short put 25.7% out of the market) which is well in 
excess of the risk presented to OCC by the short puts in the SPX 11/97 
700 series.
    Under the proposed rule change, OCC will modify Rules 601 and 602 
to provide that the short option adjustment to be applied to any 
unpaired short position will be determined using a percentage that OCC 
deems to be appropriate. A specific short option adjustment percentage 
will not be included in the rules.\11\
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    \11\ A schedule of the sliding scales that OCC intends to use 
initially is attached as Exhibit A to its filing, which is available 
for inspection at the Commission's Public Reference Room and through 
OCC. OCC will always specify a minimum short option adjustment 
percentage. OCC will inform its members of the initial schedule of 
the sliding scales through an Important Notice and will notify its 
members of any changes to the schedule.
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    OCC believes that this information provides appropriate flexibility 
to make adjustments to the sliding scales from time to time as OCC 
determines is warranted. OCC further believes that the proposed rule 
change is consistent with the approach taken in Rule 60(c)(1)(C)(1) and 
Rule 602(c)(1)(ii)(C)(1) which both permit OCC to use such formulas, 
assumptions, and data as it deems appropriate for purposes of 
calculating additional margin.
    OCC believes that the proposed rule change is consistent with 
Section 17A of the Act \12\ and the rules and regulations thereunder 
because it furthers the public interest by reducing the 
overcollateralization of certain short positions in deep out of the 
money options. In addition, OCC believes that the proposed rule change 
should remove an impediment to market liquidity while still providing 
OCC with appropriate protection to the risks presented by short out of 
the money option positions.
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    \12\ 15 U.S.C. 78q-1.
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B. Self-Regulatory Organization's Statement on Burden on Competition

    OCC does not believe that the proposed rule change would impose any 
burden 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 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 so 
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, N.W., Washington, D.C. 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 Commission's Public Reference Section, 450 Fifth Street, N.W., 
Washington, D.C. 20549. Copies of such filing also will be available 
for inspection and coping at the principal office of OCC. All 
submissions should refer to File No. SR-OCC-98-11 and should be 
submitted by January 12, 1999.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\13\
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    \13\ 17 CFR 200-30(a) (12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-33911 Filed 12-22-98; 8:45 am]
BILLING CODE 8010-01-M