[Federal Register Volume 68, Number 42 (Tuesday, March 4, 2003)]
[Notices]
[Pages 10291-10293]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-4951]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47402; File No. SR-OCC-2002-11]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change To Modify the Stock/Loan Hedge 
Program

February 25, 2003.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on May 21, 2002, The Options 
Clearing Corporation (``OCC'') filed with the Securities and Exchange 
Commission (``Commission'') and on July 16 and September 26, 2002, 
amended 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 on the proposed rule 
change from interested parties.
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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 proposed rule change would modify OCC's Stock/Loan Hedge 
Program (``Hedge Program'') to establish: (i) Heightened financial 
requirements as a condition for clearing members to designate accounts 
as margin-ineligible; (ii) additional eligibility requirements for 
eligible securities; and (iii) limits on the notional value of the 
stock loan/borrow position that a clearing member may maintain in a 
single stock in a margin-ineligible account.

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 these 
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

    The purpose of the proposed rule change is to modify OCC's Hedge 
Program, under which OCC operates a centralized facility for clearing 
stock loan/borrow transactions between OCC clearing members. In order 
to provide enhanced risk management while maintaining the flexibility 
of the current program, OCC proposes to establish: (i) Heightened 
financial requirements as a condition for clearing members to designate 
accounts as margin-ineligible; (ii) additional eligibility requirements 
for eligible securities; and (iii) limits on the notional value of the 
stock loan/borrow position that a clearing member may maintain in a 
single stock in a margin-ineligible account.
    OCC's Hedge Program is intended to facilitate stock lending 
transactions among OCC's clearing members. Clearing members effecting 
stock loan/borrow transactions through the Hedge Program obtain the 
advantages of centralized clearing of those transactions as well as 
reduced credit risk through the substitution of OCC as the counterparty 
in all transactions. Unless a clearing member has designated an account 
as margin-ineligible for purposes of the Hedge Program, stock loan and 
borrow positions are margined by OCC's TIMS \3\ margin system using the 
same basic risk assessment procedures that are used for positions in 
options or futures. For many clearing members, this results in an 
important advantage of the Hedge Program. By taking into consideration 
the reduction in risk where stock loan/borrow positions are on the 
opposite side of the market from option positions on the same 
underlying stock, the margin system will calculate a reduced margin 
requirement for the account containing the offsetting positions.\4\
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    \3\ The Theoretical Intermarket Margin System, known as TIMS, 
uses advanced portfolio theory to recognize economically and 
statistically reasonable hedges among various positions and to 
correctly assess the dollar risk of those positions.
    \4\ While similar offsets may exist between positions in index 
options, on the one hand, and a group of stock loan/borrow positions 
that are identified as baskets comprised of constituent securities 
in the index, the stock borrow basket/stock loan basket feature of 
the Hedge Program, although provided for in the OCC By-Laws and 
Rules, has not been placed into operation for systems reasons. OCC 
is proposing in this filing to add an interpretation following 
Section 2 of Article XXI of the By-Laws stating that OCC will 
provide notice to its clearing members when this feature becomes 
operative.

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[[Page 10292]]

    For other clearing members, however, the margin offset or hedging 
aspect of the Hedge Program is of little or no benefit. For these 
clearing members, the nature of their business or the organization of 
their business within the firm is such that they rarely if ever have 
stock loan/borrow transactions that provide any significant offset 
against their options positions. These firms may nevertheless desire to 
use the Hedge Program because of its other benefits. The participation 
of these clearing members, which tend to be the larger clearing 
members, is desirable from OCC's perspective because they contribute 
liquidity to the program and facilitate inclusion in the program of the 
hedging activity of some of OCC's less well-capitalized clearing 
members. It reduces OCC's risk when a market maker clearing firm, for 
example, carries stock loan/borrow positions in the same OCC account as 
the positions that the loan/borrow positions hedge.\5\ However, in 
order to do that, the clearing firm must find a stock loan counterparty 
that is willing to submit the transaction to OCC for clearance. If the 
counterparty is not itself entering into the transaction for hedging 
purposes, it may be willing to clear the transaction through OCC only 
if it can do so on a margin-ineligible basis to avoid additional cost.
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    \5\ As an economic matter, option and security futures positions 
are hedged not by a clearing member's stock loan or borrow 
positions, but by its related long or short positions in the 
underlying stock. However, it is the stock loan/borrow positions 
that generate cash mark-to-market payments when the market moves 
against the member's options or futures positions. When the loan/
borrow positions are carried in the Hedge Program, OCC is able to 
capture those payments. This is what enables OCC to reduce its 
margin requirements for the account in which the positions are 
carried.
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    For those clearing members whose stock loan/borrow positions are 
not ordinarily offset by options positions, clearing stock loan/borrow 
activity through the Hedge Program increases rather than reduces their 
risk margin requirement at OCC. In the stock loan market, collateral 
(usually equal to 100% or 102% of the value of the loaned stock) is 
provided by the borrower to the lender to secure the lender's 
obligation to return the stock. Daily mark-to-market payments between 
the borrower and lender maintain the collateral at that level. The same 
is true when stock loan activity is cleared through the Hedge Program. 
However, in addition to the collateral that is passed by OCC between 
the borrowing and lending clearing members, OCC's TIMS system also 
assesses both the borrower and the lender an amount of risk margin 
equal to one day's anticipated maximum market movement in order to 
protect OCC against a default by the borrower or the lender in its 
mark-to-market obligations. Because this risk margin is collected only 
for stock loan transactions that are submitted to OCC, clearing these 
transactions through OCC imposes additional costs on some clearing 
members.
    In order to address this issue, the Hedge Program permits clearing 
members to elect to carry stock loan and borrow transactions on a 
margin-ineligible basis. If a clearing member designates an account as 
margin-ineligible, OCC will exclude any stock loan or borrow positions 
in that account when calculating the regular margin requirement for the 
account. OCC, however, relies on other elements of its protection 
systems \6\ to assess its potential exposure with respect to positions 
carried in a margin-ineligible account. Margin will be required for 
positions carried in a margin-ineligible account if predefined 
concentration monitoring parameters are exceeded.
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    \6\ OCC especially relies on its concentration monitoring 
system, known as ConMon, which provides a comparison of the capital 
and net worth of each OCC clearing member to the market risk 
associated with the clearing member's positions. Securities Exchange 
Act Release No. 40083 (June 11, 1998), 63 FR 33424 (June 18, 1998) 
[File No. SR-OCC-98-3].
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    OCC believes that permitting clearing members to carry stock loan 
and borrow positions on a margin-ineligible basis is appropriate, safe, 
and essential to the competitiveness of the Hedge Program. However, in 
recognition of the fact that this alternative does create 
uncollateralized risk for OCC, OCC has conducted a study of credit 
practices in the stock loan market generally and has determined to 
implement certain measures to reduce its risk.
    Although OCC's current risk management practices are consistent 
with industry standards, OCC is nevertheless proposing elevated 
financial standards for clearing members wishing to designate accounts 
as margin-ineligible for purposes of the Hedge Program. Clearing 
members would be required to maintain excess net capital of at least 
$75 million in order to carry margin-ineligible accounts with OCC.\7\ 
OCC believes this requirement is sufficient to ensure strong 
participant credit standing without unduly hindering program 
participation.
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    \7\ Clearing members currently maintaining margin-ineligible 
accounts would be given a one-year grace period in which to conform 
to the minimum excess net capital requirement. If a clearing member 
is not in compliance at the end of that period, OCC would thereafter 
treat all of the clearing member's accounts as margin-eligible.
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    The excess net capital requirement would be supplemented by a 
profitability standard. A clearing member would not be permitted to 
maintain a margin-ineligible account if it has: (i) Losses in one month 
equal to or exceeding 50 percent of its excess net capital; (ii) 
cumulative losses over two consecutive months equal to or exceeding 60 
percent of its excess net capital; or (iii) cumulative losses over 
three consecutive months equal to or exceeding 70 percent of its excess 
net capital. These excess net capital and profitability standards would 
be ongoing tests and would have to be met at all times by a clearing 
member wishing to carry stock loan or borrow positions in any account 
on a margin-ineligible basis. Clearing members falling out of 
compliance with these standards would be precluded from clearing 
opening transactions in a margin-ineligible account while out of 
compliance.
    The rationale for these requirements is that unlike a participant 
in the regular stock loan market, which has the ability to consider the 
impact of new transactions on counterparty credit limits before 
entering into them, OCC becomes a counterparty solely at the discretion 
of the lender and borrower without the ability to approve or disapprove 
individual loans on a credit basis before they are accepted for 
clearance. OCC's excess net capital and profitability standards should 
substitute for a transaction-by-transaction credit review. Using these 
straightforward requirements instead of a credit limit or activity cap 
makes it unnecessary for OCC to reserve the right to reject completed 
transactions in cases where acceptance would put one of the parties 
above its cap.
    As an additional safety measure, OCC is proposing to amend the 
definition of ``Eligible Stock'' to exclude non-option stocks from the 
program subject to limited exceptions.\8\ Loans for non-option stocks 
will be permitted to be maintained (i) if the loan was accepted prior 
to the implementation of the restriction or (ii) if the stock is 
deliverable upon exercise of an

[[Page 10293]]

outstanding option (e.g., where a stock ceases to be an option stock 
but options on that stock remain outstanding or where a non-option 
stock is distributed to holders of an option stock and options on the 
latter are adjusted to require delivery of both stocks). The 
restriction applies only to non-option stocks because OCC does not want 
to limit clearing members' ability to include option hedging 
transactions in their accounts.
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    \8\ As originally filed, the proposed rule change sought to 
amend the definition of ``Eligible Stock'' to require that non-
option stocks that are the subject of program transactions have a 
price per share of at least $10.00 at the time the transaction is 
submitted to clearance. The September 26, 2002, amendment proposes 
to exclude non-option stocks from the program subject to limited 
exceptions in order to more closely align the use of the Hedge 
Program with its primary objective of recognizing the intermarket 
hedges between a participant's stock and options positions.
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    Finally, no lender or borrower would be allowed to maintain a stock 
loan or borrow position in a single issue in a margin-ineligible 
account if the notional value of the position exceeded the clearing 
member's excess net capital. This restriction is intended to address 
concentration risk. Where the positions are carried in a margin-
eligible account, the restriction is deemed unnecessary because OCC 
will hold collateral sufficient to cover the risk.
    OCC believes that the proposed rule change is consistent with the 
requirements of section 17A of the Act \9\ and the rules and 
regulations thereunder applicable to OCC because it will promote the 
prompt and accurate clearance and settlement of securities transactions 
and assure the safeguarding of securities and funds in the custody and 
control of OCC by providing for enhanced risk management while 
maintaining the flexibility of the current Hedge Program.
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    \9\ 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 the self-regulatory organization 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 20549-0609. 
Comments may also be submitted electronically at the following e-mail 
address: [email protected]. All comment letters should refer to 
File No. SR-OCC-2002-11. This file number should be included on the 
subject line if e-mail is used. To help us process and review comments 
more efficiently, comments should be sent in hardcopy or by e-mail but 
not by both methods. 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-2002-11 and should 
be submitted by March 25, 2003.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-4951 Filed 3-3-03; 8:45 am]
BILLING CODE 8010-01-P