[Federal Register Volume 68, Number 103 (Thursday, May 29, 2003)]
[Notices]
[Pages 32164-32166]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-13450]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-47898; File No. SR-OCC-2002-11]


Self-Regulatory Organizations; the Options Clearing Corporation; 
Order Approving Proposed Rule Changes To Modify the Stock/Loan Hedge 
Program

May 21, 2003.

I. Introduction

    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 proposed rule change SR-OCC-
2002-11 pursuant to section 19(b)(1) of the Securities Exchange Act of 
1934 (``Act'').\1\ Notice of the proposal was published in the Federal 
Register on March 4, 2003.\2\ For the reasons discussed below, the 
Commission is approving the proposed rule changes.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 47402 (February 25, 
2003), 68 FR 10291.
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II. Description

    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 offset may exist between positions in index 
options 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 32165]]

    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 is such that they rarely 
if ever have stock loan/borrow transactions that provide any 
significant offset against their options positions. These clearing 
members 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 the 
hedging activity of some of OCC's less well-capitalized clearing 
members.
    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 \5\ to assess its potential exposure with respect to positions 
carried in a margin-ineligible account.\6\
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    \5\ 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].
    \6\ For example, margin will be required for positions carried 
in a margin-ineligible account if predefined concentration 
monitoring parameters are exceeded.
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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 adopting 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 will 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 will 
be ongoing tests and will 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 will 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 amending 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 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 excludes 
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 will 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 exceeds 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.

[[Page 32166]]

III. Discussion

    Section 17A(b)(3)(F) of the Act requires that the rules of a 
clearing agency be designed to assure the safeguarding of securities 
and funds which are in its custody or control or for which it is 
responsible.\9\ The Commission finds that OCC's proposed rule change is 
consistent with this requirement because the elevated net capital 
requirement, the loss limitation standards, the restriction on non-
option stocks, and the concentration limitation have been designed to 
provide enhanced risk management of OCC risks resulting from clearing 
members carrying stock loan/stock borrow positions in margin-ineligible 
accounts.
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    \9\ 15 U.S.C. 78q-1(b)(3)(F).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
in particular section 17A of the Act and the rules and regulations 
thereunder.
    It is therefore ordered, pursuant to section 19(b)(2) of the Act, 
that the proposed rule change (File No. SR-OCC-2002-11) be and hereby 
is approved.

    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).
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Margaret H. McFarland,
Deputy Secretary. **FOOTNOTES**
[FR Doc. 03-13450 Filed 5-28-03; 8:45 am]
BILLING CODE 8010-01-P