[Federal Register Volume 70, Number 247 (Tuesday, December 27, 2005)]
[Notices]
[Pages 76487-76490]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E5-7841]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-52975; File No. SR-OCC-2004-20]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of a Proposed Rule Change Relating to a New Risk 
Management Methodology

December 19, 2005.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on November 15, 2004, The 
Options Clearing Corporation (``OCC'') filed with the Securities and 
Exchange Commission (``Commission''), and on May 10, 2005, and December 
13, 2005, 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, as amended, from interested persons.
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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 reflect the 
implementation of a new risk management methodology that OCC would use 
to determine the amount of margin assets required to be deposited by a 
clearing member with respect to each 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 such 
statements.\2\
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    \2\ The Commission has modified parts of these statements.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The proposed new risk management methodology, the System for 
Theoretical Analysis and Numerical Simulations, will enhance OCC's 
ability to measure the risk of the portfolios in a clearing member's 
accounts more accurately and therefore, will enable OCC to calculate 
margin requirements more precisely.
1. The Existing Risk Management Methodology: The Theoretical 
Intermarket Margining System
    Currently, OCC applies the Theoretical Intermarket Margining System 
(``TIMS'') for the calculation of clearing members' daily minimum 
margin requirements, for the determination of the size of OCC's 
clearing fund, for the computation of additional margin requirements, 
and for assessing risk in the Hedge Program. TIMS is a univariate risk 
management methodology that evaluates historical data of approximately 
3,000 underlying assets to identify the expected gain or loss on 
positions that would occur at ten price points for equity instruments 
and at twenty price points for non-equity instruments within a range of 
likely price movements of each underlying interest. TIMS requires that 
options, futures, and stock loan and borrow

[[Page 76488]]

positions that have the same underlying interest be categorized into 
classes and that classes be categorized into unique product groups 
consisting of one or more related classes. TIMS calculates the total 
risk of each clearing member account as the sum of the worst scenario 
outcomes of each product group in the account. TIMS recognizes 
offsetting positions within each clearing member account but only to 
the extent that the offsetting positions are in the same product group.
    Although TIMS has consistently produced sufficient base margin 
requirements, this methodology has a number of shortcomings that have 
risk-relevant consequences. Among these are the following:
    a. Because TIMS requires that each class group belong to only one 
product group, any offsetting effects among instruments in different 
product groups are ignored when margin requirements are calculated. 
This inherent lack of methodological flexibility tends to overestimate 
portfolio risk thereby imposing unnecessarily high margin requirements 
on clearing members.
    b. TIMS assumes perfect correlation of price movements for 
underlying interests belonging to the same product group. As a result, 
margin requirements for unhedged product group portfolios are often 
overstated, and margin requirements for hedged product group portfolios 
are often understated.
    c. TIMS calculates the total account risk as the sum of the worst 
scenario outcomes of all product groups. In that sense, TIMS does not 
measure the price risk of the total portfolio; rather it measures the 
price risk of the various subportfolios as represented by product 
groups. Since portfolio risk can never be larger than the sum of the 
portfolio components' risks, but could be smaller to the extent of any 
offsetting relationships, TIMS's aggregation of product group risks 
results in an upwardly biased estimation of a clearing member's 
portfolio risk.
    d. TIMS's aggregation methodology often implies an economically 
impossible correlation (positive or negative) between product groups in 
an account. Suppose, for example, that an account has a (delta) long 
position in the broad-based index group and a (delta) short position in 
the individual equities group. By aggregating the risks in these two 
groups, TIMS implies that a decline in all broad-based indices could 
exist simultaneously with a rise in all individual equities--an 
impossible economic scenario.
    e. In analyzing historical data, TIMS focuses on a range of 
potential price movements. However, covering 99% of all potential price 
movements does not result in coverage of 99% of all profit/loss 
outcomes, which is the desired goal. Using the TIMS method, some 
accounts may have margin requirements covering 98% of profit/loss 
outcomes while others are covered at 99.9%. These small statistical 
differences can have large dollar implications.
2. The New Risk Management Methodology: The System for Theoretical 
Analysis and Numerical Simulations
    The System for Theoretical Analysis and Numerical Simulations 
(``STANS'') preserves TIMS's analysis of the historical price movements 
of underlying assets and of the correlation of such price movements 
among underlying assets. However, STANS evaluates price risk on a 
portfolio level and more accurately evaluates the correspondence of 
price movements among underlying assets and therefore, is able to 
calculate margin requirements more accurately than TIMS.
    STANS is a multivariate risk management methodology that considers 
the range of likely price movements for each of the approximately 8,000 
assets underlying OCC options. STANS measures the historical 
correlations among the price movements of the different assets. STANS 
generates simulated returns for all underlying assets based on this 
historical data, measures the historical price volatility of each of 
these underlying assets, and evaluates the relationship structure of 
the entire portfolio. STANS reduces the imprecision produced by TIMS in 
the following ways:
    a. Because STANS does not use TIMS's product group concept, STANS 
recognizes the relationship of each asset class to all other asset 
classes rather than recognizing only the relationships among asset 
classes in the same product group. Therefore, STANS will more 
accurately identify offsetting positions, and margin requirements will 
be adjusted downward accordingly.
    b. STANS identifies a more realistic correlative relationship among 
underlying assets than TIMS. STANS does not exclude opposite moves for 
positively correlated assets. In contrast, price scenarios within the 
TIMS methodology are all concordant.
    c. Because STANS eliminates product groups, it is able to evaluate 
the interrelationships among all instruments in a clearing member's 
portfolio rather than only within a product group. STANS's estimates of 
portfolio risk are neither upwardly nor downwardly biased.
    d. STANS generates a distribution of 10,000 potential profit/loss 
outcomes for the entire portfolio rather than simply a range of 
potential price movements. As a result, margin requirements are more 
precise for every account, and therefore, STANS ensures that all 
accounts will have coverage for predicted liquidation outcomes at the 
selected confidence levels.
    These characteristics will improve the accuracy of margin 
calculations and as a result, will improve the financial stability of 
OCC and the derivatives markets. In addition, STANS allows for easy 
integration of various types of non-equity products, such as fixed-
income related products and commodities. The implementation of STANS 
thus facilitates joint risk assessment initiatives that can produce 
clearing and settlement efficiencies beneficial to investors.
    To reflect the implementation of STANS in OCC's By-Laws and Rules, 
OCC proposes to replace most of Rule 601 and to eliminate Rule 602. 
Proposed new Rule 601 is conceptual rather than attempting a 
mechanical, step-wise description of margin requirement calculations. 
It is therefore more concise than the existing Rule 601. OCC presently 
calculates margin requirements for equity and non-equity products 
separately with Rule 601 being applicable to equities and Rule 602 
being applicable to non-equitities. STANS will calculate margin on 
equity and non-equity products in one integrated set of calculations. 
Thus, the calculation of margin requirements for all products will be 
as set forth in new Rule 601. OCC proposes to delete cross-references 
to Rule 602 as appropriate throughout the Rules.
    Proposed Rule 601(c) contains a basic conceptual description of 
how, pursuant to STANS, OCC would determine the amount of margin assets 
a clearing member is required to deposit with OCC. Proposed Rule 601(c) 
uses the concepts of ``margin requirement,'' ``margin assets,'' 
``marking prices'' and ``minimum expected liquidating value'' to aid in 
the description of STANS and margin requirement calculations. 
Definitions of each of these terms have been included in the proposed 
amendments to Article I of the By-Laws or Rule 601 as appropriate. OCC 
proposes to delete terms that are defined in the existing Rule 601(b) 
that are relevant to TIMS and not relevant to STANS. For example, the 
terms ``premium margin'' and ``risk margin'' are no longer used. The 
``margin requirement'' as determined using STANS is at least equal to 
the ``minimum expected liquidating value''

[[Page 76489]]

of the account (if such expected value is less than zero). The 
``minimum expected liquidating value'' may be conceptualized as (i) the 
current net asset value of positions in the account (i.e., what used to 
be called ``premium margin'') plus (ii) an additional amount sufficient 
to cover the impact of the largest expected adverse market movement 
(i.e., what used to be called ``risk margin''). Because STANS does not 
actually derive the minimum expected liquidating value in this additive 
way and because STANS is designed to project expected values for margin 
assets whose prices are not referred to as ``premiums,'' the old 
terminology was deemed inappropriate.
    The proposed definition of ``marking price'' is quite flexible and 
allows OCC to use its discretion in determining marking prices and to 
use different marking prices for the same asset or liability depending 
upon the purpose for which a marking price is needed. An example of 
where the latter situation may occur is in the case of stock loan and 
borrow positions. Marking prices in the stock lending market are 
determined by the conventions of that market, and OCC would generally 
observe the prices used in that market for purposes of determining the 
daily marks passed through OCC between the lender and the borrower. OCC 
might, however, have a different view of the correct marking price to 
use for purposes of calculating the risk of those positions in STANS.
    The purpose of proposed Rule 601(e), ``Exclusions from Margin 
Requirement Calculation,'' is to identify in one place those positions 
that are excluded from margin requirement calculations altogether. 
Existing Rule 601(e) indicates that exercised or expired positions in 
cleared contracts or stock loan and borrow positions are excluded from 
margin requirement calculations. Rule 601(a) indicates that short 
positions in option contracts or BOUNDs for which a deposit in lieu of 
margin has been made are excluded from margin requirement calculations. 
Rule 614 indicates that long positions in cleared securities that have 
been pledged to a pledgee are excluded from margin requirement 
calculations. By definition, margin-ineligible stock loan positions and 
stock borrow positions are excluded from margin requirement 
calculations. Consolidating these provisions in one place facilitates 
understanding.
    The release of margin assets to clearing members as described in 
existing Rule 601(e) has been revised to be clearer and more concise 
and is now covered in Rule 601(f). The existing rule contains a 
somewhat artificial description of margin assets being released under a 
position-specific determination. Consistent with the more integrated 
approach of the STANS methodology, proposed Rule 601(f) simply states 
that OCC will permit the release of margin with respect to a clearing 
member's account if the amount of margin assets in a clearing member's 
account exceeds the amount of margin assets required to be in the 
account pursuant to Rule 601 and if any other obligations of the 
clearing member to OCC have been satisfied.
    Existing Rule 2111(b) and Rule 2409(b) envision that a provisional 
margin requirement will be calculated with respect to cross-rate 
foreign currency options and FX Index Options. The provisional margin 
requirement was intended to ensure that OCC would not release premiums 
due to an account of a clearing member in a non-U.S. time zone at a 
time when it was holding insufficient margin to cover a premium debit 
in a later time zone and/or increased margin requirements resulting 
from activity in cross-rate and foreign currency index options since 
the last U.S. Dollar settlement. OCC proposes to eliminate this 
provisional margin requirement and will instead simply hold any amounts 
otherwise payable to a clearing member in a different time zone until 
after the next regular settlement time in the U.S. Experience has shown 
that clearing members often instruct OCC to credit any cash from these 
early settlements to their OCC accounts instead of releasing it, and 
the amounts involved do not justify the costs of administering the more 
cumbersome procedure of calculating provisional margin requirements.
    Since June 2003, OCC has been providing information to 
representatives of the Office of Prudential Supervision and Risk 
Analysis of the Division of Market Regulation (``Division'') on the 
statistical and operational features of the STANS methodology. To 
become comfortable with the STANS methodology, the Division requested 
that OCC produce various graphs, simulations, and spreadsheets 
evidencing STANS's ability to calculate margin requirements more 
accurately than TIMS. OCC believes that it has responded to all of the 
Division's inquiries to date and has provided sufficient information 
for the Division to reach a high degree of comfort with the STANS 
methodology. The staff of OCC remains available to address any further 
questions that the Division staff may have.
    OCC expects that the amount of margin it will collect under STANS 
will be significantly less than the amount of margin it currently 
collects under TIMS. This is largely due to the fact that STANS more 
accurately identifies offsetting positions than TIMS. There would also 
be a corresponding reduction in the amount of clearing fund collected 
by OCC under STANS because under Chapter X, ``Clearing Fund 
Contributions,'' clearing fund is calculated as a percentage of margin. 
The Division requested that OCC amend its rules to increase the 
percentage used to calculate the clearing fund because the Division 
believes that for the time being the clearing fund contribution should 
not be significantly reduced. As a result, OCC filed an amendment to 
the proposed rule change to amend Chapter X, Rule 1001, ``Amount of 
Contribution,'' to increase the minimum percentage in the clearing fund 
calculation from 5 percent to 6 percent of average aggregate margin.
    OCC believes that the proposed rule change is consistent with the 
purposes and requirements of Section 17A of the Act because it is 
designed to assure the safeguarding of securities and funds which are 
in the custody or control of OCC, to reduce unnecessary costs to 
investors by facilitating more accurate margin calculations, and in 
general, to protect investors and the public interest. In addition, the 
proposed rule change is not inconsistent with OCC's existing rules, 
including any other rules currently proposed to be amended.

(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 the proposed rule change or

[[Page 76490]]

    (b) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

VI. 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. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml) or
     Send an e-mail to [email protected]. Please include 
File Number SR-OCC-2004-20 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-9303.

All submissions should refer to File Number SR-OCC-2004-20. This file 
number should be included on the subject line if e-mail is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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, 100 F Street, 
NE., Washington, DC 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of OCC and on OCC's 
Web site at http://www.optionsclearing.com.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-OCC-2004-20 
and should be submitted on or before January 17, 2006.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\3\
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    \3\ 17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
 [FR Doc. E5-7841 Filed 12-23-05; 8:45 am]
BILLING CODE 8010-01-P