[Federal Register Volume 71, Number 36 (Thursday, February 23, 2006)]
[Notices]
[Pages 9403-9405]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-2519]



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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53322; File No. SR-OCC-2004-20]


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

February 15, 2006.

I. Introduction

    On November 15, 2004, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
proposed rule change SR-OCC-2004-20 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 December 27, 2005.\2\ No 
comment letters were received. For the reasons discussed below, the 
Commission is granting approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Securities Exchange Act Release No. 52975 (December 19, 
2005), 70 FR 76487.
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II. Description

    The rule change will allow OCC to implement a new risk management 
methodology to determine the amount of margin assets required to be 
deposited by a clearing member with respect to each account of that 
clearing member. The 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.\3\
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    \3\ OCC will continue to run its TIMS methodology for purposes 
of calculating theoretical gains and losses pursuant to Rule 15c3-1a 
under the Act.
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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 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. The following are examples of these 
shortcomings:
    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. Instead, 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

    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. The following are ways in which STANS reduces the 
imprecision associated with TIMS:
    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

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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. By producing margin requirements that are 
more precise for every account, STANS ensures all accounts will have 
coverage for predicted liquidation outcomes at the selected confidence 
levels.
    These characteristics will improve the accuracy of margin 
calculations which should 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 will revise most of Rule 601 and will eliminate Rule 602. Revised 
Rule 601 is conceptual rather than 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-equities. 
Because STANS will calculate margin on equity and non-equity products 
in one integrated set of calculations, the calculation of margin 
requirements for all products will be as set forth in revised Rule 601. 
OCC proposes to delete cross-references to Rule 602 as appropriate 
throughout the Rules.
    Revised Rule 601(c) contains a basic conceptual description of how 
under STANS OCC will determine the amount of margin assets a clearing 
member is required to deposit with OCC. Revised 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 of margin requirement calculations. 
Definitions of each of these terms have been included in the amendments 
to Article I of the By-Laws or Rule 601 as appropriate.
    OCC will delete terms that were defined in Rule 601(b) that were 
relevant to TIMS but that are not relevant to STANS. For example, the 
terms ``premium margin'' and ``risk margin'' are deleted. The ``margin 
requirement'' as determined using STANS will be at least equal to the 
``minimum expected liquidating value'' 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 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 is not appropriate.
    The 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 revised Rule 601(e), ``Exclusions from Margin 
Requirement Calculation,'' is to identify in one place those positions 
that are excluded from margin requirement calculations altogether. 
Previous Rule 601(e) indicated that exercised or expired positions in 
cleared contracts or stock loan and borrow positions were excluded from 
margin requirement calculations. Rule 601(a) previously indicated that 
short positions in option contracts or BOUNDs for which a deposit in 
lieu of margin has been made were excluded from margin requirement 
calculations. Rule 614 previously indicated that long positions in 
cleared securities that have been pledged to a pledgee were 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 
previous Rule 601(e) has been revised to be clearer and more concise 
and is now covered in Rule 601(f). The previous rule contained a 
somewhat artificial description of margin assets being released under a 
position-specific determination. Consistent with the more integrated 
approach of the STANS methodology, revised 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.
    Previous Rule 2111(b) and Rule 2409(b) envisioned that a 
provisional margin requirement would 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 will 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.
    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. Accordingly, 
there would 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 of Market Regulation (``Division'') requested that OCC 
amend its rules to increase the percentage used to calculate the size 
of the clearing fund because the Division believes that for the time 
being the clearing fund should not be significantly reduced. As a 
result, OCC amended the proposed rule change to amend Chapter X, Rule 
1001, ``Amount of [Clearing

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Fund] Contribution,'' to increase the minimum percentage used in the 
clearing fund calculation from 5 percent to 6 percent of average 
aggregate margin.

III. Discussion

    Section 17A(b)(3)(F) of the Act provides that the rules of a 
clearing agency should be designed to promote the prompt and accurate 
clearance and settlement of securities transactions and to assure the 
safeguarding of securities and funds which are in its custody or 
control or for which it is responsible. OCC's margin methodology 
calculates the current replacement cost and market risk associated with 
a member's positions so that OCC may collect sufficient collateral to 
complete settlement in the event the member becomes insolvent or 
otherwise fails to meet its obligations to OCC. OCC's ability to meet 
its settlement obligations following a member insolvency is an 
important function of its role as a central counterparty.\4\ It is 
therefore necessary that OCC have an effective methodology for 
calculating risk-based margin to promote the prompt and accurate 
clearance and settlement of securities transactions and to assure the 
safeguarding of securities and funds which are in its custody or 
control or for which it is responsible.
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    \4\ The margin methodology under both TIMS and STANS uses short-
term historical returns and return volatilities to calculate the 
market risk associated with a member's positions. As a result, 
margin should provide OCC with sufficient collateral to complete 
settlement under normal market conditions. Very unusual and sudden 
market moves could result in losses to a member's account that are 
in excess of the margin on deposit with OCC. If a member becomes 
insolvent or otherwise fails to meet its obligations to OCC under 
such circumstances, OCC would access the assets in its clearing fund 
to complete settlement of the member's trades.
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    The TIMS methodology has been used by OCC since 1991 \5\ and has 
become recognized as an industry standard for measuring risk in 
portfolios comprised of options, futures, and futures on options. 
However, as discussed above, OCC believes that there are some 
shortcomings to the TIMS methodology and that the more sophisticated 
STANS methodology will better measure the market risk in a member's 
account. One of the main shortcomings of TIMS is that it recognizes 
only a limited diversification benefit for clearing member accounts by 
offsetting positions only within the same product group. Further, these 
offsets are conservative and are not based on a statistical model for 
the joint behavior of asset returns. STANS, on the other hand, 
generates simulated returns for all of the positions in the clearing 
member's account simultaneously. The statistical specification and 
subsequent simulation in STANS, rather than the ad hoc rule in TIMS, 
determines the degree of offset for correlated positions.
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    \5\ Securities Exchange Act Release Nos. 27394 (October 26, 
1989), 54 FR 46175 (November 1, 1989) [File No. SR-OCC-89-12] 
(Notice of filing for the TIMS proposal) and 28928 (March 1, 1991), 
56 FR 9995 (March 8, 1991) (Original order approving the use of TIMS 
to calculate margin on equity options on a temporary basis).
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    Because STANS is designed to allow a greater amount of offset for 
diversification than TIMS, most of OCC's members will be required to 
deposit less margin under STANS than they currently are under TIMS. For 
instance, the 20 largest accounts at OCC would have exhibited 
reductions in margin of over 50 percent as of September 2005. This 
significant reduction reflects the difference between the two 
methodologies in allowance of a diversification benefit in calculating 
the risk-based margin of a member's account. It does not reflect a 
change in the purpose of OCC's margin requirement, which is to provide 
OCC with sufficient collateral in the event a member becomes insolvent 
or otherwise fails to meet its obligations to OCC. OCC will collect 
less margin from its members under STANS because STANS will explicitly 
model a joint distribution of asset returns in order to better measure 
risk at the member portfolio level and not because OCC is changing its 
tolerance for counterparty credit risk.
    OCC has operated STANS in test mode for more than two years and has 
reviewed the methodology and the results of test operations with staff 
of the Commission's Division of Market Regulation (``Division'') during 
that time. Since June 2003, OCC has been providing information on the 
statistical and operational features of the STANS methodology to staff 
of the Office of Prudential Supervision and Risk Analysis of the 
Division. 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. As a result of these reviews, 
the Commission is of the opinion that STANS is consistent with the 
practices of other sophisticated market participants in measuring the 
risk associated with options portfolios.
    Although the Commission is satisfied that STANS has performed in 
test mode as expected thus far, it is requiring OCC to take two 
measures with respect to using the new methodology. First, OCC will 
continue to provide the Division with information regarding the 
performance of STANS. OCC will provide the Division with quarterly 
reports summarizing any instances in which a member's account 
experienced a loss that exceeded the margin requirement calculated by 
STANS and the magnitude of any such losses. Second, OCC has amended its 
clearing fund formula so that the amount of clearing fund, which is a 
percentage of average daily total margin, will not initially decrease 
with the implementation of STANS and the decrease in margin 
requirements. Because the clearing fund serves as a resource in the 
event of insufficient margin deposits, the Commission does not believe 
it is prudent at this time for the size of the clearing fund to 
significantly decrease at the same time margin requirements are 
significantly decreased. Therefore, OCC is increasing its clearing fund 
calculation so that the clearing fund will be 6 percent, instead of 5 
percent, of aggregate daily total margin.
    Accordingly, because the Commission believes the STANS methodology 
is designed to provide OCC with sufficient margin to protect itself in 
the event of a member insolvency or other inability to satisfy its 
obligations to OCC, the Commission finds that OCC's proposed rule 
change implementing STANS and revising its clearing fund calculation is 
designed to promote the prompt and accurate clearance and settlement of 
securities transactions and to assure the safeguarding of securities 
and funds which are in OCC's custody or control or for which it is 
responsible.

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 with the requirements of 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-2004-20) be and hereby 
is approved.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E6-2519 Filed 2-22-06; 8:45 am]
BILLING CODE 8010-01-P