[Federal Register Volume 83, Number 247 (Thursday, December 27, 2018)]
[Notices]
[Pages 66791-66794]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-28008]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-84838; File No. SR-OCC-2018-804]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of No Objection to Advance Notice, as Modified by Partial 
Amendment No. 1, Related to The Options Clearing Corporation's Margin 
Methodology for Incorporating Variations in Implied Volatility

December 19, 2018.

I. Introduction

    On October 22, 2018, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
advance notice SR-OCC-2018-804 (``Advance Notice'') pursuant to Section 
806(e)(1) of Title VIII of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act, entitled Payment, Clearing and Settlement 
Supervision Act of 2010 (``Clearing Supervision Act'') \1\ and Rule 
19b-4(n)(1)(i) \2\ under the Securities Exchange Act of 1934 
(``Exchange Act'') \3\ to propose changes to OCC's model for 
incorporating variations in implied volatility within OCC's margin 
methodology, the System for Theoretical Analysis and Numerical 
Simulations.\4\
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ 15 U.S.C. 78a et seq.
    \4\ See Notice of Filing infra note 6, at 83 FR 60541.
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    On October 30, 2018, OCC filed a partial amendment (``Partial 
Amendment No. 1'') to modify the Advance Notice.\5\ The Advance Notice, 
as modified by Partial Amendment No. 1, was published for public 
comment in the Federal Register on November 26, 2018,\6\ and the 
Commission received no comments regarding the proposal contained in the 
Advance Notice.\7\ This publication serves as notice of no objection to 
the Advance Notice.
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    \5\ In Partial Amendment No. 1, OCC corrected an error in 
Exhibit 5 without changing the substance of the Advance Notice. 
References to the Advance Notice from this point forward refer to 
the Advance Notice, as amended by Partial Amendment No. 1.
    \6\ Securities Exchange Act Release No. 84626 (November 19, 
2018), 83 FR 60541 (November 26, 2018) (SR-OCC-2018-804) (``Notice 
of Filing''). On October 22, 2018, OCC also filed a related proposed 
rule change (SR-OCC-2018-014) with the Commission pursuant to 
Section 19(b)(1) of the Exchange Act and Rule 19b-4 thereunder, 
seeking approval of changes to its rules necessary to implement the 
Advance Notice (``Proposed Rule Change''). 15 U.S.C. 78s(b)(1) and 
17 CFR 240.19b-4, respectively. The Proposed Rule Change was 
published in the Federal Register on November 8, 2018. Securities 
Exchange Act Release No. 84524 (Nov. 2, 2018), 83 FR 55918 (Nov. 8, 
2018) (SR-OCC-2018-014).
    \7\ Since the proposal contained in the Advance Notice was also 
filed as a proposed rule change, all public comments received on the 
proposal are considered regardless of whether the comments are 
submitted on the proposed rule change or the Advance Notice.
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II. Background

    The System for Theoretical Analysis and Numerical Simulations 
(``STANS'') is OCC's methodology for calculating margin. STANS includes 
econometric models that incorporate a number of risk factors. OCC 
defines a risk factor in STANS as a product or attribute whose 
historical data is used to estimate and simulate the risk for an 
associated product. The majority of risk factors utilized in STANS are 
the returns on individual equity securities; however, a number of other 
risk factors may be considered, including, among other things, returns 
on implied volatility risk factors.\8\
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    \8\ In December 2015, the Commission approved a proposed rule 
change and issued a Notice of No Objection to an advance notice 
filing by OCC to its modify margin methodology by more broadly 
incorporating variations in implied volatility within STANS. See 
Securities Exchange Act Release No. 76781 (December 28, 2015), 81 FR 
135 (January 4, 2016) (SR-OCC-2015-016) and Securities Exchange Act 
Release No. 76548 (December 3, 2015), 80 FR 76602 (December 9, 2015) 
(SR-OCC-2015-804).

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    As a general matter, the implied volatility of an option is a 
measure of the expected future volatility of the option's underlying 
security at expiration, which is reflected in the price of the 
option.\9\ Changes in implied volatility, therefore, result in changes 
to an option's value. In effect, the implied volatility is responsible 
for that portion of the premium that cannot be attributed to the then-
current intrinsic value of the option (i.e., the difference between the 
price of the underlying and the exercise price of the option), 
discounted to reflect its time value.
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    \9\ Using the Black-Scholes options pricing model, the implied 
volatility is the standard deviation of the underlying asset price 
necessary to arrive at the market price of an option of a given 
strike, time to maturity, underlying asset price and the current 
risk-free rate.
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    STANS includes a model that simulates variations in implied 
volatility for most of the option contracts that OCC clears (``Implied 
Volatility Model'').\10\ The purpose of OCC's Implied Volatility Model 
is to ensure that the anticipated cost of liquidating options positions 
in an account recognizes the possibility that implied volatility could 
change during the two-business day liquidation time horizon and lead to 
corresponding changes in the market prices of the options. OCC, in 
turn, uses such anticipated costs to determine and collect the amount 
of margin necessary to collateralize the exposure that OCC could face 
in the event of a Clearing Member default.
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    \10\ OCC's Implied Volatility Model excludes: (i) Binary 
options, (ii) options on commodity futures, (iii) options on U.S. 
Treasury securities, and (iv) Asians and Cliquets. These products 
were relatively new products at the time that OCC completed its last 
implied volatility margin methodology changes, and OCC had de 
minimus open interest in those options. OCC uses its Implied 
Volatility Model specifically for options that have a residual tenor 
of less than three years (``Shorter Tenor Options'').
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    One component of the Implied Volatility Model is a forecast of the 
volatility of implied volatility. In the process of performing 
backtesting and impact analyses as well as comparing the Implied 
Volatility Model to industry benchmarks, OCC determined that its 
process for forecasting the volatility of implied volatility is 
extremely sensitive to sudden spikes in volatility, which can at times 
result in over-reactive margin requirements that OCC believes are 
unreasonable and procyclical.\11\ For example, on February 5, 2018, the 
Cboe Volatility Index (``VIX'') experienced a large amount of 
volatility.\12\ Based on its review and understanding of OCC's 
analysis, the Commission understands that OCC's Implied Volatility 
Model forecasted an extreme increase in the volatility of implied 
volatility in response to the increase in the VIX on February 5, 
2018.\13\ Specifically, the Implied Volatility Model forecasted a 
volatility of implied volatility for an at-the-money, one-month tenor 
SPX position that was approximately 4 times larger than the comparable 
market index.\14\ This forecast caused aggregate margin requirements at 
OCC to jump more than 80 percent overnight due to the Implied 
Volatility Model, and margin requirements for certain individual 
Clearing Members increased by a factor of 10.\15\ Due in large part to 
the over-reaction of the Implied Volatility Model's to the rise in the 
VIX, a future shock to the VIX during a time of market stress could 
result in an increase in margin requirements that likely would impose 
additional stresses on Clearing Members.
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    \11\ See Notice of Filing, 83 FR at 60542.
    \12\ The VIX is a measure of the implied volatility of the of 
Standard & Poor's 500 index (``SPX'').
    \13\ See Notice of Filing, 83 FR at 60542.
    \14\ See Notice of Filing, 83 FR at 60542.
    \15\ See Notice of Filing, 83 FR at 60542. For example, the 
total margin requirements for one Clearing Member would have 
increased from $120 million on February 2, 2018 to $1.78 billion on 
February 5, 2018. See Notice of Filing, 83 FR at 60542, n. 22.
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    The Advance Notice proposes to modify OCC's Implied Volatility 
Model by introducing an exponentially weighted moving average \16\ for 
the daily forecasted volatility of implied volatility risk factors. 
Specifically, when forecasting the volatility for each implied 
volatility risk factor, OCC would use an exponentially weighted moving 
average of forecasted volatilities over a specified look-back period 
rather than using unweighted daily forecasted volatilities. The 
proposal would change the Implied Volatility Model's sensitivity to 
large, sudden shocks in market volatility when forecasting the 
volatility of implied volatility. Specifically, the proposal would 
result in a more measured initial response to such shocks while 
producing margin requirements that may remain elevated for a longer 
period of time following a market shock. Based on its analysis of data 
provided by OCC, the Commission understands that the margin 
requirements calculated with the current and proposed models would be 
very similar during less volatile periods, and that the likelihood that 
OCC would have sufficient margin to cover its exposures under normal 
market conditions would not decrease under the proposed model.\17\ 
However, the proposed model would present a more commensurate response 
to the extreme volatility increases in the market.
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    \16\ An exponentially weighted moving average is a statistical 
method that averages data in a way that gives more weight to the 
most recent observations.
    \17\ OCC's backtesting, which the Commission has reviewed and 
analyzed, demonstrated that coverage levels using the proposed model 
were substantially similar to the results obtained from the current 
model. See Notice, 83 FR at 60542.
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III. Discussion and Commission Findings

    Although the Clearing Supervision Act does not specify a standard 
of review for an advance notice, the stated purpose of the Clearing 
Supervision Act is instructive: To mitigate systemic risk in the 
financial system and promote financial stability by, among other 
things, promoting uniform risk management standards for systemically 
important financial market utilities (``SIFMUs'') and strengthening the 
liquidity of SIFMUs.\18\
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    \18\ See 12 U.S.C. 5461(b).
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    Section 805(a)(2) of the Clearing Supervision Act \19\ authorizes 
the Commission to prescribe regulations containing risk-management 
standards for the payment, clearing, and settlement activities of 
designated clearing entities engaged in designated activities for which 
the Commission is the supervisory agency. Section 805(b) of the 
Clearing Supervision Act \20\ provides the following objectives and 
principles for the Commission's risk-management standards prescribed 
under Section 805(a):
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    \19\ 12 U.S.C. 5464(a)(2).
    \20\ 12 U.S.C. 5464(b).
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     To promote robust risk management;
     to promote safety and soundness;
     to reduce systemic risks; and
     to support the stability of the broader financial system.
    Section 805(c) provides, in addition, that the Commission's risk-
management standards may address such areas as risk-management and 
default policies and procedures, among others areas.\21\
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    \21\ 12 U.S.C. 5464(c).
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    The Commission has adopted risk-management standards under Section 
805(a)(2) of the Clearing Supervision Act and Section 17A of the 
Exchange Act (the ``Clearing Agency Rules'').\22\ The Clearing Agency 
Rules require, among other things, each covered

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clearing agency to establish, implement, maintain, and enforce written 
policies and procedures that are reasonably designed to meet certain 
minimum requirements for its operations and risk-management practices 
on an ongoing basis.\23\ As such, it is appropriate for the Commission 
to review advance notices against the Clearing Agency Rules and the 
objectives and principles of these risk management standards as 
described in Section 805(b) of the Clearing Supervision Act. As 
discussed below, the Commission believes the proposal in the Advance 
Notice is consistent with the objectives and principles described in 
Section 805(b) of the Clearing Supervision Act,\24\ and in the Clearing 
Agency Rules, in particular Rule 17Ad-22(e)(6)(i).\25\
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    \22\ 17 CFR 240.17Ad-22. See Securities Exchange Act Release No. 
68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-08-11). 
See also Securities Exchange Act Release No. 78961 (September 28, 
2016), 81 FR 70786 (October 13, 2016) (S7-03-14) (``Covered Clearing 
Agency Standards''). The Commission established an effective date of 
December 12, 2016, and a compliance date of April 11, 2017, for the 
Covered Clearing Agency Standards. OCC is a ``covered clearing 
agency'' as defined in Rule 17Ad-22(a)(5).
    \23\ 17 CFR 240.17Ad-22.
    \24\ 12 U.S.C. 5464(b).
    \25\ 17 CFR 240.17Ad-22(e)(6)(i).
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A. Consistency With Section 805(b) of the Clearing Supervision Act

    The Commission believes that the proposal contained in the Advance 
Notice is consistent with the stated objectives and principles of 
Section 805(b) of the Clearing Supervision Act. OCC manages its credit 
exposure to Clearing Members, in part, through the collection of 
collateral based on OCC's margin methodology. As noted above, however, 
the imposition of margin requirements resulting from a model that 
overreacts to increases in implied volatility may impose stresses on 
OCC's Clearing Members. Clearing Members, particularly large Clearing 
Members or their affiliates, are active in various markets. A large, 
unexpected margin call at OCC could affect a Clearing Member's ability 
to meet its obligations to other counterparties, including other 
SIMFUs. As a consequence, the imposition of margin requirements 
resulting from a model overreaction could have implications for the 
broader financial system. As discussed below, the Commission believes 
that the changes to OCC's margin methodology proposed in the Advance 
Notice could enhance OCC's management of credit risk while reducing 
potential systemic risk.
    First, the proposal would change the Implied Volatility Model's 
response to sudden, large changes in market volatility. As noted above, 
the margin requirements produced by the current model appear to be 
overly responsive to sudden, large shocks. The proposed change would 
result in a more measured initial response to a sudden, large change in 
market volatility while maintaining elevated margin requirements 
following such a shock. Although the initial reduction in sensitivity 
would result in the collection of less margin than under the current 
model, backtesting results demonstrate that margin requirements 
produced under the proposed model would provide as consistent a level 
of coverage as margin requirements produced under the proposed model. 
In addition, the proposal would result in margin requirements that 
remain elevated for a longer period of time following a market shock, 
which could provide further support for OCC's ability to cover its 
potential future exposure to risk. Therefore, the Commission believes 
that the consistent level of coverage, taken together with the 
potential for extended elevation of margin requirements after a market 
shock, is consistent with the promotion of both robust risk management 
and safety and soundness.
    Second, the proposal could reduce the likelihood that OCC's margin 
requirements impose sudden and excessive stress on Clearing Members 
during times of broader market stress. As described above, the current 
Implied Volatility Model could result in dramatic increases in Clearing 
Member margin requirements in response to a sudden, large shock in 
market volatility. Based on its review of OCC's data comparing margin 
requirements to market data on February 5, 2018, the Commission 
understands that the size of such an increase would not necessarily be 
commensurate with the risk of the Clearing Member's portfolio because, 
as described above, the volatility of implied volatility forecasted by 
the current model on that day was 4 times the size of a comparable 
market index, resulting in margin requirements for some Clearing 
Members that rose by a factor of 10. Imposing a large, unexpected 
increase in margin requirements could impose a large, unexpected stress 
on a Clearing Member during a period of high volatility. The Commission 
believes that reducing the likelihood of unnecessarily large and 
unexpected stresses on Clearing Members could help to lessen the risk 
of Clearing Member defaults. Reducing the risk of Clearing Member 
defaults could also reduce the likelihood of contagion during times of 
market stress because Clearing Members, particularly large Clearing 
Members, tend to be active participants in multiple asset markets. 
Therefore, the Commission believes that the proposed change is 
consistent with the reduction of systemic risk and supporting the 
stability of the broader financial system.
    Accordingly, and for the reasons stated, the Commission believes 
the changes proposed in the Advance Notice are consistent with Section 
805(b) of the Clearing Supervision Act.\26\
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    \26\ 12 U.S.C. 5464(b).
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B. Consistency With Rule 17Ad-22(e)(6) Under the Exchange Act

    Rule 17Ad-22(e)(6)(i) under the Exchange Act requires that a 
covered clearing agency establish, implement, maintain, and enforce 
written policies and procedures reasonably designed to cover, if the 
covered clearing agency provides central counterparty services, its 
credit exposures to its participants by establishing a risk-based 
margin system that, among other things, considers, and produces margin 
levels commensurate with, the risks and particular attributes of each 
relevant product, portfolio, and market.\27\
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    \27\ 17 CFR 240.17Ad-22(e)(6)(i).
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    The proposed change is designed to better align the margin 
requirements produced by OCC's margin methodology with the level of 
risk posed by changes in market volatility. The component of the 
current Implied Volatility Model that forecasts the volatility of 
implied volatility is very sensitive to sudden, large changes in market 
volatility, as evidenced by the model's reaction to the large, sudden 
spike in market volatility observed on February 5, 2018 discussed above 
which produced dramatic increases in Clearing Member margin 
requirements. The proposed change to the Implied Volatility Model would 
reduce the sensitivity of the model to sudden, large changes in market 
volatility, and, as demonstrated by OCC's backtesting, would be 
unlikely to reduce the level of coverage.\28\
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    \28\ See supra note 17.
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    The Commission believes that revising the Implied Volatility Model 
could produce margin requirements that are more precise and better 
reflect the risks and particular attributes of the products cleared by 
OCC. The Commission further believes that such changes could produce 
margin levels that are commensurate with the risks of the products 
being cleared. Accordingly, based on the foregoing, the Commission 
believes that the proposed change to the Implied Volatility Model is 
consistent with Exchange Act Rule 17Ad-22(e)(6)(i).\29\
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    \29\ 17 CFR 240.17Ad-22(e)(6).
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IV. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Clearing Supervision Act, that the Commission DOES NOT OBJECT to the 
Advance Notice (SR-OCC-2018-804) and that

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OCC is AUTHORIZED to implement the proposed change as of the date of 
this notice or the date of an order by the Commission approving 
proposed rule change SR-OCC-2018-014, as modified by Partial Amendment 
No. 1, whichever is later.

    By the Commission.
Brent J. Fields,
Secretary.
[FR Doc. 2018-28008 Filed 12-26-18; 8:45 am]
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