[Federal Register Volume 83, Number 248 (Friday, December 28, 2018)]
[Notices]
[Pages 67392-67394]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-28180]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-84879; File No. SR-OCC-2018-014]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Approving Proposed Rule Change, as Modified by Partial Amendment
No. 1, Related to The Options Clearing Corporation's Margin Methodology
for Incorporating Variations in Implied Volatility
December 20, 2018.
I. Introduction
On October 22, 2018, The Options Clearing Corporation (``OCC'')
filed with the Securities and Exchange Commission (``Commission'') the
proposed rule change SR-OCC-2018-014 (``Proposed Rule Change'')
pursuant to Section 19(b) of the Securities Exchange Act of 1934
(``Exchange Act'') \1\ and Rule 19b-4 \2\ thereunder 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.\3\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Notice of Filing infra note 5, at 83 FR 55918.
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On October 30, 2018, OCC filed a partial amendment (``Partial
Amendment No. 1'') to the Proposed Rule Change.\4\ The Proposed Rule
Change, as modified by Partial Amendment No. 1, was published for
public comment in the Federal Register on November 8, 2018,\5\ and the
Commission received no comments regarding the Proposed Rule Change.
This order approves the Proposed Rule Change.
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\4\ In Partial Amendment No. 1, OCC corrected an error in
Exhibit 5 without changing the substance of the Proposed Rule
Change. References to the Proposed Rule Change from this point
forward refer to the Proposed Rule Change, as amended by Partial
Amendment No. 1.
\5\ Securities Exchange Act Release No. 84524 (Nov. 2, 2018), 83
FR 55918 (Nov. 8, 2018) (SR-OCC-2018-014) (``Notice of Filing'').
OCC also filed a related advance notice (SR-OCC-2018-804) (``Advance
Notice'') with the Commission pursuant to Section 806(e)(1) of Title
VIII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act, entitled the Payment, Clearing, and Settlement Supervision Act
of 2010 and Rule 19b-4(n)(1)(i) under the Act. 12 U.S.C. 5465(e)(1).
15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, respectively. The Advance
Notice was published in the Federal Register on November 26, 2018.
Securities Exchange Act Release No. 84626 (Nov. 19, 2018), 83 FR
60541 (Nov. 26, 2018) (SR-OCC-2018-804).
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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.\6\
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\6\ 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 (Dec. 28, 2015), 81 FR 135
(Jan. 4, 2016) (SR-OCC-2015-016) and Securities Exchange Act Release
No. 76548 (Dec. 3, 2015), 80 FR 76602 (Dec. 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.\7\ 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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\7\ 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'').\8\ The purpose of
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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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\8\ 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.\9\ For example, on February 5, 2018, the
Cboe Volatility Index (``VIX'') experienced a large amount of
volatility.\10\ 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.\11\ 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.\12\ 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.\13\ 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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\9\ See Notice of Filing, 83 FR at 55919.
\10\ The VIX is a measure of the implied volatility of the of
Standard & Poor's 500 index (``SPX'').
\11\ See Notice of Filing, 83 FR at 55919.
\12\ See id.
\13\ See id. 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 55919, n. 22.
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The Proposed Rule Change would modify OCC's Implied Volatility
Model by introducing an exponentially weighted moving average \14\ 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
Proposed Rule Change would change the Implied Volatility Model's
sensitivity to large, sudden shocks in market volatility when
forecasting the volatility of implied volatility. Specifically, the
Proposed Rule Change 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.\15\ However, the proposed model would present a more
commensurate response to the extreme volatility increases in the
market.
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\14\ An exponentially weighted moving average is a statistical
method that averages data in a way that gives more weight to the
most recent observations.
\15\ 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 55920.
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III. Discussion and Commission Findings
Section 19(b)(2)(C) of the Exchange Act directs the Commission to
approve a proposed rule change of a self-regulatory organization if it
finds that such proposed rule change is consistent with the
requirements of the Exchange Act and the rules and regulations
thereunder applicable to such organization.\16\ After carefully
considering the Proposed Rule Change, the Commission finds the proposal
is consistent with the requirements of the Exchange Act and the rules
and regulations thereunder applicable to OCC. More specifically, the
Commission finds that the proposal is consistent with Section
17A(b)(3)(F) of the Exchange Act \17\ and Rule 17Ad-22(e)(6)(i)
thereunder.\18\
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\16\ 15 U.S.C. 78s(b)(2)(C).
\17\ 15 U.S.C. 78q-1(b)(3)(F).
\18\ 17 CFR 240.17Ad-22(e)(6)(i).
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A. Consistency With Section 17A(b)(3)(F) of the Exchange Act
Section 17A(b)(3)(F) of the Exchange Act requires that the rules of
a clearing agency be designed to, among other things, assure the
safeguarding of securities and funds which are in the custody or
control of the clearing agency or for which it is responsible, and, in
general, to protect investors and the public interest.\19\ Based on its
review of the record, the Commission believes that the proposed changes
are designed to assure the safeguarding of securities and funds which
are in OCC's custody or control, and, in general, protect investors and
the public interest for the reasons set forth below.
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\19\ 15 U.S.C. 78q-1(b)(3)(F).
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First, margin deposits at OCC provide collateral to mitigate the
potential default of a Clearing Member. As noted above, OCC uses STANS,
including the Implied Volatility Model, 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. The Proposed Rule
Change 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. Following implementation of the
Proposed Rule Change, OCC's margin methodology would produce a more
measured initial response to a sudden, large change in market
volatility while maintaining elevated margin requirements following
such a shock. As described above, however, the coverage provided by
OCC's margin methodology following implementation of the Proposed Rule
Change would likely be comparable to the coverage provided
currently.\20\ Further, 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.
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\20\ See supra note 15.
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For these reasons, the Commission believes that the Proposed Rule
Change would enhance the Implied Volatility Model by enabling OCC to
determine its margin requirements more precisely and to better reflect
the risks and particular attributes of the products cleared by OCC,
thereby allowing OCC to more effectively cover its credit exposure to
its Clearing Members. By more precisely determining OCC's credit
exposure to its Clearing Members, the Proposed Rule Change is designed
to help ensure that,
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in the event of a Clearing Member default, OCC's operations would not
be disrupted and non-defaulting Clearing Members would not be exposed
to losses that they cannot anticipate or control. In this way, the
Proposed Rule Change is designed to help assure the safeguarding of
securities and funds which are in the custody or control of OCC, or for
which it is responsible, consistent with Section 17A(b)(3)(F) of the
Exchange Act.
Second, the Proposed Rule Change 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 Rule Change provides for rules designed, in general, to
protect investors and the public interest.
Accordingly, and for the reasons stated above, the Commission
believes that the Proposed Rule Change is consistent with Section
17A(b)(3)(F) of the Exchange Act.\21\
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\21\ 15 U.S.C. 78q-1(b)(3)(F).
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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.\22\
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\22\ 17 CFR 240.17Ad-22(e)(6)(i).
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The Proposed Rule 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 Rule 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.\23\
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\23\ See supra note 15.
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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 Rule Change is consistent with Exchange Act
Rule 17Ad-22(e)(6)(i).\24\
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\24\ 17 CFR 240.17Ad-22(e)(6).
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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
Exchange Act, and in particular, the requirements of Section 17A of the
Exchange Act \25\ and the rules and regulations thereunder.
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\25\ In approving this Proposed Rule Change, the Commission has
considered the proposed rules' impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f).
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Exchange Act,\26\ that the Proposed Rule Change (SR-OCC-2018-014) be,
and hereby is, approved.
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\26\ 15 U.S.C. 78s(b)(2).
\27\ 17 CFR 200.30-3(a)(12).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\27\
Brent J. Fields,
Secretary.
[FR Doc. 2018-28180 Filed 12-27-18; 8:45 am]
BILLING CODE 8011-01-P