[Federal Register Volume 84, Number 117 (Tuesday, June 18, 2019)]
[Notices]
[Pages 28368-28371]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-12884]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-86103; File No. SR-OCC-2019-802]
Self-Regulatory Organizations; The Options Clearing Corporation;
Notice of No Objection To Advance Notice Related to the Introduction of
a New Liquidation Cost Model in The Options Clearing Corporation's
Margin Methodology
June 13, 2019.
I. Introduction
On April 18, 2019, The Options Clearing Corporation (``OCC'') filed
with the Securities and Exchange Commission (``Commission'') advance
notice SR-OCC-2019-802 (``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 its margin methodology to
introduce a new model to estimate the liquidation cost for all options
and futures, as well as the securities in margin collateral.\4\ The
Advance Notice was published for public comment in the Federal Register
on May 21, 2019,\5\ and the Commission has received no comments
regarding the proposal contained in the Advance Notice.\6\ This
publication serves as notice of no objection to the Advance Notice.
---------------------------------------------------------------------------
\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 5, at 83 FR 23090.
\5\ Securities Exchange Act Release No. 85863 (May 15, 2019), 83
FR 23090 (May 21, 2019) (SR-OCC-2019-802) (``Notice of Filing''). On
April 18, 2019, OCC also filed a related proposed rule change (SR-
OCC-2019-004) 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 May 6, 2019. Securities Exchange Act Release No.
85755 (Apr. 30, 2019), 84 FR 19815 (May 6, 2019). The comment period
for the related Proposed Rule Change filing closed on May 27, 2019.
\6\ 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.
---------------------------------------------------------------------------
II. Background
The System for Theoretical Analysis and Numerical Simulations
(``STANS'') is OCC's methodology for calculating margin requirements.
OCC uses the STANS methodology to measure the exposure of portfolios of
options and futures cleared by OCC and of cash instruments that are
part of margin collateral. STANS margin requirements are intended to
cover potential losses due to price movements over a two-day risk
horizon; however, the current STANS margin requirements do not cover
the potential additional liquidation costs OCC may incur in closing out
a defaulted Clearing Member's portfolio.\7\ Closing out positions in a
defaulted Clearing Member's portfolio could entail selling longs at the
bid price and covering shorts at the ask price. Additionally, even
well-hedged portfolios consisting of offsetting longs and shorts would
require some cost to liquidate in the event of a default. The process
of modeling liquidation costs is, therefore, relevant to ensuring that
OCC holds sufficient financial resources to close-out the portfolio of
a defaulted Clearing Member.
---------------------------------------------------------------------------
\7\ OCC previously introduced a liquidation cost model into
STANS for risk managing only long-dated options on the Standard &
Poor's (``S&P'') 500 index (``SPX'') that have a tenor of three-
years or more. See Securities Exchange Act Release No. 70719
(October 18, 2013), 78 FR 63548 (October 24, 2013) (SR-OCC-2013-16).
Under the proposal described in the Advance Notice, OCC would
replace the existing liquidation model for long-dated SPX options
with the proposed model. Long-dated SPX options, however,
constituted less than 0.5 percent of open interest in SPX options
open interest at the time of filing. See Notice of Filing, 84 FR at
23091, note 8.
---------------------------------------------------------------------------
OCC is proposing to introduce a new model to its margin methodology
to estimate the liquidation cost for all options and futures, as well
as cash instruments that are part of margin collateral. According to
OCC, the purpose of this proposal is to collect additional financial
resources to guard against potential shortfalls in margin requirements
that may arise due to the costs of liquidating the portfolio of a
defaulted Clearing Member.\8\ The liquidation cost charge would be an
add-on to all accounts incurring a STANS margin charge. At a high
level, the proposed model would estimate the cost to liquidate a
portfolio based on the mid-points of the bid-ask spreads for the
financial instruments within the portfolio, and would scale up such
liquidation costs for large or concentrated positions that would likely
be more expensive to close out.
---------------------------------------------------------------------------
\8\ See Notice of Filing, 84 FR at 23091.
---------------------------------------------------------------------------
OCC's proposed liquidation cost model would calculate liquidation
costs based on risk measures, gross contract volumes, and market bid-
ask spreads. As described in the Advance Notice, the
[[Page 28369]]
liquidation cost model would include the following components: (1)
Calculation of liquidation costs for each sub-portfolio (as described
below), which would then be aggregated at the portfolio level; (2)
calculation of concentration charges that would be applied to scale-up
the liquidation costs as appropriate; and (3) establishment of the
liquidation cost as a floor on a Clearing Member's margin
requirement.\9\
---------------------------------------------------------------------------
\9\ OCC also proposes a conforming change to its Margin Policy,
which would reference OCC's model documentation.
---------------------------------------------------------------------------
A. Liquidation Costs
The proposed model would calculate two risk-based liquidation costs
for a portfolio: (1) The Vega \10\ liquidation cost (``Vega LC''), and
(2) the Delta \11\ liquidation cost (``Delta LC''). Options products
would incur both a Vega LC and a Delta LC, while Delta-one
products,\12\ such as futures contracts, Treasury securities, and
equity securities, would incur only a Delta LC.
---------------------------------------------------------------------------
\10\ The Vega of an option represents the sensitivity of the
option price to the volatility of the underlying security.
\11\ The Delta of an option represents the sensitivity of the
option price to the price of the underlying security.
\12\ A ``Delta-one product'' refers to a product for which a
change in the value of the underlying asset results in a change of
the same, or nearly the same, proportion in the value of the
product.
---------------------------------------------------------------------------
The process of calculating the Vega LC and the Delta LC for each
portfolio would require a series of steps, beginning with the
decomposition of each portfolio into a set of sub-portfolios based on
the asset underlying each instrument in the portfolio. Each sub-
portfolio would represent a class of instruments. As proposed, the
model would include 14 potential classes of underlying assets based on
the liquidity of the assets within each class.\13\
---------------------------------------------------------------------------
\13\ For example, equity securities would be divided based on
membership in commonly used market indices (e.g., the S&P 100) or
other market liquidity measures, into liquidity classes (which could
include, but would not be limited to, High Liquid Equities, Medium
Liquid Equities, and Low Liquid Equities).
---------------------------------------------------------------------------
a. Vega Liquidation Cost
To calculate the Vega LC of a sub-portfolio, OCC would group
contracts within a sub-portfolio into ``buckets'' based on each
contract's combination of tenor and Delta.\14\ OCC would then net the
long and the short positions down to a single net Vega within each
bucket. Next, OCC would estimate the average volatility spread (i.e.,
the estimated bid-ask spread on implied volatility) of the contracts in
each bucket.\15\ The Vega LC of each bucket would be the net Vega
multiplied by the average volatility spread of the bucket. The Vega LC
of a sub-portfolio would be the aggregated Vega LCs of the buckets
within that sub-portfolio. Similarly, the Vega LC of the full portfolio
would be the aggregated Vega LCs of the sub-portfolios within that
portfolio.\16\
---------------------------------------------------------------------------
\14\ For example, those options contracts with a tenor of 1
month and a Delta between 0.25 and 0.75 could be grouped in one
bucket within a sub-portfolio, while option contracts with a tenor
of 3 month and a Delta between 0.25 and 0.75 would be grouped in
another bucket. The proposed model would provide for 25 buckets
(based on combinations of tenor and Delta) for each sub-portfolio.
\15\ Rather than recalibrate the volatility spread of each
bucket as current market conditions change, the estimated volatility
spread of each bucket within a sub-portfolio would be calibrated
based on data from historical periods of market stress.
\16\ The process for aggregating Vega LCs, of both sub-
portfolios and portfolios, under the proposed model is based on the
correlations of either the bucket or the sub-portfolio being
aggregated. To simplify the portfolio-level aggregation, the
proposed model would use a single correlation value across all sub-
portfolios in a given portfolio rather than a correlation matrix. To
account for potential errors that could arise out of such a
simplification, the proposed model would require the calculation of
three portfolio-level Vega LCs based on the three different
correlation values (i.e., minimum, maximum, and average). The
portfolio Vega LC would be the highest of the three Vega LCs
calculated in this manner.
---------------------------------------------------------------------------
Under the proposed model, the Vega LC calculation process could
result in a portfolio-level Vega LC of zero because the process permits
offsets between contracts. To prevent such a result, OCC proposes
including a minimum Vega LC based on the number of contracts in each
sub-portfolio. The minimum Vega LC of a sub-portfolio would be the
total number of option contracts in the sub-portfolio multiplied by a
fixed dollar amount.\17\
---------------------------------------------------------------------------
\17\ Specifically, the minimum cost rate would initially be set
as two dollars per contract, unless the position is long and the net
asset value per contract is less than $2.00. (For a typical option
with a contract size of 100, this would occur if the option was
priced below $0.02.)
---------------------------------------------------------------------------
b. Delta Liquidation Cost
Similar to the Vega LC process, the model would calculate Delta LC
for each sub-portfolio, which would then be aggregated at the portfolio
level. OCC would first identify and net down the Delta of the positions
within each sub-portfolio. For each sub-portfolio, OCC would estimate a
bid-ask price spread (as a percentage). Such a percentage would
represent the cost of liquidating one dollar unit of the underlying
security during a period of market stress. The sub-portfolio Delta LC
would be the net dollar Delta of the sub-portfolio multiplied by the
bid-ask price spread percentage.\18\ The portfolio-level Delta LC would
be the simple sum of the sub-portfolio Delta LCs.
---------------------------------------------------------------------------
\18\ As described in the Notice of Filing, the process for
determining the Delta LC of a sub-portfolio of U.S. dollar Treasury
bonds would be different. Specifically, it would be based on the sum
of Delta LCs across six tenor buckets. See Notice of Filing, 84 FR
at 23093.
---------------------------------------------------------------------------
B. Concentration Charges
The proposed model would also address the potential risks involved
in closing out large or concentrated positions in a portfolio. The size
of an open position is typically measured against the relevant
instrument's average daily trading volume (``ADV''). Closing out a
position in excess of the ADV would be expected to increase the cost of
liquidation. To account for such considerations, the proposed model
incorporates a Vega concentration factor and a Delta concentration
factor. The concentration factors would be used to scale the Vega LCs
and the Delta LCs of each sub-portfolio and to take into account the
additional risk posed by large or concentrated positions. The
concentration factor could increase, but would not decrease the Vega
LCs and the Delta LCs.
C. Margin Floor
As noted above, the liquidation cost charge (i.e., sum of the
portfolio-level Vega LC and Delta LC) would be applied as an add-on to
the STANS margin requirement for each account. Because STANS margin
requirements are intended to cover potential losses due to price
movements over a two-day risk horizon, the STANS requirement for well-
hedged portfolios may be positive, which could result in a margin
credit instead of a charge.
To account for the risk of potentially liquidating a portfolio at
current (instead of two-day ahead) prices, OCC proposes to design the
model such that it would not permit a margin credit to offset a
portfolio's liquidation cost. Under the proposal, therefore, the final
margin requirement for a portfolio could not be lower than its
liquidation cost charge.
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.\19\
---------------------------------------------------------------------------
\19\ See 12 U.S.C. 5461(b).
---------------------------------------------------------------------------
[[Page 28370]]
Section 805(a)(2) of the Clearing Supervision Act \20\ 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 \21\ provides the following objectives and
principles for the Commission's risk-management standards prescribed
under Section 805(a):
---------------------------------------------------------------------------
\20\ 12 U.S.C. 5464(a)(2).
\21\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------
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.\22\
---------------------------------------------------------------------------
\22\ 12 U.S.C. 5464(c).
---------------------------------------------------------------------------
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'').\23\ The Clearing Agency
Rules require, among other things, each covered 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.\24\ 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,\25\ and in the Clearing
Agency Rules, in particular Rule 17Ad-22(e)(6)(i).\26\
---------------------------------------------------------------------------
\23\ 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).
\24\ 17 CFR 240.17Ad-22.
\25\ 12 U.S.C. 5464(b).
\26\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------
A. Consistency With Section 805(b) of the Clearing Supervision Act
The Commission believes that the Advance Notice is consistent with
the stated objectives and principles of Section 805(b) of the Clearing
Supervision Act. First, the Commission believes that adoption of the
proposed liquidation cost model would be consistent with the promotion
of robust risk management at OCC in several ways. In closing out a
defaulted Clearing Member's portfolio, OCC would likely incur costs
associated with the liquidation process. OCC's current margin
methodology calculates margin requirements designed to cover potential
losses due to price movements over a two-day risk horizon. It is not
designed, however, to account for liquidation costs that OCC could
incur in the process of closing out a defaulted Clearing Member's
portfolio. As described above, OCC proposes to adopt a model designed
to estimate the margin necessary to cover liquidation costs that OCC
could incur when closing out a defaulted Clearing Member's portfolio.
Adopting a model that allows for measurement of a risk not captured
elsewhere in OCC's margin methodology would provide for more
comprehensive management of OCC's risks in managing a Clearing Member
default.
Moreover, the Commission believes that the inclusion of
concentration charges in the proposed liquidation cost model would also
be consistent with the promotion of robust risk management at OCC. The
cost of liquidating a defaulted Clearing Member's portfolio is, in
part, a function of market prices and market depth present at the time
of the Clearing Member's default. The process of liquidating on a
compressed timeframe a large or concentrated position during such a
period could negatively affect such market prices for OCC. In
recognition of such costs, OCC proposes to use concentration factors to
scale up both the Vega LCs and Delta LCs based on the size of a
defaulted Clearing Member's positions relative to the average daily
volume of the financial instruments in the defaulted Clearing Member's
portfolio. Including concentration charges in OCC's proposed
liquidation cost model would be consistent with the promotion of robust
risk management by acknowledging and attempting to address issues of
market depth in the model.
In addition, the Commission believes that the use of the proposed
liquidation cost model to create a margin floor would be consistent
with promoting robust risk management at OCC. OCC's margin methodology
may produce a credit for well-hedged portfolios because it is focused
on the potential losses resulting from price movements over a two-day
risk horizon. OCC could, however, incur costs in the process of closing
out a defaulted Clearing Member's portfolio at current prices, rather
than prices two days into the future. OCC's proposal acknowledges this
potential gap by requiring that a Clearing Member post, at a minimum,
margin to cover the liquidation cost of its portfolio. Adopting rules
designed to cover costs that OCC may incur in closing out a defaulted
Clearing Member's portfolio at current prices, in addition to potential
future losses, would be consistent with the promotion of robust risk
management at OCC by increasing the likelihood that OCC would have
sufficient financial resources to manage the default of a Clearing
Member.
Second, the Commission believes that enhancing OCC's ability to
manage the default of a Clearing Member through the calculation of
liquidation costs and the use of concentration charges to take into
account the additional risk posed by large or concentrated positions to
OCC would be consistent with the promotion of safety and soundness. The
OCC would apply concentration charges to increase the Vega LCs and
Delta LCs relative to the size and concentration of positions within a
Clearing Member's portfolio. The Commission believes that setting the
proposed model as a margin floor would also be consistent with the
promotion of safety and soundness. The amendments to the margin model
proposed in the Advance Notice should provide OCC with additional
resources on which it could rely to manage the potential credit losses
arising out of the default of a Clearing Member. By increasing its
available financial resources, OCC would decrease the likelihood that a
default would exceed OCC's resources and threaten the safety and
soundness of OCC's ongoing operations.
Finally, the Commission believes that the proposal is generally
consistent with reducing systemic risk and supporting the broader
financial system. As discussed above, OCC proposes to identify and
manage the potential cost of liquidating a defaulted Clearing Member's
portfolio. OCC's estimation of such potential costs would be calibrated
based on historical periods of market stress. OCC proposes to collect
resources designed to cover such costs in the form of margin.
Collecting additional margin to support OCC's ability to close out a
default Clearing
[[Page 28371]]
Member's portfolio during a period of market stress could reduce the
potentiality that OCC would mutualize a loss arising out of the close-
out process. While unavoidable under certain circumstances, reducing
the potentiality of loss mutualization during periods of market stress
could reduce the potential knock-on effects to non-defaulting Clearing
Members, their customers and the broader options market arising out of
a Clearing Member default. The Commission believes, therefore, that
adoption of a liquidation cost model calibrated based on periods of
market stress would be consistent with the reduction of systemic risk
and supporting the stability of the broader financial system.
Accordingly, and for the reasons stated above, the Commission
believes the changes proposed in the Advance Notice are consistent with
Section 805(b) of the Clearing Supervision Act.\27\
---------------------------------------------------------------------------
\27\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------
B. Consistency With Rule 17Ad-22(e)(6)(i) Under the Exchange Act
Rule 17Ad-22(e)(6)(i) under the Exchange Act requires, in part,
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, at a minimum, considers, and produces margin levels
commensurate with, the risks and particular attributes of each relevant
product, portfolio, and market.\28\
---------------------------------------------------------------------------
\28\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------
As described above, the liquidation cost that OCC could incur in
the process of closing out a Clearing Member's portfolio is, in part, a
function of the spread between the bid and the ask prices of financial
instruments within the portfolio. The STANS methodology attempts to
address potential losses resulting from changes in price over a two-day
period. As described above, however, STANS is not designed to account
for liquidation costs. OCC's proposed model would be designed to
account for particular attributes of the products in a defaulted
Clearing Member's portfolio, including the bid-ask spreads and average
daily volume of such products.\29\ Further, the proposal would
acknowledge the purpose of the proposed liquidation cost model as
distinct from the STANS methodology by using the proposed liquidation
cost model as a floor on a Clearing Member's margin requirements.
---------------------------------------------------------------------------
\29\ As noted above, OCC proposes to incorporate the proposed
model into its margin methodology documentation and to reference the
margin add-on in its Margin Policy.
---------------------------------------------------------------------------
OCC's proposal would be tailored to the particular attributes of
products in a Clearing Member's portfolio. As described above, OCC
would use the proposed model to calculate two risk-based liquidation
costs for each portfolio: (1) The Vega LC and (2) the Delta LC.\30\ The
Commission believes, therefore, that the adoption of the proposed
liquidation cost model designed to produce margin levels commensurate
with the risks of liquidating a Clearing Member's portfolio is
consistent with Exchange Act Rule 17Ad-22(e)(6)(i).\31\
---------------------------------------------------------------------------
\30\ Options products would incur both a Vega LC and a Delta LC,
while Delta-one products such as futures contracts, Treasury
securities, and equity securities would incur only a Delta LC.
\31\ 17 CFR 240.17Ad-22(e)(6)(i).
---------------------------------------------------------------------------
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
Advance Notice (SR-OCC-2019-802) and that 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-
2019-004, whichever is later.
By the Commission.
Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-12884 Filed 6-17-19; 8:45 am]
BILLING CODE 8011-01-P