[Federal Register Volume 84, Number 120 (Friday, June 21, 2019)]
[Notices]
[Pages 29267-29270]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-13113]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-86119; File No. SR-OCC-2019-004]
Self-Regulatory Organizations; the Options Clearing Corporation;
Order Approving Proposed Rule Change Related to the Introduction of a
New Liquidation Cost Model in the Options Clearing Corporation's Margin
Methodology
June 17, 2019.
I. Introduction
On April 18, 2019, the Options Clearing Corporation (``OCC'') filed
with the Securities and Exchange Commission (``Commission'') the
proposed rule change SR-OCC-2019-004 (``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 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.\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 4, at 84 FR 19815.
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The Proposed Rule Change was published for public comment in the
Federal Register on May 6, 2019,\4\ and the Commission received no
comments regarding the Proposed Rule Change. This order approves the
Proposed Rule Change.
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\4\ Securities Exchange Act Release No. 85755 (Apr. 30, 2019),
84 FR 19815 (May 6, 2019) (SR-OCC-2019-004) (``Notice of Filing'').
OCC also filed a related advance notice (SR-OCC-2019-802) (``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 Exchange 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 May 21,
2019. Securities Exchange Act Release No. 85863 (May 15, 2019), 84
FR 23090 (May 21, 2019) (SR-OCC-2019-802).
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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.\5\ 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
[[Page 29268]]
sufficient financial resources to close-out the portfolio of a
defaulted Clearing Member.
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\5\ 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 Proposed Rule Change, 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
19816, note 7.
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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.\6\ 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.
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\6\ See Notice of Filing, 84 FR at 19816.
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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 Proposed Rule Change, the 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.\7\
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\7\ OCC also proposes a conforming change to its Margin Policy,
which would reference OCC's model documentation.
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A. Liquidation Costs
The proposed model would calculate two risk-based liquidation costs
for a portfolio: (1) The Vega \8\ liquidation cost (``Vega LC''), and
(2) the Delta \9\ liquidation cost (``Delta LC''). Options products
would incur both a Vega LC and a Delta LC, while Delta-one
products,\10\ such as futures contracts, Treasury securities, and
equity securities, would incur only a Delta LC.
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\8\ The Vega of an option represents the sensitivity of the
option price to the volatility of the underlying security.
\9\ The Delta of an option represents the sensitivity of the
option price to the price of the underlying security.
\10\ 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.
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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.\11\
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\11\ 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).
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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.\12\ 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.\13\ 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.\14\
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\12\ 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.
\13\ 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.
\14\ 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.
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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.\15\
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\15\ 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.)
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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.\16\ The portfolio-level Delta LC would
be the simple sum of the sub-portfolio Delta LCs.
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\16\ 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 19818.
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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
[[Page 29269]]
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
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.\17\ 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 \18\ and Rule 17Ad-22(e)(6)(i)
thereunder.\19\
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\17\ 15 U.S.C. 78s(b)(2)(C).
\18\ 15 U.S.C. 78q-1(b)(3)(F).
\19\ 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.\20\
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 for the reasons set
forth below.
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\20\ 15 U.S.C. 78q-1(b)(3)(F).
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OCC manages its credit exposure to Clearing Members, in part,
through the collection of collateral based on OCC's margin methodology.
As noted above, OCC's current margin methodology is not designed to
account for liquidation costs that OCC could incur in the process of
closing out a defaulted Clearing Member's portfolio. 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. The Commission believes that adopting a
model designed to identify and measure a risk not addressed elsewhere
in OCC's margin methodology--namely, the cost to liquidate a defaulted
Clearing Member's portfolio during periods of market stress--would
improve OCC's margin methodology by generating margin requirements
designed to more fully cover OCC's credit exposure to each of its
Clearing Members.
Moreover, the Commission believes that the inclusion of
concentration charges in the proposed liquidation cost model would
enhance the measurement of risk described above. 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 further facilitate the generation of requirements designed
to more fully cover OCC's credit exposure to each of its Clearing
Members.
The Commission also believes that the use of the proposed
liquidation cost model to create a margin floor would improve the
management of OCC's credit exposures through the collection of margin.
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.
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 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
assuring the safeguarding of securities and funds which are in OCC's
custody or control or for which it is responsible consistent with the
requirements of 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)(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.\22\
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\22\ 17 CFR 240.17Ad-22(e)(6)(i).
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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.\23\ Further, the proposal
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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.
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\23\ 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.
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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. 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).\24\
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\24\ 17 CFR 240.17Ad-22(e)(6)(i).
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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-2019-004) be,
and hereby is, approved.
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\26\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\27\
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\27\ 17 CFR 200.30-3(a)(12).
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Vanessa A. Countryman,
Acting Secretary.
[FR Doc. 2019-13113 Filed 6-20-19; 8:45 am]
BILLING CODE 8011-01-P