[Federal Register Volume 84, Number 131 (Tuesday, July 9, 2019)]
[Notices]
[Pages 32816-32821]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-14627]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-86296; File No. SR-OCC-2019-005]
Self-Regulatory Organizations; The Options Clearing Corporation;
Notice of Filing of Proposed Rule Change Related to the Options
Clearing Corporation's Vanilla Option Model and Smoothing Algorithm
July 3, 2019.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act'' or ``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice
is hereby given that on June 28, 2019, the Options Clearing Corporation
(``OCC'') filed with the Securities and Exchange Commission
(``Commission'') the proposed rule change as described in Items I, II,
and III below, which Items have been prepared by OCC. The Commission is
publishing this notice to solicit comments on the proposed rule change
from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Clearing Agency's Statement of the Terms of Substance of the
Proposed Rule Change
The proposed rule change is filed in connection with proposed
changes to formalize and update OCC's models for: (1) Generating
theoretical values, implied volatilities and certain risk sensitivities
for plain vanilla listed options (``Vanilla Option Model'') and (2)
estimating fair or ``smoothed'' prices of plain vanilla listed options
based on their bid and ask price quotes (``Smoothing Algorithm''). The
proposed changes are discussed in detail in Item II below.
The proposed changes to Chapter 17 (Vanilla Option Model) and
Chapter 18 (Smoothing Algorithm) of OCC's Margins Methodology are
contained in confidential Exhibits 5A and 5B of the filing. Material
proposed to be added is marked by underlining and material proposed to
be deleted is marked by strikethrough text. OCC also has included
backtesting and impact analysis of the proposed model changes in
confidential Exhibit 3.
The proposed rule change is available on OCC's website at https://www.theocc.com/about/publications/bylaws.jsp. All terms with initial
capitalization that are not otherwise defined herein have the same
meaning as set forth in the OCC By-Laws and Rules.\3\
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\3\ OCC's By-Laws and Rules can be found on OCC's public
website: http://optionsclearing.com/about/publications/bylaws.jsp.
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II. Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
In its filing with the Commission, OCC included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. OCC has prepared summaries, set forth in sections (A),
(B), and (C) below, of the most significant aspects of these
statements.
(A) Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
(1) Purpose
The purpose of the proposed rule change is to introduce
enhancements to OCC's Vanilla Option Model, which is used to generate
theoretical values, implied volatilities and risk sensitives for plain
vanilla listed options, and to the Smoothing Algorithm, which is used
to estimate fair prices of listed option contracts cased on their bid
and ask price quotes. Specifically, the proposed methodology
enhancements to the Vanilla Option Model would include: (1) Replacing
use of an interest rate yield curve with constant interest rates; (2)
replacing use of the last paid dividends with a schedule of forecasted
dividends; (3) using borrowing costs as an input in valuations; (4)
replacing the binomial tree used to price American-style options with a
binomial tree that has a higher rate of convergence; and (5) using
additional ``Greeks'' as inputs in valuations. Proposed enhancements to
the Smoothing Algorithm would include: (1) Aligning the binomial tree
using in the Vanilla Option Model with the binomial tree used in the
Smoothing Algorithm; (2) using basis futures prices which close at the
same time as the underlying indices to prevent price discrepancies; (3)
capping unacceptably high volatilities in out-of-the-money regions more
gradually to make convexity in pricing changes more continuous and
eliminate associated arbitrage opportunities; (4) using current market
prices of plain vanilla listed options to generate prices for short-
dated FLEX options; and (5) using borrowing costs as an independent
input in the pricing of plain vanilla listed options.
Background
OCC's margin methodology, the System for Theoretical Analysis and
Numerical Simulations (``STANS''), is OCC's proprietary risk management
system that calculates Clearing Member margin requirements.\4\ STANS
utilizes large-scale Monte Carlo simulations to forecast price and
volatility movements in determining a Clearing Member's margin
requirement.\5\ The STANS margin requirement is calculated at the
portfolio level of Clearing Member legal entity marginable net
positions tier account (tiers can be customer, firm, or market marker)
and consists of an estimate of a 99% two-day expected shortfall (``99%
Expected Shortfall'') and an add-on for model risk (the concentration/
dependence stress test charge). The STANS methodology is used to
measure the exposure of portfolios of options and futures cleared by
OCC and cash instruments in margin collateral.
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\4\ See Securities Exchange Act Release No. 53322 (February 15,
2006), 71 FR 9403 (February 23, 2006) (SR-OCC-2004-20). A detailed
description of the STANS methodology is available at http://optionsclearing.com/risk-management/margins/.
\5\ See OCC Rule 601.
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STANS margin requirements are comprised of the sum of several
components, each reflecting a different
[[Page 32817]]
aspect of risk. The base component of the STANS margin requirement for
each account is obtained using a risk measure known as 99% Expected
Shortfall. Under the 99% Expected Shortfall calculation, an account has
a base margin excess (deficit) if its positions in cleared products,
plus all existing collateral--whether of types included in the Monte
Carlo simulation or of types subjected to traditional ``haircuts'' --
would have a positive (negative) net worth after incurring a loss equal
to the average of all losses beyond the 99% value at risk (or ``VaR'')
point. This base component is then adjusted by the addition of a stress
test component, which is obtained from consideration of the increases
in 99% Expected Shortfall that would arise from market movements that
are especially large and/or in which various kinds of risk factors
exhibit perfect or zero correlations in place of their correlations
estimated from historical data, or from extreme adverse idiosyncratic
movements in individual risk factors to which the account is
particularly exposed.\6\
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\6\ STANS margins may also include other add on charges, which
are considerably smaller than the base and stress test components,
and many of which affect only a minority of accounts.
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Two primary components of STANS are the Vanilla Option Model, which
is used to generate theoretical values, implied volatilities and
certain risk sensitivities for plain vanilla listed options, and the
Smoothing Algorithm, which is used to estimate fair prices of listed
option contracts based on their bid and ask price quotes. OCC's current
Vanilla Option Model and Smoothing Algorithm and proposed changes
thereto are discussed in detail below.
Vanilla Option Model
The Vanilla Option Model is OCC's model for generating theoretical
values, implied volatilities and certain risk sensitivities for plain
vanilla listed options.\7\ The theoretical values generated by OCC's
Vanilla Option Model are the estimated values (as opposed to current
market prices) of plain vanilla options derived from algorithms that
use a series of predetermined inputs, such as the price of the stock or
index underlying the option, the option's exercise price, the risk-free
interest rate, the amount of time until the option's expiration and the
volatility of the option. For European options (including FLEX
options), the Vanilla Option Model generates theoretical values using a
pricing algorithm that is based on the Black-Scholes formula. For
American options, the Vanilla Option Model generates theoretical values
using a modified Jarrow-Rudd (``JR'') binomial tree.\8\
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\7\ With respect to the Vanilla Option Model, ``plain vanilla
listed options'' are (1) all listed vanilla European and American
options on equities, exchange traded funds and exchange traded notes
(collectively, ``ETPs''), equity indices, futures on equity indices,
currencies or commodities, and (2) vanilla flexible exchange options
(``vanilla FLEX options''). Collectively, these plain vanilla
options account for about 95 percent of the total contracts cleared
by OCC.
\8\ OCC uses a modified JR binomial tree for American options
because the algorithm based on the Black-Scholes formula does not
work for valuing American options, due to their early exercise
feature.
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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 current option premium in the market. The
implied volatilities are used in STANS to generate price scenarios for
estimating potential losses of clearing members' portfolios. Given the
current market price for a plain vanilla option, the aforementioned
pricing algorithms for European and American options will generate the
implied volatility of the price of the option's underlying asset.
The risk sensitivities calculated by the Vanilla Option Model are
certain values--namely, Delta, Gamma and Vega--that measure the risk of
a plain vanilla option in relation to underlying variables.\9\
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\9\ ``Delta'' measures the change in the option value with
respect to a change in the price of an underlying asset. ``Gamma''
measures the change in Delta in response to a 1% change in the price
of the underlying asset. ``Vega'' measures the change in the option
value corresponding to a 1% change in the underlying asset's
volatility.
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Smoothing Algorithm
In the absence of OCC's Smoothing Algorithm, the end-of-day ``fair
price'' of a plain vanilla listed option contract would simply be the
closing mid-point price (i.e., the mid-point between the bid and ask
prices) for such contract. However, there often is a wide difference
between the closing bid and ask price quotes for option contracts,
which could result in a closing mid-point price that may contain
arbitrage opportunities. Closing bid and ask price quotes also tend to
be ``noisy,'' meaning that quotes can fluctuate randomly in a way that
is not reflective of the contract's fair value, which similarly could
result in a closing mid-point price that may contain arbitrage
opportunities. Therefore, OCC uses its Smoothing Algorithm in an
attempt to minimize the impact of wide and/or noisy closing price
quotes on individual plain vanilla listed option contracts, thereby
producing a more fair or ``smoothed'' price. The Smoothing Algorithm
works by attempting to simultaneously estimate fair values for put and
call prices on all plain vanilla listed options included in the Vanilla
Option Model, as well as options on non-equity securities,\10\ with the
same underlying and expiration date.
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\10\ E.g., the Cboe Volatility (VIX) Index.
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The Smoothing Algorithm consists of four steps. The first step is a
preprocessing procedure, which is used to filter out ``bad'' price
quotes.\11\ The second step is an implied forward price calculation,
which estimates the forward prices of securities underlying the options
by using the prices from the near-the-money options on the same
securities at all tenors or expiration dates. The third step \12\
performs the smoothing, in which theoretical prices are generated for
all plain vanilla listed options at all strikes by using corresponding
bid and ask price quotes and forward prices (which were calculated in
step two).\13\ The fourth step consists of constructing a volatility
surface \14\ based on linear interpolation \15\ of total variance \16\
among the smoothed prices and
[[Page 32818]]
performing any necessary post-processing.\17\
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\11\ The Smoothing Algorithm filters out certain poor-quality
price quotes. The price quotes are excluded from the algorithm if
they meet one or more of the following conditions: (i) Prices for
options that expired or have a remaining maturity of less than a
certain number of days, where that number is specified by a control
parameter; (ii) prices for options that have only ``one-sided
contracts'' (i.e., contracts for which prices exist only for either
the call or the put, but not for both); (iii) prices for options
whose ask prices are zero; (iv) prices for options with negative bid
and ask spreads; or (v) prices for any American options if the ask
price is less than the intrinsic value of the option.
\12\ The third step as described applies to European options.
For American options, the Smoothing Algorithm first extracts the
European option prices from the American prices (or ``de-
Americanizes'' the prices) using the Vanilla Option Model, then
performs smoothing on the resultant European prices, and finally
converts the smoothed European prices into American prices (or ``re-
Americanizes'' the prices) using the Vanilla Option Model.
\13\ The theoretical prices in step three are generated by
solving an optimization problem, which ensures that the theoretical
prices generated satisfy both arbitrage-free conditions and bid and
ask spread constraints.
\14\ A ``volatility surface'' is a three-dimensional graph
showing the levels of the implied volatilities for all the options
listed on the same underlying security with different strikes or
maturity dates.
\15\ ``Linear interpolation'' is a mathematical method of curve
fitting by using linear polynomials to construct new data points
within the range of a discrete set of known data points.
\16\ The ``total variance'' of a random variable is defined as
the sum of the variances over a given period of time. If the
variance is a constant, the total variance is a simple product of
its value and length of the time period.
\17\ Post-processing addresses contracts that are filtered out
of the smoothing process during pre-processing due to either bad or
missing price quotes. In post-processing, the theoretical prices for
these contracts are approximated from the implied volatility data
that are already obtained by the smoothing algorithm.
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OCC's Smoothing Algorithm is intended to ensure that the option
prices generated are smooth, free of arbitrage opportunities and within
bid and ask price spreads. The fair value prices that result from the
Smoothing Algorithm are used by OCC in calculating margin requirements,
risk sensitivities, stress testing and calculation of the Clearing
Fund. In addition, the end-of-day fair value prices of options
contracts produced by the Smoothing Algorithm are published to all
Clearing Members, as well as to other market participants.
Proposed Changes
OCC is proposing to enhance its margin methodology by addressing a
series of limitations that presently exist in each of the Vanilla
Option Model and the Smoothing Algorithm, as described below.
Vanilla Option Model Proposed Changes
The Vanilla Option Model has five limitations that would be
addressed by the proposed changes. First, the Vanilla Option Model uses
constant interest rates--the published London Inter-bank Offered Rate
(``LIBOR'') for maturities up to 12 months and published swap rates
from maturities two to ten years--as opposed to an interest rate yield
curve.\18\ By using constant interest rates, the Vanilla Option Model
assumes that interest rates remain constant during the lifetime of an
option (i.e., the interest rates remain constant at each time-step or
node in the JR binomial tree). To address this limitation, OCC proposes
to change the Vanilla Option Model to instead use an interest rate
curve generated by using OCC's chosen benchmark rate(s) (currently
LIBOR), Eurodollar futures prices and swap rates. The use of an
interest rate curve will allow the Vanilla Option Model to assume
variable interest rates over the lifetime of an option (i.e., interest
rates can vary at each time-step or node in the binomial tree).
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\18\ The ``swap rate'' is the fixed interest rate that a swap
counterparty demands in exchange for the uncertainty of having to
pay the short-term floating rate over time.
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Second, the Vanilla Option Model uses either a constant yield (for
index options for all tenors) or a constant projection (for single-name
stock options for all tenors) determined by the issuer's last paid or
announced dividend. However, an issuer's last paid or announced
dividend is not always an accurate prediction of an issuer's future
dividends, whereas forecasted dividends are the result of a more
comprehensive analysis of the issuer's fundamentals, resulting in a
dividend projection that is more sensitive to the particular issuer's
circumstances. To address this limitation, OCC proposes to change the
Vanilla Option Model to use a schedule of forecasted dividends,
received from an established industry data service provider, instead of
relying on the issuer's last paid or announced dividend.\19\
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\19\ In the event the primary data source for these dividends is
unavailable, OCC has a backup data provider for forecasted
dividends.
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Third, the Vanilla Option Model currently does not use borrowing
costs,\20\ which could allow for potential inconsistencies in implied
volatilities for calls and puts in options with the same strike and
tenor. To address this limitation, OCC proposes to modify the Vanilla
Option Model to use borrowing costs as an input in the valuation of
plain vanilla options.\21\
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\20\ Borrowing costs are the costs that may be incurred by an
option buyer or seller to borrow the underlying security of the
option.
\21\ The borrowing costs used by the Vanilla Option Model would
be calculate from market prices of options or futures.
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Fourth, as stated above, for pricing American options the Vanilla
Option Model is based on a 49-step modified JR binomial tree; however,
the fixed number of steps is not large enough for accurately evaluating
long-dated options (e.g., FLEX options). To address this limitation,
OCC proposes that the Vanilla Option Model instead price American
options using a variable number of steps \22\ that increases linearly
with the expiration of the option. In addition, OCC proposes to replace
the JR binomial tree with the Leisen-Reimer (``LR'') binomial tree,
which has a higher rate of convergence than the JR binomial tree.
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\22\ The number of LR tree steps would vary between minimum and
maximum parameters, depending on an option's tenor. OCC would
initially set these minimum and maximum parameters at 51 and 501,
respectively, and they would be subject to change based on OCC's
determination. OCC would modify the minimum and maximum parameters
to achieve a balance between pricing accuracy and speed of pricing
calculations. The larger the number of the steps, the more accurate
the pricing, but the longer the calculation time. For example, OCC's
initial choice of a maximum 1001 steps did not result in an optimal
balance between accuracy and speed; therefore, OCC reduced the
maximum number of steps to 501.
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Fifth, the Vanilla Option Model only calculates a limited number of
risk sensitivities for the price of options (i.e., Delta, Gamma and
Vega) with respect to market variables; the model, however, is limited
in that it does not calculate Theta and Rho.\23\ The proposed
enhancements to the Vanilla Option Model would enable the model to
calculate Theta and Rho, in addition to Delta, Gamma and Vega.\24\
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\23\ ``Theta'' measures the change in the option value for a one
day change in the time to expiration of the option. ``Rho'' measures
the change in the option value with respect to a 1 basis point
change in the interest rate.
The Vanilla Option Model has a further limitation in that it
relies on a perturbation method of calculating Delta and Gamma,
which is less efficient than calculating Delta and Gamma from the
same tree.
\24\ The Vanilla Option Model presently calculates Delta and
Gamma using the perturbation method. The perturbation method
requires the use of two binomial trees, which introduces instability
issues. The proposed changes would result in Delta and Gamma being
calculated from a single binomial tree, which results in improved
stability.
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Smoothing Algorithm Enhancements
Presently, the Smoothing Algorithm has five limitations that would
be addressed by the proposed enhancements. First, though the Smoothing
Algorithm uses the Vanilla Option Model as a component for generating
smoothed prices, the Smoothing Algorithm uses a LR binomial tree,
whereas the Vanilla Option Model uses a JR binomial tree. The JR
binomial tree used in the current Vanilla Option Model does not account
for implied forward prices as generated in the Smoothing Algorithm.
This inconsistency in binomial trees allows for unequal put and call
volatilities and thus for potential violations of put and call parity
in margin calculations. The proposed change to the Vanilla Option Model
to use a LR binomial tree, as previously described, would not only
enhance the Vanilla Option Model but would eliminate the current
inconsistency between the Vanilla Option Model and Smoothing Algorithm
by using a LR binomial tree for both models.
Second, the Smoothing Algorithm uses index futures to approximate
theoretical spot prices for the plain vanilla listed options on certain
indices, but this method suffers from the absence of synchronization
between the futures market and the market for the underlying
indices.\25\ Trading in the underlying indices closes at 3:00 p.m.
Central Time, but trading in the index futures and plain vanilla listed
options on those indices closes at 3:15 p.m. The
[[Page 32819]]
difference in closing times could result in poorly smoothed prices
whenever the options trading between 3:00 p.m. and 3:15 p.m. is
volatile. Poorly smoothed prices could result in implied volatilities
of poorer quality, and this could create problems in OCC's margin and
risk calculations. In order to address this limitation, the Smoothing
Algorithm would use basis futures on the same indices to approximate
theoretical spot prices. Trading in basis futures has the benefit of
closing at 3:00 p.m., which would allow OCC to use a reported closing
price.\26\ Basis futures prices represent the spreads between the
futures prices and the underlying price; these spreads are relatively
stable throughout the day, including between their closing at 3:00 p.m.
and the closing of the index options market at 3:15 p.m., thereby
providing a better approximation of the theoretical sport prices in the
plain vanilla options at 3:15 p.m.
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\25\ Using the 3:00 p.m. index futures price suffers from
another shortcoming in that the 3:00 p.m. price is not an official
closing price, but rather it is the last trade price before 3:00
p.m. (as observed in a manual process by OCC employees).
\26\ By using the reported closing price for basis futures, the
proposed changes to the Smoothing Algorithm also would eliminates
the algorithm's reliance on a manual process to observe pre-close
futures prices.
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Third, the Smoothing Algorithm deals with unacceptably high
volatilities that are sometimes generated in the out-of-the-money
regions by capping these volatilities to a lower value. This leads to a
jump in the rate of change of the volatility with respect to the strike
and may create negative convexity of the option prices versus strike,
i.e., butterfly arbitrage opportunities. The proposed changes to the
Smoothing Algorithm would still cap unacceptably high volatilities
generated in out-of-the-money regions to a lower value, but the capping
would be done in a more gradual manner. By capping unacceptable high
volatilities in a more gradual manner, changes in the convexity of
prices would not be as discontinuous as in the current Smoothing
Algorithm, which would eliminate the opportunities for butterfly
arbitrage.
Fourth, to generate prices for short-dated FLEX options, the
Smoothing Algorithm combines the prices calculated from the prior day's
implied volatilities for all FLEX options with current market prices.
By combining the prior day's implied volatilities with current market
prices, the Smoothing Algorithm may not generate prices that are
consistent with then-current market prices.\27\ In order to address
this limitation, OCC proposes to change the Smoothing Algorithm to use
volatilities implied from current market prices of plain vanilla listed
options to price short-dated FLEX options.\28\
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\27\ The reason that the Smoothing Algorithm uses the prior
day's implied volatilities is that the implied volatilities are
received from a third-party data service provider; the provider's
quotes are delayed by one day.
\28\ The Smoothing Algorithm for long-dated FLEX options would
remain unchanged.
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Fifth, the Smoothing Algorithm currently does not have the ability
to use borrowing costs as an independent input.\29\ To address this
limitation, OCC proposes to modify the Smoothing Algorithm to provide
for the ability to use borrowing costs as an independent input in the
pricing of plain vanilla listed options. Under the proposed changes,
the borrowing costs for each underlying security would be implied from
at-the-money (or near at-the-money) options listed on such security.
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\29\ The Smoothing Algorithm currently combines borrowing costs
and dividends into a single input, referred to as ``implied
dividends,'' which is then used to price plain vanilla listed
options. However, the combined ``implied dividends'' input can
differ from the actual dividend, and this difference can result in
potential mispricing of certain types of options.
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Clearing Member Outreach
To inform Clearing Members of the proposed change, OCC has provided
overviews of the proposed changes to its Financial Risk Advisory
Council \30\ and, prior to implementing the proposed rule change, will
provide overviews to the OCC Roundtable,\31\ as well as through
Information Memoranda to all Clearing Members describing the proposed
change.
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\30\ The Financial Risk Advisory Council is a working group
comprised of exchanges, Clearing Members and indirect participants
of OCC.
\31\ The OCC Roundtable was established to bring Clearing
Members, exchanges and OCC together to discuss industry and
operational issues. It is comprised of representatives of the senior
OCC staff, participant exchanges and Clearing Members, representing
the diversity of OCC's membership in industry segments, OCC-cleared
volume, business type, operational structure and geography.
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Given that changes in margins are expected,\32\ OCC expects to
conduct an extended parallel implementation for Clearing Members prior
to implementation. Additionally, OCC will perform targeted and direct
outreach with Clearing Members that would be most impacted by the
proposed change and would work closely with such Clearing Members to
coordinate the implementation and associated funding for such Clearing
Members resulting from the proposed change.\33\
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\32\ OCC expects that the proposed changes, in aggregate, would
reduce total margins by a small amount. In particular, margin
reductions are expected for Clearing Members who hold risk
offsetting positions. However, the ultimate impact on any particular
Clearing Member's margin requirements would necessarily vary based
on trading strategies and market conditions. More specifically,
backtesting results for the period from March 2018 through February
2019 showed small reductions to total margins, in aggregate, with an
average difference of 1.3% between the proposed model and the
production model. At the Clearing Member level, the difference in
margin requirements between the proposed model and the production
model for Clearing Members comprising 99% of OCC's total daily
margin (such Clearing Members, the ``top Clearing Members'') on most
days of the backtesting period was less than 10%. The largest
increase and decrease to daily margin requirements observed within
top Clearing Members during the backtesting period was 42% and 30%,
respectively. On average, only 5% of the top Clearing Members
experienced a daily margin decrease or increase of 10% or greater
under the proposed model over the same period.
\33\ Specifically, OCC will discuss with those Clearing Members
how they plan to satisfy any increase in their margin requirements
associated with the proposed change.
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Implementation Timeframe
OCC expects to implement the proposed changes to the Vanilla Option
Model and Smoothing Algorithm no sooner than August 1, 2019 and no
later than one hundred eighty (180) days from the date OCC receives all
necessary regulatory approvals for the filings. OCC will announce the
implementation date of the proposed change by an Information Memo
posted to its public website no less than 6 weeks prior to
implementation.
(2) Statutory Basis
OCC believes that the proposed rule change is consistent with
Section 17A of the Act \34\ and the rules thereunder applicable to OCC.
Section 17A(b)(3)(F) of Act \35\ requires that the rules of a clearing
agency be designed to assure the safeguarding of securities and funds
which are in the custody or control of the clearing agency or for which
it is responsible. The proposed rule change would enhance two of the
primary components of OCC's STANS methodology by addressing five
limitations of the Vanilla Option Model and five limitations of the
Smoothing Algorithm.
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\34\ 15 U.S.C. 78q-1.
\35\ 15 U.S.C. 78q-1(b)(3)(F).
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With respect to the Vanilla Option Model, the proposed rule change
would incorporate interest rate yield curves, forecasted dividends and
borrowing costs into the theoretical pricing of plain vanilla listed
options. Including these three inputs improves the Vanilla Option
Model's theoretical pricing and helps to preserve the consistency
between implied call volatility and implied put volatility in options
at the same strike price and same maturity. The proposed rule change
also would introduce the LR binomial tree to replace the fixed, 49-step
JR binomial tree for pricing of American options. The LR binomial tree
would use a
[[Page 32820]]
variable number of steps that increases linearly with the expiration of
an option, to more accurately price long-dated American options. The LR
binomial tree also converges at a considerably higher rate than the JR
binomial tree. The proposed rule change would also enable OCC to
calculate two additional risk sensitivities--namely, Theta and Rho--for
plain vanilla listed options.
With respect to the Smoothing Algorithm, the proposed rule change
would improve implied volatility smoothing by eliminating the
inconsistency between the binomial trees used by the Vanilla Option
Model and the Smoothing Algorithm and by eliminating the
synchronization issue from using the 3:00 p.m. index futures price to
approximate theoretical spot prices for plain vanilla listed options on
certain indices. The proposed rule change also would improve the
Smoothing Algorithm by more gradually capping unacceptably high
volatilities sometimes generated in the out-of-the-money regions, which
would eliminate the opportunities for butterfly arbitrage, and by using
borrowing costs in the pricing of plain vanilla listed options.
Each of the aforementioned enhancements is expected to produce
margin requirements that are more accurate and commensurate with the
risks presented by Clearing Members, thereby improving OCC's margins
for plain vanilla listed options. Because OCC uses the margin it
collects from a defaulting Clearing Member to protect other Clearing
Members from losses resulting from the default, OCC believes the
proposed rule changed is designed to assure the safeguarding of
securities and funds in its custody or control in accordance with
Section 17A(b)(3)(F) of the Act.\36\
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\36\ Id.
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Rule 17Ad-22(b)(2) \37\ requires, in part, that a registered
clearing agency that performs central counterparty services establish,
implement, maintain and enforce written policies and procedures
reasonably designed use margin requirements to limit its credit
exposures to participants under normal market conditions and use risk-
based models and parameters to set margin requirements. As noted above,
OCC uses STANS as its risk-based margin methodology. The proposed rule
change would enhance STANS by addressing several limitations in two of
the primary components of STANS: The Vanilla Option Model and the
Smoothing Algorithm. With respect to the Vanilla Option Model, OCC
believes the proposed changes would enable the model to produce more
accurate theoretical valuations of plain vanilla listed options, and
for American options, would enable the mode to more accurately evaluate
long-dates options. With respect to the Smoothing Algorithm, OCC
believes the proposed rule change will enhance the model's implied
volatility smoothing by improving the approximate theoretical spot
prices for plain vanilla listed options on certain indices and by
eliminating opportunities for butterfly arbitrage. Accordingly, OCC
believes the proposed rule change would improve the methodology used to
calculate margin requirements designed to limit OCC's credit exposures
to participants under normal market conditions in a manner consistent
with Rule 17Ad-22(b)(2).\38\
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\37\ 17 CFR 240.17Ad-22(b)(2).
\38\ Id.
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Rule 17Ad-22(e)(6)(i) and (iii) \39\ further requires OCC to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to cover its credit exposures to its
participants by establishing a risk-based margin system that: (1)
Considers, and produces margin levels commensurate with, the risks and
particular attributes of each relevant product, portfolio, and market
and (2) calculates margin sufficient to cover its potential future
exposure to participants in the interval between the last margin
collection and the close out of positions following a participant
default. As noted above, the proposed rule change would address certain
existing limitations in the Vanilla Option Model and the Smoothing
Algorithm, each of which is a primary component of OCC's STANS
methodology. By addressing the aforementioned limitations of the
Vanilla Option Model, OCC believes that the model will produce more
accurate theoretical valuations of plain vanilla listed options,
including improved theoretical valuations for long-dated American
options. By addressing the aforementioned limitations of the Smoothing
Algorithm, OCC believes that the proposed rule change will enhance
implied volatility smoothing, improve the approximate theoretical spot
prices for plain vanilla listed options on certain indices and
eliminate opportunities for butterfly arbitrage. Accordingly, OCC
believes the proposed changes are consistent with Rule 17Ad-22(e)(6)(i)
and (iii).\40\
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\39\ 17 CFR 240.17Ad-22(e)(6)(i) and (iii).
\40\ Id.
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The proposed rule changes are not inconsistent with the existing
rules of OCC, including any other rules proposed to be amended.
(B) Clearing Agency's Statement on Burden on Competition
Section 17A(b)(3)(I) of the Act requires that the rules of a
clearing agency do not impose any burden on competition not necessary
or appropriate in furtherance of the purposes of Act.\41\ OCC believes
that any competitive impact imposed by the proposed model changes would
be necessary and appropriate in furtherance of the purposes of Act.\42\
The proposed changes are primarily designed to enhance two primary
components of OCC's STANS margin methodology. As described above, the
proposed model changes are necessary to produce margin results that are
more commensurate with the risks associated with clearing plain vanilla
listed options. Therefore, any competitive impact imposed by the
changes would be necessary in further of the purposes of the Act.
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\41\ 15 U.S.C. 78q-1(b)(3)(I).
\42\ Id.
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Furthermore, the proposed enhancements to the margin methodology
would apply to all Clearing Members clearing plain vanilla listed
options at OCC. The overall impact of the proposed rule change on
margins will depend on the composition of the portfolio in question,
but any fluctuations in margin requirements would be the same for any
Clearing Members with identical portfolios. Similarly, the enhancements
to the Smoothing Algorithm would result in improved end-of-day fair
value prices of options contracts, which would be published to all
Clearing Members, as well as to other market participants. Therefore,
OCC does not believe that the proposed rule change would unfairly
inhibit access to OCC's services or disadvantage or favor any
particular user in relationship to another user. Accordingly, OCC
believes that any competitive impact would be appropriate in
furtherance of the safeguarding of securities and funds which are in
the custody or control of OCC or for which it is responsible, and in
general, the protection of investors and the public interest; and,
therefore, appropriate in furtherance of the purposes of the Act.
(C) Clearing Agency's Statement on Comments on the Proposed Rule Change
Received From Members, Participants or Others
Written comments on the proposed rule change were not and are not
[[Page 32821]]
intended to be solicited with respect to the proposed rule change and
none have been received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 45 days of the date of publication of this notice in the
Federal Register or within such longer period up to 90 days (i) as the
Commission may designate if it finds such longer period to be
appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
(A) By order approve or disapprove the proposed rule change, or
(B) institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Exchange Act. Comments may be submitted
by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to [email protected]. Please include
File Number SR-OCC-2019-005 on the subject line.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number SR-OCC-2019-005. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's internet website (http://www.sec.gov/rules/sro.shtml).
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for website viewing and printing in
the Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549, on official business days between the hours of 10:00 a.m. and
3:00 p.m. Copies of such filing also will be available for inspection
and copying at the principal office of OCC and on OCC's website at
https://www.theocc.com/about/publications/bylaws.jsp.
All comments received will be posted without change. Persons
submitting comments are cautioned that we do not redact or edit
personal identifying information from comment submissions. You should
submit only information that you wish to make available publicly.
All submissions should refer to File Number SR-OCC-2019-005 and
should be submitted on or before July 30, 2019.
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\43\ 17 CFR 200.30-3(a)(12).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\43\
Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-14627 Filed 7-8-19; 8:45 am]
BILLING CODE 8011-01-P