[Federal Register Volume 84, Number 147 (Wednesday, July 31, 2019)]
[Notices]
[Pages 37373-37378]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-16312]



[[Page 37373]]

-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-86488; File No. SR-OCC-2019-804]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Advance Notice Related to The Options Clearing 
Corporation's Vanilla Option Model and Smoothing Algorithm

July 26, 2019.
    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 (``Act'' or ``Exchange Act''),\3\ notice is hereby given that on 
June 28, 2019, the Options Clearing Corporation (``OCC'') filed with 
the Securities and Exchange Commission (``Commission'') an advance 
notice 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 advance notice from interested persons.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    This advance notice 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 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. 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.\4\
---------------------------------------------------------------------------

    \4\ OCC's By-Laws and Rules can be found on OCC's public 
website: http://optionsclearing.com/about/publications/bylaws.jsp.
---------------------------------------------------------------------------

II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Advance Notice

    In its filing with the Commission, OCC included statements 
concerning the purpose of and basis for the advance notice and 
discussed any comments it received on the advance notice. 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 and B below, 
of the most significant aspects of these statements.

(A) Clearing Agency's Statement on Comments on the Advance Notice 
Received From Members, Participants or Others

    Written comments were not and are not intended to be solicited with 
respect to the proposed change and none have been received. OCC will 
notify the Commission of any written comments received by OCC.

(B) Advance Notices Filed Pursuant to Section 806(e) of the Payment, 
Clearing, and Settlement Supervision Act

Description of the Proposed Change
    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.\5\ STANS 
utilizes large-scale Monte Carlo simulations to forecast price and 
volatility movements in determining a Clearing Member's margin 
requirement.\6\ 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.
---------------------------------------------------------------------------

    \5\ 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/.
    \6\ See OCC Rule 601.
---------------------------------------------------------------------------

    STANS margin requirements are comprised of the sum of several 
components, each reflecting a different 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.\7\
---------------------------------------------------------------------------

    \7\ 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.
---------------------------------------------------------------------------

    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.\8\ 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

[[Page 37374]]

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.\9\
---------------------------------------------------------------------------

    \8\ 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.
    \9\ 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.
---------------------------------------------------------------------------

    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.\10\
---------------------------------------------------------------------------

    \10\ ``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.
---------------------------------------------------------------------------

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,\11\ with the 
same underlying and expiration date.
---------------------------------------------------------------------------

    \11\ E.g., the Cboe Volatility (VIX) Index.
---------------------------------------------------------------------------

    The Smoothing Algorithm consists of four steps. The first step is a 
preprocessing procedure, which is used to filter out ``bad'' price 
quotes.\12\ 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 \13\ 
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).\14\ The fourth step consists of constructing a volatility 
surface \15\ based on linear interpolation \16\ of total variance \17\ 
among the smoothed prices and performing any necessary post-
processing.\18\
---------------------------------------------------------------------------

    \12\ 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.
    \13\ 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.
    \14\ 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.
    \15\ 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.
    \16\ ``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.
    \17\ 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.
    \18\ 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.
---------------------------------------------------------------------------

    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.\19\ 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).
---------------------------------------------------------------------------

    \19\ 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.
---------------------------------------------------------------------------

    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

[[Page 37375]]

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.\20\
---------------------------------------------------------------------------

    \20\ In the event the primary data source for these dividends is 
unavailable, OCC has a backup data provider for forecasted 
dividends.
---------------------------------------------------------------------------

    Third, the Vanilla Option Model currently does not use borrowing 
costs,\21\ 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.\22\
---------------------------------------------------------------------------

    \21\ Borrowing costs are the costs that may be incurred by an 
option buyer or seller to borrow the underlying security of the 
option.
    \22\ The borrowing costs used by the Vanilla Option Model would 
be calculate from market prices of options or futures.
---------------------------------------------------------------------------

    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 \23\ 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.
---------------------------------------------------------------------------

    \23\ 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.
---------------------------------------------------------------------------

    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.\24\ The proposed 
enhancements to the Vanilla Option Model would enable the model to 
calculate Theta and Rho, in addition to Delta, Gamma and Vega.\25\
---------------------------------------------------------------------------

    \24\ ``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.
    \25\ 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.
---------------------------------------------------------------------------

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.\26\ 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 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.\27\ 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.
---------------------------------------------------------------------------

    \26\ 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).
    \27\ 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.
---------------------------------------------------------------------------

    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.\28\ 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.\29\
---------------------------------------------------------------------------

    \28\ 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.
    \29\ The Smoothing Algorithm for long-dated FLEX options would 
remain unchanged.
---------------------------------------------------------------------------

    Fifth, the Smoothing Algorithm currently does not have the ability 
to use borrowing costs as an independent

[[Page 37376]]

input.\30\ 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.
---------------------------------------------------------------------------

    \30\ 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.
---------------------------------------------------------------------------

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 \31\ and, prior to implementing the proposed change, will 
provide overviews to the OCC Roundtable,\32\ as well as through 
Information Memoranda to all Clearing Members describing the proposed 
change.
---------------------------------------------------------------------------

    \31\ The Financial Risk Advisory Council is a working group 
comprised of exchanges, Clearing Members and indirect participants 
of OCC.
    \32\ 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.
---------------------------------------------------------------------------

    Given that changes in margins are expected,\33\ 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.\34\
---------------------------------------------------------------------------

    \33\ 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.
    \34\ Specifically, OCC will discuss with those Clearing Members 
how they plan to satisfy any increase in their margin requirements 
associated with the proposed change.
---------------------------------------------------------------------------

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.
Expected Effect on and Management of Risk
    OCC believes that the proposed changes would reduce the nature and 
level of risk presented by OCC because they 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.
    With respect to the Vanilla Option Model, the proposed changes 
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 changes 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 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 changes 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 changes 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 changes 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.
    The proposed model would be used by OCC to calculate margin 
requirements designed to limit its credit exposures to participants, 
and OCC uses the margin it collects from a defaulting Clearing Member 
to protect other Clearing Members from losses as a result of the 
default and ensure that OCC is able to continue the prompt and accurate 
clearance and settlement of its cleared products. Accordingly, OCC 
believes the proposed changes would promote robust risk management for 
plain vanilla listed options and promote safety and soundness 
consistent with the objectives and principles of Section 805(b) of the 
Clearing Supervision Act.\35\
---------------------------------------------------------------------------

    \35\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

    For the foregoing reasons, OCC believes that the proposed change 
would enhance OCC's management of risk and reduce the nature or level 
of risk presented to OCC.
Consistency With the Clearing Supervision Act
    The stated purpose of the Clearing Supervision Act is 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 and strengthening the 
liquidity of systemically important financial market utilities.\36\ 
Section 805(a)(2) of the Clearing Supervision Act \37\ also authorizes 
the Commission to prescribe risk management standards for the payment, 
clearing and settlement activities of designated clearing entities, 
like OCC, for which the Commission is the supervisory agency. Section 
805(b) of the Clearing Supervision Act \38\ states that the objectives 
and principles for risk management standards prescribed under Section 
805(a) shall be to:
---------------------------------------------------------------------------

    \36\ 12 U.S.C. 5461(b).
    \37\ 12 U.S.C. 5464(a)(2).
    \38\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

     Promote robust risk management;
     Promote safety and soundness;
     Reduce systemic risks; and

[[Page 37377]]

     Support the stability of the broader financial system.
    OCC believes the proposed changes are consistent with the 
objectives and principles of Section 805(b) of the Clearing Supervision 
Act.\39\ As described above, STANS margin requirements are comprise of 
the sum of several components, each reflecting a different aspect of 
risk. 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. As explained 
above, OCC proposes certain changes to address certain existing 
limitations in the Vanilla Option Model and the Smoothing Algorithm. 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 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. As a result, OCC believes the proposed change 
would promote robust risk management and safety and soundness while 
reducing systemic risks and would thereby support the stability of the 
broader financial system.
---------------------------------------------------------------------------

    \39\ 12 U.S.C. 5464(b).
---------------------------------------------------------------------------

    The Commission has adopted risk management standards under Section 
805(a)(2) of the Clearing Supervision Act and the Act, which include 
Commission Rules 17Ad-22(b)(2) and (e)(6).\40\
---------------------------------------------------------------------------

    \40\ 17 CFR 240.17Ad-22. See Securities Exchange Act Release 
Nos. 68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-
08-11) (``Clearing Agency Standards''); 78961 (September 28, 2016, 
81 FR 70786 (October 13, 2016) (S7-03-14) (``Standards for Covered 
Clearing Agencies''). The Standards for Covered Clearing Agencies 
became effective on December 12, 2016. OCC is a ``covered clearing 
agency'' as defined in Rule 17Ad-22(a)(5) and therefore OCC must 
comply with section (e) of Rule 17Ad-22.
---------------------------------------------------------------------------

    Rule 17Ad-22(b)(2) \41\ 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 
changes 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 changes 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 changes 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).\42\
---------------------------------------------------------------------------

    \41\ 17 CFR 240.17Ad-22(b)(2).
    \42\ Id.
---------------------------------------------------------------------------

    Rule 17Ad-22(e)(6)(i) and (iii) \43\ 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 changes 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 changes 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).\44\
---------------------------------------------------------------------------

    \43\ 17 CFR 240.17Ad-22(e)(6)(i) and (iii).
    \44\ Id.
---------------------------------------------------------------------------

    The changes are not inconsistent with the existing rules of OCC, 
including any other rules proposed to be amended.

III. Date of Effectiveness of the Advance Notice and Timing for 
Commission Action

    The proposed change may be implemented if the Commission does not 
object to the proposed change within 60 days of the later of (i) the 
date the proposed change was filed with the Commission or (ii) the date 
any additional information requested by the Commission is received. OCC 
shall not implement the proposed change if the Commission has any 
objection to the proposed change.
    The Commission may extend the period for review by an additional 60 
days if the proposed change raises novel or complex issues, subject to 
the Commission providing the clearing agency with prompt written notice 
of the extension. A proposed change may be implemented in less than 60 
days from the date the advance notice is filed, or the date further 
information requested by the Commission is received, if the Commission 
notifies the clearing agency in writing that it does not object to the 
proposed change and authorizes the clearing agency to implement the 
proposed change on an earlier date, subject to any conditions imposed 
by the Commission.
    OCC shall post notice on its website of proposed changes that are 
implemented.
    The proposal shall not take effect until all regulatory actions 
required with respect to the proposal are completed.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the advance 
notice is consistent with the Clearing Supervision 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

[[Page 37378]]

     Send an email to [email protected]. Please include 
File Number SR-OCC-2019-804 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE, Washington, DC 20549.

All submissions should refer to File Number SR-OCC-2019-804. 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 advance notice that are filed with the 
Commission, and all written communications relating to the advance 
notice 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 the filing also will be available for inspection 
and copying at the principal office of the self-regulatory 
organization.
    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-2019-804 and 
should be submitted on or before August 15, 2019.

    By the Commission.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019-16312 Filed 7-30-19; 8:45 am]
 BILLING CODE 8011-01-P