[Federal Register Volume 84, Number 165 (Monday, August 26, 2019)]
[Notices]
[Pages 44649-44652]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-18260]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-86713; File No. SR-OCC-2019-804]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of No Objection To Advance Notice Related to The Options 
Clearing Corporation's Vanilla Option Model and Smoothing Algorithm

August 20, 2019.

I. Introduction

    On June 28, 2019, The Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') advance 
notice SR-OCC-2019-804 (``Advance Notice'') pursuant to Section 
806(e)(1) of Title VIII of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act, entitled Payment, Clearing and Settlement 
Supervision Act of 2010 (``Clearing Supervision Act'') \1\ and Rule 
19b-4(n)(1)(i) \2\ under the Securities Exchange Act of 1934 
(``Exchange Act'') \3\ to propose changes to its margin methodology 
regarding the estimation of prices for listed options contracts.\4\ The 
Advance Notice was published for public comment in the Federal Register 
on July 31, 2019,\5\ and the Commission has received no comments 
regarding the changes proposed in the Advance Notice.\6\ This 
publication serves as notice of no objection to the Advance Notice.
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ 15 U.S.C. 78a et seq.
    \4\ See Notice of Filing infra note 5, at 84 FR 37373.
    \5\ Securities Exchange Act Release No. 86488 (Jul. 26, 2019), 
84 FR 37373 (Jul. 31, 2019) (SR-OCC-2019-804) (``Notice of 
Filing''). On June 28, 2019, OCC also filed a related proposed rule 
change (SR-OCC-2019-005) with the Commission pursuant to Section 
19(b)(1) of the Exchange Act and Rule 19b-4 thereunder (``Proposed 
Rule Change''). 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, 
respectively. In the Proposed Rule Change, which was published in 
the Federal Register on July 9, 2019, OCC seeks approval of proposed 
changes to its rules necessary to implement the Advance Notice. 
Securities Exchange Act Release No. 86296 (July 3, 2019), 84 FR 
32821 (July 9, 2019). The comment period for the related Proposed 
Rule Change filing closed on July 30, 2019.
    \6\ Since the proposal contained in the Advance Notice was also 
filed as a proposed rule change, all public comments received on the 
proposal are considered regardless of whether the comments are 
submitted on the proposed rule change or the Advance Notice.
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II. Background

    The System for Theoretical Analysis and Numerical Simulations 
(``STANS'') is OCC's methodology for calculating margin requirements. 
STANS margin requirements are driven by several components, each 
reflecting a different aspect of risk. Two primary components of STANS 
are the models that OCC uses to (1) generate theoretical values, 
implied volatilities, and certain risk sensitivities for plain vanilla 
listed options (the ``Vanilla Option Model''); \7\ and (2) estimate 
fair prices of listed option contracts based on their bid and ask price 
quotes (the ``Smoothing Algorithm'').\8\ The changes proposed in the 
Advance Notice are designed to address five limitations of the current 
Vanilla Option Model and five limitations of the current Smoothing 
Algorithm.
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    \7\ Plain vanilla listed options are commonly understood to 
encompass options with standardized terms (e.g., a predetermined 
strike price, classification as a call vs. put) and settlement 
structures (e.g., American-style, European-style). As described in 
the Notice of Filing, the Vanilla Option Model is designed to 
address such options, including (1) all listed vanilla European and 
American options on exchange traded funds and exchange traded notes 
(collectively, ``ETPs''), equities, equity indices, futures on 
equity indices, currencies or commodities, and (2) vanilla flexible 
exchange options (``vanilla FLEX options''). See Notice of Filing, 
84 FR at 37373, n. 8. As of the time of filing, plain vanilla 
options accounted for approximately 95 percent of the total 
contracts cleared by OCC. See id.
    \8\ OCC uses the Smoothing Algorithm to estimate prices on all 
plain vanilla listed options included in the Vanilla Option Model, 
as well as options on non-equity securities (e.g., the Cboe 
Volatility Index). See Notice of Filing, 84 FR at 37374.
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A. Vanilla Option Model

    OCC relies on the Vanilla Option Model to generate theoretical 
values,

[[Page 44650]]

implied volatilities, and risk sensitivities for plain vanilla listed 
options. The theoretical values that OCC generates with the Vanilla 
Option Model are the estimated values (as opposed to current market 
prices) derived from algorithms that use a series of predetermined 
inputs.\9\ Given the current market price of a plain vanilla option, 
OCC uses such algorithms to estimate the implied volatility of the 
option.\10\ OCC uses the risk sensitivities that it calculates to 
measure potential changes in an option's price in relation to the asset 
underlying the option.\11\ As discussed below, OCC proposes five 
changes to the Vanilla Option Model.
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    \9\ For example, OCC generates theoretical values for American 
style options using a modified Jarrow-Rudd (``JR'') binomial tree.
    \10\ 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.
    \11\ OCC uses the Vanilla Option Model to calculate Delta, 
Gamma, and Vega. Delta measures the change in the price of an option 
with respect to a change in the price of an underlying asset. Gamma 
measures the change in Delta in response to a 1 percent change in 
the price of the underlying asset. Vega measures the change in the 
price of an option corresponding to a 1 percent change in the 
underlying asset's volatility.
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(1) Interest Rates
    The Vanilla Option Model currently assumes that interest rates 
remain constant over time. OCC proposes to revise the Vanilla Option 
Model to account for changes in interest rates over the life of an 
option. To model such interest rate changes, OCC would rely on an 
interest rate curve based on LIBOR, Eurodollar futures, and swap-rates.
(2) Dividends
    The Vanilla Option Model currently assumes constant dividends such 
that future dividends would be based on an issuer's last paid or 
announced dividend. OCC has acknowledged, however, that prior dividends 
are not always an accurate predictor of future dividends.\12\ OCC 
proposes to use dividend forecasts obtained from a third-party service 
provider as an input to the Vanilla Option Model instead of relying on 
the issuer's last paid or announced dividend.
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    \12\ See Notice of Filing, 84 FR at 37374-75.
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(3) Borrowing Costs
    The Vanilla Option Model does not currently account for the costs 
that may be incurred by an option buyer or seller who must borrow the 
security underlying an option (i.e., ``Borrowing Costs''). OCC has 
acknowledged that the failure to incorporate Borrowing Costs could 
cause OCC to model implied volatilities inconsistently across puts and 
calls with the same strike and tenor.\13\ OCC proposes to calculate 
Borrowing Costs based on the market prices of options and futures, and 
to use such Borrowing Costs as an input of the Vanilla Option Model.
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    \13\ See Notice of Filing, 84 FR at 37375.
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(4) Binomial Tree
    As noted above, the Vanilla Option Model uses the JR binomial tree 
to generate theoretical values for American-style options. OCC has 
acknowledged, however, that the Leisen Reimer (``LR'') binomial tree 
has a higher rate of convergence than the JR tree.\14\ OCC proposes to 
replace the JR binomial tree with the LR binomial tree in the Vanilla 
Option Model.
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    \14\ See id.
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    Further, the Vanilla Option Model employs a fixed number of steps 
in the JR binomial tree. OCC has acknowledged that the current number 
of steps is insufficient for accurately evaluating long-dated 
options.\15\ OCC proposes to introduce a variable number of steps in 
the LR binomial tree. As proposed, the minimum number of steps in the 
LR binomial tree would be greater than the current fixed number of 
steps in the JR binomial tree that is currently used by the Vanilla 
Option Model.
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    \15\ See id.
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(5) Risk Sensitivities
    OCC currently uses the Vanilla Option Model to calculate three risk 
sensitivities: Delta, Gamma, and Vega. OCC stated that the Vanilla 
Option Model does not currently calculate Theta or Rho.\16\ OCC 
proposes to use the Vanilla Option Model to calculate Theta and Rho 
while continuing to calculate Delta, Gamma, and Vega.
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    \16\ See id. Theta is a measurement of the relationship between 
an option's price and remaining time to expiration. Rho is a 
measurement of the relationship between an option's price and 
changes in the risk-free rate.
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B. Smoothing Algorithm

    The Smoothing Algorithm is a four-step process that OCC uses to 
estimate fair values for plain vanilla listed options based on closing 
bid and ask price quotes. First, OCC filters out certain, poor-quality 
price quotes.\17\ Second, OCC estimates the forward prices of the 
securities underlying the options. Third, OCC generates theoretical 
option prices based on bid and ask quotes and the forward prices 
estimated in the previous step.\18\ Finally, as described in the Notice 
of Filing, OCC constructs a volatility surface based on the smoothed 
prices from the prior steps, and uses that surface to approximate 
prices for contracts that were filtered out in the Smoothing 
Algorithm's first step.\19\ As discussed below, OCC proposes to make 
five changes to the Smoothing Algorithm.
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    \17\ As described in the Notice of Filing, 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. See Notice of Filing, 84 FR at 37374, n. 12.
    \18\ OCC applies a series of constraints when generating such 
theoretical option prices based on the implied forward prices 
calculated in the Smooth Algorithm's second step.
    \19\ See Notice of Filing, 84 FR at 37374, n. 18.
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(1) Model Inconsistencies
    Currently, the Smoothing Algorithm uses the LR binomial tree as 
part of the price smoothing process. As discussed above, the Vanilla 
Option Model currently uses the JR binomial tree. OCC has acknowledged 
that the inconsistency between the Vanilla Option Model and the 
Smoothing Algorithm could result in violations of put and call parity 
in OCC's margin calculations.\20\ The proposal to replace the JR 
binomial tree with the LR binomial tree in the Vanilla Option Model 
would resolve the inconsistency between the Vanilla Option Model and 
the Smoothing Algorithm.
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    \20\ See Notice of Filing, 84 FR at 37375.
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(2) Theoretical Spot Prices
    As noted above, the Smoothing Algorithm estimates the forward 
prices of securities underlying options, and uses the estimated forward 
prices to generate theoretical option prices. The estimation of forward 
prices relies, in part, on spot prices. Currently, the Smoothing 
Algorithm approximates spot prices for indices underlying options 
(i.e., theoretical spot prices) based on the prices of related index 
futures observed prior to the close of the futures markets. The 
relevant futures markets close at 3:15 p.m. Central Time; however, the 
markets for the underlying indices close at 3 p.m. Central Time. OCC 
has acknowledged that this difference in closing times could result in 
poorly smoothed prices whenever options trading between 3:00 p.m. and 
3:15 p.m. is volatile, which could result in problems in OCC's margin 
calculations.\21\ OCC proposes, for the

[[Page 44651]]

purpose of calculating theoretical spot prices, to rely on basis 
futures \22\ rather than index futures. The relevant markets for basis 
futures close at 3 p.m. Central Time, which aligns with the 3 p.m. 
close of the market for the underlying indices.
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    \21\ See id.
    \22\ Basis futures prices represent the spreads between the 
prices of futures and the assets underlying those futures. OCC 
states that these spreads are relatively stable throughout the day, 
including between their closing at 3:00 p.m. and the closing of the 
related index options market at 3:15 p.m. See id.
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(3) Volatility Cap
    As noted above, OCC uses the Smoothing Algorithm to construct a 
volatility surface based on theoretical option prices. The process for 
constructing such a volatility surface includes the application of 
certain restrictions to ensure that prices satisfy arbitrage-free 
conditions and bid and ask spread constraints. One such restriction 
involves capping unacceptably high volatilities. Currently, the 
Smoothing Algorithm imposes an abrupt cap on volatilities that causes 
the rate of change of volatility to change sharply at the point of the 
cap (i.e., the current cap causes a sudden change in an otherwise 
gradual process). OCC has acknowledged that such a jump may create 
negative convexity of the option prices versus strike prices (i.e., 
butterfly arbitrage opportunities).\23\ OCC proposes to impose a more 
gradual process for constraining unacceptably high volatilities with 
the intention of eliminating opportunities for butterfly arbitrage.
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    \23\ See id.
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(4) Short-Dated FLEX Options
    Currently, the Smoothing Algorithm generates prices for short-dated 
FLEX options by combining current market prices with implied 
volatilities from the prior day. OCC has acknowledged that combining 
prices and implied volatilities from different days in this way may 
cause the Smoothing Algorithm to generate option prices that are 
inconsistent with current market prices.\24\ OCC proposes to generate 
prices for short-dated FLEX options based on current market prices and 
the volatilities implied by such prices.\25\
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    \24\ See id.
    \25\ OCC is not proposing to change the Smoothing Algorithm's 
process regarding the generation of prices for long-dated FLEX 
options. See Notice of Filing, 84 FR at 37375, n. 29.
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(5) Borrowing Costs
    Currently, the Smoothing Algorithm does not directly consider 
Borrowing Costs when estimating fair prices for listed options. OCC has 
acknowledged that the Smoothing Algorithm instead relies on implied 
dividends,\26\ which can result in mispricing.\27\ OCC proposes to use 
Borrowing Costs, implied from listed option prices, as an independent 
input into the Smoothing Algorithm.
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    \26\ Implied dividends are a combination of Borrowing Costs and 
dividends. See Notice of Filing, 84 FR at 37375, n. 30.
    \27\ See id.
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III. Discussion and Commission Findings

    Although the Clearing Supervision Act does not specify a standard 
of review for an advance notice, the stated purpose of the Clearing 
Supervision Act is instructive: To mitigate systemic risk in the 
financial system and promote financial stability by, among other 
things, promoting uniform risk management standards for systemically 
important financial market utilities (``SIFMUs'') and strengthening the 
liquidity of SIFMUs.\28\
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    \28\ See 12 U.S.C. 5461(b).
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    Section 805(a)(2) of the Clearing Supervision Act \29\ authorizes 
the Commission to prescribe regulations containing risk-management 
standards for the payment, clearing, and settlement activities of 
designated clearing entities engaged in designated activities for which 
the Commission is the supervisory agency. Section 805(b) of the 
Clearing Supervision Act \30\ provides the following objectives and 
principles for the Commission's risk-management standards prescribed 
under Section 805(a):
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    \29\ 12 U.S.C. 5464(a)(2).
    \30\ 12 U.S.C. 5464(b).
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     To promote robust risk management;
     to promote safety and soundness;
     to reduce systemic risks; and
     to support the stability of the broader financial system.
    Section 805(c) provides, in addition, that the Commission's risk-
management standards may address such areas as risk-management and 
default policies and procedures, among others areas.\31\
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    \31\ 12 U.S.C. 5464(c).
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    The Commission has adopted risk-management standards under Section 
805(a)(2) of the Clearing Supervision Act and Section 17A of the 
Exchange Act (the ``Clearing Agency Rules'').\32\ The Clearing Agency 
Rules require, among other things, each covered clearing agency to 
establish, implement, maintain, and enforce written policies and 
procedures that are reasonably designed to meet certain minimum 
requirements for its operations and risk-management practices on an 
ongoing basis.\33\ As such, it is appropriate for the Commission to 
review advance notices against the Clearing Agency Rules and the 
objectives and principles of these risk management standards as 
described in Section 805(b) of the Clearing Supervision Act. As 
discussed below, the Commission believes the changes proposed in the 
Advance Notice are consistent with the objectives and principles 
described in Section 805(b) of the Clearing Supervision Act,\34\ and in 
the Clearing Agency Rules, in particular Rule 17Ad-22(e)(6)(i) and 
(iii).\35\
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    \32\ 17 CFR 240.17Ad-22. See Securities Exchange Act Release No. 
68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-08-11). 
See also Securities Exchange Act Release No. 78961 (September 28, 
2016), 81 FR 70786 (October 13, 2016) (S7-03-14) (``Covered Clearing 
Agency Standards''). The Commission established an effective date of 
December 12, 2016 and a compliance date of April 11, 2017 for the 
Covered Clearing Agency Standards. OCC is a ``covered clearing 
agency'' as defined in Rule 17Ad-22(a)(5).
    \33\ 17 CFR 240.17Ad-22.
    \34\ 12 U.S.C. 5464(b).
    \35\ 17 CFR 240.17Ad-22(e)(6)(i) and (iii).
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A. Consistency With Section 805(b) of the Clearing Supervision Act

    The Commission believes that the Advance Notice is consistent with 
the stated objectives and principles of Section 805(b) of the Clearing 
Supervision Act. The Commission believes that several of the proposed 
changes are consistent with the promotion of robust risk management as 
well as safety and soundness because they would address shortcomings in 
the assumptions underlying the Vanilla Option Model and the Smoothing 
Algorithm. The introduction of dynamic, rather than constant, interest 
rate and dividend data as inputs to the Vanilla Option Model would 
provide a more accurate representation of option market dynamics. 
Additionally, the use of basis futures, as opposed to index futures, to 
generate theoretical spot prices for indices underlying options could 
avoid problems in OCC's margin calculations arising from differences in 
market closing times. Similarly, the estimating prices for short-dated 
FLEX options based on price and implied volatility data from the same 
day (as opposed to different days) would better align with prices 
observed in the market. Further, the introduction of Borrowing Costs 
would allow OCC to account for a known cost not currently addressed in 
OCC's models. The Commission believes that the proposed changes 
described above would better align the Vanilla Option Model and the 
Smoothing Algorithm with the subject matter that they are designed to 
model.

[[Page 44652]]

The Commission also believes that the changes proposed to address model 
design issues identified in the Vanilla Option Model and the Smoothing 
Algorithm would be consistent with the promotion of robust risk 
management as well as safety and soundness. As noted above, OCC 
proposes to change the way the Smoothing Algorithm addresses 
unacceptably high volatilities to ensure that theoretical option prices 
satisfy certain arbitrage-free conditions (i.e., eliminating butterfly 
arbitrage opportunities). OCC also proposes to use the same binomial 
tree in both the Vanilla Option Model and the Smoothing Algorithm to 
enhance model consistency. The proposal to use a LR binomial tree with 
a variable number of steps, as opposed to the current fixed number of 
steps in a JR binomial tree, would allow the Vanilla Option Model to 
more accurately price long-dated options. Additionally, the move to the 
LR binomial tree would allow OCC to generate additional risk 
sensitivity data. Such data could allow OCC to better understand the 
risks present in Clearing Members' portfolios.
    Further, the Commission believes that, given OCC's role as a SIFMU, 
the changes proposed by OCC are consistent with reducing systemic risk 
and supporting the stability of the broader financial system. The 
Vanilla Option Model and the Smoothing Algorithm are two of the 
fundamental components of OCC's margin methodology. Improving the 
accuracy and precision of these models would improve the accuracy and 
precision of OCC's margin calculations, and could give OCC a better 
understanding of the risks posed by its Clearing Members. Improving 
OCC's margin calculations and understanding of its exposures would 
facilitate OCC's ability to manage potential Clearing Member defaults. 
Accordingly, and for the reasons stated above, the Commission believes 
the changes proposed in the Advance Notice are consistent with Section 
805(b) of the Clearing Supervision Act.\36\
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    \36\ 12 U.S.C. 5464(b).
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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 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.\37\
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    \37\ 17 CFR 240.17Ad-22(e)(6)(i).
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    As discussed above, certain changes that OCC proposes would be 
designed to better align the assumptions underlying the Vanilla Option 
Model and the Smoothing Algorithm with the products to which they are 
applied as well as the related markets. The introduction of dynamic, 
rather than constant, interest rate and dividend data as inputs to the 
Vanilla Option Model would provide a more accurate representation of 
the particular attributes of options markets. The estimation of prices 
for short-dated FLEX options based on prices and implied volatilities 
from the same day (as opposed to different days) would better align 
with prices observed in the market. Additionally, accounting for 
Borrowing Costs would better align OCC's margin requirements with 
particular attributes of plain vanilla options by accounting for the 
costs facing options market participants. Further, the move to a LR 
binomial tree in the Vanilla Option Model would allow OCC to generate 
additional risk data relevant to the products that OCC clears. The 
Commission believes, therefore, that adoption of the proposed changes 
designed to align OCC's models assumptions with market dynamics are 
consistent with Exchange Act Rule 17Ad-22(e)(6)(i).\38\
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    \38\ Id.
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C. Consistency With Rule 17Ad-22(e)(6)(iii) Under the Exchange Act

    Rule 17Ad-22(e)(6)(iii) under the Exchange Act requires that a 
covered clearing agency establish, implement, maintain, and enforce 
written policies and procedures reasonably designed to cover, if the 
covered clearing agency provides central counterparty services, its 
credit exposures to its participants by establishing a risk-based 
margin system that, at a minimum, 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.\39\
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    \39\ 17 CFR 240.17Ad-22(e)(6)(iii).
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    As discussed above, certain changes that OCC proposes to make to 
the Vanilla Option Model and the Smoothing Algorithm would address 
model design issues. OCC proposes to change the way the Smoothing 
Algorithm addresses unacceptably high volatilities to ensure that 
theoretical option prices satisfy certain arbitrage-free conditions 
(i.e., eliminating butterfly arbitrage opportunities). OCC also 
proposes to enhance model consistency by using the same binomial tree 
in both the Vanilla Option Model and the Smoothing Algorithm. Further, 
the proposal to replace the binomial tree's fixed number of steps with 
a variable number of steps would allow the Vanilla Option Model to more 
accurately price long-dated options. Finally, the use of basis futures, 
as opposed to index futures, to generate theoretical spot prices for 
indices underlying options could avoid problems in OCC's margin 
calculations arising from market volatility between 3:00 p.m. and 3:15 
p.m.
    The Commission believes that changes proposed to reduce model risk 
generally facilitate the effective functioning of the relevant models. 
The Vanilla Option Model and the Smoothing Algorithm estimate prices 
that OCC uses to set margin requirements. Better price estimates would 
allow OCC to better calculate margin sufficient to cover its potential 
future exposure to Clearing Members. The Commission believes, 
therefore, that adoption of the changes proposed to address design 
issues in OCC's margin methodology are consistent with Exchange Act 
Rule 17Ad-22(e)(6)(iii).\40\
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    \40\ Id.
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IV. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Clearing Supervision Act, that the Commission does not object to 
Advance Notice (SR-OCC-2019-804) and that OCC is authorized to 
implement the proposed change as of the date of this notice or the date 
of an order by the Commission approving proposed rule change SR-OCC-
2019-005, whichever is later.

    By the Commission.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019-18260 Filed 8-23-19; 8:45 am]
 BILLING CODE 8011-01-P