[Federal Register Volume 84, Number 167 (Wednesday, August 28, 2019)]
[Notices]
[Pages 45188-45191]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-18481]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-86731; File No. SR-OCC-2019-005]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Approving Proposed Rule Change Related to The Options Clearing
Corporation's Vanilla Option Model and Smoothing Algorithm
August 22, 2019.
I. Introduction
On June 28, 2019, the Options Clearing Corporation (``OCC'') filed
with the Securities and Exchange Commission (``Commission'') the
proposed rule change SR-OCC-2019-005 (``Proposed Rule Change'')
pursuant to Section 19(b) of the Securities Exchange Act of 1934
(``Exchange Act'') \1\ and Rule 19b-4 \2\ thereunder to propose changes
to OCC's margin methodology regarding the estimation of prices for
listed options contracts.\3\ The Proposed Rule Change was published for
public comment in the Federal Register on July 9, 2019,\4\ and the
Commission has received no comments regarding the Proposed Rule
Change.\5\ This order approves the Proposed Rule Change.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Notice of Filing infra note 4, at 84 FR 32821.
\4\ Securities Exchange Act Release No. 886296 (July 3, 2019),
84 FR 32821 (July 9, 2019) (SR-OCC-2019-004) (``Notice of Filing'').
OCC also filed a related advance notice (SR-OCC-2019-804) (``Advance
Notice'') with the Commission pursuant to Section 806(e)(1) of Title
VIII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act, entitled the Payment, Clearing, and Settlement Supervision Act
of 2010 and Rule 19b-4(n)(1)(i) under the Exchange Act. 12 U.S.C.
5465(e)(1). 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, respectively.
The Advance Notice was published in the Federal Register on July 31,
2019. Securities Exchange Act Release No. 86488 (Jul. 26, 2019), 84
FR 37373 (Jul. 31, 2019) (SR-OCC-2019-804).
\5\ Since the proposal contained in the Proposed Rule Change was
also filed as an advance notice, all public comments received on the
proposal are considered regardless of whether the comments are
submitted on the Proposed Rule Change or 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''); \6\ and (2) estimate
fair prices of listed option contracts based on their bid and ask price
quotes (the ``Smoothing Algorithm'').\7\ The changes proposed in the
Proposed Rule Change are designed to address five limitations of the
current Vanilla Option Model and five limitations of the current
Smoothing Algorithm.
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\6\ 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 32817, n.7. As of the time of filing, plain vanilla options
accounted for approximately 95 percent of the total contracts
cleared by OCC. See id.
\7\ 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 32817.
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A. Vanilla Option Model
OCC relies on the Vanilla Option Model to generate theoretical
values, 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.\8\ Given the current market price of a plain
vanilla option, OCC uses such algorithms to estimate the implied
volatility of the option.\9\ 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.\10\ As discussed below,
OCC proposes five changes to the Vanilla Option Model.
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\8\ For example, OCC generates theoretical values for American
style options using a modified Jarrow-Rudd (``JR'') binomial tree.
\9\ 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.
\10\ 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.\11\ 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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\11\ See Notice of Filing, 84 FR at 32818.
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[[Page 45189]]
(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.\12\ 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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\12\ See id.
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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.\13\ OCC proposes to
replace the JR binomial tree with the LR binomial tree in the Vanilla
Option Model.
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\13\ 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.\14\ 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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\14\ 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.\15\ 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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\15\ 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.\16\ 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.\17\ 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.\18\ As discussed below, OCC proposes to make
five changes to the Smoothing Algorithm.
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\16\ 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 32817, n.11.
\17\ 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.
\18\ See Notice of Filing, 84 FR at 32818, n.17.
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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.\19\ 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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\19\ See Notice of Filing, 84 FR at 32818.
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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.\20\ OCC proposes, for the purpose of calculating
theoretical spot prices, to rely on basis futures \21\ 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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\20\ See Notice of Filing, 84 FR at 32818-19.
\21\ 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 Notice of Filing, 84
FR at 32819.
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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).\22\ 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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\22\ 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.\23\ OCC proposes to generate
prices for short-dated FLEX options
[[Page 45190]]
based on current market prices and the volatilities implied by such
prices.\24\
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\23\ See id.
\24\ 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 32819, n.28.
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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,\25\ which can result in mispricing.\26\ OCC proposes to use
Borrowing Costs, implied from listed option prices, as an independent
input into the Smoothing Algorithm.
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\25\ Implied dividends are a combination of Borrowing Costs and
dividends. See Notice of Filing, 84 FR at 32819, n.29.
\26\ See id.
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III. Discussion and Commission Findings
Section 19(b)(2)(C) of the Exchange Act directs the Commission to
approve a proposed rule change of a self-regulatory organization if it
finds that such proposed rule change is consistent with the
requirements of the Exchange Act and the rules and regulations
thereunder applicable to such organization.\27\ After carefully
considering the Proposed Rule Change, the Commission finds the proposal
is consistent with the requirements of the Exchange Act and the rules
and regulations thereunder applicable to OCC. More specifically, the
Commission finds that the proposal is consistent with Section
17A(b)(3)(F) of the Exchange Act \28\ and Rules 17Ad-22(e)(6)(i) and
(iii).\29\
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\27\ 15 U.S.C. 78s(b)(2)(C).
\28\ 15 U.S.C. 78q-1(b)(3)(F).
\29\ 17 CFR 240.17Ad-22(e)(6)(i) and (iii).
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A. Consistency With Section 17A(b)(3)(F) of the Exchange Act
Section 17A(b)(3)(F) of the Exchange Act requires that the rules of
a clearing agency be designed to, among other things, assure the
safeguarding of securities and funds which are in the custody or
control of the clearing agency or for which it is responsible.\30\
Based on its review of the record, the Commission believes that the
proposed changes are designed to assure the safeguarding of securities
and funds which are in OCC's custody or control for the reasons set
forth below.
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\30\ 15 U.S.C. 78q-1(b)(3)(F).
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OCC manages its credit exposure to Clearing Members, in part,
through the collection of collateral based on OCC's margin methodology.
As noted above, two primary components of OCC's margin methodology are
the Vanilla Option Model and the Smoothing Algorithm. Several of the
proposed changes 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.
Other of the proposed changes would address model design issues
identified in the Vanilla Option Model and the Smoothing Algorithm. 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.
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.
The Commission believes that the proposed changes would improve OCC's
margin methodology as described above. Improving OCC's margin
methodology could reduce the potentiality that OCC would mutualize a
loss arising out of the process of closing out a defaulted Clearing
Member's portfolio. While unavoidable under certain circumstances,
reducing the potentiality of loss mutualization during periods of
market stress could reduce the potential knock-on effects to non-
defaulting Clearing Members, their customers and the broader options
market arising out of a Clearing Member default. The Commission
believes, therefore, that the proposed improvements to OCC's margin
methodology are consistent with assuring the safeguarding of securities
and funds which are in OCC's custody or control or for which it is
responsible consistent with the requirements of Section 17A(b)(3)(F) of
the Exchange Act.\31\
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\31\ 15 U.S.C. 78q-1(b)(3)(F).
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B. Consistency With Rule 17Ad-22(e)(6)(i) Under the Exchange Act
Rule 17Ad-22(e)(6)(i) under the Exchange Act requires 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.\32\
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\32\ 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
[[Page 45191]]
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).\33\
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\33\ Id.
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C. Consistency With Rule 17Ad-22(e)(6)(i) 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.\34\
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\34\ 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 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).\35\
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\35\ Id.
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IV. Conclusion
On the basis of the foregoing, the Commission finds that the
Proposed Rule Change is consistent with the requirements of the
Exchange Act, and in particular, the requirements of Section 17A of the
Exchange Act \36\ and the rules and regulations thereunder.
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\36\ In approving this Proposed Rule Change, the Commission has
considered the proposed rules' impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f).
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Exchange Act,\37\ that the Proposed Rule Change (SR-OCC-2019-005) be,
and hereby is, approved.
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\37\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\38\
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\38\ 17 CFR 200.30-3(a)(12).
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Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019-18481 Filed 8-27-19; 8:45 am]
BILLING CODE 8011-01-P