Self-Regulatory Organizations; The Options Clearing Corporation; Order Granting Approval of a Proposed Rule Change Relating to a New Risk Management Methodology, 9403-9405 [E6-2519]
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Federal Register / Vol. 71, No. 36 / Thursday, February 23, 2006 / Notices
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–53322; File No. SR–OCC–
2004–20]
Self-Regulatory Organizations; The
Options Clearing Corporation; Order
Granting Approval of a Proposed Rule
Change Relating to a New Risk
Management Methodology
February 15, 2006.
I. Introduction
On November 15, 2004, The Options
Clearing Corporation (‘‘OCC’’) filed with
the Securities and Exchange
Commission (‘‘Commission’’) proposed
rule change SR–OCC–2004–20 pursuant
to Section 19(b)(1) of the Securities
Exchange Act of 1934 (‘‘Act’’).1 Notice
of the proposal was published in the
Federal Register on December 27,
2005.2 No comment letters were
received. For the reasons discussed
below, the Commission is granting
approval of the proposed rule change.
II. Description
The rule change will allow OCC to
implement a new risk management
methodology to determine the amount
of margin assets required to be
deposited by a clearing member with
respect to each account of that clearing
member. The new risk management
methodology, the System for Theoretical
Analysis and Numerical Simulations,
will enhance OCC’s ability to measure
the risk of the portfolios in a clearing
member’s accounts more accurately and
therefore, will enable OCC to calculate
margin requirements more precisely.3
rwilkins on PROD1PC63 with NOTICES
1. The Existing Risk Management
Methodology: The Theoretical
Intermarket Margining System
Currently, OCC applies the
Theoretical Intermarket Margining
System (‘‘TIMS’’) for the calculation of
clearing members’ daily minimum
margin requirements, for the
determination of the size of OCC’s
clearing fund, for the computation of
additional margin requirements, and for
assessing risk in the Hedge Program.
TIMS is a univariate risk management
methodology that evaluates historical
data of approximately 3,000 underlying
assets to identify the expected gain or
loss on positions that would occur at ten
price points for equity instruments and
at twenty price points for non-equity
1 15
U.S.C. 78s(b)(1).
Exchange Act Release No. 52975
(December 19, 2005), 70 FR 76487.
3 OCC will continue to run its TIMS methodology
for purposes of calculating theoretical gains and
losses pursuant to Rule 15c3–1a under the Act.
2 Securities
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16:15 Feb 22, 2006
Jkt 205001
instruments within a range of likely
price movements of each underlying
interest. TIMS requires that options,
futures, and stock loan and borrow
positions that have the same underlying
interest be categorized into classes and
that classes be categorized into unique
product groups consisting of one or
more related classes. TIMS calculates
the total risk of each clearing member
account as the sum of the worst scenario
outcomes of each product group in the
account. TIMS recognizes offsetting
positions within each clearing member
account but only to the extent that the
offsetting positions are in the same
product group.
Although TIMS has consistently
produced sufficient base margin
requirements, this methodology has a
number of shortcomings that have riskrelevant consequences. The following
are examples of these shortcomings:
a. Because TIMS requires that each
class group belong to only one product
group, any offsetting effects among
instruments in different product groups
are ignored when margin requirements
are calculated. This inherent lack of
methodological flexibility tends to
overestimate portfolio risk thereby
imposing unnecessarily high margin
requirements on clearing members.
b. TIMS assumes perfect correlation of
price movements for underlying
interests belonging to the same product
group. As a result, margin requirements
for unhedged product group portfolios
are often overstated, and margin
requirements for hedged product group
portfolios are often understated.
c. TIMS calculates the total account
risk as the sum of the worst scenario
outcomes of all product groups. In that
sense, TIMS does not measure the price
risk of the total portfolio. Instead, it
measures the price risk of the various
subportfolios as represented by product
groups. Since portfolio risk can never be
larger than the sum of the portfolio
components’ risks, but could be smaller
to the extent of any offsetting
relationships, TIMS’s aggregation of
product group risks results in an
upwardly biased estimation of a clearing
member’s portfolio risk.
d. TIMS’s aggregation methodology
often implies an economically
impossible correlation (positive or
negative) between product groups in an
account. Suppose, for example, that an
account has a (delta) long position in
the broad-based index group and a
(delta) short position in the individual
equities group. By aggregating the risks
in these two groups, TIMS implies that
a decline in all broad-based indices
could exist simultaneously with a rise
PO 00000
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Fmt 4703
Sfmt 4703
9403
in all individual equities—an
impossible economic scenario.
e. In analyzing historical data, TIMS
focuses on a range of potential price
movements. However, covering 99% of
all potential price movements does not
result in coverage of 99% of all profit/
loss outcomes, which is the desired
goal. Using the TIMS method, some
accounts may have margin requirements
covering 98% of profit/loss outcomes
while others are covered at 99.9%.
These small statistical differences can
have large dollar implications.
2. The New Risk Management
Methodology: The System for
Theoretical Analysis and Numerical
Simulations
STANS preserves TIMS’s analysis of
the historical price movements of
underlying assets and of the correlation
of such price movements among
underlying assets. However, STANS
evaluates price risk on a portfolio level
and more accurately evaluates the
correspondence of price movements
among underlying assets and therefore,
is able to calculate margin requirements
more accurately than TIMS.
STANS is a multivariate risk
management methodology that
considers the range of likely price
movements for each of the
approximately 8,000 assets underlying
OCC options. STANS measures the
historical correlations among the price
movements of the different assets.
STANS generates simulated returns for
all underlying assets based on this
historical data, measures the historical
price volatility of each of these
underlying assets, and evaluates the
relationship structure of the entire
portfolio. The following are ways in
which STANS reduces the imprecision
associated with TIMS:
a. Because STANS does not use
TIMS’s product group concept, STANS
recognizes the relationship of each asset
class to all other asset classes rather
than recognizing only the relationships
among asset classes in the same product
group. Therefore, STANS will more
accurately identify offsetting positions,
and margin requirements will be
adjusted downward accordingly.
b. STANS identifies a more realistic
correlative relationship among
underlying assets than TIMS. STANS
does not exclude opposite moves for
positively correlated assets. In contrast,
price scenarios within the TIMS
methodology are all concordant.
c. Because STANS eliminates product
groups, it is able to evaluate the
interrelationships among all
instruments in a clearing member’s
portfolio rather than only within a
E:\FR\FM\23FEN1.SGM
23FEN1
rwilkins on PROD1PC63 with NOTICES
9404
Federal Register / Vol. 71, No. 36 / Thursday, February 23, 2006 / Notices
product group. STANS’s estimates of
portfolio risk are neither upwardly nor
downwardly biased.
d. STANS generates a distribution of
10,000 potential profit/loss outcomes for
the entire portfolio rather than simply a
range of potential price movements. By
producing margin requirements that are
more precise for every account, STANS
ensures all accounts will have coverage
for predicted liquidation outcomes at
the selected confidence levels.
These characteristics will improve the
accuracy of margin calculations which
should improve the financial stability of
OCC and the derivatives markets. In
addition, STANS allows for easy
integration of various types of nonequity products, such as fixed-income
related products and commodities. The
implementation of STANS thus
facilitates joint risk assessment
initiatives that can produce clearing and
settlement efficiencies beneficial to
investors.
To reflect the implementation of
STANS in OCC’s By-Laws and Rules,
OCC will revise most of Rule 601 and
will eliminate Rule 602. Revised Rule
601 is conceptual rather than a
mechanical, step-wise description of
margin requirement calculations. It is
therefore more concise than the existing
Rule 601. OCC presently calculates
margin requirements for equity and nonequity products separately with Rule
601 being applicable to equities and
Rule 602 being applicable to nonequities. Because STANS will calculate
margin on equity and non-equity
products in one integrated set of
calculations, the calculation of margin
requirements for all products will be as
set forth in revised Rule 601. OCC
proposes to delete cross-references to
Rule 602 as appropriate throughout the
Rules.
Revised Rule 601(c) contains a basic
conceptual description of how under
STANS OCC will determine the amount
of margin assets a clearing member is
required to deposit with OCC. Revised
Rule 601(c) uses the concepts of
‘‘margin requirement,’’ ‘‘margin assets,’’
‘‘marking prices,’’ and ‘‘minimum
expected liquidating value’’ to aid in the
description of STANS and of margin
requirement calculations. Definitions of
each of these terms have been included
in the amendments to Article I of the
By-Laws or Rule 601 as appropriate.
OCC will delete terms that were
defined in Rule 601(b) that were
relevant to TIMS but that are not
relevant to STANS. For example, the
terms ‘‘premium margin’’ and ‘‘risk
margin’’ are deleted. The ‘‘margin
requirement’’ as determined using
STANS will be at least equal to the
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16:15 Feb 22, 2006
Jkt 205001
‘‘minimum expected liquidating value’’
of the account if such expected value is
less than zero. The ‘‘minimum expected
liquidating value’’ may be
conceptualized as (i) the current net
asset value of positions in the account
(i.e., what used to be called ‘‘premium
margin’’) plus (ii) an additional amount
sufficient to cover the impact of the
largest expected adverse market
movement (i.e., what used to be called
‘‘risk margin’’). Because STANS does
not derive the ‘‘minimum expected
liquidating value’’ in this additive way
and because STANS is designed to
project expected values for margin
assets whose prices are not referred to
as ‘‘premiums,’’ the old terminology is
not appropriate.
The definition of ‘‘marking price’’ is
quite flexible and allows OCC to use its
discretion in determining marking
prices and to use different marking
prices for the same asset or liability
depending upon the purpose for which
a marking price is needed. An example
of where the latter situation may occur
is in the case of stock loan and borrow
positions. Marking prices in the stock
lending market are determined by the
conventions of that market, and OCC
would generally observe the prices used
in that market for purposes of
determining the daily marks passed
through OCC between the lender and
the borrower. OCC might, however,
have a different view of the correct
marking price to use for purposes of
calculating the risk of those positions in
STANS.
The purpose of revised Rule 601(e),
‘‘Exclusions from Margin Requirement
Calculation,’’ is to identify in one place
those positions that are excluded from
margin requirement calculations
altogether. Previous Rule 601(e)
indicated that exercised or expired
positions in cleared contracts or stock
loan and borrow positions were
excluded from margin requirement
calculations. Rule 601(a) previously
indicated that short positions in option
contracts or BOUNDs for which a
deposit in lieu of margin has been made
were excluded from margin requirement
calculations. Rule 614 previously
indicated that long positions in cleared
securities that have been pledged to a
pledgee were excluded from margin
requirement calculations. By definition,
margin-ineligible stock loan positions
and stock borrow positions are excluded
from margin requirement calculations.
Consolidating these provisions in one
place facilitates understanding.
The release of margin assets to
clearing members as described in
previous Rule 601(e) has been revised to
be clearer and more concise and is now
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Fmt 4703
Sfmt 4703
covered in Rule 601(f). The previous
rule contained a somewhat artificial
description of margin assets being
released under a position-specific
determination. Consistent with the more
integrated approach of the STANS
methodology, revised Rule 601(f) simply
states that OCC will permit the release
of margin with respect to a clearing
member’s account if the amount of
margin assets in a clearing member’s
account exceeds the amount of margin
assets required to be in the account
pursuant to Rule 601 and if any other
obligations of the clearing member to
OCC have been satisfied.
Previous Rule 2111(b) and Rule
2409(b) envisioned that a provisional
margin requirement would be calculated
with respect to cross-rate foreign
currency options and FX Index Options.
The provisional margin requirement
was intended to ensure that OCC would
not release premiums due to an account
of a clearing member in a non-U.S. time
zone at a time when it was holding
insufficient margin to cover a premium
debit in a later time zone and/or
increased margin requirements resulting
from activity in cross-rate and foreign
currency index options since the last
U.S. Dollar settlement. OCC will
eliminate this provisional margin
requirement and will instead simply
hold any amounts otherwise payable to
a clearing member in a different time
zone until after the next regular
settlement time in the U.S. Experience
has shown that clearing members often
instruct OCC to credit any cash from
these early settlements to their OCC
accounts instead of releasing it, and the
amounts involved do not justify the
costs of administering the more
cumbersome procedure of calculating
provisional margin requirements.
OCC expects that the amount of
margin it will collect under STANS will
be significantly less than the amount of
margin it currently collects under TIMS.
This is largely due to the fact that
STANS more accurately identifies
offsetting positions than TIMS.
Accordingly, there would be a
corresponding reduction in the amount
of clearing fund collected by OCC under
STANS because under Chapter X,
‘‘Clearing Fund Contributions,’’ clearing
fund is calculated as a percentage of
margin. The Division of Market
Regulation (‘‘Division’’) requested that
OCC amend its rules to increase the
percentage used to calculate the size of
the clearing fund because the Division
believes that for the time being the
clearing fund should not be significantly
reduced. As a result, OCC amended the
proposed rule change to amend Chapter
X, Rule 1001, ‘‘Amount of [Clearing
E:\FR\FM\23FEN1.SGM
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Federal Register / Vol. 71, No. 36 / Thursday, February 23, 2006 / Notices
Fund] Contribution,’’ to increase the
minimum percentage used in the
clearing fund calculation from 5 percent
to 6 percent of average aggregate margin.
rwilkins on PROD1PC63 with NOTICES
III. Discussion
Section 17A(b)(3)(F) of the Act
provides that the rules of a clearing
agency should be designed to promote
the prompt and accurate clearance and
settlement of securities transactions and
to assure the safeguarding of securities
and funds which are in its custody or
control or for which it is responsible.
OCC’s margin methodology calculates
the current replacement cost and market
risk associated with a member’s
positions so that OCC may collect
sufficient collateral to complete
settlement in the event the member
becomes insolvent or otherwise fails to
meet its obligations to OCC. OCC’s
ability to meet its settlement obligations
following a member insolvency is an
important function of its role as a
central counterparty.4 It is therefore
necessary that OCC have an effective
methodology for calculating risk-based
margin to promote the prompt and
accurate clearance and settlement of
securities transactions and to assure the
safeguarding of securities and funds
which are in its custody or control or for
which it is responsible.
The TIMS methodology has been used
by OCC since 1991 5 and has become
recognized as an industry standard for
measuring risk in portfolios comprised
of options, futures, and futures on
options. However, as discussed above,
OCC believes that there are some
shortcomings to the TIMS methodology
and that the more sophisticated STANS
methodology will better measure the
market risk in a member’s account. One
of the main shortcomings of TIMS is
that it recognizes only a limited
diversification benefit for clearing
member accounts by offsetting positions
only within the same product group.
Further, these offsets are conservative
4 The margin methodology under both TIMS and
STANS uses short-term historical returns and
return volatilities to calculate the market risk
associated with a member’s positions. As a result,
margin should provide OCC with sufficient
collateral to complete settlement under normal
market conditions. Very unusual and sudden
market moves could result in losses to a member’s
account that are in excess of the margin on deposit
with OCC. If a member becomes insolvent or
otherwise fails to meet its obligations to OCC under
such circumstances, OCC would access the assets
in its clearing fund to complete settlement of the
member’s trades.
5 Securities Exchange Act Release Nos. 27394
(October 26, 1989), 54 FR 46175 (November 1, 1989)
[File No. SR–OCC–89–12] (Notice of filing for the
TIMS proposal) and 28928 (March 1, 1991), 56 FR
9995 (March 8, 1991) (Original order approving the
use of TIMS to calculate margin on equity options
on a temporary basis).
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Jkt 205001
and are not based on a statistical model
for the joint behavior of asset returns.
STANS, on the other hand, generates
simulated returns for all of the positions
in the clearing member’s account
simultaneously. The statistical
specification and subsequent simulation
in STANS, rather than the ad hoc rule
in TIMS, determines the degree of offset
for correlated positions.
Because STANS is designed to allow
a greater amount of offset for
diversification than TIMS, most of
OCC’s members will be required to
deposit less margin under STANS than
they currently are under TIMS. For
instance, the 20 largest accounts at OCC
would have exhibited reductions in
margin of over 50 percent as of
September 2005. This significant
reduction reflects the difference
between the two methodologies in
allowance of a diversification benefit in
calculating the risk-based margin of a
member’s account. It does not reflect a
change in the purpose of OCC’s margin
requirement, which is to provide OCC
with sufficient collateral in the event a
member becomes insolvent or otherwise
fails to meet its obligations to OCC. OCC
will collect less margin from its
members under STANS because STANS
will explicitly model a joint distribution
of asset returns in order to better
measure risk at the member portfolio
level and not because OCC is changing
its tolerance for counterparty credit risk.
OCC has operated STANS in test
mode for more than two years and has
reviewed the methodology and the
results of test operations with staff of
the Commission’s Division of Market
Regulation (‘‘Division’’) during that
time. Since June 2003, OCC has been
providing information on the statistical
and operational features of the STANS
methodology to staff of the Office of
Prudential Supervision and Risk
Analysis of the Division. To become
comfortable with the STANS
methodology, the Division requested
that OCC produce various graphs,
simulations, and spreadsheets
evidencing STANS’s ability to calculate
margin requirements more accurately
than TIMS. As a result of these reviews,
the Commission is of the opinion that
STANS is consistent with the practices
of other sophisticated market
participants in measuring the risk
associated with options portfolios.
Although the Commission is satisfied
that STANS has performed in test mode
as expected thus far, it is requiring OCC
to take two measures with respect to
using the new methodology. First, OCC
will continue to provide the Division
with information regarding the
performance of STANS. OCC will
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9405
provide the Division with quarterly
reports summarizing any instances in
which a member’s account experienced
a loss that exceeded the margin
requirement calculated by STANS and
the magnitude of any such losses.
Second, OCC has amended its clearing
fund formula so that the amount of
clearing fund, which is a percentage of
average daily total margin, will not
initially decrease with the
implementation of STANS and the
decrease in margin requirements.
Because the clearing fund serves as a
resource in the event of insufficient
margin deposits, the Commission does
not believe it is prudent at this time for
the size of the clearing fund to
significantly decrease at the same time
margin requirements are significantly
decreased. Therefore, OCC is increasing
its clearing fund calculation so that the
clearing fund will be 6 percent, instead
of 5 percent, of aggregate daily total
margin.
Accordingly, because the Commission
believes the STANS methodology is
designed to provide OCC with sufficient
margin to protect itself in the event of
a member insolvency or other inability
to satisfy its obligations to OCC, the
Commission finds that OCC’s proposed
rule change implementing STANS and
revising its clearing fund calculation is
designed to promote the prompt and
accurate clearance and settlement of
securities transactions and to assure the
safeguarding of securities and funds
which are in OCC’s custody or control
or for which it is responsible.
IV. Conclusion
On the basis of the foregoing, the
Commission finds that the proposed
rule change is consistent with the
requirements of the Act and in
particular with the requirements of
Section 17A of the Act and the rules and
regulations thereunder.
It is therefore ordered, pursuant to
Section 19(b)(2) of the Act, that the
proposed rule change (File No. SR–
OCC–2004–20) be and hereby is
approved.
For the Commission by the Division of
Market Regulation, pursuant to delegated
authority.6
J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E6–2519 Filed 2–22–06; 8:45 am]
BILLING CODE 8010–01–P
6 17
E:\FR\FM\23FEN1.SGM
CFR 200.30–3(a)(12).
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Agencies
[Federal Register Volume 71, Number 36 (Thursday, February 23, 2006)]
[Notices]
[Pages 9403-9405]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-2519]
[[Page 9403]]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-53322; File No. SR-OCC-2004-20]
Self-Regulatory Organizations; The Options Clearing Corporation;
Order Granting Approval of a Proposed Rule Change Relating to a New
Risk Management Methodology
February 15, 2006.
I. Introduction
On November 15, 2004, The Options Clearing Corporation (``OCC'')
filed with the Securities and Exchange Commission (``Commission'')
proposed rule change SR-OCC-2004-20 pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'').\1\ Notice of the proposal
was published in the Federal Register on December 27, 2005.\2\ No
comment letters were received. For the reasons discussed below, the
Commission is granting approval of the proposed rule change.
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ Securities Exchange Act Release No. 52975 (December 19,
2005), 70 FR 76487.
---------------------------------------------------------------------------
II. Description
The rule change will allow OCC to implement a new risk management
methodology to determine the amount of margin assets required to be
deposited by a clearing member with respect to each account of that
clearing member. The new risk management methodology, the System for
Theoretical Analysis and Numerical Simulations, will enhance OCC's
ability to measure the risk of the portfolios in a clearing member's
accounts more accurately and therefore, will enable OCC to calculate
margin requirements more precisely.\3\
---------------------------------------------------------------------------
\3\ OCC will continue to run its TIMS methodology for purposes
of calculating theoretical gains and losses pursuant to Rule 15c3-1a
under the Act.
---------------------------------------------------------------------------
1. The Existing Risk Management Methodology: The Theoretical
Intermarket Margining System
Currently, OCC applies the Theoretical Intermarket Margining System
(``TIMS'') for the calculation of clearing members' daily minimum
margin requirements, for the determination of the size of OCC's
clearing fund, for the computation of additional margin requirements,
and for assessing risk in the Hedge Program. TIMS is a univariate risk
management methodology that evaluates historical data of approximately
3,000 underlying assets to identify the expected gain or loss on
positions that would occur at ten price points for equity instruments
and at twenty price points for non-equity instruments within a range of
likely price movements of each underlying interest. TIMS requires that
options, futures, and stock loan and borrow positions that have the
same underlying interest be categorized into classes and that classes
be categorized into unique product groups consisting of one or more
related classes. TIMS calculates the total risk of each clearing member
account as the sum of the worst scenario outcomes of each product group
in the account. TIMS recognizes offsetting positions within each
clearing member account but only to the extent that the offsetting
positions are in the same product group.
Although TIMS has consistently produced sufficient base margin
requirements, this methodology has a number of shortcomings that have
risk-relevant consequences. The following are examples of these
shortcomings:
a. Because TIMS requires that each class group belong to only one
product group, any offsetting effects among instruments in different
product groups are ignored when margin requirements are calculated.
This inherent lack of methodological flexibility tends to overestimate
portfolio risk thereby imposing unnecessarily high margin requirements
on clearing members.
b. TIMS assumes perfect correlation of price movements for
underlying interests belonging to the same product group. As a result,
margin requirements for unhedged product group portfolios are often
overstated, and margin requirements for hedged product group portfolios
are often understated.
c. TIMS calculates the total account risk as the sum of the worst
scenario outcomes of all product groups. In that sense, TIMS does not
measure the price risk of the total portfolio. Instead, it measures the
price risk of the various subportfolios as represented by product
groups. Since portfolio risk can never be larger than the sum of the
portfolio components' risks, but could be smaller to the extent of any
offsetting relationships, TIMS's aggregation of product group risks
results in an upwardly biased estimation of a clearing member's
portfolio risk.
d. TIMS's aggregation methodology often implies an economically
impossible correlation (positive or negative) between product groups in
an account. Suppose, for example, that an account has a (delta) long
position in the broad-based index group and a (delta) short position in
the individual equities group. By aggregating the risks in these two
groups, TIMS implies that a decline in all broad-based indices could
exist simultaneously with a rise in all individual equities--an
impossible economic scenario.
e. In analyzing historical data, TIMS focuses on a range of
potential price movements. However, covering 99% of all potential price
movements does not result in coverage of 99% of all profit/loss
outcomes, which is the desired goal. Using the TIMS method, some
accounts may have margin requirements covering 98% of profit/loss
outcomes while others are covered at 99.9%. These small statistical
differences can have large dollar implications.
2. The New Risk Management Methodology: The System for Theoretical
Analysis and Numerical Simulations
STANS preserves TIMS's analysis of the historical price movements
of underlying assets and of the correlation of such price movements
among underlying assets. However, STANS evaluates price risk on a
portfolio level and more accurately evaluates the correspondence of
price movements among underlying assets and therefore, is able to
calculate margin requirements more accurately than TIMS.
STANS is a multivariate risk management methodology that considers
the range of likely price movements for each of the approximately 8,000
assets underlying OCC options. STANS measures the historical
correlations among the price movements of the different assets. STANS
generates simulated returns for all underlying assets based on this
historical data, measures the historical price volatility of each of
these underlying assets, and evaluates the relationship structure of
the entire portfolio. The following are ways in which STANS reduces the
imprecision associated with TIMS:
a. Because STANS does not use TIMS's product group concept, STANS
recognizes the relationship of each asset class to all other asset
classes rather than recognizing only the relationships among asset
classes in the same product group. Therefore, STANS will more
accurately identify offsetting positions, and margin requirements will
be adjusted downward accordingly.
b. STANS identifies a more realistic correlative relationship among
underlying assets than TIMS. STANS does not exclude opposite moves for
positively correlated assets. In contrast, price scenarios within the
TIMS methodology are all concordant.
c. Because STANS eliminates product groups, it is able to evaluate
the interrelationships among all instruments in a clearing member's
portfolio rather than only within a
[[Page 9404]]
product group. STANS's estimates of portfolio risk are neither upwardly
nor downwardly biased.
d. STANS generates a distribution of 10,000 potential profit/loss
outcomes for the entire portfolio rather than simply a range of
potential price movements. By producing margin requirements that are
more precise for every account, STANS ensures all accounts will have
coverage for predicted liquidation outcomes at the selected confidence
levels.
These characteristics will improve the accuracy of margin
calculations which should improve the financial stability of OCC and
the derivatives markets. In addition, STANS allows for easy integration
of various types of non-equity products, such as fixed-income related
products and commodities. The implementation of STANS thus facilitates
joint risk assessment initiatives that can produce clearing and
settlement efficiencies beneficial to investors.
To reflect the implementation of STANS in OCC's By-Laws and Rules,
OCC will revise most of Rule 601 and will eliminate Rule 602. Revised
Rule 601 is conceptual rather than a mechanical, step-wise description
of margin requirement calculations. It is therefore more concise than
the existing Rule 601. OCC presently calculates margin requirements for
equity and non-equity products separately with Rule 601 being
applicable to equities and Rule 602 being applicable to non-equities.
Because STANS will calculate margin on equity and non-equity products
in one integrated set of calculations, the calculation of margin
requirements for all products will be as set forth in revised Rule 601.
OCC proposes to delete cross-references to Rule 602 as appropriate
throughout the Rules.
Revised Rule 601(c) contains a basic conceptual description of how
under STANS OCC will determine the amount of margin assets a clearing
member is required to deposit with OCC. Revised Rule 601(c) uses the
concepts of ``margin requirement,'' ``margin assets,'' ``marking
prices,'' and ``minimum expected liquidating value'' to aid in the
description of STANS and of margin requirement calculations.
Definitions of each of these terms have been included in the amendments
to Article I of the By-Laws or Rule 601 as appropriate.
OCC will delete terms that were defined in Rule 601(b) that were
relevant to TIMS but that are not relevant to STANS. For example, the
terms ``premium margin'' and ``risk margin'' are deleted. The ``margin
requirement'' as determined using STANS will be at least equal to the
``minimum expected liquidating value'' of the account if such expected
value is less than zero. The ``minimum expected liquidating value'' may
be conceptualized as (i) the current net asset value of positions in
the account (i.e., what used to be called ``premium margin'') plus (ii)
an additional amount sufficient to cover the impact of the largest
expected adverse market movement (i.e., what used to be called ``risk
margin''). Because STANS does not derive the ``minimum expected
liquidating value'' in this additive way and because STANS is designed
to project expected values for margin assets whose prices are not
referred to as ``premiums,'' the old terminology is not appropriate.
The definition of ``marking price'' is quite flexible and allows
OCC to use its discretion in determining marking prices and to use
different marking prices for the same asset or liability depending upon
the purpose for which a marking price is needed. An example of where
the latter situation may occur is in the case of stock loan and borrow
positions. Marking prices in the stock lending market are determined by
the conventions of that market, and OCC would generally observe the
prices used in that market for purposes of determining the daily marks
passed through OCC between the lender and the borrower. OCC might,
however, have a different view of the correct marking price to use for
purposes of calculating the risk of those positions in STANS.
The purpose of revised Rule 601(e), ``Exclusions from Margin
Requirement Calculation,'' is to identify in one place those positions
that are excluded from margin requirement calculations altogether.
Previous Rule 601(e) indicated that exercised or expired positions in
cleared contracts or stock loan and borrow positions were excluded from
margin requirement calculations. Rule 601(a) previously indicated that
short positions in option contracts or BOUNDs for which a deposit in
lieu of margin has been made were excluded from margin requirement
calculations. Rule 614 previously indicated that long positions in
cleared securities that have been pledged to a pledgee were excluded
from margin requirement calculations. By definition, margin-ineligible
stock loan positions and stock borrow positions are excluded from
margin requirement calculations. Consolidating these provisions in one
place facilitates understanding.
The release of margin assets to clearing members as described in
previous Rule 601(e) has been revised to be clearer and more concise
and is now covered in Rule 601(f). The previous rule contained a
somewhat artificial description of margin assets being released under a
position-specific determination. Consistent with the more integrated
approach of the STANS methodology, revised Rule 601(f) simply states
that OCC will permit the release of margin with respect to a clearing
member's account if the amount of margin assets in a clearing member's
account exceeds the amount of margin assets required to be in the
account pursuant to Rule 601 and if any other obligations of the
clearing member to OCC have been satisfied.
Previous Rule 2111(b) and Rule 2409(b) envisioned that a
provisional margin requirement would be calculated with respect to
cross-rate foreign currency options and FX Index Options. The
provisional margin requirement was intended to ensure that OCC would
not release premiums due to an account of a clearing member in a non-
U.S. time zone at a time when it was holding insufficient margin to
cover a premium debit in a later time zone and/or increased margin
requirements resulting from activity in cross-rate and foreign currency
index options since the last U.S. Dollar settlement. OCC will eliminate
this provisional margin requirement and will instead simply hold any
amounts otherwise payable to a clearing member in a different time zone
until after the next regular settlement time in the U.S. Experience has
shown that clearing members often instruct OCC to credit any cash from
these early settlements to their OCC accounts instead of releasing it,
and the amounts involved do not justify the costs of administering the
more cumbersome procedure of calculating provisional margin
requirements.
OCC expects that the amount of margin it will collect under STANS
will be significantly less than the amount of margin it currently
collects under TIMS. This is largely due to the fact that STANS more
accurately identifies offsetting positions than TIMS. Accordingly,
there would be a corresponding reduction in the amount of clearing fund
collected by OCC under STANS because under Chapter X, ``Clearing Fund
Contributions,'' clearing fund is calculated as a percentage of margin.
The Division of Market Regulation (``Division'') requested that OCC
amend its rules to increase the percentage used to calculate the size
of the clearing fund because the Division believes that for the time
being the clearing fund should not be significantly reduced. As a
result, OCC amended the proposed rule change to amend Chapter X, Rule
1001, ``Amount of [Clearing
[[Page 9405]]
Fund] Contribution,'' to increase the minimum percentage used in the
clearing fund calculation from 5 percent to 6 percent of average
aggregate margin.
III. Discussion
Section 17A(b)(3)(F) of the Act provides that the rules of a
clearing agency should be designed to promote the prompt and accurate
clearance and settlement of securities transactions and to assure the
safeguarding of securities and funds which are in its custody or
control or for which it is responsible. OCC's margin methodology
calculates the current replacement cost and market risk associated with
a member's positions so that OCC may collect sufficient collateral to
complete settlement in the event the member becomes insolvent or
otherwise fails to meet its obligations to OCC. OCC's ability to meet
its settlement obligations following a member insolvency is an
important function of its role as a central counterparty.\4\ It is
therefore necessary that OCC have an effective methodology for
calculating risk-based margin to promote the prompt and accurate
clearance and settlement of securities transactions and to assure the
safeguarding of securities and funds which are in its custody or
control or for which it is responsible.
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\4\ The margin methodology under both TIMS and STANS uses short-
term historical returns and return volatilities to calculate the
market risk associated with a member's positions. As a result,
margin should provide OCC with sufficient collateral to complete
settlement under normal market conditions. Very unusual and sudden
market moves could result in losses to a member's account that are
in excess of the margin on deposit with OCC. If a member becomes
insolvent or otherwise fails to meet its obligations to OCC under
such circumstances, OCC would access the assets in its clearing fund
to complete settlement of the member's trades.
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The TIMS methodology has been used by OCC since 1991 \5\ and has
become recognized as an industry standard for measuring risk in
portfolios comprised of options, futures, and futures on options.
However, as discussed above, OCC believes that there are some
shortcomings to the TIMS methodology and that the more sophisticated
STANS methodology will better measure the market risk in a member's
account. One of the main shortcomings of TIMS is that it recognizes
only a limited diversification benefit for clearing member accounts by
offsetting positions only within the same product group. Further, these
offsets are conservative and are not based on a statistical model for
the joint behavior of asset returns. STANS, on the other hand,
generates simulated returns for all of the positions in the clearing
member's account simultaneously. The statistical specification and
subsequent simulation in STANS, rather than the ad hoc rule in TIMS,
determines the degree of offset for correlated positions.
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\5\ Securities Exchange Act Release Nos. 27394 (October 26,
1989), 54 FR 46175 (November 1, 1989) [File No. SR-OCC-89-12]
(Notice of filing for the TIMS proposal) and 28928 (March 1, 1991),
56 FR 9995 (March 8, 1991) (Original order approving the use of TIMS
to calculate margin on equity options on a temporary basis).
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Because STANS is designed to allow a greater amount of offset for
diversification than TIMS, most of OCC's members will be required to
deposit less margin under STANS than they currently are under TIMS. For
instance, the 20 largest accounts at OCC would have exhibited
reductions in margin of over 50 percent as of September 2005. This
significant reduction reflects the difference between the two
methodologies in allowance of a diversification benefit in calculating
the risk-based margin of a member's account. It does not reflect a
change in the purpose of OCC's margin requirement, which is to provide
OCC with sufficient collateral in the event a member becomes insolvent
or otherwise fails to meet its obligations to OCC. OCC will collect
less margin from its members under STANS because STANS will explicitly
model a joint distribution of asset returns in order to better measure
risk at the member portfolio level and not because OCC is changing its
tolerance for counterparty credit risk.
OCC has operated STANS in test mode for more than two years and has
reviewed the methodology and the results of test operations with staff
of the Commission's Division of Market Regulation (``Division'') during
that time. Since June 2003, OCC has been providing information on the
statistical and operational features of the STANS methodology to staff
of the Office of Prudential Supervision and Risk Analysis of the
Division. To become comfortable with the STANS methodology, the
Division requested that OCC produce various graphs, simulations, and
spreadsheets evidencing STANS's ability to calculate margin
requirements more accurately than TIMS. As a result of these reviews,
the Commission is of the opinion that STANS is consistent with the
practices of other sophisticated market participants in measuring the
risk associated with options portfolios.
Although the Commission is satisfied that STANS has performed in
test mode as expected thus far, it is requiring OCC to take two
measures with respect to using the new methodology. First, OCC will
continue to provide the Division with information regarding the
performance of STANS. OCC will provide the Division with quarterly
reports summarizing any instances in which a member's account
experienced a loss that exceeded the margin requirement calculated by
STANS and the magnitude of any such losses. Second, OCC has amended its
clearing fund formula so that the amount of clearing fund, which is a
percentage of average daily total margin, will not initially decrease
with the implementation of STANS and the decrease in margin
requirements. Because the clearing fund serves as a resource in the
event of insufficient margin deposits, the Commission does not believe
it is prudent at this time for the size of the clearing fund to
significantly decrease at the same time margin requirements are
significantly decreased. Therefore, OCC is increasing its clearing fund
calculation so that the clearing fund will be 6 percent, instead of 5
percent, of aggregate daily total margin.
Accordingly, because the Commission believes the STANS methodology
is designed to provide OCC with sufficient margin to protect itself in
the event of a member insolvency or other inability to satisfy its
obligations to OCC, the Commission finds that OCC's proposed rule
change implementing STANS and revising its clearing fund calculation is
designed to promote the prompt and accurate clearance and settlement of
securities transactions and to assure the safeguarding of securities
and funds which are in OCC's custody or control or for which it is
responsible.
IV. Conclusion
On the basis of the foregoing, the Commission finds that the
proposed rule change is consistent with the requirements of the Act and
in particular with the requirements of Section 17A of the Act and the
rules and regulations thereunder.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change (File No. SR-OCC-2004-20) be and hereby
is approved.
For the Commission by the Division of Market Regulation,
pursuant to delegated authority.\6\
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\6\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
[FR Doc. E6-2519 Filed 2-22-06; 8:45 am]
BILLING CODE 8010-01-P