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, 45188-45191 [2019-18481]
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Federal Register / Vol. 84, No. 167 / Wednesday, August 28, 2019 / Notices
only one method. The Commission will
post all comments on the Commission’s
internet website (https://www.sec.gov/
rules/sro.shtml). Copies of the
submission, all subsequent
amendments, all written statements
with respect to the proposed rule
change that are filed with the
Commission, and all written
communications relating to the
proposed rule change between the
Commission and any person, other than
those that may be withheld from the
public in accordance with the
provisions of 5 U.S.C. 552, will be
available for website viewing and
printing in the Commission’s Public
Reference Room, 100 F Street NE,
Washington, DC 20549 on official
business days between the hours of 10
a.m. and 3 p.m. Copies of the filing also
will be available for inspection and
copying at the principal office of the
Exchange. All comments received will
be posted without change. Persons
submitting comments are cautioned that
we do not redact or edit personal
identifying information from comment
submissions. You should submit only
information that you wish to make
available publicly. All submissions
should refer to File Number SR–
CboeBZX–2019–044 and should be
submitted by September 18, 2019.
Rebuttal comments should be submitted
by October 2, 2019.
For the Commission, by the Division of
Trading and Markets, pursuant to delegated
authority.40
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019–18484 Filed 8–27–19; 8:45 am]
BILLING CODE 8011–01–P
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
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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
40 17 CFR 200.30–3(a)(12); 17 CFR 200.30–
3(a)(57).
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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.
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
1 15
U.S.C. 78s(b)(1).
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.
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.
2 17
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the Proposed Rule Change are designed
to address five limitations of the current
Vanilla Option Model and five
limitations of the current Smoothing
Algorithm.
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.
(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 swaprates.
(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.
8 For example, OCC generates theoretical values
for American style options using a modified JarrowRudd (‘‘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.
11 See Notice of Filing, 84 FR at 32818.
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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.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.
(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.
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.
(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.
B. Smoothing Algorithm
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The Smoothing Algorithm is a fourstep 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
12 See
id.
id.
14 See id.
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.
13 See
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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.
(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.
(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;
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.
19 See Notice of Filing, 84 FR at 32818.
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45189
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.
(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.
(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
20 See
Notice of Filing, 84 FR at 32818–19.
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.
22 See id.
23 See id.
21 Basis
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based on current market prices and the
volatilities implied by such prices.24
(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.
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 selfregulatory 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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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.
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
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.
25 Implied dividends are a combination of
Borrowing Costs and dividends. See Notice of
Filing, 84 FR at 32819, n.29.
26 See id.
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).
30 15 U.S.C. 78q–1(b)(3)(F).
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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
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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
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
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
31 15
32 17
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U.S.C. 78q–1(b)(3)(F).
CFR 240.17Ad–22(e)(6)(i).
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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
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
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 arbitragefree 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
33 Id.
34 17
CFR 240.17Ad–22(e)(6)(iii).
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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
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.
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.
For the Commission, by the Division of
Trading and Markets, pursuant to delegated
authority.38
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 2019–18481 Filed 8–27–19; 8:45 am]
BILLING CODE 8011–01–P
SECURITIES AND EXCHANGE
COMMISSION
Sunshine Act Meetings
Notice is hereby given,
pursuant to the provisions of the
Government in Sunshine Act, Public
Law 94–409, that the Securities and
Exchange Commission Investor
Advisory Committee will hold a
telephonic meeting on Thursday,
September 5, 2019.
PLACE: The meeting will be open to the
public via telephone at 1–800–260–0719
in the United States or (651) 291–1170
outside the United States, participant
code 470756.
STATUS: This meeting will begin at 11:00
a.m. (ET) and conclude at 12:30 p.m.
and will be open to the public via
telephone. The meeting will be webcast
by audio-only on the Commission’s
website at www.sec.gov.
MATTERS TO BE CONSIDERED: On August
12, 2019, the Commission issued notice
of the Committee meeting (Release No.
33–10670), indicating that the meeting
is open to the public via telephone, and
inviting the public to submit written
comments to the Committee. This
TIME AND DATE:
35 Id.
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).
37 15 U.S.C. 78s(b)(2).
38 17 CFR 200.30–3(a)(12).
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Sunshine Act notice is being issued
because a quorum of the Commission
may attend the meeting.
The agenda for the meeting includes:
Welcome remarks; a discussion
regarding the proxy process (including a
recommendation from the Investor as
Owner Subcommittee).
CONTACT PERSON FOR MORE INFORMATION:
For further information and to ascertain
what, if any, matters have been added,
deleted or postponed; please contact
Vanessa A. Countryman from the Office
of the Secretary at (202) 551–5400.
Dated: August 26, 2019.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2019–18719 Filed 8–26–19; 4:15 pm]
BILLING CODE 8011–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–86729; File No. SR–ICC–
2019–010]
Self-Regulatory Organizations; ICE
Clear Credit LLC; Notice of Filing of
Proposed Rule Change, SecurityBased Swap Submission, or Advance
Notice Relating to the ICC Clearing
Rules
August 22, 2019.
Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934,1 and
Rule 19b–4 thereunder,2 notice is
hereby given that on August 8, 2019,
ICE Clear Credit LLC (‘‘ICC’’) filed with
the Securities and Exchange
Commission the proposed rule change,
security-based swap submission, or
advance notice as described in Items I,
II and III below, which Items have been
prepared by ICC. The Commission is
publishing this notice to solicit
comments on the proposed rule change,
security-based swap submission, or
advance notice from interested persons.
I. Clearing Agency’s Statement of the
Terms of Substance of the Proposed
Rule Change, Security-Based Swap
Submission, or Advance Notice
The principal purpose of the
proposed rule change is to make
changes to the ICC Clearing Rules (the
‘‘ICC Rules’’) to address the treatment of
certain investment losses, custodial
losses and other non-default losses.
1 15
2 17
E:\FR\FM\28AUN1.SGM
U.S.C. 78s(b)(1).
CFR 240.19b–4.
28AUN1
]]>Agencies
[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
