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Letter to Clearing Member Firms - OCC To Lower Costs for Users of U.S. Equity Derivatives Markets

August 03, 2020

Dear Colleagues:

We want to provide you with information on some important initiatives we are working on which will reduce our fees, support a year-end refund to clearing members and strengthen our prefunded resources with a persistent minimum level of skin-in-the-game.

Funding Operations and Critical Initiatives

OCC today is in a stronger financial position than ever before, having significantly increased our liquidity resources by expanding and diversifying our committed credit facilities with both banks and non-bank providers to $3 billion while also ensuring a minimum of $3.5 billion of cash in the clearing fund.  Earlier this year, the SEC formally approved OCC’s Capital Management Policy.  The Policy sets forth our approach to managing capital to ensure that we have the financial resilience to meet your needs and fulfill our role as a Systemically Important Financial Market Utility.  Importantly, that policy also establishes the framework for OCC’s “skin-in-the-game,” strengthening the alignment between OCC's management and our clearing member firms to maintain the necessary level of pre-funded financial resources in the event of a clearing member default.

As you know, we are also at this time investing significant resources in our Renaissance Initiative to update and upgrade our technology infrastructure, for critical clearing and settlement services, risk systems and data management.  As we said at the time of the announcement, Renaissance is the most significant initiative OCC has undertaken in 20 years, and we continue to work closely with stakeholders to shepherd this project to completion.  We take seriously our duty to manage OCC in a way that ensures we meet regulatory expectations and responsibly invest in OCC’s infrastructure while also serving market participants as a financially responsible steward of clearing services.

Reduced Clearing Fees and Year-End Refunds

Of course, for many reasons, 2020 has been an extraordinary year in terms of transaction and contract volume.  While volatility has receded from the March highs, we continue to see record volume in both trades and contracts. June 2020 total cleared contract volume was 693,042,180 contracts, the highest month ever – up 80.7 percent from June 2019 volume and beating the previous record of 670,646,998 cleared contracts set in March 2020 by over 3 percent. Three trading days in June landed within the top five trading days on record, with Friday, June 12 clearing 48,039,191 contracts – the second highest cleared contract volume day in our history.  Throughout this period, we have been proud of OCC’s ability to scale our processing volume and deliver our services within the quality standards that you rely on while the vast majority of our staff have been working from home.  With the volume and a strong focus on expense discipline we have achieved significant operating leverage.  Because of that leverage, and consistent with the Capital Management Policy, we are now in a position where we can begin taking steps to lower costs of clearing for market participants. 

The first step we are taking is to reduce our clearing fee from five and a half cents per contract to four and a half cents per contract effective September 1, 2020, subject to regulatory review. 

Because over 95% of our revenue is generated from clearing fees, and given the challenge of forecasting during a time of global pandemic, a presidential election and dramatic reductions in fees for retail clients, we are being appropriately conservative in how we use our tools to lower costs of clearing for market participants. 

At this time, based on our forecasts, which are subject to change based upon changes in market volumes, we anticipate being able to provide a clearing fee refund of approximately $80-$100 million for 2020 after year end, even while continuing our significant investment in Renaissance and other critical initiatives.  As is our usual practice, we will assess ending cash balances, our capital needs and 2021 forecast to establish the refund amount with oversight by and approval of OCC’s Board of Directors.

Meeting Global Standards by Enhancing Our Approach to Skin-in-the-Game

OCC, clearing firms, exchanges and market participants have a common interest in ensuring that our risk management framework is sufficiently robust so that defaults do not occur, and that in the unlikely event that there is a clearing member default, the prefunded financial resources of the defaulting clearing member are sufficient to fully cover its obligations to OCC. This is the fundamental characteristic of a “defaulter pay” model, and we believe the cornerstone of CCP resilience. OCC has confidence in its risk management framework underpinning the defaulter pay model as it includes robust membership standards and ongoing clearing member monitoring, a highly sophisticated methodology for calculating initial margin, a conservative clearing fund sized for “Cover 2” (while considering a wide range of extreme but plausible scenarios) and effective liquidity risk and capital management. 

The approval of the OCC’s Capital Management Policy in January marked the first time we had incorporated “skin-in-the-game” (SITG) into our approach to capital management and resiliency.  We are proud of that initiative and particularly the fact that executive deferred compensation is included, which is a powerful alignment of interest between management and clearing members.  We take seriously the interest of the industry and international regulators in seeing more significant SITG at CCPs. 

In considering this issue, we have reviewed relevant papers from industry participants and  stakeholders, examined other CCPs’ practices relative to skin-in-the-game (with regard to placement, amount and business model) and analyzed regulatory requirements and guidance, particularly as they relate to our ability to achieve European recognition.

Many of you may be familiar with the paper originally released in October 2019, “A Path Forward for CCP Resilience, Recovery, and Resolution.”  The paper, which originally had nine signatories  (Allianz, Blackrock, Citi, Goldman Sachs, Société Générale, J.P. Morgan Chase, State Street, T. Rowe Price and Vanguard), was re-released in March with ten additional firms as signatories (ABN AMRO Clearing, Barclays, Deutsche Bank, Commonwealth Bank of Australia, Franklin Templeton, Guardian Life, Ivy Investments, Nordea, TIAA, and UBS).  One of the paper’s significant recommendations is that CCPs should have SITG in a more defined manner than the variable amount provided by our Capital Management Policy.  Additionally, as OCC seeks recognition in Europe, we are cognizant of the European Market Infrastructure Regulation expectation that SITG be a minimum of 25 percent of the CCP’s regulatory capital requirement.

Our analysis led us to conclude that enhancing our approach to skin-in the game could:

  • Further strengthen our pre-funded financial resources;
  • Further align the interests of OCC management and market participants; and
  • Align more closely with international standards.

We will be seeking SEC approval to amend OCC’s Capital Management Policy to provide a minimum level of SITG of $62 million (this would be inclusive of the current $3 million contribution of the Management Executive Deferred Compensation Plan).  Our goal in recommending a minimum amount of skin-in-the game is to increase alignment with our clearing firms and market participants and to strengthen our eventual consideration for European recognition.  We observe that the relatively low level of persistent SITG under the Capital Management Policy, specifically, the EDCP balance, makes OCC an exception by comparison to other CCPs. Increasing the minimum amount of OCC’s SITG will further enhance our alignment with clearing firms, as well as reduce the likelihood of a draw on the clearing fund and the resulting cost borne by clearing firms. Defaults that result in a clearing fund draw are a direct cost to each clearing firm.  We believe that reducing that risk is a significant factor in the sell-side’s interest in increasing CCPs’ SITG.  Clearing firms’ interest in reducing this potential cost remains consistent regardless of whether the CCP is structured as a public company or an industry utility as OCC is. 

We have evaluated the level of SITG that other CCPs commit, as well as current European requirements. As noted above, EMIR establishes a floor for SITG for CCPs of 25 percent of minimum regulatory capital, which for OCC would be $62M, the minimum level for which we plan to seek approval. 

Funds allocated to provide the non-EDCP portion of the minimum SITG come from OCC’s operating cash flow on a pretax basis. Because there is no expense impact to OCC unless the funds are used, the amount allocated for SITG remains part of retained earnings in shareholders’ equity on our balance sheet. The allocation and use of such funds will be prescribed in the proposed amendments to OCC’s capital management policy, and any future change to the use of those funds in OCC’s default management waterfall would require a rule filing with and approval by the SEC – effectively making them a restricted asset to the benefit of market participants. 

***

We remain committed to the responsible management of OCC and its resources, as well as to being as transparent as possible with you and other stakeholders.  These unprecedented times have provided us with an opportunity to enhance OCC’s financial resilience to the benefit of all stakeholders.

We hope that you will agree that the steps we have outlined here, along with our Renaissance Initiative to rebuild OCC’s technology infrastructure, will enhance our support of you as market participants.  All of us at OCC will continue to work tirelessly to deliver effective and efficient services for your firms, our participating exchanges and business partners, while meeting the regulatory expectations of our role as a Systemically Important Financial Market Utility.  We will hold industry calls this week to further discuss this with you and address any questions you may have.

 

John P. Davidson                                                       Scot E. Warren

Chief Executive Officer                                            Chief Operating Officer

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