As the financial services landscape changes, so does OCC. The legislative and regulatory drive to make greater use of central counterparties following the financial crisis underscores the importance of OCC. Our role in contributing to sound capital markets and the stability of the broader economy is evident. We are fundamentally altering how we do things— policies and procedures, internal business controls, testing and validation processes, core risk management methodologies and capital management—to enhance our resiliency and meet the heightened standards of a systemically important institution.
It is the dawn of a new era. Systemically important financial market utilities like OCC are challenged with heightened regulatory requirements. But with great challenges, come great opportunities. We embrace the opportunity to play a larger, more important role in the world¹s capital markets and to provide an unprecedented level of safety to investors. These changes are closely aligned with our core mission of risk management, operational integrity and internal controls. OCC is prepared for what tomorrow brings.
At the center of the options industry is OCC. Participants rely on us for the performance of every transaction we clear. We hold approximately $100 billion in collateral deposited by clearing members and move billions of dollars every day. In October alone, 491 million total options contracts traded. Clearing at these heights goes hand-in-hand with the need for superior risk management. OCC’s central counterparty guarantee secures a safe, strong marketplace.
“The driver behind the changes at OCC is a keen focus on bolstering our resiliency.”
On behalf of the Board of Directors and employees of OCC,
I am pleased to share our 2014 Annual Report as we continue on our mission to deliver world class risk management, clearance and settlement services to support our clearing member firms and to help grow this increasingly important marketplace.
Continued strong growth in the U.S. options industry, despite the changing landscape that we operate in, has been one constant that has benefitted us all. 2014 represented the second highest year in our 41-year history, with cleared contract volume of more than 4.3 billion. 2014 also was a year of tremendous change at OCC as we took aggressive steps to increase our resiliency, enhance our capital base, and further strengthen our governance and management structure. Additionally, working with our exchange partners in the U.S. Securities Markets Coalition, we advanced our leadership position in Washington on several important industry issues.
In 2012, OCC was designated a Systemically Important Financial Market Utility (SIFMU) by the Financial Stability Oversight Council. This designation significantly expanded the regulatory requirements and regulators’ expectations for how we conduct business at OCC. In addition to direct regulation by the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodities Futures Trading Commission (CFTC), we are now subject to the prudential oversight of the Board of Governors of the Federal Reserve System. As a systemically important institution, we recognize the critical role we play in promoting financial stability and integrity in every market we serve. This has prompted a comprehensive review of every aspect of our business: policies and procedures, regulatory compliance, internal business controls, testing and validation processes, and core risk management methodologies.
The driver behind the changes taking place at OCC is a keen focus on bolstering our resiliency. Notable accomplishments toward this effort include expanding our control functions (compliance, enterprise risk management and internal audit), developing a comprehensive risk framework, enhancing the validation of our margin and clearing fund models, enhancing our liquidity risk management capabilities, and increasing support to our business functions so that they can focus on continuous improvement to our systems, business processes and internal controls.
Like other systemically important financial institutions, we increased our transparency with market users by publishing our Disclosure Framework for Financial Market Infrastructures. We also developed a Recovery and Wind Down Plan that recognizes our critical importance to the proper functioning of the U.S. capital markets and the broader economy, which we will soon be sharing with our regulators and thereafter with our market users.
To support continued growth in our markets and ensure that we have adequate resources, we increased our committed liquidity facilities from $2 to $3 billion. In an effort to reduce pro-cyclicality and capacity concerns, we also were the first major clearinghouse to diversify our committed credit facilities by establishing credit facilities with highly-qualified nonbank financial institutions. Additionally, working closely with our exchange partners, we led the development and adoption of a principles-based set of exchange risk controls standards designed to reduce the risk of errors or unintended activity that could cause or contribute to a financial loss to market participants and OCC. Adoption of these new standards represents a major step forward in our collective goal of enhancing industry protections.
STRONG CAPITAL PLAN
In March 2014, the SEC published its Covered Clearing Agency proposal, including new capital requirements that will necessitate a large increase in shareholders’ equity at OCC. In March 2015, following months of work and dialogue with regulators, the SEC approved a new capital plan that enables OCC to be compliant with the proposed new standards. As required by the plan, OCC’s stockholders, Chicago Board Options Exchange, Incorporated, International Securities Exchange, LLC, NASDAQ OMX PHLX, LLC, NYSE MKT LLC, and NYSE Arca, Inc. have contributed $150 million in equity capital, increasing OCC shareholders’ equity to approximately $247 million. The stockholders also commit to provide specified replenishment capital if needed.
Under the plan, after retaining equity capital sufficient to ensure that OCC remains above its target capital requirement, OCC will pay a refund equal to 50 percent of distributable earnings before tax. The exchange stockholders will then receive dividends equal to the after-tax income in excess of the amount required to maintain OCC’s target capital requirement. The plan also stipulates that OCC targets a 25 percent buffer margin on revenue, a reduction of 6 percent from the 31 percent average over the last decade. The reduction in target buffer margin reflects OCC’s commitment to operating as an industry utility and ensuring that market participants benefit as much as possible from OCC’s operational efficiencies in the future.
Finally, the new capital plan enables OCC to refund $33.3 million from 2014 fees to its clearing members and return to a lower average fee schedule during the second quarter of 2015. Cumulative refunds and discounts since 1974 exceed $2 billion.
The new plan strengthens OCC’s capital base and facilitates OCC’s compliance with proposed SEC regulations applicable to SIFMUs well in advance of the expected implementation date.
The alternative would have been to institute an immediate and prolonged large increase in fees that likely would have had severe negative consequences including widened bid/ask spreads, reduced liquidity and higher costs for investors.
GOVERNANCE AND MANAGEMENT ENHANCEMENTS
Effecting change requires engaged governance and strong leadership. We continue to strengthen our governance processes, and as a systemically important institution we are mindful of our responsibility to the public to secure sound financial markets. We have increased the number of public directors on our Board to five to ensure that we have the broad perspectives that best support taking into account public interests when making decisions. In 2015, we appointed two new public directors. Thomas Cardello, owner of Venice Group, LLC, and Robert Litterman, Chairman of the Risk Committee at Kepos Capital, will enhance the diversity, skills and expertise of our Board, especially in the critical area of risk management.
We strengthened our leadership team with the promotions of Michael McClain to President and COO, John Fennell to Executive Vice President, Financial Risk, and Jim Kustusch to Senior Vice President, Operations. We also expanded our team, welcoming Kim McGarry as Chief Financial Officer, Tracy Raben as Chief Human Resources Officer, Laurie Flom as head of Enterprise Risk Management, John Grace as Chief Risk Officer, Scot Warren as Executive Vice President, Business Development and OIC, and Luke Moranda as Chief Information Officer. With this leadership team in place and with the continued commitment and dedication of our employees, we are well prepared to execute on our priorities as we continue to effectuate the changes necessary to meet the heightened expectations that regulators and market participants have for OCC.
LEADERSHIP IN WASHINGTON
Working with our exchange partners in the U.S. Securities Markets Coalition, OCC strengthened its presence in Washington as a leading industry advocate on important regulatory, legislative and tax issues affecting our industry. The year started with an ongoing focus on a tax reform proposal by the Chairman of the House Ways and Means Committee that would require options to be marked to market and treat any gains as ordinary income rather than capital gains. The proposal would also treat an appreciated stock position as being sold if an investor enters into a related risk-reducing options transaction that bears no economic resemblance to actually selling the stock. We worked diligently to ensure that members of Congress and the Administration understand the potentially devastating impact that this aspect of the proposal would have on options market participants.
OCC and the Coalition also worked with the Treasury Department and IRS to minimize the impact of a proposed rule that could potentially discourage foreign investors from using listed options by subjecting certain of their transactions to dividend withholding tax. We have been active with our Coalition partners in addressing the impact on the listed options market of certain provisions of the capital rules for banks adopted by regulators at the end of 2013. Such rules may be interpreted to require a U.S. bank, when calculating its trade exposures to customers, to
“We continue to enhance our resiliency, strengthen market protections and deliver efficiencies for our stakeholders.”
disregard risk-reducing properties of certain “spread” positions in listed options and to impose capital requirements that are entirely unrelated to the economic risks entailed in such transactions. This could result in a dramatic increase in the capital required to support customer positions for many market making firms, despite the limited risk. Finally, we have been actively working with European and U.S. regulators to ensure that OCC is recognized as a Qualifying Central Counterparty under the European Market Infrastructure Regulation regime. The recognition would have a significant positive effect on the regulatory capital requirements for OCC’s European bank-affiliated clearing members with respect to their exposures to OCC.
While our business and regulatory environment continues to change, the OCC mission is the same.
We remain committed to providing confidence in the markets we serve through a robust and transparent risk management framework, delivered in an efficient and cost-effective manner. As the foundation for secure markets, we will continue to enhance our resiliency, strengthen market protections and deliver efficiencies for
all of our stakeholders, enabling them to better serve their customers.
Craig S. Donohue
“Ongoing enhancements to OCC’s risk management systems increase the overall performance of our clearing capabilities.”
Thanks to the commitment and hard work of our employees, in 2014 OCC strengthened its long-standing position as a reliable leader in clearing and settlement services, safely and efficiently processing steadily increasing contract volume and serving the needs of our clearing member firms and other market participants. October was the second highest monthly volume on record with 491 million options contracts cleared. Average daily volume totaled 16.9 million contracts. Open interest, or the total number of options contracts outstanding, peaked on November 20 with 367.5 million contracts. Beyond options, it was a record year for OCC cleared futures markets. Year-end futures volume totaled 67.7 million contracts, exceeding 2013 volume by 14 percent. Securities lending activity posted strong numbers with 1.2 million new transactions and an average daily loan value of more than $131 billion.
As a systemically important financial market utility, OCC’s highest priority is accelerating the progress we are making in adapting to new regulatory standards and completing our regulatory remediation objectives. We made significant headway toward this objective in 2014 and we remain fully engaged in this effort. Meeting these new standards necessitated an increase in operating costs of 22 percent, which was done after a strategic review of expenses to generate savings that would not negatively impact our resiliency, including changes to employee benefits plans as well as the new capital plan. These efforts greatly minimized the impact of our increased expenses on fees, resulting in an average of 3.3 cents per cleared contract after refunds. Net income before taxes for fiscal year 2014 was $109.1 million. We will continue to take steps to ensure that we are disciplined in managing costs while improving our capabilities to strengthen market protections for our stakeholders and their customers.
OCC’s guarantee function is supported by a comprehensive system of safeguards—a sophisticated risk management framework combined with a deep pool of financial resources that consist of prudent margin requirements and a clearing fund intended to provide coverage in extreme market conditions.
In 2014 we implemented advanced stress testing designed to strengthen our risk framework and ensure resilience of our financial resources. We received SEC approval in December to limit a clearing member’s ability to deposit collateral that does not hedge its exposure or that presents wrong-way risk. We improved monitoring capabilities to better forecast concentrations of liquidity demands and, where these concentrations are excessive, mitigate the risk through intra-day margin calls. The bulk of our expense increase has been dedicated to complementing our expertise in equity derivatives risk management with deeper centers of excellence around vertical financial risk areas. We have constructed specific functions dedicated to credit, liquidity, market and default risk. By focusing on specific areas while building a broad understanding of our total financial resources, we enable innovations in risk management.
“While building a broad understanding of our total financial resources, we enable innovations in risk management.”
Mitigating model risk is an important focus at OCC. We implemented a process that continuously assesses the adequacy and performance of existing models during periods of evolving market conditions. We also bolstered the infrastructure that supports our independent model validation program.
We continue to reduce systemic risk while providing capital efficiencies and increased liquidity for our members through our cross-margin program. By recognizing the offsetting value of hedged positions across clearinghouses such as the Chicago Mercantile Exchange (CME) and ICE Clear US, cross-margining increases the overall resiliency of the derivatives markets, especially during times of market disruption. OCC/CME cross-margin participants realized an average daily reduction in margin requirements of $700 million in 2014, or an average of 54 percent savings per participant.
Ongoing enhancements to OCC’s risk management systems increase the overall performance of our clearing capabilities. The final and most complex phase of ENCORE Prices culminated this past June. This technology upgrade spanned three years and has improved processing speed, resulting in earlier price feeds to members.
We also implemented changes to futures processing. We now calculate SPAN margins for segregated customer futures accounts and compare those results with OCC’s STANS margin, ensuring that clearing margin is enhanced by price risk coverage that reflects the greater protection on any day. This allows us to leverage the quantitative basis of value at risk and portfolio margining to determine prudent SPAN parameters while maintaining consistency and transparency.
OCC’s innovative services are designed to help grow and protect the markets. In April, OCC launched clearing services for dealer-to-dealer over-the-counter (OTC) S&P 500® equity index options transactions. The new clearing service preserves the bespoke and flexible nature of OTC transactions while providing centralized clearing and risk management efficiencies fully backed by OCC’s financial safeguards. We supported the development and launch of new exchange products including the Short-Term Volatility Index, the CBOE/CBOT 10-Year U.S. Treasury Note Volatility Index, and OCX.Weekly futures.
Our efforts to ensure that the listed options markets remain vibrant and liquid in the eyes of regulators underscore the importance of continued education. A strong education program contributes to stronger policy making and fosters more prudent investors. To that end, OCC continues to lead The Options Industry Council (OIC), an industry collective whose mission is to educate investors about the responsible use of exchange-listed options. In August, OIC released the results of its second benchmark study, which found the growing use of options among financial advisors has never been greater. OIC also supported a study on European demand for options that reflected steady use of options with an increase in more sophisticated strategies. Other initiatives included a mobile application for iOS devices, new live seminar curriculum and an interactive Options Glossary. Strategic alliances with Borsa Istanbul, Saxo Bank and Shanghai Stock Exchange as well as a Memorandum of Understanding with China Futures Association provide a cost-efficient way to expand OIC’s educational reach beyond our borders. We remain committed to creating greater awareness and understanding of the value and importance of these markets.
OCC continues to identify and implement efficiencies that benefit our market participants. Shifting standard expiration processing from Saturday to Friday has driven trade date reconciliation by clearing members and promoted a consistent expiration process across all options products. This past April the exchanges supported members’ request to move up trade submission deadlines, providing firms with additional time to complete allocations, trade date reconciliation and verification of customer instructions.
Efforts to streamline trade clearing and balancing have improved the overall process as we move toward an expiration window close of 8:30 p.m. CT. Enhancements to OCC’s website increased communication and transparency with clearing members and customers. All OCC-issued information memos are now accessible to the public, and a redesigned Email Alerts Center allows subscription options to support the additional memo categories.
Resiliency within the financial services community is supported through rigorous business continuity efforts. A key focus for the year was cybersecurity. In collaboration with ChicagoFIRST, OCC implemented a national cybersecurity framework designed to strengthen a company’s cybersecurity posture and better understand cyber risk. An October industry-wide connectivity test validated communications capabilities between OCC’s backup site and key exchange and clearing member systems. We hold a leadership role in ChicagoFIRST and remain active in local and national organizations and industry initiatives focused on security and business continuity, including the Chicago Office of Emergency Management Communications, Financial Services Sector Coordinating Council for Critical Infrastructure Protection and Homeland Security, and Financial Services Information Sharing and Analysis Center.
In an economic environment undergoing constant change, OCC continually strives to support the markets that we serve with a focus on innovation and creating greater efficiencies. Enhancements to systems and operations implemented in 2014 not only ensure reliable clearing, settlement and risk management services but also prepare us for what tomorrow brings. Throughout our history we have safely guided our customers through a dynamic marketplace, and the year ahead will be no exception.
Michael W. McClain
Chief Operating Officer