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Risk USA Conference and SIFMA Listed Options Symposium

OCC's Executive Chairman, Craig Donohue gave the following speech at the Risk USA Conference (October 21) and as the keynote address at the SIFMA Listed Options Symposium (October 30) in which he discusses how CCPs are meeting the heightened expectations of new standards, the impact of the new clearing environment on market participants and the direction of risk management moving forward.

Increasing the Resiliency of Central Counterparties and the
Transformation of Clearing


I'm delighted to be with you today to speak about the changes that are taking place in the post-trade arena of central counterparty clearing. As the former CEO of CME Group, and now Executive Chairman of The Options Clearing Corporation (OCC), I hope I can shed some light on the challenges and opportunities that lie ahead for all of us as we adjust to the sweeping changes brought about by the financial crisis and the Dodd-Frank Act.

But first, let me tell you a little bit about us. OCC is the world's largest equity derivatives clearing organization. As the sole clearing house for all listed options exchanges in the United States, we clear transactions for all forms of equity options, a variety of futures contracts, and stock loan transactions. U.S. options markets have experienced very strong growth since 1973. Today, we clear more than 5,897 instruments with average daily volumes of approximately 17 million, representing average notional value of $4.4 trillion per day. The complexity of the task becomes clearer when you consider that there are more than 750,000 different strike prices. To support this activity, we hold approximately $100 billion in collateral deposited by clearing members and move approximately $4.5 billion per day between and among 120 clearing members as part of our daily settlement cycle. Throughout our 40-year history we have given market participants the confidence they need to feel secure in using our cleared markets. That confidence is based on the strength of our risk management system, the size and quality of our financial resources, and the rigorous membership and capital standards that we employ.

Exchanges have changed drastically over the last 15 years. As we have seen, those changes have also introduced new complexities and vulnerabilities that we must navigate in order to ensure that our markets remain safe for investors. While exchanges experienced tremendous transformation and growth during the last decade and a half, it is now the post-trade areas of clearance and settlement that are undergoing tremendous change. And this is what I would like to talk with you about today.

The current environment for clearing houses is best understood by looking back to the 2008 financial crisis, which exposed major structural weaknesses in our financial market systems. One of the key problems that contributed to the crisis was the fact that the OTC derivatives markets had mushroomed to nearly $600 trillion in gross notional exposures1. This was equivalent to about 10 times world GDP2 in that same year. The OTC market had grown much larger than the supporting infrastructure and risk management mechanisms that it utilized. For example:

  • there was a significant backload of unconfirmed trades in the credit default swaps market;
  • many OTC counterparties failed to adequately margin or collateralize their exposures to each other; and
  • many OTC positions were infamously "marked-to-myth" rather than marked-to-market in any objective fashion3

As you may recall, swap dealers and their customers operated on the basis of bilateral credit extension and mutual confidence. However, as the subprime mortgage bubble burst and OTC counterparties began to examine their credit relationships, they focused on counterparties with significant mortgage-related assets–or so-called "toxic assets"–on their balance sheets. As they did so, it became clear that some of these firms were not likely to survive and some of them, of course, did not. Trading and credit extension with weak counterparties ground to a halt, creating massive asset and company de-valuation, panic selling, and ultimately credit and lending gridlock.

In stark contrast, the listed markets, including those cleared and guaranteed by OCC, functioned extremely well. Market participants continued to use our centrally cleared stock, options and futures markets for trading and hedging purposes without significant fear that their transactions would not be performed. So, you might ask yourself, why? What accounted for this difference in investor behavior? Well, fundamentally, I would say that it is because market participants understood the distinctive features of central counterparty clearing and the value of our guarantee of performance. Like most clearing houses, at OCC, we:

  • operate a fully collateralized system;
  • revalue positions and effectuate settlements on a daily basis;
  • accept only high-quality collateral;
  • work with effective and diligent regulators; and
  • maintain stringent financial and membership requirements, including a substantial guarantee fund and assessment powers to ensure financial stability.

Given these differences in the functioning of listed and OTC markets, it is not surprising that the G20 countries and the U.S. Congress determined that clearing houses could reduce systemic risks in OTC derivatives markets4. It was clear to them that the business and risk management model that we had developed was superior to the loosely-knit post-trade practices of large financial institutions in the swaps market. As a result, one of the major policy decisions coming out of the financial crisis was to require that standardized swaps be cleared through central counterparties in order to strengthen market protections for OTC market participants. As you can imagine, this initially resulted in substantial opposition from the industry given the magnitude of the change in business practices, operational models, and capital and margin requirements now imposed on market participants.

One of the chief arguments made by swap dealers was that mandating clearing of standardized swaps would simply concentrate more risk in clearing houses5. This argument, which has some merit, gained currency with regulators and legislators. While it did not dissuade them from adopting the mandatory swaps clearing provisions of Dodd-Frank, it did cause them to recognize that shifting OTC derivatives to central counterparties could further concentrate market risks and that central counterparties themselves were perhaps already "too big to fail." This recognition has created a paradigm shift in the way that clearing houses are regulated. Former Fed Chairman Ben Bernanke noted a few years ago that the handful of large clearing houses today are supporting more integrated markets and consolidated, global financial firms where problems at one clearing house could have a significant impact on the others6.

With the passage of Dodd-Frank and similar initiatives around the globe, regulation of central counterparties has been fundamentally transformed. In 2012, CPSS/IOSCO issued Principles for Financial Market Infrastructures7 (PFMI), which set new international standards for systemically important organizations such as central securities depositories, trade repositories, and central counterparties. Meeting these new standards also impacts clearing members in beneficial ways. Qualifying clearing houses, those that meet the PFMI standards, bring a lower risk weighting to their members, incentivizing clearing houses to develop resilient risk frameworks to garner a coveted Qualified Central Counterparty (QCCP) status. Basel III applies a risk weight of 2% to a bank's exposure to a QCCP for exchange-listed and OTC derivatives transactions. Working with a QCCP significantly lowers capital costs for clearing members.

In July 2012, OCC was designated a Systemically Important Financial Market Utility (SIFMU) by the Financial Stability Oversight Council8. This expanded the scope, frequency and participants in OCC's regulatory oversight. In addition to direct regulation by the SEC and the CFTC, we are now subject to the prudential oversight of the Board of Governors of the Federal Reserve System. The SIFMU designation was based on the determination that any failure of or a disruption to OCC's functioning could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets, thereby threatening the stability of the U.S. financial system.

Following on the heels of the PFMIs and the separate rulemakings by the CFTC and Fed, the SEC has now proposed its own rules9 to implement the PFMI standards for OCC and other covered clearing agencies. The net result of this is that regulatory standards for clearing houses are now similar to those in place for complex, systemically important banking institutions. These best practices standards and rules subject systemically important clearing houses to significantly heightened regulatory requirements. In general, these provisions are designed to promote robust risk management, and safety and soundness, by ensuring that clearing houses:

  • conduct their operations in compliance with applicable risk-management standards;
  • provide a well-founded, transparent and enforceable legal framework for their activities;
  • provide advance notice and review of changes to their rules, procedures, and operations that could materially affect the nature or level of their risks; and
  • meet other requirements relating to management of clearing member defaults, facilitating the portability of customer accounts when such defaults occur, and self-reporting of compliance standards.

So, with that backdrop, let me turn to how these changes are impacting us and what we are doing to successfully adapt.

Adapting to New Standards and Heightened Expectations

As a systemically important institution, we recognize the critical role we play in promoting financial stability and integrity in every market that we serve. And that is why we have undertaken a comprehensive review of every aspect of our business: our policies and procedures, our internal business controls, our testing and validation processes, and our core risk management methodologies.

First, we are fundamentally altering how we do things in order to significantly enhance our resiliency.

Meeting heightened expectations has had a major impact on our organization. We will add more than 100 employees over a two-year period in order to ensure that we have the resources needed to develop the kinds of policies, procedures, internal controls, and testing and validation capabilities that we need. Part of the increased headcount is attributable to our adoption of the three lines of defense model, which distinguishes among three groups involved in effective risk management:

  • operational managers that own and manage risks;
  • the enterprise risk management and compliance functions to help build and/or monitor the first-line of defense controls; and
  • internal auditors who provide the board and management with independent assurance based on the highest levels of independence and objectivity within the organization.

In the last two years we have been expanding our compliance, enterprise risk management and internal audit functions so that we can ensure we have the right risk appetite and framework, the ability to regularly test the design and operational effectiveness of our controls, and the effectiveness of our governance framework and risk management processes.

In terms of enterprise risk management, we have adopted a comprehensive board-approved risk appetite framework, which helps us achieve our risk management goals by communicating acceptable risk levels to employees. The framework includes risk statements, risk metrics and an outline of the roles and responsibilities of those managing and monitoring our risks, allowing us to articulate the level and types of risk we're willing to assume to achieve our strategic objectives. We have also begun implementing risk and control self-assessments, and scenario analyses, to help us identify risks and guide our measurement of the severity and frequency of those risks.

Our second line also includes validation of the models that are developed, documented and tested in the first line business functions in order to provide effective challenge and ensure that the models we employ produce expected results. This is a critical aspect of our organization because it includes the validation of our margin models and clearing fund sizing, the two key aspects of our financial resources and safeguards.

These three lines of defense and the work being done in each are fundamental to the way we are meeting the heightened expectations of our regulators and market participants. More recently, however, as we have begun maturing our control functions, we are also stepping back to make sure that we have adequate resources in our first line business functions to focus on continuous improvement of our systems and procedures and to ensure that gaps and deficiencies are found and addressed as much as possible by the first line functions.

Second, we are taking steps to enhance transparency about how we operate and how we would effectuate an orderly recovery or wind down of our critical operations.

In terms of transparency, regulators have called on central counterparties to provide market participants with information sufficient for them to identify and evaluate the risks and costs of using our services. This transparency is intended to assist market participants, regulators and the broader public in understanding our activities and risk management practices and to promote sound decision-making by external stakeholders. Our self-assessment disclosure document, which is available on our website, is intended to provide transparency to the public about how we operate and how we make decisions. It helps market participants understand at a fairly granular and detailed level how we manage risk and deal with market emergencies, including the default of a clearing member firm.

Similarly, our Recovery & Wind Down plan, which is nearly complete, lays out the critical risks that could be realized from our business and the manner in which we would seek to either recover from a significant stress event or the manner in which we would wind down in the event that we cannot recover. This so-called "living will" has already resulted in positive enhancements to our policies and procedures and provided more of a road map for us to follow should significant risk events materialize.

Third, we are taking steps to bolster our capital to enhance our resiliency from operational or business losses.

Under newly proposed regulatory capital requirements, we must hold liquid net assets equal to 6 months of forward-looking operating expenses or such higher amount as may be necessary to cover our quantified business risks10. Additionally, our capital plan must ensure that we maintain capital in an amount determined by the Board of Directors to be sufficient to ensure a recovery or orderly wind down of our critical operations and services. While these new capital requirements will certainly strengthen our balance sheet and enhance our resiliency, they are also having a significant near-term impact on market participants as we have increased costs in order to accumulate required capital.

One interesting development has been recent calls by market participants, principally JP Morgan and BlackRock, to ensure that clearing houses have adequate "skin in the game" in terms of the mutualized risk structure and default waterfall11. The idea is that CCPs need to commit more of their capital to the default waterfall so they have sufficient incentives to ensure that effective risk management takes priority over profit making. This notion of "skin-in-the-game" is probably well placed in the context of a for-profit, exchange-owned clearing house. OCC, however, is fundamentally different. We operate as an industry utility, charging the lowest fees in the industry and refunding operating profits to market participants rather than our exchange stock holders, who traditionally receive no dividends or distributions of operating profit. Given these significant differences, we believe OCC is uniquely aligned with market participants who themselves place a much higher priority on effective risk management than low fees and annual refunds.

Fourth, we are further enhancing our financial risk management capabilities.

In addition to our historical focus on market and credit exposure, we have recently taken steps to improve our resiliency in liquidity and default risk management. In terms of liquidity risk management, we have significantly improved our liquidity forecasting abilities to ensure that we have sufficient liquidity to meet future settlement demands by our clearing firms. In addition to expanding our authority to require liquidity margin calls, we recently expanded our committed credit facilities from $2 to $3 billion. We are also in the process of diversifying these facilities to include approximately $1 billion in committed funding from non-bank providers, thereby reducing cross-exposure risk and pro-cyclicality during times of stress.

Let me illustrate these changes with a few examples. The calculation of margin and clearing fund size is based on extremely sophisticated financial models running on high speed computers. I am told that the mathematics and statistics upon which they are based are not rocket science; but I do know that we employ former astrophysicists and other scientists to build and maintain our models. Due to the vital nature of the models, it is crucial that they perform as intended. In light of our systemic role, we now have an independent group of scientists and programmers to validate the work of the model developers.

Another example is our default management processes. Fortunately, defaults happen only very rarely. To ensure the orderly wind down of a defaulting member so that market disruptions are minimized, we have strengthened our default management. OCC has developed, implemented and tested with market participants an innovative auction process for liquidating a defaulting member's portfolio. Our auction platform enables us to efficiently engage potential bidders either through a sealed bid or a Dutch auction format, minimizing the time it takes to transfer positions and collateral, and maximizing the value of the assets being sold. The infrastructure and regular testing allows OCC to operate with a higher degree of confidence.

Finally, we have taken important steps to enhancing pre- and post-trade risk control standards to reduce systemic risk from erroneous trades.

One of the emerging areas of clearing house risk that we had to deal with is the financial risk posed by trading errors in financial markets. In recent years, there have been numerous examples in stock, options and futures markets involving direct access, automated trading systems creating erroneous trades that result in significant financial losses to qualifying clearing member firms and their customers. At OCC, we are obligated to accept all matched trades from our participant exchanges, creating the possibility that significant erroneous trades might impact the financial wherewithal of a clearing member firm or potentially OCC itself.

In order to reduce these risks, OCC has worked collaboratively with its participant exchanges to adopt the following principles-based standards:

  • price reasonability checks designed to prevent the display and execution of quotes and orders at extreme prices;
  • drill-through protections that restrict the prices at which orders may be executed and prevent marketable orders from improperly trading through many price increments in a short period of time;
  • activity-based protections designed to address risk beyond price such as a high frequency of trades in a set period of time;
  • kill switches to enable the termination of access to an options exchange's trading system under certain defined circumstances.

Subject to regulatory approval, implementation of these standards is planned for June 201612. In order to incentivize exchange participants to meet these new standards, after the implementation date, OCC will impose an additional $.02 risk-based charge per contract side for transactions executed on exchanges that have not demonstrated compliance with these standards.

While it's critical for markets to have strong pre-trade risk controls, these processes are not fool-proof and clearing houses need to have post-trade controls to assist in identifying not only erroneously priced trades that escape the exchange's controls, but controls that identify aggregations of trades submitted from multiple markets. While individually, these trades may be priced reasonably, in the aggregate the quantity may present credit issues for the executing member. Knight Capital provides an example where credit controls tied to kill-switch capabilities, while not preventing the problem, could have potentially stopped the bleeding before it became a crisis. Losing a participant that accounted for a significant percentage of equity market liquidity would have had devastating residual effects on our markets beyond the default itself.

In an effort to move towards this vision, OCC is developing a number of post-trade controls intended to first identify potentially erroneously priced trades and validate their accuracy before being cleared. Next, we will be implementing real-time credit controls intended to identify the aggregation of exposure coming from any of our 12 markets that will not only alert a clearing firm of a potential issue, but also will be used by OCC to determine when additional margin should be deposited by a member to collateralize the exposure, and in extreme scenarios identify when a kill-switch should be engaged. The combination of these pre- and post-trade risk controls will increase the overall certainty of an executed trade and minimize occurrences of market disruption caused by these otherwise technical issues.

Central Counterparty Clearing is the Next Frontier

The next decade will bring significant growth and innovation in the post-trade landscape. Clearing houses will be expanding their services to meet regulatory mandates for centralized clearing of standardized swaps. Additionally, increased capital requirements will create incentives for market participants to seek greater capital and operating efficiencies by working more closely with clearing houses and custodians.

At OCC, our strategy is to extend our capabilities to securities finance and OTC markets. Today, OCC is the only clearing house for securities lending transactions where we guarantee return of stock or cash to bi-lateral and exchange traded stock loan participants. This innovative solution maintains liquidity sources during times of stress. We are also working to introduce the same benefits to the equity repo markets. Finally, we are continuing to work with our exchange participants to expand the breadth of options and futures products cleared at OCC.


At OCC we will continue to look for ways to reduce risk in the markets we serve. The changing regulatory environment provides us an important opportunity to continue our industry leadership by further enhancing our resiliency and meeting the heightened expectations that our stakeholders have for us as a systemically important institution. Further strengthening our institution will enhance investor confidence and will expand our business opportunities.

1 Bank for International Settlements – OTC Derivatives Market Activity in the Second Half of 2007, Published May 2008

2 According to the World Bank Group, Global GDP in 2007 Was Approximately $56.5 Trillion (in USD)

3 'Mark to Myth' Assets Soar at European Banks

4 In the Washington Summit on November 15, 2008 the declarations on Prudent Oversight stated, "Supervisors and regulators, building on the imminent launch of central counterparty services for credit default swaps (CDS) in some countries, should: speed efforts to reduce the systemic risks of CDS and over-the-counter (OTC) derivatives transactions; insist that market participants support exchange traded or electronic trading platforms for CDS contracts; expand OTC derivatives market transparency; and ensure that the infrastructure for OTC derivatives can support growing volumes.

5 Clearing House Concentration Risk

6 Clearinghouses, Financial Stability, and Financial Reform, remarks by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System at the 2011 Financial Markets Conference sponsored by the Federal Reserve Bank of Atlanta Stone Mountain, Georgia on April 4, 2011. "What was once a landscape of numerous, separate clearinghouses that operated largely independently from one another has now become dominated by fewer and larger clearinghouses supporting more integrated markets and consolidated, global financial firms. Moreover, the same globally active banks participate in all of the major clearinghouses, and the major clearinghouses often rely on similar sets of banks for payment services, funding, settlement, and emergency liquidity. In such a world, problems at one clearinghouse could have significant effects on others, even in the absence of explicit operational links. The need for strong risk management and oversight will only increase as we go forward." (Emphasis added)

7 Principles for Financial Market Infrastructures by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO)

8 Financial Stability Oversight Council Makes First Designations in Effort to Protect Against Future Financial Crises

9 Standards for Covered Clearing Agencies

10 SEC Proposes Rules for Systemically Important and Security-Based Swap Clearing Agencies

11 JP Morgan Tells Clearers to Build Bigger Buffers

12 OCC and The U.S. Options Exchanges Announce New Risk Control Standards to Strengthen Industry Protections