June 2014 Newsletter

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In This Issue

Industry Insight: Craig Donohue

Craig DonohueStrengthening risk controls in the options industry is a top priority for OCC. Executive Chairman Craig S. Donohue offers a detailed look at how OCC is working with the U.S. options exchanges to develop a uniform set of principles-based exchange risk control protections that will enhance the market infrastructure.

OCC and the options exchanges recently announced they have adopted a series of pre- and post-trade risk controls. What is the significance of that?

Strengthening risk controls in the options industry has been a high priority among regulators, exchanges, market participants and OCC. By working collaboratively with our options exchange partners to develop and implement a uniform set of exchange risk control protections, we will strengthen critical market infrastructure in the U.S. options industry. OCC places great importance on providing market participants with innovative risk management solutions while promoting financial stability and integrity in every market that we serve. As a leading voice in the options industry, we are proud to be part of an initiative to reduce market disruptions.

How were these principles developed and what is included?

In developing these new protections, OCC and the exchanges adopted a principles-based approach that balances the need for consistent risk protocols across the different exchange models and technologies in the marketplace, and the need for exchange participants to continue to adapt and innovate. The principles are designed to enhance the monitoring of trading activity on a real-time basis and reduce the risk of errors or other inappropriate activity that poses a material risk of significant market disruption. These new principles are consistent with ongoing initiatives by the exchanges to enhance exchange risk controls and will supplement enhanced OCC post-trade controls that are currently under development.

Are there additional details on the pre-trade risk controls that you can share?

Each options exchange that clears and settles through OCC will follow a number of pre-trade exchange risk controls. These include: price reasonability checks to prevent execution of orders at extreme prices;drill-through protections, such as price collars, will restrict orders from immediately trading up or down an unlimited number of price intervals and allow market liquidity to be refreshed prior to the execution of additional transactions; activity-based protections will extend exchange risk controls to factors other than just “price,” such as controls based on time, quantity or notional value; and kill switches will cancel existing orders or block new orders on an exchange-wide or product-specific basis based on established triggers.

What about OCC and the post-trade risk controls, what is being done?

To further strengthen post-trade controls, OCC is in the process of implementing price filters to identify and send for validation potentially erroneous trades priced significantly away from the market. As an initial step, trades identified with prices exceeding $2,000 will be subject to manual review for reasonability by OCC and exchange staff. We are continuing development of more sophisticated post-trade controls, including an automated price collar that will analyze all incoming options trades on a real-time basis using options pricing models to identify with precision any erroneous trades.

Are there any other principles or controls the industry is working on?

The U.S. options exchanges are working together to develop a uniform obvious error rule to nullify or adjust transactions that meet the definition of an obvious or catastrophic error. Once completed, OCC will adopt a requirement that all OCC participant exchanges apply the uniform rule. We are also working with the exchanges and other market participants to develop market-wide credit controls that will apply to OCC clearing members and their customers, accounting for activity conducted across all options exchanges.

When will these principles be implemented as practice?

We will work on the timeframe for implementation of these pre- and post-trade risk controls at OCC’s July Board meeting and introduce a schedule in the near future.

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OCC Submits Comment Letter on Covered Clearing Agency Proposal

The Securities and Exchange Commission (SEC) recently proposed the adoption of a new regulatory framework for covered clearing agencies. As a covered clearing agency, OCC will ultimately be subjected to the prescribed risk management standards of this proposal.

OCC supports the SEC’s ongoing efforts to strengthen the regulation of registered clearing agencies and shares its goal of ensuring the safety and soundness of the marketplace. After careful review and analysis of the proposal, OCC submitted a comment letter to the SEC that addresses several areas on which the company believes could be improved through minor modifications or interpretive guidance. Comments on the issues that OCC considers to be the most important include:

  • Capital Requirements: OCC endorses the SEC’s proposal to require that OCC hold equity capital in reserve to cover at least six months of operating expenses. However, OCC urges the Commission not to take too narrow a view of what sources of funding would be considered equity. In addition to accepting common stock and retained earnings as sources of equity funding, OCC believes that appropriately structured preferred stock should also be accepted. Raising equity capital through the issuance of common stock is difficult for an organization like OCC given its ownership and governance structure. Increasing OCC’s retained earnings by eliminating clearing fee discounts was the most certain and pragmatic near-term approach to meeting the required amount of surplus capital.

  • Collateral Risk Management: OCC supports the proposal’s requirement to establish policies and procedures to limit the assets it accepts as collateral to those with low credit, liquidity and market risks. OCC encourages the Commission to adopt a flexible and holistic approach to applying these requirements particularly with respect to equity securities. OCC believes that accepting equity securities as collateral is especially appropriate in a true portfolio margining system such as OCC’s STANS in which collateral assets and the positions they support are considered collectively in determining margin requirements. OCC’s ability to accept equity securities as collateral is critically important in its efforts to reduce systemic risk in equity derivatives markets.  

Click here to view the comment letter.

The rule proposal can be viewed here.

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Risk Magazine Highlights OCC Leadership in the Transformation of Clearing

The latest issue of Risk Magazine, one of the preeminent publications for news about financial risk management, highlights OCC’s role in the business and regulatory transformations now under way in the clearing environment.

OCC’s Chief Operating Officer Mike McClain discussed the impact of new regulations on the over-the-counter derivatives market and looked at recent developments such as OCC’s launch of over-the counter (OTC) options clearing in a series of questions with the magazine.

“Dodd-Frank and the subsequent Systemically Important Financial Market Utility (SIFMU) designations of several organizations have had tremendous impacts on both transparency and risk reduction. We are undergoing a transformation as a result of the SIFMU designation, which is taking us beyond technical risk modelling, margin calculation and trade clearing into a resilient hub for safe and efficient markets. It has been one of the most important shifts in our history and we are pleased with the results thus far,” McClain told the magazine.

“Until now, central counterparty clearing had not been available for OTC US equity options. With the launch of OTC S&P 500 index options clearing, OCC applies its proven risk management expertise in exchange-traded US equity options to the OTC side of the business. Our established systems and processes will support this business and our members will achieve operational and capital efficiencies by putting OTC and listed positions in the same clearing house,” McClain added.

The full interview can be found in the new OCC Views section of the website here.

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OCC Successfully Launches Clearing OTC S&P 500 Equity Index Options

As part of its mission to provide market participants with innovative risk management solutions and promote financial stability in the markets it serves, OCC launched over-the-counter (OTC) S&P 500®* equity index option clearing services on April 25. OCC is the first clearinghouse in the U.S. to clear OTC equity index options, bringing capital and operational efficiencies and enhanced customer protections to the OTC equity derivatives marketplace.

This initiative provides market participants with advanced OTC risk management solutions. OCC is using its existing risk systems and tools to monitor clearing member credit, market and liquidity risks. The OTC clearing program is backed by OCC’s system of safeguards, including rigorous membership standards, prudent margin requirements and a clearing fund.

This initiative provides market participants with advanced OTC risk management solutions.

In connection with novation, where OCC becomes the counterparty to trade participants, OCC delivers centralized risk management and standardized margining practices. Positions in OTC options will be commingled with listed positions within OCC’s existing clearing member account structure to provide portfolio benefits and account for margin portfolio margining offsets.

Day-one participants included JP Morgan Clearing Corp, Deutsche Bank, Barclays, Morgan Stanley and BNP Paribas, among others. All day-one participants completed rigorous pre-launch testing between their firms, MarkitSERV and OCC.

A second phase, dealer-to-client clearing, is scheduled to launch later this year. The recent approval of Securities and Exchange Commission and Securities Investor Protection Corporation (SIPC) rule changes necessary to support the OTC clearing initiative enhances the protections that will be afforded to customers in the event of a liquidation of their broker-dealer and serves to mitigate counterparty risk. While margin offsets will remain an important feature, phase two will also bring clients greater customer protection through the SIPC.

For more information, please click here.

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OCC to Use SPAN for Futures Customer Gross Margin Calculations

OCC will begin using the Standard Portfolio Analysis of Risk (SPAN®)** margin methodology when performing Customer Gross Margin (CGM) calculations for all customer segregated futures accounts, including all non-proprietary cross-margining accounts, on Friday, July 11.

OCC is making this change to reduce potential burdens on futures customers associated with Commodity Futures Trading Commission regulations that link clearinghouse margin with customer margin. In particular, the regulations require Derivatives Clearing Organizations (DCOs) to collect initial margin for customer segregated futures accounts on a gross basis and to also have rules requiring clearing members to collect initial margin from their customers in an amount that is greater than the amount the DCO collects from clearing members.

Today, OCC’s proprietary System for Theoretical Analysis and Numerical Simulations (STANS) methodology is used to perform these calculations. However, STANS margin parameters are recalibrated daily, which could raise issues for customers. Therefore, OCC is making the move to conform with futures industry convention.

Alongside the CGM SPAN calculation, OCC will continue to calculate the net (i.e., all positions in a single portfolio) requirement using the STANS methodology. If the net STANS requirement exceeds the gross SPAN requirement, OCC will collect from Clearing Members the incremental difference as an enhanced margin surcharge.

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Donohue Addresses Leading SIFMU Role at 32nd Options Industry Conference

In a speech on May 1 OCC Executive Chairman Craig Donohue addressed attendees of the 32nd Annual Options Industry Conference on how OCC is adapting to the new regulatory environment in its role as a Systemically Important Financial Market Utility (SIFMU). The speech, “Heightened Expectations for Systemically Important Clearing Houses: How OCC Is Meeting the Challenge,” covered the latest operational developments at OCC and the evolving post-trade landscape. Mr. Donohue also provided background on OCC’s fee structure after the recent elimination of discounts and temporary suspension of refunds.

OCC has provided the lowest clearing fees in the industry by a significant margin for its 40-year history. As regulation of central clearing counterparties has fundamentally transformed around the world with the passage of Dodd Frank and other initiatives, OCC has made critical changes to meet heightened standards and its expanded regulatory oversight. The elimination of the discount allows OCC to accumulate additional surplus necessary to meet heightened regulatory requirements and even with this change, OCC’s fee schedule is the lowest among major clearinghouses in the world. Looking forward, Mr. Donohue stated that OCC is working on a five-year, forward-looking model of expenses, capital requirements and refunds to ensure an even more predictable and transparent model to benefit its stakeholders.

Craig Donohue, Executive Chairman, addressed  attendees on how OCC is meeting the challenge in a new regulatory environment
Craig Donohue, Executive Chairman, addressed attendees on how OCC is meeting the challenge in a new regulatory environment.

Industry Conference Focuses on Key Issues for Continued Growth

Coming off the second highest volume year in history, the options industry continues to experience strong growth. This year’s Options Industry Conference, led by host exchange BATS Options and organized by OCC, was held April 30 – May 2 at the Hyatt Regency Lost Pines Resort in Austin, Texas. The conference drew more than 450 options industry professionals and featured three days of thought-provoking panel sessions and networking opportunities.

The conference kicked off with Exchange Updates followed by a Fireside Chat with Industry Representatives.The Fireside Chat, a new, open forum for discussing topics impacting the industry, brought together OCC representatives Joe Corcoran (Government Relations), Alan Grigoletto (OIC Education) and Carolyn Mitchell (Business Development & Strategy) along with Ellen Greene of the SIFMA Options Committee and Jim Toes of the Security Traders Association.

Joe Corcoran provided an update on Chairman Camp’s draft tax bill and OCC’s ongoing efforts to educate regulators on industry concerns about the proposal. Ellen Greene spoke on SIFMA’s efforts to harmonize options rules across exchanges including uniform rules for obvious and catastrophic errors and uniform permanent programs in pennies. Alan Grigoletto covered OIC’s ever expanding role in options education. Carolyn Mitchell discussed OCC’s recently launched OTC clearing solution and the latest developments with streamlining the Options Disclosure Document. Jim Toes shared his perspective on the current level of knowledge regarding market structure on the Capitol Hill.

Fireside Chat with Industry Representatives panel: (left to right) Jim Toes, STA; Ellen Greene, SIFMA; Carolyn Mitchell, OCC; Alan Grigoletto, OIC; and Joe Corcoran, OCC.
Fireside Chat with Industry Representatives panel: (left to right) Jim Toes, STA; Ellen Greene, SIFMA; Carolyn Mitchell, OCC; Alan Grigoletto, OIC; and Joe Corcoran, OCC.

Andy Nybo of the TABB Group presented on the state of the options industry sharing  his views on current volume trends and the return of the retail investor to the options market. He also presented analysis from the latest European TABB group study, which illustrated an increased demand for U.S options coming from European investors. The Exchange Leaders panel followed with a focus on the role of trading technology in the marketplace. Exchange leaders expressed interest in working with OCC to improve pre- and post-trade risk controls for a safer marketplace.

New to this year’s conference lineup was A WILD® Perspective panel moderated by Ellen Greene and comprised of Francine Fang, KCG Holdings; Elizabeth Martin, Goldman Sachs; Sapna Patel, Morgan Stanley; and Jessica Titlebaum, Orc Group. The panelists shared their experiences in the industry and how they got started in derivatives. Keynote speaker Chesley B. “Sully” Sullenberger, III gave an exhilarating account of his crucial decision making as the pilot of the “Miracle on the Hudson.” An Industry Legends panel featured seasoned professionals who discussed significant events that impacted the options market over the past four decades. This was followed by a Market Makers panel and an address from Gregg E. Berman of the SEC. Alan Grigoletto moderated the final session of the conference on the importance of education and how it is driving industry growth.

This year’s Joseph W. Sullivan Award was given to Blair Hull, Ketchum Trading, LLC, for his outstanding contributions to the U.S. options industry throughout his career.

Steven Crutchfield, NYSE Options (right), presented Blair Hull with the 2014 Joseph W. Sullivan Award.
Steven Crutchfield, NYSE Options (right), presented Blair Hull with the 2014 Joseph W. Sullivan Award.

The 2015 Options Industry Conference will be led by BOX Options Exchange and held May 6-8 in Miami Beach, Florida, at the Fontainebleau Hotel.

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From the Hill

Today’s Washington is certainly uncertain because of the monumental upset in Virginia’s Seventh District, where Majority Leader Eric Cantor (R-Virginia) lost his primary contest by 11 points to David Brat, an economics professor at Randolph-Macon College virtually unknown to anyone outside of his district.

This is the biggest political surprise in many years, and may be the biggest primary upset in the history of modern politics. Congressional leaders have lost in general elections, but very few, if any, have been defeated in a primary by a member of their own party. Majority Leader Cantor’s loss has huge ramifications for the immediate future of the House leadership. Less than two hours after his loss was announced, articles were already written about the post-Cantor House and who will take his place as Majority Leader after he steps down effective July 31.

The loss of Majority Leader Cantor will have many effects across the business landscape, including the likelihood of the Export-Import Bank’s charter not being reauthorized, and immigration reform including the expansion of the H1-B Visa program favored by the technology industry not being considered this year. His loss also further exposes the chasm between the pro-business and conservative populist sides of the Republican party.

Democrats are no doubt pleased with these recent developments, but few dispassionate political observers are extrapolating Congressman Cantor’s loss into anything beyond a few thousand constituents being frustrated with their Congressman’s national profile growing at the expense of their local priorities.

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Update to Clearing Fund Allocation Formula

As previously announced, beginning on May 1, 2014, OCC transitioned to the final formula by which Clearing Fund contributions are allocated among members. This formula incorporates a blended allocation with open interest accounting for 50% of the allocation, total risk margin accounting for 35% and volume accounting for 15%. Phase I of the formula change went into effect on November 1, 2013 and resulted in the implementation of an interim formula (open interest 75%, total risk margin 17.5%, volume 7.5%). This phased approach mitigated the impact on members that would have been realized from a transition conducted in one stage.

Prior to November 1, 2013, clearing members contributed an amount equal to their proportionate share of open interest, subject to a $150,000 minimum. The new allocation formula better reflects a clearing member’s level of participation in the marketplace and the risks it presents to OCC through the inclusion of volume and total risk margin.

For more information please contact the Member Services Help Desk at (800) 621-6072 or memberservices@theocc.com.

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*Standard & Poor’s and S&P are registered trademarks of Standard & Poor’s Financial Services LLC, a part of McGraw Hill Financial. Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones"). These trademarks have been licensed to S&P Dow Jones Indices LLC. It is not possible to invest directly in an index. S&P Dow Jones Indices LLC, Dow Jones, S&P and their respective affiliates (collectively "S&P Dow Jones Indices") do not sponsor, endorse, sell, or promote any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment return based on the performance of any index. This document does not constitute an offer of services in jurisdictions where S&P Dow Jones Indices does not have the necessary licenses. S&P Dow Jones Indices receives compensation in connection with licensing its indices to third parties.

**SPAN is a registered trademark of the Chicago Mercantile Exchange Inc., used herein under license. Chicago Mercantile Exchange Inc. assumes no liability in connection with use of SPAN by any person or entity.

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The information contained in this newsletter is for general information purposes only. Although every attempt is made to ensure the accuracy of the information, OCC assumes no responsibility for any errors or omissions. All materials pertaining to rules and specifications are made subject to and are superseded by the By-Laws and Rules of OCC.