Self-Regulatory Organizations; The Options Clearing Corporation; Order Approving a Proposed Rule Change, as Modified by Amendment No. 1, To Modify the Options Clearing Corporation's Margin Methodology by Incorporating Variations in Implied Volatility

On October 5, 2015, The Options Clearing Corporation (“OCC”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change SR-OCC-2015-016 pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 19b-4 thereunder. The proposed rule change was published for comment in the Federal Register on October 19, 2015. The Commission did not receive any comments on the proposed rule change. On November 19, 2015, OCC filed Amendment No. 1 to the proposed rule change. On November 20, 2015, pursuant to Section 19(b)(2)(A)(ii)(I) of the Exchange Act, the Commission extended the time period within which to approve, disapprove, or institute proceedings to determine whether to disapprove the proposed rule change to January 17, 2016. This order approves the proposed rule change.

Description

As proposed by OCC, it is modifying its margin methodology by more broadly incorporating variations in implied volatility within OCC's System for Theoretical Analysis and Numerical Simulations (“STANS”). As explained below, OCC believes that expanding the use of variations in implied volatility within STANS for substantially all option contracts available to be cleared by OCC that have a residual tenor of less than three years (“Shorter Tenor Options”) will enhance OCC's ability to ensure that option prices and the margin coverage related to such positions more appropriately reflect possible future market value fluctuations and better protect OCC in the event it must liquidate the portfolio of a suspended clearing member.

Implied Volatility in STANS Generally

According to OCC, STANS is OCC's proprietary risk management system that calculates clearing members' margin requirements. According to OCC, the STANS methodology uses Monte Carlo simulations to forecast price movement and correlations in determining a clearing member's margin requirement. According to OCC, under STANS, the daily margin calculation for each clearing member account is constructed to ensure OCC maintains sufficient financial resources to liquidate a defaulting member's positions, without loss, within the liquidation horizon of two business days.

As described by OCC, the STANS margin requirement for an account is composed of two primary components: A base component and a stress test component. According to OCC, the base component is obtained from a risk measure of the expected margin shortfall for an account that results under Monte Carlo price movement simulations. For the exposures that are observed regarding the account, the base component is established as the estimated average of potential losses higher than the 99% VaR threshold. In addition, OCC augments the base component using the stress test component. According to OCC, the stress test component is obtained by considering increases in the expected margin shortfall for an account that would occur due to: (i) Market movements that are especially large and/or in which certain risk factors would exhibit perfect or zero correlations rather than correlations otherwise estimated using historical data or (ii) extreme and adverse idiosyncratic movements for individual risk factors to which the account is particularly exposed.

According to OCC, including variations in implied volatility within STANS is intended to ensure that the anticipated cost of liquidating each Shorter Tenor Option position in an account recognizes the possibility that implied volatility could change during the two business day liquidation time horizon in STANS and lead to corresponding changes in the market prices of the options. According to OCC, generally speaking, the implied volatility of an option is a measure of the expected future volatility of the value of the option's annualized standard deviation of the price of the underlying security, index, or future at exercise, which is reflected in the current option premium in the market. Using the Black-Scholes options pricing model, the implied volatility is the standard deviation of the underlying asset price necessary to arrive at the market price of an option of a given strike, time to maturity, underlying asset price and given the current risk-free rate. In effect, the implied volatility is responsible for that portion of the premium that cannot be explained by the then-current intrinsic value of the option, discounted to reflect its time value. According to OCC, it currently incorporates variations in implied volatility as risk factors for certain options with residual tenors of at least three years (“Longer Tenor Options”).

Implied Volatility for Shorter Tenor Options

OCC is proposing certain modifications to STANS to more broadly incorporate variations in implied volatility for Shorter Tenor Options. Consistent with its approach for Longer Tenor Options, OCC will model a volatility surface for Shorter Tenor Options by incorporating into the econometric models underlying STANS certain risk factors regarding a time series of proportional changes in implied volatilities for a range of tenors and absolute deltas. Shorter Tenor Option volatility points will be defined by three different tenors and three different absolute deltas, which produce nine “pivot points.” In calculating the implied volatility values for each pivot point, OCC will use the same type of series-level pricing data set to create the nine pivot points that it uses to create the pivot points used for Longer Tenor Options, so that the nine pivot points will be the result of a consolidation of the entire series-level dataset into a smaller and more manageable set of pivot points before modeling the volatility surface.

According to OCC, it considered incorporating more than nine pivot points but concluded that would not be appropriate for Shorter Tenor Options because: (i) Back-testing results, from January 2008 to May 2013, revealed that using more pivot points did not produce more meaningful information (i.e. more pivot points produced a comparable number of under-margined instances) and (ii) given the large volume of Shorter Tenor Options, using more pivot points could increase computation time and, therefore, would impair OCC from making timely calculations.

Under OCC's model for Shorter Tenor Options, the volatility surfaces will be defined using tenors of one month, three months, and one year with absolute deltas, in each case, of 0.25, 0.5, and 0.75, thus resulting in the nine implied volatility pivot points. OCC believes that it is appropriate to focus on pivot points representing at- and near-the-money options because prices for those options are more sensitive to variations in implied volatility over the liquidation time horizon of two business days. According to OCC, four factors explain 99% variance of implied volatility movements: (i) A parallel shift of the entire surface; (ii) a slope or skewness with respect to delta; (iii) a slope with respect to time to maturity; and (iv) a convexity with respect to the time to maturity. According to OCC, the nine correlated pivot points, arranged by delta and tenor, give OCC the flexibility to capture these factors.

According to OCC, it first will use its econometric models to jointly simulate changes to implied volatility at the nine pivot points and changes to underlying prices. For each Shorter Tenor Option in the account of a clearing member, changes in its implied volatility then will be simulated according to the corresponding pivot point and the price of the option will be computed to determine the amount of profit or loss in the account under the particular STANS price simulation. Additionally, as OCC does today, it will continue to use simulated closing prices for the assets underlying options in the account of a clearing member that are scheduled to expire within the liquidation time horizon of two business days to compute the options' intrinsic value and use those values to help calculate the profit or loss in the account.

Effects of the Proposed Change and Implementation

OCC believes that the proposed change will enhance OCC's ability to ensure that STANS appropriately takes into account normal market conditions that OCC may encounter in the event that, pursuant to OCC Rule 1102, it suspends a defaulted clearing member and liquidates its accounts. Accordingly, OCC believes that the change will promote OCC's ability to ensure that margin assets are sufficient to liquidate the accounts of a defaulted clearing member without incurring a loss.

OCC estimates that this change generally will increase margin requirements overall, but will decrease margin requirements for certain accounts with certain positions. Specifically, OCC expects this change to increase aggregate margins by about 9% ($1.5 billion). OCC also estimates the change will most significantly affect customer accounts and least significantly affect firm accounts, with the effect on market maker accounts falling in between.

According to OCC, it expects customer accounts to experience the largest margin increases because positions considered under STANS for customer accounts typically consist of more short than long options positions, and therefore reflect a greater magnitude of directional risk than other account types. According to OCC, positions considered under STANS for customer accounts typically consist of more short than long options positions to facilitate clearing members' compliance with Commission requirements for the protection of certain customer property under Exchange Act Rule 15c3-3(b). Therefore, OCC segregates the long option positions in the customer accounts of each clearing member and does not assign the long option positions any value when determining the margin for the customer account, resulting in higher margin.

OCC expects margin requirements to decrease for accounts with underlying exposure and implied volatility exposure in the same direction, such as concentrated call positions, due to the negative correlation typically observed between these two factors. According to OCC, over the back-testing period, about 28% of the observations for accounts on the days studied had lower margins under the proposed methodology and the average reduction was about 2.7%. Parallel results will be made available to the membership in the weeks ahead of implementation.

To help clearing members prepare for the proposed change, OCC has provided clearing members with an information memorandum explaining the proposal, including the planned timeline for its implementation, and discussed with certain other clearinghouses the likely effects of the change on OCC's cross-margin agreements with them. OCC also published an information memorandum to notify clearing members of the submission of this filing to the Commission. Subject to all necessary regulatory approvals regarding the proposed change, OCC intends to begin making parallel margin calculations with and without the changes in the margin methodology. The commencement of the calculations will be announced by an information memorandum, and OCC will provide the calculations to clearing members each business day. OCC also will provide at least thirty days prior notice to clearing members before implementing the change. OCC believes that clearing members will have sufficient time and data to plan for the potential increases in their respective margin requirements.

II. 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 the proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to such organization.

The Commission finds that the proposed rule change is consistent with Section 17A(b)(3)(F) of the Exchange Act and Rule 17Ad-22(b)(2) under the Exchange Act. Rule 17Ad-22(b)(2) under the Exchange Act requires OCC to establish, implement, maintain and enforce written policies and procedures reasonably designed to use margin requirements to limit its credit exposures to participants under normal market conditions and use risk-based models and parameters to set margin requirements, among other things. Through this proposal, OCC is modifying its margin methodology, which is designed to use margin requirements to limit its credit exposures to clearing members holding Shorter Tenor Options under normal market conditions. Specifically, OCC is modifying its risk-based model, STANS, to set margin requirements in a way that includes changes in implied volatility for Shorter Tenor Options. With this change in place, STANS is now designed to recognize a range of possible changes in implied volatility during the two business day liquidation time horizon that could lead to corresponding changes in the market prices of Shorter Tenor Options. Therefore, OCC's change is consistent with Rule 17Ad-22(b)(2) under the Exchange Act.

By limiting its credit exposure in this way that is consistent with Rule 17Ad-22(b)(2) under the Exchange Act, OCC is less likely to be subject to disruptions in its operations as a result of a participant default, thereby promoting the prompt and accurate clearance and settlement of securities transactions, consistent with Section 17A(b)(3)(F) of the Exchange Act. Section 17A(b)(3)(F) of the Exchange Act requires OCC to have rules designed to, among other things, promote the prompt and accurate clearance and settlement of securities transactions, and to assure the safeguarding of securities and funds which are in the custody or control of OCC or for which it is responsible. This change is also consistent with assuring the safeguarding of securities and funds which are in the custody or control of OCC. According to OCC, it has custody and control of margin deposits it requires members to post to limit credit exposure to members under normal market conditions. According to OCC, in the event of a member default, that member's margin deposits are the first pool of resources OCC would use to cover losses associated with the default. With this change in place, STANS is now designed to recognize a range of possible changes in implied volatility during the two business day liquidation time horizon that could lead to corresponding changes in the market prices of Shorter Tenor Options. This change is designed to enable OCC to more accurately calculate the amount of margin a member must post, and, therefore, make it less likely, in the event of a member default, that OCC will need to access mutualized clearing fund deposits to cover losses associated with such member's default, which is consistent with assuring the safeguarding of securities and funds which are in the custody or control of OCC or for which OCC is responsible. Therefore, this change is consistent with Section 17A(b)(3)(F) of the Exchange Act.

III. Conclusion

On the basis of the foregoing, the Commission finds that the proposal is consistent with the requirements of the Exchange Act and in particular with the requirements of Section 17A of the Exchange Act and the rules and regulations thereunder.

It is therefore ordered, pursuant to Section 19(b)(2) of the Exchange Act, that the proposed rule change (SR-OCC-2015-016), as modified by Amendment No. 1, be, and it hereby is, approved as of the date of this order or the date of a notice by the Commission authorizing OCC to implement OCC's advance notice proposal that is consistent with this proposed rule change (SR-OCC-2015-804), whichever is later.