[Federal Register Volume 83, Number 248 (Friday, December 28, 2018)]
[Notices]
[Pages 67392-67394]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-28180]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-84879; File No. SR-OCC-2018-014]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Approving Proposed Rule Change, as Modified by Partial Amendment 
No. 1, Related to The Options Clearing Corporation's Margin Methodology 
for Incorporating Variations in Implied Volatility

December 20, 2018.

I. Introduction

    On October 22, 2018, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') the 
proposed rule change SR-OCC-2018-014 (``Proposed Rule Change'') 
pursuant to Section 19(b) of the Securities Exchange Act of 1934 
(``Exchange Act'') \1\ and Rule 19b-4 \2\ thereunder to propose changes 
to OCC's model for incorporating variations in implied volatility 
within OCC's margin methodology, the System for Theoretical Analysis 
and Numerical Simulations.\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Notice of Filing infra note 5, at 83 FR 55918.
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    On October 30, 2018, OCC filed a partial amendment (``Partial 
Amendment No. 1'') to the Proposed Rule Change.\4\ The Proposed Rule 
Change, as modified by Partial Amendment No. 1, was published for 
public comment in the Federal Register on November 8, 2018,\5\ and the 
Commission received no comments regarding the Proposed Rule Change. 
This order approves the Proposed Rule Change.
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    \4\ In Partial Amendment No. 1, OCC corrected an error in 
Exhibit 5 without changing the substance of the Proposed Rule 
Change. References to the Proposed Rule Change from this point 
forward refer to the Proposed Rule Change, as amended by Partial 
Amendment No. 1.
    \5\ Securities Exchange Act Release No. 84524 (Nov. 2, 2018), 83 
FR 55918 (Nov. 8, 2018) (SR-OCC-2018-014) (``Notice of Filing''). 
OCC also filed a related advance notice (SR-OCC-2018-804) (``Advance 
Notice'') with the Commission pursuant to Section 806(e)(1) of Title 
VIII of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act, entitled the Payment, Clearing, and Settlement Supervision Act 
of 2010 and Rule 19b-4(n)(1)(i) under the Act. 12 U.S.C. 5465(e)(1). 
15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, respectively. The Advance 
Notice was published in the Federal Register on November 26, 2018. 
Securities Exchange Act Release No. 84626 (Nov. 19, 2018), 83 FR 
60541 (Nov. 26, 2018) (SR-OCC-2018-804).
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II. Background

    The System for Theoretical Analysis and Numerical Simulations 
(``STANS'') is OCC's methodology for calculating margin. STANS includes 
econometric models that incorporate a number of risk factors. OCC 
defines a risk factor in STANS as a product or attribute whose 
historical data is used to estimate and simulate the risk for an 
associated product. The majority of risk factors utilized in STANS are 
the returns on individual equity securities; however, a number of other 
risk factors may be considered, including, among other things, returns 
on implied volatility risk factors.\6\
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    \6\ In December 2015, the Commission approved a proposed rule 
change and issued a Notice of No Objection to an advance notice 
filing by OCC to its modify margin methodology by more broadly 
incorporating variations in implied volatility within STANS. See 
Securities Exchange Act Release No. 76781 (Dec. 28, 2015), 81 FR 135 
(Jan. 4, 2016) (SR-OCC-2015-016) and Securities Exchange Act Release 
No. 76548 (Dec. 3, 2015), 80 FR 76602 (Dec. 9, 2015) (SR-OCC-2015-
804).
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    As a general matter, the implied volatility of an option is a 
measure of the expected future volatility of the option's underlying 
security at expiration, which is reflected in the price of the 
option.\7\ Changes in implied volatility, therefore, result in changes 
to an option's value. In effect, the implied volatility is responsible 
for that portion of the premium that cannot be attributed to the then-
current intrinsic value of the option (i.e., the difference between the 
price of the underlying and the exercise price of the option), 
discounted to reflect its time value.
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    \7\ 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 the current 
risk-free rate.
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    STANS includes a model that simulates variations in implied 
volatility for most of the option contracts that OCC clears (``Implied 
Volatility Model'').\8\ The purpose of

[[Page 67393]]

OCC's Implied Volatility Model is to ensure that the anticipated cost 
of liquidating options positions in an account recognizes the 
possibility that implied volatility could change during the two-
business day liquidation time horizon and lead to corresponding changes 
in the market prices of the options. OCC, in turn, uses such 
anticipated costs to determine and collect the amount of margin 
necessary to collateralize the exposure that OCC could face in the 
event of a Clearing Member default.
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    \8\ OCC's Implied Volatility Model excludes: (i) Binary options, 
(ii) options on commodity futures, (iii) options on U.S. Treasury 
securities, and (iv) Asians and Cliquets. These products were 
relatively new products at the time that OCC completed its last 
implied volatility margin methodology changes, and OCC had de 
minimus open interest in those options. OCC uses its Implied 
Volatility Model specifically for options that have a residual tenor 
of less than three years (``Shorter Tenor Options'').
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    One component of the Implied Volatility Model is a forecast of the 
volatility of implied volatility. In the process of performing 
backtesting and impact analyses as well as comparing the Implied 
Volatility Model to industry benchmarks, OCC determined that its 
process for forecasting the volatility of implied volatility is 
extremely sensitive to sudden spikes in volatility, which can at times 
result in over-reactive margin requirements that OCC believes are 
unreasonable and procyclical.\9\ For example, on February 5, 2018, the 
Cboe Volatility Index (``VIX'') experienced a large amount of 
volatility.\10\ Based on its review and understanding of OCC's 
analysis, the Commission understands that OCC's Implied Volatility 
Model forecasted an extreme increase in the volatility of implied 
volatility in response to the increase in the VIX on February 5, 
2018.\11\ Specifically, the Implied Volatility Model forecasted a 
volatility of implied volatility for an at-the-money, one-month tenor 
SPX position that was approximately 4 times larger than the comparable 
market index.\12\ This forecast caused aggregate margin requirements at 
OCC to jump more than 80 percent overnight due to the Implied 
Volatility Model, and margin requirements for certain individual 
Clearing Members increased by a factor of 10.\13\ Due in large part to 
the over-reaction of the Implied Volatility Model's to the rise in the 
VIX, a future shock to the VIX during a time of market stress could 
result in an increase in margin requirements that likely would impose 
additional stresses on Clearing Members.
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    \9\ See Notice of Filing, 83 FR at 55919.
    \10\ The VIX is a measure of the implied volatility of the of 
Standard & Poor's 500 index (``SPX'').
    \11\ See Notice of Filing, 83 FR at 55919.
    \12\ See id.
    \13\ See id. For example, the total margin requirements for one 
Clearing Member would have increased from $120 million on February 
2, 2018 to $1.78 billion on February 5, 2018. See Notice of Filing, 
83 FR at 55919, n. 22.
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    The Proposed Rule Change would modify OCC's Implied Volatility 
Model by introducing an exponentially weighted moving average \14\ for 
the daily forecasted volatility of implied volatility risk factors. 
Specifically, when forecasting the volatility for each implied 
volatility risk factor, OCC would use an exponentially weighted moving 
average of forecasted volatilities over a specified look-back period 
rather than using unweighted daily forecasted volatilities. The 
Proposed Rule Change would change the Implied Volatility Model's 
sensitivity to large, sudden shocks in market volatility when 
forecasting the volatility of implied volatility. Specifically, the 
Proposed Rule Change would result in a more measured initial response 
to such shocks while producing margin requirements that may remain 
elevated for a longer period of time following a market shock. Based on 
its analysis of data provided by OCC, the Commission understands that 
the margin requirements calculated with the current and proposed models 
would be very similar during less volatile periods, and that the 
likelihood that OCC would have sufficient margin to cover its exposures 
under normal market conditions would not decrease under the proposed 
model.\15\ However, the proposed model would present a more 
commensurate response to the extreme volatility increases in the 
market.
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    \14\ An exponentially weighted moving average is a statistical 
method that averages data in a way that gives more weight to the 
most recent observations.
    \15\ OCC's backtesting, which the Commission has reviewed and 
analyzed, demonstrated that coverage levels using the proposed model 
were substantially similar to the results obtained from the current 
model. See Notice, 83 FR at 55920.
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III. 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 such proposed rule change is consistent with the 
requirements of the Exchange Act and the rules and regulations 
thereunder applicable to such organization.\16\ After carefully 
considering the Proposed Rule Change, the Commission finds the proposal 
is consistent with the requirements of the Exchange Act and the rules 
and regulations thereunder applicable to OCC. More specifically, the 
Commission finds that the proposal is consistent with Section 
17A(b)(3)(F) of the Exchange Act \17\ and Rule 17Ad-22(e)(6)(i) 
thereunder.\18\
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    \16\ 15 U.S.C. 78s(b)(2)(C).
    \17\ 15 U.S.C. 78q-1(b)(3)(F).
    \18\ 17 CFR 240.17Ad-22(e)(6)(i).
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A. Consistency With Section 17A(b)(3)(F) of the Exchange Act

    Section 17A(b)(3)(F) of the Exchange Act requires that the rules of 
a clearing agency be designed to, among other things, assure the 
safeguarding of securities and funds which are in the custody or 
control of the clearing agency or for which it is responsible, and, in 
general, to protect investors and the public interest.\19\ Based on its 
review of the record, the Commission believes that the proposed changes 
are designed to assure the safeguarding of securities and funds which 
are in OCC's custody or control, and, in general, protect investors and 
the public interest for the reasons set forth below.
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    \19\ 15 U.S.C. 78q-1(b)(3)(F).
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    First, margin deposits at OCC provide collateral to mitigate the 
potential default of a Clearing Member. As noted above, OCC uses STANS, 
including the Implied Volatility Model, to determine and collect the 
amount of margin necessary to collateralize the exposure that OCC could 
face in the event of a Clearing Member default. The Proposed Rule 
Change would change the Implied Volatility Model's response to sudden, 
large changes in market volatility. As noted above, the margin 
requirements produced by the current model appear to be overly 
responsive to sudden, large shocks. Following implementation of the 
Proposed Rule Change, OCC's margin methodology would produce a more 
measured initial response to a sudden, large change in market 
volatility while maintaining elevated margin requirements following 
such a shock. As described above, however, the coverage provided by 
OCC's margin methodology following implementation of the Proposed Rule 
Change would likely be comparable to the coverage provided 
currently.\20\ Further, the proposal would result in margin 
requirements that remain elevated for a longer period of time following 
a market shock, which could provide further support for OCC's ability 
to cover its potential future exposure to risk.
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    \20\ See supra note 15.
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    For these reasons, the Commission believes that the Proposed Rule 
Change would enhance the Implied Volatility Model by enabling OCC to 
determine its margin requirements more precisely and to better reflect 
the risks and particular attributes of the products cleared by OCC, 
thereby allowing OCC to more effectively cover its credit exposure to 
its Clearing Members. By more precisely determining OCC's credit 
exposure to its Clearing Members, the Proposed Rule Change is designed 
to help ensure that,

[[Page 67394]]

in the event of a Clearing Member default, OCC's operations would not 
be disrupted and non-defaulting Clearing Members would not be exposed 
to losses that they cannot anticipate or control. In this way, the 
Proposed Rule Change is designed to help assure the safeguarding of 
securities and funds which are in the custody or control of OCC, or for 
which it is responsible, consistent with Section 17A(b)(3)(F) of the 
Exchange Act.
    Second, the Proposed Rule Change could reduce the likelihood that 
OCC's margin requirements impose sudden and excessive stress on 
Clearing Members during times of broader market stress. As described 
above, the current Implied Volatility Model could result in dramatic 
increases in Clearing Member margin requirements in response to a 
sudden, large shock in market volatility. Based on its review of OCC's 
data comparing margin requirements to market data on February 5, 2018, 
the Commission understands that the size of such an increase would not 
necessarily be commensurate with the risk of the Clearing Member's 
portfolio because, as described above, the volatility of implied 
volatility forecasted by the current model on that day was 4 times the 
size of a comparable market index, resulting in margin requirements for 
some Clearing Members that rose by a factor of 10. Imposing a large, 
unexpected increase in margin requirements could impose a large, 
unexpected stress on a Clearing Member during a period of high 
volatility. The Commission believes that reducing the likelihood of 
unnecessarily large and unexpected stresses on Clearing Members could 
help to lessen the risk of Clearing Member defaults. Reducing the risk 
of Clearing Member defaults could also reduce the likelihood of 
contagion during times of market stress because Clearing Members, 
particularly large Clearing Members, tend to be active participants in 
multiple asset markets. Therefore, the Commission believes that the 
Proposed Rule Change provides for rules designed, in general, to 
protect investors and the public interest.
    Accordingly, and for the reasons stated above, the Commission 
believes that the Proposed Rule Change is consistent with Section 
17A(b)(3)(F) of the Exchange Act.\21\
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    \21\ 15 U.S.C. 78q-1(b)(3)(F).
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B. Consistency With Rule 17Ad-22(e)(6) Under the Exchange Act

    Rule 17Ad-22(e)(6)(i) under the Exchange Act requires that a 
covered clearing agency establish, implement, maintain, and enforce 
written policies and procedures reasonably designed to cover, if the 
covered clearing agency provides central counterparty services, its 
credit exposures to its participants by establishing a risk-based 
margin system that, among other things, considers, and produces margin 
levels commensurate with, the risks and particular attributes of each 
relevant product, portfolio, and market.\22\
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    \22\ 17 CFR 240.17Ad-22(e)(6)(i).
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    The Proposed Rule Change is designed to better align the margin 
requirements produced by OCC's margin methodology with the level of 
risk posed by changes in market volatility. The component of the 
current Implied Volatility Model that forecasts the volatility of 
implied volatility is very sensitive to sudden, large changes in market 
volatility, as evidenced by the model's reaction to the large, sudden 
spike in market volatility observed on February 5, 2018 discussed 
above, which produced dramatic increases in Clearing Member margin 
requirements. The Proposed Rule Change to the Implied Volatility Model 
would reduce the sensitivity of the model to sudden, large changes in 
market volatility, and, as demonstrated by OCC's backtesting, would be 
unlikely to reduce the level of coverage.\23\
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    \23\ See supra note 15.
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    The Commission believes that revising the Implied Volatility Model 
could produce margin requirements that are more precise and better 
reflect the risks and particular attributes of the products cleared by 
OCC. The Commission further believes that such changes could produce 
margin levels that are commensurate with the risks of the products 
being cleared. Accordingly, based on the foregoing, the Commission 
believes that the Proposed Rule Change is consistent with Exchange Act 
Rule 17Ad-22(e)(6)(i).\24\
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    \24\ 17 CFR 240.17Ad-22(e)(6).
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
Proposed Rule Change is consistent with the requirements of the 
Exchange Act, and in particular, the requirements of Section 17A of the 
Exchange Act \25\ and the rules and regulations thereunder.
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    \25\ In approving this Proposed Rule Change, the Commission has 
considered the proposed rules' impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\26\ that the Proposed Rule Change (SR-OCC-2018-014) be, 
and hereby is, approved.
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    \26\ 15 U.S.C. 78s(b)(2).
    \27\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\27\
Brent J. Fields,
Secretary.
[FR Doc. 2018-28180 Filed 12-27-18; 8:45 am]
 BILLING CODE 8011-01-P