Document ID: SEC-2015-1085-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Options Clearing Corp.
Posted Date: 2015-06-30T04:00Z

[Federal Register Volume 80, Number 125 (Tuesday, June 30, 2015)]
[Notices]
[Pages 37323-37326]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-15994]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-75290; File No. SR-OCC-2014-810]

Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of No Objection to an Advance Notice Concerning Modifications To 
Backtesting Procedures in Order To Enhance Monitoring of Margin 
Coverage and Model Risk Exposure

June 24, 2015.
    On November 13, 2014, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
advance notice SR-OCC-2014-810 (``Advance Notice'') pursuant to Section 
806(e)(1) of the Payment, Clearing, and Settlement Supervision Act of 
2010 (``Payment, Clearing and Settlement Supervision Act'') \1\ and 
Rule 19b-4(n)(1)(i) under

[[Page 37324]]

the Securities Exchange Act of 1934 (``Exchange Act'') to modify 
backtesting procedures to better identify and make improvements to its 
monitoring of its margin methodology and to enhance its ability to 
manage risk.\2\ The Advance Notice was published for comment in the 
Federal Register on December 11, 2014.\3\ On January 9, 2015, pursuant 
to section 806(e)(1)(D) of the Payment, Clearing and Settlement 
Supervision Act,\4\ the Commission required OCC to provide additional 
information concerning the Advance Notice.\5\ The Commission did not 
receive any comments on the Advance Notice. This publication serves as 
a notice of no objection to the Advance Notice.
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    \1\ 12 U.S.C. 5465(e)(1). The Financial Stability Oversight 
Council designated OCC a systemically important financial market 
utility on July 18, 2012. See Financial Stability Oversight Council 
2012 Annual Report, Appendix A, http://www.treasury.gov/initiatives/fsoc/Documents/2012%20Annual%20Report.pdf. Therefore, OCC is 
required to comply with the Clearing Supervision Act and file 
advance notices with the Commission. See 12 U.S.C. 5465(e).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ See Securities Exchange Act Release No. 73749 (December 5, 
2014), 79 FR 73673 (December 11, 2014) (SR-OCC-2014-810) 
(``Notice'').
    \4\ 12 U.S.C. 5465(e)(1)(D).
    \5\ The Commission received a response from OCC with the 
additional information for consideration on April 29, 2015, which, 
pursuant to Sections 806(e)(1)(E) and (G) of the Payment, Clearing 
and Settlement Supervision Act, initiated a new 60 day period of 
review. See 12 U.S.C. 5465(e)(1)(E) and 12 U.S.C. 5465(e)(1)(G).
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I. Description of the Advance Notice

    As described in OCC's Notice,\6\ the proposed change modifies OCC's 
backtesting procedures to enhance its monitoring of margin coverage and 
model risk exposure. Such monitoring will allow OCC to better identify 
and make improvements to its margin methodology and thus enhance OCC's 
ability to manage risk.\7\
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    \6\ See supra note 3.
    \7\ If OCC determines that the results of these modified 
backtesting procedures require changes to its margin model, OCC may 
be required to file an advance notice to effect those changes. See 
id.
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    OCC implements backtesting procedures to test its methodology for 
determining the amount of margin to collect from clearing members and 
validate the assumptions and mechanisms inherent in its methodology and 
to make any necessary changes to the methodology. Each trading day, OCC 
estimates the risk exposure of accounts and uses this estimate as a 
basis for each account's margin charge. On the following business day, 
OCC's current backtesting procedures compare an account's observed 
profit and loss (``P&L'') with the prior day's estimated risk using a 
variety of analytical and statistical tools. These daily tests measure 
the performance of OCC's risk measures for each account, and, 
therefore, also measure the performance of OCC's underlying margin 
methodology. OCC's backtesting program enables OCC to assess 
performance of its margining systems and determine whether financial 
risks are adequately or inadequately captured by the quantitative 
models in use.
    OCC has conducted daily backtesting of margin accounts since 2006. 
OCC employs the ``traffic light'' test published by the Basel Committee 
on Banking Supervision in 1996 (the ``Traffic Light Test'').\8\ In 
conducting the Traffic Light Test, OCC determines the actual number of 
instances in which the realized loss on an account exceeded the margin, 
referred to as an ``exceedance,'' over an observation period of one 
year. The number of exceedances during the observation period is 
compared against the number of expected exceedances under the 
assumption that the exceedances are independent and identically 
distributed over time. When backtesting results reveal the potential 
opportunity for remediation of OCC's margin methodology, OCC undertakes 
a root cause analysis to determine the cause of any issues. Any 
significant shortcomings of OCC's methodology lead to OCC undertaking a 
model improvement project designed to correct the problems. After 
analyzing the exceedances, OCC provides monthly reports to OCC's 
Enterprise Risk Management Committee (``ERMC''), which include, among 
other things, pertinent conclusions based on results from the full set 
of backtests.
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    \8\ See ``Supervisory Framework for the Use of `Backtesting' in 
Conjunction with Internal Model Approach to Market Risk Capital 
Requirement.'' Located at http://www.bis.org/publ/bcbs22.htm.
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    OCC analyzed its backtesting program and identified several 
enhancements to the program, as discussed in more detail below: (1) 
Enhancement of and increase in the number of statistical tests, (2) 
data set changes, (3) forecast horizon changes, and (4) root cause 
analysis changes.

1. Enhancement of and Increase in the Number of Statistical Tests

    As proposed in the Notice, OCC will enhance an existing statistical 
test and add three new statistical tests. OCC proposed to enhance its 
existing Traffic Light Test so that it may be applied to exceedances 
across all of OCC's margin accounts. Given that exceedances are not 
independent across margin accounts, OCC will enhance this test to 
address the dependency of exceedances between accounts.
    In addition to the enhanced Traffic Light Test, OCC will implement 
three other industry standard tests related to exceedances in order to 
provide a more comprehensive set of tests. First, OCC will add the 
Kupiec Test,\9\ which is a new proportion of failures test that 
compares the actual number of exceedances with the number that would be 
expected in light of the confidence level associated with the 
calculation of margin. For example, when calculating margin with a 
confidence level of 99%, the number of exceedances is expected to be 1% 
of the total observations (i.e., the P&Ls for all accounts for all days 
during the measurement period). If the actual number of exceedances is 
near the expected number, this is an indication that the calculated 
margin requirements are not inaccurate estimates of the accounts' 
estimated losses.
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    \9\ See, Kupiec, P. ``Techniques for Verifying the Accuracy of 
Risk Management Models,'' Journal of Derivatives, v3, P73-84 (1995).
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    Second, OCC will add the Christoffersen Independence Test,\10\ 
which is a new statistical test that measures the extent to which 
exceedances are independent of each other. Specifically, if OCC's 
margin models are correctly assessing risk, the probability of an 
exceedance occurring at any two points in time should be the same as 
the probability of an exceedance occurring at either point in time, 
individually, without the exceedance occurring at the other point in 
time. Third, OCC will add the Probtile test, which compares the 
distribution of the daily observed P&L to the daily forecasted P&L 
distribution. If the distribution of these P&L ratios approximates a 
uniform random distribution, this is an indication that OCC's margin 
models are not providing inaccurate forecasts of potential losses in an 
account. Combined, these new statistical tests will provide OCC with 
additional pertinent information to evaluate the effectiveness of its 
models in determining margin coverage.
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    \10\ See, Christoffersen, Peter, ``Evaluating Interval 
Forecasts.'' International Economic Review, 39 (4), 841-862 (1998).
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2. Data Set Changes

    In addition to the changes to its backtesting program, as described 
above, OCC also will make two enhancements to the data sets being 
backtested to allow for testing against various assumed portfolio and 
market data scenarios, in addition to the performance of actual 
portfolios against actual, current market conditions. First, OCC will 
backtest hypothetical portfolios, allowing for the design and 
monitoring of portfolios that have magnified sensitivities to 
particular aspects of the models used in the

[[Page 37325]]

margin computations. Backtesting against hypothetical portfolios will 
provide a more comprehensive insight into the adequacy of the 
underlying model assumptions under market conditions prevailing in the 
backtest observation periods.
    Under the second data set enhancement, OCC will backtest current 
accounts against earlier observation periods. The market data observed 
over the observation period is used to generate the margin forecasts 
and P&L and observation periods will be chosen to reflect special 
market conditions. OCC believes this enhancement should be useful 
because even though margin coverage might be adequate in the current 
environment, margin coverage could be inadequate under stressed 
conditions, such as periods of high volatility. The ability to select 
specific observation periods will not limit the backtesting to the 
current environments but rather will highlight performance of margin 
coverage and model performance in market scenarios other than 
prevailing market conditions.

3. Forecast Horizons Changes

    Currently, OCC conducts backtesting using a one-day time horizon, 
which means that it compares calculated margin with realized P&Lthat 
occur on the business day following the calculation. However, OCC's 
margin calculations assume that positions will be liquidated over a 
two-day period, resulting in the test comparing two-day margin numbers 
to a one-day P&L calculation. This difference requires OCC to make 
adjustments to its existing backtesting methodology in its testing to 
account for the difference between the two-day liquidation period used 
in its margin calculation and the one-day horizon used in the P&L 
calculation.
    Pursuant to the proposal, OCC will revise its backtesting 
methodology to take into account losses over a two-day time horizon, 
which will match the two-day liquidation period used in the margin 
calculation without such adjustments. OCC will implement the necessary 
functionality into its backtesting system to conduct a two-day time 
horizon backtest, which will compare calculated margin against a two-
day P&L calculation. OCC also will revise its backtesting methodology 
to compare one-day margin calculations against one-day P&L 
calculations, and will implement system functionality for such a test. 
All issues identified in any of these backtesting results will be 
reported to the ERMC. OCC believes that its adoption of the additional 
forecast horizons tests will allow it to have a more accurate view of 
the sufficiency of its margin methodology.

4. Root Cause Analysis Changes

    Currently, OCC's backtesting staff conducts investigations, as 
necessary, in order to identify the root cause of exceedances. The 
investigation itself is a manual process that is dependent upon the 
facts and circumstances pertaining to a given exceedance. Pursuant to 
its proposal, OCC will now make system modifications that will provide 
OCC's backtesting staff with additional tools to facilitate such 
investigations. Specifically, OCC will add system functionality that 
should reveal attribution of losses due to underlying price movements 
and implied volatility movements. Further, these improvements will 
allow OCC to incorporate hypothetical accounts and positions into the 
tests and will allow OCC to identify risk factors that move above or 
below the projected values. These changes should improve OCC's ability 
to conduct investigations and root cause analyses that identify the 
root cause of exceedances by providing OCC with additional automated 
investigative tools which should, in turn, lead to improving OCC's 
backtesting methodology and its margin coverage.

II. Discussion and Commission Findings

    Although Title VIII does not specify a standard of review for an 
advance notice, the Commission believes that the stated purpose of 
Title VIII is instructive.\11\ The stated purpose of Title VIII is to 
mitigate systemic risk in the financial system and promote financial 
stability by, among other things, promoting uniform risk management 
standards for systemically-important financial market utilities and 
strengthening the liquidity of systemically important financial market 
utilities.\12\
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    \11\ See 12 U.S.C. 5461(b).
    \12\ Id.
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    Section 805(a)(2) of the Payment, Clearing and Settlement 
Supervision Act \13\ authorizes the Commission to prescribe risk 
management standards for the payment, clearing, and settlement 
activities of designated clearing entities and financial institutions 
engaged in designated activities for which it is the supervisory agency 
or the appropriate financial regulator. Section 805(b) of the Payment, 
Clearing and Settlement Supervision Act \14\ states that the objectives 
and principles for the risk management standards prescribed under 
Section 805(a) shall be to:
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    \13\ 12 U.S.C. 5464(a)(2).
    \14\ 12 U.S.C. 5464(b).
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     Promote robust risk management;
     promote safety and soundness;
     reduce systemic risks; and
     support the stability of the broader financial system.
    The Commission has adopted risk management standards under Section 
805(a)(2) of the Payment, Clearing and Settlement Supervision Act 
(``Clearing Agency Standards'').\15\ The Clearing Agency Standards 
became effective on January 2, 2013, and require registered clearing 
agencies that perform central counterparty (``CCP'') services to 
establish, implement, maintain, and enforce written policies and 
procedures that are reasonably designed to meet certain minimum 
requirements for their operations and risk management practices on an 
ongoing basis.\16\ As such, it is appropriate for the Commission to 
review advance notices against these Clearing Agency Standards, and the 
objectives and principles of these risk management standards as 
described in Section 805(b) of the Payment, Clearing and Settlement 
Supervision Act.\17\
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    \15\ 17 CFR 240.17Ad-22.
    \16\ The Clearing Agency Standards are substantially similar to 
the risk management standards established by the Board of Governors 
of the Federal Reserve System governing the operations of designated 
financial market utilities that are not clearing entities and 
financial institutions engaged in designated activities for which 
the Commission or the Commodity Futures Trading Commission is the 
Supervisory Agency. See Financial Market Utilities, 77 FR 45907 
(August 2, 2012).
    \17\ 12 U.S.C. 5464(b).
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    The Commission believes that the proposal in this Advance Notice is 
designed to further the objectives and principles of Section 805(b) of 
the Payment, Clearing and Settlement Supervision Act.\18\ The 
Commission believes that the additional backtesting improvements should 
promote robust risk management by providing OCC with additional tools 
to test the performance of its margin methodology in a more 
comprehensive manner and better evaluate the effectiveness of its 
models in determining model coverage. First, the enhancement to OCC's 
existing Traffic Light Test and the adoption of the three new 
statistical tests should provide a more comprehensive set of tests for 
it to use to evaluate its margin models. Second, the enhancement of the 
data sets to be backtested should provide OCC with additional 
informative data on the performance of margin coverage and model 
performance in market scenarios other than prevailing market 
conditions.

[[Page 37326]]

Third, revising the backtesting methodology to take into account losses 
over a two-day time horizon, should allow OCC to have a more accurate 
view of the sufficiency of its margin methodology. Finally, system 
modifications that should reveal attribution of losses due to 
underlying price movements and implied volatility movements should 
provide OCC with additional, automated investigative tools to conduct 
analysis into the root causes of exceedances.
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    \18\ 12 U.S.C. 5464(b).
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    In addition, the Commission believes that the proposal in this 
Advance Notice is consistent with Clearing Agency Standards, in 
particular, Rule 17Ad-22(b)(4) under the Exchange Act,\19\ which, in 
relevant part, requires registered clearing agencies that perform 
central counterparty services establish, implement, maintain, and 
enforce written policies and procedures reasonably designed to provide 
for an annual model validation consisting of evaluating the performance 
of the clearing agency's margin models and the related parameters and 
assumptions associated with such models. The Commission believes that 
this proposal is consistent with Exchange Act Rule 17Ad-22(b)(4) \20\ 
because it provides OCC with the ability to employ improved statistical 
tests to better evaluate the performance of its margin models and thus 
improving its ability to validate such models.
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    \19\ 17 CFR 240.17Ad-22(b)(3).
    \20\ Id.
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III. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Payment, Clearing and Settlement Supervision Act,\21\ that the 
Commission does not object to advance notice proposal (SR-OCC-2014-810) 
and that OCC is authorized to implement the proposal.
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    \21\ 12 U.S.C. 5465(e)(1)(I).

    By the Commission.
Robert W. Errett,
Deputy Secretary.
[FR Doc. 2015-15994 Filed 6-29-15; 8:45 am]
 BILLING CODE 8011-01-P