
[Federal Register Volume 79, Number 147 (Thursday, July 31, 2014)]
[Notices]
[Pages 44480-44483]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-18038]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-72677; File No. SR-OCC-2014-15]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Proposed Rule Change To Process All Sell 
Transactions Prior to the Exercise of Long Options in Market-Maker 
Accounts To Ensure That Only Net Long Positions May Be Exercised

July 25, 2014.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on July 17, 2014, The Options Clearing Corporation (``OCC'') filed with 
the Securities and Exchange Commission (``Commission'') the proposed 
rule change as described in Items I and II below, which Items have been 
prepared by OCC. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Clearing Agency's Statement of the Terms of Substance of the 
Proposed Rule Change

    This proposed rule change, coupled with the related system 
modifications, will curtail use of a trading strategy known as 
``dividend plays'' in the options industry. OCC proposed to add an 
interpretation and policy to Rules 801 and 805, respectively, stating 
that OCC will process all sales of options in a Market-Maker's account 
prior to the exercise of any long call options in the account to ensure 
that only net long positions in a particular series may be exercised.

II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

    In its filing with the Commission, OCC included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified

[[Page 44481]]

in Item IV below. OCC has prepared summaries, set forth in sections 
(A), (B), and (C) below, of the most significant aspects of these 
statements.

(A) Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Proposed Rule Change

1. Purpose
    This proposed rule change would add an interpretation and policy to 
Rules 801 and 805, respectively, stating that OCC will, in respect of 
Market-Maker accounts, process all sell transactions prior to the 
exercise of long options in the account, to ensure that only net long 
positions may be exercised. This proposed change, coupled with the 
related system modifications, would have the effect of implementing a 
policy approved by the OCC Board of Directors intended to curtail use 
of a trading strategy known as ``dividend plays'' in the options 
industry.
Background
    Dividend plays are an options trading strategy that has been 
executed on options exchanges for many years. The purpose of the 
trading strategy is to capture the dividend income of a stock through 
the exercise of in-the-money call options on the day prior to the 
stock's ``ex-dividend'' date, which is the date that determines whether 
the holder of a stock is entitled to the stock's dividend. Where stock 
is transferred before the ex-dividend date, the new owner of the stock 
is entitled to the dividend. In order to capture this dividend income, 
a trader will buy a large number of call options of the same series on 
a stock on the day prior to the stock's ex-dividend date and then write 
an offsetting number of call options of the same series on the same 
stock at the same price. Because the two transactions are exactly 
offsetting and executed at the same price, the trader's position in the 
call options is net neutral and has limited market risk. At the end of 
the day, the trader then exercises all of its long call options even 
though the trader's net position is neutral. OCC, using its standard 
assignment process, then assigns all of that day's exercised long call 
options of the same series across all options writers.
    If all in-the-money long call options of the same series were 
exercised on the day prior to the ex-dividend date, the trader, and all 
other market participants in the relevant option series, would be 
assigned all its short call positions and would not have a resulting 
long stock position that is entitled to the dividend. However, a 
certain percentage of open interest in in-the-money call options goes 
unexercised on the day prior to the ex-dividend date. Generally, this 
failure is due to a number of factors, including transaction costs, the 
ignorance of certain market participants of the mechanics of call 
options and ex-dividend dates, inattentiveness by certain market 
participants in monitoring their positions and irrationality.\3\
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    \3\ See e.g., Veronica K. Pool, Hans R. Stool, Robert E. Whaley, 
Failure to exercise call options: An anomaly and a trading game, 11 
J. Fin. Markets 1 (2007); Jia Hao, Avner Kalay, Stewart Mayhew, Ex-
Dividend Arbitrage in Options Markets, 23 Rev. Fin. Stud. 271, Issue 
1 (2009).
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    Because traders executing a dividend play exercise 100% of their 
long call options, it increases the overall percentage of open interest 
that gets exercised. OCC's standard assignment processing will close 
out a large portion of a traders' short position established that day, 
but will also close out a large portion of other, pre-existing, market 
participants' short positions. The larger the position taken by a 
trader executing a dividend play compared to the pre-existing open 
interest, the higher the proportion of pre-existing open interest that 
will be closed out, and a larger share of unassigned short positions 
will be left to the dividend play trader. For every short call position 
that is not assigned, a trader executing the dividend play does not 
have to deliver stock and is able to capture the dividend payment for 
the shares of stock it remains long.
    The vast majority of dividend play activity occurs in Market-Maker 
accounts and OCC's processing sequence makes it possible for market 
makers to execute conventional dividend plays, as described above. OCC 
processes exercises after option purchases but before options sales, 
also known as ``writing'' transactions. This processing sequence 
permits a market maker executing a dividend play to buy and sell equal 
quantities of call options of a given series and exercise the purchased 
call options even though the market maker's position is neutral. If OCC 
processed sales before exercises, market-makers' purchases and sales on 
a given day would offset each other, and when OCC processed the 
exercises, there would no net long call positions to exercise. This 
would make the conventional dividend play impossible. However, OCC 
processes exercises before sales in order to reduce operational risk 
for clearing members clearing options transactions in accounts other 
than Market-Maker accounts.
    Positions in accounts other than Market-Maker accounts are carried 
on a gross basis, meaning that an account can be both long and short 
the same series. This means that trades must be coded as opening or 
closing transactions. If OCC processed sales before exercises in an 
account other than a Market-Maker account, a coding error could cause 
rejection of exercise instructions that could result in substantial 
losses. However, coding errors do not present a risk with respect to 
Market-Maker accounts, where positions are carried on a net basis and 
trades do not have to be coded as opening or closing transactions.
OCC Review of Dividend Plays
    In December 2012, the Securities Industry and Financial Markets 
Association's (``SIFMA'') Listed Options Trading Committee requested 
that OCC formally review dividend plays.\4\ SIFMA expressed a concern 
that OCC could suffer losses as a result of an operational error in 
processing dividend plays. Because successful dividend plays rely on 
part in the dividend trader's having a large position compared to the 
pre-existing open interest in the series of options subject to the 
dividend play, SIFMA believed that an operational error in processing 
dividend trades could result in a clearing member being liable for a 
settlement amount that could place the clearing member in financial 
peril and potentially exceed the collateral deposited by the clearing 
member with OCC. Following receipt of the SIFMA letter, OCC initiated a 
comprehensive review of dividend plays.
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    \4\ See Letter from Ellen Greene, Vice President of SIFMA, to 
Wayne P. Luthringshausen, Chairman and Chief Executive Officer of 
OCC (December 3, 2012) (the ``SIFMA Letter'') available at http://www.sifma.org/issues/item.aspx?id=8589942317.
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    In connection with its review of dividend plays OCC noted that 
these transactions represent only a small number of OCC cleared 
options, and that most of the dividend play trading is cleared through 
two large clearing members that are large and well-capitalized and have 
robust risk management processes. OCC's therefore concluded that 
dividend plays did not materially increase OCC's risk. As requested by 
OCC's Board of Directors, OCC's Operations Roundtable further evaluated 
the proposed change in OCC's processing sequence to determine whether 
there were any unintended consequences to implementing the proposed 
change. The Operations Roundtable, which consists of operations staff 
of a cross-section of OCC's clearing members and operations

[[Page 44482]]

staff of the options exchanges, carefully reviewed the proposal over 
several months and concluded that no material unintended consequences 
would result from its implementation.
    Dividend plays generally may be perceived negatively in the 
marketplace and have been criticized as unfair to retail investors and 
as distorting options transactions volume.\5\ OCC determined that while 
it should not take action to eliminate or restrict dividend plays based 
on these factors, nor should it facilitate these transactions. OCC's 
processing sequence, under which sale transactions are processed after 
exercises, is generally designed to reduce the operational risk to 
clearing members that results from potential miscoding of, for example, 
an opening trade for the account of one clearing member customer as a 
closing trade for the account of another clearing member customer. 
However, this coding risk does not exist with respect to Market-Maker 
accounts, where positions are carried on a net basis. Accordingly, OCC 
concluded that its processing sequence unnecessarily allowed certain 
market makers to execute dividend plays and therefore is proposing to 
change it so that for these accounts sale transactions are processed 
before exercises. The change would have the effect of significantly 
restricting dividend plays because large long positions that would 
otherwise be exercised would be offset by sale transactions.
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    \5\ SIFMA Letter, p. 1.
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Proposed Amendment
    OCC proposes to amend the Rules to add an interpretation and policy 
to Rule 801 and to Rule 805 to state, with respect to Market-Maker 
accounts, that sell transactions will be processed before exercises. 
Because the definition of ``Market-Maker Account'' in Article 1 of 
OCC's By-Laws would include a JBO Participants' account, the 
interpretation and policy clarifies that this netting will not be 
applied to JBO Participants' accounts until such time as OCC determines 
on not less than 30 days' notice to clearing members that OCC is able 
to identify, on a subaccount basis, the transactions of a JBO 
Participant within JBO Participants' accounts, in which case JBO 
Participants' accounts shall be considered Market-Maker accounts. OCC 
also proposes to modify OCC's systems to make a corresponding change in 
the processing sequence. This change in the processing sequence would 
only applied to Market-Maker accounts (and, potentially subaccounts in 
JBO Participants' accounts), and would not change the processing 
sequence, and the associated protection against coding errors, 
applicable to clearing member accounts other than Market-Maker 
accounts.
2. Statutory Basis
    OCC believes that the proposed rule change is consistent with 
Section 17A(b)(3)(F) of the Securities Exchange Act of 1934, as amended 
(the ``Exchange Act''),\6\ and the rules and regulations thereunder, 
including Rule 17Ad-22(d)(1) \7\ and Rule 17Ad-22(d)(4),\8\ because the 
changes are designed to provide a well-founded, transparent and 
enforceable legal framework for the exercise of long and short call 
options and to minimize sources of operational risk to clearing members 
through the development of appropriate systems, controls and 
procedures. The proposed change achieves this purpose by clearly 
stating in the rules that OCC will, in respect of Market-Maker 
accounts, process all sell transactions prior to the exercise of long 
options in the account, thereby making this processing sequence 
transparent, and by instituting corresponding system changes in the 
processing sequence for exercised call options in Market-Maker 
accounts. The proposed rule change is not inconsistent with the 
existing rules of OCC, including any other rules proposed to be 
amended.
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    \6\ 15 U.S.C. 78q-1(b)(3)(F).
    \7\ 17 CFR 240.17Ad-22(d)(1).
    \8\ 17 CFR 240.17Ad-22(d)(4).
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(B) Clearing Agency's Statement on Burden on Competition

    OCC does not believe that the proposed rule change would impose any 
burden on competition.\9\ The proposed interpretation and policy 
primarily affects market makers and would provide notice to all market 
makers of the change in OCC's processing sequence with respect to 
Market-Maker accounts. The proposed rule change would not unfairly 
inhibit access to OCC's services or disadvantage or favor any 
particular user in relationship to another user because the proposed 
rule change would be applied uniformly to all Market-Maker accounts. 
The change would have the effect of curtailing dividend plays, but this 
limitation will apply equally to all exchanges and all clearing members 
and by extension all market-maker customers of clearing members.
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    \9\ 15 U.S.C. 78q-1(b)(3)(I).
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    For the foregoing reasons, OCC believes that the proposed rule 
change is in the public interest, would be consistent with the 
requirements of the Exchange Act applicable to clearing agencies, and 
would not impose a burden on competition.

(C) Clearing Agency's Statement on Comments on the Proposed Rule Change 
Received From Members, Participants, or Others

    Written comments on the proposed rule change were not and are not 
intended to be solicited with respect to the proposed rule change and 
none have been received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period up to 90 days (i) as the 
Commission may designate if it finds such longer period to be 
appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-OCC-2014-15 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-OCC-2014-15. This file 
number should be included on the subject line if email is used. To help 
the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the

[[Page 44483]]

proposed rule change between the Commission and any person, other than 
those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for Web site viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE., 
Washington, DC 20549-1090 on official business days between the hours 
of 10:00 a.m. and 3:00 p.m. Copies of the filing also will be available 
for inspection and copying at the principal office of OCC and on OCC's 
Web site: http://www.theocc.com/components/docs/legal/rules_and_bylaws/sr_occ_14_15.pdf.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-OCC-2014-15 
and should be submitted on or before August 21, 2014.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-18038 Filed 7-30-14; 8:45 am]
BILLING CODE 8011-01-P


