
[Federal Register Volume 79, Number 238 (Thursday, December 11, 2014)]
[Notices]
[Pages 73673-73676]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-29002]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-73749; File No. SR-OCC-2014-810]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Advance Notice Concerning Modifications To Back 
Testing Procedures in Order To Enhance Monitoring of Margin Coverage 
and Model Risk Exposure

December 5, 2014.
    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 \1\ (``Payment, 
Clearing and Settlement Supervision Act'') and Rule 19b-4(n)(1)(i) 
under the Securities Exchange Act of 1934 \2\ notice is hereby given 
that on November 13, 2014, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') the 
advance notice as described in Items I and II below, which Items have 
been

[[Page 73674]]

prepared by OCC.\3\ The Commission is publishing this notice to solicit 
comments on the advance notice from interested persons.
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ OCC initially filed a similar advance notice on October 31, 
2014, as File No. SR-OCC-2014-808. However to correct certain errors 
in that filing relating to two backtesting program tests, OCC 
withdrew it and made a new filing (File No. SR-OCC-2014-810) on 
November 13, 2014.
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I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    This advance notice is filed by OCC in connection with a proposed 
change to its operations (the ``Change'') in the form of modifications 
to its back testing procedures in order to enhance its monitoring of 
margin coverage and model risk exposure.

II. Clearing Agency's Statement of the Purpose of, and Statutory Basis 
for, the Advance Notice

    In its filing with the Commission, OCC included statements 
concerning the purpose of and basis for the advance notice and 
discussed any comments it received on the advance notice. The text of 
these statements may be examined at the places specified in Item IV 
below. OCC has prepared summaries, set forth in sections (A) and (B) 
below, of the most significant aspects of these statements.

(A) Clearing Agency's Statement on Comments on the Advance Notice 
Received From Members, Participants or Others

    Written comments on the advance notice were not and are not 
intended to be solicited with respect to the advance notice and none 
have been received.

(B) Advance Notices Filed Pursuant to Section 806(e) of the Payment, 
Clearing and Settlement Supervision Act

Description of Change
    The proposed Change would modify OCC's back testing procedures in 
order to enhance its monitoring of margin coverage and model risk 
exposure. Such monitoring would allow OCC to identify and make 
improvements to its margin methodology and enhance OCC's ability to 
manage risk.
    OCC has implemented back testing procedures in order 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 on accounts and 
uses this estimate as a basis for each account's margin charge. On the 
following business day, OCC's back tests 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 the account's risk measures, and therefore, also 
measure the performance of OCC's underlying methodology for calculating 
these measures. OCC's back testing 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.
    Currently, OCC employs the ``traffic light'' test published by the 
Basel Committee on Banking Supervision in 1996 (the ``Traffic Light 
Test'').\4\ In conducting the Traffic Light Test, OCC determines the 
actual number of instances in which the realized loss on an account 
exceeded the margin, known 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 that are 
independent and identically distributed over time. OCC will employ an 
enhanced version of the Traffic Light Test that takes into account the 
dependency of exceedances between accounts.
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    \4\ 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 has conducted daily back testing of margin accounts since 2006. 
OCC's staff analyzes the exceedances and makes monthly reports to OCC's 
Enterprise Risk Management Committee (``ERMC'').\5\ The reports to the 
ERMC include pertinent conclusions based on results from the full set 
of back tests. When back testing reveals 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 failures 
of OCC's methodology lead to OCC undertaking a model improvement 
project designed to correct the problems.
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    \5\ The Enterprise Risk Management Committee is chaired by the 
Chief Risk Officer, and consists of the Executive Chairman, Chief 
Operations Officer, General Counsel, Chief Information Officer, 
Chief Audit Executive, the Chief Compliance Officer and other 
members as determined by the Chair.
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    OCC has analyzed its back testing program and identified several 
enhancements to the program. The following section details the nature 
of the proposed enhancements.\6\
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    \6\ The relevant systems changes are scheduled to be installed 
on December 5, 2014.
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1. Proposed Enhancement of and Increase in Statistical Tests
    The proposed changes would enhance existing statistical tests and 
add three new statistical tests. The first proposed change to OCC's 
back testing program is that OCC proposes to enhance the 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 so that it will produce a 
single numerical output that measures aggregation across margin 
accounts.
    In addition to the enhanced Traffic Light Test, OCC will implement 
other industry standard tests based on exceedances in order to provide 
a more comprehensive set of tests. The second proposed change to OCC's 
back testing program is that OCC will add the Kupiec Test,\7\ 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 accurate estimates of the accounts' estimated losses.
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    \7\ See, Kupiec, P. ``Techniques for Verifying the Accuracy of 
Risk Management Models,'' Journal of Derivatives, v3, P73-84. 
(1995).
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    The third proposed change to OCC's back testing program is that OCC 
will add the Christoffersen Independence Test,\8\ 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. The fourth proposed 
change to OCC's back testing program is a new test, the Probtile test, 
that compares the distribution of the daily observed P&L to the daily 
forecasted P&L distribution. If the distribution of P&L movement ratios 
approximates a uniform random distribution, this is an indication that

[[Page 73675]]

OCC's margin models are providing accurate forecasts of potential 
losses in an account. Combined, these new statistical tests will 
provide OCC with the pertinent information necessary to evaluate the 
effectiveness of its models in determining margin coverage.
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    \8\ See, Christoffersen, Peter, ``Evaluating Interval 
Forecasts.'' International Economic Review, 39 (4), 841-862. (1998). 
Economic Review, 39 (4), 841-862. (1998).
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2. Proposed Data Set Changes
    OCC proposes to enhance the data sets being back tested 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 would back test 
hypothetical portfolios, allowing for the design and monitoring of 
portfolios that have magnified sensitivities to particular aspects of 
the models used in the margin computations. Back testing against 
hypothetical portfolios would provide a more comprehensive insight into 
the adequacy of the underlying model assumptions under market 
conditions prevailing in the back test observation periods.
    Under the second data set enhancement, OCC would back test current 
accounts against earlier observation periods. Currently, accounts are 
``frozen'' by assuming that the time to maturity and the degree to 
which options are in-the-money or out-of-the-money remain constant 
during the chosen observation period. The market data observed over the 
observation period is used to generate the margin forecasts and P&L. 
Under the enhancement, observation periods would be chosen to reflect 
special market conditions, which is 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 would 
not limit the back testing to the current environments but rather would 
highlight performance of margin coverage and model performance in 
market scenarios other than prevailing market conditions.
3. Proposed Forecast Horizons Changes
    Currently, OCC conducts back testing using a one-day time horizon, 
which means that it compares calculated margin with realized profit and 
losses that occur on the business day following the calculation. OCC's 
margin calculations assume that positions would be liquidated over a 
two-day period. This test, therefore, compares two-day margin numbers 
to a one-day profit and loss calculation. OCC's existing back testing 
methodology makes adjustments 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 profit and loss 
calculation. OCC intends to revise its back testing methodology to take 
into account losses over a two-day time horizon, without such 
adjustments, which would match the two-day liquidation period used in 
the margin calculation. OCC therefore proposes to implement 
functionality into its back testing system to conduct a two-day time 
horizon back test, which will compare calculated margin against a two-
day profit and loss calculation. OCC also proposes to revise its back 
testing methodology to compare one-day margin calculations against one-
day profit and loss calculations, and will implement system 
functionality for such a test. Issues identified in any of these back 
tests 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. Proposed Root Cause Analysis Changes
    The proposed Change will improve OCC's ability to conduct root 
cause analyses by providing OCC's back testing staff with additional, 
automated, investigation tools. Currently, and when necessary, OCC's 
back test staff conducts investigations in order to identify the root 
cause exceedances. The investigation itself is a manual process that is 
dependent upon the facts and circumstances pertaining to a given 
exceedance. OCC is now proposing to make system modifications that will 
provide OCC's back testing staff with addition tools that will 
facilitate such investigations. Specifically, OCC proposes to add 
system functionality that will show attribution of losses due to 
underlying price movements and implied volatility movements. Further, 
under the improvements OCC would be able to incorporate hypothetical 
accounts and positions into the tests and would be able to identify 
risk factors that move above or below the projected values. These 
changes will improve OCC's ability to conduct investigations that 
identify the root cause of exceedances, which will in turn lead to 
improving OCC's back testing methodology and its margin coverage.
Anticipated Effect on and Management of Risk
    OCC believes the proposed Change to its back testing procedures 
would reduce the level of risk presented by OCC because it would 
enhance OCC's back testing by providing it with more tools to identify 
gaps in its margin methodology and develop corrective changes 
thereto.\9\ For example, enhanced and increased statistical testing 
would provide additional information about the adequacy of margin 
coverage and thus strengthen the assessment of margin and model 
performance. Changes to data sets would include hypothetical portfolios 
and earlier observation periods would allow testing of margin coverage 
under a greater variety of market conditions. Modifying the tests to 
take into account losses over a two-day period would increase the 
accuracy of the testing because this two-period matches the assumed 
liquidation period used in the margin calculations. OCC would also be 
able to more accurately determine the root cause of exceedances, while 
rejecting results that incorrectly suggest a needed improvement in its 
margin methodology, and then would be able to narrowly tailor solutions 
to the identified root causes. Ultimately, by allowing OCC to more 
readily and precisely identify gaps in its margin methodology, the 
Change will reduce risk to OCC and the markets that it serves.
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    \9\ Depending on the nature of a proposed change, it may be 
necessary for OCC to file a proposed rule change filing or advance 
notice filing with the Commission.
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Consistency With the Payment, Clearing and Settlement Supervision Act
    The Change is consistent with Section 805(b)(1) of Payment, 
Clearing and Settlement Supervision Act because it promotes robust risk 
management.\10\ OCC's receipt of margin from its clearing members 
protects OCC and market participants from risks presented by the 
markets OCC serves. OCC uses back testing in order to evaluate the 
sufficiency and adequacy of the amount of margin it collects from its 
clearing members. As described above, the Change will provide OCC will 
[sic] additional tools to identify gaps in its margin methodology. Such 
identification process will lead to improvements to OCC margin models 
thereby promoting robust risk management.
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    \10\ 12 U.S.C. 5465(b)(1).
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III. Date of Effectiveness of the Advance Notice and Timing for 
Commission Action

    The proposed change may be implemented if the Commission does not 
object to the proposed change within 60 days of the later of (i) the 
date that the Commission receives the notice

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of proposed change, or (ii) the date the Commission receives any 
further information it requests for consideration of the notice. The 
clearing agency shall not implement the proposed change if the 
Commission has any objection to the proposed change.
    The Commission may extend the period for review by an additional 60 
days if the proposed change raises novel or complex issues, subject to 
the Commission providing the clearing agency with prompt written notice 
of the extension. A proposed change may be implemented in less than 60 
days from the date the advance noticed is filed, or the date further 
information requested by the Commission is received, if the Commission 
notifies the clearing agency in writing that it does not object to the 
proposed change and authorizes the clearing agency to implement the 
proposed change on an earlier date, subject to any conditions imposed 
by the Commission.
    The clearing agency shall post notice on its Web site of proposed 
changes that are implemented.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed 
change, is consistent with the Payment, Clearing and Settlement 
Supervision 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-2014-810 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-2014-810. 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 advance notice that are filed 
with the Commission, and all written communications relating to the 
advance notice 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 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_810.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-2014-810 
and should be submitted on or before January 2, 2015.

    By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-29002 Filed 12-10-14; 8:45 am]
BILLING CODE 8011-01-P


