[Federal Register Volume 82, Number 247 (Wednesday, December 27, 2017)]
[Notices]
[Pages 61354-61360]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-27832]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-82371; File No. SR-OCC-2017-811]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of Filing of Advance Notice Concerning Proposed Changes to The 
Options Clearing Corporation's Margin Methodology

December 20, 2017.
    Pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act, entitled Payment, Clearing 
and Settlement Supervision Act of 2010 (``Clearing Supervision Act'') 
\1\ and Rule 19b-4(n)(1)(i) under the Securities Exchange Act of 1934 
(``Act''),\2\ notice is hereby given that on November 13, 2017, The 
Options Clearing Corporation (``OCC'') filed with the Securities and 
Exchange Commission (``Commission'') an advance notice 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 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).
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I. Clearing Agency's Statement of the Terms of Substance of the Advance 
Notice

    This advance notice is filed in connection with proposed changes to 
OCC's margin methodology to move away from the existing monthly data 
source provided by its current vendor and towards obtaining and 
incorporating daily price and returns (adjusted for any corporate 
actions) data of securities to estimate accurate margins.\3\ This would 
be further supported by enhancing OCC's econometric model applied to 
different risk factors; \4\ improving the sensitivity and stability of 
correlation estimates between them; and enhancing OCC's methodology 
around the treatment of securities with limited historical data. OCC 
also proposes to make a few clarifying and clean-up changes to its 
margin methodology unrelated to the proposed changes described above.
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    \3\ OCC also has filed a proposed rule change with the 
Commission in connection with the proposed changes. See SR-OCC-2017-
022.
    \4\ The use of risk factors in OCC's margin methodology is 
discussed in more detail in the Description of the Proposed Change 
section below.
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    The proposed changes to OCC's Margins Methodology document are 
contained in confidential Exhibit 5 of the filing. The proposed changes 
are described in detail in Item III below. The proposed changes do not 
require any changes to the text of OCC's By-Laws or Rules. All terms 
with initial capitalization that are not otherwise defined herein have 
the same meaning as set forth in the OCC By-Laws and Rules.\5\
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    \5\ OCC's By-Laws and Rules can be found on OCC's public 
website: http://optionsclearing.com/about/publications/bylaws.jsp.
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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.

[[Page 61355]]

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

    Written comments were not and are not intended to be solicited with 
respect to the proposed rule change and none have been received. OCC 
will notify the Commission of any written comments received by OCC.

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

Description of the Proposed Change
Background
    OCC's margin methodology, the System for Theoretical Analysis and 
Numerical Simulations (``STANS''), is OCC's proprietary risk management 
system that calculates Clearing Member margin requirements.\6\ STANS 
utilizes large-scale Monte Carlo simulations to forecast price and 
volatility movements in determining a Clearing Member's margin 
requirement.\7\ The STANS margin requirement is calculated at the 
portfolio level of Clearing Member accounts with positions in 
marginable securities and consists of an estimate of a 99% expected 
shortfall \8\ over a two-day time horizon and an add-on margin charge 
for model risk (the concentration/dependence stress test charge).\9\ 
The STANS methodology is used to measure the exposure of portfolios of 
options and futures cleared by OCC and cash instruments in margin 
collateral.
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    \6\ See Securities Exchange Act Release No. 53322 (February 15, 
2006), 71 FR 9403 (February 23, 2006) (SR-OCC-2004-20).
    \7\ See OCC Rule 601.
    \8\ The expected shortfall component is established as the 
estimated average of potential losses higher than the 99% value at 
risk threshold. The term ``value at risk'' or ``VaR'' refers to a 
statistical technique that, generally speaking, is used in risk 
management to measure the potential risk of loss for a given set of 
assets over a particular time horizon.
    \9\ A detailed description of the STANS methodology is available 
at http://optionsclearing.com/risk-management/margins/.
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    A ``risk factor'' within OCC's margin system may be defined 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 the STANS methodology are total returns on 
individual equity securities. Other risk factors considered include: 
Returns on equity indexes; returns on implied volatility \10\ risk 
factors that are a set of nine chosen volatility pivots per product; 
\11\ changes in foreign exchange rates; and changes in model parameters 
that sufficiently capture the model dynamics from a larger set of data.
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    \10\ 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 (i.e., the difference between the price of the 
underlying and the exercise price of the option) of the option, 
discounted to reflect its time value.
    \11\ 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. 34-76781 (December 28, 2015), 81 
FR 135 (January 4, 2016) (SR-OCC-2015-016) and Securities Exchange 
Act Release No. 34-76548 (December 3, 2015), 80 FR 76602 (December 
9, 2015) (SR-OCC-2015-804).
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    Under OCC's current margin methodology, OCC obtains monthly price 
data for most of its equity-based products \12\ from a widely used 
industry vendor. This data arrives around the second week of every 
month in arrears and requires a maximum of about four weeks for OCC to 
process the data after any clean up and reruns as may be required prior 
to installing into OCC's margin system. As a result, correlations and 
statistical parameters for risk factors at any point in time represent 
back-dated data and therefore may not be representative of the most 
recent market data. In the absence of daily updates, OCC employs an 
approach where one or many identified market proxies (or ``scale-
factors'') are used to incorporate day-to-day market volatility across 
all associated asset classes throughout.\13\ The scale factor approach, 
however, assumes a perfect correlation of the volatilities between the 
security and its scale factor, which gives little room to capture the 
idiosyncratic risk of a given security and which may be different from 
the broad market risk represented by the scale factor.
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    \12\ The securities underlying these products are also known as 
risk factors within OCC's margin system.
    \13\ Earlier this year, the Commission approved a proposed rule 
change, and issued a Notice of No Objection to an advance notice 
filing, by OCC which, among other things: (1) Expanded the number of 
scale factors used for equity-based products to more accurately 
measure the relationship between current and long-run market 
volatility with proxies that correlate more closely to certain 
products carried within the equity asset class, and (2) applied 
relevant scale factors to the greater of (i) the estimated variance 
of 1-day return scenarios or (ii) the historical variance of the 
daily return scenarios of a particular instrument, as a floor to 
mitigate procyclicality. See Securities Exchange Act Release No. 
80147 (March 3, 2017), 82 FR 13163 (March 9, 2017) (SR-OCC-2017-001) 
and Securities Exchange Act Release No. 80143 (March 2, 2017), 82 FR 
13036 (March 8, 2017) (SR-OCC-2017-801).
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    In risk management, it is a common practice to establish a floor 
for volatility at a certain level in order to protect against 
procyclicality \14\ in the model. OCC imposes a floor on volatility 
estimates for its equity-based products using a 500-day look back 
period. These monthly updates coupled with the dependency of margins on 
scale factors and the volatility floor can result in imprecise changes 
in margins charged to Clearing Members, specifically across periods of 
heavy volatility when the correlation between the risk factor and a 
scale factor fluctuate.
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    \14\ A quality that is positively correlated with the overall 
state of the market is deemed to be ``procyclical.'' For example, 
procyclicality may be evidenced by increasing margin or Clearing 
Fund requirements in times of stressed market conditions and low 
margin or Clearing Fund requirements when markets are calm. Hence, 
anti-procyclical features in a model are measures intended to 
prevent risk-based models from fluctuating too drastically in 
response to changing market conditions.
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    OCC's current methodology for estimating covariance and 
correlations between risk factors relies on the same monthly data 
described above, resulting in a similar lag time between updates. In 
addition, correlation estimates are based off historical returns 
series, with estimates between a pair of risk factors being highly 
sensitive to the volatility of either risk factor in the chosen pair. 
The current approach therefore results in potentially less stable 
correlation estimates that may not be representative of current market 
conditions.
    Finally, under OCC's existing margin methodology, theoretical price 
scenarios for ``defaulting securities'' \15\ are simulated using 
uncorrelated return scenarios with an average zero return and a pre-
specified volatility called ``default variance.'' The default variance 
is estimated as the average of the top 25 percent quantile of the 
conditional variances of all securities. As a result, these default 
estimates may be impacted by extremely illiquid securities with 
discontinuous data. In addition, the default variance (and the 
associated scale factors used to scale up volatility) is also subject 
to sudden jumps with the monthly simulation installations across 
successive months because it is derived from monthly data updates, as 
opposed to daily updates, which are prone to wider fluctuations and are 
subject to adjustments using scale factors.
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    \15\ Within the context of OCC's margin system, securities that 
do not have enough historical data for calibration are classified as 
``defaulting securities.''

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[[Page 61356]]

Proposed Changes
    OCC proposes to modify its margin methodology by: (1) Obtaining 
daily price data for equity products (including daily corporate action-
adjusted returns of equities where price and thus returns of securities 
are adjusted for any dividends issued, stock splits, etc.) for use in 
the daily estimation of econometric model parameters; (2) enhancing its 
econometric model for updating statistical parameters (e.g., parameters 
concerning correlations or volatility) for all risk factors that 
reflect the most recent data obtained; (3) improving the sensitivity 
and stability of correlation estimates across risk factors by using de-
volatized \16\ returns (but using a 500 day look back period); and (4) 
improving OCC's methodology related to the treatment of defaulting 
securities that would result in stable and realistic risk estimates for 
such securities.\17\
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    \16\ De-volatization is a process of normalizing historical data 
with the associated volatility thus enabling any comparison between 
different sets of data.
    \17\ In addition to the proposed methodology changes described 
herein, OCC also would make some clarifying and clean-up changes, 
unrelated to the proposed changes described above, to update its 
margin methodology to reflect existing practices for the daily 
calibration of seasonal and non-seasonal energy models and the 
removal of methodology language for certain products that are no 
longer cleared by OCC.
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    The purpose of the proposed changes is to enhance OCC's margin 
methodology to mitigate the issues described above that arise from the 
current monthly update and scale factor approach. Specifically, by 
introducing daily (as opposed to monthly) updates for price data (and 
thereby allowing for daily updates of statistical parameters in the 
model) and making other proposed model enhancements described herein, 
the proposed changes are designed to result in more accurate and 
responsive margin requirements and a model that is more stable and 
proactive during times of market volatility, with margins that are 
based off of the most recent market data. In addition, the proposed 
changes are intended to improve OCC's approach to estimating covariance 
and correlations between risk factors in an effort to achieve more 
stable and sensitive correlation estimations and improve OCC's 
methodology related to the treatment of defaulting securities by 
reducing the impact that illiquid securities with discontinuous data 
have on default variance estimates.
    The proposed changes are described in further detail below.
1. Daily Updates of Price Data
    OCC proposes to introduce daily updates for price data for equity 
products, including daily corporate action-adjusted returns of 
equities, Exchange Traded Funds (``ETFs''), Exchange Traded Notes 
(``ETNs'') and certain indexes. The daily price data would be obtained 
from a widely used external vendor, as is the case with the current 
monthly updates. The purpose of the proposed change is to ensure that 
OCC's margin methodology is reliant on data that is more representative 
of current market conditions, thereby resulting in more accurate and 
responsive margin requirements.
    As described above, OCC currently obtains price data for all 
securities on a monthly basis from a third party vendor. After 
obtaining the monthly price data, additional time is required for OCC 
to process the data prior to installing into OCC's margin system. As a 
result, correlations and statistical parameters for risk factors at any 
point in time represent back-dated data and therefore may not be 
representative of the most recent market data. To mitigate pro-
cyclicality within its margin methodology in the absence of daily 
updates, OCC employs the use of scale-factors to incorporate day-to-day 
market volatility across all associated asset classes. While the scale 
factors help to reduce procyclicality in the model, the scale factors 
do not necessarily capture the idiosyncratic risks of a given security, 
which may be different from the broad market risk represented by the 
scale factor.
    OCC proposes to address these issues associated with its current 
margin methodology by eliminating its dependency on monthly price data, 
which arrives in arrears and requires additional time for OCC to 
process prior to installing into OCC's margin system, through the 
introduction of daily updates for price data for equity products. The 
introduction of daily price updates would enable OCC's margin 
methodology to better capture both market as well idiosyncratic risk by 
allowing for daily updates to the parameters associated with of the 
econometric model (discussed below) that capture the risk associated 
with a particular product, and therefore ensure that OCC's margin 
requirements are based on more current market conditions. As a result, 
OCC would also reduce its reliance on the use of scale factors to 
incorporate day-to-day market volatility, which, as noted above, give 
little room to capture the idiosyncratic risk of a given security and 
which may be different from the broad market risk represented by the 
scale factor. In addition, the processing time between receipt of the 
data and installation into the margin system would be reduced as the 
data review and processing for daily prices would be incorporated into 
OCC's daily price editing process.
2. Proposed Enhancements to the Econometric Model
    In addition to introducing daily updates for price and corporate 
action-adjusted returns data, OCC is proposing enhancements to its 
econometric model for calculating statistical parameters for all 
qualifying risk factors that reflect the most recent data obtained 
(e.g., OCC would be able to calculate parameters such as volatility and 
correlations on a daily basis using the new daily price data discussed 
above). Specifically, OCC proposes to enhance its econometric model by: 
(i) Introducing daily updates for statistical parameters; (ii) 
introducing features in its econometric model that are designed to take 
into account asymmetry in the model used to forecast volatility 
associated with a risk factor; (iii) modifying the statistical 
distribution used to model the returns of equity prices; (iv) 
introducing a second-day forecast for volatility into the model to 
estimate the two-day scenario distributions for risk factors; and (v) 
imposing a floor on volatility estimates using a 10-year look back 
period.
    These proposed model enhancements are described in detail below.
i. Daily Updates for Statistical Parameters
    Under the proposal, the statistical parameters for the model would 
be updated on a daily basis using the new daily price data obtained by 
OCC (as described in section 1 above).\18\ As a result, OCC would no 
longer need to rely on scale factors to approximate day-to-day market 
volatility for equity-based products. Statistical parameters would be 
calibrated on daily basis, allowing OCC to calculate more accurate 
margin requirements that are representative of the most recent market 
data.
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    \18\ OCC notes that this change would apply to most risk factors 
with the exception of certain equity indexes, Treasury securities, 
and energy futures products, which are already updated on a daily 
basis.
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ii. Proposed Enhancements To Capture Asymmetry in Conditional Variance
    In addition to the daily update of statistical parameters, OCC 
proposes to include new features in its econometric model that are 
designed to take into account asymmetry in the conditional variance 
process. The econometric model currently used in STANS for all

[[Page 61357]]

risk factors is a GARCH(1,1) with Student's t-distributed innovations 
of logarithmic returns \19\, which is a relatively straightforward and 
widely used model to forecast volatility.\20\ The current approach for 
forecasting the conditional variance for a given risk factor does not, 
however, consider the asymmetric volatility phenomenon observed in 
financial markets (also called the ``leverage effect'') where 
volatility is more sensitive and reactive to market downturns. As a 
result, OCC proposes to enhance its model by adding new features (i.e., 
incorporating asymmetry into its forecast volatility) designed to allow 
the conditional volatility forecast to be more sensitive to market 
downturns and thereby capture the most significant dynamics of the 
relationship between price and volatility observed in financial 
markets. OCC believes the proposed enhancement would result in more 
accurate and responsive margin requirements, particularly in market 
downturns.
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    \19\ The Student's t-distribution is a widely used statistical 
distribution to model the historical logarithmic price returns data 
of a security that allows for the presence of fat tails (aka 
kurtosis) or a non-zero conditional fourth moment.
    \20\ See generally Tim Bollerslev, ``Generalized Autoregressive 
Conditional Heteroskedasticity,'' Journal of Econometrics, 31(3), 
307-327 (1986). The acronym ``GARCH'' refers to an econometric model 
that can be used to estimate volatility based on historical data. 
The general distinction between the ``GARCH variance'' and the 
``sample variance'' for a given time series is that the GARCH 
variance uses the underlying time series data to forecast 
volatility.
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iii. Proposed Change in Statistical Distribution
    OCC further proposes to change the statistical distribution used to 
model the returns of equity prices. OCC's current methodology uses a 
fat tailed distribution \21\ (the Student's t-distribution) to model 
returns; however, price scenarios generated using very large log-return 
scenarios (positive) that follow this distribution can approach 
infinity and could potentially result in excessively large price jumps, 
a known limitation of this distribution. OCC proposes to move to a more 
defined distribution (Standardized Normal Reciprocal Inverse Gaussian 
or NRIG) for modeling returns, which OCC believes would more 
appropriately simulate future returns based on the historical price 
data for the products in question (i.e., it has a better ``goodness of 
fit'' \22\ to the historical data) and allows for more appropriate 
modeling of fat tails. As a result, OCC believes that the proposed 
change would lead to more consistent treatment of log returns both on 
the upside as well as downside of the distribution.
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    \21\ A data set with a ``fat tail'' is one in which extreme 
price returns have a higher probability of occurrence than would be 
the case in a normal distribution.
    \22\ The goodness of fit of a statistical model describes the 
extent to which observed data match the values generated by the 
model.
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iv. Second-Day Volatility Forecast
    OCC also proposes to introduce a second-day forecast for volatility 
into the model to estimate the two-day scenario distributions for risk 
factors.\23\ Under the current methodology, OCC typically uses a two-
day horizon to determine its risk exposure to a given portfolio. This 
is done by simulating 10,000 theoretical price scenarios for the two-
day horizon using a one-day forecast conditional variance, and the 
value at risk and expected shortfall components of the margin 
requirement are then determined from the simulated profit/loss 
distributions. These one-day and two-day returns scenarios are both 
simulated using the one-day forecast conditional variance estimate. 
This could lead to a risk factor's coverage differing substantially on 
volatile trading days. As a result, OCC proposes to introduce a second-
day forecast variance for all equity-based risk factors. The second-day 
conditional variance forecast would be estimated for each of the 10,000 
Monte Carlo returns scenarios, resulting in more accurately estimated 
two-day scenario distributions, and therefore more accurate and 
responsive margin requirements.
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    \23\ This proposed change would not apply to STANS implied 
volatility scenario risk factors. For those risk factors, OCC's 
existing methodology would continue to apply. See supra note 11.
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v. Anti-Procyclical Floor for Volatility Estimates
    Additionally, OCC proposes to modify its floor for volatility 
estimates. OCC currently imposes a floor on volatility estimates for 
its equity-based products using a 500-day look back period. OCC 
proposes to extend this look back period to 10-years (2520 days) in the 
enhanced model and to apply this floor to volatility estimates for 
other products (excluding implied volatility risk factor scenarios). 
The proposed model described herein is calibrated from historical data, 
and as a result, the level of the volatilities generated by the model 
will vary from time to time. OCC is therefore proposing to establish a 
volatility floor for the model using a 10-year look back period to 
reduce the risk of procyclicality in its margin model. OCC believes 
that using a longer 10-year look back period will ensure that OCC 
captures sufficient historical events/market shocks in the calculation 
of its anti-procyclical floor. The 10-year look back period also is in 
line with requirements of the European Market Infrastructure Regulation 
(including regulations thereunder) \24\ concerning the calibration of 
risk factors.
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    \24\ Regulation (EU) No 648/2012 of the European Parliament and 
of the Council of 4 July 2012 on OTC derivatives, central 
counterparties and trade repositories. Specifically, the proposed 
floor would be compliant with Article 28 of Commission Delegated 
Regulation (EU) No. 153/2013 of 19 December 2012 Supplementing 
Regulation (EU) No. 648/2012 of the European Parliament and of the 
Council with regard to Regulatory Technical Standards on 
Requirements for Central Counterparties (the ``Regulatory Technical 
Standards'').
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3. Proposed Enhancements to Correlation Estimates
    As described above, OCC's current methodology for estimating 
covariance and correlations between risk factors relies on the same 
monthly price data feeding the econometric model, resulting in a 
similar lag time between updates. In addition, correlation estimates 
are based off historical returns series, with estimates between a pair 
of risk factors being highly sensitive to the volatility of either risk 
factors in the chosen pair. The current approach therefore results in 
correlation estimates being sensitive to volatile historical data.
    In order to address these limitations, OCC proposes to enhance its 
methodology for calculating correlation estimates by moving to a daily 
process for updating correlations (with a minimum of one week's lag) to 
ensure Clearing Member account margins are more current and thus more 
accurate. Moreover, OCC proposes to enhance its approach to modeling 
correlation estimates by de-volatizing \25\ the returns series to 
estimate the correlations. Under the proposed approach, OCC would first 
consider the returns excess of the mean (i.e., the average estimated 
from historical data sample) and then further scale them by the 
corresponding estimated conditional variances. OCC believes that by 
using de-volatized returns, which is a widely suggested approach in 
relevant literature, it would lead to normalizing returns across a 
variety of asset classes and make the correlation estimator less 
sensitive to sudden market jumps and therefore more stable.
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    \25\ See supra note 16.
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4. Defaulting Securities Methodology
    Finally, OCC proposes to enhance its methodology for estimating the 
defaulting variance in its model. OCC's margin system is dependent on 
market

[[Page 61358]]

data to determine Clearing Member margin requirements. Securities that 
do not have enough historical data are classified as to be a 
``defaulting security'' within OCC systems (e.g., IPO securities). As 
noted above, within current STANs systems, the theoretical price 
scenarios for defaulting securities are simulated using uncorrelated 
return scenarios with a zero mean and a default variance, with the 
default variance being estimated as the average of the top 25 percent 
quantile of the conditional variances of all securities. As a result, 
these default estimates may be impacted by extremely illiquid 
securities with discontinuous data. In addition, the default variance 
(and the associated scale factors used to scale up volatility) is also 
subject to sudden jumps with the monthly simulation installations 
across volatile months. To mitigate these concerns, OCC proposes to: 
(i) Use only optionable equity securities to estimate the default 
variance; (ii) use a shorter time series to enable calibration of the 
model for all securities; and (iii) simulating default correlations 
with the driver Russell 2000 index (``RUT'').
i. Proposed Modifications to Securities and Quantile Used in Estimation
    OCC proposes that only optionable equity securities, which are 
typically more liquid, be considered while estimating the default 
variance. This limitation would eliminate from the estimation almost 
all illiquid securities with discontinuous data that could contribute 
to high conditional variance estimates and thus a high default 
variance. In addition, OCC proposes to estimate the default variance as 
the lowest estimate of the top 10% of the floored conditional variance 
across the risk factors. This change in methodology is designed to 
ensure that while the estimate is aggressive it is also robust to the 
presence of outliers caused by a few extremely volatile securities that 
influence the location parameter of a distribution. Moreover, as a 
consequence of the daily updates described above, the default variances 
would change daily and there would be no scale factor to amplify the 
effect of the variance on risk factor coverage.
ii. Proposed Change in Time Series
    In addition, OCC proposes to use a shorter time series to enable 
calibration of the model for all securities. Currently, OCC does not 
calibrate parameters for defaulting securities that have historical 
data of less than two years. OCC is proposing to shorten this time 
period to around 6 months (180 days) to enable calibration of the model 
for all securities within OCC systems. OCC believes that this shorter 
time series is sufficient to produce stable calibrated parameters.
iii. Proposed Default Correlation
    Finally, OCC proposes that returns scenarios for defaulting 
securities, securities with insufficient historical data, be simulated 
using a default correlation with the driver RUT.\26\ The RUT Index is a 
small cap index and is hence a natural choice to represent most new 
issues that are small cap and deemed to be a ``defaulting security.'' 
The default correlation is roughly equal to the median of all 
positively correlated securities with the index. Since 90% of the risk 
factors in OCC systems correlate positively to the RUT index, OCC would 
only consider those risk factors to determine the median. OCC believes 
that the median of the correlation distribution has been steady over a 
number of simulations and is therefore proposing that it replace the 
current methodology of simulating uncorrelated scenarios, which OCC 
believes is not a realistic approach.
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    \26\ OCC notes that, in certain limited circumstances where 
there are reasonable grounds backed by the existing return history 
to support an alternative approach in which the returns are strongly 
correlated with those of an existing risk factor (a ``proxy'') with 
a full price history, the Margins Methodology allows OCC's Financial 
Risk Management staff to construct a ``conditional'' simulation to 
override any default treatment that would have otherwise been 
applied to the defaulting security.
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Anticipated Effect on and Management of Risk
    OCC believes that the proposed changes would reduce the nature and 
level of risk presented by OCC because they would result in a margin 
methodology that is more accurate, responsive, stable, and robust, 
thereby reducing risks to OCC, its Clearing Members, and the markets it 
serves.
    As noted above, OCC's current margin methodology relies on monthly 
price data being obtained from a third party vendor. This data arrives 
monthly in arrears and requires additional time for OCC to process the 
data prior to installing into OCC's margin system. As a result, 
correlations and statistical parameters for risk factors at any point 
in time represent back-dated data and therefore may not be 
representative of the most recent market data. To mitigate 
procyclicality within its margin methodology in the absence of daily 
updates, OCC employs a scale factor approach to incorporate day-to-day 
market volatility across all associated asset classes throughout.\27\ 
For the reasons noted above, these monthly updates coupled with the 
dependency of margins on scale factors can result in imprecise changes 
in margins charged to Clearing Members, specifically across periods of 
heavy volatility.
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    \27\ See supra note 13 and accompanying text.
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    OCC proposes to enhance its margin methodology to introduce daily 
updates for equity price data, thereby allowing for daily updates of 
statistical parameters in its margin model for most risk factors. In 
addition, the proposed changes would introduce features to the model to 
better account for the asymmetric volatility phenomenon observed in 
financial markets and allow for conditional volatility forecast to be 
more sensitive to market downturns. The proposed changes would also 
introduce a new statistical distribution for modeling equity price 
returns that OCC believes would have a better goodness of fit and would 
more appropriately account for fat tails. Moreover, the proposed 
changes would introduce a second-day volatility forecast into the model 
to provide for more accurate and timely estimations of its two-day 
scenario distributions. OCC also proposes to enhance its econometric 
model by establishing a volatility floor using a 10-year look back 
period to reduce procyclicality in the margin model. OCC believes the 
proposed changes would result in more accurate and responsive margin 
requirements and a model that is more stable and proactive during times 
of market volatility, with risk charges that are based off of most 
recent market data.
    In addition, the proposed changes are intended to improve OCC's 
approach to estimating covariance and correlations between risk factors 
in an effort to achieve more stable and sensitive correlation 
estimations and improve OCC's methodology related to the treatment of 
defaulting securities by reducing the impact that illiquid securities 
with discontinuous data have on default variance estimates.
    The proposed methodology changes would be used by OCC to calculate 
margin requirements designed to limit its credit exposures to 
participants, and OCC uses the margin it collects from a defaulting 
Clearing Member to protect other Clearing Members from losses that may 
result from such a default. As a result, OCC believes the proposed 
changes would result in the reduction of risk for OCC, its Clearing 
Members, and the markets it serves.
Clearing Member Outreach
    OCC has discussed the proposed changes with its Financial Risk

[[Page 61359]]

Advisory Council \28\ at a meeting held on October 25, 2016. OCC also 
provided general updates to members at OCC Roundtable \29\ meetings on 
June 20, 2017, and November 9, 2017. Clearing Members expressed 
interest in seeing how reactive margin changes would be under the 
proposal; however, there were no objections or significant concerns 
expressed regarding the proposed changes. OCC will provide at least 30-
days of parallel reporting prior to implementation so that Clearing 
Members can see the impact of the proposed changes. In addition, OCC 
would publish an Information Memorandum to all Clearing Members 
describing the proposed change and will provide additional periodic 
Information Memoranda updates prior to the implementation date. 
Additionally, OCC would perform targeted and direct outreach with 
Clearing Members that would be most impacted by the proposed changes to 
the margin methodology and OCC would work closely with such Clearing 
Members to coordinate the implementation and associated funding for 
such Clearing Members resulting from the proposed change.\30\
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    \28\ The Financial Risk Advisory Council is a working group 
consisting of representatives of Clearing Members and exchanges 
formed by OCC to review and comment on various risk management 
proposals.
    \29\ The OCC Roundtable was established to bring Clearing 
Members, exchanges and OCC together to discuss industry and 
operational issues. It is comprised of representatives of the senior 
OCC staff, participant exchanges and Clearing Members, representing 
the diversity of OCC's membership in industry segments, OCC-cleared 
volume, business type, operational structure and geography.
    \30\ Specifically, OCC will discuss with those Clearing Members 
how they plan to satisfy any increase in their margin requirements 
associated with the proposed change.
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Consistency With the Payment, Clearing and Settlement Supervision Act
    The stated purpose of the Clearing Supervision Act 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.\31\ 
Section 805(a)(2) of the Clearing Supervision Act \32\ also authorizes 
the Commission to prescribe risk management standards for the payment, 
clearing and settlement activities of designated clearing entities, 
like OCC, for which the Commission is the supervisory agency. Section 
805(b) of the Clearing Supervision Act \33\ states that the objectives 
and principles for risk management standards prescribed under Section 
805(a) shall be to:
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    \31\ 12 U.S.C. 5461(b).
    \32\ 12 U.S.C. 5464(a)(2).
    \33\ 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 Clearing Supervision Act and the Act, which include 
Commission Rules 17Ad-22(b)(1), (b)(2) and (e)(6).\34\
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    \34\ 17 CFR 240. 17Ad-22. See Securities Exchange Act Release 
Nos. 68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-
08-11) (``Clearing Agency Standards''); 78961 (September 28, 2016, 
81 FR 70786 (October 13, 2016) (S7-03-14) (``Standards for Covered 
Clearing Agencies''). The Standards for Covered Clearing Agencies 
became effective on December 12, 2016. OCC is a ``covered clearing 
agency'' as defined in Rule 17Ad-22(a)(5) and therefore OCC must 
comply with new section (e) of Rule 17Ad-22.
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    Rules 17Ad-22(b)(1) and (2) \35\ require that a registered clearing 
agency that performs central counterparty services establish, 
implement, maintain and enforce written policies and procedures 
reasonably designed to, in part: (1) Measure its credit exposures to 
its participants at least once a day and limit its exposures to 
potential losses from defaults by its participants under normal market 
conditions so that the operations of the clearing agency would not be 
disrupted and non-defaulting participants would not be exposed to 
losses that they cannot anticipate or control and (2) 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.
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    \35\ 17 CFR 240.17Ad-22(b)(1) and (2).
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    As noted above, the proposed changes would introduce the use of 
daily price updates into OCC's margin methodology, which allows for 
daily updates to the statistical parameters in the model (e.g., 
parameters concerning volatility and correlation). These changes would 
be supported by a number of other risk-based enhancements to OCC's 
econometric model designed to: (i) More appropriately account for 
asymmetry in conditional variance; (ii) more appropriately model the 
statistical distribution of price returns; (iii) provide for an anti-
procyclical floor for volatility estimates based on a 10-year look back 
period; and (iv) more accurately model second-day volatility forecasts. 
Moreover, the proposed changes would improve OCC's approach to 
estimating covariance and correlations between risk factors in an 
effort to achieve more stable and sensitive correlation estimations and 
improve OCC's methodology related to the treatment of defaulting 
securities by reducing the impact that illiquid securities with 
discontinuous data have on default variance estimates.
    OCC would use the risk-based model enhancements described herein to 
measure its credit exposures to its participants on a daily basis and 
determine margin requirements based on such calculations. The proposed 
enhancements concerning daily price updates, daily updates of 
statistical parameters, and to more appropriately account for asymmetry 
in conditional variance would result in more accurate and responsive 
margin requirements and a model that is more stable and proactive 
during times of market volatility, with margin charges that are based 
off of the most recent market data. In addition, the proposed 
modifications to extend the look back period for determining volatility 
estimates for equity-based products from 500 days to 10 years will help 
to ensure that OCC captures sufficient historical events/market shocks 
in the calculation of its anti-procyclical floor. Additionally, the 
proposed changes would enhance OCC's margin methodology for calculating 
correlation estimates by moving to a daily process for updating 
correlations (with a minimum of one week's lag) so that Clearing Member 
account margins are more current and thus more accurate and using de-
volatized returns to normalize returns across a variety of asset 
classes and make the correlation estimator less sensitive to sudden 
market jumps and therefore more stable. Finally, the proposed changes 
to OCC's methodology for the treatment of defaulting securities is 
designed to result in stable and realistic risk estimates for such 
securities The proposed changes are therefore designed to ensure that 
OCC sets margin requirements, using risk-based models and parameters, 
that would serve to limit OCC's exposures to potential losses from 
defaults by its participants under normal market conditions so that the 
operations of OCC would not be disrupted and non-defaulting 
participants would not be exposed to losses that they cannot anticipate 
or control. Accordingly, OCC believes the proposed changes are 
consistent with Rules 17Ad-22(b)(1) and (2).\36\
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    \36\ Id.

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[[Page 61360]]

    Rule 17Ad-22(e)(6) \37\ further requires OCC to establish, 
implement, maintain and enforce written policies and procedures 
reasonably designed to cover its credit exposures to its participants 
by establishing a risk-based margin system that, among other things: 
(i) Considers, and produces margin levels commensurate with, the risks 
and particular attributes of each relevant product, portfolio, and 
market; (ii) calculates margin sufficient to cover its potential future 
exposure to participants in the interval between the last margin 
collection and the close out of positions following a participant 
default; and (iii) uses reliable sources of timely price data and uses 
procedures and sound valuation models for addressing circumstances in 
which pricing data are not readily available or reliable.
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    \37\ 17 CFR 240.17Ad-2(e)(6).
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    As described in detail above, the proposed changes are designed to 
ensure that, among other things, OCC's margin methodology: (i) More 
appropriately accounts for asymmetry in conditional variance; (ii) more 
appropriately models the statistical distribution of price returns, 
(iii) more accurately models second-day volatility forecasts; (iv) 
improves OCC's approach to estimating covariance and correlations 
between risk factors to provide for stable and sensitive correlation 
estimations; and (v) improves OCC's methodology related to the 
treatment of defaulting securities by reducing the impact that illiquid 
securities with discontinuous data have on default variance estimates. 
These methodology enhancements would be used to calculate daily margin 
requirements for OCC's Clearing Members. In this way, the proposed 
changes are designed to consider, and produce margin levels 
commensurate with, the risks and particular attributes of each relevant 
product, portfolio, and market and to calculate margin sufficient to 
cover its potential future exposure to participants in the interval 
between the last margin collection and the close out of positions 
following a participant default.
    Moreover, the proposed changes would introduce daily updates for 
price data for equity products, including daily corporate action-
adjusted returns of equities, ETFs, ETNs, and certain indexes. This 
daily price data would be obtained from a widely used and reliable 
industry vendor. In this way, the proposed changes would ensure that 
OCC uses reliable sources of timely price data in its margin 
methodology, which better reflect current market conditions than the 
current monthly updates, thereby resulting in more accurate and 
responsive margin requirements.
    For these reasons, OCC believes that the proposed changes are 
consistent with Rule 17Ad 22(e)(6).\38\
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    \38\ Id.
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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 the proposed change was filed with the Commission or (ii) the date 
any additional information requested by the Commission is received. OCC 
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 notice 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.
    OCC shall post notice on its website of proposed changes that are 
implemented.
    The proposal shall not take effect until all regulatory actions 
required with respect to the proposal are completed.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the advance 
notice is consistent with the Clearing 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 [email protected]. Please include 
File Number SR-OCC-2017-811 on the subject line.

Paper Comments

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

All submissions should refer to File Number SR-OCC-2017-811. 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 website (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 website 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 website at 
hhttps://www.theocc.com/about/publications/bylaws.jsp.
    All comments received will be posted without change. Persons 
submitting comments are cautioned that we do not redact or edit 
personal identifying information from comment submissions. You should 
submit only information that you wish to make available publicly. All 
submissions should refer to File Number SR-OCC-2017-811 and should be 
submitted on or before January 17, 2018.

    By the Commission.
Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-27832 Filed 12-26-17; 8:45 am]
BILLING CODE 8011-01-P


