[Federal Register Volume 83, Number 103 (Tuesday, May 29, 2018)]
[Notices]
[Pages 24536-24541]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-11454]



[[Page 24536]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-83305; File No. SR-OCC-2017-811]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of No Objection To Advance Notice Filing Concerning The Options 
Clearing Corporation's Margin Methodology

May 23, 2018.

I. Introduction

    On November 13, 2017, The Options Clearing Corporation (``OCC'') 
filed with the Securities and Exchange Commission (``Commission'') 
advance notice SR-OCC-2017-811 (``Advance Notice'') pursuant to Section 
806(e)(1) of the Payment, Clearing, and Settlement Supervision Act of 
2010 (``Payment Supervision Act'') \1\ and Rule 19b-4(n)(1)(i) under 
the Securities Exchange Act of 1934 (``Exchange Act'') \2\ to propose 
several enhancements to OCC's margin methodology, the System for 
Theoretical Analysis and Numerical Simulations (``STANS''), OCC's 
proprietary risk management system that calculates clearing member 
margin requirements.\3\ The proposed changes would modify OCC's margin 
methodology to: (1) Obtain daily price data for equity products 
(including daily corporate action-adjusted returns of equities where 
prices 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) enhance 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) improve the sensitivity and stability of 
correlation estimates across risk factors by using de-volatized \4\ 
returns (but using a 500 day look back period); and (4) improve OCC's 
methodology related to the treatment of defaulting securities \5\ that 
would result in stable and realistic risk estimates for such 
securities.\6\ The Advance Notice was published for comment in the 
Federal Register on December 27, 2017.\7\ On January 11, 2018, the 
Commission requested OCC provide it with additional information 
regarding the Advance Notice.\8\ OCC responded to this request for 
information on January 23, 2018.\9\ On March 22, 2018, the Commission 
determined that the Advance Notice raises complex issues because OCC 
proposes to make detailed, substantial, and numerous changes to its 
margin methodology.\10\ As such, the Commission extended review period 
of the Advance Notice until May 23, 2018.\11\ As of May 23, 2018, the 
Commission has received one comment letter on the proposal contained in 
the Advance Notice.\12\ This publication serves as 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 (``SIFMU'') on July 18, 2012. See Financial Stability 
Oversight Council 2012 Annual Report, Appendix A, available at 
http://www.treasury.gov/initiatives/fsoc/Documents/2012%20Annual%20Report.pdf. Therefore, OCC is required to comply 
with the Payment 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 Notice infra note 7, at 82 FR 61355.
    \4\ De-volatization is a process of normalizing historical data 
with the associated volatility thus facilitating comparison between 
different sets of data.
    \5\ Within the context of OCC's margin system, securities that 
do not have enough historical data for calibration are classified as 
``defaulting securities.'' See Notice, 82 FR at 61355, note 15.
    \6\ See Notice infra note 7, at 82 FR 61354.
    \7\ Exchange Act Release No. 82371 (Dec. 20, 2017), 82 FR 61354 
(Dec. 27, 2017) (SR-OCC-2017-811) (``Notice''). On November 13, 
2017, OCC also filed a related proposed rule change (SR-OCC-2017-
022) with the Commission pursuant to Exchange Act Section 19(b)(1) 
and Rule 19b-4 thereunder, seeking approval of changes to its rules 
necessary to implement the proposal contained in the Advance Notice 
(``Proposed Rule Change''). 15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-
4, respectively. The Proposed Rule Change was published in the 
Federal Register on December 4, 2017. Exchange Act Release No. 82161 
(Nov. 28, 2017), 82 FR 57306 (Dec. 4, 2017) (SR-OCC-2017-022).
    \8\ See Memorandum from Office of Clearance and Settlement, 
Division of Trading and Markets, dated January 12, 2018, available 
at https://www.sec.gov/comments/sr-occ-2017-811/occ2017811.htm.
    \9\ See Memorandum from Office of Clearance and Settlement, 
Division of Trading and Markets, dated March 6, 2018, available at 
https://www.sec.gov/comments/sr-occ-2017-811/occ2017811.htm.
    \10\ See Extension Notice, 82 FR at 13315.
    \11\ Id.
    \12\ See letter from Michael Kitlas, dated November 28, 2017, to 
Eduardo A. Aleman, Assistant Secretary, Commission, available at 
https://www.sec.gov/comments/sr-occ-2017-022/occ2017022.htm 
(``Kitlas Letter''). After reviewing the Kitlas Letter, the 
Commission believes that it is nonresponsive to the Advance Notice 
and therefore outside the scope of the proposal.
    Since the proposal contained in the Advance Notice was also 
filed as a proposed rule change, all public comments received on the 
proposal are considered regardless of whether the comments are 
submitted on the Proposed Rule Change or the Advance Notice.
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II. Background \13\
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    \13\ The description of the background of the proposal is 
substantially excerpted from the Notice. See Notice, 82 FR at 61355.
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OCC's Current Margin Methodology

    OCC's margin methodology, the System for Theoretical Analysis and 
Numerical Simulations (``STANS''), calculates clearing member margin 
requirements.\14\ STANS utilizes large-scale Monte Carlo simulations to 
forecast price and volatility movements in determining a clearing 
member's margin requirement.\15\ 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 \16\ over a two-day time horizon and an add-on 
margin charge for model risk (the concentration/dependence stress test 
charge).\17\ The STANS methodology is used to measure the exposure of 
portfolios of options and futures cleared by OCC and cash instruments 
in margin collateral.\18\
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    \14\ See Exchange Act Release No. 53322 (Feb. 15, 2006), 71 FR 
9403 (Feb. 23, 2006) (File No. SR-OCC-2004-20).
    \15\ See OCC Rule 601; see also Notice, 82 FR at 61355.
    \16\ See Notice, 82 FR at 61355.
     The expected shortfall component is established as the 
estimated average of potential losses higher than the 99% value at 
risk threshold. See Notice, 82 FR at 61355, note 8.
    \17\ See Notice, 82 FR at 61355. A detailed description of the 
STANS methodology is available at http://optionsclearing.com/risk-management/margins/. See Notice, 82 FR at 61355, note 9.
    \18\ See Notice, 82 FR at 61355.
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    A ``risk factor'' within OCC's margin system may be defined as a 
product or attribute whose historical data are used to estimate and 
simulate the risk for an associated product.\19\ 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 risk factors 
that are a set of nine chosen volatility pivots per product; changes in 
foreign exchange rates; securities underlying equity-based products; 
and changes in model parameters that sufficiently capture the model 
dynamics from a larger set of data.\20\
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    \19\ Id.
    \20\ Id.
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    Under OCC's current margin methodology, OCC obtains monthly price 
data for most of its equity-based products from a third-party 
vendor.\21\ This data arrive around the second week of every month in 
arrears and require approximately four weeks for OCC to process prior 
to installing into OCC's margin system.\22\ As a result, correlations 
and statistical parameters for risk factors at any point in time 
represent stale data and therefore may not be representative of the 
most recent market data.\23\ In the absence of daily updates, OCC 
employs an approach

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where one or more identified market proxies (or ``scale-factors'') are 
used to incorporate day-to-day market volatility across all associated 
asset classes throughout.\24\ 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 is different from the broad 
market risk represented by the scale-factor.\25\
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    \21\ Id.
    \22\ Id.
    \23\ Id.
    \24\ Id.
    \25\ Id.
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    In addition, OCC imposes a floor on volatility estimates for its 
equity-based products using a 500-day look back period.\26\ OCC 
believes that using monthly price data, 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.\27\
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    \26\ See Notice, 82 FR at 61355.
     In risk management, it is a common practice to establish a 
floor for volatility at a certain level in order to protect against 
procyclicality in the model. See Notice, 82 FR at 61355, note 14.
    \27\ See Notice, 82 FR at 61355.
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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.\28\ 
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.\29\ Accordingly, OCC believes that the current approach results 
in potentially less stable correlation estimates that may not be 
representative of current market conditions.\30\
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    \28\ Id.
    \29\ Id.
    \30\ Id.
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    Finally, under OCC's existing margin methodology, theoretical price 
scenarios for ``defaulting securities'' \31\ are simulated using 
uncorrelated return scenarios with an average zero return and a pre-
specified volatility called ``default variance.'' \32\ The default 
variance is estimated as the average of the top 25 percent quantile of 
the conditional variances of all securities.\33\ As a result, OCC 
believes that these default estimates may be impacted by extremely 
illiquid securities with discontinuous data.\34\ In addition, OCC 
believes that the default variance (and the associated scale-factors 
used to scale up volatility) is also subject to sudden jumps 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.\35\
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    \31\ See supra note 5.
    \32\ See Notice, 82 FR at 61355.
    \33\ Id.
    \34\ Id.
    \35\ Id.
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III. Description of the Proposal in the Advance Notice \36\
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    \36\ The description of the proposal is substantially excerpted 
from the Notice. See Notice, 82 FR at 61356-61358.
     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 herein, 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. See Notice, 82 FR at 61356, note 17.
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    The Advance Notice proposes changes to OCC's margin methodology, 
STANS. More specifically, OCC proposes to: (1) Obtain 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) enhance 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) improve the sensitivity and stability of 
correlation estimates across risk factors by using de-volatized \37\ 
returns (but using a 500 day look back period); and (4) improve OCC's 
methodology related to the treatment of defaulting securities \38\ that 
would result in stable and realistic risk estimates for such 
securities.
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    \37\ De-volatization is a process of normalizing historical data 
with the associated volatility thus facilitating comparison between 
different sets of data.
    \38\ See supra note 5.
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    As a general matter, OCC believes that introducing daily updates 
for price data would result in more accurate margin requirements that 
are based off of the most recent market data. OCC also believes that 
the other model enhancements would, among other things, improve OCC's 
approach to estimating covariance and correlations between risk factors 
in an effort to achieve more accurate and timely correlation 
estimations.\39\ OCC further represents that the proposed changes would 
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. Each of these 
proposals is discussed in more detail below.
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    \39\ OCC's covariance and correlation analytics estimate whether 
risk factors are positively or inversely related and to what extent 
any relationship exists.
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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.\40\ OCC believes that the proposed 
change would help 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.\41\ In 
addition, OCC believes that the introduction of daily price updates 
would enable OCC's margin methodology to better capture both market and 
idiosyncratic risk by allowing for daily updates to the parameters 
associated with the econometric model (discussed below) that captures 
the risk associated with a particular product, and therefore help 
ensure that OCC's margin requirements are based on more current market 
conditions.\42\ As a result, OCC would also reduce its reliance on the 
use of scale-factors to incorporate day-to-day market volatility, which 
OCC believes give little room to capture the idiosyncratic risk of a 
given security and is different from the broad market risk represented 
by the scale-factor.\43\
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    \40\ See Notice, 82 FR at 61356.
    \41\ Id.
    \42\ Id.
    \43\ Id.
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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). More 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

[[Page 24538]]

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 from a reliable third-party (as described above).\44\ As a result, 
OCC would no longer need to rely on scale-factors to approximate day-
to-day market volatility for equity-based products.\45\ OCC believes 
that calibrating statistical parameters on a daily basis would allow 
OCC to calculate more accurate margin requirements that represent the 
most recent market data.\46\
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    \44\ See Notice, 82 FR at 61356. 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. See Notice, 82 FR 61356, 
at note 18.
    \45\ See Notice, 82 FR at 61356.
    \46\ Id.
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ii. Proposed Enhancements To Capture Asymmetry in Conditional Variance
    The current approach for forecasting the conditional variance for a 
given risk factor does not consider the asymmetric volatility 
phenomenon observed in financial markets (also called the ``leverage 
effect'') where volatility is more accurate and timely and reactive to 
market downturns.\47\ Under the proposal, OCC would amend its 
econometric model to include new features (i.e., incorporating 
asymmetry into its forecast volatility) designed to allow the 
conditional volatility forecast to be more accurate and timely to 
market downturns and thereby capture the most significant dynamics of 
the relationship between price and volatility observed in financial 
markets.\48\ OCC believes the proposed enhancement would result in more 
accurate and responsive margin requirements, particularly in market 
downturns.\49\
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    \47\ See Notice, 82 FR at 61357.
    \48\ Id.
    \49\ Id.
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iii. Proposed Change in Statistical Distribution
    OCC also proposes to change the statistical distribution used to 
model the returns of equity prices. OCC's current methodology uses a 
fat tailed distribution \50\ (the Student's t-distribution) to model 
returns; \51\ 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.\52\ Under the proposal, OCC 
would adopt 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 and allows for more 
appropriate modeling of fat tails.\53\ 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.\54\
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    \50\ 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. See Notice, 82 FR at 61357, note 
21.
    \51\ See Notice, 82 FR at 61357.
    \52\ Id.
    \53\ Id.
    \54\ Id.
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iv. Second Day Volatility Forecast
    OCC further proposes to introduce a second-day forecast for 
volatility into the econometric model to estimate the two-day scenario 
distributions for risk factors.\55\ Under the current methodology, OCC 
typically uses a two-day horizon to determine its risk exposure to a 
given portfolio.\56\ This is done by simulating 10,000 theoretical 
price scenarios for the two-day horizon using a one-day forecast 
conditional variance; the value at risk and expected shortfall 
components of the margin requirement are then determined from the 
simulated profit/loss distributions.\57\ These one-day and two-day 
returns scenarios are both simulated using the one-day forecast 
conditional variance estimate.\58\ OCC believes that this could lead to 
a risk factor's coverage differing substantially on volatile trading 
days.\59\ As a result, OCC proposes to introduce a second-day forecast 
variance for all equity-based risk factors.\60\ 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.\61\
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    \55\ Id. 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 Notice, 82 FR at 
61357, note 23.
    \56\ See Notice, 82 FR at 61357.
    \57\ Id.
    \58\ Id.
    \59\ Id.
    \60\ Id.
    \61\ Id.
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v. Anti-Procyclical Floor for Volatility Estimates
    In addition, 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.\62\ Under 
the proposal, OCC would extend this look back period to 10 years (2520 
days) in the enhanced model and apply this floor to volatility 
estimates for other products (excluding implied volatility risk factor 
scenarios).\63\ OCC believes that using a longer 10-year look back 
period will help ensure that OCC captures sufficient historical events/
market shocks in the calculation of its anti-procyclical floor.\64\
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    \62\ Id.
    \63\ Id.
    \64\ Id.
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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.\65\ 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.\66\ The current approach 
therefore results in correlation estimates being sensitive to volatile 
historical data.\67\
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    \65\ Id.
    \66\ Id.
    \67\ Id.
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    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 
help ensure clearing member account margins are more current and thus 
more accurate.\68\ Moreover, OCC proposes to enhance its approach to 
modeling correlation estimates by de-volatizing \69\ the returns series 
to estimate the correlations.\70\ 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

[[Page 24539]]

variances.\71\ OCC believes that using de-volatized returns 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.\72\
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    \68\ Id.
    \69\ Id.
    \70\ Id.
    \71\ Id.
    \72\ Id.
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4. Defaulting Securities Methodology

    Under the proposal, OCC would enhance its methodology for 
estimating the defaulting variance in its model.\73\ OCC's margin 
system is dependent on market data to determine clearing member margin 
requirements.\74\ Securities that do not have enough historical data 
are classified as ``defaulting securities'' within OCC systems.\75\ 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.\76\ As a 
result, these default estimates may be impacted by extremely illiquid 
securities with discontinuous data.\77\ In addition, the default 
variance (and the associated scale-factors used to scale up volatility) 
is also subject to sudden jumps across volatile months.\78\ To mitigate 
these concerns, OCC proposes to: (i) Use only optionable equity 
securities to estimate the defaulting variance; (ii) use a shorter time 
series to enable calibration of the model for all securities; and (iii) 
simulate default correlations with the driver Russell 2000 index 
(``RUT'').\79\
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    \73\ Id.
    \74\ See Notice, 82 FR at 61357-61358.
    \75\ See Notice, 82 FR at 61358.
    \76\ Id.
    \77\ Id.
    \78\ Id.
    \79\ Id.
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i. Proposed Modifications to Securities and Quantile Used in Estimation
    Under the proposal, only optionable equity securities, which are 
typically more liquid, would be considered while estimating the default 
variance.\80\ 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.\81\ 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.\82\ OCC believes that 
this change in methodology would help 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.\83\ 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.\84\
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    \80\ Id.
    \81\ Id.
    \82\ Id.
    \83\ Id.
    \84\ Id.
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ii. Proposed Change in Time Series
    Under the proposal, OCC would use a shorter time series to enable 
calibration of the model for all securities.\85\ Currently, OCC does 
not calibrate parameters for defaulting securities that have historical 
data of less than two years.\86\ OCC is proposing to shorten this time 
period to approximately 6 months (180 days) to enable calibration of 
the model for all securities within OCC systems.\87\ OCC believes that 
this shorter time series is sufficient to produce stable calibrated 
parameters.\88\
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    \85\ Id.
    \86\ Id.
    \87\ Id.
    \88\ Id.
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iii. Proposed Default Correlation
    Under the proposal, returns scenarios for defaulting securities 
\89\ would be simulated using a default correlation with the driver 
RUT.\90\ The default correlation of the RUT index is roughly equal to 
the median of all positively correlated securities with the index.\91\ 
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.\92\ 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.\93\
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    \89\ See supra note 5.
    \90\ See Notice, 82 FR at 61358. 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, OCC's margin 
methodology allows its Financial Risk Management staff to construct 
a ``conditional'' simulation to override any default treatment that 
would have otherwise been applied to the defaulting security. See 
Notice, 82 FR at 61358, note 26.
    \91\ See Notice, 82 FR at 61358.
    \92\ Id.
    \93\ Id.
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IV. Discussion and Commission Findings

    Although the Act does not specify a standard of review for an 
advance notice, the stated purpose of the Act is instructive: To 
mitigate systemic risk in the financial system and promote financial 
stability by, among other things, promoting uniform risk management 
standards for SIFMUs and strengthening the liquidity of SIFMUs.\94\
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    \94\ See 12 U.S.C. 5461(b).
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    Section 805(a)(2) of the Act \95\ authorizes the Commission to 
prescribe regulations containing risk-management standards for the 
payment, clearing, and settlement activities of designated clearing 
entities engaged in designated activities for which the Commission is 
the supervisory agency. Section 805(b) of the Act \96\ provides the 
following objectives and principles for the Commission's risk-
management standards prescribed under Section 805(a):
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    \95\ 12 U.S.C. 5464(a)(2).
    \96\ 12 U.S.C. 5464(b).
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     To promote robust risk management;
     to promote safety and soundness;
     to reduce systemic risks; and
     to support the stability of the broader financial system.
    Section 805(c) provides, in addition, that the Commission's risk-
management standards may address such areas as risk-management and 
default policies and procedures, among others areas.\97\
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    \97\ 12 U.S.C. 5464(c).
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    The Commission has adopted risk-management standards under Section 
805(a)(2) of the Act and the Exchange Act (the ``Clearing Agency 
Rules'').\98\ The Clearing Agency Rules require, among other things, 
each covered clearing agency to establish, implement, maintain, and 
enforce written policies and procedures that are reasonably designed to 
meet certain minimum requirements for operations and risk-management 
practices on an ongoing

[[Page 24540]]

basis.\99\ As such, it is appropriate for the Commission to review 
advance notices for consistency with the objectives and principles for 
risk-management standards described in the Clearing Agency Rules.
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    \98\ 17 CFR 240.17Ad-22. See Securities Exchange Act Release No. 
68080 (October 22, 2012), 77 FR 66220 (November 2, 2012) (S7-08-11). 
See also Securities Exchange Act Release No. 78961 (September 28, 
2016), 81 FR 70786 (October 13, 2016) (S7-03-14) (``Covered Clearing 
Agency Standards''). The Commission established an effective date of 
December 12, 2016, and a compliance date of April 11, 2017, for the 
Covered Clearing Agency Standards. On March 4, 2017, the Commission 
granted covered clearing agencies a temporary exemption from 
compliance with Rule 17Ad-22(e)(3)(ii) and certain requirements in 
Rules 17Ad-22(e)(15)(i) and (ii) until December 31, 2017, subject to 
certain conditions. OCC is a ``covered clearing agency'' as defined 
in Rule 17Ad-22(a)(5).
    \99\ 17 CFR 240.17Ad-22.
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A. Consistency With Section 805(b) of the Act

    The Commission believes that the proposal contained in OCC's 
Advance Notice is consistent with the stated objectives and principles 
of Section 805(b) of the Act. Specifically, as discussed below, the 
Commission believes that the changes proposed in the Advance Notice are 
consistent with promoting robust risk management in the area of credit 
risk and promoting safety and soundness, which in turn, would help 
reduce systemic risks and support the stability of the broader 
financial system.\100\
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    \100\ 12 U.S.C. 5464(b).
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    The Commission believes that the proposed changes promote robust 
risk management by enhancing OCC's margin methodology for the reasons 
set forth below.
    First, as noted above, the STANS methodology is used to measure the 
exposure of portfolios of options and futures cleared by OCC and cash 
instruments in margin collateral on behalf of its clearing members, 
which allows OCC to calculate its clearing members' margin 
requirements. Currently, STANS makes these calculation based on monthly 
price data obtained from a third-party vendor. To make the calculations 
more accurate and representative of recent market data, OCC proposes to 
amend its margin methodology to require the use of daily updates for 
equity price data instead of monthly updates, thereby reducing OCC's 
reliance on scale-factors.\101\ Accordingly, the Commission believes 
that changing to daily price data updates would result in more accurate 
and timely estimations of OCC's clearing members' margin requirements.
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    \101\ See supra note 40.
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    Second, the proposal discussed above to amend OCC's margin 
methodology to require the use of daily updates for price data would 
allow for updates to the margin model's statistical parameters on a 
daily, instead of monthly, basis.\102\ Similarly, the proposal would 
also amend STANS to introduce other features that would improve the 
accuracy of its models and, consequently, produce risk exposure and 
margin requirement calculations that better reflect current market 
conditions. For example, the proposal would: (i) Amend STANS to account 
for the asymmetric volatility phenomenon observed in financial markets 
and allow for conditional volatility forecast to be more accurate and 
timely to market downturns;\103\ (ii) amend the statistical 
distribution for modeling equity price returns to more appropriately 
model fat tails and, consequently, more accurately model returns; (iii) 
introduce a second-day volatility forecast into the model to provide 
for more accurate and timely estimations of its two-day scenario 
distributions then currently provided by its one-day forecast variance; 
and (iv) amend STANS to impose a volatility floor using a 10-year look 
back period to reduce procyclicality in the margin model by capturing 
sufficient market events in its calculations. Accordingly, the 
Commission believes that the introduction of enhancements to improve 
the accuracy of the STANS margin models would enable OCC to more 
effectively calculate clearing members' margin requirements.
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    \102\ See supra note 40.
    \103\ See Notice, 82 FR at 61357.
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    Third, as described earlier, OCC proposes to enhance its approach 
to model correlation estimates by moving to a daily process for 
updating correlations and by de-volatizing the return series to 
estimate the correlations. This change is intended to lead to 
normalized returns across a variety of asset classes and make the 
correlation estimator less sensitive to sudden market jumps and 
therefore more stable. Accordingly, the Commission believes that 
updating the correlations daily and de-volatizing the return series to 
reduce the estimator's sensitivity to market jumps promotes more 
accurate and robust models within the STANS methodology.
    Finally, to enhance its methodology for estimating the defaulting 
securities in its model, OCC proposes to: (i) Modify the method for 
estimating the default variance to include only optionable equity 
securities; (ii) use a shorter time series of six months instead of two 
years to enable calibration of the model for all securities within OCC 
systems; and (iii) simulate return scenarios for defaulting securities 
assuming a default correlation with the driver RUT. Accordingly, the 
Commission believes these changes will mitigate the effect that 
extremely illiquid securities with discontinuous data can have on OCC's 
default estimates, while further decreasing the degree to which the 
default variance is subject to sudden jumps across volatile months.
    Taken together, the Commission believes that these proposals would 
improve the accuracy of OCC's credit exposure calculations and, 
consequently, OCC's calculations of its clearing members' margin 
requirements. Therefore, the Commission believes the changes proposed 
in the Advance Notice would promote robust risk management, consistent 
with Section 805(b) of the Act.\104\
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    \104\ 12 U.S.C. 5464(b).
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    The Commission further believes that the proposed changes would 
help promote safety and soundness, reduce systemic risk and support the 
stability of the broader financial system. As described above, the 
proposed changes are designed to better limit OCC's credit exposure to 
the clearing members in the event of a clearing member default. More 
specifically, the daily updates of the pricing data, the enhancements 
to the econometric model, and the enhancements to the correlation 
estimates promote more accurate and stable model measurements that have 
less volatility. Moreover, the enhancements to the defaulting 
securities methodology will decrease the manner in which the default 
estimates are affected by illiquid securities and reducing the amount 
to which the default variance is subject to sudden jumps.
    By better limiting credit exposure to its clearing members, OCC's 
proposed changes are designed to help ensure that, in the event of a 
clearing member default, OCC's operations would not be disrupted and 
that its SIFMU functions would therefore be able to continue in a safe 
and sound manner. Furthermore, the ongoing safe and sound functioning 
of OCC via an enhanced ability to determine margin requirements should 
help ensure that non-defaulting clearing members would not be exposed 
to losses that they cannot anticipate or control. As such, the 
Commission finds that the proposed changes are consistent with the 
promotion of safety and soundness, which in turn, would reduce systemic 
risks and support the stability of the broader financial system, 
consistent with Section 805(b) of the Act.\105\
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    \105\ Id.
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    Therefore, the Commission believes the changes proposed in the 
Advance Notice are consistent with Section 805(b) of the Act.\106\
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    \106\ Id.
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B. Consistency With Exchange Act Rule 17Ad-22(e)(6)

    The Commission believes that the changes proposed in the Advance

[[Page 24541]]

Notice are consistent with Rule 17Ad-22(e)(6) under the Exchange Act, 
which requires that OCC 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 is not 
readily available or reliable.\107\
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    \107\ 17 CFR 240.17AD-22(e)(6).
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    As described above, the proposal contained in the Advance Notice 
would make several amendments to OCC's margin methodology designed to 
improve how it: (i) Accounts for asymmetry in conditional variance; 
\108\ (ii) models the statistical distribution of price returns; \109\ 
(iii) models second-day volatility forecasts; \110\ (iv) estimates 
covariance and correlations between risk factors to provide for stable 
and sensitive correlation estimations; \111\ and (v) treats defaulting 
securities by reducing the impact that illiquid securities with 
discontinuous data have on default variance estimates.\112\
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    \108\ See Notice of Filing of Advance Notice, 82 FR at 61357.
    \109\ Id.
    \110\ Id.
    \111\ Id.
    \112\ See Notice of Filing of Advance Notice, 82 FR at 61357-
61358.
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    The Commission believes the modifications proposed are designed to 
improve the manner in which STANS would calculate daily margin 
requirements for OCC's clearing members. Consequently, the Commission 
believes that the proposal is designed both (i) to consider, and 
produce margin levels commensurate with, the risks and particular 
attributes of each relevant product, portfolio, and market \113\ and 
(ii) to calculate margin sufficient to cover OCC's potential future 
exposure to participants in the interval between the last margin 
collection and the close out of positions following a participant 
default.\114\ Additionally, as discussed in the Advance Notice,\115\ 
the proposal would introduce daily updates for price data for equity 
products. This data would be obtained from a reliable industry vendor. 
Consequently, the Commission believes that the proposal contained in 
the Advance Notice would help ensure that OCC's margin methodology 
would utilize a reliable source of timely price data, which would 
better reflect current market conditions than the current monthly 
updates, and thereby result in more accurate and responsive margin 
requirements.\116\ Consequently, the Commission finds that the proposal 
is consistent with Exchange Act Rule 17Ad-22(e)(6).
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    \113\ See 17 CFR 240.17Ad-22(e)(6)(i).
    \114\ See 17 CFR 240.17Ad-22(e)(6)(iii).
    \115\ See Notice, 82 FR at 61356.
    \116\ See 17 CFR 240.17Ad-22(e)(6)(iv).
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V. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Payment Supervision Act,\117\ that the Commission does not object to 
Advance Notice (SR-OCC-2017-811) and that OCC is authorized to 
implement the proposed change.
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    \117\ 12 U.S.C. 5465(e)(1)(G).

    By the Commission.
Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2018-11454 Filed 5-25-18; 8:45 am]
 BILLING CODE 8011-01-P


