[Federal Register Volume 84, Number 98 (Tuesday, May 21, 2019)]
[Notices]
[Pages 23096-23098]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-10523]



[[Page 23096]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-85870; File No. SR-OCC-2019-801]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Notice of No Objection to Advance Notice Related to The Options 
Clearing Corporation's Margin Methodology for Volatility Index Futures

May 15, 2019.

I. Introduction

    On March 18, 2019, the Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') advance 
notice SR-OCC-2019-801 (``Advance Notice'') 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) \2\ under the Securities Exchange Act of 1934 
(``Exchange Act'') \3\ to propose changes to OCC's margin methodology 
for futures on indexes designed to measure volatilities implied by 
prices of options on a particular underlying interest.\4\
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    \1\ 12 U.S.C. 5465(e)(1).
    \2\ 17 CFR 240.19b-4(n)(1)(i).
    \3\ 15 U.S.C. 78a et seq.
    \4\ See Notice of Filing infra note 5, at 84 FR 16915.
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    The Advance Notice was published for public comment in the Federal 
Register on April 23, 2019,\5\ and the Commission has not received 
comments regarding the proposal contained in the Advance Notice.\6\ 
This publication serves as notice of no objection to the Advance 
Notice.
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    \5\ Securities Exchange Act Release No. 85670 (April 17, 2019), 
84 FR 16915 (April 23, 2019) (SR-OCC-2019-801) (``Notice of 
Filing''). On March 18, 2019, OCC also filed a related proposed rule 
change (SR-OCC-2019-002) with the Commission pursuant to Section 
19(b)(1) of the Exchange Act and Rule 19b-4 thereunder, seeking 
approval of changes to its rules necessary to implement 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 April 3, 2019. Securities Exchange Act 
Release No. 85440 (Mar. 28, 2019), 84 FR 13082 (Apr. 3, 2019) (SR-
OCC-2019-002).
    \6\ 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

    The System for Theoretical Analysis and Numerical Simulations 
(``STANS'') is OCC's methodology for calculating Clearing Member margin 
requirements. STANS includes econometric models to forecast price and 
volatility movements in determining Clearing Member margin 
requirements, which are calculated at the portfolio level of Clearing 
Member accounts with positions in marginable securities.\7\ The STANS 
methodology measures the exposure of portfolios containing options, 
futures, and cash instruments.
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    \7\ See Notice of Filing, 84 FR at 16915.
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    Certain indices are designed to measure the volatility implied by 
the prices of options on a particular reference index or asset 
(``Volatility Indexes'').\8\ OCC clears futures contracts on Volatility 
Indexes (``Volatility Index Futures'').\9\ Currently, OCC models the 
future settlement prices of Volatility Index Futures in STANS based on 
the index underlying the futures contract. In this modeling process, 
OCC assumes that the values of the underlying index follow a long-term 
stable process, notwithstanding any short-term fluctuations. On a daily 
basis, OCC recalibrates the distribution that defines this process so 
that the expected final settlement prices of the Volatility Index 
Futures match the then currently-observed market prices.
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    \8\ For example, the Cboe Volatility Index (``VIX'') is designed 
to measure the 30-day expected volatility of the Standard & Poor's 
500 index (``SPX''). 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 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. See Notice, 84 FR at 16916, n. 10.
    \9\ A designated clearing agency, such as OCC, is required to 
provide advance notice to the Commission of any proposed change to 
its rules, procedures, or operations that could materially affect 
the nature or level of risks presented by such designated clearing 
agency. 12 U.S.C. 5465(e)(1); see also 17 CFR 204.19b-4(n)(1)(i). 
Further, Rule 19b-4(n) states that such changes may include changes 
that materially affect, among other things, risk management or 
financial resources. 17 CFR 204.19b-4(n)(2)(ii). The Advance Notice 
relates to Volatility Index Futures, such as futures on the VIX or 
VIX-like indices. Such futures, and options on those futures, 
comprise a material portion of the contracts that OCC clears and 
settles, and, as such, account for a material portion of the risk 
that OCC manages. The Advance Notice concerns changes to the way OCC 
risk manages exposures based on Volatility Index Futures and the 
financial resources available to OCC to manage the default of a 
Clearing Member engaged in trading Volatility Index Futures.
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    OCC's current methodology for modeling future settlement prices of 
Volatility Index Futures is subject to certain limitations because the 
model is based on the Volatility Indexes underlying the relevant 
futures contracts. First, Volatility Indexes cannot be invested in and, 
therefore, cannot be replicated by static portfolios of traded 
contracts. Second, the term structure of the futures market cannot be 
modeled using just the underlying Volatility Indexes.\10\ Finally, 
because of the term structure of the futures market, futures on a 
volatility index are less volatile and may have a lower probability of 
extreme price movements than the underlying index itself. Additionally, 
due to the limitations of modeling the term structure, the current 
model may under-margin positions in certain strategies that Clearing 
Members may deploy that involve spreads between delivery dates.
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    \10\ Similar to a stock index (e.g., SPX), a Volatility Index 
does not have an expiration. By contrast, there may be a variety of 
futures contracts with varying expiry dates on any one Volatility 
Index. For example, the VIX does not have an expiration date, but 
market participants may trade VIX futures that expire on different 
dates.
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    The Advance Notice includes changes that OCC believes would address 
the limitations described above. The construction of and reliance on 
``synthetic'' futures is essential to the changes that OCC 
proposes.\11\ According to OCC, its current model was developed before 
sufficient data on Volatility Index Futures was available for the 
construction of synthetic futures.\12\ OCC also represented that, in 
recent years, it has seen significant growth in trading volume for 
Volatility Index Futures.\13\ As described in more detail below, OCC 
proposes to: (1) Estimate future settlement prices based on synthetic 
futures rather than the Volatility Indexes underlying Volatility Index 
Futures; (2) modify the statistical distribution that OCC uses to model 
price returns of the synthetic futures; and (3) introduce an anti-
procyclical floor to reduce the potential for sudden increases in 
margin requirements that could result from corrections in abnormally 
low levels of volatility.
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    \11\ A ``synthetic'' futures time series refers to a uniform 
substitute for a time series of daily settlement prices for actual 
futures contracts. Such a time series would be based on the 
historical returns of futures contracts with approximately the same 
tenor.
    \12\ See Notice, 84 FR at 16916.
    \13\ See id.
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(1) Daily Re-Estimation of Prices Using ``Synthetic'' Futures

    OCC proposes to modify the way it estimates future settlement 
prices for Volatility Index Futures. OCC currently models future 
settlement prices based

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on the index underlying the futures contract. OCC proposes to model the 
distribution of future settlement prices based on synthetic futures. 
Such synthetic futures would be based on the historical returns of 
futures contracts with approximately the same tenor. For any one 
underlying interest, there may be a variety of futures contracts with 
varying expiry dates. As a result of this variety of contracts and 
maturities, there is no single, continuous times series for the various 
futures that reference a given underlying interest. Synthetic futures, 
however, can be used to generate a continuous time series of prices for 
each futures contract across multiple expirations.
    OCC proposes to use the price return histories of synthetic futures 
in its daily price simulation process alongside the underlying 
interests of OCC's other cleared and cross-margin products and 
collateral. OCC believes that the use of synthetic futures would allow 
OCC's margin system to better approximate correlations between futures 
contracts of different tenors by creating more price data points and 
margin offsets.
    OCC proposes to update the historical synthetic time series for 
Volatility Indexes daily. OCC would then map this time series to the 
corresponding futures contracts. Following the expiration date of the 
front contract (i.e., the futures contract with the earliest expiration 
date), each contract within a time series would be replaced with a 
contract maturing one month later. While synthetic time series contain 
returns from different contracts, a return on any given date would be 
constructed from prices of a single contract. OCC would estimate the 
distribution parameters for synthetic time series daily using recent 
historical observations. OCC believes that daily re-estimation of 
prices using synthetic futures instead of the current process, which is 
based solely on the underlying Volatility Indexes, would allow OCC's 
model for Volatility Index Futures to more accurately reflect current 
market conditions and achieve better margin coverage across the term 
curve.\14\ Thus, OCC believes the proposed changes would result in 
margin requirements that respond more appropriately to changes in 
market volatility and therefore are more accurate for Clearing 
Members.\15\
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    \14\ See Notice, 84 FR at 16917.
    \15\ See id.
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(2) Statistical Distribution for Modeling Price Returns

    OCC proposes to modify the statistical distribution it uses to 
model price returns of synthetic futures. The model that OCC currently 
uses for modeling price returns across its margin system, including for 
Volatility Index Futures, assumes a symmetric distribution of returns. 
OCC believes, however, that an asymmetric distribution would better fit 
the historical data underlying synthetic futures.\16\ OCC also believes 
that employing an asymmetric distribution for modeling price returns of 
synthetic futures would provide a more consistent framework for 
treatment of returns on both the upside and downside of the 
distribution.\17\
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    \16\ See id.
    \17\ See id.
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(3) Anti-Procyclical Floor

    OCC proposes to introduce a new floor for variance estimates of the 
Volatility Index Futures. OCC would calculate this variance floor based 
on the Volatility Indexes underlying the Volatility Index Futures. As 
noted above, OCC assumes that the values of the underlying index follow 
a long-term stable process, notwithstanding any short-term 
fluctuations. OCC anticipates that such a floor would prevent sudden 
increases in margin requirements that would otherwise result from the 
normalization of volatility from abnormally low levels.\18\
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    \18\ See Notice, 84 FR at 16918.
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III. Discussion and Commission Findings

    Although the Clearing Supervision Act does not specify a standard 
of review for an advance notice, the stated purpose of the Clearing 
Supervision 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 systemically 
important financial market utilities (``SIFMUs'') and strengthening the 
liquidity of SIFMUs.\19\
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    \19\ See 12 U.S.C. 5461(b).
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    Section 805(a)(2) of the Clearing Supervision Act 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.\20\ Section 805(b) of the 
Clearing Supervision Act provides the following objectives and 
principles for the Commission's risk management standards prescribed 
under Section 805(a): \21\
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    \20\ 12 U.S.C. 5464(a)(2).
    \21\ 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.
    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 other areas.\22\
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    \22\ 12 U.S.C. 5464(c).
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    The Commission has adopted risk management standards under Section 
805(a)(2) of the Clearing Supervision Act and Section 17A of the 
Exchange Act (the ``Clearing Agency Rules'').\23\ 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 its operations and risk-management practices on an 
ongoing basis.\24\ As such, it is appropriate for the Commission to 
review advance notices against the Clearing Agency Rules and the 
objectives and principles of these risk management standards as 
described in Section 805(b) of the Clearing Supervision Act. As 
discussed below, the Commission believes the proposal in the Advance 
Notice is consistent with the objectives and principles described in 
Section 805(b) of the Clearing Supervision Act,\25\ and in the Clearing 
Agency Rules, in particular Rule 17Ad-22(e)(6)(i).\26\
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    \23\ 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. OCC is a ``covered clearing 
agency'' as defined in Rule 17Ad-22(a)(5).
    \24\ 17 CFR 240.17Ad-22(e).
    \25\ 12 U.S.C. 5464(b).
    \26\ 17 CFR 240.17Ad-22(e)(6)(i).
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A. Consistency With Section 805(b) of the Clearing Supervision Act

    The Commission believes that the Advance Notice is consistent with 
the stated objectives and principles of Section 805(b) of the Clearing 
Supervision Act. OCC manages its credit exposure to Clearing Members, 
in part, through the collection of collateral based on OCC's margin 
methodology. As noted above, OCC's current process for setting margin 
requirements to collateralize risks posed by Volatility Index Futures 
is limited because the model is based on the Volatility Indexes 
underlying the relevant futures contracts. These limitations relate, in 
part, to the term structure of the futures market, which is not an 
attribute of the

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underlying Volatility Indexes. By contrast, synthetic futures, like 
those proposed by OCC, can be used to generate a continuous time series 
of futures contract prices across multiple expirations. Additionally, 
OCC proposes to modify the statistical distribution that it uses to 
model price returns of synthetic futures such that the resulting curve 
would better fit the historical data. Finally, OCC proposes to reduce 
the potential for sudden margin increases resulting from market 
corrections of abnormally low volatility levels through the 
implementation of a floor on variance estimates for Volatility Index 
Futures. The Commission believes that OCC's proposal to use synthetic 
futures to model Volatility Index Futures contracts, taken together 
with modification of the relevant statistical distribution and 
inclusion of a variance floor, is consistent with the promotion of 
robust risk management because it is designed to address a known 
limitation of OCC's current models--namely an inability to account for 
the term structure of Volatility Index Futures--and produce margin 
requirements that respond more appropriately to market volatility.
    Similarly, these changes are consistent with the promotion of 
safety and soundness and the reduction of systemic risk because they 
are designed to increase the accuracy of OCC's margin requirements 
while avoiding sudden shocks to OCC's Clearing Members. Finally, the 
inclusion of a variance floor designed to reduce the likelihood of 
sudden margin increases resulting from expected corrections in market 
volatility is consistent with supporting the stability of the broader 
financial system.
    Accordingly, and for the reasons stated, the Commission believes 
the changes proposed in the Advance Notice are consistent with Section 
805(b) of the Clearing Supervision Act.\27\
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    \27\ 12 U.S.C. 5464(b).
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B. Consistency With Rule 17Ad-22(e)(6)(i) Under the Exchange Act

    Rule 17Ad-22(e)(6)(i) under the Exchange Act requires that a 
covered clearing agency establish, implement, maintain, and enforce 
written policies and procedures reasonably designed to cover, if the 
covered clearing agency provides central counterparty services, its 
credit exposures to its participants by establishing a risk-based 
margin system that, at a minimum, considers, and produces margin levels 
commensurate with, the risks and particular attributes of each relevant 
product, portfolio, and market.\28\
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    \28\ 17 CFR 240.17Ad-22(e)(6)(i).
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    OCC proposes to base its estimation of final settlement prices for 
Volatility Index Futures on synthetic futures rather than the 
Volatility Indexes underlying Volatility Index Futures. As described 
above, a margin process based on synthetic futures, as opposed to an 
underlying index, could more accurately model future price movements 
for Volatility Index Futures because the synthetic futures can be used 
to generate a continuous time series of futures contract prices across 
multiple expirations, while the underlying index alone is insufficient 
to model the term structure of the futures market. OCC further proposes 
to adjust the econometric model that it would use to estimate final 
settlement prices by applying a distribution that better fits 
observable data of the Volatility Index Futures. Finally, OCC's 
proposal includes a variance estimate floor to avoid sudden margin 
increases where the immediate volatility of the Volatility Index 
Futures deviates significantly from the long-run volatility of the 
underlying index. The Commission believes, therefore, that OCC's 
proposal is designed to better account for the term structure of 
futures contracts, align margin requirements with observable data, and 
incorporate historical volatility data, thereby producing margin levels 
commensurate with the particular attributes of Volatility Index 
Futures. Further, the Commission believes the proposed changes could 
result in margin requirements that respond more appropriately to 
changes in market volatility.
    Accordingly, based on the foregoing, the Commission believes that 
the proposed change to OCC's margin methodology for Volatility Index 
Futures is consistent with Exchange Act Rule 17Ad-22(e)(6)(i).\29\
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    \29\ Id.
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IV. Conclusion

    It is therefore noticed, pursuant to Section 806(e)(1)(I) of the 
Clearing Supervision Act, that the Commission does not object to the 
Advance Notice (SR-OCC-2019-801) and that OCC is authorized to 
implement the proposed change as of the date of this notice or the date 
of an order by the Commission approving proposed rule change SR-OCC-
2019-002, whichever is later.

    By the Commission.
Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-10523 Filed 5-20-19; 8:45 am]
 BILLING CODE 8011-01-P


