[Federal Register Volume 84, Number 99 (Wednesday, May 22, 2019)]
[Notices]
[Pages 23620-23622]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-10640]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-85873; File No. SR-OCC-2019-002]


Self-Regulatory Organizations; The Options Clearing Corporation; 
Order Approving Proposed Rule Change Related to The Options Clearing 
Corporation's Margin Methodology for Volatility Index Futures

May 16, 2019.

I. Introduction

    On March 18, 2019, the Options Clearing Corporation (``OCC'') filed 
with the Securities and Exchange Commission (``Commission'') the 
proposed rule change SR-OCC-2019-002 (``Proposed Rule Change'') 
pursuant to Section 19(b) of the Securities Exchange Act of 1934 
(``Exchange Act'') \1\ and Rule 19b-4 \2\ thereunder to propose changes 
to OCC's margin methodology for futures on indices designed to measure 
volatilities implied by prices of options on a particular underlying 
interest (such indexes being ``Volatility Indexes'' and futures 
contracts on such Volatility Indexes being ``Volatility Index 
Futures.'').\3\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Notice of Filing infra note 4, at 84 FR 13082.
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    The Proposed Rule Change was published for public comment in the 
Federal Register on April 3, 2019,\4\ and the Commission received no 
comments regarding the Proposed Rule Change. This order approves the 
Proposed Rule Change.
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    \4\ Securities Exchange Act Release No. 85440 (Mar. 28, 2019), 
84 FR 13082 (Apr. 3, 2019) (SR-OCC-2019-002) (``Notice of Filing''). 
OCC also filed a related advance notice (SR-OCC-2019-801) (``Advance 
Notice'') with the Commission pursuant to Section 806(e)(1) of Title 
VIII of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act, entitled the Payment, Clearing, and Settlement Supervision Act 
of 2010 and Rule 19b-4(n)(1)(i) under the Act. 12 U.S.C. 5465(e)(1). 
15 U.S.C. 78s(b)(1) and 17 CFR 240.19b-4, respectively. The Advance 
Notice was published in the Federal Register on April 23, 2019. 
Securities Exchange Act Release No. 85670 (Apr. 17, 2019), 84 FR 
16915 (Ap. 23, 2019) (SR-OCC-2019-801).
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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.\5\ The STANS 
methodology measures the exposure of portfolios containing options, 
futures, and cash instruments.
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    \5\ See Notice of Filing, 84 FR at 13083.
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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'').\6\ OCC clears futures contracts

[[Page 23621]]

on Volatility Indexes (``Volatility Index Futures''). 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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    \6\ 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 13083, n. 10.
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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.\7\ 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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    \7\ 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 Proposed Rule Change 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.\8\ According to OCC, its current model was developed before 
sufficient data on Volatility Index Futures was available for the 
construction of synthetic futures.\9\ OCC also represented that, in 
recent years, it has seen significant growth in trading volume for 
Volatility Index Futures.\10\ 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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    \8\ 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.
    \9\ See Notice, 84 FR at 13084.
    \10\ 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 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.\11\ 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.\12\
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    \11\ See Notice, 84 FR at 13085.
    \12\ 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.\13\ 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.\14\
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    \13\ See id.
    \14\ 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.\15\
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    \15\ See id.
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III. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Exchange Act directs the Commission to 
approve a proposed rule change of a self-regulatory organization if it 
finds that such proposed rule change is consistent with the 
requirements of the Exchange Act and the rules and regulations 
thereunder applicable to such organization.\16\ After carefully 
considering the Proposed Rule Change, the Commission finds the proposal 
is consistent with the requirements of the Exchange Act and the rules 
and regulations thereunder applicable to

[[Page 23622]]

OCC. More specifically, the Commission finds that the proposal is 
consistent with Section 17A(b)(3)(F) of the Exchange Act \17\ and Rule 
17Ad-22(e)(6)(i) thereunder.\18\
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    \16\ 15 U.S.C. 78s(b)(2)(C).
    \17\ 15 U.S.C. 78q-1(b)(3)(F).
    \18\ 17 CFR 240.17Ad-22(e)(6)(i).
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A. Consistency With Section 17A(b)(3)(F) of the Exchange Act

    Section 17A(b)(3)(F) of the Exchange Act requires that the rules of 
a clearing agency be designed to, among other things, assure the 
safeguarding of securities and funds which are in the custody or 
control of the clearing agency or for which it is responsible.\19\ 
Based on its review of the record, the Commission believes that the 
proposed changes are designed to assure the safeguarding of securities 
and funds which are in OCC's custody or control for the reasons set 
forth below.
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    \19\ 15 U.S.C. 78q-1(b)(3)(F).
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    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 
underlying Volatility Indexes. By contrast, synthetic futures, like 
those proposed by OCC, can be used to generate a continuous time series 
of prices for each futures contract 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 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. The 
Commission believes that rules designed to set margin requirements that 
respond more appropriately to market volatility would support OCC's 
ability to determine the amount of collateral it must collect to manage 
potential credit losses that could arise out of a Clearing Member's 
default during normal market conditions. Further, the Commission 
believes that the effective management of potential credit losses that 
could arise out of a Clearing Member default would support the 
safeguarding of the securities and funds of non-defaulting Clearing 
Members within OCC's control. Accordingly, and for the reasons stated 
above, the Commission believes that the Proposed Rule Change is 
consistent with Section 17A(b)(3)(F) of the Exchange Act.\20\
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    \20\ Id.
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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.\21\
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    \21\ 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).\22\
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    \22\ Id.
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IV. Conclusion

    On the basis of the foregoing, the Commission finds that the 
Proposed Rule Change is consistent with the requirements of the 
Exchange Act, and in particular, the requirements of Section 17A of the 
Exchange Act \23\ and the rules and regulations thereunder.
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    \23\ In approving this Proposed Rule Change, the Commission has 
considered the proposed rules' impact on efficiency, competition, 
and capital formation. See 15 U.S.C. 78c(f).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\24\ that the Proposed Rule Change (SR-OCC-2019-002) be, 
and hereby is, approved.
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    \24\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\25\
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    \25\ 17 CFR 200.30-3(a)(12).
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Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-10640 Filed 5-21-19; 8:45 am]
 BILLING CODE 8011-01-P


