The Options Clearing Corporation
One North Wacker Drive, Suite 600, Chicago, Illinois 60606
William H. Navin
Executive Vice President and General Counsel
Tel: 312.322.1817 Fax: 312.322.1836
October 23, 2002
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: S7-34-02, Rule 15c3-3a Reserve Requirements for Margin Related to Security Futures Products
Dear Mr. Katz:
The Options Clearing Corporation ("OCC") submits this letter to comment on the above-captioned proposed rulemaking by the Commission. The Commission has proposed amendments to the formula for determining the customer reserve requirements of broker-dealers under the Securities Exchange Act of 1934 (the "Exchange Act"). The proposed amendments would permit a broker-dealer to treat margin related to security futures products ("SFPs") purchased or sold in customer securities accounts that is required and on deposit with a clearing organization as a "debit item" in calculating its reserve requirement under the formula in Rule 15c3-3a. The effect of permitting such a debit is to reduce the amount that the broker-dealer is required to set aside in the "special bank account for the exclusive benefit of customers" under Rule 15c3-3(e). The debit is appropriate because the funds held by the clearing organization represent funds already set aside by the broker to satisfy customer claims, and a similar debit is provided for options margin on deposit at OCC.1
While OCC supports the Commission's determination to provide such a debit, OCC strongly objects to the requirements that would be imposed under the present proposal as a condition to the availability of the debit. One of these requirements would have what we assume to be the wholly unintended consequence of making the debit unavailable for margin deposited with a registered clearing agency that complies with the Commission's registration standard limiting permissible uses of clearing fund deposits. Another would have the effect of forcing fundamental changes in the handling of customer funds and securities by OCC, its clearing members, and their custodians, and would substantially reduce the efficiency of the clearing process for options as well as SFPs. Other requirements are less seriously or immediately harmful, but are nevertheless inappropriate, unnecessary and potentially harmful as applied to a registered clearing agency. Although some or all of these requirements may be appropriate as applied to a clearing organization not subject to the Commission's regulation, none of them are necessary or appropriate as applied to OCC.
As currently in effect, Item 13 of the reserve formula in Rule 15c3-3a allows a broker-dealer to take a debit (i.e., to reduce its reserve requirement) in the amount of "[m]argin required and on deposit with The Options Clearing Corporation for all option contracts written or purchased in customer accounts."2 It would be simple enough to amend Item 13 to cover SFP margin on the same terms as options margin. Indeed, we suspect that is exactly what the Commission would have proposed, had it not been forced to address another issue unique to SFPs.
As noted in the Commission's release, the Commodity Futures Modernization Act (the "CFMA") created a regulatory framework for the trading of security futures products ("SFPs"), including single stock and narrow-based index futures and options on such futures. Under that framework, SFPs would be jointly regulated by the Commission and the Commodity Futures Trading Commission (the "CFTC"). The CFMA permits SFPs to be cleared by either a registered clearing agency (a "Clearing Agency") regulated by the Commission under Section 17A of the Exchange Act, or by a derivatives clearing organization (a "DCO") registered under Section 5b of the Commodity Exchange Act (the "CEA") and regulated by the CFTC. 3
Under the joint regulatory structure, transactions in security futures may be effected by a broker-dealer for the securities accounts of its customers whether the transactions are cleared by a Clearing Agency or a DCO. Thus, the Commission staff has had to consider whether and under what circumstances SFP margin on deposit at a DCO that is not also a Clearing Agency should be entitled to a debit in the reserve formula.
OCC's Objections to the Commission's Proposal
The Commission's proposal would permit an identical debit for SFP margin deposited with either a Clearing Agency or a DCO. However, the SFP debit is subject to several additional conditions not applicable to the options margin debit. The apparent reason for these additional conditions is to provide the Commission with some assurance as to the safety of margin deposits held by DCOs not regulated by the Commission. But rather than limit the application of the conditions to DCOs, the Commission also proposes to impose these conditions on OCC as a condition to providing a reserve formula debit for SFP margin held at OCC but not as a condition to providing such a debit for options margin.4 There is no rational basis for such an inconsistency.
The Commission's proposed amendment to Rule 15c3-3a would permit a broker-dealer to include its SFP customer clearing margin deposit as a debit item subject to four specific conditions identified in paragraphs 2(a) through 2(d) of Note G to proposed Item 14. Paragraphs 2(a) through 2(c) are wholly inappropriate as applied to OCC.5 Subparagraph 2(a)(ii) sets forth an alternative financial test that OCC, which is one of the largest and most respected clearing organizations in the world, would not meet and in part could not meet without violating the Commission's clearing agency registration standards. Paragraph (b) would require OCC to fundamentally change the way in which OCC and its clearing members handle margin deposits and would substantially reduce the efficiency of the clearing process. Subparagraph (c)(ii) also contains a requirement that OCC would not currently meet and that is inconsistent with industry standards. The remaining provisions of paragraph (c), while innocuous, are also completely unnecessary as applied to a Clearing Agency.
Paragraph (2)(a) of Note G to proposed Item 14 provides that a Clearing Agency or DCO must either (i) maintain the highest investment-grade rating from a nationally recognized statistical rating organizations or (ii) have security deposits from clearing members in connection with regulated options or futures transactions of at least $500 million and retain assessment power over member firms of at least $1.5 million. There are a number of things wrong with this test.
While OCC currently has a "AAA" counterparty credit rating from Standard & Poor's Corporation and therefore meets the first prong of this test, maintenance of this credit rating is to some degree outside OCC's control. Moreover, OCC operated successfully and safely for many years without such a rating; many other sound clearing organizations (including the Clearing Division of the CME) do not have such a rating; and we do not believe that it is appropriate for the current proposal to be conditioned on such a rating. Although the rule includes an alternative test, that test is also unsatisfactory. While it is not clear from the text of the rule itself, the release makes clear that the term "security deposits from clearing members" refers to deposits that the clearing organization "may use . . . to secure its general obligations to creditors." Not only would this exclude "margin" or "performance bond" deposits; it would also exclude OCC's clearing fund, which can only be used to meet specified clearing-related obligations, and not OCC's "general obligations to creditors."6 We are sure that this was not the intent, but it is nevertheless the effect.
Furthermore, although OCC currently maintains a clearing fund that substantially exceeds the $500 million test, OCC has filed a rule change for Commission approval that would change the manner in which its clearing fund is calculated in order to bring the fund to a level that better approximates OCC's true risk.7 OCC anticipates that the proposed rule change, if approved, would under current market conditions result in a significant reduction in the size of the clearing fund. As may be seen from the table in footnote 7, there is no proposed $500 million minimum, and the size of the fund would be related to risk margin, which is in turn affected by a number of factors including overall open interest and can vary substantially over time.8 Thus it is conceivable that OCC's clearing fund under the new formula could fall below $500 million. If that were to occur, it would not reflect any reduction in OCC's creditworthiness, but would instead reflect a reduction in the size of the potential obligations that the clearing fund might be called upon to satisfy. Nevertheless, it would prevent OCC from satisfying Paragraph 2(b) even if OCC's clearing fund otherwise qualified as an acceptable "security deposit." 9
Equally troubling from our perspective is the requirement that a Clearing Agency "retains assessment power over member firms of at least $1.5 billion." Although once again not clear on the face of proposed Note G, we infer from the text of the release that this is intended to be an additional $1.5 billion over and above the amount held in the clearing fund. Also, we assume by "assessment power" that the Commission means the legal right to compel clearing members in the aggregate to deposit that amount. If these interpretations of proposed Note G are correct, OCC would not meet that standard today.
If a clearing member failure or other specified event results in a charge against OCC's clearing fund, each clearing member has an obligation under Section 6 of Article VIII of OCC's By-Laws, to contribute its pro rata share of the charge up to an amount not to exceed 100% of its existing clearing fund requirement. Based on the current size of OCC's clearing fund, the maximum aggregate additional contribution that OCC could compel clearing members to make would be less than $1.5 billion.10 Although OCC can levy additional assessments greater than 100% of each clearing member's existing requirement, it does not have the legal right to compel any clearing member to meet that demand if the clearing member chooses instead to terminate its membership, close out its positions, and cease its clearing activity. We assume that this ability to make a call for additional funds that is not legally enforceable is not what the Commission meant by "assessment power."
Because the Commission's proposal as written would impose separate requirements for a clearing organization's basic "security deposit" and its assessment power, a clearing organization with a $500 million clearing fund and $1.5 billion of assessment power would meet the standard, but a clearing organization with a $10 billion clearing fund and no assessment power would not. Or, as with OCC, a clearing organization with a $1.2 billion clearing fund and $1.2 billion of assessment power would not meet the standard. We do not believe that this was the Commission's intent.
Our comment is not merely that the particular standards set forth in proposed Note G are wrong and should be modified. Our more fundamental comment is that we do not believe that there is any reason to require a Clearing Agency subject to the full regulatory authority of the Commission to meet additional or different standards in order to be deemed a sufficiently sound repository for customer margin deposits related to SFP transactions. Surely any Clearing Agency that the Commission has found to meet the standards for continued registration under Section 17A of the Exchange Act, and whose rules have been approved by the Commission under Section 19 of the Exchange Act, must be sufficiently creditworthy to hold a deposit of customer funds. Otherwise, it should not be permitted to do business as a Clearing Agency at all. Note G of the reserve formula is not the appropriate place to set minimum financial requirements for a Clearing Agency that is comprehensively regulated by the Commission.
The proposed requirement is even more peculiar when one considers that the stated purpose of the rule amendment is to permit a debit in the reserve formula only for margin deposits related to SFPs. There is surely nothing about clearing SFPs that would justify the imposition of these new financial requirements on a Clearing Agency. The reason for imposing the new financial requirements is presumably to give the Commission some assurance as to the creditworthiness of a DCO that would be holding funds of securities customers but which is not subject to the Commission's regulatory oversight. If the Commission is not comfortable in simply relying upon the regulatory oversight of the CFTC to ensure the creditworthiness of any such DCO, then that would be a reason to impose minimum requirements with respect to DCOs under Note G. It would not be a reason, however, to impose new requirements on a Clearing Agency that is already fully regulated by the Commission. Neither fairness nor safety and soundness considerations require the Commission to provide identical treatment for an entity that is already subject to extensive regulation by the Commission and one that is not. They are obviously not similarly situated in the most relevant respect.
Moreover, these requirements would as a practical matter discriminate against Clearing Agencies. By imposing requirements that today can only be met by one or two DCOs, and not by OCC (in part because of OCC's compliance with the Commission's own clearing agency registration requirements), the Commission would in practical effect be allowing a reserve formula debit only for customer margin deposited with DCOs that the Commission does not regulate, and not with an established Clearing Agency that the Commission does regulate. We recognize that this was not the intent of the Commission or its staff, and that the clearing fund requirement in Note G could be modified to conform it to the use restrictions in Section 17A noted above. Our point is to emphasize the risks of including in the reserve formula additional and potentially conflicting standards for a Clearing Agency that is already subject to extensive regulation under other provisions of the Exchange Act and regulations thereunder.
Paragraph 2(b) of Note G to Item 14 provides, as a further condition to the availability of the debit, that a DCO or Clearing Agency must deposit "customer margin in a bank account separate from other margin deposits of clearing members, and must require the bank to provide a written acknowledgement that the property in the account is held free of any lien of the bank or person claiming through the bank." As applied to OCC at least, this is an entirely new requirement that would require OCC to make very substantial changes in the way that it handles clearing member margin deposits for non-futures accounts.11 Those changes would not enhance customer protection and would impose substantial additional costs on OCC's clearing members, their custodians, and ultimately the customers who trade listed options. They would also exacerbate an awkward and inefficient mismatch between the way OCC is required to treat customer funds and the way all other Clearing Agencies treat such funds.
OCC does not presently maintain separate deposit accounts or custody accounts for margin collateral deposited by its clearing members in respect of different account types.12 Pursuant to Article VI, Section 3 of its By-Laws, OCC, unlike other Clearing Agencies, requires clearing members to maintain separate accounts on OCC's books for customer, firm and market-maker business.13 OCC presently calculates a separate margin requirement for each of these accounts. When a clearing member deposits margin with OCC, it is required to specify the account for which the margin is being deposited. The same is true of withdrawals. However, all cash deposited as collateral with respect to all account types of all clearing members (other than segregated futures accounts and cross-margining accounts) is commingled by OCC in deposit accounts at OCC's settlement banks. Similarly, securities pledged to OCC as margin with respect to all account types are commingled at The Depository Trust Company ("DTC") or in the pledgor's bank custody account (in the case of government securities). None of these accounts are segregated as between customer and proprietary assets. In the case of assets deposited in respect of the segregated futures accounts provided for in Section 3(f) of Article VI of the By-Laws, OCC and its clearing members will, of course, maintain separate deposit and custody accounts as required under Section 4d(2) of the CEA. But the customer protection regime provided for in the CEA, which is based upon "segregation in gross" of customer funds, is different in concept from the customer protection regime developed by the Commission under Section 15 of the Exchange Act, which is based primarily upon a net segregation requirement represented by the reserve formula of Rule 15c3-3a. In the case of OCC, the Commission's present proposal would impose the requirements of both customer protection schemes simultaneously, which is both unnecessary and quite unworkable for OCC.
Although proposed new Item 14 of the reserve formula, and therefore the provisions of Note G, would apply only to margin deposited in respect of SFPs, OCC does not calculate separate margin requirements on a product-by-product basis. OCC has been a pioneer in the development of risk-based margining techniques that determine margin requirements based upon the net risk of a portfolio of positions in options and other securities and derivative products. As a result, OCC will not determine a separate margin requirement for SFPs, and it will not be possible for clearing members to distinguish the customer margin deposited in respect of SFPs from that deposited in respect of options.
Furthermore, even if it were possible to separately identify customer SFP margin, OCC could not maintain SFP customer margin collateral separate from SFP proprietary margin collateral unless OCC restructured its system of deposit accounts and clearing members restructured their DTC and bank custody accounts to segregate customer from proprietary assets. This would require establishing numerous additional bank accounts and custody accounts (and incurring the continuing costs of maintaining those accounts) and would burden OCC and its clearing members with the need to process transfers of funds and securities among those accounts as often as daily, all to no good purpose, given that customer property held by OCC as margin is already adequately protected by Rule 15c3-3.
Fidelity Bond Coverage
Paragraph (2)(c)(ii) of Note G requires that a Clearing Agency or DCO must maintain fidelity bond coverage of its employees and agents. Although OCC maintains fidelity bond coverage for employees, it does not have coverage that would apply to non-employee agents, other than contract employees and outside counsel. OCC has been advised by its insurance agent that such coverage is not readily available. Many people and entities may act as agents of OCC from time to time for specified purposes. The need to protect against potential defalcation in these agents' obligations to OCC, and the most appropriate means of protection, are better addressed on a case-by-case basis in light of the particular services rendered.
Special Issue for SFPs Traded on OneChicago
As we understand it, the underlying purpose of the Commission's proposal is to make it feasible for broker-dealers that are members of DCOs to carry customer SFP positions with DCOs in securities accounts rather than futures accounts. However, in the case of SFPs traded on OneChicago, certain positions carried by CME members with CME (i.e., those resulting from trades where one side cleared through CME and the other through OCC) will in turn be carried by CME with OCC under an associate clearinghouse relationship.14 Other positions (i.e., those resulting from trades where both sides cleared through CME) will be carried only with CME. OCC's associate clearinghouse agreement with CME allows CME to maintain only two accounts with OCC: a proprietary account and a segregated futures account. If broker-dealer A were to carry positions in OneChicago SFPs with CME in a securities account, and FCM B were to carry such positions with CME in a futures account, the only OCC account in which CME could carry A's or B's positions would be CME's segregated futures account, where the positions would necessarily be commingled. Before permitting broker-dealers to carry positions in OneChicago futures with CME in a securities account, the Commission would need to determine whether such commingling is permissible under Rule 15c3-3.15 In addition, if options on security futures are later traded subject to these arrangements, it will presumably be necessary to carry long option positions in an account where they can be treated as "fully-paid" or "excess margin" securities for purposes of Rule 15c3-3, for which there are no provisions in the existing CME accounts at OCC.16
The Release gives no explanation or justification for indirectly imposing on Clearing Agencies, which are already fully and comprehensively regulated by the Commission, a set of new regulatory requirements that can only be met, as a practical matter, by DCOs that are not registered as Clearing Agencies. OCC strongly urges the Commission to make paragraphs 2(a) through (c) of Note G applicable only to DCOs that are not also Clearing Agencies.
We would be pleased to discuss any of these issues with you further. Please feel free to contact me at (312) 322-1817 or Andy Naughton at (312) 322-2007.
/s/ William H. Navin
William H. Navin
cc: Michael Macchiaroli, SEC
Jerry Carpenter, SEC
|1|| See Item 13 of Rule 15c3-3a.
|2 ||Note F to Item 13 restricts the debit to margin held in certain forms.
|3 ||OCC is registered both as a Clearing Agency and as a DCO.
|4 ||Indeed, under OCC's risk-based margin system, it will be impossible to distinguish the clearing margin applicable to non-segregated SFPs from the clearing margin applicable to options.
|5 ||Paragraph 2(d) is limited in its application to clearing organizations that are not registered Clearing Agencies, and we therefore refrain from comment on that provision.
|6 ||See OCC By-Laws, Art. VIII, Secs. 1 and 5. This limitation was imposed to meet the Commission's own clearing agency registration standards, which provide (with a limited exception not relevant here) that "the rules of the clearing agency should limit the purposes for which the clearing fund may be used to protecting participants and the clearing agency (i) from the defaults of participants and (ii) from clearing agency losses (not including day-to-day operating expenses) such as losses of securities not covered by insurance or other resources of the clearing agency." Rel. No. 34-16900 (Jun. 17, 1980), CCH Fed. Sec. L. Rep. para;26,203G at 19,289-3. (Emphasis added.)
|7 ||See SR-OCC-2002-03. Under this proposed rule change, the aggregate clearing fund would be a function of the "risk margin" (excluding the premium value of options, which is fully collateralized by margin deposits) on deposit at OCC as follows:
|RISK MARGIN LEVEL
||Clearing Fund %
|> $0 < $5 Billion
||10% of Risk Margin
|> $5 Billion < $10 Billion
||$500 Million + 6% of Risk Margin (in excess of $5 Billion)
|> $10 Billion < $15 Billion
||$800 Million + 5% of Risk Margin (in excess of $10 Billion)
|> $15 Billion
||$1.05 Billion + 4% of Risk Margin (in excess of $15 Billion)
|8 ||In the last four years, OCC's average daily margin requirements (including premium as well as risk margin) have varied from a high of $39.4 billion in January, 1999 to a low of $18.9 billion in February, 2002.
|9 ||We also note that some insurers offer clearing member default insurance that could be used as a substitute for some portion of the clearing fund, thereby creating another circumstance in which the size of the clearing fund might be reduced without reducing the amount of protection against risk.
|10 ||At the end of September, 2002, OCC's clearing fund was $1.16 billion.
|11 ||OCC will of course observe Commodity Exchange Act segregation requirements with respect to funds deposited with OCC as margin in a segregated futures account (By-Laws, Article VI, Sec. 3(f)) or a cross-margining account.
|12 ||Indeed, OCC maintains no custody accounts for securities, which make up the vast majority of OCC's margin deposits. Securities pledged by clearing members to OCC through The Depository Trust Company ("DTC") are carried in a pledged field in the DTC account of the pledging clearing member. Securities pledged to OCC through a custodian bank continue to be held in the account of the pledgor at the custodian bank but subject to OCC's control. This makes it unnecessary for OCC to account to pledgors for interest, dividends, etc. on pledged securities.
|13 ||Article VI, Section 3 provides for separate accounts for individual market-makers and alternatively permits combined market-maker accounts in which transactions for multiple market-makers may be cleared. In addition, so-called "joint back office" or "JBO" transactions are carried in a combined account separate from other account types. Finally, OCC provides a "futures segregated funds account" in which a clearing member that is a fully-registered futures commission merchant must clear the transactions of its futures customers subject to the segregation requirements of Section 4d(2) of the Commodity Exchange Act.
|14|| See SR-OCC-2002-07.
|15 ||A similar issue arises under the CFTC's segregation rules.
|16 ||This issue does not arise for security futures because a future represents a liability of the customer as well as an asset, and is therefore never treated as fully paid.