July 18, 2002
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
Re: Notice of Filing of Proposed Rule Change by the Chicago Board Options Exchange, Incorporated Related to Customer Portfolio and Cross-Margining Requirements (Release No. 34-45630; File No. SR-CBOE-2002-03)
Dear Mr. Jonathan G. Katz:
The Federal Reserve Bank of Chicago (the "Bank") appreciates the opportunity to comment on the above-referenced proposal by the Chicago Board Options Exchange ("CBOE"). The Bank welcomes the Securities and Exchange Commission's ("SEC") efforts. As you are aware, the Federal Reserve Board (the "Board") amended Regulation T in 1998 to allow securities exchanges, subject to SEC approval, to develop portfolio margining as an alternative to strategy-based margining.1 To that end, the CBOE, working with other market participants, has proposed a rule change that would allow certain customers to use portfolio margining for broad-based index options and other specified securities.2 The proposed rule change would be implemented under a two-year pilot program.
The Bank recognizes that a number of operational and regulatory issues may need to be resolved before the SEC can approve the CBOE proposal.3 Assuming that such issues are resolved, the Bank supports the CBOE proposal to adopt portfolio margining. Both strategy-based and portfolio margining can be, and have been, used to set margins at prudential levels. The latter approach, however, can be more efficient-requiring lower margins to provide a similar level of prudential protection. In addition, the adoption of portfolio margining by the CBOE would expand the opportunity for such an approach to be used to margin security futures contracts.4
PORTFOLIO MARGINING OFFERS EFFICIENCIES OVER STRATEGY-BASED MARGINING
Options exchanges, subject to SEC approval, set margin requirements for customers. Margin is the collateral that customers must deposit and maintain with their brokers to ensure the fulfillment of their financial obligations.5 If, for example, a customer defaulted, the broker could keep at the very least the margin deposit. Exchanges set margins based on their risk tolerance and judgment. In general, setting margins entails balancing the competing objectives of ensuring (1) contract integrity, or having sufficiently large margins, and (2) adequate trading volume, or having sufficiently small margins. In addition to the margin level, itself, the adequacy of margin also depends other factors, such as the frequency with which margin calls are made and the time within which such calls must be met.6
Currently, the CBOE sets margin requirements for customers using a strategy-based margining system, composed of a set of margin formulas that are defined in exchange rules.7 In general, margin for individual options positions are based on the market value of an option plus a fixed percentage of the value of the underlying instrument.8 Combinations of options and related positions with offsetting risks and, thus, lower combined risk may receive the benefit of lower margin. In particular, the CBOE has defined in its margin rules the specific combinations of offsetting positions that are eligible for lower margin. Importantly, combinations of positions that offset each other but are not specifically defined in the rules are not afforded any margin reduction.
In contrast to the CBOE's strategy-based margining system, portfolio margining is based on options pricing models.9 In general, portfolio margining evaluates all options and related positions as a group (or portfolio) and sets margin requirements for the portfolio as a whole. Based on options pricing models, it estimates the largest theoretical loss that a portfolio could lose under a given range of market conditions and over a specified period. Margins are then set to cover the largest estimated loss that the portfolio is reasonably expected to suffer. In considering the total value of the portfolio under different market scenarios, portfolio margining fully realizes all offsetting positions and reduces margins accordingly.
Both strategy-based and portfolio margining can be, and have been, used to set prudential margin requirements for securities options. However, portfolio margining is potentially more efficient than the CBOE's strategy-based system from an operational and market perspective. By implicitly recognizing any offsetting positions, portfolio margining eliminates the need to define by rule each specific combination of positions eligible for lower margin. This, in turn, eliminates the need for securities exchanges to periodically revise their margin rules and the SEC to review them as new combinations of offsetting positions are identified. Similarly, as noted by the CBOE, portfolio margining would also eliminate the task of separately computing margin requirements for each position or strategy, which can be cumbersome for complex portfolios.
More significantly, portfolio margining, in comparison to the CBOE's strategy-based system, could more accurately align the risk exposures of, and margins levels for, portfolios of options and related positions, especially well-diversified portfolios. Unrestricted by specific offset rules, portfolio margining recognizes more fully offsetting positions in a portfolio and estimates more accurately the net risk exposure of the portfolio.10 Moreover, using options pricing models rather than a fixed percentage of the underlying instrument, portfolio margining estimates more accurately the risk exposure of individual positions in a portfolio.11 As a result, portfolio margining can be used to set more appropriate margin levels for portfolios, reducing the potential of setting margins too high or low. Such an outcome may result in lower net margin requirements, reducing trading costs of market participants and increasing market liquidity and efficiency.
OTHER BENEFITS OF PORTFOLIO MARGINING FOR OPTIONS
The Commodity Futures Modernization Act of 2000 ("CFMA") lifted the ban on trading security futures and gave the Board authority over customer margin requirements for such products.12 In March 2001, the Board delegated its margin authority jointly to the SEC and Commodity Futures Trading Commission ("CFTC").13 In delegating its margin authority, the Board noted it amended Regulation T, so that portfolio margining, approved by the SEC, could be used in lieu of strategy-based margining. The Board added that it anticipates the creation of security futures will provide the opportunity to develop portfolio margining for all securities, including security options and security futures.
In October 2001, the SEC and CFTC jointly proposed customer margin rules for security futures.14 Reflecting statutory requirements, the proposed rules would establish a strategy-based margining approach for security futures-mirroring the margin requirements for exchange-traded options.15 In the proposal, the SEC and CFTC stated that if portfolio margining were approved by the SEC for exchange-traded options, a comparable portfolio margining system could be developed for security futures. In response to initial comments received on the proposed margin rules, the SEC and CFTC Chairmen stated that the CFMA does not require portfolio margining for security futures to be deferred until it has been approved for exchange-traded options, provided the intent of the CFMA was met.16 Nevertheless, the approval and implementation of portfolio margining by the CBOE would expand opportunities for the security futures market to use such a margining system.
The adoption of an SEC-approved portfolio margining system by the CBOE would benefit not only the exchange, itself, but also other exchanges and markets. It would enable the CBOE to set margin requirements to more accurately reflect the risk exposure of options and related positions-potentially reducing the trading costs of market participants and increasing the liquidity and efficiency of the market. Moreover, it would expand opportunities for other securities exchanges and security futures exchanges to develop and implement portfolio margining systems.
The Bank hopes that its comments are helpful in the SEC's review of the CBOE proposal to develop portfolio margining for certain customers. If you have any questions, please feel free to contact Richard Lamm (312-322-6807), James Moser (312-322-5769), or Richard Tsuhara (312-322-4031).
Again, thank you for the opportunity to comment.
|1||63 FR 2805 (January 16, 1998).|
|2||The CBOE worked with the New York Stock Exchange, American Stock Exchange, the Chicago Board of Trade, Chicago Mercantile Exchange, and The Options Clearing Corporation.|
|3||One such issue involves the coverage of Securities Investor Protection Corporation insurance to futures positions held in a securities margin account for cross-margining purposes.|
|4||66 FR 50720 (October 4, 2001).|
|5||In the options market, margins may refer to (1) an extension of credit involving a long-term listed option or (2) a performance bond that serves to guarantee the performance of an options contract.|
|6||It is also important to note that margins are only one component of sophisticated risk-management systems of exchanges and clearing organizations.|
|7||The strategy-based margining system for exchange-traded securities options was originally embodied in Regulation T. In the first years of exchange trading of options, different exchanges imposed different margin requirements. By 1977, a common margin system had emerged. In January 1977, the Board promulgated regulations for all options equivalent to those being followed by the exchanges. See Board of Governors of the Federal Reserve System, A Review and Evaluation of Federal Margin Regulations, December 1984, p. 53.|
|8||For a detailed description of margin requirements for options, see CBOE, Margin Manual, April 2000.|
|9||The Options Clearing Corporation adopted portfolio margining for its clearing members in 1986. Shortly thereafter, in 1988, the Chicago Mercantile Exchange adopted its portfolio margining system.|
|10||For a comparison of strategy-based and portfolio margining, see Paul H. Kupiec and A. Patricia White, Regulatory Competition and the Efficiency of Alternative Derivative Product Margining Systems, Federal Reserve Board, Washington, D.C., Finance and Economics Discussion Series, 96-11, February 1996.|
|11||Strategy-based margining does not estimate the future price of options positions but rather implicitly estimates the risk exposure of options positions based on a fixed percentage of the value of the underlying stock.|
|13||Letter from Jennifer J. Johnson, Secretary of the Board, to James E. Newsome, Acting CFTC Chairman, and Laura S. Unger, Acting SEC Chairman, March 6, 2001.|
|14||66 FR 50720 (October 4, 2001).|
|15||The Securities Exchange Act of 1934, as amended by the CFMA, requires that margin requirements for security futures be (1) consistent with margin requirements for comparable options traded on a securities exchange and (2) no lower than the lowest level of margin, exclusive of premium, required for comparable options traded on a securities exchange.|
|16||See Joint Press Release by SEC and CFTC, Release: 4593-01, December 21, 2001.|