November 7, 2002
Mr. Jonathan G. Katz
Re: Margin Rule Change Relating to Customer Margin Requirements
Dear Mr. Katz:
OneChicago, LLC ("OneChicago") appreciates this opportunity to respond to comments made in letters to the Commission with respect to the above-referenced rule change proposal (the "Margin Rule") of OneChicago.1 The Margin Rule, which establishes customer margin requirements for transactions in security futures products traded on OneChicago, was based on and was intended to reflect the criteria enunciated by the Commission and the Commodity Futures Trading Commission ("CFTC"). Nonetheless, in response to comments from interested parties2 and Commission staff, OneChicago has revised the Margin Rule to clarify the circumstances in which a member of OneChicago will be exempt from customer margin requirements because it qualifies as a market maker for OneChicago products ("Market Maker")
As initially filed with the Commission, the Margin Rule would have deemed a member to be a Market Maker holding itself out as being willing to buy and sell security futures for its own account on a regular or continuous basis if it satisfied either of two alternative tests. The first of these measures (the "Revenue Test") would have provided that a Market Maker satisfies this requirement if at least 75 per cent of its gross revenue on an annual basis is derived from business activities or occupations from trading listed financial derivatives and the instruments underlying those derivatives. The alternative test would have required generally that at least 50 per cent of a Market Maker's trading activity on OneChicago in any quarter be in the contracts to which such Market Maker had been assigned (the "Activity Test").
As described more fully in Amendment No. 1 to File No. SR-OC-2002-01, OneChicago has substantially modified the Margin Rule by eliminating the Revenue Test. In its place, OneChicago has restructered the Activity Test. As revised, the Activity Test sets forth three alternative measures of market-making activity. It is expected that OneChicago's lead market makers will qualify as Market Makers under the first such measure, set forth in paragraph (n)(ii)(C)(1) of the revised Margin Rule, which generally requires two-sided quotations with a maximum bid/ask spread throughout the trading day for all delivery months of specified contracts. Other market makers are expected to qualify as Market Makers under the second or third measures, set forth in paragraph (n)(ii)(C)(2) and (3), respectively, of the revised Margin Rule. The second measure generally requires members to respond to at least 75 per cent of the requests for quotation for all delivery months of specified contracts with two-sided quotations with a maximum bid/ask spread. The core of the third measure is a general requirement that a member make bids or offers at or near the best market during at least 50 per cent of the trading day, subject to additional conditions and requirements depending on the nature of the market maker assignment for such member. The revised Activity Test to a significant extent follows similar requirements for market makers on other U.S. options or security futures exchanges, as adapted to take into account existing practices and standards in the U.S. futures markets.
All of the Comment Letters objected to the proposed Revenue Test. OneChicago initially developed the proposed Revenue Test based on guidance offered by the Commission and the CFTC in the Margin Release,3 as well as direct consultation with the Commission's staff in the Division of Market Regulation. The Margin Rule has been revised to eliminate the Revenue Test altogether. This makes moot the objection that the Revenue Test would permit the inappropriate use of leverage and create systemic risk (see NASD Letter at 3-4; MS/GS Letter at 2), so we need not provide any further response to those and similar comments.4
A number of the Comment Letters urged the Commission not to approve the Margin Rule in the form in which it was published for public comment on the ground that approval of the Margin Rule would be inconsistent with the requirements of Section 7(c)(2)(B) of the Securities Exchange Act of 1934 (the "Exchange Act"), which requires that margin requirements for security futures products be consistent with the margin requirements for comparable option products. As a threshold matter, it is clear that OneChicago's Margin Rule does not need to be identical to or otherwise mirror the particulars of the margin rules of the five option exchanges. See ISE Letter at 3 (ISE "not suggesting that the Commission require OneChicago to adopt rules identical to what is required by the five listed option exchanges"). Compare CBOE Rule 8.7.03(A) (75 per cent of volume required to be in appointed classes) and PCX Rule 6.35.03 (same) with ISE Rule 804(e)(2)(i) (60 per cent) and Amex Rule 958.03 (50 per cent). By any reasonably objective standard, OneChicago's revised Margin Rule is "consistent with" the rules of the option exchanges.
The Comment Letters also objected to the absence of specific, measurable obligations for Market Makers on OneChicago. That concern has been addressed in the revised Margin Rule which, as noted, requires Market Makers to provide continuous two-sided quotations, to respond to requests for quotation, or to maintain bids or offers on assigned contracts.
Amex objected on the ground that OneChicago's Margin Rule does not include sanctions for non-compliance with Market Maker obligations. See Amex Letter at 3. Amex may have overlooked that in the version initially proposed and published, as well as in the revised form OneChicago has resubmitted, the Margin Rule provides that a Market Maker that fails to comply with applicable Rules of OneChicago, Commission Rules 400 through 406 and CFTC Regulations 41.41 through 41.49 is subject to disciplinary action. Sanctions in such a case include, but are not limited to, revocation of Market Maker status.
A number of the comments are perplexing. For example, one of the objections that was voiced is that floor brokers and floor traders on futures exchanges are not subject to net capital requirements (see MS/GS Letter at 2, 3-4). The same observation could be made about option market makers, see Exchange Act Rule 15c3-1(c)(2)(vi)(N), and no one suggests that they not receive market maker margin treatment. The same commenters stated that futures clearing brokers are not required to demonstrate the financial ability to carry positions in security futures products for exchange members who would qualify as market makers (see MS/GS Letter at page 2). Such a statement is without foundation; CFTC Regulation 1.17 and the minimum financial requirements of the futures exchanges all require that a futures commission merchant ("FCM") maintain adjusted net capital of at least four per cent of customer segregated funds (an amount which includes required margin deposits as well as open trade equity) and to deduct from net capital the amount of undermargined and deficit customer and non-customer accounts. An FCM that is also a "full" broker-dealer is, of course, additionally subject to the Commission's net capital requirements. In a similar vein, the MS/GS Letter suggested (at page 4) that affording Market Maker status to the individual members of OneChicago could result in inequities in the event that the Market Maker's carrying broker were to be liquidated under Subchapter IV of Chapter 7 of the Bankruptcy Code and Part 190 of the CFTC's regulations. This argument is based on the flawed premise that a Market Maker, because it is subject to a lesser margin requirement, will get a disproportionate share of the bankruptcy estate. To the contrary, a Market Maker, like any other "customer," is entitled to nothing more than its pro rata share of "customer property." If a Market Maker has reduced margin requirements, its share of the customer estate will be correspondingly reduced.
The NASD has objected that OneChicago's Margin Rule would provide margin reductions to a Market Maker who holds his positions in a securities account (NASD Letter at 4). More specifically, the NASD has stated that it intends to adopt its own margin rules for security futures products and that OneChicago's Margin Rule would be in conflict therewith. Putting aside the question of whether NASD's new rules or rule amendments will, in fact, conflict with the Margin Rule as revised, OneChicago (like the other self-regulatory organizations) should be free to adopt its own rule and to apply that rule to its own members. This is not in any way to suggest that OneChicago's Margin Rule should supersede the NASD's (or NYSE's) requirements. There may be circumstances, however, in which broker-dealers that do not do a customer business will be members only of OneChicago (and not the NASD or NYSE); in such a case, the dealer should be able to claim the advantages of market maker margin treatment without regard to whether he carries his positions in a securities or a futures account.
One of the commenters suggested that Market Maker margin treatment be afforded only in respect of a Market Maker's assigned contracts (MS/GS Letter at 5). This is a more rigorous standard than that which is applied by the option exchanges and would, if adopted, make OneChicago's Margin Rule not "consistent with margin requirements for comparable option contracts," as required by Section 7(c)(2)(B) of the Exchange Act.
Finally, NQLX objected to a number of the strategy-based margin offsets that are authorized by the Margin Rule to the extent that they would authorize a margin reduction for positions involving securities (other than security futures) inasmuch as that portion of the Margin Rule applies only to positions carried in a futures account (NQLX Letter at 6). In support of its position, NQLX noted that the Commission and the CFTC declined to authorize the cross-margining of positions. OneChicago prefers to retain the full range of permitted margin offsets, so that they can be made effective if OneChicago later amends the Margin Rule to apply it to securities accounts or the Commission at some future date takes steps that would permit these margin offsets to be conferred on positions in a futures account.
For the reasons set forth above and in OneChicago's resubmission of the Margin Rule, OneChicago believes that the Margin Rule, as revised, is entirely consistent with the requirements of the Exchange Act and Commission Rules 400 through 406. OneChicago therefore believes that the Margin Rule does not warrant any further substantive analysis and maintains its request for accelerated effectiveness of the Margin Rule pursuant to Section 19(b)(2) of the Exchange Act.
cc: Ms. Annette L. Nazareth