October 23, 2002
Mr. Jonathan Katz, Secretary
Re: OneChicago, LLC - Notice of Filing of Proposed Rule Change by OneChicago Relating to Customer Margin Requirements for Security Futures - File No. SR-OC-2002-01; Release No. 34-46555
Dear Mr. Katz,
Morgan Stanley and Goldman, Sachs & Co.1 appreciate the opportunity to comment on the Rule Change proposal filed by OneChicago, LLC, on September 26, 2002, relating to Customer Margin.
We urge the Commission to reject the "Market Maker Exclusion" contained in the proposed Rule Change. We believe that the proposed Market Maker Exclusion (1) would be imprudent, in that it would expose the marketplace to systemic credit risk; (2) would violate the requirements of the Commodity Futures Modernization Act of 2000, in that it would create a significant disparity in the treatment of security options market makers, on the one hand, and security futures market makers, on the other hand; and (3) exceeds the scope of the discretion afforded self-regulatory organizations by the Commission and the CFTC in defining those entities eligible for exemption from federal margin requirements in connection with security futures activities.
We believe that the definition proposed in the Rule Change exposes the market place to significant systemic risk. By defining "market maker" so broadly that it would include substantially all floor brokers in any futures product as well as a significant number of member firms that are proprietary traders, the definition defies common usage and encourages leverage and risk taking by a broad class of member firms, regardless of whether they provide liquidity to facilitate customer trading in security futures.
The OneChicago definition includes floor brokers, floor traders and market makers for commodity futures as well as member firms whose primary business is to carry out speculative trading rather than to provide continuous quotations or liquidity. Under the proposed Rule Change, the predicate condition to be a market maker, i.e., "hold[ing] itself out as being willing to buy and sell security futures for its own account on a regular or continuous basis" is defined to include any "market maker" 2 for which "at least seven-five percent (75%) 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, including security futures, stock index futures and options, stock and index options, stocks, foreign currency futures and options, foreign currencies, interest rate futures and options, fixed income instruments and commodity futures and options ...."
This provision characterizes "fixed income instruments and commodity futures and options" as "financial derivatives." As a result, the rule leads to the anomalous result that a floor broker specializing in corn futures would be eligible to trade security futures on a margin free basis. A futures commission merchant (FCM) or broker dealer carrying positions for a commodity futures floor broker would not be likely to understand the equities market sufficiently or have a sufficient risk management systems to maintain the positions prudently and adequately absent customer margin requirements. This, in turn, could lead to increased insolvencies among carrying FCMs and broker dealers as well as to confusion and attendant losses by other lenders and market intermediaries. In addition, because carrying broker dealers and FCMs will not be exempt from posting margin at the clearing house level with respect to the floor brokers, traders and market makers' positions, the exemption will potentially strain the resources of the clearing brokers and FCMs since they will have to finance the clearing house margin themselves. It seems ironic to us that the Commission prohibits broker dealers from providing more than 50% leverage to customers holding highly liquid, diversified cash equity positions yet are comfortable allowing broker dealers and FCMs to provide infinite leverage to futures trading firms, trading an untested, equity look-alike product, whose liquidity is uncertain, at best.
We believe that the OneChicago definition injects risk into the system by encouraging a broad class of traders to speculate in the instrument without requiring that those traders or their carrying brokers or FCMs have the requisite financial wherewithal to carry the positions. Under applicable CFTC Rules (see, e.g., CFTC Rule 1.17), futures floor brokers and traders are not subject to minimum equity requirements or net capital rules unless they qualify as an FCM or an introducing broker. Because floor brokers, floor traders and market makers in security futures are not subject to federal net capital requirements, there is a heightened risk that their trading or other activities could give rise to their own insolvency. In addition, carrying broker dealers and FCMs are not subject to net capital requirements with respect to the positions of floor brokers, floor traders and market makers carried by them. This too increases systemic risk and the possibility that a carrying broker dealer or FCM will be rendered insolvent by trading losses from the floor brokers, floor traders and market makers whose accounts they carry. Notwithstanding that regulations do not subject these entities to any capital oversight or minimums, the OneChicago rule proposes to exempt floor brokers, floor traders and market makers from all margin requirements.
The OneChicago definition is not consistent with the discretion granted by the Commission and the CFTC to self-regulatory organizations to establish a definition of market maker that would qualify such person for an exclusion. In their joint margin release, the Commission and CFTC suggest that member firms whose revenue is derived from trading "listed financial-based derivatives" might be an appropriate class to reference for the exclusion. In the release, the regulators define "financial-based derivatives" (67 Fed. Reg. 157 at p.53153 (Aug. 14, 2002)3 as being limited to "security futures, stock index futures, stock and index options, foreign currency futures and options, and interest rate futures and options."4 OneChicago was not given authority by the Commission and the CFTC to expand the class of exempt borrowers beyond member firms that trade in "financial-based derivatives," as defined by the Commission and the CFTC and consistent with the common usage of the term.
OneChicago's Market Maker Exclusion violates the spirit of the Commodity Futures Modernization Act of 2000 requirement that margin treatment for security futures be "consistent with the margin requirements for comparable option contracts" since it would not be accompanied by any attendant capital requirement on the part of the guaranteeing/clearing broker. First, unlike the rules of the listed options exchanges, OneChicago does not limit the exclusion to financing of market making positions. The Options exchanges generally reserve exempt margin treatment for market making positions and their related hedges. Rule 12.3 of the Chicago Board Options Exchange, for example, limits those positions eligible for "good faith" margin to positions in which the member makes a market and direct offsets to those positions. The exclusion for options market makers is justified for policy reasons given the market's interest in ensuring that there is adequate liquidity in the product. Although we believe that the same policy objective would apply to security futures, we believe that the exclusion drafted by OneChicago is so overly broad that it fails to address the policy needs and, instead, provides an unjustified windfall to a select group of traders and speculators.
In addition, unlike the regime for market makers in listed options, neither OneChicago nor the CFTC provides minimum equity or net capital requirements for floor brokers and traders in security futures. Whereas an options market maker or its clearing firm is subject to net capital haircuts imposed by Rule 15c3-1 under the Securities Exchange Act of 1934 as well as, in the case of the clearing broker, to effective limits on the aggregate risk from positions that the clearing firm may carry, under OneChicago's Rule Change for security futures there would be no capital requirements imposed either on a floor broker that qualifies for the market maker exclusion from customer margin or on its carrying broker dealer or FCM. This lack of parity provides a significant incentive for firms to trade in security futures rather than in listed options. We believe that this regulatory advantage for security futures is both unwarranted from a policy perspective and contrary to the intention of Congress to ensure comparability of regulatory treatment between the products.
Exempting floor traders, floor brokers and market makers from the customer margin rules would be inconsistent with what we understand to be their status as customers under CFTC Part 190 in the event of a bankruptcy of the clearing firm. Because a floor broker, floor trader or market maker that is unaffiliated with an insolvent carrying FCM is likely to be treated as a "customer," we are concerned that a bankruptcy receiver or trustee would count positive open trade equity held by the floor broker, floor trader or market maker in a segregated account as a "customer asset" and pay out to the floor broker, floor trader or market maker a pro rata share of the available pool of assets (comprised of customer margin and open trade equity) pari passu with other customers, notwithstanding that the floor broker, floor trader or market maker never contributed margin to the account. This result seems to us to be both unwise and unjust.
* * * * *
We believe that security futures could be a beneficial product. The product provides a useful tool for hedging as well as to carry out a number of arbitrage and trading strategies. Notwithstanding the potential benefits to be provided by the product, security futures are leveraged and, accordingly, present a number of risks. In light of these risks, it is critical that the product be subject to a sound, workable and efficient margining system.
We are concerned, however, that the market maker exemptions proposed by OneChicago and NQLX, as proposed, would encourage imprudent risk taking, speculation and leverage, in circumstances where potential systemic credit risk has not been adequately addressed. We are particularly concerned by this prospect in the context of an untested product with which regulators and self-regulatory organizations have no experience.
We are similarly concerned that the failure of the margin rules to comply with applicable statutory and regulatory standards would give rise to competitive disparities that are not justified by legitimate product or market distinctions.
Accordingly, we urge the Commission not to approve either the OneChicago Rule Change proposal or the NQLX Rule Change proposal until those rules have been revised to either subject market makers and floor brokers and traders to customer margin or to impose on those entities or on their carrying broker dealers or FCMs appropriate net capital requirements. 5 In addition, in the event that OneChicago continues to provide an exclusion from the margin rules for market makers, we recommend that the Commission require the exchange to narrow the exemption to cover only designated market making and related positions held by a person that both (i) registers as a market maker with respect to the designated contracts and (ii) provides continuous two-sided quotations or responds to requests for quotations with two-sided quotations throughout the trading day with respect to the designated contracts.
In addition, we ask the Commission, together with the CFTC, to re-evaluate the treatment accorded to floor brokers and other exempted borrowers with respect to security futures in the event of an insolvency of a carrying broker dealer or FCM. We believe that the regulators should consider whether it might not be more appropriate to treat exempted borrowers as non-customers for purposes of the segregation and bankruptcy regimes (similar to the way that broker dealers and floor brokers are treated for purposes of the Securities Investor Protection Act). It is our view that margin policy is fundamentally intertwined with customer protection, capital and insolvency regimes and needs to be justified within those frameworks.
Should you have any questions, please feel free to contact John P. Davidson, of Morgan Stanley, at (718) 754-5150 or Mitchell J. Lieberman, of Goldman Sachs, at (212) 902-5182.
cc: Annette Nazareth, Esq.
Jane Thorpe, Esq.