Feb. 19, 2024
Dear Madam or Sir,
Thank you for providing the opportunity to offer feedback on SR-OCC-2024-001 34-99393 titled "Proposed Rule Change by The Options Clearing Corporation Concerning Its Process for Adjusting Certain Parameters in Its Proprietary System for Calculating Margin Requirements During Periods When the Products It Clears and the Markets It Serves Experience High Volatility" (PDF, Federal Register) as a retail investor. I have several concerns regarding the OCC rule proposal, do not support its approval, and appreciate the chance to provide input.
I am particularly troubled by the lack of transparency evident in our financial system, exemplified by this rule proposal among others. The details provided in Exhibit 5, along with supporting information (refer to Exhibit 3), are extensively redacted, hindering public review and making it impractical for the public to offer meaningful comments on this proposal. Without ample opportunity for public review, this proposal should be rejected on those grounds alone.
Public review is crucial, especially considering that the OCC's Proposed Rule lays blame on U.S. regulators for not mandating the adoption of prescriptive procyclicality controls. Given that "procyclicality may be evidenced by increasing margin in times of stressed market conditions," an increase in margin requirements could strain a Clearing Member's ability to obtain liquidity, potentially exposing the OCC to financial risks. The OCC, designated as a Systemically Important Financial Market Utility (SIFMU), owes transparency to everyone reliant on the US financial system. The OCC's attempt to shift responsibility to U.S. regulators for not mandating regulations to protect itself raises doubts about the reliability of both the SRO and U.S. regulators in safeguarding our financial markets.
This specific OCC rule proposal seems tailored to shield Clearing Members from the risks of potentially costly trades by routinely reducing margin requirements as requested by Clearing Members, thus escalating risks for the OCC. According to the OCC rule proposal:
The OCC collects margin collateral from Clearing Members to mitigate market risk associated with their positions.
The OCC employs a proprietary system, STANS ("System for Theoretical Analysis and Numerical Simulation"), to compute margin requirements for each Clearing Member, with one model possibly yielding "procyclical" outcomes correlated with volatility, which could jeopardize member stability during periods of heightened volatility.
An escalation in margin requirements could hinder a Clearing Member's liquidity access to meet obligations to the OCC. If a Clearing Member defaults, liquidating its positions could lead to losses absorbed by the Clearing Fund, potentially creating liquidity problems for non-defaulting Clearing Members.
Essentially, systemic risk looms because Clearing Members collectively lack adequate capitalization or are excessively leveraged, so a single Clearing Member's failure due to poor risk management amidst high volatility could trigger a cascade of failures. In simpler terms, a Clearing Member's poor investment choices could ignite a systemic financial crisis due to excessive risk-taking and inadequate capitalization among Clearing Members as a whole.
The OCC's rule proposal endeavors to avert a systemic financial crisis by reducing margin requirements using "idiosyncratic" and "global" control settings, with one instance revealing a $2.6 billion reduction in aggregate margin requirements after implementing idiosyncratic control settings for a particular risk factor. The OCC has opted to waive margin calls for Clearing Members over 200 times in less than four years, with durations varying up to 190 days, and has implemented "global" control settings in response to significant events such as the onset of the COVID-19 pandemic and the "meme-stock" episode on January 27, 2021.
These rules essentially create an uneven playing field for other market participants, including retail investors, who bear the brunt of long-tail risks while the OCC consistently waives margin calls for Clearing Members by repeatedly lowering their margin requirements. Therefore, this rule proposal should be rejected, and Clearing Members should be subject to clearly defined margin requirements like other investors.
According to the OCC, this rule proposal and the special margin reduction procedures exist because a single Clearing Member's default could trigger a series of defaults, potentially exposing the OCC to financial risk. Consequently, Clearing Members who fail to effectively manage their portfolio risk against long-tail events essentially become "Too Big To Fail." Hence, this rule proposal should be rejected, and Clearing Members should face the consequences of inadequate risk management, including against long-tail events.
This rule proposal formalizes an inherent conflict of interest for the Financial Risk Management (FRM) Officer. While the FRM Officer's role ostensibly aims to safeguard OCC's interests, the scenario outlined in the OCC proposal, where a Clearing Member's failure exposes the OCC to financial risk, necessitates the FRM Officer's intervention to prevent Clearing Member failure and protect the OCC. Consequently, the FRM Officer becomes nothing more than an administrative rubber stamp for reducing margin requirements for Clearing Members at risk of failure. Unfortunately, rubber-stamping margin requirement reductions undermines the protection from market risks associated with Clearing Members' positions provided by the margin collateral collected by the OCC. Thus, this rule proposal should be rejected, and the OCC should enforce adequate margin requirements to safeguard itself and minimize the extent of any necessary bailouts.
Given the issues outlined above, please consider the following recommendations:
Increase and strictly enforce margin requirements proportional to the risks associated with Clearing Member positions instead of reducing them. Clearing Members should be incentivized to structure their portfolios to accommodate stressed market conditions and long-tail risks. The current rule proposal incentivizes Clearing Members to become Too Big To Fail, thereby pressuring the OCC into implementing idiosyncratic controls more frequently to privatize profits and socialize losses.
Implement external auditing and oversight as a "fourth line of defense," akin to the model described in "The Four Lines of Defense Model" for financial institutions, with enhanced public reporting to ensure proactive identification and management of risks before they become systemically significant.
Rearrange the order of loss allocation in the OCC's Loss Allocation waterfall, swapping "3. OCC’s own pre-funded financial resources" and "4. Clearing fund deposits of non-defaulting firms." This rearrangement would encourage Clearing Members to police each other, with each Clearing Member ensuring others undertake appropriate risk management measures, as their Clearing Fund deposits would be at risk after a suspended firm's deposits are exhausted. This adjustment would also enhance protection for the OCC, a SIFMU, by allocating losses to the clearing corporation only after Clearing Member deposits are depleted. Consequently, the public would benefit from a reduced risk of needing to bail out a systemically important clearing agency.
Thank you for the opportunity to provide feedback, as a fair, transparent, and resilient market benefits all investors.
[1] https://www.federalregister.gov/d/2024-01386/p-11 [2] https://www.federalregister.gov/d/2024-01386/p-8 [3] https://www.federalregister.gov/d/2024-01386/p-7 [4] https://www.federalregister.gov/d/2024-01386/p-50 [5] https://www.federalregister.gov/d/2024-01386/p-51 [6] https://en.wikipedia.org/wiki/Long_tail [7] https://www.federalregister.gov/d/2024-01386/p-45 [8] https://www.federalregister.gov/d/2024-01386/p-79 [9] https://www.theocc.com/getmedia/e8792e3c-8802-4f5d-bef2-ada408ed1d96/default-rules-and-procedures.pdf, which is publicly available and linked to from the OCC’s web page on Default Rules & Procedures at https://www.theocc.com/risk-management/default-rules-and-procedures [10] https://www.federalregister.gov/documents/2021/04/12/2021-07454/self-regulatory-organizations-the-options-clearing-corporation-notice-of-no-objection-to-advance [11] https://www.federalregister.gov/d/2024-01386/p-16 [12] https://www.bis.org/fsi/fsipapers11.pdf
Sincerely,
A Concerned Retail Investor