[Federal Register Volume 63, Number 50 (Monday, March 16, 1998)]
[Proposed Rules]
[Pages 12713-12717]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-6580]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 1
Amendments to Minimum Financial Requirements for Futures
Commission Merchants
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rules.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') proposes to amend its minimum financial requirements for
futures commission merchants (``FCMs''). The proposed amendment would
eliminate the charge against the net capital of an FCM, presently
required by rule 1.17(c)(5)(iii). The charge is four percent of the
market value of options sold by customers trading on contract markets
or foreign boards of trade. It is generally referred to as the ``short
option value charge'' or ``SOV charge''. The original intent in
adopting this rule was to require FCMs to provide additional capital to
offset the risk of short options positions carried on behalf of
customers. The Commission is proposing to rescind this rule because it
has determined that the charge is not closely correlated to the actual
risk of the options carried on behalf of customers and, in any event,
there are adequate other protections in place to address the risk of
short options. In particular, the Standard Portfolio Analysis of Risk
(``SPAN'') margining system has been effectively used to set
appropriate levels of risk margin and there are many other non-capital
protections. These protections include effective self-regulatory
organization (``SRO'') audit and financial surveillance programs and
modern risk management and control systems at FCMs. Because of the
demonstrated effectiveness of these programs, the Commission believes
it may now be appropriate to rescind the SOV charge.
The Commission wishes to receive comments on this proposal.
Comments are desired not only on the specific proposal itself, but also
on all of the components of the system of protections that are designed
to address the risk of short options, which are described below.
DATES: Comments must be received on or before May 15, 1998. Any
requests for an extension of the comment period must be made in writing
to the Commission within the comment period.
ADDRESSES: Comments may be sent to: Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,
D.C. 20581. Attn.: Secretariat with a reference to the Minimum
Financial Requirement Rule--SOV Charge. Also, comments may be E-mailed
to secretary@cftc.gov''.
FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Chief
Accountant, 202-418-5459 or paulb@cftc.gov''; or Lawrence B. Patent,
Associate Chief Counsel, 202-418-5439 or lpatent@cftc.gov''. Mailing
address: Division of Trading and Markets, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,
D.C. 20581.
SUPPLEMENTARY INFORMATION:
I. Background
On July 7, 1982,1 the Commission proposed amendments to
the rule governing the computation of net capital for FCMs to recognize
the difference in risk between the purchase and sale of commodity
options. The sale of an option (``short option'') poses a greater risk
to an FCM than does the purchase of an option (``long option'') because
the risk of a short option is unlimited. In contrast, long options pose
a risk to the carrying FCM which is limited to the premium on the
option. Once the premium is collected from the customer who purchased
the option, there is no further risk of financial loss to the FCM or
the customer. In this connection, the Commission has proposed the
repeal of Commission Regulation 33.4(a)(2) which requires the full
payment of a commodity option premium at the time the option is
purchased. The proposal was initially published for comment on December
19, 1997. The comment period was extended to March 4, 1998. The effect
of the repeal would be to permit the futures-style margining of
commodity options traded on regulated futures exchanges and is
discussed in the initial notice of proposed rulemaking.2
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\1\ 47 FR 30261 (July 13, 1982).
\2\ 63 FR 6112 (February 6, 1998), Extension of comment period
to March 4, 1998; See also 62 FR 66569 (December 19, 1997), Initial
request for comment.
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To recognize the risk of carrying short options, the Commission
adopted, effective September 21, 1982,3 a safety factor
charge of four percent of the market value of exchange-traded (domestic
and foreign) options granted or sold by an FCM's customers--the short
option value charge (``SOV charge''), as set forth in Regulation
1.17(c)(5)(iii).4 However, over the years since its
adoption, there have been complaints that the charge was not
proportional to the risk of the options and was excessive in its
financial burden upon the FCMs in terms of the cost of the capital
required to carry the positions.
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\3\ 47 FR 41513 (September 21, 1982).
\4\ Commission rules referred to herein can be found at 17 CFR
Ch. I (1997).
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In June 1995, both the Chicago Board of Trade (``CBOT'') and the
Chicago Mercantile Exchange (``CME'') urged the Commission to rescind
the SOV charge. In the alternative, the two exchanges asked for some
degree of relief from the SOV charge in the event that the Commission
felt that complete rescission of the charge was not possible. Their
letters cited, among other reasons for rescission or the requested
relief, that: (a) Short options positions may serve to reduce the risk
of a portfolio that would carry greater risk absent the short options
positions, and (b) the risks of short option positions are already
adequately addressed by the risk-based margining system currently being
used by all commodity exchanges in the U.S. and many abroad.
They pointed out that the charge was adopted in 1982, prior to the
development of risk-based margining systems. While the charge was
intended to serve as an additional regulatory capital safety factor for
option positions, they contended that it is now excessive and no longer
justified because of the use of margining systems that
[[Page 12714]]
adequately measure portfolio risk and, therefore, assess appropriate
margins on the entire portfolio.
The Commission staff felt that there was some merit to the position
of the exchanges and others who had criticized the efficacy of the SOV
charge. Therefore, to temper the impact of the charge, while the matter
was studied further, on July 26, 1995, the Division of Trading and
Markets (``Division'') issued Interpretative Letter No. 95-
65.5 That letter provided partial relief through a ``no
action'' position that would allow FCMs to reduce the four percent SOV
charge applicable to short options positions carried by professional
traders and market makers.6 An FCM that wished to avail
itself of the relief under the ``no action'' position was required to
prepare certain supporting calculations and obtain approval from its
designated self-regulatory organization (``DSRO'') to take the relief.
The Division subsequently expanded this relief to include any customer
account carried by an FCM, in Interpretative Letter No. 97-46, dated
June 12, 1997, provided the same conditions could be met by the
additional accounts.7
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\5\ CFTC Interpretative Letter No. 95-65, [1994-1996 Transfer
Binder] Comm. Fut. L. Rep. (CCH) para. 26,495 (July 26,1995).
\6\ The reduction in the charge cannot exceed 50 percent of the
pre-relief charge calculated for all SOV on a firm-wide basis.
\7\ CFTC Interpretative Letter No. 97-46, [Current Binder] Comm.
Fut. L. Rep. (CCH) para. 27,086 (June 12,1997). This letter also
provided some relief pertaining to the required supporting
calculations.
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However, only five FCMs have taken advantage of the relief. This
small number resulted from the fact that the relief required what were
viewed as burdensome calculations and, in any event, the relief was
limited to fifty percent of the total charge. The FCM community also
communicated to the Commission that the relief provided by the Division
failed to address the theoretical deficiencies of the rule. In a letter
dated September 26, 1997, the Joint Audit Committee (``JAC'')
8 formally suggested that the net capital charge on SOV be
eliminated. The JAC letter stated the following:
\8\ JAC is comprised of representatives from each commodity
exchange and National Futures Association who coordinate the
industry's audit and ongoing surveillance activities to promote a
uniform framework of self-regulation.
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* * * Since the limited relief was granted, the JAC has closely
monitored the application of the relief. From JAC's experience and
from discussions with FCMs, many firms feel that the conditions for
relief are too restrictive and complicated. Thus, they are not able
to expend their resources to take advantage of the relief. In fact,
there are only five FCMs which have applied for such relief.
During periods of high volatility, the capital charge will
increase as the value of the applicable short option increases.
However, this charge does not necessarily relate to the risk
applicable to a particular options portfolio. Selling options may
actually serve to reduce risk in a portfolio. As a result, some
firms have made a business decision to refuse large, lucrative
customer accounts due to an unwillingness to absorb the charge. The
fact that this decision is made for cost rather than risk reasons is
clearly not in the best interest of any participant in the U.S.
futures industry. This outdated regulation forces the concentration
of exchange traded short options in a few firms.
In general, FCMs have little control over reducing the charge.
Requiring additional collateral has no impact on the charge itself
and will instead increase the FCM's capital requirements. We believe
the SPAN 9 performance bond system adequately captures
the risk in options portfolios and the undermargined charge to
capital appropriately reflects risk in an FCM's capital computation.
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\9\ SPAN is an acronym for Standard Portfolio Analysis of Risk.
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The charge has a significant impact on the viability of the
exchange traded options markets. When market users can not find an
FCM willing to absorb the charge, the liquidity of our markets is
directly impacted. For all the reasons stated above, we again
request the CFTC eliminate this charge in its entirety . . .
II. Discussion
As stated above, the Commission proposes that the SOV charge be
rescinded for two reasons: (1) The rule has not resulted in capital
charges proportionate to risk; and (2) the SPAN margining system and
other non-capital components of the system of protections are much
better developed and executed than they were when the SOV charge was
first adopted. These factors are discussed below in two sections. The
first section addresses the theoretical deficiencies of the SOV charge,
and the second section is a summary of non-capital protections.
A. Theoretical Deficiencies of the SOV Charge
The current charge based on four percent of SOV has not, in
practice, resulted in capital charges which are proportionate to risk.
The following situations are illustrative:
Multiple Strikes--Exchanges typically list multiple strikes with
the same underlying futures contract in a given option contract month.
Option premium typically increases across strikes, moving from out-of-
the-money strikes to in-the-money strikes. Moving to deep-in-the-money
strikes increases the option intrinsic value and the resulting premium.
At some deep-in-the-money point the deltas of the different strikes
will be the same. Therefore, while two deep-in-the-money strikes may
have very similar or even identical risk profiles, the deeper-in strike
will have a higher intrinsic value and a higher premium, yielding a
higher SOV charge. The SOV charges for the two options can differ 200
percent or more, even though those options have the same underlying
futures, the same time to expiration, and the same risk profiles.
Risk-Reducing Strategies--Short options positions are often used as
one component of a trading strategy. The other positions used in the
strategy could be futures, other derivatives, or cash instruments. In
such strategies, the short options positions may be intended as a risk-
reducing position, as demonstrated by the fact that the introduction of
the short options positions into the portfolio results in a reduction
in the SPAN-based margin requirement for the portfolio. Despite the
fact that these positions are risk-reducing, the short option values
for these portfolios increase markedly in trending markets. In
practice, the Commission notes that some FCMs which have carried the
accounts of traders who do a great deal of these kinds of strategies
have faced large capital charges in trending markets. Because the short
options component of such strategies is actually risk-reducing, the SOV
charge has not served its intended purpose in these cases.
The following examples will illustrate the problem with short
calls. (Also, the same problem applies to short puts.)
Deep-In-The-Money Short Dated Short Call--A deep-in-the-money short
dated short call has a risk profile essentially like a short futures
position. The one major difference between the short call and the
futures contract is that the call has a large intrinsic value which
translates into a large premium and a corresponding large SOV charge.
Therefore, FCMs incur a significant extra capital requirement for the
short call even though there is no extra capital requirement to carry
essentially the same risk with equivalent short futures contracts. In
this case, the capital requirement is excessive compared to the risk,
as indicated by the margin requirement on the futures contract.
Deep-Out-Of-The-Money Short Dated Call--A deep-out-of-the-money
short dated call displays more of the unique risk characteristics
associated with options. While initially it has a low
[[Page 12715]]
delta 10 this short call has a high gamma 11 as
it approaches the money, introducing the potential for significant
losses from extreme underlying moves. For normal underlying moves, this
deep-out short call has little risk. Only extreme moves far beyond the
normal performance bond coverage levels would cause significant losses
for this option. However, because this deep-out short call has no
intrinsic value and little time value, it typically has very low
premium and therefore has a correspondingly low capital charge. Because
this kind of risk rarely materializes into actual losses, it is best
addressed by the non-capital protections. These protections are
described below.
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\10\ Delta measures the amount an option price changes for a
one-point change in the price of the underlying product.
\11\ Gamma is a risk variable that measures the amount that the
delta of an option changes given a one-point change in the price of
the underlying product.
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As discussed below, the Commission believes that the SPAN margining
system, since its introduction in December 1988, appears to have
provided adequate margins. Also, SPAN is being refined on an ongoing
basis by the CME, the CBOT, and the other SROs which use it. Finally,
the Commission has previously reported to the Federal Reserve Board
that the SPAN margining system has met its performance goals for many
years, with respect to futures margins on stock index futures
contracts.
B. Summary of Non-Capital Protections
There are protections against the risk of short options other than
net capital charges. In this connection, the Commission believes that
the non-capital components of the system of protections in place are
now stronger than they were when the SOV charge was put into place.
Risk management models have been refined over the years; there have
been enhancements in Commission and SRO audit and surveillance
programs; FCM risk management systems and controls have improved
significantly compared to what was available and in place at many firms
when the SOV charge was first adopted; and technological advancements
have improved communication among clearing organizations, FCMs and
their customers. Therefore, the Commission has preliminarily concluded
not only that the SOV charge has not worked to provide a risk-based
protection, as hoped, but also that these other non-net capital
protections have been improved over the years and have resulted in an
overall strengthening of the system, well beyond what was in place when
the SOV charge was adopted. The primary non-capital protections are
described below.
Portfolio Margining System
Performance bond requirements are referred to commonly as
``margin'' requirements. Margin requirements typically are set at
levels which cover 95 to 99 percent of a product's expected daily price
change over a period of time. To ensure that margin requirements are
set at appropriate levels, historical volatility price charts are
reviewed by product and spreads between products. SPAN is a risk-
measuring margin methodology adopted by all U.S. and numerous foreign
futures exchanges. SPAN uses option pricing models to calculate the
theoretical gains and losses on options under various market situations
(e.g., prices up, prices down, volatility up, volatility down, and
extreme price movements). As noted above, the Commission has reported
to the Federal Reserve Board on the effectiveness of SPAN in setting
margins in equities-related futures contracts.
Financial Surveillance and Position Reporting Systems
Generally, it is the large traders which pose the greatest risk to
FCMs. To deal with this risk, the U.S. futures industry has a very
complete and current system of position reporting. This permits close
monitoring of the positions of large traders and is the foundation of
an effective program of financial surveillance conducted by the SROs.
As explained below, current positions are assessed prospectively--what
financial effect would such positions have if the market moved
significantly one way or the other. The advanced reporting systems in
place permit assessments to be done at the account level, which is
where risk to the firms must be evaluated. Using account level data
along with other information, the SROs' sophisticated programs are
designed to identify risks to the clearing system, including
financially troubled FCMs or FCMs that carry high-risk positions.
To accomplish this goal, SROs monitor market developments
throughout the day, make intra-day variation margin calls on clearing
members, and follow up with individual FCMs regarding potential
problems. There have been occasions in the past when customers holding
very large or concentrated positions have caused financial problems for
their carrying FCMs. Large trader monitoring systems are designed to
identify such traders before losses occur. Although it is not possible
to obviate the possibility of an FCM failure due to the default of a
large trader, the systems operated by the SROs improve the control of
this risk by permitting scrutiny of large trader positions by the SROs.
Scrutiny is carried out by the SROs on a systematic basis.
Using the large trader information, SROs perform stress testing of
positions using ``what if'' price simulations based on open positions
carried by clearing member FCMs in order to determine an FCM's
potential risk in relation to its excess net capital. Daily pay/collect
variation margin is aggregated for periods of time to monitor losses
compared to the excess capital of the firm. Potential losses revealed
by the stress testing, which are determined to be large in relation to
an FCM's most recently reported capital, will indicate that the firm
should be contacted by SRO surveillance staff to obtain assurances that
the FCM has properly evaluated the creditworthiness of its customers
and the adequacy of collateral in place.
As noted elsewhere, as a part of its oversight program, the
Division regularly reviews the procedures used by the SROs to conduct
financial surveillance over member-FCMs. The Division's reviews, as
well as experience over many years working with the SROs in identified
problem situations, reveal that the systems generally have been
effective. The systems also have improved over time, because the SROs
have shown a willingness to learn from experience. However, it should
be noted that financial surveillance at the SRO level, including any
review work done at an FCM during an in-field examination, is not a
substitute for an effective risk management and control system operated
by the FCM itself. The Commission believes that the audit and financial
surveillance programs operated by the SROs have been effective in
encouraging the development of equally good risk management and control
systems at FCMs. In this connection, as explained below, the SROs
ensure that FCMs have appropriate risk management and control systems
in place and make recommendations when their in-field audits reveal
inadequate systems.
Capital and Segregation Requirements for FCMs
The Commission's capital and segregation requirements are part of
the protections built into the system against the risk of short options
positions. All FCMs must meet the Commission's net capital and
segregation requirements, as
[[Page 12716]]
well as SRO requirements. An FCM which is a clearing member also must
have capital requirements which are higher than those set by the
Commission. Commission regulations require firms to keep current books
and records, prepare a daily segregation calculation and a formal,
monthly capital calculation, among other things. FCMs must be in
compliance with the net capital and segregation rules at all times.
Material inadequacies in internal control must be reported. The demands
of these recordkeeping and reporting requirements serve as an element
of the overall system of internal controls. The daily segregation
calculation, especially, will reveal problems in customers' accounts
very quickly, when and if they occur.
The basic capital requirement is set at four percent of an FCM's
liabilities to its customers. The segregation rule requires an FCM to
have sufficient funds in segregation to meet its liabilities to its
customers. The underlying concept of segregation is that by separating,
i.e., segregating, the funds of customers from the proprietary funds of
the FCM, there will be sufficient funds available to pay off the FCM's
liabilities to its customers in the event of the FCM's failure due to
proprietary losses. As already stated, in order to demonstrate to
itself and regulators that it is in compliance with the segregation
requirements, an FCM is required to prepare a daily computation of the
status of the segregated accounts, which shows that there are
sufficient funds in segregation. One of the elements of the computation
is to ascertain the status of deficits in the accounts of customers.
Any deficit which is not covered by appropriate collateral must be made
up by the firm with funds of its own. Deficits outstanding for more
than one day have a direct and immediate impact upon firm capital and
may cause a firm to be undercapitalized. An FCM must report to the
Commission in the event its capital falls below the early warning
level, which is 150 percent of required capital. Although the capital
rule provides some discretion to the Commission in allowing an FCM to
come back into capital compliance, with respect to undersegregation,
there is no grace period.12 Therefore, it is prudent for an
FCM to carry excess net capital and funds in segregation in amounts
commensurate with the type of business it handles.
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\12\ The Commission has proposed to amend Regulation 1.12, its
early warning notification rule, to add a requirement that an FCM
promptly report to the Commission and the FCM's DSRO whenever it
knows or should have known that it does not have sufficient funds in
segregated accounts to meet its obligations to customers who are
trading on U.S. markets or set aside in special accounts to meet its
obligations to customers who are trading on non-U.S. markets. 63 FR
2188 (January 14, 1998).
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SRO Programs of In-Field Audits of FCMs
The Commission believes that the in-field audit program conducted
by the SROs over their member-FCMs has resulted in a high level of
compliance with the Commission's and the SROs' financial rules.
Commission rules require SROs to have these programs in place. To this
end, each FCM's DSRO conducts an annual audit of each FCM assigned to
it under the Joint Audit Plan. Under the plan, a full-scope audit is
conducted every other year, and a limited-scope records review is
conducted in the alternate year. The audits are conducted according to
the Joint Audit Program, which is designed and regularly updated for
new developments by the JAC. The Commission reviews the Joint Audit
Program each time it is updated.
The full-scope audit, conducted using the Joint Audit Program,
includes a review of the systems and controls that the FCM has in
place. In this connection, members of JAC complete a Financial and Risk
Management Internal Controls questionnaire for each FCM audit. The
questionnaire covers the firm's procedures for: opening new accounts,
monitoring non-customer trading, assessing the impact of potential
market movements on customer and non-customer trading, and ensuring
that the segregation of duties is appropriate. Furthermore, during the
course of the audit, a review is made of account documentation, margin
procedures, undermargined account net capital charges, debit/deficit
accounts and sales practices. Such reviews provide information to
assess the firm's overall internal control and risk management
procedures.
The JAC has initiated a project to revise its in-field audit
approach to be more explicitly risk-based. That is, in planning and
performing in-field audits, the DSRO will place a greater emphasis upon
review and identification of potentially high risk areas at an FCM at
the outset of an audit. The results of this early audit survey and
planning work will translate into a more focused targeting by the DSRO
of the total available audit resources upon the areas of highest risk
at an FCM.
III. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') 5 U.S.C. 601 et seq.,
requires that agencies, in proposing rules, consider the impact of
those rules on small businesses. The Commission has previously
determined that FCMs are not ``small entities'' for purposes of the
Regulatory Flexibility Act.13 Therefore, the Chairperson, on
behalf of the Commission, hereby certifies, pursuant to 5 U.S.C.
605(b), that the action taken herein will not have a significant
economic impact on a substantial number of small entities.
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\13\ 47 FR 18619-18620.
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B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 14 imposes certain
requirements on federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of
information as defined by the Paperwork Reduction Act. While this
proposed rule has no burden, the group of rules (3038-0024) of which
this is a part has the following burden:
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\14\ Pub. L. 104-13 (May 13, 1995).
Average burden hours per response: 128.
Number of Respondents: 3143.
Frequency of response: On occasion.
Copies of the OMB-approved information collection package
associated with this rule may be obtained from Desk Officer, CFTC,
Office of Management and Budget, Room 10202, NEOB Washington, DC 20503,
(202) 395-7340.
List of Subjects in 17 CFR Part 1
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements, Net capital requirements.
In consideration of the foregoing and pursuant to the authority
contained in the Commodity Exchange Act and, in particular, Sections
4f, 4g and 8a (5) thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission
hereby proposes to amend Chapter I of Title 17 of the Code of Federal
Regulations as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,
6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a,
12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24.
Sec. 1.17 [Amended]
2. Section 1.17(c)(5)(iii) is removed and reserved.
[[Page 12717]]
Issued in Washington, DC on March 9, 1998, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 98-6580 Filed 3-13-98; 8:45 am]
BILLING CODE 6351-01-P
