[Federal Register Volume 59, Number 54 (Monday, March 21, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-6413]
[[Page Unknown]]
[Federal Register: March 21, 1994]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-33761; File No. S7-7-94]
RIN 3235-AG14
Capital Requirements for Brokers or Dealers Under the Securities
Exchange Act of 1934
AGENCY: Securities and Exchange Commission (``Commission'').
ACTION: Proposed rule amendments.
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SUMMARY: The Commission is proposing for comment amendments that would
allow broker-dealers to use a theoretical pricing model when
calculating capital charges for listed options and related positions.
Haircuts for options and related positions, when computed using this
model, would more accurately reflect the risk inherent in broker-
dealers' option positions. The proposed amendments are intended to
provide capital charges that better protect broker-dealers against
market risk.
DATES: The requested written data, views, arguments or comments must be
received on or before May 16, 1994.
ADDRESSES: People wishing to submit written data, views, arguments, or
comments should file three copies with Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW., Stop 6-9,
Washington, DC 20549. All written data, views, arguments, or comments
should refer to File No. S7-7-94. All comments received will be
available for public inspection and copying in the Commission's Public
Reference Room, 450 Fifth Street, NW., Washington, DC 20549.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, (202) 272-2904; Roger G. Coffin, Branch Chief, (202) 272-
7375; Timothy H. Thompson, Branch Chief, (202) 272-2372; or Bradley W.
Paulson, Staff Attorney (202) 272-2396; Office of Capital Markets and
Financial Responsibility, Division of Market Regulation, Securities and
Exchange Commission.
SUPPLEMENTARY INFORMATION:
I. Introduction
In May 1993, the Commission issued a concept release soliciting
public comment on issues relating to the standards imposed on
derivative products by the net capital rule (``Concept
Release'').1 The Concept Release noted that, at the time, the
Commission's staff was studying a recommendation to adopt a theoretical
pricing model developed by The Options Clearing Corporation (``OCC'')
to determine haircuts for broker-dealers' option positions under the
net capital rule. The Concept Release specifically asked questions on
the use of theoretical pricing formulas to determine haircuts for over-
the-counter (``OTC'') options. The Commission is now proposing for
comment amendments to the net capital rule, that would allow broker-
dealers to use data derived from OCC's theoretical pricing model to
determine haircuts for listed options and related positions.2
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\1\Securities Exchange Act Rel. No. 32256 (May 4, 1993), 58 FR
27486 (May 10, 1993).
\2\Simultaneous with this release, the Division of Market
Regulation (``Division'') is issuing a letter stating that it will
recommend no enforcement action to the Commission if, pursuant to
the terms of that letter, broker-dealers use theoretical pricing
data provided by OCC to calculate haircuts for listed options and
related positions.
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The proposed amendments will not change the current strategy-based
haircut methodology for OTC options. As noted in the Concept Release,
before adequate charges for OTC options can be determined, it will be
necessary to ascertain the manner in which the credit risk associated
with these positions can be adequately measured. The Commission,
however, continues to be interested in studying the applicability of
the proposed theoretical pricing haircut methodology to assess the
market risk for OTC options and currently is evaluating, among other
things, the comment letters addressing the questions for comment set
forth in the Concept Release.
II. Historical and Technical Background
A. Current Net Capital Treatment of Options
The Commission's net capital rule requires that every registered
broker-dealer maintain sufficient liquid assets to enable those firms
that fall below the minimum net capital requirements to liquidate in an
orderly fashion without the need for a formal proceeding. Generally,
net capital, as defined by Rule 15c3-1, is a broker-dealer's net worth
plus liabilities subordinated in accordance with Appendix D of the net
capital rule, minus assets not readily convertible into cash and
certain percentages, or haircuts, of a firm's proprietary securities
positions, including option positions.
Currently, the net capital rule provides two basic capital
treatments for option positions held by broker-dealers. The first
approach, which is set forth in Appendix A to Rule 15c3-1, assumes that
the option will be exercised or held to expiration. The second
approach, a premium-based approach, assumes that options are used as
trading positions. This approach is contained in paragraph (c)(2)(x) of
Rule 15c3-1. Both methodologies of computing charges provide for lower
haircuts for certain risk offsetting positions held by broker-dealers,
although the premium-based approach recognizes more types of offset
positions. The provisions of Appendix A were designed for firms
clearing their proprietary listed option and related positions.3
While market-makers on the floors of the option exchanges are exempt
from the net capital rule,4 a clearing firm endorsing or
guaranteeing the listed option positions of non-clearing market-makers
is required to charge the premium-based haircuts to its capital. The
premium-based approach also can be used by a clearing firm if its
business is limited almost exclusively to effecting (either directly or
as agent) and clearing market-making transactions in listed
options.5
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\3\In a letter dated October 23, 1985, the Commission's staff
issued no-action relief allowing broker-dealers clearing their
proprietary listed option and related positions to apply a premium-
based haircut methodology. Letter from Michael A. Macchiaroli,
Assistant Director, to Michael Minikes, Chairman, Capital Committee,
Securities Industry Association, (October 23, 1985).
\4\17 CFR 240.15c3-1(b)(1).
\5\17 CFR 240.15c3-1(a)(7).
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As currently drafted, paragraph (c)(2)(x)(F) of Rule 15c3-1
provides that, if the haircuts for a particular market-maker's account
exceed the equity in the account, the carrying broker-dealer may not
extend further credit to the market-maker unless the carrying broker-
dealer requires the additional deposit of sufficient equity to
eliminate the net capital charge. However, the Division, in an
interpretive letter approved by the Commission, has allowed the
carrying broker-dealer to forego this requirement if it takes a charge
against its capital to the extent that the equity in the market-maker's
account is insufficient to cover the haircuts.6
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\6\Letter from Lee A. Pickard, Director, Division, Commission,
to Joseph W. Sullivan, President, Chicago Board Options Exchange
(April 8, 1977).
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B. Development of Option Pricing Models
Over the last 30 years, several models have been developed to
determine the value of an option.7 Initially, these models were
applied to warrants, because, at the time, that market was more
active.8 Option pricing formulas have been refined and are now
widely used to calculate option prices by assigning pre-determined
values to the factors that are known to affect their prices.
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\7\An option gives the holder the right to buy (i.e., a call) or
sell (i.e., a put) a particular underlying instrument at a certain
price for a limited period of time. An option's price, or
``premium,'' has two components, the option's intrinsic value and
the ``time value.'' An option's intrinsic value is the difference
between the price of the underlying instrument and the strike price.
The time value is the amount by which the premium exceeds the
option's intrinsic value.
\8\Fischer Black, ``How We Came Up With the Formula'' in The
Financial Derivatives Reader 176 (Kolb ed. 1992).
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In 1973, Fischer Black and Myron Scholes introduced a formula to
calculate European call option prices.9 The primary factors
affecting the price of an option are: The value of the underlying
asset, the exercise price of the option, the price volatility of the
underlying asset, the risk-free rate of interest and the remaining time
to expiration. The payment of dividends on the stock, as well as the
exercise timing of the option (i.e., American or European), also can be
factors in the pricing of an option.
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\9\Fischer Black & Myron Scholes, The Pricing of Options and
Corporate Liabilities 3 J. Polit. Econ. 637 (May-June 1973).
A European option can be exercised only on the expiration date,
while an American option can be exercised at any time prior to
expiration date.
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Subsequent to the development of the Black-Scholes formula, John
Cox, Stephen Ross and Mark Rubinstein developed a binomial pricing
model to determine the value of options.10 Unlike the Black-
Scholes formula, which employs ``mathematical tools * * * [that] are
quite advanced'' to determine the probable value of the underlying
instrument at the time of expiration, the Cox-Ross Rubinstein model
replicates periodical upward and downward movements in the value of an
option until the option's expiration date.11 By determining
different probable option values at various periods during the life of
an option, the Cox-Ross-Rubinstein model is able to incorporate
dividend yields, and American option prices can be determined.
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\1\0John Cox, Mark Rubinstein & Stephen Ross, Option Pricing: A
Simplified Approach 7 J. Fin. Econ. 229 (1979).
\1\1Id. at 230.
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Based on the Cox-Ross-Rubinstein model, OCC has developed the
Theoretical Intermarket Margining System (``TIMS'') to measure the
market risk associated with participants' positions and establish
clearing house margin requirements.12 Likewise, for the last
several years, option pricing models, including the Cox-Ross-Rubinstein
model, have been commonly used by market professionals to develop
trading strategies and to manage market risk. In light of such
industry-wide usage, recommendations have been made urging the
Commission to adopt option pricing models to set capital charges.
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\1\2Securities Exchange Act Rel. No. 23167 (April 22, 1986), 51
FR 16127 (April 30, 1986).
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The proposed amendments to Rule 15c3-1 would establish a haircut
methodology based on the Cox-Ross-Rubinstein binomial model. This model
would be used to determine an option's theoretical gains and losses
after re-pricing the option in relation to assumed changes in the value
of the underlying instrument. At least initially, OCC would run the
model as explained below and deliver to interested broker-dealers the
gains and losses from each option positions which would be downloaded
by the broker-dealer into a spreadsheet provided by OCC. The
spreadsheet would contain all of the broker-dealer's relevant
positions.
III. Description of the Proposed Rule Amendment
With respect to each option series13 it clears, OCC would
collect the following information on a daily basis:
\1\3An option series includes option contracts of the same type
(either a call or a put) and exercise style covering the same
underlying instrument with the same exercise price, expiration date
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and number of underlying units.
(i) The dividend streams for the underlying securities,
(ii) Interest rates (either the current call rate or the
Eurodollar rate for the maturity date which approximates the
expiration date of the option),
(iii) Days to expiration, and
(iv) Closing underlying security and option prices from various
vendors.
Using these values and the binomial model, OCC would measure the
implied volatility for each option series.
OCC then would input to the model the resulting implied volatility
for each option series and other data, except the underlying value,
used in the calculation of the implied volatility. For each option
series, the model would calculate theoretical prices at ten equidistant
valuation points within a range consisting of an increase or a decrease
of the following percentages of the daily market price of the
underlying instrument:
(i) +(-)15% for equity securities with a ready market, narrow-
based indexes, and non-high-cap, broad- based indexes,
(ii) +(-)6% for major market currencies,14 and
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\1\4Deutsche Mark, British Pound, Swiss Franc, French Franc,
Canadian Dollar, Japanese Yen and European Currency Unit.
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(iii) +(-)10% for high-cap, broad-based indexes.
On a daily basis, OCC would use the model to determine the
theoretical gains/losses between the option's closing price and the
theoretical price at each one of the ten equidistant valuation points.
OCC would provide daily these theoretical gain/loss amounts to broker-
dealers.
Upon receipt of the theoretical gain/loss amounts, the broker-
dealer would download the information to a theoretical pricing haircut
spreadsheet. The broker-dealer must add to the spreadsheet all
proprietary or market-maker positions to be haircut. The spreadsheet
generates a profit/loss amount at each valuation point for each option
series and related positions covering the same underlying asset. The
greatest loss at any of the valuation points becomes the haircut for
those positions. The spreadsheet has been programmed to compute a
minimum haircut charge and identify the greater of the computed or
minimum charge as the haircut.
For example, assume a portfolio consisting of IBM common stock and
various puts and calls on IBM common stock with different strikes and
expiration dates. OCC would re-price each option position assuming that
the price of the IBM common stock had moved up or down by a maximum of
15%, at ten valuation points (i.e., -15%, -12%, -9%, -6%, -3%, +3%,
+6%, +9%, +12%, +15%). The single, maximum net loss amount at any one
of the ten valuation points would become the haircut for the portfolio.
Within any portfolio type involving the same underlying stock,
index or currency, 100% of a position's gain at any one valuation point
will be allowed to offset another position's loss at the same valuation
point. Between qualified stock baskets (provided that the stock basket
represents no less than 90% of a high-cap, broad-based index's
capitalization or 100% of the capitalization of a narrow-based
index)15 offset by index options, or futures or futures options on
the same underlying index, 95% of gains would offset losses at the same
valuation point. Among high-cap, broad-based index options, futures and
futures options, 90% of the gain on one high-cap, broad-based index
position in the same market group, e.g. U.S. or Japan, would offset the
loss on a position on a different high-cap, broad-based index at the
same valuation point. Among non-high-cap, broad-based index options,
futures and futures options, 75% of the gain on one non-high-cap,
broad-based index position shall offset the loss on a position on a
different non-high-cap, broad-based index at the same valuation point.
The difference in offsets are designed to take into account liquidity
and execution risk in different markets.
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\1\5The proposed amendments would not recognize stock basket
offsets for non-high-cap, broad-based indexes.
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IV. Discussion of Issues Pertaining to the Proposed Theoretical Pricing
Haircut Methodology
A. Pilot Program
At the request of the Commission's staff, The Chicago Board Options
Exchange, Inc. (``CBOE'') and OCC established a pilot program to
compare the results achieved under the current haircut methodology and
the theoretical pricing approach. The pilot study was conducted from
April 22, 1992, through July 31, 1992, and included twelve firms
clearing either independent or proprietary market-maker accounts. The
pilot program included approximately 1,400 market-maker accounts.
The study employed the methodology that is now being proposed to
replace the current treatment for options and related positions set
forth in the net capital rule. As part of the pilot study, a minimum
charge of \1/8\ of a point per option contract was applied when the
theoretical pricing haircut for the class or product group reflected
little or no market exposure. This minimum charge (raised to \1/4\ of a
point in the current proposal), was assessed to account for liquidation
risk.
During the pilot study period, the proposed haircut methodology
resulted in an average haircut level reduction of 38% for self-clearing
market-maker firms. This average remained generally constant throughout
the pilot study period. This reduction in haircut levels seemed to have
resulted from the fact that, while these firms take large positions,
they tend to be more active in covering their market risk.
The results of the pilot study revealed that haircut charges for
non-clearing market-maker firms increased by an average of 3%. Of the
non-clearing market-maker accounts, 70% reflected a haircut change of
less than +(-) $50,000. At the same time, however, total deductions for
those firms (reflecting an increase in haircuts above the equity levels
kept in the market-maker accounts) increased by an average of 59%. The
decrease or minor increase in haircut levels, accompanied by a
substantial increase in deductions, seemed to have been the result of a
redistribution of haircuts to accounts containing positions with
greater market exposure but with less equity to cover the haircut
increase.
This conclusion appeared to be further confirmed by the fact that,
under the proposed methodology, haircut charges for accounts with short
positions appeared to increase.16 During the pilot study, CBOE and
OCC selected ten accounts that reflected significant differences
between the current haircut methodology and theoretical pricing
haircuts. Five of these accounts consisted of index option positions,
while the rest consisted of equity options. As a general rule, when
using theoretical prices to calculate haircuts, excess short positions
resulted in a substantial haircut increase. This also was true in the
case of index option accounts, where, assuming a +(-) 10% underlying
movement, accounts with excess short positions endured an increase in
haircut levels, unless the risk associated with the short positions was
offset by the profit in another position.
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\1\6Past market experiences have shown that short option
positions tend to be particularly risky. In relation to the Market
Break of 1987, the Division noted the link between substantial
market-maker losses and short option positions. At the time, the
Division concluded that ``* * * the present net capital treatment
accorded to short options positions is inadequate to insure against
the risks of major market movements.'' Division, The October 1987
Market Break 5-46 (February 1988).
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To further test the level of market protection provided by the
proposed underlying price movement assumptions, the Commission's staff
required CBOE and OCC to compare haircuts under the proposed
theoretical price-based methodology and under the current methodology,
assuming a 22% daily downward market move for two days. In addition,
given the magnitude of this market move, implied volatilities were
assumed to double in size. The results of this test seemed to be
consistent with the general conclusions of the pilot study.
B. Underlying Price Movement Assumption for Certain Index and Currency
Options
One of the principal variables affecting the value of an option is
the price of the underlying instrument. The Commission, therefore,
believes that underlying price movement assumptions for the proposed
theoretical pricing model should be consistent with the volatility
assumptions currently incorporated in the net capital rule. These
assumptions are: 6% for major market foreign currencies, 15% for
equities with a ready market, narrow-based indexes and 10% for high-
cap, broad-based indexes and non-high-cap broad-based indexes. These
underlying price movement assumptions reflect the risk stemming from
major movements in the value of the option's underlying instrument.
While CBOE and OCC agree with the Commission with regard to the
underlying price movement assumptions for equities with a ready
market,17 they believe that, with respect to high-cap, broad-based
index options, a +(-)10% underlying price movement assumption for all
broker-dealers may be too large. Similarly, the Philadelphia Stock
Exchange (``Phlx'') believes that an underlying price movement
assumption of +(-)6% for major market foreign currency options may be
too large for non-clearing market-makers. CBOE, OCC and Phlx,
therefore, have recommended the following underlying price movement
assumptions: (i) +6%, (-)8% for high-cap, broad-based index positions
of non-clearing option market-makers and a +(-)10% underlying
volatility assumption for all other broker-dealers, and (ii) +(-)4\1/
2\% for the major market foreign currency positions of non-clearing
option market-makers and a +(-)6% for all other broker-dealers.
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\1\7Letter from Mary L. Bender, First Vice President, CBOE &
John C. Hiatt, Executive Vice President, OCC to Michael A.
Macchiaroli, Associate Director, Division, Commission (May 7, 1993)
at 7.
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CBOE and OCC note that during the pilot study, haircuts for non-
clearing index market-makers increased by an average of approximately
27% and deductions increased by 121%. The data, however, provides very
little information indicating whether this percentage is entirely due
to the application of a +(-)10%, rather than if the proposed +6%, (-)8%
underlying price movement assumption, or whether the increase was the
result of account positions reflecting a larger market exposure. The
data provided, however, shows that during the course of the study there
were days when the application of a +(-)10% underlying price movement
assumption resulted in haircut reductions. Moreover, in one case for
which detailed account information was provided, the data showed that,
in the absence of excess naked short positions, theoretical pricing
haircuts assuming a +(-)10% underlying price movement resulted in an
81% reduction in haircut levels.
In light of the concerns raised and the lack of sufficient data,
the Commission is requesting comments on the recommendation set forth
by CBOE, OCC and Phlx. In particular, the Commission would like to
receive information on the impact upon traders, their clearing firms
and the pricing and liquidity of the index and currency markets
resulting from the implementation of a +(-)10% underlying volatility
assumption for high-cap, broad-based index options and a +(-)6% for
major market currency options and related positions. The Commission
also would welcome information regarding the cost of keeping the
underlying price movement assumptions at the proposed levels, rather
than at the levels recommended by CBOE, OCC and Phlx.18 In this
regard, the Commission invites commentators to discuss the extent to
which foregoing the added protection afforded by a +(-)10% underlying
price movement for high-cap, broad-based index options and a +(-)6% for
major market currency options and related positions is justified in
light of the possibility of sudden market movements such as those
experienced in 1987 and 1989.
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\1\8In this regard, the Commission encourages commentators to
consider, in particular, the impact that the marginal cost of
capital will have on the proposed rule amendment.
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C. Series Specific Volatilities and Constant Short-term Interest Rates
Prices derived from theoretical pricing models are a function of
the variables inputted. In computing the theoretical price of an
option, the Cox-Ross-Rubinstein model, like the Black-Scholes formula,
assumes that the implied volatility will remain constant over the life
of the option. Accordingly, the underlying instrument's price is
expected to change smoothly, never reflecting a sudden large movement.
Likewise, in computing theoretical prices it is assumed that the short-
term interest rate never changes.
(1) Series Specific Volatilities
Failure to take into account abrupt changes in an option's implied
volatility could result in unrealistic theoretical prices and less than
adequate capital requirements.19 The proposed rule amendment
requires the use of daily calculated series specific implied
volatilities. It has been suggested, however, that implied volatility
inputs should be allowed to fluctuate within chosen parameters.
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\1\9See generally Fischer Black, ``How to use the Holes in Black
Scholes'' in The Financial Derivatives Reader 198 (Kolb ed. 1992).
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There seems to be, however, little market consensus as to the
manner in which such adjustment can be implemented. Although it appears
that the underlying price movement assumptions embodied in the proposed
rule amendment are sufficiently large to adequately address any
concerns raised by the use of a constant implied volatility measure,
the Commission solicits comments on this issue.
(2) Constant Short-Term Interest Rates
Some commentators have suggested that interest rate variables
should be allowed to fluctuate within chosen parameters when computing
theoretical pricing haircuts. Aside from the computational burden
associated with allowing interest rates to fluctuate within chosen
parameters,20 it is generally believed that option prices are not
so sensitive to changes in interest rates so as to warrant changes in
the model's interest rate factor. Moreover, as previously noted, it
would seem that the substantial proposed underlying price movement
assumptions should compensate for any pricing problem associated with a
constant interest rate input.
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\2\0Altering the interest rate assumption would result in a
substantial increase in the number of computer calculations
necessary to determine theoretical pricing haircuts.
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D. Minimum Charges
During the pilot program, a minimum haircut of \1/8\ of a point per
option contract was applied. Pursuant to a recommendation by OCC and
CBOE, the proposed amendments would increase the minimum charge to \1/
4\ of a point per contract. The Commission believes that this increase
is appropriate to account for liquidation and decay risk in the prices
of long and short options in those instances in which application of
the theoretical pricing haircut methodology results in little or no
charge.
The proposed minimum charge presumes that a basic equity option
contract covers 100 shares. To the extent that an option or futures
contract exceeds the size of a basic option contract the minimum charge
would have to be increased by the additional percentage amount of
underlying units. For example, if an IBM option contract covered 500
shares instead of the usual 100, the minimum charge would be $125
((i.e., 5 x 25).
E. Distribution of Theoretical Pricing Data
The theoretical pricing haircut methodology set forth in the
proposed rule amendment seems to provide appropriate capital levels for
broker-dealers. While the securities industry generally supports the
proposal and its immediate implementation, the Commission believes that
there are several details in the proposed rule that should be observed
closely, and continued to be discussed in light of the public comment
received in response to this proposal.
In this regard, particular concerns have been raised respecting the
use of proprietary versions of option pricing models to calculate
haircuts. During the pilot study, OCC calculated the theoretical value
for each option series. Accordingly, the values inputted to determine
the theoretical pricing haircuts and, consequently, the resulting
haircuts were consistent among broker-dealers with the same positions.
In order to secure reliable results during the pilot study, moreover,
OCC applied editing procedures to ensure the accuracy of the resulting
values.21
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\2\1Prices for options and underlying assets were supplied by at
least two sources, private vendors and the exchanges where the
products were traded. OCC would perform a direct comparison of the
supplied price data. Subsequently, OCC would subject option prices
to a reasonableness check by calculating theoretical prices for
every option series. Ranges based on the option's theoretical price
were then set. An option's price was verified if a market price fell
outside its designated range. OCC would use a theoretical price in
place of a market price that fell outside its designated range.
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In light of the reliance on the choices made concerning the model's
variables, the use of proprietary models could result in significantly
different theoretical prices given the same assumed underlying price
movement. The Commission believes, therefore that there is a need for a
controlled environment that ensures the integrity of the haircut
results for all broker-dealers using the proposed methodology. Allowing
broker-dealers to employ any proprietary model and/or failing to
control the sources of the various values inputted to the model would
substantially hinder the ability to examine the accuracy of option
haircuts and their effectiveness as a way of ensuring adequate capital
levels. For this reason, the proposed amendments to Rule 15c3-1 would
require broker-dealers to use exclusively the theoretical pricing
values produced and distributed nightly by OCC (or such other entity as
the Commission may designate).
While the proposed amendments provide authority for the Commission
to designate other providers of theoretical option prices, OCC is
designated in the rule as a provider because it is presently in a
unique position with respect to the listed securities option positions
in that it is the issuer of the options, the clearing agent of the
options, and the entity that currently sets margin requirements for its
clearing members by use of a theoretical pricing model. The Commission
also considers it critical that OCC is subject to Commission inspection
and regulation.
The Commission solicits comment on whether it is preferable to
continue to use a single theoretical pricing model or whether, and
subject to what conditions, the Commission should consider allowing the
use of alternative models. The Commission also requests comments on
whether limitations should be imposed on fees charged by entities
providing theoretical prices.
F. Alternative Strategy-Based Methodology
As a practical matter, to be able to implement the proposed haircut
methodology, broker-dealers will be required to have a computerized
interface with OCC's system.22 This linkage would allow broker-
dealers to receive timely the theoretical gain/loss amounts provided by
OCC. In addition, the computer system would enable broker-dealers to
make the multiple calculations that are necessary in order to apply
such data to their option positions.
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\2\2For broker-dealers requiring theoretical gains/losses data,
OCC is considering a menu approach to select the classes of options
for which values are needed. This approach is intended to reduce the
expense and transmission time of providing values which are not
needed.
For broker-dealers who are not participants, OCC is considering
the possibility of establishing a dial-up facility to provide
theoretical gain/loss amounts. The particular characteristics of
this facility would be determined in conjunction with the potential
users.
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The Commission realizes that broker-dealers with limited option
positions might find it not cost effective to implement a computerized
interface with OCC. In order to address this concern, the proposed
amendments contain an alternative strategy-based haircut methodology.
This alternative methodology generally follows the conservative
approach currently embodied in Appendix A to the net capital rule.
Broker-dealers employing the proposed strategy-based methodology
would be required to eliminate from net worth the time value associated
with long or short option positions. In addition, this alternative
haircut methodology will allow only certain basic strategies used by
broker-dealers to offset market risk. In particular, broker-dealers
would be allowed to take a reduced charge for hedged positions
consisting of a long underlying position and an offsetting short call,
a short underlying position and an offsetting long call, and a long
underlying position and an offsetting long put. The Commission believes
that these strategies will allow broker-dealers who do not want to use
the theoretical price-based methodology to maintain lower haircut
requirements that are consistent with the market risk associated with
their option positions.
V. Discussion of Related Issues
In connection with the adoption of a theoretical pricing haircut
methodology, the Commission believes it is necessary to make the
following changes to the net capital rule:
A. Deletion of Paragraph (a)(7) of the Net Capital Rule
As previously stated, the net capital rule contains two haircut
methodologies, the premium-based approach and the approach embodied in
Appendix A to Rule 15c3-1. Currently, pursuant to the provisions of
paragraph (a)(7) of the net capital rule, the premium-based approach is
available to a clearing firm, if its business is limited almost
exclusively to effecting (either directly or as agent) and clearing
market-making transactions in listed options.
The proposed amendments would delete paragraph (a)(7) of the net
capital rule. The Commission believes that this provision is no longer
necessary, because the proposed amendments would eliminate the
distinction between the premium-based approach and the approach set
forth in Appendix A.
B. Steps To Be Taken by a Broker-Dealer Carrying the Account of an
Option Market-Maker, When Equity in That Account Is Insufficient To
Cover Haircuts
Pursuant to the provisions of a 1977 interpretive letter, carrying
broker-dealers are not required to refrain from extending credit in a
market-maker account when haircuts for that account exceed the equity
in the account.23 This interpretation is conditioned on the
carrying broker-dealer taking a charge against capital to the extent
that the equity is insufficient to cover the haircuts. The proposed
amendments would incorporate this interpretation into the net capital
rule.
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\2\3Supra note 7.
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VI. Request for Comments
The Commission invites interested persons to submit written data,
views, arguments and/or comments on the proposed amendments. The
Commission is particularly interested in receiving comments from
broker-dealers on how these proposed rule amendments would affect their
required capital levels. Also, the Commission is interested in analyses
from broker-dealers on the ability of the theoretical pricing models to
accurately predict the risks in trading these instruments.
VII. Effects on Competition and Summary of Initial Regulatory
Flexibility Analysis
Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a)(2), requires
the Commission, in adopting rules under the Exchange Act, to consider
the anti-competitive effect of the rule, if any, and to balance any
impact against the regulatory benefits to be gained. The Commission has
considered the proposed amendments in light of this standard and
believes, preliminarily, that if adopted they would not likely impose
any significant burden on competition that is not necessary or
appropriate in furtherance of the Exchange Act. The Commission solicits
comment on this preliminary view.
In accordance with 5 U.S.C. 603, the Commission has prepared an
Initial Regulatory Flexibility Analysis (``IRFA'') concerning the
proposed amendments. The analysis notes that the proposed amendments
would implement a haircut methodology that employs a mathematical
formula to determine the theoretical value of options. The purpose of
these amendments is to make haircuts reflect more accurately the risks
associated with option positions.
Because of the complexity of the formula used to compute
theoretical prices, and in order to ensure the integrity of the
resulting haircuts, the Commission is proposing that only the OCC
theoretical pricing haircut program be utilized. Accordingly, to be
able to use this system it will be necessary for a broker-dealer to
have an automate interface with OCC's computer system. This would
enable broker-dealers to receive reliable, nightly data necessary to
calculate haircuts.
The proposed amendments will impact ``small business[es]'' or
``small organization[s],'' as those terms are defined in 17 CFR 240.0-
10(c), subject to Rule 15c3-1, insofar as they would be required to
implement a computer interface with OCC to be able to comply with the
requirements of the proposed rule amendment. In order to reduce the
impact on these broker-dealers, the proposed amendments set forth an
alternative haircut methodology that is based on the basic option
strategies used by broker-dealers.
A copy of the IRFA may be obtained by contacting Timothy H.
Thompson, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street NW., Washington, DC 20549, tel: (202) 272-
2372.
VIII. Statutory Analysis
The amendments are proposed pursuant to the authority conferred on
the Commission by section 15(c)(3) of the Act.
List of Subjects in 17 CFR Part 240
Brokers, Reporting and recordkeeping requirements, Securities.
For the reasons set forth in the preamble, Title 17 Chapter II of
the Code of Federal Regulation is proposed to be amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
1. The authority citation for part 240 continues to read in part as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg,
77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p,
78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37,
80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
Sec. 240.15c3-1 [Amended]
2. Section 240.15c3-1 is amended by removing and reserving
paragraph (a)(7).
3. Section 240.15c3-1 is amended by adding an undesignated center
heading before paragraph (c)(2)(x) and revising paragraph (c)(2)(x) to
read as follows:
Sec. 240.15c3-1 Net capital requirements for brokers or dealers.
* * * * *
(c) * * *
(2) * * *
Brokers or Dealers Carrying Accounts of Listed Options Specialists
(x)(A) With respect to any transaction in listed options for which
a broker or dealer acts as a guarantor, endorser or carrying broker or
dealer for listed options purchased or written by a specialist that is
either not otherwise subject to the provisions of this section or is
described in paragraph (c)(2)(vi)(N) of this section, such broker or
dealer shall adjust its net worth by deducting as of noon of the next
business day the amounts computed as of the prior business day pursuant
to Sec. 240.15c3-1a. The required deductions may be reduced by any
liquidating equity that exists in such specialist's market maker
account as of the close of the prior business day or by the deposit of
additional funds or securities in the account by noon of the next
business day, and shall be increased to the extent of any liquidating
deficit in such account. In no event shall excess equity in the
specialist's market maker account result in an increase of the net
capital of any such guarantor, endorser, or carrying broker or dealer.
(B) Definitions. (1) The term listed option shall mean a
standardized option as defined in Sec. 240.9b-1 that is traded on a
registered national securities exchange or the automated facilities of
a registered national securities association and is subject to the
transaction reporting requirements of the registered entity where it
trades.
(2) For purposes of this provision, the equity in an individual
specialist's market maker account shall be computed by:
(i) Marking all securities positions long or short in the account
to their respective current market values;
(ii) Adding (deducting in the case of a debit balance) the credit
balance carried in such specialist's market maker account; and
(iii) Adding (deducting in the case of short positions) the market
value of positions long in such account.
(C) No guarantor, endorser or carrying broker or dealer shall
permit the sum of the deductions required pursuant to Sec. 240.15c3-1
in respect of all transactions in specialists' market maker accounts
guaranteed, endorsed or carried by such broker or dealer to exceed
1,000 percent of such broker's or dealer's net capital as defined in
Sec. 240.15c3-1(c)(2) for any period exceeding three business days. If
at any time such sum exceeds 1,000 percent of such broker's or dealer's
net capital, then the broker or dealer shall:
(1) Immediately transmit telegraphic or telephone facsimile notice
of such event to the Division of Market Regulation in the headquarter's
office of the Commission in Washington, DC, to the district or regional
office of the Commission for the district or region in which the broker
or dealer maintains its principal place of business and to its
examining authority designated pursuant to section 17(d) of the
Securities Exchange Act of 1934 Act (``Designated Examining
Authority''); and
(2) Be subject to the prohibitions against withdrawal of equity
capital set forth in Sec. 240.15c3-1(e), and to the prohibitions
against reduction, prepayment and repayment of subordination agreements
set forth in paragraph (b)(11) of Sec. 240.15c3-1d, as if such broker
or dealer's net capital were below the minimum standards specified by
each of those paragraphs.
(D) If at any time there is a liquidating deficit in a specialist's
market maker account, then the broker or dealer guaranteeing, endorsing
or carrying listed options transactions in such specialist's market
maker account may not extend any further credit in that account, and
shall take steps to liquidate promptly existing positions in the
account. The broker or dealer also shall transmit by the close of
business of the following business day telegraphic or telephone
facsimile notice to its Designated Examining Authority and the
Designated Examining Authority of the specialist, if different from its
own.
* * * * *
4. Section 240.15c3-1a is revised to read as follows:
Sec. 240.15c3-1a Options (Appendix A to 17 CFR 240.15c3-1).
(a) Definitions. (1) The term unlisted option shall mean any option
not included in the definition of listed option provided in paragraph
(c)(2)(x) of Sec. 240.15c3-1.
(2) For purposes of this section, the term option series includes
listed option contracts of the same type (either a call or a put) and
exercise style, covering the same underlying security with the same
exercise price, expiration date, and number of underlying units.
(3) For purposes of this Appendix A to Sec. 240.15c3-1, the term
related instrument within an option class or product group includes
futures contracts and options on futures contracts covering the same
underlying instrument. In relation to options on major market foreign
currencies a related instrument within an option class also shall
include forward contracts on the same underlying currency.
(4) For purposes of this Appendix A to Sec. 240.15c3-1, the term
underlying instrument includes long and short positions, as
appropriate, covering the same major market foreign currency, the same
security, other than an option contract (underlying security), or a
security which is exchangeable for or convertible into the underlying
security within a period of 90 days. If the conversion or exchange
requires the payment of money or results in a loss upon conversion at
the time when the security is deemed an underlying instrument for
purposes of this Appendix A to Sec. 240.15c3-1, the broker or dealer
will deduct from net worth the full amount of the conversion loss or
the amount required for the conversion or exchange. The term underlying
security shall not be deemed to include futures contracts, options on
futures contracts or unlisted products.
(5) For the purposes of this Appendix A to Sec. 240.15c3-1, the
term product group is two or more option classes, related instruments
and underlying instruments in the same portfolio type for which it has
determined a percentage of offsetting profits may be applied to losses
at the same valuation point.
(b) Every broker or dealer shall deduct from net worth, in
calculating net capital, the amount resulting from the computation
required under the provisions of paragraph (b)(1) of this section,
unless it elects to calculate the required deductions in accordance
with the provisions of paragraph (b)(2) of this section.
Theoretical Pricing Charges
(1)(i) Definitions. (A) The terms theoretical gains and losses
shall mean the gain and loss in the value of individual option series
and the value of related instruments within that option's class, at ten
equidistant intervals (valuation points) ranging from an assumed
movement (both up and down) in the current market value of the
underlying instrument equal to the percentage corresponding to the
deductions otherwise required under Sec. 240.15c3-1 for the underlying
instrument. Theoretical gains and losses shall be calculated by The
Options Clearing Corporation, or such other entity as the Commission
may designate, using an approved theoretical options pricing model.
(B) The term approved theoretical options pricing model shall mean
a mathematical model, previously provided in writing to the Commission,
which is used by The Options Clearing Corporation to calculate
theoretical gains and losses.
(C) The term major market foreign currency shall mean the currency
of a sovereign nation whose short-term debt is rated in the highest
category by at least two nationally recognized statistical rating
organizations for which there is a substantial inter-bank forward
currency market. For purposes of this section, the European Currency
Unit (ECU) shall be deemed a major market foreign currency.
(D) The term qualified stock basket shall mean a set or basket of
stock positions with an aggregate market value at least equal to the
aggregate underlying value of a particular index option and related
instrument within that index option's class, provided that the set or
basket of stock represents no less than 90% of the capitalization for a
high-cap or non-high-cap broad-based market index, or, in the case of a
narrow-based index, no less than 100% of the capitalization for such
narrow-based index.
(ii) With respect to positions involving listed options in a single
specialist's market maker account, and, separately, with respect to
positions involving listed option positions in its proprietary or other
account, the broker or dealer shall group long and short positions into
the following portfolio types:
(A) Equity options on the same underlying instrument and positions
in that underlying instrument;
(B) Options on the same major market foreign currency, positions in
that major market foreign currency and related instruments within those
options' class;
(C) High-cap broad-based market index options, related instruments
within an option class and qualified stock baskets on the same index;
(D) All other high-cap broad-based market index options and related
instruments within the index option's class or product group;
(E) Non-high-cap broad based index options on the same index and
related instruments within that index option's class and qualified
stock baskets in the same index;
(F) All other non-high-cap broad-based market index options and
related instruments within that index option's class or product group,
and
(G) Narrow-based index options, related instruments within the
index option's class and qualified stock baskets on the same index.
(iii) Before making the computation, each broker or dealer shall
obtain from The Options Clearing Corporation the theoretical gains and
losses for each options series and for the related instruments within
those options' class in each specialist's market maker account
guaranteed, endorsed or carried by a broker or dealer, or in the
proprietary or other accounts of that broker or dealer.
(A) Upon receipt of the theoretical gains and losses, for each one
of the portfolio types described above, the broker or dealer shall
multiply the corresponding theoretical gains and losses at each of the
ten equidistant valuation points by the number of positions held in a
particular options series, the related instruments within those options
class and the positions in the same underlying instrument.
(B) In determining the aggregate profit or loss for each portfolio
type, the broker or dealer will be allowed the following offsets:
(1) Between options on the same underlying instrument, positions
covering the same underlying instrument and related instruments within
the options' class, 100% of a position's gain shall offset another
position's loss at the same valuation point;
(2) Between high-cap broad-based market index options or related
instruments within the option class and qualified stock baskets on the
same index, 95% of gains shall offset losses at the same valuation
point;
(3) Between narrow-based market index options or related
instruments within the option class and qualified stock baskets on the
same index, 95% of gains shall offset losses at the same valuation
point;
(4) Among positions involving options series covering different
high-cap broad-based index options within the same product group, 90%
of the gain in a high-cap broad-based market index option and related
instruments within that index option's class shall offset the loss at
the same valuation point in a different high-cap broad-based market
index option and related instruments within that index option's class;
(5) Among positions involving options series covering different
non-high-cap broad-based index options within the same product group,
75% of the gain in a non-high-cap broad-based market index option and
related instruments within that index option's class shall offset the
loss at the same valuation point in another non-high-cap broad-based
market index option and related instruments within that index option's
class or product group; and
(6) Between non-high-cap broad-based market index options or
related instruments within the same options class and qualified stock
baskets on the same index, 95% of the gains shall offset losses at the
same valuation point.
(C) For each portfolio type, the total deduction shall be the
larger of:
(1) The amount for any of the ten equidistant valuation points
representing the largest theoretical loss after applying the offsets
provided above; or
(2) A minimum charge equal to one quarter (\1/4\) point times the
multiplier for each equity and index option contract and each related
instrument within the option's class or product group, or $25 for each
option on a major market foreign currency with the minimum charge for
futures contracts and options on futures contracts adjusted for
contract size differentials, not to exceed market value in the case of
long positions in options and options on futures contracts; or
(3) In the case of portfolio types involving index options and
related instruments offset by a qualified stock basket, there will be a
minimum charge of 5% of the market value of the qualified stock basket
for high-cap broad-based and narrow-based indexes; or
(4) In the case of portfolio types involving index options and
related instruments offset by a qualified stock basket, there will be a
minimum charge of 10% of the market value of the qualified stock basket
for non-high-cap broad-based indexes.
Alternative Strategy Based Charges
(2) A broker or dealer may elect not to apply the method described
in paragraph (b)(1) of this section and, instead, calculate adjustments
to net worth in accordance with the provisions of this paragraph
(b)(2).
(i) Definitions. (A) The term intrinsic value or in-the-money
amount shall mean the amount by which the exercise value, in the case
of a call, is less than the current market value of the underlying
instrument, and, in the case of a put, is greater than the current
market value of the underlying instrument.
(B) The term out-of-the-money amount shall mean the amount by which
the exercise value, in the case of a call, is greater than the current
market value of the underlying instrument, and, in the case of a put,
is less than the current market value of the underlying instrument.
(C) The term time value shall mean the current market value of an
option contract that is in excess of its intrinsic value.
(ii) Every broker or dealer electing to calculate adjustments to
net worth in accordance with the provisions of this paragraph (b)(2)
must make the following adjustments to net worth:
(A) Add the time value of a short position in a listed option; and
(B) Deduct the time value of a long position in a listed option,
which relates to a position in the same underlying instrument or in a
related instrument within the option class or product group as
recognized in the strategies enumerated in paragraph (b)(2)(iii)(D) of
this section.
(iii) In computing net capital after the adjustments provided for
in paragraph (b)(2)(ii) of this section, every broker or dealer shall
deduct the percentages specified in this paragraph (b)(2)(iii) for all
listed option positions, positions covering the same underlying
instrument and related instruments within the options' class or product
group. However, where computing the deductions required for commodity
or securities positions, other than a listed option position, if said
positions have no related listed option position the broker or dealer
shall compute the required deductions for such commodity or securities
positions separately.
Uncovered Short Calls
(A) Where a broker or dealer is short a call, deducting the
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1 of the current market value of the underlying
instrument for such option reduced by the out-of-the-money amount, to
the extent that such reduction does not operate to increase net
capital. In no event shall this deduction be less than the greater of
$250 for each short call option contract for 100 shares or 50% of the
aforementioned percentage.
Uncovered Short Puts
(B) Where a broker or dealer is short a put, deducting the
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1 of the current market value of the underlying
instrument for such option reduced by the out-of-the-money amount, to
the extent that such reduction does not operate to increase net
capital. In no event shall the deduction provided by this paragraph be
less than the greater of $250 for each short put option contract for
100 shares or 50% of the aforementioned percentage.
Long Positions
(C) Where a broker or dealer is long puts or calls, deducting 50
percent of the market value of the net long put and call positions in
the same options series.
Certain Security Positions With Offsetting Options
(D)(1) Where a broker or dealer is long a put for which it has an
offsetting long position in the same number of units of the same
underlying instrument, or in a related instrument within the option
class or product group covering the same number of units of the same
underlying instrument, deducting the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the long offsetting position,
not to exceed the out-of-the money amount. In no event shall the
deduction provided by this paragraph be less than $25 for each option
contract for 100 shares, provided that the minimum charge need not
exceed the intrinsic value of the option.
(2) Where a broker or dealer is long a call for which it has an
offsetting short position in the same number of units of the same
underlying instrument, or in a related instrument within the option
class or product group covering the same number of units of the same
underlying instrument, deducting the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the short offsetting position,
not to exceed the out-of-the-money amount. In no event shall the
deduction provided by this paragraph be less than $25 for each option
contract for 100 shares, provided that the minimum charge need not
exceed the intrinsic value of the option.
(3) Where a broker or dealer is short a call for which it has an
offsetting long position in the same number of units of the same
underlying instrument, or in a related instrument within the option
class or product group covering the same number of units of the same
underlying instrument, deducting, the percentage required by paragraphs
(c)(2)(vi) (A) through (K) of Sec. 240.15c3-1 of the current market
value of the underlying instrument for the offsetting long position
reduced by the short call's intrinsic value. In no event shall the
deduction provided by this paragraph be less than $25 for each option
contract for 100 shares.
(c) With respect to transactions involving unlisted options, every
broker or dealer shall determine the value of unlisted option positions
in accordance with the provision of paragraph (c)(2)(i) of
Sec. 240.15c3-1, and shall deduct the percentages of all securities
positions or unlisted options in the proprietary or other accounts of
the broker or dealer specified in this paragraph (c). However, where
computing the deduction required for a security position as if the
security position had no related unlisted option position and positions
in unlisted options as if uncovered would result in a lesser deduction
from net worth, the broker or dealer may compute such deductions
separately.
Uncovered Calls
(1) Where a broker or dealer is short a call, deducting, 15 percent
(or such other percentage required by paragraphs (c)(2)(vi) (A) through
(K) of Sec. 240.15c3-1) of the current market value of the security
underlying such option reduced by any excess of the exercise value of
the call over the current market value of the underlying security. In
no event shall the deduction provided by this paragraph be less than
$250 for each option contract for 100 shares.
Uncovered Puts
(2) Where a broker or dealer is short a put, deducting 15 percent
(or such other percentage required by paragraphs (c)(2)(vi) (A) through
(K) of Sec. 240.15c3-1) of the current market value of the security
underlying the option reduced by any excess of the market value of the
underlying security over the exercise value of the put. In no event
shall the deduction provided by this paragraph be less than $250 for
each option contract for 100 shares.
Covered Calls
(3) Where a broker or dealer is short a call and long equivalent
units of the underlying security, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the current market value of the underlying security
reduced by any excess of the current market value of the underlying
security over the exercise value of the call. No reduction under this
paragraph shall have the effect of increasing net capital.
Covered Puts
(4) Where a broker or dealer is short a put and short equivalent
units of the underlying security, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the current market value of the underlying security
reduced by any excess of the exercise value of the put over the market
value of the underlying security. No such reduction shall have the
effect of increasing net capital.
Conversion Accounts
(5) Where a broker or dealer is long equivalent units of the
underlying security, long a put written or endorsed by a broker or
dealer and short a call in its proprietary or other accounts, deducting
5 percent (or 50 percent of such other percentage required by
paragraphs (c)(2)(vi) (A) through (K) of Sec. 240.15c3-1) of the
current market value of the underlying security.
(6) Where a broker or dealer is short equivalent units of the
underlying security, long a call written or endorsed by a broker or
dealer and short a put in his proprietary or other accounts, deducting
5 percent (or 50 percent of such other percentage required by
paragraphs (c)(2)(vi) (A) through (K) of Sec. 240.15c3-1) of the market
value of the underlying security.
Long Options
(7) Where a broker or dealer is long a put or call endorsed or
written by a broker or dealer, deducting 15 percent (or such other
percentage required by paragraphs (c)(2)(vi) (A) through (K) of
Sec. 240.15c3-1) of the market value of the underlying security, not to
exceed any value attributed to such option in paragraph (c)(2)(i) of
Sec. 240.15c3-1.
Dated: March 15, 1994.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-6413 Filed 3-18-94; 8:45 am]
BILLING CODE 8010-01-P
