Risk: What impact has the Dodd-Frank reform had on transparency and risk reduction?
Mike McClain: Dodd-Frank and the subsequent Systemically Important Financial Market Utility (SIFMU) designations of several organisations has had tremendous impacts on both transparency and risk reduction. Our regulators at OCC, led by the Securities and Exchange Commission (SEC), have increased their focus on our business and this has led to frank discussions on risk management, business controls, policies and procedures. We are undergoing a transformation as a result of the SIFMU designation, which is taking us beyond technical risk modelling, margin calculation and trade clearing into a resilient hub for safe and efficient markets. It has been one of the most important shifts in our history and we are pleased with the results thus far.
Risk: What motivated OCC to start clearing over-the-counter (OTC) equity derivatives?
Mike McClain: Until now, central counterparty clearing had not been available for OTC US equity options. With the launch of OTC S&P 500 index options clearing, OCC applies its proven risk management expertise in exchange-traded US equity options to the OTC side of the business. Clearing OTC options is a natural fit for OCC since we clear all options listed on the 12 US options exchanges, and clear futures products and securities lending transactions. Our established systems and processes will support this business and our members will achieve operational and capital efficiencies by putting OTC and listed positions in the same clearing house.
Risk: Why did you start with options? Are they mandated for clearing?
Mike McClain: OTC options are not mandated for central clearing, but clearing benefits have become widely recognised. We worked with market participants to build a clearing solution that delivers efficiencies, and started with the OTC S&P 500 index option because it is the world’s most widely followed stock-market index. We launched the dealer-to-dealer solution on April 25 with six day-one participants.
Risk: You received several regulatory approvals. Can you tell us more about that?
Mike McClain: OCC received SEC approval to clear OTC S&P 500 index options. Included in this approval were changes that enable OCC to portfolio margin-listed and OTC positions that are held in a single account. OCC also received no action relief from the SEC to permit OTC options to be treated the same as other listed options for purposes of Rule15c3-1, enabling broker dealers to calculate capital charges for positions in OTC options and market-makers to trade in OTC options without making themselves ineligible for capital treatment. Approved changes to OCC’s margin model for longer-tenor options strengthen risk management. Finally, a Securities Investor Protection Corporation (SIPC) rule change broadens the definition of ‘standardised options’ to include OTC options cleared by OCC, enhancing customer protection in the event of a liquidation of their broker dealer.
Risk: What benefits will clearing provide to participants?
Mike McClain: OCC collaborated with market participants to formulate a clearing and risk mitigation solution that would provide capital efficiencies and financial stability. OCC manages risk through financial safeguards that include rigorous admission standards, member surveillance activities, collection of high-quality margin collateral and a mutualised clearing fund. We use our proprietary System for Theoretical Analysis and Numerical Simulations (STANS) risk system to measure clearing-member portfolio risk and establish margin requirements. STANS ensures positions are properly valued and collateralised – which reduces credit risk and protects clearing members and OCC against any possible defaults. As world financial markets are linked, mitigating systemic risk in one market strengthens all markets.
The clearing service will mitigate counterparty and systemic risk through OCC’s guarantee, which is backed by the same margin and clearing fund regimes that have served the listed options markets for 41 years. This guarantee assures performance to clearing members through the substitution of OCC as counterparty. Clearing members can leverage existing clearing and risk management systems, including collateral valuations and default management solutions. Also, since OCC is offering portfolio margining of its listed and OTC products, market participants can benefit from margin offsets. These trades will also be fungible with other OTC positions.
Risk: How does the clearing service work?
Mike McClain: OTC options trades must meet specific requirements to be clearing-eligible. They need to be bilaterally negotiated, not matched through an exchange; have an expiration date of between four months and five years; and meet notional value parameters. Bespoke terms that can be customised include type, premium, strike price, expiration date, exercise style, size and settlement value calculation.
Once the trade is negotiated and entered into MarkitSERV’s affirmation platform, affirmed trades are sent to OCC for clearing. Counterparties must be eligible contract participants and transactions must be cleared through an OCC clearing member. Once OCC receives the trade, it is subject to most of the same basic rules, procedures and risk management policies used for listed options.
Risk: What’s next for OTC clearing?
Mike McClain: Later this year, OCC will launch its dealer-to-client clearing solution for OTC index options, and client protections available in listed markets will apply to OTC accounts. We have interest in leveraging our risk management capabilities in some of the mandated volatility and equity swap products, but the best-positioned swap execution facilities in these asset classes are our current participant exchanges. Many recent exchange product innovations offer the same hedging opportunities as their OTC counterparts, with full transparency and the safety of a clearing house.