OCC at risk of losing AA+ S&P rating
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The Commission has proposed amendments to the formula for determining the customer reserve requirements of broker-dealers under the Securities Exchange Act of the "Exchange Act". The proposed amendments would permit a broker-dealer to treat margin related to security options clearing corporation credit rating products "SFPs" purchased or sold in customer securities accounts that is required and on deposit with a clearing organization as a "debit item" in options clearing corporation credit rating its reserve requirement under the formula in Rule 15ca.
The effect of permitting such a debit is to reduce the amount that the broker-dealer is required to set aside in the "special bank account for the exclusive benefit of customers" under Rule 15c e. The debit is appropriate because the funds held by the clearing organization represent funds already set aside by the broker to satisfy customer claims, and a similar debit is provided for options margin on deposit at OCC. One of these requirements would have what we assume to be the wholly unintended consequence of making the debit unavailable for margin deposited with a registered clearing agency that complies with options clearing corporation credit rating Commission's registration standard limiting permissible uses of clearing fund deposits.
Another would have the effect of forcing fundamental changes in the handling of customer funds and securities by OCC, its clearing members, and their custodians, and would substantially reduce the efficiency of the clearing process for options as well as SFPs. Other requirements are less seriously or immediately harmful, but are nevertheless inappropriate, unnecessary and potentially harmful as applied to a registered clearing agency.
Although some or all of these requirements may be appropriate as applied to a clearing organization not subject to the Commission's regulation, none of them are necessary or appropriate as applied to OCC. Background As currently in effect, Item 13 of the reserve formula in Rule 15ca allows a broker-dealer to take a debit i. Indeed, we suspect that is exactly what the Commission would have proposed, had it not been forced to address another issue options clearing corporation credit rating to SFPs.
As noted in the Commission's release, the Commodity Futures Modernization Act the "CFMA" created a regulatory framework for the trading of security futures products "SFPs"including single stock and narrow-based index futures and options on options clearing corporation credit rating futures.
Thus, the Commission staff has had to consider whether and under what circumstances SFP margin on deposit at a DCO that is not also a Clearing Options clearing corporation credit rating should be entitled to a debit in the reserve formula. However, options clearing corporation credit rating SFP debit is subject to several additional conditions not applicable to the options margin debit. The apparent reason for these additional conditions is to provide the Commission with some assurance as to the safety of margin deposits held by DCOs not regulated by the Commission.
But rather than limit the application of the conditions to DCOs, the Commission also proposes to impose these conditions on OCC as a options clearing corporation credit rating to providing a reserve formula debit for SFP margin held at OCC but not as a condition to providing such a debit for options margin. The Commission's proposed amendment to Rule 15ca would permit a broker-dealer to include its SFP customer clearing margin deposit as a debit item subject to four specific conditions identified in paragraphs 2 a through 2 d of Note G to proposed Item Paragraphs 2 a through 2 c are wholly inappropriate as applied to OCC.
Paragraph b would require OCC to fundamentally change the way in which OCC and its clearing members handle margin deposits and would options clearing corporation credit rating reduce the efficiency of the clearing process. Subparagraph c ii also contains a requirement that OCC would not currently meet and that is inconsistent with industry standards.
The remaining provisions of paragraph cwhile innocuous, are also completely unnecessary as options clearing corporation credit rating to a Clearing Agency. There are a number of things wrong with this test. Moreover, OCC operated successfully and safely for many years without such a rating; many other sound clearing organizations including the Clearing Division of the CME do not have such a rating; and we do not believe that it is appropriate for the current proposal to be conditioned on such a rating.
Although the rule includes an alternative test, that test is also unsatisfactory. While it is not clear from the text of the rule itself, the release makes clear that the term "security deposits from clearing members" refers to deposits that the clearing organization "may use.
If that were to occur, it would not reflect any reduction in OCC's creditworthiness, but would instead reflect a reduction in the size of the potential obligations that the clearing fund might be called upon to satisfy. Nevertheless, it would prevent OCC from satisfying Paragraph 2 b even if OCC's clearing fund otherwise qualified as an acceptable "security deposit. Also, we assume by "assessment power" that the Commission means the legal right to compel clearing members in the aggregate to deposit that amount.
We assume that this ability to make a call for additional funds that is not legally enforceable is not what the Commission meant by "assessment power. We do not believe that this was the Commission's intent. Our comment is not merely that the particular standards set forth in proposed Note G are wrong and should be modified. Our more fundamental comment is that we do not believe that there is any reason to require a Clearing Agency subject to the full regulatory authority of the Commission to meet additional or different standards in order to be deemed a sufficiently sound repository for customer margin deposits related to SFP transactions.
Surely any Clearing Agency that the Commission has found to meet the standards for continued registration under Section 17A of the Exchange Act, and whose rules have been approved by the Commission under Section 19 of the Exchange Act, must be sufficiently creditworthy to hold a deposit of customer funds.
Otherwise, it should not be permitted to do business as a Clearing Agency at all. Note G of the reserve formula is not the appropriate place to set minimum financial requirements for a Clearing Agency that is comprehensively regulated by the Commission. The proposed requirement is even more peculiar when one considers that the stated purpose of the rule amendment is to permit a debit in the reserve formula only for margin deposits related to SFPs.
There is surely nothing about clearing SFPs that would justify the imposition of these new financial requirements options clearing corporation credit rating a Clearing Agency. The reason for imposing the new financial requirements is presumably to give the Commission some assurance as to the creditworthiness of a DCO that would be holding funds of securities customers but which is not subject to the Commission's regulatory oversight.
If the Commission is not comfortable in simply relying upon the regulatory oversight of the CFTC to ensure the creditworthiness of any such DCO, then that would be a reason to impose minimum requirements with respect to Options clearing corporation credit rating under Note G. It would not be a reason, however, to impose new requirements on a Clearing Agency that is already fully regulated by the Commission.
Neither fairness nor safety and soundness considerations require the Commission to provide identical treatment for an entity that is already subject to extensive regulation by the Commission and one that is not. They are obviously not similarly situated in the most relevant respect. Moreover, these requirements would as a practical matter discriminate against Clearing Agencies. By imposing requirements that today can only be options clearing corporation credit rating by one or two DCOs, and not by OCC in part because options clearing corporation credit rating OCC's compliance with the Commission's own clearing agency registration requirementsthe Commission would in practical effect be allowing a reserve formula options clearing corporation credit rating only for customer margin deposited with DCOs that the Commission does not regulate, and not with an established Clearing Agency that the Commission does regulate.
We recognize that this was not the intent of the Commission or its staff, and that the clearing fund requirement in Note G could be modified to conform it to the use restrictions in Section 17A noted options clearing corporation credit rating. Our point is to emphasize the risks of including in the reserve formula additional and potentially conflicting standards for a Clearing Agency that is already subject to extensive regulation options clearing corporation credit rating other provisions of the Exchange Act and regulations thereunder.
Segregation Requirements Paragraph 2 b of Note G to Item 14 provides, as a further condition to the availability of the debit, that a DCO or Clearing Agency must deposit "customer margin in a bank account separate from other margin deposits of clearing members, and must require the bank to provide a written acknowledgement that the property in the account is held free of any lien of the bank or person claiming through the bank.
They would also exacerbate an awkward and inefficient mismatch between the way OCC is required to treat customer funds and the way all other Clearing Agencies treat such funds.
OCC does not presently maintain separate deposit accounts or custody accounts for margin collateral deposited by its clearing members in respect of different account types. When a clearing member deposits margin with OCC, it is required to specify the account options clearing corporation credit rating which the margin is being deposited. The same is true of withdrawals. However, all cash deposited as collateral with respect to all account types of all clearing members other options clearing corporation credit rating segregated futures accounts and cross-margining accounts is commingled options clearing corporation credit rating OCC in deposit accounts at OCC's settlement banks.
Similarly, securities pledged to OCC as margin with respect to all account types are commingled at The Depository Trust Company "DTC" or in the pledgor's bank custody account in the case of government securities.
None of these accounts are segregated as between customer and proprietary assets. In the case of assets deposited in respect of the segregated futures accounts provided for in Section 3 f of Article VI of the By-Laws, OCC and its clearing members will, of course, maintain separate deposit and custody accounts as required under Section 4d 2 of the CEA.
But the customer protection regime provided for in the CEA, which is based upon "segregation in gross" of customer funds, is different in concept from the customer protection regime developed by the Commission under Section 15 of the Exchange Act, which options clearing corporation credit rating based primarily upon a net segregation requirement represented by the reserve formula of Rule 15ca.
In the case of OCC, the Commission's present proposal would impose the requirements of both customer protection schemes simultaneously, which is both unnecessary and quite unworkable for OCC. Although proposed new Item 14 of the reserve formula, and therefore the provisions of Note G, would apply only to margin deposited in respect of SFPs, OCC does not calculate separate margin requirements on a product-by-product basis. OCC has been a pioneer in the development of risk-based margining techniques that determine margin requirements based upon the net risk of a portfolio of positions in options and other securities and derivative products.
As a result, OCC will not determine a separate margin requirement for SFPs, and it will not be possible for clearing members to distinguish the customer margin deposited in respect of Options clearing corporation credit rating from that deposited in respect of options.
Furthermore, even if options clearing corporation credit rating were possible to separately identify customer SFP margin, OCC could not maintain SFP customer margin collateral separate from SFP proprietary margin collateral unless OCC restructured its system of deposit accounts and clearing members restructured their DTC and bank custody accounts to segregate customer from proprietary assets.
This would require establishing numerous additional bank accounts and custody accounts and incurring the continuing costs of maintaining those accounts and would burden OCC and its clearing members with the need to process transfers of funds and securities among those accounts as often as daily, all to no good purpose, given that customer property held by OCC as margin is already adequately protected by Rule 15c Although OCC maintains fidelity bond coverage for employees, it does not have coverage that would apply to non-employee agents, other than contract employees and outside counsel.
OCC has been advised by options clearing corporation credit rating insurance agent that such coverage is not readily available. Many people and entities may act as agents of OCC from time to time for specified purposes.
The need to protect against potential defalcation in these agents' obligations to OCC, and the most appropriate means of protection, options clearing corporation credit rating better addressed on a case-by-case basis in light of the particular services rendered. Before permitting broker-dealers to carry positions in OneChicago futures with CME in a securities account, the Commission would need to determine whether such commingling is permissible under Rule 15c We would be pleased to discuss any of these issues with you further.
Please feel free to contact me at or Andy Naughton at Indeed, under OCC's risk-based margin system, it will be impossible to distinguish the clearing margin applicable to non-segregated SFPs from the clearing margin applicable to options. Paragraph 2 d is limited in its application to clearing organizations that are not registered Clearing Agencies, and we therefore refrain from comment on that provision. This limitation options clearing corporation credit rating imposed to meet the Commission's own clearing agency registration standards, which provide with a limited exception not relevant here that "the rules of the clearing agency should limit the purposes for which the clearing fund may be used to protecting participants and the clearing agency i from the defaults of participants and ii from clearing agency losses not including day-to-day operating expenses such as losses of securities not covered by insurance or other resources of the clearing agency.
Under this proposed rule change, the aggregate clearing fund would be a function of the "risk margin" excluding the premium value of options, which is fully collateralized by margin deposits on deposit at OCC as follows: We also note that some insurers offer clearing member default insurance that could be used as a substitute for some portion of the clearing fund, thereby creating another circumstance in which the size of the clearing fund might be reduced without reducing the amount of protection against risk.
Securities pledged to OCC through a custodian bank continue to be held in the account of the pledgor at the custodian bank but subject to OCC's control. This makes it unnecessary for OCC to account to pledgors for interest, dividends, etc.
Article VI, Section 3 provides for separate accounts for individual market-makers and alternatively permits combined market-maker accounts in which transactions for multiple market-makers may be cleared. In addition, so-called "joint back office" or "JBO" transactions are carried in a combined account separate from other account types. Finally, OCC provides options clearing corporation credit rating "futures segregated funds account" in which a options clearing corporation credit rating member that is a fully-registered futures commission merchant must clear the transactions of its futures customers subject to the segregation requirements of Section 4d 2 of the Commodity Exchange Act.
This issue options clearing corporation credit rating not arise for security futures because a future represents a liability of the customer as well as an asset, and is therefore never treated as fully paid.