Regulatory Reform and the Role of an Industry Utility
Legislators and regulators in Washington, D.C. are working to make changes to the way banks and markets are governed in the U.S. and how those rules are to be enforced. While this is true around the world, this article will focus on the U.S.
Also true around the world, some of the ideas under consideration are welcome, others are not. Politics are, of course, involved, but there are times when the less welcome ideas arise from a lack of knowledge. It is important that exchanges and clearinghouses work to inform those responsible for making the changes to ensure they have a thorough understanding of how the markets operate.The Options Clearing Corporation is working with its participant exchanges to inform those on Capitol Hill and in government agencies tasked with devising, approving, and implementing regulatory reform efforts. OCC and its exchanges share a consensus view on a number of issues being debated in Washington allowing us to present a common argument on what is best for the industry. Those issues include ways to resolve jurisdictional disputes between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), the need to implement customer portfolio margining to promote prudent risk management, and the appropriateness of providing effective risk disclosure to options customers.When our participant exchanges agree on issues such as these, it allows OCC to take a coordinating role, much as is it did with the multi-year effort to modernize options symbology. The efforts in Washington are another example of the way OCC extends its industry utility role beyond trade processing.
Providing Utility Services Beyond Clearing
OCC operates as a market utility providing low cost, high quality services to the markets that we clear and to our 119 clearing members. Our unique corporate structure is the key to our ability to do this. OCC is owned by five of the exchanges that it serves. Each owner is represented on our board. However, the majority of our directors represent clearing members. These clearing members are the broker-dealers and futures commission merchants that are active on the markets that OCC clears. We operate, in effect, as a not for profit corporation rebating to our clearing members any revenues in excess of those needed to operate OCC. Operating as a low cost utility does not preclude OCC from providing high quality, innovative services. For example, five years ago, OCC installed a total re-write of its clearing system to provide straight-through processing and three years ago OCC implemented its proprietary STANS risk margining system. STANS is a true portfolio margining system using large-scale Monte Carlo simulations to forecast price moves and correlations to make margin determinations. In essence, our governance structure ensures that OCC is run for the benefit of the markets it serves, the intermediaries active in those markets, and the ultimate customers of those intermediaries.Beyond our operational role, OCC provides utility services to the industry in the areas of marketing and lobbying. Since 1992, OCC has provided the management support for The Options Industry Council, which has successfully educated millions of investors in the responsible use of equity options. The Washington office has been serving OCC, and the options industry generally, for more than a decade.
Being Heard In Washington
Perhaps at no time since OCC opened an office in Washington has there been a greater possibility for action that could profoundly impact OCC and the markets it serves. OCC is an active participant in the regulatory reform discussion that has been underway in the U.S. over the past year. That active participation benefits the markets that OCC clears for and the options industry as well as OCC. One important aspect of the ongoing effort in Washington to modernize the U.S. regulatory system is harmonization of the regulatory efforts of the SEC and the CFTC. Unlike many jurisdictions, U.S. regulation of derivatives is split between the SEC which oversees the trading of options on securities and the CFTC which oversees the trading of futures. Last year, the Obama Administration asked the SEC and CFTC to submit a report to Congress outlining ways that regulation of derivatives could be harmonized. The agencies convened a first ever joint meeting of the Commissions in September 2009 to hear from respected members of the industry and academe on how to achieve harmonization of the two regulatory schemes. Appropriately, OCC was invited to testify at this historic meeting. OCC operates under the jurisdiction of both regulatory agencies as it provides central counterparty (CCP) clearing and settlement services to 14 exchanges and trading platforms for options, financial and commodity futures, security futures, and securities lending transactions. OCC’s testimony focused on issues of concern to the entire options industry.
Jurisdictional Dispute Resolution
OCC’s testimony highlighted the need to develop a mechanism to resolve jurisdictional disputes between the SEC and CFTC over new products. OCC is proud of its support of exchange innovation through its assistance of the introduction of new products. New products offer a way for exchanges to satisfy evolving customer needs. When product introduction is delayed needlessly by jurisdictional disputes, exchanges and their customers are frustrated. Unfortunately, determining the jurisdictional status of new products has created significant delays in their introduction in a number of cases. Also, when the jurisdictional status of a product is unclear, OCC cannot take the risk of a court ruling that could declare disputed contracts null and void with significant financial impact on OCC and its members. This is not an issue when one of our exchanges wants us to clear a product that is clearly a future or clearly a security. As both a derivatives clearing organization and a registered clearing agency, we are authorized to clear both products. However, when an exchange approaches us with a product whose status is unclear under the futures and securities laws, delays in launching the product invariably ensue. A couple of years ago, a dispute between the CFTC and SEC over the regulatory status of credit default options delayed the introduction of this product for months. Similar jurisdictional disputes delayed the introduction of options on gold and silver ETFs for years. These have proven to be very popular products but investors were denied the ability to use them while the SEC and CFTC debated which agency had jurisdiction over them. During the testimony, OCC urged the SEC and CFTC to develop a method of resolving these types of disputes that is transparent and expeditious, suggesting the agencies should not hesitate to seek the Treasury Department or the proposed Financial Services Oversight Council act as a mediator, and, if necessary, a tiebreaker in difficult cases. Lengthy jurisdictional disputes that deprive markets of the ability to list new products and customers of the choice to trade them do not serve the interests of anyone and are, appropriately, a source of embarrassment to the SEC and CFTC. Creation of a dispute resolution mechanism is a prominent recommendation in the joint report that the agencies issued last year.
Customer Portfolio Margining
OCC’s testimony identified customer portfolio margining as another area that cries out for harmonization between the agencies. OCC has been working with the U.S. options exchanges for a number of years to gain regulatory approval for broker-dealers to offer qualified customers portfolio margining of all securities-related positions, whether regulated by the SEC or CFTC, in a single account. Today, the SEC permits many customers to have their securities accounts margined on a portfolio basis as occurs on the futures side. However, these customers cannot fully enjoy the risk reducing and capital efficiency benefits of portfolio margining because they cannot carry their broad-based stock index futures positions in securities portfolio margining accounts. Two important changes must occur before that happens. First, Congress needs to amend the Securities Investor Protection Act (SIPA) to allow broad-based index futures products to be treated as securities for SIPA purposes when included in an SEC-regulated portfolio margining account. After this is done, the CFTC must provide exemptive relief from the Commodity Exchange Act’s requirements regarding segregation of customer funds to permit those futures products to be carried in securities accounts. OCC urged the CFTC and SEC to support the targeted changes to SIPA that passed the U.S. House of Representatives in 2008 as an important step toward full customer portfolio margining. The ongoing impasse between the agencies on how to permit customer portfolio margining essentially punishes customers who choose to use a full range of securities and securities-related futures in a responsible and risk-reducing fashion by imposing substantially higher margins on them than is justified by the risk of their portfolio. OCC was pleased that the agencies identified action on customer portfolio margining as the top recommendation in the Joint Report.
Effective Investor Risk Disclosure
OCC and the exchanges have been working to educate investors on the responsible use of equity options for nearly 18 years through The Options Industry Council. The success in teaching investors the proper use of this tool is responsible for a significant portion of the trading volume growth we have seen in the last decade. But when it comes to the current method of customer risk disclosure, OCC urged the SEC move towards the effective model used by the CFTC. A customer is now required to receive a copy of “Characteristics and Risks of Standardized Options,” known as the Options Disclosure Document (ODD), prior to opening an options account. OCC fully supports providing adequate disclosure about options to customers and understands the important role that disclosure plays in the U.S. securities laws. However, the current ODD is more than 158 pages in length and difficult to understand. Customers would be better served if the ODD was simplified and streamlined. On the futures side, customers receive a generic risk disclosure document that is short and easy to understand. Following this model for options disclosure would likely promote a better understanding of the risks that exchange-traded options pose than the current dense, lengthy ODD. Detailed information regarding particular options products is much more effectively presented on exchange web sites and through other modern means that can provide interactive, targeted information responsive to investors’ needs. The Joint Report agreed and recommended greater consistency in risk disclosure while the SEC said it intends to review the current ODD.Current Status
After the SEC/CFTC Harmonization Meeting, OCC spearheaded the submission of a comment letter from itself and the majority of the U.S. options exchanges that highlighted areas addressed in a number of areas of regulatory disparity between the SEC and CFTC. The letter focused on areas addressed in OCC’s testimony as well as additional areas of regulatory disparity that require immediate attention. The letter also offered suggestions to the agencies and Congress on how to address these disparities.
In October 2009, the SEC and CFTC released their Joint Report on Harmonization of Regulation. As noted, the recommendations of the report reflect the issues raised in the testimony and the comment letter by OCC and the options exchanges. Legislation pending in Congress would facilitate customer portfolio margining and create a mechanism to resolve jurisdictional disputes between the SEC and CFTC. We are still awaiting SEC and CFTC action on speeding approvals of new products and from the SEC on a streamlined ODD.
OCC’s advocacy on all of these issues helped to move them closer to a resolution that will benefit the options industry. OCC, as an industry utility, is an effective advocate for the industry because it is not impaired by competitive concerns on its own behalf. As a result, OCC can coordinate the consensus view and present to legislators and regulators the united opinion of competing participants on what is best for the marketplace.
About Susan Milligan
Susan Milligan is Senior Vice President, Government Relations and Communications at The Options Clearing Corporation (OCC), and serves as the Executive Director of The Options Industry Council (OIC).
Prior to joining OCC in May 2001, Ms. Milligan was Counsel, Government Relations, at the New York Stock Exchange. Before that, she was legal assistant to Commodity Futures Trading Commission (CFTC) Commissioner Sheila Bair, and was her Executive Assistant during the time that Commissioner Bair was Acting Chairman of the CFTC. While at the CFTC, she also acted as legal assistant to Chairman Wendy Gramm and was an attorney in the Office of General Counsel.
Ms. Milligan received her B.A. magna cum laude from Dickinson College and her J.D. from The Washington College of Law at American University.