[Federal Register: March 16, 1998 (Volume 63, Number 50)]

[Proposed Rules]

[Page 12713-12717]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]





17 CFR Part 1

Amendments to Minimum Financial Requirements for Futures

Commission Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.


SUMMARY: The Commodity Futures Trading Commission ("Commission" or

"CFTC") proposes to amend its minimum financial requirements for

futures commission merchants ("FCMs"). The proposed amendment would

eliminate the charge against the net capital of an FCM, presently

required by rule 1.17(c)(5)(iii). The charge is four percent of the

market value of options sold by customers trading on contract markets

or foreign boards of trade. It is generally referred to as the "short

option value charge" or "SOV charge". The original intent in

adopting this rule was to require FCMs to provide additional capital to

offset the risk of short options positions carried on behalf of

customers. The Commission is proposing to rescind this rule because it

has determined that the charge is not closely correlated to the actual

risk of the options carried on behalf of customers and, in any event,

there are adequate other protections in place to address the risk of

short options. In particular, the Standard Portfolio Analysis of Risk

("SPAN") margining system has been effectively used to set

appropriate levels of risk margin and there are many other non-capital

protections. These protections include effective self-regulatory

organization ("SRO") audit and financial surveillance programs and

modern risk management and control systems at FCMs. Because of the

demonstrated effectiveness of these programs, the Commission believes

it may now be appropriate to rescind the SOV charge.

    The Commission wishes to receive comments on this proposal.

Comments are desired not only on the specific proposal itself, but also

on all of the components of the system of protections that are designed

to address the risk of short options, which are described below.

DATES: Comments must be received on or before May 15, 1998. Any

requests for an extension of the comment period must be made in writing

to the Commission within the comment period.

ADDRESSES: Comments may be sent to: Commodity Futures Trading

Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,

D.C. 20581. Attn.: Secretariat with a reference to the Minimum

Financial Requirement Rule--SOV Charge. Also, comments may be E-mailed

to "[email protected]".


Accountant, 202-418-5459 or "[email protected]"; or Lawrence B. Patent,

Associate Chief Counsel, 202-418-5439 or "[email protected]". Mailing

address: Division of Trading and Markets, Commodity Futures Trading

Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,

D.C. 20581.


I. Background

    On July 7, 1982,1 the Commission proposed amendments to

the rule governing the computation of net capital for FCMs to recognize

the difference in risk between the purchase and sale of commodity

options. The sale of an option ("short option") poses a greater risk

to an FCM than does the purchase of an option ("long option") because

the risk of a short option is unlimited. In contrast, long options pose

a risk to the carrying FCM which is limited to the premium on the

option. Once the premium is collected from the customer who purchased

the option, there is no further risk of financial loss to the FCM or

the customer. In this connection, the Commission has proposed the

repeal of Commission Regulation 33.4(a)(2) which requires the full

payment of a commodity option premium at the time the option is

purchased. The proposal was initially published for comment on December

19, 1997. The comment period was extended to March 4, 1998. The effect

of the repeal would be to permit the futures-style margining of

commodity options traded on regulated futures exchanges and is

discussed in the initial notice of proposed rulemaking.2


    \1\ 47 FR 30261 (July 13, 1982).

    \2\ 63 FR 6112 (February 6, 1998), Extension of comment period

to March 4, 1998; See also 62 FR 66569 (December 19, 1997), Initial

request for comment.


    To recognize the risk of carrying short options, the Commission

adopted, effective September 21, 1982,3 a safety factor

charge of four percent of the market value of exchange-traded (domestic

and foreign) options granted or sold by an FCM's customers--the short

option value charge ("SOV charge"), as set forth in Regulation

1.17(c)(5)(iii).4 However, over the years since its

adoption, there have been complaints that the charge was not

proportional to the risk of the options and was excessive in its

financial burden upon the FCMs in terms of the cost of the capital

required to carry the positions.


    \3\ 47 FR 41513 (September 21, 1982).

    \4\ Commission rules referred to herein can be found at 17 CFR

Ch. I (1997).


    In June 1995, both the Chicago Board of Trade ("CBOT") and the

Chicago Mercantile Exchange ("CME") urged the Commission to rescind

the SOV charge. In the alternative, the two exchanges asked for some

degree of relief from the SOV charge in the event that the Commission

felt that complete rescission of the charge was not possible. Their

letters cited, among other reasons for rescission or the requested

relief, that: (a) Short options positions may serve to reduce the risk

of a portfolio that would carry greater risk absent the short options

positions, and (b) the risks of short option positions are already

adequately addressed by the risk-based margining system currently being

used by all commodity exchanges in the U.S. and many abroad.

    They pointed out that the charge was adopted in 1982, prior to the

development of risk-based margining systems. While the charge was

intended to serve as an additional regulatory capital safety factor for

option positions, they contended that it is now excessive and no longer

justified because of the use of margining systems that

[[Page 12714]]

adequately measure portfolio risk and, therefore, assess appropriate

margins on the entire portfolio.

    The Commission staff felt that there was some merit to the position

of the exchanges and others who had criticized the efficacy of the SOV

charge. Therefore, to temper the impact of the charge, while the matter

was studied further, on July 26, 1995, the Division of Trading and

Markets ("Division") issued Interpretative Letter No. 95-

65.5 That letter provided partial relief through a "no

action" position that would allow FCMs to reduce the four percent SOV

charge applicable to short options positions carried by professional

traders and market makers.6 An FCM that wished to avail

itself of the relief under the "no action" position was required to

prepare certain supporting calculations and obtain approval from its

designated self-regulatory organization ("DSRO") to take the relief.

The Division subsequently expanded this relief to include any customer

account carried by an FCM, in Interpretative Letter No. 97-46, dated

June 12, 1997, provided the same conditions could be met by the

additional accounts.7


    \5\ CFTC Interpretative Letter No. 95-65, [1994-1996 Transfer

Binder] Comm. Fut. L. Rep. (CCH) para. 26,495 (July 26,1995).

    \6\ The reduction in the charge cannot exceed 50 percent of the

pre-relief charge calculated for all SOV on a firm-wide basis.

    \7\ CFTC Interpretative Letter No. 97-46, [Current Binder] Comm.

Fut. L. Rep. (CCH) para. 27,086 (June 12,1997). This letter also

provided some relief pertaining to the required supporting



    However, only five FCMs have taken advantage of the relief. This

small number resulted from the fact that the relief required what were

viewed as burdensome calculations and, in any event, the relief was

limited to fifty percent of the total charge. The FCM community also

communicated to the Commission that the relief provided by the Division

failed to address the theoretical deficiencies of the rule. In a letter

dated September 26, 1997, the Joint Audit Committee ("JAC")

8 formally suggested that the net capital charge on SOV be

eliminated. The JAC letter stated the following:

    \8\  JAC is comprised of representatives from each commodity

exchange and National Futures Association who coordinate the

industry's audit and ongoing surveillance activities to promote a

uniform framework of self-regulation.


    * * * Since the limited relief was granted, the JAC has closely

monitored the application of the relief. From JAC's experience and

from discussions with FCMs, many firms feel that the conditions for

relief are too restrictive and complicated. Thus, they are not able

to expend their resources to take advantage of the relief. In fact,

there are only five FCMs which have applied for such relief.

    During periods of high volatility, the capital charge will

increase as the value of the applicable short option increases.

However, this charge does not necessarily relate to the risk

applicable to a particular options portfolio. Selling options may

actually serve to reduce risk in a portfolio. As a result, some

firms have made a business decision to refuse large, lucrative

customer accounts due to an unwillingness to absorb the charge. The

fact that this decision is made for cost rather than risk reasons is

clearly not in the best interest of any participant in the U.S.

futures industry. This outdated regulation forces the concentration

of exchange traded short options in a few firms.

    In general, FCMs have little control over reducing the charge.

Requiring additional collateral has no impact on the charge itself

and will instead increase the FCM's capital requirements. We believe

the SPAN 9 performance bond system adequately captures

the risk in options portfolios and the undermargined charge to

capital appropriately reflects risk in an FCM's capital computation.


    \9\ SPAN is an acronym for Standard Portfolio Analysis of Risk.


    The charge has a significant impact on the viability of the

exchange traded options markets. When market users can not find an

FCM willing to absorb the charge, the liquidity of our markets is

directly impacted. For all the reasons stated above, we again

request the CFTC eliminate this charge in its entirety . . .

II. Discussion

    As stated above, the Commission proposes that the SOV charge be

rescinded for two reasons: (1) The rule has not resulted in capital

charges proportionate to risk; and (2) the SPAN margining system and

other non-capital components of the system of protections are much

better developed and executed than they were when the SOV charge was

first adopted. These factors are discussed below in two sections. The

first section addresses the theoretical deficiencies of the SOV charge,

and the second section is a summary of non-capital protections.

A. Theoretical Deficiencies of the SOV Charge

    The current charge based on four percent of SOV has not, in

practice, resulted in capital charges which are proportionate to risk.

The following situations are illustrative:

    Multiple Strikes--Exchanges typically list multiple strikes with

the same underlying futures contract in a given option contract month.

Option premium typically increases across strikes, moving from out-of-

the-money strikes to in-the-money strikes. Moving to deep-in-the-money

strikes increases the option intrinsic value and the resulting premium.

At some deep-in-the-money point the deltas of the different strikes

will be the same. Therefore, while two deep-in-the-money strikes may

have very similar or even identical risk profiles, the deeper-in strike

will have a higher intrinsic value and a higher premium, yielding a

higher SOV charge. The SOV charges for the two options can differ 200

percent or more, even though those options have the same underlying

futures, the same time to expiration, and the same risk profiles.

    Risk-Reducing Strategies--Short options positions are often used as

one component of a trading strategy. The other positions used in the

strategy could be futures, other derivatives, or cash instruments. In

such strategies, the short options positions may be intended as a risk-

reducing position, as demonstrated by the fact that the introduction of

the short options positions into the portfolio results in a reduction

in the SPAN-based margin requirement for the portfolio. Despite the

fact that these positions are risk-reducing, the short option values

for these portfolios increase markedly in trending markets. In

practice, the Commission notes that some FCMs which have carried the

accounts of traders who do a great deal of these kinds of strategies

have faced large capital charges in trending markets. Because the short

options component of such strategies is actually risk-reducing, the SOV

charge has not served its intended purpose in these cases.

    The following examples will illustrate the problem with short

calls. (Also, the same problem applies to short puts.)

    Deep-In-The-Money Short Dated Short Call--A deep-in-the-money short

dated short call has a risk profile essentially like a short futures

position. The one major difference between the short call and the

futures contract is that the call has a large intrinsic value which

translates into a large premium and a corresponding large SOV charge.

Therefore, FCMs incur a significant extra capital requirement for the

short call even though there is no extra capital requirement to carry

essentially the same risk with equivalent short futures contracts. In

this case, the capital requirement is excessive compared to the risk,

as indicated by the margin requirement on the futures contract.

    Deep-Out-Of-The-Money Short Dated Call--A deep-out-of-the-money

short dated call displays more of the unique risk characteristics

associated with options. While initially it has a low

[[Page 12715]]

delta 10 this short call has a high gamma 11 as

it approaches the money, introducing the potential for significant

losses from extreme underlying moves. For normal underlying moves, this

deep-out short call has little risk. Only extreme moves far beyond the

normal performance bond coverage levels would cause significant losses

for this option. However, because this deep-out short call has no

intrinsic value and little time value, it typically has very low

premium and therefore has a correspondingly low capital charge. Because

this kind of risk rarely materializes into actual losses, it is best

addressed by the non-capital protections. These protections are

described below.


    \10\ Delta measures the amount an option price changes for a

one-point change in the price of the underlying product.

    \11\ Gamma is a risk variable that measures the amount that the

delta of an option changes given a one-point change in the price of

the underlying product.


    As discussed below, the Commission believes that the SPAN margining

system, since its introduction in December 1988, appears to have

provided adequate margins. Also, SPAN is being refined on an ongoing

basis by the CME, the CBOT, and the other SROs which use it. Finally,

the Commission has previously reported to the Federal Reserve Board

that the SPAN margining system has met its performance goals for many

years, with respect to futures margins on stock index futures


B. Summary of Non-Capital Protections

    There are protections against the risk of short options other than

net capital charges. In this connection, the Commission believes that

the non-capital components of the system of protections in place are

now stronger than they were when the SOV charge was put into place.

Risk management models have been refined over the years; there have

been enhancements in Commission and SRO audit and surveillance

programs; FCM risk management systems and controls have improved

significantly compared to what was available and in place at many firms

when the SOV charge was first adopted; and technological advancements

have improved communication among clearing organizations, FCMs and

their customers. Therefore, the Commission has preliminarily concluded

not only that the SOV charge has not worked to provide a risk-based

protection, as hoped, but also that these other non-net capital

protections have been improved over the years and have resulted in an

overall strengthening of the system, well beyond what was in place when

the SOV charge was adopted. The primary non-capital protections are

described below.

Portfolio Margining System

    Performance bond requirements are referred to commonly as

"margin" requirements. Margin requirements typically are set at

levels which cover 95 to 99 percent of a product's expected daily price

change over a period of time. To ensure that margin requirements are

set at appropriate levels, historical volatility price charts are

reviewed by product and spreads between products. SPAN is a risk-

measuring margin methodology adopted by all U.S. and numerous foreign

futures exchanges. SPAN uses option pricing models to calculate the

theoretical gains and losses on options under various market situations

(e.g., prices up, prices down, volatility up, volatility down, and

extreme price movements). As noted above, the Commission has reported

to the Federal Reserve Board on the effectiveness of SPAN in setting

margins in equities-related futures contracts.

Financial Surveillance and Position Reporting Systems

    Generally, it is the large traders which pose the greatest risk to

FCMs. To deal with this risk, the U.S. futures industry has a very

complete and current system of position reporting. This permits close

monitoring of the positions of large traders and is the foundation of

an effective program of financial surveillance conducted by the SROs.

As explained below, current positions are assessed prospectively--what

financial effect would such positions have if the market moved

significantly one way or the other. The advanced reporting systems in

place permit assessments to be done at the account level, which is

where risk to the firms must be evaluated. Using account level data

along with other information, the SROs' sophisticated programs are

designed to identify risks to the clearing system, including

financially troubled FCMs or FCMs that carry high-risk positions.

    To accomplish this goal, SROs monitor market developments

throughout the day, make intra-day variation margin calls on clearing

members, and follow up with individual FCMs regarding potential

problems. There have been occasions in the past when customers holding

very large or concentrated positions have caused financial problems for

their carrying FCMs. Large trader monitoring systems are designed to

identify such traders before losses occur. Although it is not possible

to obviate the possibility of an FCM failure due to the default of a

large trader, the systems operated by the SROs improve the control of

this risk by permitting scrutiny of large trader positions by the SROs.

Scrutiny is carried out by the SROs on a systematic basis.

    Using the large trader information, SROs perform stress testing of

positions using "what if" price simulations based on open positions

carried by clearing member FCMs in order to determine an FCM's

potential risk in relation to its excess net capital. Daily pay/collect

variation margin is aggregated for periods of time to monitor losses

compared to the excess capital of the firm. Potential losses revealed

by the stress testing, which are determined to be large in relation to

an FCM's most recently reported capital, will indicate that the firm

should be contacted by SRO surveillance staff to obtain assurances that

the FCM has properly evaluated the creditworthiness of its customers

and the adequacy of collateral in place.

    As noted elsewhere, as a part of its oversight program, the

Division regularly reviews the procedures used by the SROs to conduct

financial surveillance over member-FCMs. The Division's reviews, as

well as experience over many years working with the SROs in identified

problem situations, reveal that the systems generally have been

effective. The systems also have improved over time, because the SROs

have shown a willingness to learn from experience. However, it should

be noted that financial surveillance at the SRO level, including any

review work done at an FCM during an in-field examination, is not a

substitute for an effective risk management and control system operated

by the FCM itself. The Commission believes that the audit and financial

surveillance programs operated by the SROs have been effective in

encouraging the development of equally good risk management and control

systems at FCMs. In this connection, as explained below, the SROs

ensure that FCMs have appropriate risk management and control systems

in place and make recommendations when their in-field audits reveal

inadequate systems.

Capital and Segregation Requirements for FCMs

    The Commission's capital and segregation requirements are part of

the protections built into the system against the risk of short options

positions. All FCMs must meet the Commission's net capital and

segregation requirements, as

[[Page 12716]]

well as SRO requirements. An FCM which is a clearing member also must

have capital requirements which are higher than those set by the

Commission. Commission regulations require firms to keep current books

and records, prepare a daily segregation calculation and a formal,

monthly capital calculation, among other things. FCMs must be in

compliance with the net capital and segregation rules at all times.

Material inadequacies in internal control must be reported. The demands

of these recordkeeping and reporting requirements serve as an element

of the overall system of internal controls. The daily segregation

calculation, especially, will reveal problems in customers' accounts

very quickly, when and if they occur.

    The basic capital requirement is set at four percent of an FCM's

liabilities to its customers. The segregation rule requires an FCM to

have sufficient funds in segregation to meet its liabilities to its

customers. The underlying concept of segregation is that by separating,

i.e., segregating, the funds of customers from the proprietary funds of

the FCM, there will be sufficient funds available to pay off the FCM's

liabilities to its customers in the event of the FCM's failure due to

proprietary losses. As already stated, in order to demonstrate to

itself and regulators that it is in compliance with the segregation

requirements, an FCM is required to prepare a daily computation of the

status of the segregated accounts, which shows that there are

sufficient funds in segregation. One of the elements of the computation

is to ascertain the status of deficits in the accounts of customers.

Any deficit which is not covered by appropriate collateral must be made

up by the firm with funds of its own. Deficits outstanding for more

than one day have a direct and immediate impact upon firm capital and

may cause a firm to be undercapitalized. An FCM must report to the

Commission in the event its capital falls below the early warning

level, which is 150 percent of required capital. Although the capital

rule provides some discretion to the Commission in allowing an FCM to

come back into capital compliance, with respect to undersegregation,

there is no grace period.12 Therefore, it is prudent for an

FCM to carry excess net capital and funds in segregation in amounts

commensurate with the type of business it handles.


    \12\ The Commission has proposed to amend Regulation 1.12, its

early warning notification rule, to add a requirement that an FCM

promptly report to the Commission and the FCM's DSRO whenever it

knows or should have known that it does not have sufficient funds in

segregated accounts to meet its obligations to customers who are

trading on U.S. markets or set aside in special accounts to meet its

obligations to customers who are trading on non-U.S. markets. 63 FR

2188 (January 14, 1998).


SRO Programs of In-Field Audits of FCMs

    The Commission believes that the in-field audit program conducted

by the SROs over their member-FCMs has resulted in a high level of

compliance with the Commission's and the SROs' financial rules.

Commission rules require SROs to have these programs in place. To this

end, each FCM's DSRO conducts an annual audit of each FCM assigned to

it under the Joint Audit Plan. Under the plan, a full-scope audit is

conducted every other year, and a limited-scope records review is

conducted in the alternate year. The audits are conducted according to

the Joint Audit Program, which is designed and regularly updated for

new developments by the JAC. The Commission reviews the Joint Audit

Program each time it is updated.

    The full-scope audit, conducted using the Joint Audit Program,

includes a review of the systems and controls that the FCM has in

place. In this connection, members of JAC complete a Financial and Risk

Management Internal Controls questionnaire for each FCM audit. The

questionnaire covers the firm's procedures for: opening new accounts,

monitoring non-customer trading, assessing the impact of potential

market movements on customer and non-customer trading, and ensuring

that the segregation of duties is appropriate. Furthermore, during the

course of the audit, a review is made of account documentation, margin

procedures, undermargined account net capital charges, debit/deficit

accounts and sales practices. Such reviews provide information to

assess the firm's overall internal control and risk management


    The JAC has initiated a project to revise its in-field audit

approach to be more explicitly risk-based. That is, in planning and

performing in-field audits, the DSRO will place a greater emphasis upon

review and identification of potentially high risk areas at an FCM at

the outset of an audit. The results of this early audit survey and

planning work will translate into a more focused targeting by the DSRO

of the total available audit resources upon the areas of highest risk

at an FCM.

III. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act ("RFA") 5 U.S.C. 601 et seq.,

requires that agencies, in proposing rules, consider the impact of

those rules on small businesses. The Commission has previously

determined that FCMs are not "small entities" for purposes of the

Regulatory Flexibility Act.13 Therefore, the Chairperson, on

behalf of the Commission, hereby certifies, pursuant to 5 U.S.C.

605(b), that the action taken herein will not have a significant

economic impact on a substantial number of small entities.


    \13\ 47 FR 18619-18620.


B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 14 imposes certain

requirements on federal agencies (including the Commission) in

connection with their conducting or sponsoring any collection of

information as defined by the Paperwork Reduction Act. While this

proposed rule has no burden, the group of rules (3038-0024) of which

this is a part has the following burden:


    \14\ Pub. L. 104-13 (May 13, 1995).

Average burden hours per response: 128.

Number of Respondents: 3143.

Frequency of response: On occasion.

    Copies of the OMB-approved information collection package

associated with this rule may be obtained from Desk Officer, CFTC,

Office of Management and Budget, Room 10202, NEOB Washington, DC 20503,

(202) 395-7340.

List of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and

recordkeeping requirements, Net capital requirements.

    In consideration of the foregoing and pursuant to the authority

contained in the Commodity Exchange Act and, in particular, Sections

4f, 4g and 8a (5) thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission

hereby proposes to amend Chapter I of Title 17 of the Code of Federal

Regulations as follows:


    1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,

6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a,

12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24.

Sec. 1.17  [Amended]

    2. Section 1.17(c)(5)(iii) is removed and reserved.

[[Page 12717]]

    Issued in Washington, DC on March 9, 1998, by the Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 98-6580 Filed 3-13-98; 8:45 am]


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