By John Fennell, OCC Executive Vice President and Chief Risk Officer
April 25, 2017
As the agency for all U.S. options exchanges and in our role as a Systemically Important Financial Market Utility, OCC is a strong advocate for our exchanges, clearing firms and all market participants. Our clearing members commit capital and provide a secure environment for the clearance and settlement of transactions originating with direct trading participants in the listed options market, including market makers. These market makers are critical to enhancing the overall resilience of the options markets by providing liquidity and ensuring an orderly market by taking the opposite side of trades from options buyers and sellers, especially during times of market stress. This is evidenced by the fact that registered market makers currently account for one side of approximately 90 percent of all customer originating trades executed on the Chicago Board Options Exchange.
The efficiency and resilience of the listed options market (i) allows market participants to hedge risks, particularly short-term risks, (ii) enhances the liquidity of the overall securities markets, (iii) provides a cost-effective means of adjusting an investment’s risk/return characteristics, and (iv) provides market participants with the ability to create more diverse risk-return alternatives. These features tend to make participation in the underlying equity markets more attractive to a greater number of participants, thus increasing the liquidity of those markets and promoting capital formation and economic growth.
Critical to a market maker’s ability to stand behind their commitment to supply market liquidity is their ability to hedge the complex risks associated with large diversified options portfolios with other options. As a result, instead of having to close out open positions to mitigate risk, market makers are able to neutralize their exposures without extinguishing the open interest. This is a more effective approach to managing risk while continuing to promote capital formation and economic growth through the listed options market.
This approach to managing risk is being impacted by the use of the Current Exposure Method (CEM) in the Leverage Ratio as it is applied to exchange-traded derivatives exposures, such as listed options. The application of the Leverage Ratio, which neglects to consider the hedging benefits between options and other attributes unique to options, will result in vastly increased capital requirements for general clearing members offering clearing services to market makers and liquidity providers. This will fundamentally threaten clearing members’ business models and impact the liquidity and stability of global financial markets.
While the Basel Committee on Banking Supervision has led an effort to reconsider the application of the CEM methodology within the Leverage Ratio, the lack of progress towards the adoption of the Standardized Approach for Counterparty Credit Risk (SA-CCR) method continues to create serious economic disincentives for participants in the exchange-traded market. The proposed revisions and the introduction of a modified version of SA-CCR would dramatically reduce the unintended consequences the listed options industry currently faces on CEM.
While SA-CCR may be adopted globally, the timing of implementation across the U.S. and Europe, if not aligned, could result in significant regulatory arbitrage across these two jurisdictions, impairing liquidity in options markets and undermining the central clearing models. This would be counter to the steps regulators across the globe have been pursuing to endeavor to shape the OTC derivatives market to resemble that of the exchange-traded market – favoring central clearing and on-venue trading of all contracts to ensure that these markets become more standardized, more transparent, and above all, to mitigate systemic risk.
These are admirable goals that all market participants should desire, and which OCC and the U.S. listed options industry aspire to achieve.