[Federal Register Volume 79, Number 147 (Thursday, July 31, 2014)]
[Notices]
[Pages 44480-44483]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-18038]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-72677; File No. SR-OCC-2014-15]
Self-Regulatory Organizations; The Options Clearing Corporation;
Notice of Filing of Proposed Rule Change To Process All Sell
Transactions Prior to the Exercise of Long Options in Market-Maker
Accounts To Ensure That Only Net Long Positions May Be Exercised
July 25, 2014.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on July 17, 2014, The Options Clearing Corporation (``OCC'') filed with
the Securities and Exchange Commission (``Commission'') the proposed
rule change as described in Items I and II below, which Items have been
prepared by OCC. The Commission is publishing this notice to solicit
comments on the proposed rule change from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Clearing Agency's Statement of the Terms of Substance of the
Proposed Rule Change
This proposed rule change, coupled with the related system
modifications, will curtail use of a trading strategy known as
``dividend plays'' in the options industry. OCC proposed to add an
interpretation and policy to Rules 801 and 805, respectively, stating
that OCC will process all sales of options in a Market-Maker's account
prior to the exercise of any long call options in the account to ensure
that only net long positions in a particular series may be exercised.
II. Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
In its filing with the Commission, OCC included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified
[[Page 44481]]
in Item IV below. OCC has prepared summaries, set forth in sections
(A), (B), and (C) below, of the most significant aspects of these
statements.
(A) Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Proposed Rule Change
1. Purpose
This proposed rule change would add an interpretation and policy to
Rules 801 and 805, respectively, stating that OCC will, in respect of
Market-Maker accounts, process all sell transactions prior to the
exercise of long options in the account, to ensure that only net long
positions may be exercised. This proposed change, coupled with the
related system modifications, would have the effect of implementing a
policy approved by the OCC Board of Directors intended to curtail use
of a trading strategy known as ``dividend plays'' in the options
industry.
Background
Dividend plays are an options trading strategy that has been
executed on options exchanges for many years. The purpose of the
trading strategy is to capture the dividend income of a stock through
the exercise of in-the-money call options on the day prior to the
stock's ``ex-dividend'' date, which is the date that determines whether
the holder of a stock is entitled to the stock's dividend. Where stock
is transferred before the ex-dividend date, the new owner of the stock
is entitled to the dividend. In order to capture this dividend income,
a trader will buy a large number of call options of the same series on
a stock on the day prior to the stock's ex-dividend date and then write
an offsetting number of call options of the same series on the same
stock at the same price. Because the two transactions are exactly
offsetting and executed at the same price, the trader's position in the
call options is net neutral and has limited market risk. At the end of
the day, the trader then exercises all of its long call options even
though the trader's net position is neutral. OCC, using its standard
assignment process, then assigns all of that day's exercised long call
options of the same series across all options writers.
If all in-the-money long call options of the same series were
exercised on the day prior to the ex-dividend date, the trader, and all
other market participants in the relevant option series, would be
assigned all its short call positions and would not have a resulting
long stock position that is entitled to the dividend. However, a
certain percentage of open interest in in-the-money call options goes
unexercised on the day prior to the ex-dividend date. Generally, this
failure is due to a number of factors, including transaction costs, the
ignorance of certain market participants of the mechanics of call
options and ex-dividend dates, inattentiveness by certain market
participants in monitoring their positions and irrationality.\3\
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\3\ See e.g., Veronica K. Pool, Hans R. Stool, Robert E. Whaley,
Failure to exercise call options: An anomaly and a trading game, 11
J. Fin. Markets 1 (2007); Jia Hao, Avner Kalay, Stewart Mayhew, Ex-
Dividend Arbitrage in Options Markets, 23 Rev. Fin. Stud. 271, Issue
1 (2009).
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Because traders executing a dividend play exercise 100% of their
long call options, it increases the overall percentage of open interest
that gets exercised. OCC's standard assignment processing will close
out a large portion of a traders' short position established that day,
but will also close out a large portion of other, pre-existing, market
participants' short positions. The larger the position taken by a
trader executing a dividend play compared to the pre-existing open
interest, the higher the proportion of pre-existing open interest that
will be closed out, and a larger share of unassigned short positions
will be left to the dividend play trader. For every short call position
that is not assigned, a trader executing the dividend play does not
have to deliver stock and is able to capture the dividend payment for
the shares of stock it remains long.
The vast majority of dividend play activity occurs in Market-Maker
accounts and OCC's processing sequence makes it possible for market
makers to execute conventional dividend plays, as described above. OCC
processes exercises after option purchases but before options sales,
also known as ``writing'' transactions. This processing sequence
permits a market maker executing a dividend play to buy and sell equal
quantities of call options of a given series and exercise the purchased
call options even though the market maker's position is neutral. If OCC
processed sales before exercises, market-makers' purchases and sales on
a given day would offset each other, and when OCC processed the
exercises, there would no net long call positions to exercise. This
would make the conventional dividend play impossible. However, OCC
processes exercises before sales in order to reduce operational risk
for clearing members clearing options transactions in accounts other
than Market-Maker accounts.
Positions in accounts other than Market-Maker accounts are carried
on a gross basis, meaning that an account can be both long and short
the same series. This means that trades must be coded as opening or
closing transactions. If OCC processed sales before exercises in an
account other than a Market-Maker account, a coding error could cause
rejection of exercise instructions that could result in substantial
losses. However, coding errors do not present a risk with respect to
Market-Maker accounts, where positions are carried on a net basis and
trades do not have to be coded as opening or closing transactions.
OCC Review of Dividend Plays
In December 2012, the Securities Industry and Financial Markets
Association's (``SIFMA'') Listed Options Trading Committee requested
that OCC formally review dividend plays.\4\ SIFMA expressed a concern
that OCC could suffer losses as a result of an operational error in
processing dividend plays. Because successful dividend plays rely on
part in the dividend trader's having a large position compared to the
pre-existing open interest in the series of options subject to the
dividend play, SIFMA believed that an operational error in processing
dividend trades could result in a clearing member being liable for a
settlement amount that could place the clearing member in financial
peril and potentially exceed the collateral deposited by the clearing
member with OCC. Following receipt of the SIFMA letter, OCC initiated a
comprehensive review of dividend plays.
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\4\ See Letter from Ellen Greene, Vice President of SIFMA, to
Wayne P. Luthringshausen, Chairman and Chief Executive Officer of
OCC (December 3, 2012) (the ``SIFMA Letter'') available at http://www.sifma.org/issues/item.aspx?id=8589942317.
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In connection with its review of dividend plays OCC noted that
these transactions represent only a small number of OCC cleared
options, and that most of the dividend play trading is cleared through
two large clearing members that are large and well-capitalized and have
robust risk management processes. OCC's therefore concluded that
dividend plays did not materially increase OCC's risk. As requested by
OCC's Board of Directors, OCC's Operations Roundtable further evaluated
the proposed change in OCC's processing sequence to determine whether
there were any unintended consequences to implementing the proposed
change. The Operations Roundtable, which consists of operations staff
of a cross-section of OCC's clearing members and operations
[[Page 44482]]
staff of the options exchanges, carefully reviewed the proposal over
several months and concluded that no material unintended consequences
would result from its implementation.
Dividend plays generally may be perceived negatively in the
marketplace and have been criticized as unfair to retail investors and
as distorting options transactions volume.\5\ OCC determined that while
it should not take action to eliminate or restrict dividend plays based
on these factors, nor should it facilitate these transactions. OCC's
processing sequence, under which sale transactions are processed after
exercises, is generally designed to reduce the operational risk to
clearing members that results from potential miscoding of, for example,
an opening trade for the account of one clearing member customer as a
closing trade for the account of another clearing member customer.
However, this coding risk does not exist with respect to Market-Maker
accounts, where positions are carried on a net basis. Accordingly, OCC
concluded that its processing sequence unnecessarily allowed certain
market makers to execute dividend plays and therefore is proposing to
change it so that for these accounts sale transactions are processed
before exercises. The change would have the effect of significantly
restricting dividend plays because large long positions that would
otherwise be exercised would be offset by sale transactions.
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\5\ SIFMA Letter, p. 1.
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Proposed Amendment
OCC proposes to amend the Rules to add an interpretation and policy
to Rule 801 and to Rule 805 to state, with respect to Market-Maker
accounts, that sell transactions will be processed before exercises.
Because the definition of ``Market-Maker Account'' in Article 1 of
OCC's By-Laws would include a JBO Participants' account, the
interpretation and policy clarifies that this netting will not be
applied to JBO Participants' accounts until such time as OCC determines
on not less than 30 days' notice to clearing members that OCC is able
to identify, on a subaccount basis, the transactions of a JBO
Participant within JBO Participants' accounts, in which case JBO
Participants' accounts shall be considered Market-Maker accounts. OCC
also proposes to modify OCC's systems to make a corresponding change in
the processing sequence. This change in the processing sequence would
only applied to Market-Maker accounts (and, potentially subaccounts in
JBO Participants' accounts), and would not change the processing
sequence, and the associated protection against coding errors,
applicable to clearing member accounts other than Market-Maker
accounts.
2. Statutory Basis
OCC believes that the proposed rule change is consistent with
Section 17A(b)(3)(F) of the Securities Exchange Act of 1934, as amended
(the ``Exchange Act''),\6\ and the rules and regulations thereunder,
including Rule 17Ad-22(d)(1) \7\ and Rule 17Ad-22(d)(4),\8\ because the
changes are designed to provide a well-founded, transparent and
enforceable legal framework for the exercise of long and short call
options and to minimize sources of operational risk to clearing members
through the development of appropriate systems, controls and
procedures. The proposed change achieves this purpose by clearly
stating in the rules that OCC will, in respect of Market-Maker
accounts, process all sell transactions prior to the exercise of long
options in the account, thereby making this processing sequence
transparent, and by instituting corresponding system changes in the
processing sequence for exercised call options in Market-Maker
accounts. The proposed rule change is not inconsistent with the
existing rules of OCC, including any other rules proposed to be
amended.
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\6\ 15 U.S.C. 78q-1(b)(3)(F).
\7\ 17 CFR 240.17Ad-22(d)(1).
\8\ 17 CFR 240.17Ad-22(d)(4).
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(B) Clearing Agency's Statement on Burden on Competition
OCC does not believe that the proposed rule change would impose any
burden on competition.\9\ The proposed interpretation and policy
primarily affects market makers and would provide notice to all market
makers of the change in OCC's processing sequence with respect to
Market-Maker accounts. The proposed rule change would not unfairly
inhibit access to OCC's services or disadvantage or favor any
particular user in relationship to another user because the proposed
rule change would be applied uniformly to all Market-Maker accounts.
The change would have the effect of curtailing dividend plays, but this
limitation will apply equally to all exchanges and all clearing members
and by extension all market-maker customers of clearing members.
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\9\ 15 U.S.C. 78q-1(b)(3)(I).
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For the foregoing reasons, OCC believes that the proposed rule
change is in the public interest, would be consistent with the
requirements of the Exchange Act applicable to clearing agencies, and
would not impose a burden on competition.
(C) Clearing Agency's Statement on Comments on the Proposed Rule Change
Received From Members, Participants, or Others
Written comments on the proposed rule change were not and are not
intended to be solicited with respect to the proposed rule change and
none have been received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action
Within 45 days of the date of publication of this notice in the
Federal Register or within such longer period up to 90 days (i) as the
Commission may designate if it finds such longer period to be
appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
(A) By order approve or disapprove such proposed rule change, or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Act. Comments may be submitted by any of
the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an email to [email protected]. Please include
File Number SR-OCC-2014-15 on the subject line.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090.
All submissions should refer to File Number SR-OCC-2014-15. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the
[[Page 44483]]
proposed rule change between the Commission and any person, other than
those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for Web site viewing and
printing in the Commission's Public Reference Room, 100 F Street NE.,
Washington, DC 20549-1090 on official business days between the hours
of 10:00 a.m. and 3:00 p.m. Copies of the filing also will be available
for inspection and copying at the principal office of OCC and on OCC's
Web site: http://www.theocc.com/components/docs/legal/rules_and_bylaws/sr_occ_14_15.pdf.
All comments received will be posted without change; the Commission
does not edit personal identifying information from submissions. You
should submit only information that you wish to make available
publicly. All submissions should refer to File Number SR-OCC-2014-15
and should be submitted on or before August 21, 2014.
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\10\
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\10\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-18038 Filed 7-30-14; 8:45 am]
BILLING CODE 8011-01-P