[Federal Register Volume 79, Number 238 (Thursday, December 11, 2014)]
[Notices]
[Pages 73673-73676]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-29002]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-73749; File No. SR-OCC-2014-810]
Self-Regulatory Organizations; The Options Clearing Corporation;
Notice of Filing of Advance Notice Concerning Modifications To Back
Testing Procedures in Order To Enhance Monitoring of Margin Coverage
and Model Risk Exposure
December 5, 2014.
Pursuant to Section 806(e)(1) of Title VIII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act entitled the Payment,
Clearing, and Settlement Supervision Act of 2010 \1\ (``Payment,
Clearing and Settlement Supervision Act'') and Rule 19b-4(n)(1)(i)
under the Securities Exchange Act of 1934 \2\ notice is hereby given
that on November 13, 2014, The Options Clearing Corporation (``OCC'')
filed with the Securities and Exchange Commission (``Commission'') the
advance notice as described in Items I and II below, which Items have
been
[[Page 73674]]
prepared by OCC.\3\ The Commission is publishing this notice to solicit
comments on the advance notice from interested persons.
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\1\ 12 U.S.C. 5465(e)(1).
\2\ 17 CFR 240.19b-4(n)(1)(i).
\3\ OCC initially filed a similar advance notice on October 31,
2014, as File No. SR-OCC-2014-808. However to correct certain errors
in that filing relating to two backtesting program tests, OCC
withdrew it and made a new filing (File No. SR-OCC-2014-810) on
November 13, 2014.
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I. Clearing Agency's Statement of the Terms of Substance of the Advance
Notice
This advance notice is filed by OCC in connection with a proposed
change to its operations (the ``Change'') in the form of modifications
to its back testing procedures in order to enhance its monitoring of
margin coverage and model risk exposure.
II. Clearing Agency's Statement of the Purpose of, and Statutory Basis
for, the Advance Notice
In its filing with the Commission, OCC included statements
concerning the purpose of and basis for the advance notice and
discussed any comments it received on the advance notice. The text of
these statements may be examined at the places specified in Item IV
below. OCC has prepared summaries, set forth in sections (A) and (B)
below, of the most significant aspects of these statements.
(A) Clearing Agency's Statement on Comments on the Advance Notice
Received From Members, Participants or Others
Written comments on the advance notice were not and are not
intended to be solicited with respect to the advance notice and none
have been received.
(B) Advance Notices Filed Pursuant to Section 806(e) of the Payment,
Clearing and Settlement Supervision Act
Description of Change
The proposed Change would modify OCC's back testing procedures in
order to enhance its monitoring of margin coverage and model risk
exposure. Such monitoring would allow OCC to identify and make
improvements to its margin methodology and enhance OCC's ability to
manage risk.
OCC has implemented back testing procedures in order to test its
methodology for determining the amount of margin to collect from
clearing members and validate the assumptions and mechanisms inherent
in its methodology and to make any necessary changes to the
methodology. Each trading day, OCC estimates the risk on accounts and
uses this estimate as a basis for each account's margin charge. On the
following business day, OCC's back tests compare an account's observed
profit and loss (``P&L'') with the prior day's estimated risk using a
variety of analytical and statistical tools. These daily tests measure
the performance of the account's risk measures, and therefore, also
measure the performance of OCC's underlying methodology for calculating
these measures. OCC's back testing program enables OCC to assess
performance of its margining systems and determine whether financial
risks are adequately or inadequately captured by the quantitative
models in use.
Currently, OCC employs the ``traffic light'' test published by the
Basel Committee on Banking Supervision in 1996 (the ``Traffic Light
Test'').\4\ In conducting the Traffic Light Test, OCC determines the
actual number of instances in which the realized loss on an account
exceeded the margin, known as an ``exceedance,'' over an observation
period of one year. The number of exceedances during the observation
period is compared against the number of expected exceedances that are
independent and identically distributed over time. OCC will employ an
enhanced version of the Traffic Light Test that takes into account the
dependency of exceedances between accounts.
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\4\ See, ``Supervisory Framework for the Use of `Backtesting' in
Conjunction with Internal Model Approach to Market Risk Capital
Requirement.'' Located at http://www.bis.org/publ/bcbs22.htm.
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OCC has conducted daily back testing of margin accounts since 2006.
OCC's staff analyzes the exceedances and makes monthly reports to OCC's
Enterprise Risk Management Committee (``ERMC'').\5\ The reports to the
ERMC include pertinent conclusions based on results from the full set
of back tests. When back testing reveals the potential opportunity for
remediation of OCC's margin methodology, OCC undertakes a root cause
analysis to determine the cause of any issues. Any significant failures
of OCC's methodology lead to OCC undertaking a model improvement
project designed to correct the problems.
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\5\ The Enterprise Risk Management Committee is chaired by the
Chief Risk Officer, and consists of the Executive Chairman, Chief
Operations Officer, General Counsel, Chief Information Officer,
Chief Audit Executive, the Chief Compliance Officer and other
members as determined by the Chair.
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OCC has analyzed its back testing program and identified several
enhancements to the program. The following section details the nature
of the proposed enhancements.\6\
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\6\ The relevant systems changes are scheduled to be installed
on December 5, 2014.
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1. Proposed Enhancement of and Increase in Statistical Tests
The proposed changes would enhance existing statistical tests and
add three new statistical tests. The first proposed change to OCC's
back testing program is that OCC proposes to enhance the Traffic Light
Test so that it may be applied to exceedances across all of OCC's
margin accounts. Given that exceedances are not independent across
margin accounts, OCC will enhance this test so that it will produce a
single numerical output that measures aggregation across margin
accounts.
In addition to the enhanced Traffic Light Test, OCC will implement
other industry standard tests based on exceedances in order to provide
a more comprehensive set of tests. The second proposed change to OCC's
back testing program is that OCC will add the Kupiec Test,\7\ which is
a new proportion of failures test that compares the actual number of
exceedances with the number that would be expected in light of the
confidence level associated with the calculation of margin. For
example, when calculating margin with a confidence level of 99%, the
number of exceedances is expected to be 1% of the total observations,
i.e., the P&Ls for all accounts for all days during the measurement
period. If the actual number of exceedances is near the expected
number, this is an indication that the calculated margin requirements
are accurate estimates of the accounts' estimated losses.
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\7\ See, Kupiec, P. ``Techniques for Verifying the Accuracy of
Risk Management Models,'' Journal of Derivatives, v3, P73-84.
(1995).
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The third proposed change to OCC's back testing program is that OCC
will add the Christoffersen Independence Test,\8\ which is a new
statistical test that measures the extent to which exceedances are
independent of each other. Specifically, if OCC's margin models are
correctly assessing risk, the probability of an exceedance occurring at
any two points in time should be the same as the probability of an
exceedance occurring at either point in time, individually, without the
exceedance occurring at the other point in time. The fourth proposed
change to OCC's back testing program is a new test, the Probtile test,
that compares the distribution of the daily observed P&L to the daily
forecasted P&L distribution. If the distribution of P&L movement ratios
approximates a uniform random distribution, this is an indication that
[[Page 73675]]
OCC's margin models are providing accurate forecasts of potential
losses in an account. Combined, these new statistical tests will
provide OCC with the pertinent information necessary to evaluate the
effectiveness of its models in determining margin coverage.
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\8\ See, Christoffersen, Peter, ``Evaluating Interval
Forecasts.'' International Economic Review, 39 (4), 841-862. (1998).
Economic Review, 39 (4), 841-862. (1998).
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2. Proposed Data Set Changes
OCC proposes to enhance the data sets being back tested to allow
for testing against various assumed portfolio and market data
scenarios, in addition to the performance of actual portfolios against
actual, current market conditions. First, OCC would back test
hypothetical portfolios, allowing for the design and monitoring of
portfolios that have magnified sensitivities to particular aspects of
the models used in the margin computations. Back testing against
hypothetical portfolios would provide a more comprehensive insight into
the adequacy of the underlying model assumptions under market
conditions prevailing in the back test observation periods.
Under the second data set enhancement, OCC would back test current
accounts against earlier observation periods. Currently, accounts are
``frozen'' by assuming that the time to maturity and the degree to
which options are in-the-money or out-of-the-money remain constant
during the chosen observation period. The market data observed over the
observation period is used to generate the margin forecasts and P&L.
Under the enhancement, observation periods would be chosen to reflect
special market conditions, which is useful because even though margin
coverage might be adequate in the current environment, margin coverage
could be inadequate under stressed conditions, such as periods of high
volatility. The ability to select specific observation periods would
not limit the back testing to the current environments but rather would
highlight performance of margin coverage and model performance in
market scenarios other than prevailing market conditions.
3. Proposed Forecast Horizons Changes
Currently, OCC conducts back testing using a one-day time horizon,
which means that it compares calculated margin with realized profit and
losses that occur on the business day following the calculation. OCC's
margin calculations assume that positions would be liquidated over a
two-day period. This test, therefore, compares two-day margin numbers
to a one-day profit and loss calculation. OCC's existing back testing
methodology makes adjustments in its testing to account for the
difference between the two-day liquidation period used in its margin
calculation and the one-day horizon used in the profit and loss
calculation. OCC intends to revise its back testing methodology to take
into account losses over a two-day time horizon, without such
adjustments, which would match the two-day liquidation period used in
the margin calculation. OCC therefore proposes to implement
functionality into its back testing system to conduct a two-day time
horizon back test, which will compare calculated margin against a two-
day profit and loss calculation. OCC also proposes to revise its back
testing methodology to compare one-day margin calculations against one-
day profit and loss calculations, and will implement system
functionality for such a test. Issues identified in any of these back
tests will be reported to the ERMC. OCC believes that its adoption of
the additional forecast horizons tests will allow it to have a more
accurate view of the sufficiency of its margin methodology.
4. Proposed Root Cause Analysis Changes
The proposed Change will improve OCC's ability to conduct root
cause analyses by providing OCC's back testing staff with additional,
automated, investigation tools. Currently, and when necessary, OCC's
back test staff conducts investigations in order to identify the root
cause exceedances. The investigation itself is a manual process that is
dependent upon the facts and circumstances pertaining to a given
exceedance. OCC is now proposing to make system modifications that will
provide OCC's back testing staff with addition tools that will
facilitate such investigations. Specifically, OCC proposes to add
system functionality that will show attribution of losses due to
underlying price movements and implied volatility movements. Further,
under the improvements OCC would be able to incorporate hypothetical
accounts and positions into the tests and would be able to identify
risk factors that move above or below the projected values. These
changes will improve OCC's ability to conduct investigations that
identify the root cause of exceedances, which will in turn lead to
improving OCC's back testing methodology and its margin coverage.
Anticipated Effect on and Management of Risk
OCC believes the proposed Change to its back testing procedures
would reduce the level of risk presented by OCC because it would
enhance OCC's back testing by providing it with more tools to identify
gaps in its margin methodology and develop corrective changes
thereto.\9\ For example, enhanced and increased statistical testing
would provide additional information about the adequacy of margin
coverage and thus strengthen the assessment of margin and model
performance. Changes to data sets would include hypothetical portfolios
and earlier observation periods would allow testing of margin coverage
under a greater variety of market conditions. Modifying the tests to
take into account losses over a two-day period would increase the
accuracy of the testing because this two-period matches the assumed
liquidation period used in the margin calculations. OCC would also be
able to more accurately determine the root cause of exceedances, while
rejecting results that incorrectly suggest a needed improvement in its
margin methodology, and then would be able to narrowly tailor solutions
to the identified root causes. Ultimately, by allowing OCC to more
readily and precisely identify gaps in its margin methodology, the
Change will reduce risk to OCC and the markets that it serves.
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\9\ Depending on the nature of a proposed change, it may be
necessary for OCC to file a proposed rule change filing or advance
notice filing with the Commission.
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Consistency With the Payment, Clearing and Settlement Supervision Act
The Change is consistent with Section 805(b)(1) of Payment,
Clearing and Settlement Supervision Act because it promotes robust risk
management.\10\ OCC's receipt of margin from its clearing members
protects OCC and market participants from risks presented by the
markets OCC serves. OCC uses back testing in order to evaluate the
sufficiency and adequacy of the amount of margin it collects from its
clearing members. As described above, the Change will provide OCC will
[sic] additional tools to identify gaps in its margin methodology. Such
identification process will lead to improvements to OCC margin models
thereby promoting robust risk management.
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\10\ 12 U.S.C. 5465(b)(1).
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III. Date of Effectiveness of the Advance Notice and Timing for
Commission Action
The proposed change may be implemented if the Commission does not
object to the proposed change within 60 days of the later of (i) the
date that the Commission receives the notice
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of proposed change, or (ii) the date the Commission receives any
further information it requests for consideration of the notice. The
clearing agency shall not implement the proposed change if the
Commission has any objection to the proposed change.
The Commission may extend the period for review by an additional 60
days if the proposed change raises novel or complex issues, subject to
the Commission providing the clearing agency with prompt written notice
of the extension. A proposed change may be implemented in less than 60
days from the date the advance noticed is filed, or the date further
information requested by the Commission is received, if the Commission
notifies the clearing agency in writing that it does not object to the
proposed change and authorizes the clearing agency to implement the
proposed change on an earlier date, subject to any conditions imposed
by the Commission.
The clearing agency shall post notice on its Web site of proposed
changes that are implemented.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed
change, is consistent with the Payment, Clearing and Settlement
Supervision 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-2014-810 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-2014-810. 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 advance notice that are filed
with the Commission, and all written communications relating to the
advance notice 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 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_810.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-2014-810
and should be submitted on or before January 2, 2015.
By the Commission.
Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2014-29002 Filed 12-10-14; 8:45 am]
BILLING CODE 8011-01-P