Enhancing the Resiliency of OCC and the U.S. Options Industry
Remarks by Michael McClain
President and Chief Operating Officer, OCC
Options Industry Conference
May 7, 2015
Thank you. It is a pleasure for me to be here with you today representing OCC. You are a very important group for us, and we appreciate your time at this conference.
I want to thank our hosts at BOX for being this year's lead exchange and for giving me this opportunity to talk about the progress and momentum underway at OCC. Sustained growth in an industry like ours is the result of the hard work done by all market participants and everyone in this room plays an important role in driving that growth.
- Exchanges bring buyers and sellers together by providing competitive, transparent and liquid markets.
- Clearing members and their customers have facilitated major growth in our markets.
- Market makers provide the liquidity that is critical to making our markets more efficient for public customers to transact.
- And finally OCC provides the needed financial stability and integrity by guaranteeing every transaction in our market.
As the foundation for secure markets, it is important for OCC to ensure that the listed options markets remain vibrant, resilient and liquid in the eyes of regulators and the investing public. Much of what you will hear from me today is about what we are doing to provide that confidence, but I would like to start with the importance of continued education. We share your view that a strong education program contributes to better and more effective policy making, and fosters more knowledgeable and prudent investors.
At this week's World Federation of Exchanges and IOMA meeting, U.S. options education was mentioned on multiple occasions as the example of how to strengthen non-U.S. derivatives markets. That is why OCC supports the work of The Options Industry Council as it relates to education programs and the development of powerful thought leadership, and we applaud the work of our OIC partner exchanges and member firms.
When it comes to the work of the OIC and how we can promote greater awareness and understanding of the value of listed options markets, we cannot rest on our laurels. So last fall, with the cooperation of the Leo Burnett Business agency, we fielded a study with the goal of measuring the impact of advertising on OIC. Four hundred seventy-nine individual investors and 263 financial advisors were interviewed to see if our campaign increased awareness levels and likelihood to use OIC educational offerings.
The results were very positive for OIC! The study found that the advertising campaign increased OIC's brand awareness among individual investors by 33 percent. Search, magazine, and internet advertisements, including video, were the channels with the highest recall among those surveyed. Significantly more investors are using OIC's educational services this year compared to last year.
In particular, OIC experienced a big directional shift in certain perceptions among individual investors. Among those surveyed, OIC had a significant improvement as a trustworthy expert, empowered educator, and as a recommended and respected organization.
Among financial advisors, the survey results showed that our advertising increased their likelihood to use OIC’s educational offerings in the future by 56 percent. We also saw a positive shift in financial advisor brand perceptions of OIC. This includes: a 65 percent increase in OIC being seen as a trustworthy expert, 55 percent viewing OIC as a leader in the industry, and 42 percent viewing OIC as an innovative source.
While we are pleased with these results, we know we have more to do if we want OIC to have a greater impact on your work and in promoting the value of the listed options market.
The continued developments in the U.S. options industry, despite the changing landscape in which we operate, have been the one constant that has benefited us all. In addition to OIC, working with our exchange partners in the U.S. Securities Markets Coalition, OCC strengthened its presence in Washington as a leading advocate on important regulatory, legislative and tax issues affecting our industry.
This started with an ongoing focus on a tax reform proposal by the chairman of the House Ways and Means Committee that would require options to be marked-to-market and treat any gains as ordinary income rather than capital gains. The proposal would also treat an appreciated stock position as being sold if an investor enters into a related risk-reducing options transaction that bears no economic resemblance to actually selling the stock.
The coalition works diligently to ensure that members of Congress and the Administration understand the devastating impacts that many of their proposals have on listed options markets. Unfortunately, our focus cannot be U.S.-only. OCC is actively engaged with European regulators to ensure that OCC is recognized as a Qualifying Central Counterparty, or QCCP, under the European Market Infrastructure Regulation regime.
Even though OCC only clears for U.S. markets, this recognition is critical to our clearing members who are affiliated with non-U.S. banks so that they are not subject to penalizing capital charges for providing clearing services to U.S. options customers.
OCC values its leadership and contribution to both OIC and the U.S. Securities Markets Coalition. They serve as examples of where our unique and central position in the markets improve the industry overall.
Turning to OCC, 2014 represented the second highest year in our 41 years of serving clients and markets, with cleared contract volume of more than 4.3 billion. We also achieved significant progress and built tremendous momentum against some of our key strategic initiatives. We took aggressive steps to increase our resiliency, enhance our capital base and strengthen our oversight and leadership.
As a SIFMU, OCC’s highest priority is accelerating our progress and improving our quality in adapting to new regulatory standards. I am pleased to say that in April we passed the halfway mark toward our specific goals in this area, and our changes have been positive and well received by our regulators.
We are meeting the aggressive regulatory goals we have set for ourselves along with several resiliency objectives that go beyond remediation. While meeting these new standards requires a substantial investment in our resources, our primary focus is getting it right the first time and implementing resiliency improvements that will benefit the industry rather than simply “check the box” on an examination report. This does not mean, however, that we will ignore operational efficiency. OCC will continue to take the steps necessary to ensure that we remain disciplined in managing costs while strengthening market protections for all market participants.
After all, our pricing, which is among the lowest in the world, contributes to liquid, safe and secure markets, and is in and of itself a factor in market resiliency.
Let me be more specific about where we are making investments. Our guarantee is supported by a sophisticated risk management framework, combined with a deep pool of financial resources that consist of prudent margin requirements and a clearing fund intended to provide coverage in extreme but plausible market conditions.
The majority of our investment in 2014 and 2015 went into improving this framework. These changes include: a stress testing framework to ensure that our margin and clearing fund are adequate in extreme but plausible market events; collateral management improvements that improve the quality of our collateral positions in a default; liquidity monitoring improvements that improve the quality of our collateral positions in a default; and, post-trade controls to stop obvious pricing problems before they create larger systemic issues.
With the support of our board, in 2014 we began expanding our expertise in our risk management functions. We are building separate and deep centers of excellence in credit, liquidity, market and default risk management. Specific focus and attention is leading to innovative solutions, many of which are putting us ahead of our peers.
We understand that these efforts need significant checks and balances. For this reason, we build a new infrastructure that independently validates our risk models. This is a way of managing the risk of our risk management. We also implemented processes that continuously assess the adequacy and performance of existing models in evolving market conditions. Collectively, the enhancements and improved rigor in risk management has increased market resiliency and improved the confidence of market participants and regulators.
We are aware, however, that some of the changes impose higher margin and clearing fund requirements. We remain mindful of the demand that increasing collateral requirements places on the industry. That is why we continue to consider capital efficiencies wherever possible.
By recognizing hedges in other markets through our cross margin programs with CME and ICE, we can both manage clearinghouse risk and provide a means for members to manage their own collateral levels. In 2014, OCC and CME cross-margin participants realized an average daily reduction in margin requirements of $700 million, an average of 54 percent savings per participant.
Perhaps even more significant, OCC continues to consider the specific collateral posted in the margin calculation. This provides another way clearing members can help us help them by awarding credit for quality collateral that offsets OCC position risk. Capital efficiencies like these provide a unique win/win for the industry since OCC mitigates position risk through hedging and participants reduce their collateral obligation. OCC remains conscientious to the potential unintended consequences and risk to participants of increasing financial clearinghouse resources.
As many of you are aware, the SEC published its Covered Clearing Agency proposal, including new capital requirements that required a large increase in shareholders’ equity at OCC. Our board of directors worked extensively with regulators, clearing members, and exchanges as it weighed different capital models. The board concluded that our proposed capital plan was the best option to ensure compliance with capital and liquidity requirements. Other alternatives that were examined posed unfeasible and significant tax, compliance or shareholder issues. Without a plan, OCC faced enormous fee increases or worse, regulatory compliance issues.
Earlier this year, the SEC approved OCC’s capital plan through its no objection to our advance notice filing, and our proposed rule change in support of the plan was approved by the SEC through delegated authority to its staff after extensive consideration of industry comments. Although implementation of the plan has been paused while the SEC evaluates petitions, we remain confident that we are on the right track. We know that not all participants agree on the approach, but we are encouraged and very pleased with the broad support for the substantial increase in OCC capital. Our intent to ensure that OCC is adequately capitalized is, as one market participant defined it in a recent news story, “prudent”.
This capital plan is a major step forward for OCC. It enables us to meet proposed regulatory requirements well in advance of expected implementation, and serves as a great example of OCC’s proactive approach to regulatory expectations. The plan bolsters our financial resiliency by providing ready access to $364 million in equity capital and allows OCC to refund over $33 million to clearing members and reduce clearing fees.
While OCC capital is important to business and operational risk, liquidity of the collateral we hold against market risk is key in supporting growth and resiliency in the options market. We increased our committed liquid facilities from $2 to $3 billion through the use of a new and innovative approach to committed liquidity. A full third of our liquidity is now committed and pre-funded through a facility with the pension fund CalPERS. This new facility fulfills our goal of reducing our reliance on clearing members during a time when they are least likely to be in a position to support us. A risk known as pro-cyclicality.
This new and innovative approach to liquidity has the added benefit of diversifying our dependence on banks while their committed facilities contract as they undergo their own regulatory pressures. Increasing our total resources through this innovative solution will facilitate the growth of the U.S. options industry and the futures markets that we serve while also enhancing OCC’s resiliency.
Moving to transaction risk, working closely with our exchange partners, we led the development and adoption of a principles-based set of exchange risk controls standards designed to reduce the risk of unintended activity that could cause or contribute to significant financial loss. Adoption of these new standards represents a major step forward in our collective goal of enhancing industry protections. This was a cooperative effort of our board and our exchange partners, and we are pleased with these initial steps.
Affecting this huge level of change requires engaged governance and strong leadership. Our board of directors and staff has spent countless hours on these and many other resiliency initiatives. We asked a lot of our board directors and employees, and they have delivered.
To sustain this high level of change and resiliency, OCC paid special attention to board composition and senior management in 2014 and 2015. We increased the number of public directors on the OCC board to five to ensure that we have the broad perspectives that take into account public interests when making decisions. The number of new public directors is actually less important than the overall competence and quality of our individual directors. Our new public directors are already enhancing the diversity, skills and expertise of our board, especially in the critical area of risk management.
I know that many of you have seen a lot of new faces at OCC. This was due to a concerted effort to strengthen our leadership team. We have tapped outside banking experience with our new Chief Risk Officer, Chief Financial Officer and Chief Information Officer. To continue to deliver a high level of service to our exchanges, we have brought in trading and clearing expertise to head up our product development and OIC areas. Finally, we recognize that our business is unique and can only run efficiently with OCC-specific knowledge and expertise. For this reason, we identified our very best leaders and promoted from within to fill senior management gaps in Operations and Financial Risk Management, where there is now over 50 years of OCC experience in those two positions alone.
By combining outside talent and expertise with specific inside experience, we are achieving high levels of leadership and performance from the management team. As I noted earlier, our new board and executive team has already made significant progress toward our goal of resiliency, and I am confident we can achieve more in the coming years.
With this team in place, and with the continued commitment and dedication of our employees in Chicago, Texas, Washington, and New York, OCC continues to execute on our priorities to meet the heightened expectations of regulators and market participants.
Looking forward, we know that we are not alone in the new regulatory landscape. We continue to focus our efforts on improving resiliency in order to maintain a safe and sound central counterparty for the options industry. This will always be our primary objective. Looking beyond this year, we have an opportunity to further leverage OCC’s unique position in the industry to support market participants in their own risk mitigation efforts.
For clearing members, we are working on enhancements to post trade processing that will enable them to manage their own intra-day risk at OCC. For customers and other market participants, we are designing clearing solutions that would reduce the impact of regulatory capital charges on transactions that are not cleared today. For exchanges and liquidity providers, we plan to build on pre and post-trade controls by seeking ways to implement real-time credit checks and automated circuit breakers.
We are excited about all of the innovations that OCC can bring to the industry and are focused on collaborating with all participants in the design of these solutions to make our markets more secure and attractive to those who rely on us.
In closing, the work we are doing on regulatory remediation and improving our capital position is very positive for OCC, and for the market participants we serve. Our board of directors and senior leadership team believe these initiatives will strengthen an already strong clearinghouse.
As the foundation for secure markets, we will continue to enhance our resiliency, strengthen market protections, and deliver efficiencies for all market participants. We also will work with you and the OIC to ensure that continued education about the importance of the listed options markets remains paramount.
Thank you again for giving me the opportunity to be with you today, and I hope that everyone has a very successful and productive conference.
REGISTER FOR THE OPTIONS
- Free, unbiased options education
- Learn in-person and online
- Advance at your own pace