PORTFOLIO MARGIN and CROSS-MARGIN AN OVERVIEW OF THE BROAD BASED INDEX OPTION PILOT PROGRAMS FOR...

PORTFOLIO MARGIN and CROSS-MARGIN

AN OVERVIEW OF THE BROAD BASED INDEXOPTION PILOT PROGRAMS FOR CUSTOMERS

Richard Lewandowski - Chicago Board Options Exchange

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History Past and current margining of listed options and securities

underlying listed options .

Studies of the 1987 market crash advocate cross-margining. “Report of the Presidential Task Force on Market

Mechanisms” (the “Brady Commission”) “The October 1987 Market Break” (SEC) “Working Group on Financial Markets” (Dept. of the

Treasury, FRB, SEC and CFTC)

Net Capital - haircuts on options strategy based prior to April 1994. SEC no-action letter in April 1994 allows portfolio

methodology. SEC changes Net Capital Rule in Sept. 1997 to formally

allow portfolio methodology as an alternative to strategy based requirements.

Proposed customer program will parallel haircut methodology.

Portfolio Margin and Cross-Margin Pilot Plan Proposal

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History Since April 1986, OCC has utilized portfolio margin. Since 1988, Futures Commission Merchants (“FCM”) have

applied a portfolio (SPAN) margin requirement. Final changes to Reg. T (effective April 1, 1998)

Permit portfolio margining as an alternative to Reg. T. Self-regulatory organization (“SRO”) rules needed to

implement portfolio margining SEC approval required.

Portfolio Margin Committee formed - recommendations made.


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Plan Overview Joint effort by CBOE, OCC, NYSE, AMEX, CME and CBOT to

implement portfolio margin system for customers. An alternative to the current “position” or “strategy” based

margin. Pilot program initially.

Limits a firm’s gross portfolio margin requirements to 1,000 percent of its net capital.

Firms can select accounts as they deem appropriate. Participant criteria may be modified based on the pilot

experience. Plan also provides for cross-margin - margin requirement

determined using the same portfolio margin facility. Pilot will only permit portfolio margining of:

Broad based U.S. listed securities index options Related exchange traded funds (i.e., SPDRS,

DIAMONDS) Related index futures and options on those futures.

No stock baskets permitted at this time.


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Plan Overview Portfolio margining objective - determine margin based on

potential risk in a portfolio as a whole. Margin required is derived based on the greatest projected net

loss in an account given various scenarios of underlying price increases and decreases and implied volatility changes.

Positions grouped by class. Gain or loss on each position is calculated for assumed

moves in the underlying, both up and down. Theoretical pricing formula is employed for options gains /

losses. Netting of gains / losses within class groups. Offsets (gains) applied between classes, if eligible. Greatest loss is the portfolio margin requirement for that

class. Total of class requirements is overall portfolio margin

requirement. Per contract minimum of $37.50 (.375 X $100 multiplier). Firms can impose an “add-on” (house) requirement if desired.


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Plan Overview Option theoretical values supplied by The Options Clearing

Corporation. Provides for uniform margin requirements across broker-dealers.

Broker-dealers organize customer positions into a firm or vendor supplied spreadsheet.

Portfolio margin requirement calculated within the spreadsheet application using option theoretical values obtained from the OCC.

Process is the same as is currently in place for computing haircuts under the Securities & Exchange Commission’s capital rule.

Market ranges for computing gains and losses: high-cap broad based indexes --- +6% / -8% of the closing price

of the index non-high- cap broad based indexes --- +/- 10% of the closing

price of the index


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Plan Overview Portfolio margin computation done at close of each business

day. Portfolio margin requirement is both the initial and

maintenance margin requirement - not necessary to determine whether an increase in the requirement is due to a new commitment or adverse market moves.

Margin call arises if requirement greater than net liquidating equity in the portfolio margin account (cross-margin account).

Margin call must be met by the end of business on T+1 (one day settlement).


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Plan Overview Liquidating or hedging to meet a margin call is allowed. Minimum Equity Requirement.

Account equity of at least five million dollars. Accounts may be aggregated if same owner. Not applicable to a broker-dealer, an affiliate of the clearing

broker-dealer, or to the cross-margining activity of a member of a national futures exchange.

Firms may impose a higher minimum equity (house) requirement if desired.

Equity call must be met by T+3 (three business day settlement). If equity call not met, no new orders may be accepted (except

opening orders that reduce margin requirement). Account guarantees prohibited (for equity or margin).


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Plan Overview Required Disclosure

Firm must provide customer with a standard disclosure statement prior to opening a portfolio margin and/or cross-margin account.

Customers must sign an attestation acknowledging that they have received the disclosure document and are aware of the risks involved.

Not applicable to broker-dealers, affiliates of the clearing broker-dealer, and members of futures exchanges.

To offer cross-margining, a broker-dealer must: also be an FCM and either be a clearing FCM or have an affiliate that is a clearing

FCM.

Cross-margin account would be a securities account. SEC customer protection rules and SIPC coverage apply.

Internal risk analysis procedures required of each firm.


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Plan Overview

CBOE filed a rule change with the SEC in January 2002 to go forward with the pilot.

NYSE filed a similar rule change with the SEC in May 2002.

Final work to be completed before the pilot can begin: Customer Protection changes at the SEC and CFTC concerning

cross-margin account SIPC protection for non-securities products and balances in a

cross-margin account Hypothecation of customers’ long options positions at the

clearing house level (SEC)

PORTFOLIO MARGIN and CROSS-MARGIN AN OVERVIEW OF THE BROAD BASED INDEX OPTION PILOT PROGRAMS FOR...

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