OTC options clearing not mandated but beneficial

The benefits of cross margining are driving the US’ Options Clearing Corporation to launch a clearing service for OTC options despite it not being mandated.

The benefits of cross-margining are driving the US’ Options Clearing Corporation (OCC) to launch a clearing service for OTC options despite it not being mandated.

The new service will begin with the clearing of OTC S&P 500 equity index options, and the OCC said it was open to looking at other products as well in the future. It’s set to launch as early as next month for dealer-to-dealer trades and August for dealer-to-client trades.

Carolyn Mitchell, OCC’s first vice-president of business development, told theTRADEnews.com the idea to begin clearing OTC options was sparked shortly after the Dodd-Frank Act was passed.

The OCC began planning with a group of brokers to begin clearing OTC S&P 500 index options. “It’s the largest contract in the US, which is why we started there. Although it’s not required under Dodd-Frank, participants certainly see the benefits of clearing," Mitchell said.

As for whether the clearing of OTC options will be popular for European market participants, the OCC believes so.

Last week, TABB Group released an updated report on the use of US-listed equity options by European investors. The report found options were being used for directional and volatility strategies, and index options continued to be popular, accounting for 9% of total trading volume in US equity options markets.

Given the volume coming from Europe, the OCC suspects European investors will also look at OTC contracts.

The advantages

Mitchell said that with a clearing house sitting in between both buyer and seller, the most obvious advantage of clearing is the reduction of counterparty risk.

“There is also portfolio margining between listed and OTC positions. If market participants put OTC contracts with their listed activities, then the hedges will give offsets and reduce overall margin – that’s very efficient,” she said.

Clearing also offers fungibility benefits, as market participants will be able to open a position with one counterparty and close with another.

The OCC began working on the new service two years ago, getting regulatory approval, performing tests and making sure risk management systems were in place. 

In January this year, the Securities and Exchange Commission (SEC) approved a Securities Investor Protection Corporation rule change, which broadens the definition of standardised options to include OTC options cleared by OCC.

The change extends the protection given to customers in the event of a liquidation of a broker, as standardised OTC options will now be subject to closeout or transfer in a Securities Investor Protection Act proceeding.

“It was a two years process as we not only had to make many changes to help with the regulatory process, but we also made sure there wouldn’t be an impact to our existing listed business,” Mitchell said. 

Timing has been a big factor as well, she said. With market participants already dealing with piles of regulation – including the European market infrastructure regulation – OCC had to make sure its timeline accommodated mandated deadlines. “The dealers we are working with have asked for a gap in time just to make sure everything is set.” 

The OCC has yet to set a launch date as a final round of tests is required, but it expects to have them done within the next two weeks.

“We want to make sure that everything comes out perfectly during this test and we’ll be able to turn it on within a day,” Mitchell said.

Converge OTC Clearing, a subsidiary of the Canadian Derivatives Clearing Corporation, which is owned by the TMX Group, also offers OTC equity options clearing.