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February 16, 2007

New Portfolio Rules to Boost Options Volume

By Nina Mehta

Options contract volume is expected to increase under new portfolio margining rules as hedge funds and proprietary trading firms benefit from lower margin requirements. Most qualified investors can expect to see their margin requirements decrease.

"There's no question this will increase options volume since it reduces the significant cost of capital in trading equity options," says Neal Wolkoff, chairman and chief executive of the American Stock Exchange.

New risk-based portfolio margining rules will come into play for a broad range of products on April 2, for the first time since the Federal Reserve formulated its Regulation T initial margin requirements in the wake of the stock market crash of 1929. Eligible products for portfolio margining pilot programs include equities, equity options, narrow-based index options, single-stock futures and unlisted derivatives.

Under the new rules, member firms of the Chicago Board Options Exchange and the New York Stock Exchange will be able to calculate margin requirements for approved customer accounts across portfolios. The Securities and Exchange Commission approved rule filings from the two exchanges in December.

"This will completely revolutionize the way financing is done on stocks and stock options," says Bill Brodsky, chairman and chief executive of the CBOE. Brodsky worked with NYSE chief John Thain, regulators and other market participants to push for cross-product portfolio margining in recent years.

At least initially, hedge funds and proprietary trading firms are likely to be the main beneficiaries of these new rules, rather than traditional fund companies and retail investors.

Hedge funds and prop firms now won't have to scramble to avoid the Reg T margin requirements. Many hedge funds moved portfolios offshore to avoid the 50 percent initial margin and 25 percent maintenance margin requirements for securities. Some prop shops set up "joint back offices" (JBOs) with large clearing firms. Clearers use risk-based margining and therefore have lower margining requirements.

"The SEC wasn't blind," says Steve Sanders, senior vice president for product development at options firm Interactive Brokers. "They decided they'd rather regulate the business than see it go somewhere else." Regulators in many other countries allow a risk-based margining system.

Prop trading firms will be able to operate more efficiently. "They can avoid JBOs, which are a hassle and have some barriers to entry, and simply set themselves up as customers of a clearing firm," says Peter Lawler, head of institutional development at brokerage firm OptionsHouse.

Portfolio margining evaluates multiple products as a group and determines the margin required for the entire portfolio, taking into account its theoretical level of risk and offsetting positions, according to CBOE's Brodsky. The minimum margin requirement for securities will now be 15 percent.

Broker-dealers must apply SEC-approved pricing models to calculate portfolio margins for customer accounts. The methodology will stress-test portfolios to determine margin requirements, based on expected gains and losses as a result of market movements. The NYSE has suggested that brokers may eventually use their internal risk-based methodologies to calculate margins for customers.