Looking Beyond Pennies

The nitty-gritty on portfolio margining and its expected impact

The U.S. listed options marketplace is facing two important structural changes this year. The first of these is the pilot plan that began in February to quote options in penny increments. Thirteen options classes were included in the pilot as a test for the industry. Moving from nickel and dime increments to pennies has produced a wide range of predictions, many based on decimalization in the stock markets in 2001. Dire warnings of imploding market data systems and a loss of liquidity providers are countered with sunny forecasts of pennies giving a turbo boost to the already tremendous options volume growth.

Outside of exchange consolidation rumors, nothing is being talked about more than penny trading. However, it is the second-and more subtle-change that has the potential to have a much greater impact on the marketplace. That impact is almost universally seen as a positive force for expanding options trading volume.

Leap Forward

On April 2, new rules allowing broker-dealers to use a risk-based portfolio approach for the margining of customer accounts took effect. This expansion of customer portfolio margining helps U.S. equities markets take a major leap forward, allowing securities firms to participate on a level playing field with the futures and international equities markets with regard to customer margining. Previously, margin rules governing U.S. equity markets followed a strategy-based approach requiring broker-dealers to identify approved hedged positions (or strategies) and imposed a set margin requirement for each position. Portfolio margining now allows broker-dealers to group products based on a related underlying asset into portfolios, with the margin requirement based on the risk of the portfolio, as opposed to a set amount.

Under these new rules, risk-based customer portfolio margining will be based on the Options Clearing Corp.’s TIMS margin methodology, which determines the maximum loss associated with a portfolio, given a percentage move in an underlying asset. A portfolio containing offsetting positions in the derivative and underlying asset reflects less market risk and requires less equity to collateralize the account. This margining method adds leverage to customers’ capital available for reinvestment.

Long Effort

Risk-based margins for customers have been the standard for U.S. futures and international securities markets for years. While customers in these markets have been enjoying the benefits of portfolio margining, it has taken a long-term effort to bring customer portfolio margining to the U.S. securities markets.

In January 1998, the Federal Reserve amended Regulation T, which opened the door for portfolio margining. The Fed was explicitly seeking to advance the use of portfolio margining with these changes. The Fed left it to the industry and the Securities and Exchange Commission to work out the details.

Working out those details required years of negotiation. After many years of discussion, in early 2002, the Chicago Board Options Exchange and the New York Stock Exchange filed rule changes with the SEC to allow portfolio margining for a limited class of customers in limited types of instruments. Those rule changes, and subsequent amendments, eventually led to a customer portfolio-margining pilot program that was finally approved in July 2005. This first phase of the pilot, however, limited the eligible asset classes to broad-based index options and futures, and related products.

Congress Involved

Approval of the CBOE and NYSE rule changes to implement the first phase of the pilot came only after Congress became interested in the issue of portfolio margining for customers, while addressing reauthorization of the Commodity Futures Trading Commission. By the end of 2005, Congress and the President’s Working Group on Financial Markets reached consensus that the pilot should be expanded to equity options and security futures. In July 2006, the SEC approved NYSE rules to expand the customer portfolio-margining pilot to these products. Both the first and second phases of the pilot also required that customers maintain $5 million minimum net equity to be eligible to participate.

Ultimately, only one firm, Fimat, chose to participate in the pilot program. It is likely that other firms were deterred less by the restrictions and limitations of the first and second phases of the pilot than by their desire to wait for a broadening of the pilot already on the drawing board when its second phase was approved.

With all the activity in Washington, the broker-dealer community began to realize that broad customer portfolio margining might actually happen. The NYSE, which entered the options market after its merger with Arca, also took an interest in customer portfolio margining after years of caution. Against this backdrop, the CBOE and the NYSE filed changes to expand the scope of portfolio margining. These rule filings, with subsequent amendments, culminated in the rules approved by the SEC in December 2006 and the April 2 launch date.

In addition to eliminating the $5 million minimum requirement, except when a customer’s portfolio includes OTC derivatives, the latest phase of the portfolio-margining pilot widely expands the eligible asset classes to include equities, narrow-based index options, narrow-based index futures, and OTC derivatives. A number of broker-dealers were expected to have been approved to offer portfolio margining to their customers on April 2.

The Rub

Although the new CBOE and NYSE rules are a huge step forward, nearly 10 years after the Fed amended Reg T, obstacles remain before customers can fully realize the increased efficiency achievable through a portfolio-margining program. For example, the NYSE and CBOE rules permit equity index futures to be put into a securities portfolio margining account. Currently, this is not feasible, because futures and securities are overseen by different regulators and subject to different insolvency regimes. These differences will need to be addressed before “cross-margining” of futures and securities can occur. Efforts to resolve these issues are under way.

It will take some time before the impact of customer portfolio margining on the options markets is felt. As more broker-dealers choose to offer portfolio margining to their customers and more customers enjoy the benefits of portfolio margining, profound and positive changes to the options industry are likely.

Susan Milligan is senior vice president, government relations and communications, at the Options Clearing Corp.