Clearing the Deck

A Historic Change in the Leveraging of Securities Purchasing: The Advent of Margining By Michael Jamroz

n December 12, 2006, the Securities eligible products to any eligible Options Clearing Corporation to determine Oand Exchange Commission approved equity security and any derivative based on margin requirements for its members. proposed amendments to the margin rules of an equity security or equity security based Although OCC now uses a model known as the New York Stock Exchange and the index. “STANS” to determine its margin require- Chicago Board Options Exchange. Those The amendments to NYSE Rule 431 and ments, it has agreed to provide certain assis- amendments will dramatically alter the CBOE Rule 12.4—the portfolio margin tance in the application of portfolio amount of credit that securities firms may rules—will allow securities firms that are margining, as discussed later in this article. extend to their customers. Instead of the per- members of those organizations to use a pre- Under the portfolio margin rules, the secu- centage-based margin requirements embed- scribed mathematical model to compute rities firm must aggregate all eligible positions ded in federal and self-regulatory organization margin requirements on all margin-eligible for the customer into a separate margin margin rules, U.S. securities firms will now be equity-based products. Those products account or sub-account clearly identified as a able to apply a prescribed quantitative model include: “portfolio margin account.” Those positions to determine margin requirements for equity • Equity securities that have a “ready market” must be sorted into positions that are related securities and positions related to equity secu- under SEC Rule 15c3-1 and certain other because they are associated with the same rities. For large customers with sophisticated control and restricted securities (Note that equity security or index. For each portfolio of trading accounts, that model should result in convertible bonds are treated as an equity related positions, the firm must revalue them much lower margin levels, and it does so in a security under the margin rules); for 10 equidistant assumed upward and down- way that is much more closely related to the • Listed equity security futures contracts; ward market movements. The assumed market economic of the portfolio than the cur- • Listed equity options; movements vary on the type of equity prod- rent requirements. • Listed equity index options, index warrants ucts that make up the portfolio. High capital- and index futures; ization, broad-based market index portfolios • Listed equity futures options; have high and low valuation points of +6% The Portfolio • Equity exchange-traded funds; and and -8%, while portfolios based on a single Margin Amendments • Over-the-counter derivatives on equity equity security have high and low valuation Following the amendments to Reg T in securities and the products described above. points of +/-15%. The margin requirement is 1998 that made portfolio margining possi- As the rules limit the availability of portfo- the largest computed loss at any equidistant ble, the securities industry began to debate lio margining to products related to equity point. The margin computed becomes both what direction the proposed changes to the securities, it is not available for debt positions, the initial and maintenance margin require- margin rules should take. Much of the dis- money market funds, foreign exchange, physi- ment for the customer. cussion took place in industry committees cal commodities or related derivatives. Non- Firms employing portfolio margining may coordinated by the Securities Industry equity products and money market funds may, obtain the theoretical prices of their portfolio Association and involved what the appro- however, be used as collateral to satisfy the for the assumed market movements directly priate levels of margin should be and to minimum equity in the portfolio margin from the OCC or develop their own models what extent firms should be allowed to uti- account. for determining those prices. Firms seeking to lize their own models. In 2002 enough of a The mathematical model that securities employ their own theoretical pricing models consensus was reached to enable the NYSE firms may use must follow specific parameters must have them approved by the SEC. and CBOE to file their first proposed port- that are outlined in the adopted rules. Those The rules also include a minimum of $.375 folio margin rule amendments. Three years parameters are the equivalent of the model for each listed option, unlisted derivative, later, the SEC approved the portfolio mar- currently employed by securities firms to deter- security futures product and related instru- gin rule filings of the NYSE and CBOE on a mine regulatory capital charges for listed ment, multiplied by the contract or instru- pilot basis. In December 2006, the SEC options positions under SEC Rule 15c3-1a. ment’s multiplier. In addition, accounts of approved an expansion to that pilot, which, That model, popularly known as “TIMS”, is persons other than registered broker-dealers among other things expanded the range of based on the method that was developed by and members of futures exchanges must main-

34 Futures Industry tain at least $5 million of equity in the portfo- must furnish the customer with a risk disclo- The rules also require that management lio margin account before that account may sure. The securities self-regulatory organizations must periodically review the above processes include an unlisted derivative. with authority over margin requirements—the to make sure the guidelines are followed. NYSE, the CBOE and the National Management must also make sure that data Association of Securities Dealers—intend to can be accessed on a timely basis and that sys- Margin Deficiencies separately publish a sample risk disclosure that tems can capture, monitor and report it. All margin deficiencies in a portfolio mar- their members may use as a guideline. The firm gin account must be met by the third day fol- must receive a signed acknowledgement that lowing the trade date. If the deficiency is not the customer understands the risk disclosure Issues and Observations met by then, the firm is prohibited from before the account is opened. Related to Portfolio Margining accepting new orders in that account, unless Prior to offering portfolio margining gener- As a general matter, the portfolio margin those orders operate to reduce the ally, securities firms must have their rules will have a beneficial impact on the and margin requirement in the account. If the management procedures approved by their industry. They will move the margin require- customer does not satisfy the margin defi- designated examining authority (DEA)—the ments for large customers with complex trad- ciency by offsetting trades or depositing addi- NYSE, the CBOE or the NASD. The portfo- ing positions from a somewhat rigid set of tional equity into the account, the firm must lio margin rules include specific requirements requirements that are based on discrete trading eliminate the deficiency by liquidating posi- that those procedures must meet. The firm strategies to a portfolio-based model that tions in the account. Securities firms are pro- must have procedures for: allows more credit for risk-reducing positions, hibited, however, from allowing customers to • Obtaining and reviewing account documen- which is closer to how firms actually manage make a practice of meeting margin deficiencies tation necessary to establish credit limits; the risk of large customer accounts. Those by liquidating positions in its portfolio margin • Determination, review and approval of firms also currently employ many of the credit account. Transfers of margin equity from other credit limits; risk management processes that are mandated accounts are allowed, but account guarantees • Monitoring credit risk exposure during and by the rules. are not. at the end of the day and the type, scope To some degree, the rules also create a Although margin deficiencies must be and frequency of exposure reporting to sen- “level playing field” by relying on TIMS. Firms met by the third day following trade date, ior management; use the TIMS model to compute proprietary securities firms must take a deduction to their • Management’s response when credit limits capital charges for listed options positions and Rule 15c3-1 regulatory net capital for those have been exceeded; related hedges as well as the margin require- deficiencies on the day following trade date. • The use of stress testing; ments for market makers. The portfolio mar- Also, the total amount of leverage that firms • Managing the impact of portfolio margining gin rules will now cause TIMS to be the may offer in their portfolio margin accounts credit extension on the firm’s overall risk standard for not only proprietary trading and is limited. exposure; market makers but also large customers, most Securities firms cannot allow the aggregate • The review and testing of the risk proce- notably funds. It should also reduce the margin requirement in all of its portfolio mar- dures by internal audit or a comparable amount of transaction structuring that cur- gin accounts to exceed 10 times their SEC independent group; and rently takes place to lower the collateral levels Rule 15c3-1 net capital for more than three • Requesting additional margin, including that firms demand of those customers. business days. On the fourth business day, the whether the request was made because of firm is prohibited from opening additional the credit standing of the customer or the portfolio margin accounts until the firm’s risk of the position(s) in the account. Cross Margining, SIPA and aggregate margin requirement is below 10 It is worthy to note that the stress testing Futures Segregation Requirements times its net capital. This limit presents one of called for under the procedures listed above is One of the critical issues that has not been the most significant constraints on the ability expected to be different from the calculations resolved yet is the treatment of futures and of a securities firm to offer portfolio margin to of assumed market movements in the rules futures options. First, Section 4d(a)(2) of the its customers, as it prevents the firms from used to determine margin requirements. The Commodity Exchange Act and Rule 1.20 pro- extending credit in an amount exceeding 10 stress testing should also take into account, for hibit margin received in connection with a times its regulatory capital. example, all of the positions in the portfolio futures transaction to be commingled with Prior to opening a portfolio margin account margin account in aggregate and should also other assets. This prohibition conflicts with with an individual customer, the securities firm consider illiquid and concentrated positions. the portfolio margin rules, under which all

January/February 2007 35 Clearing the Deck continued

whether the addition of a future into a port- Regulation T and the Role of SROs in Margin Limit Setting folio margin account would cause that Following the stock market crash of 1929, the Federal government initiated a series of finan- account to become a commodity futures cial regulatory reforms that shaped much of our system today. Among them was the creation of account and not afforded protection under the Securities and Exchange Commission in 1934. Also in 1934, the Board of Governors of the SIPA. The SEC staff has indicated that the Federal Reserve System adopted its margin rules. The Fed was reacting to the rampant specula- agency will propose amendments to Rule tion in the stock markets, which was fueled by the ability of investors to fund purchases of secu- 15c3-3 that will deem all futures positions in rities through pledges of their portfolio. Since there was no limit on how much they could borrow a securities account to be liquidated upon liq- using their shares and the price of their shares was inflated, investors bought additional securi- uidation of the firm and any remaining bal- ties, putting up very little money of their own. Once the market crashed and the margin calls ance will be presumed to be converted into a came, those investors suffered severe losses and the tragedy that many of our ancestors free credit balance covered under SIPA. It is endured ensued. uncertain to what degree the availability of The Fed’s margin rules established limits on how much pledge value an investor could place SIPA protection presents an issue, however. on the shares it wanted to use as collateral. For much of recent history, the Fed restricted Hedge funds and other sophisticated traders investors from borrowing more than 50% on the value of the securities that they purchased. For are the most likely customers for portfolio investors that borrowed from securities firms, that restriction was embodied in its Regulation T. margining, and it is unlikely that their choice In 1998, the Fed amended Reg T to allow securities brokerage firms that had portfolio mar- of prime broker is based on the availability of gining programs that were approved by the self-regulatory organizations to use those programs SIPA protection. Many of those customers to compute customer margin requirements in lieu of the amounts required under Reg T. currently hold assets at international finan- Under the system adopted when the SEC was created in 1934, the front-line supervisors of cial service firms in locations where SIPA securities firms are those SROs that are associated with securities marketplaces that have protection is unavailable. responsibility to examine their members, known as designated examining authorities (DEA). Today, we recognize them primarily as the NYSE, the National Association of Securities Dealers, and the CBOE. The DEAs have numerous rules that govern various aspects relating to conditions Competitive Issues and processes for membership, and standards for conducting business and maintaining fair The portfolio margin initiative also raises practices. Most DEAs also have margin rules with which their members must comply. some interesting competitive issues. While Reg T governs the amount of margin that must be obtained at the outset of a transac- Previously, both the margin rules and the tion, the DEA margin rules govern the amount of margin that must be maintained thereafter. The SEC’s net capital rule posed significant imped- DEA margin rules were also created with a different purpose in mind. As previously explained, iments that largely prevented U.S. registered the Fed margin rules were adopted to prevent investor leverage from inflating the stock market. broker-dealers from transacting over-the- The DEA margin rules are intended, however, to protect securities firms from over-extending counter derivatives in the U.S. firm. Although credit to their customers. As DEA rules go, the margin rules are also somewhat unique in that a the portfolio margin rules relax the margin great amount of effort is extended to make them consistent among the DEAs. For among other requirements for over-the-counter derivatives, reasons, this effort insures that all investors are governed by the same leverage limitations no conservative regulatory capital charges for matter what marketplace they are operating in. those positions remain for most firms. Firms that qualify and have applied to the SEC for consolidated supervised entity (CSE) status, equity securities-related positions are com- Industry professionals differ, however, on however, are not required to assume that the bined and margin is computed and held on a whether the CFTC has the statutory authority counterparty has defaulted when computing commingled basis in the portfolio margin to remedy that problem. In addition, the cus- capital charges for unlisted derivative posi- account. Margin provided by the customer for tomer margin requirements of the futures tions. They are also allowed to use value-at- futures transactions must be segregated under exchanges may need to be altered in order for risk (VAR) mathematical models to compute the CEA rules and may not be considered as customers to enjoy the full benefit of portfolio their market risk charges for regulatory capital equity in the portfolio margin account. margining. purposes. With lower capital charges and the Second, the general view of many futures Moving the futures position into the port- benefits of portfolio margining, those firms will industry professionals is that Section 4d(a)(2) folio margin account also gives rise to an now have far less regulatory impediment to also prohibits the placement of a futures posi- issue under the Securities Investor Protection conduct their over-the-derivatives business in tion into the portfolio margin account. Act. A question has been raised as to their U.S. registered broker-dealer entities.

36 Futures Industry The present portfolio margin rules do not risk management and operating processes Credit Risk Management Procedures. allow for the use of models other than TIMS, and procedures. Firms can prepare them- Firms should begin drafting and implementing such as VAR, to calculate the margin require- selves to offer their customers increased the written portfolio margining credit proce- ment. As CSE-approved firms have already financing of securities products as soon as dures required by the rules. Those provisions achieved SEC approval to use their own mod- the rules become effective by taking the fol- govern, among other things, the setting, els for computing regulatory capital charges, lowing steps. reviewing and escalation of credit limits and presumably they will lead an industry effort to The Mathematical Model and exceptions, and the monitoring of intraday seek the ability to apply them in computing Theoretical Prices. The calculation of the risk from individual customers and the risk portfolio margin requirements as well. portfolio margin requirement can be viewed exposure the firm has to its portfolio margin The other competitive issue relates to as having two primary components: 1) the business overall. Some of the procedures may banks that conduct lending under the Fed’s calculation of theoretical prices of instru- require considerable effort for firms that do not Regulation U. Generally, Reg U limits entities ments in the account at equidistant intervals already have those processes in place. Firms that are not broker-dealers from lending more up and down; and 2) the application of those that have primarily been relying on the mar- than 50% of the value of “margin stock” that prices to the positions in the account to gin rules for credit protection may have to is used as collateral for the loan. Generally determine the amount of the largest theoreti- implement a formal credit risk management most publicly traded equity securities are mar- cal loss. As mentioned earlier, the portfolio structure that has credit limit setting and limit gin stock. Reg U does not contain the provi- margining rules use the same parameters exception escalation processes. The require- sion in Reg T that allows broker-dealers to use derived from the TIMS model that firms use ments for stress testing and intraday credit a DEA-approved portfolio margin system to to calculate their regulatory capital charges monitoring may also pose significant opera- compute margin. As a result, broker-dealers for their proprietary listed options positions. tional challenges for certain firms. will be able to offer their customers much Those firms rely on OCC to provide them Disclosures. The DEAs will provide spe- more leverage than banks when financing the with the theoretical prices needed to calcu- cific sample portfolio margining risk disclo- purchase of margin stock. Ironically, banks late the assumed losses on their positions. sures and firms should read them and consider currently enjoy an advantage for loans secured Those firms will likely look to import the how they can incorporate them into their cus- by non-margin stock. Banks may extend credit current process they have in place for deter- tomer documentation process. up to 100% of the value of non-margin stock, mining capital charges for use in their portfo- Education. The advent of portfolio mar- while broker-dealers are required to have their lio margining calculations. The portfolio gining will greatly alter the way firms conduct customer pay for non-margin stock in full. margining rules also provide that firms may securities business with their customers. Firms devise their own models to compute theoreti- should begin educational programs for both cal market prices. Those models must be pre- their sales personnel and investors. Firms may What Should Securities approved by the SEC, and the SEC, of consider including in the customer education Firms Do to Prepare? course, has the discretion to require all firms process the request for additional information The portfolio margining rules will likely to use the prices provided by the OCC, if it that they will need from customers in order to prompt a dramatic change in how securities chooses to. conduct credit analysis. firms may finance equity securities activities of Systems and Operations. The implemen- their large customers that engage in complex tation of portfolio margining poses significant Michael Jamroz is a partner in the financial serv- trading. In particular, firms that offer prime systems, operations and other infrastructure ices regulatory consulting group of Deloitte & brokerage services to hedge funds and other challenges. First, firms that do not already Touche. Prior to joining Deloitte & Touche in 1993, sophisticated traders will have more freedom have the TIMS model will have to install it. he worked in the division of market regulation of to offer their customers leveraged financing of Firms should also consider discussing with the Securities and Exchange Commission. equity securities positions without having to their system vendors the need for establishing structure complex transactions involving for- an additional portfolio margining account. eign domiciled affiliates. Finally, once the futures regulators amend Although the rules do not become effec- their rules to allow for portfolio margining, tive until April 2, firms should begin to pre- firms will have to make systems changes to pare now, as much work will need to be provide for the combination of futures and done in obtaining regulatory approvals and securities products. Many firms maintain those making systems alterations and changes to products on separate systems.

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