Recently implemented regulatory capital rules governing banking organizations are inadvertently dampening liquidity in the options market because they do not take into account the risk reducing characteristics of options and instead impose unnecessarily inflated capital requirements for option positions that can be riskless or risk reducing.
Issue: Regulatory Capital Rules Governing Banking Organizations
The Basel Committee on Banking Supervision (Basel Committee) consists of senior representatives of bank supervisory authorities and central banks from many of the major financial jurisdictions, including the U.S. The Basel Committee adopted a framework to reduce systemic market risk by requiring banks to increase capital and/or decrease leverage for certain risk exposures (Basel III). The Office of the Comptroller of the Currency and Board of Governors of the Federal Reserve System have adopted rules in order to implement various aspects of Basel III in the U.S., including the manner in which Risk-Weighted Assets (RWA) are calculated. Unfortunately, current requirements obligate large U.S. bank holding companies to calculate their RWA using a standardized approach known as the Current Exposure Method (CEM). Under CEM, options risk is measured by notional amount, and the actual risk of exposure to option positions is ignored. For example, CEM fails to recognize that an option that is far out-of-the money will have a very low delta value (i.e., the option's value is less sensitive to changes in the value of the underlying security or index). CEM also fails to properly allow offsetting risks to be netted (i.e., offsetting of positions) when calculating capital charges.
Although the Basel Committee agreed to replace CEM by January 2017 with a more risk-sensitive method known as the Standardized Approach for measuring Counterparty Credit Risk exposures (SA-CCR), the Board of Governors of the Federal Reserve has not yet implemented SA-CCR, and the transition is not imminent. The effect is that CEM grossly overstates a bank's actual economic exposure to listed option positions, which requires banking organizations to hold capital that is disproportionate to the actual risks posed by the option positions, including via a bank-owned clearing firm's listed options business. This problem is especially acute in high notional value products like CBOE's S&P 500 Index options.
Impact: Bank-Owned Clearing Firms Clear the Majority of Market-Maker Transactions
All listed options transactions in the U.S. are cleared at the Options Clearing Corporation (OCC). The OCC is comprised of clearing members that effectively guarantee the performance of the parties to an options transaction. Option market-makers on exchanges like CBOE clear their trades through OCC clearing members. The vast majority of these clearing members are subsidiaries of bank-holding companies that are now subject to option-insensitive capital requirements that govern the method by which banking organizations calculate capital charges and affect the amount of capital the banking organizations must maintain.
Regulatory Capital Rules Unintentionally Harm the Listed Options Market
Current regulatory capital rules are not properly calibrated because they are not sufficiently risk sensitive. The regulatory capital rules fail to account for an options' delta and fail to fully recognize the offsetting of positions with opposite economic exposure (i.e., long positions and short positions). The gross overstatement of a bank's actual economic exposure requires banking organizations to hold capital that is disproportionate to the actual risks posed by a bank-owned clearing firm's listed options business. Thus, bank holding companies are increasingly less willing to maintain the capital necessary to allow their affiliates to clear options transactions. The immediate effect is that bank affiliated clearing firms are now instructing market-makers to curtail their options trading activity in order to reduce the bank affiliated clearing firm's regulatory capital footprint. This reduces liquidity in the options market to the detriment of investors.
Market-Makers are Critical to the Options Market
In the listed options market, liquidity is supplied by professional market-makers. Most investor orders are executed against market-maker quotations. Due in part to the dispersion of trading interest across hundreds of options series in a single options class, the majority of individual options series would have no posted liquidity if options market-makers were not present. In short, market-maker liquidity provision is critical to vibrant option markets, which is why the impact of detrimental bank capital regulations on market-maker liquidity is so concerning to CBOE.
Options are Important Risk Mitigation Tools
Options are first and foremost incredibly useful and powerful risk mitigation tools that can help protect an investor's financial portfolio. From buying puts to hedge the downside risk of owning a stock to writing covered calls to collect income and cap potential losses, listed options strategies are protective tools employed by institutions, pension funds, and individual investors. Importantly, option positions can offset one-another and curtail risk. More option positions should not necessarily equate to higher capital requirements - options used in combination often reduce risk and should thereby reduce a capital requirement - not increase it.
We Need a Solution
Market-maker liquidity is the backbone of the options industry. A regulatory capital regime that unintentionally causes market-makers to limit their options trading activity will reduce liquidity and harm all options users, including individual investors and pension funds.
CBOE stands ready to work with interested parties on a meaningful solution which could include:
- Interpretive relief from the Board of Governors of the Federal Reserve that will allow bank-owned clearing members to apply a more risk-sensitive methodology to listed options.
- Adoption of SA-CCR: Although the members of the Basel Committee, including the U.S., agreed to adopt the more risk-sensitive RWA calculation method knows as SA-CCR by January 2017, the United States has not yet implemented SA-CCR and is not close to implementing SA-CCR.
- Legislation that properly identifies the risk profile of listed options.
Bank Capital Summary Sheet
CBOE is also concerned that the Basel III supplemental leverage ratio, currently scheduled to go into effect in 2018, will not adequately take into consideration its effect on the U.S. options and futures markets. The leverage ratio is a separate requirement that is defined as the capital measure (the numerator), which constitutes Tier 1 capital, divided by the exposure measure (the denominator). CBOE is concerned that the leverage ratio does not account for the fact that segregated customer initial margin for centrally cleared derivatives, which is designed to reduce the clearing firm's exposure in order to guarantee the customer's performance, cannot be used to leverage the customer's clearing member firm. Absent any capital recognition for such reduced exposure, clearing firms may incur unnecessarily high capital costs that do not accurately reflect the exposure reduction achieved from segregated customer initial margin for cleared derivatives.
Read CBOE's July 2016 Joint Comment Letter on bank capital regulation
Read CBOE's January 2016 Comment Letter on the Federal Reserve Board's Total Loss-Absorbing Capacity (T-LAC) Proposal
Read CBOE's October 2015 Joint Comment Letter on bank capital regulation.