An Interview with Michael McClain, Executive Vice President, Business Operations Group of The Options Clearing Corporation (OCC)
Michael McClain has been with the OCC since 2001. He recently participated in a panel at the FIA Expo Chicago on “The Impact of Regulatory Reform on the Equity Options Markets.” He spoke with Sarah Rudolph, editor of JLN Options, about OCC’s new agreement with Standard & Poor’s to clear over-the-counter options.
Q: OCC and Standard & Poor’s recently agreed to a deal for OCC to clear customized (OTC) options contracts on the S&P index products. Could you tell me a little bit about how the arrangement works and what was the reason behind it?
A: When it started to look from a regulatory perspective like OTC derivatives were going to have to be cleared, we thought OCC was a natural fit as the largest U.S. equity derivatives clearing house. The best place for us to start was with options, since we do in the high 90th percentile of options clearing.
When you look at over-the-counter options, it’s hard to clear a big chunk of them without clearing the S&P 500. It’s a very popular contract. And if we were going to clear that, we had to license that product.
Q: How does the arrangement work?
A: Obviously we get all our trades now from exchanges. What’s new is that we will get a bilateral negotiated trade directly from the Street. We feel strongly that the OTC options business and the listed options business have existed together and are very symbiotic. They help each other. When those OTC contracts are struck, the listed markets are there so the OTC options can be hedged [with an options contract traded on an exchange]. So the two markets are very complementary.
Just to be safe, we have requirements for minimum notional value amounts and minimum duration on the OTC trades which have to be met to bring the contract directly to clearing. For example, you can’t do an over-the-counter trade and clear it with the OCC if the duration of the contract is under 4 months.
Q: What is the reason for that?
A: A huge percentage of the contracts done on exchanges are 3 months and under. [Requiring the duration of the OTC contracts to be at least four months] keeps the complementary relationship. What we don’t want to happen is for the volume at the options exchanges to go to OTC. We think these are good protections. And these requirements shouldn’t affect OTC volume because OTC options contracts are typically of much longer duration and higher notional value than the exchange traded contracts. You see a lot of contracts on the OTC market that are for multiple years. Also, on exchanges, a lot of contracts go off at 50 lots, whereas the OTC contracts are much bigger — in the 500,000s. And the people doing those types of very large trades are coming to the listed markets to hedge.
Q: So does clearing at OCC reduce the need to go to the listed markets to hedge?
A: No, they still need to hedge the risk. Going to a clearing house mitigates counterparty risk, but not the risk of your position. You still need to hedge that market risk. What we think, and what is a big part of our value proposition, is that if you hedge the OTC options in the same clearing house [OCC], we can give you credit in your account, so your margin goes down. If we allowed another clearing house to do this, and if hedging still went on, a dealer would pay margin on an OTC contract, but would also be paying separate margin for the exchange-listed contracts, because we don’t see or control both sides of the position. So he would be paying margin twice. [In this OCC arrangement], your hedge is recognized against your original position in the same account.
Q: I unfortunately missed your panel at the recent FIA Expo on the impact of regulatory reform on the options markets. How does this move to clear OTC options fit in with regulatory measures? Is it in response to any particular regulations?
A: It is definitely not a direct response, because the regulations in Dodd-Frank carved out options from the rules about what has to be cleared. The Dodd Frank legislation doesn’t talk about OTC options, so it is really up to the regulators whether there will be rules that will force clearing or not. We did this because there is an OTC options market out there, and we think that even if no one is forced to clear OTC options, we’re going to offer an alternative. (We started this initiative before Dodd-Frank.)
Q: OCC plans to begin clearing the S&P index-linked contracts in mid-2011. What are your plans for clearing other products, any other indexes?
A: We would most likely expand into other listed lookalike options, whether they be other indexes or single share options. There are other equity derivatives products out there we’re also looking at. We’re not sure yet which path we’re going to take.
Q: Can you briefly run down what people discussed on the FIA Expo panel about how regulations will affect options trading?
A: Right now as far as options trading, the Dodd-Frank legislation has carved that out. We don’t know what is going to happen in the regulations when it comes time for the SEC — the biggest equity options regulator — to implement rules. On the panel, we talked a bit about what happens if they go down the path of requiring other derivatives products to be cleared at a Swap Execution Facility (SEF). That’s something regulators need to be careful about because they haven’t really defined what an SEF is yet, but the more you read about it, the more it is starting to sound like an exchange. And what we don’t want in the options industry is something that is regulated much less than an exchange but that is operated like an exchange.