MEMBER REGULATION. notice

Transcription

1 MEMBER REGULATION notice Contacts: J. Tan (416) R. Corner (416) MR0330 January 13, 2005 ATTENTION: Ultimate Designated Persons Chief Financial Officers Panel Auditors Distribute internally to: Corporate Finance Credit Institutional Internal Audit Legal & Compliance Operations Registration Regulatory Accounting Research Retail Senior Management Trading desk Training Amendments to Regulation and Capital and margin requirements for positions in and offsets involving exchange-traded derivatives On December 17, 2004, IDA Bulletins #3362, #3363, #3364 and #3365 were issued to amend sections of Regulations and , which detail the capital and margin requirements for positions in and offsets involving exchange-traded derivatives. This Member Regulation Notice is being issued to: provide a background of the strategy-based rules and the issues that are being addressed by the amendments; detail the specific rule changes; and explain the reasons for the amendments. A sorted list of the amended IDA Regulations that detail the capital and margin requirements for positions in and offsets involving exchange-traded derivatives is included as Attachment #1. It is hoped that this list will be a useful tool in finding the capital and margin rules that relate to a particular offset strategy. STRATEGY-BASED RULES BACKGROUND The existing capital and margin rules set out requirements for individual derivative positions and offset strategies involving multiple derivative positions. As a result, these rules are referred to as strategy-based rules. These strategy-based rules set out the requirement for a particular derivative position or offset strategy, based on its calculated worst-case scenario loss. The current strategy-based rules have been developed over the last couple of decades, largely by staff at the Toronto Stock Exchange ( TSX ) and the Bourse de Montréal ( BdM ), as new exchange traded derivative products have been introduced. The last major revision to the IDA requirements relating to exchange-traded derivatives, as set out in Regulations and , took place in August 1998, when the rules relating to TSX derivative products were adopted. As part of a general review of Regulation 100, improvements to the strategy-based capital and margin rules for positions in and offsets involving exchange traded derivatives have been identified and are being made with recent implementation of amendments to Regulations and These improvements include simplifying, broadening the application of and removing the excess conservatism in the existing requirements. TORONTO Suite 1600, 121 King Street West, Toronto, Ontario M5H 3T9 Telephone: (416) Fax: (416) CALGARY Suite 2300, 355 Fourth Avenue S.W., Calgary, Alberta T2P 0J1 Telephone: (403) Fax: (403) HALIFAX Suite 1620, TD Centre, 1791 Barrington Street, Halifax, Nova Scotia B3J 3K9 Telephone: (902) Fax: (902) MONTRÉAL Suite 2802, 1 Place Ville Marie, Montréal, Québec, H3B 4R4 Téléphone: (514) Télécopieur: (514) VANCOUVER Suite 1325, P.O. Box 11614, 650 West Georgia Street, Vancouver, B.C. V6B 4N9 Telephone: (604) Fax: (604)

2 January 13, MR0330 IMPROVEMENTS TO THE STRATEGY-BASED RULES The following are the improvements that have been made to the strategy-based rules: 1. Rule simplification The previous rules were too product specific, which in a number of instances, resulted in significant rule duplication, and in a few instances, resulted in the rule not being available for a similar product. As an example of rule duplication, there were six separate instances where capital rules were set out for a covered call strategy involving specific TSX index products. Because these rules were specific to TSX index products they were not applicable to other index products such as those based on the U.S. S&P 500 Index or the U.K. FTSE 100 Index. As a result, it was concluded that specific derivative product rules should be replaced with rules with broader application in order to both remove rule redundancy and make the rule available for similar products that currently exist or may be introduced in the future. This has been done by: Replacing the previous specific index product group rules with generic rules that apply to all qualifying indices; Establishing definitions for the terms index [Reg (a)(xii)] and qualifying basket of index securities [Reg (a)(xxiv)] in order to limit the use of these generic rules; A definition for the term index was needed in order to restrict the use of the floating margin rate methodology to those indices, both sector indices and broadly based indices that meet specified criteria. A definition for the term qualifying basket of index securities was needed to allow for varying cumulative weighting percentage requirements to be met for an index basket to be considered a qualifying basket for offset purposes, based on the number of issues included in the index. This addresses the operational issues associated with hedging larger index baskets while ensuring the price correlations relating to hedging with smaller index baskets are kept high. Establishing a definition for the term tracking error margin rate [Reg (a)(xxvi)] to ensure that where cross product offsets are being performed, the margin requirement calculated is sufficient to cover any imperfect price correlation. The term tracking error margin rate means the last calculated regulatory margin interval for the tracking error resulting from a particular offset strategy. The method of calculation and the margin rate reset policy is the same as that used for the floating margin rate. This tracking error requirement applies, where appropriate, to the following index product pairings: (i) index participation unit options versus index basket, (ii) index options versus index participation units, (iii) index participation unit options versus index options, (iv) index options versus index futures and (v) index participation unit options versus index futures. Further, as a by-product of the level of duplication within the previous strategy-based rules, the previous rules were lengthy, the drafting language was not clear and it was difficult to find the rule that applied to a specific offset strategy. These issues have been addressed by: Standardizing the drafting language used to improve consistency of rule wording, and inserting descriptive rule titles and re-ordering the rules so that they are easier to find thus reducing the likelihood of improper application or different interpretation of the rules. Amending the definition of floating margin rate to give the SROs the ability to determine the regular margin rate reset period. The previous definition set the regular reset period at 60 trading days. The new definition allows greater discretion in setting this period and accommodates the current practice of the Bourse de Montréal to reset rates each month.

3 January 13, MR0330 Included as Attachment #2 is a current list of floating margin rates and tracking error margin rates for the Bourse de Montréal traded products as calculated by the Bourse de Montréal staff. This list will be updated and published on a monthly basis by the Bourse de Montréal staff. Similar rates for other qualifying index products will be calculated and published from time to time by IDA staff. 2. Broadening rule application In a number of instances, the previous rules only permitted the use of certain offset strategies within Member firm accounts. There was no policy rational for not allowing client account use of these rules. The amended rules now allow for client account use of the following offset strategies: Individual Equity Derivative Offsets 1. Long call - long put spread [Reg (f)(iii)]; 2. Long call - short call - long put [Reg (f)(iv)]; 3. Short call - long warrant [Reg (f)(v)]; 4. Short call - long put - long underlying [Reg (g)(v)]; 5. Long call - short put - short underlying [Reg (g)(vi)]; Index Derivative Offsets 1. Box Spread - [Reg (h)(i)(A)]; 2. Long Butterfly Spread [Reg (h)(i)(B)]; 3. Short Butterfly Spread [Reg (h)(i)(C)]; 4. Long qualifying index basket or long index participation units - long index put options - short index call options [Reg (h)(iii)(E)]; 5. Long qualifying index basket - long index participation unit put options - short index participation unit call options [Reg (h)(iii)(E)]; 6. Short qualifying index basket or short index participation units - long index call options - short index put options [Reg (h)(iii)(F)]; 7. Short qualifying index basket - long index participation unit call options - short index participation unit put options [Reg (h)(iii)(F)]; 8. Short index call - long index future [Reg (h)(vi)(A)]; 9. Short index put - short index future [Reg (h)(vi)(B)]; 10. Long index call - short index future [Reg (h)(vi)(C)]; 11. Long index put - long index future [Reg (h)(vi)(D)]; 12. Short index call - long index put - long index future [Reg (h)(vi)(E)]; 13. Long index call - short index put - short index future [Reg (h)(vi)(F)];

4 January 13, MR Removal of excess conservatism As a result of our rule review of the derivatives offset rules, we identified a number of existing offset strategies where the capital and margin requirements were too conservative in relation to the risk associated with the strategy. The following is a list of rules where amendments have been made to reduce this conservatism: Amendment 1. The minimum customer credit requirement for a short put option position [Regulation 100.9(d)(ii)]. 2. The capital and margin requirements for a short call option versus short put option offset [Regulations 100.9(f)(ii), 100.9(h)(ii)(B), (f)(ii) and (h)(ii)(B)]. 3. The capital and margin requirements for a short call option versus long underlying security offset [Regulations 100.9(g)(i), 100.9(h)(iii)(A), (g)(i) and (h)(iii)(A)]. Rational for the change The amended requirement changes the minimum margin requirement for a short put option to include a minimum percentage amount based on the aggregate exercise value of the option rather than the market value of the underlying security. This minimum requirement only comes into effect when the short put option is deep out-of-the-money. The change corrects the anomaly in the previous rule where, as the market price of a security increases, the minimum margin requirement also increases. This change also conforms the requirement for short put options to that set out in NASD 2520(f)(2)(D). There was an anomaly in the previous requirement for spreads where both options were in-the-money and the calculated margin requirement for each individual short option was the same. The amended requirement assumes both options will be exercised if they are in-the-money and determines a margin requirement in this instance based on the difference between the exercise values of both options. The previous approach was to require the normal margin requirement on the underlying interest based on the lesser of: (i) the market value of the stock, and (ii) the exercise value of the call options. Under this approach, where the options were either at-the-money or in-the-money, the margin requirement was calculated based on exercise value of the call options no matter how in-the-money the call options were. This lead to significantly higher than necessary margin requirements for offsets involving options that were deep inthe-money. The amended requirement limits the margin requirement for an offset involving deep in-the-money call options to the maximum loss that would be experienced with a price decrease equal to the normal margin requirement on the underlying security.

5 January 13, MR0330 Amendment 4. The capital and margin requirements for a short put option versus short underlying security offset [Regulations 100.9(g)(ii), 100.9(h)(iii)(B), (g)(ii) and (h)(iii)(B)]. 5. The capital and margin requirements for a long put option versus long underlying security offset [Regulations 100.9(g)(iv), 100.9(h)(iii)(D), (g)(iv) and (h)(iii)(D)]. 6. Eliminate the 0.5% cushion rate included in the previous floating margin rate calculation [Regulations 100.9(a)(x)]. 7. Revise the margin and capital requirements in a uniform manner for unhedged long options and affected offset positions [Regulations 100.9(a)(xxv), 100.9(c)(i), 100.9(f)(iii), (c)(i) and (f)(iii)]. Rational for the change The previous approach was to require the normal margin requirement on the underlying interest based on the greater of: (i) the market value of the stock, and (ii) the exercise value of the put option. Under this approach where the option is either at-the-money or in-themoney, the margin required was the exercise value of the put option no matter how in-themoney the put option was. This lead to significantly higher than necessary margin requirements for hedges involving options that were deep in-the-money. The amended requirement limits the margin requirement for an offset involving a deep in-the-money put option to the maximum loss that would be experienced with a price increase equal to the normal margin requirement on the underlying security. The previous approach gave no loan value to the intrinsic value of the put option. As a result, in situations where the put option was in-the-money, the net loan value granted to the combined long stock/long put options positions was significantly less than the exercise value of the put option. The amended approach only requires margin on an offset involving an in-the-money put option to the extent of any time value. The amendment deletes the 0.5% cushion in the previous mechanics used in determining the floating margin rate because that measure of conservatism is no longer required. The previous requirements granted regulatory value to long options in Member firm accounts but not to customer accounts. No regulatory value was given to time value component in either type of accounts. The amendments grant regulatory value to long positions in customer and firm accounts and link the margin and capital requirements to the risk profiles of these positions.

6 January 13, MR Provide Members the alternative to use TIMS and SPAN risk margining systems to calculate the margin requirements for firm account derivative positions only The strategybased rules do not cover all offset strategies. It is increasingly being recognized that value at risk ( VaR ) models, including the TIMS and SPAN methodologies, evaluate more efficiently the risk of a derivatives portfolio and an increasing number of financial institutions and derivative clearing houses are adopting more sophisticated VaR methodologies that are less capital intensive for the purposes of measuring their principal trading inventory risk. New Regulation (k) provides an alternative to Member firms to continue using amended strategy-based rules or to use TIMS and SPAN methodology to determine the capital requirements for the firm account positions in derivatives listed on the Bourse de Montréal. Since these capital requirements are based on an evaluation of the overall risk of derivatives portfolio, the amendment will reduce the regulatory capital requirement for Member firms that choose to adopt TIMS and SPAN methodology. Whichever methodology is selected, it must be used consistently and cannot be changed without the prior consent of the Bourse de Montréal.